The Paired Trade

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Like moMANon, I’m a little nervous about the market right now.  Not nervous enough to sell everything and dig out the bomb shelter, but nervous enough to add some defensive positions to my personal portfolio.  My current allocation is approx. 65% long equities, 25% cash, and 10% “defensive” positions in a volatility ETF and some gold mining and silver equities.  Yes, 0% in bonds, which moMANon would hate but I just can’t get comfortable with the limited upside, potentially severe downside nature of bonds in today’s environment.  I’ve decided to move up my defensive allocation by short selling a REIT to offset a long position I have in another REIT.

Tomorrow I’m pulling the trigger on a short sell of Regency Centers Corporation (REG), which is a company that owns and operates retail shopping centers throughout the country and is structured as a Real Estate Investment Trust (REIT).  A few weeks ago I generally laid out my arguments of why I’m interested in shorting retail-focused REIT’s: https://atginvestments.com/2014/06/12/speaking-of-summer-shorts/

Since that post, Regency has announced an unsolicited offer to buy a smaller retail REIT called AmREIT, Inc., (AMRE) out of Houston, TX at $22 per share, which is a 20% premium to their current share price, $2 psf premium to their all-time high share price, and a 4% premium to their net asset value (essentially value of their real estate and other assets less liabilities).  While there may be some SG&A (corporate overhead cost) synergies from a merger, this acquisition would still likely be dilutive from a combined earnings per share and P/E standpoint for Regency.  In my opinion Regency has offered to buy a bunch of retail centers at a price above their fair market value for a product type that I personally feel is already getting overvalued.

My offsetting “pair” to this trade is a long position in HCP, Inc. (HCP), which is a REIT that owns and operates healthcare-related real estate (senior housing, medical and assisted living facilities).   While this isn’t a perfect market-neutral trade with REG, I think it will protect me from substantial losses on REG if future gains in the overall market are driven by easy money and low interest rates.  HCP offers  a current dividend of 5.3% vs. 3.4% for REG, which means that I’ll make a 1.9% annual return if the two stocks move positively in tandem.

Email me/ leave a comment  if you’d like to go into deeper analysis and rationale for this trade, but the following table lays out the main reasons for why I’m longing this healthcare-related REIT and shorting a retail-related REIT:

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As compared to Regency, HCP offers a better dividend with a lower payout ratio and cheaper P/E valuation, not to mention a product type (healthcare-related real estate) I’m much more bullish on than retail real estate.  The only clear advantage that Regency has over HCP I can ascertain is that consensus earnings growth over the next 5 years is higher than for HCP (5.9% vs. 3.0%).  Regency doesn’t have an overly impressive track record of earnings growth over the past 5 years (7.9%) and I think the moat-like qualities of grocery anchored real estate are fading quickly. In contract  HCP has grown earnings 31% annually over the past 5 years and has increased their dividend every single year since their IPO in 1985.  Maybe the analysts are right and REG outperforms HCP over the next several years, but I’m comfortable going against the grain on this bet.

 

 

 

 

 

 

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Speaking of Summer Shorts…

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Up until about a year ago, I had never shorted a stock.  In basic terms, shorting a stock means you actually borrow it rather than buy it in hopes that it goes down in price so you can buy it back later at a cheap price when returning the shares.  One look at the S&P chart over the last 100 years quickly explains why shorting a stock is usually a bad idea- you are taking a contrary bet within a market that as a whole has had a fairly steady upward trajectory over time.  Not only are the odds not in your favor but  you have to pay interest for the privilege of borrowing the stocks you are shorting.

My first short was inspired last May as a result of leaked comments from the CEO of Abercrombie and Fitch (Mike Jeffries), who basically said that he didn’t want dorks or fat kids wearing Abercrombie clothes.   The market barely blinked at this comment despite well organized protests online from high school students who urged their peers to shun the store and donate their Abercrombie clothes to Goodwill.  The comments ticked me off at a personal level, but on a common sense level I knew that retail sales for the specialty apparel shops were already under fire, and that this could only hurt them further heading into the next quarter’s sales.  Also, I had a gut instinct that Abercrombie’s glory days were in the past, back when I was a dorky high schooler in the mid 1990’s and too insecure to throw on “Woods “ cologne despite its reputation as a chick magnet.  I digress…   Short story long is that it worked out well for me when the stock tanked after the 2Q-13 earnings were announced.

Today I am very interested in shorting a retail REIT (specifically, a company focused on owning grocery-anchored retail centers) for a variety of what I deem to be common sense reasons:

  1. It is completely absurd what grocery-anchored shopping centers are selling for today on a projected return and cap rate basis. Well located retail properties today are selling for current returns as low as 5%, even less in prime markets.  Institutional investors are fleeing to this property type and justifying huge price tags by considering their “recession-proof,  safe haven characteristics”.

