The Weekly Summary
We talked about "rotation" throughout September. Last week the circular forces of market sentiment gave us a big win, with our Aggressive portfolio surging 5% and our High Technology recommendations adding another 4% to that score. As a result, the BMR universe as a whole made some nice progress while the S&P 500 dropped 1%. Any week where you keep making money in the face of a broad market decline is a good one.
We have a track record of outperformance to maintain. Thanks to this week, our YTD is once again close to double what the S&P 500 has produced. BMR stocks are up 33% compared to 18% in the broad market. Looking toward the final quarter of a bumpy year, we're excited to see how much farther we can extend that lead over the next three months, no matter whether Wall Street pivots up or down.
If the bulls are back in charge, our stocks have more room to run before straining historical limits. Despite the volatility of the last few weeks, the S&P 500 is only 2% from its record peak. The BMR universe, on the other hand, has already absorbed a full correction without losing their aplomb or endangering their YTD gains, so we don't need to break any records to keep this rally going.
Either way, we have a strong defense to go with our high-scoring recommendations. As the coming earnings season evolves, the end of 2019 could play out like what we saw last year or finally give investors a reward for their long-term perseverance. A year ago, Wall Street was on the verge of a serious correction. Having already stomached a lot of that downside this time around, we see no reason our outperformance can't continue no matter where the S&P 500 twists.
That twist may go down. While Friday revealed that the job market is pensive enough to justify at least one more interest rate cut, the trade war, stalled earnings, and indifferent economic data keep many investors on edge. The Fed now has a tight needle to thread. If rates go down because a strong economy isn't generating inflation, Wall Street will cheer. However, every hint of a recession ahead will feed the negativity that is already holding some of our favorite stocks back.
We'd rather live in a boom and swallow the occasional rate hike than watch the Fed struggle to keep the economy from stalling. But until corporate earnings demonstrate that the boom is back, investors will vacillate and stocks will spin. The good news is that the next quarterly earnings cycle starts on October 15 with the big Banks. Once the season gets underway, we'll know a lot more about how the year will end.
There’s always a bull market here at The Bull Market Report! Gary Jefferson takes a vacation this week so we have extra space for The Big Picture to really dig into what's driving the rotation into "defensive" stocks and how sustainable that strategy really is. As you'll recall, we urged some defensive moves months ago, so we were ahead of the curve. Since the biggest question facing the market now is how much fear is justified, we're leaning into the defensive side of the BMR universe with in-depth updates on most of our REIT recommendations and a few of our favorite High Yield stocks. We still love our growth stocks. We still believe in the economy's power to defy any obstacle. However, this is a great moment to review our less volatile options so you know which names to reach for no matter where the market swings, especially if the market turns south.
Key Market Indicators
BMR Companies and Commentary
The Big Picture: The Dogs Of Fear Aren't Barking
After another week of yield-paying sectors smashing all-time records while the high-tech heart of Wall Street remains depressed, other investors are starting to hum the refrain we started singing last week. Money is flowing into Utilities, Real