 

  1. Traditionally there has been a view that grocery-anchored retail is cushioned from e-commerce competition because people still prefer to shop for food at grocery stores, which drives traffic to the surrounding retail.   Even if one were to agree with this premise (which I think is hogwash- Amazon, Walmart, and others have the grocery market in their cross-hairs), retail-anchored grocery owners traditionally make their money from the surrounding retail rents, not the grocers themselves who can negotiate extremely low rental rates.  In other words, the property owners are primarily depending on capital appreciation and income from other retailers that are less recession and e-commerce proof.

 

  1. When I compare retail REIT dividend yields and P/E valuations with other REIT vehicle options (like CLNY, one of my favorite plays), they tend to have both lower dividend yields and higher P/E ratios.  That’s not good- it only makes sense if you believe that their potential for growth is much higher than other REIT vehicles.  A lot of the top retail REIT’s offer dividends around 3-3.5% with current forward P/E ratios around 20.  That does not get me excited when I can buy CLNY with a 6%+ dividend yield and an 11.5 forward P/E.

 

I have yet to select which specific retail REIT I’d like to short.  I need to do some research and a find a REIT that has recently made a bunch of dumb acquisitions, has high debt exposure, and market concentration in areas that I think are more susceptible to e-commerce competition on the grocery side.  Regency Centers (REG) and Acadia (AKR) are two initial REIT’s that come to mind, but I still need to do more homework  After all, the decision to short a stock warrants a higher standard of justification than going long on a stock for the reasons mentioned earlier.

Against the grain we go,

Maverick

 

 

 

High Yield Options: What’s their Sensitivity to Rising Rates?

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Today there are several different options available for investors searching for high yielding/ dividend securities in a low treasury rate environment. I can only imagine how often a new client walks into a financial advisor’s office and says “if you can get me a nice safe 5% return today I’d be very happy.”

With 30-year treasury rates at 3.57% one has no choice but to move up the risk scale and consider possibilities such as high dividend yielding stocks, preferred stock, high-yield bonds, REITs (real estate investment trusts), MREITs (mortgage real estate investment trusts), MLP’s (master limited partnerships), etc.

Right now my personal portfolio is lacking in yield right now. I have a healthcare REIT (HCP, yielding 5.9%), two high yielding oil rig stocks (Transocean and Ensco, both around 5.5%) and a mortgage REIT (Colony Financial, yielding 6.4%), but no bond or preferred stock exposure (in my actively managed account). I’ve been hesitant to buy bonds or preferred stock over common fears that interest rates will suddenly jump once the economy is back on track and a subsequent drop in principal value will wipe out the benefit of current yield. Hence, I’ve been grabbing yield from other securities that I perceive as less directly correlated to interest rate movements. Today I finally decided to see what the real correlation (extent to which they move in tandem) has been between the 10 year treasury rates and various yield vehicles over the past 7 years:

 

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After running the correlations based on monthly total return data (i.e. including dividends and interest as part of the return) over a few different periods I quickly realized how complex the answer to my initial question proves to be. With the exception of the Total Bond Market ETF (BND), which maintained a strong negative correlation with the 10-year treasury rate over every period tested except the financial crisis of 2009, the other yield vehicles exhibited a wide range of correlations (both positive and negative), making any definitive conclusion difficult. Below are a couple of personal observations based on the data:

• Vanguard REIT Index (VNQ): As I expected there has been relatively volatile correlation between REITs and treasury rates over the past 7 years. If you believe that the economy will continue to steadily improve then I think REITs can make for an attractive yield option in the face of rising rates, particularly given real estate’s ability to act as an inflation hedge. (Keep in mind REITs are more correlated to the market than private real estate funds, however.)

• Preferred Stock ETF (PFF): Correlation between the preferred stock ETF and rates have been extremely volatile over the past 7 years, with the correlation being highly negative in 2013. While the data isn’t conclusive my gut tells me that this vehicle won’t get rocked by rising rates any time soon and has a place in a dividend portfolio.

• High Yield Bond ETF (HYG): When comparing the annual correlations for HYG, which ranged from (0.52) to 0.76, I can’t figure out why the cumulative 7-yr correlation is (0.63). Logically this doesn’t make sense to me but I checked the formulas multiple times and couldn’t find an error. On a cumulative basis it does make sense that the correlation for high yield debt would fall in between that of preferred stock and the bond market overall, however.

• Colony Financial (CLNY): I added this specific mortgage REIT only because it’s one of my favorite investments right now. While classified as a mortgage REIT, Colony has a fairly diversified real estate strategy that includes a large pool of single family homes held as rental product, loan origination, investment in distressed debt world-wide, equity interests in hotels, etc. I bought it as a yield pillar (to borrow a phrase from moMANon) with the idea that their strategic flexibility, low cost of capital and super smart investment team could overcome rising rate risk. So far that appears to be holding up as evidenced by a cumulative correlation against treasury rates of only (.14) since inception of the company.

While this analysis would have been infinitely more enlightening if I could have compared each vehicle over a longer period of time (such as when rates sky-rocketed in the late 1970’s), I hope you manage to find some value in the data as you decide what yield vehicles make sense for your portfolio. As you consider alternative yield options Continue reading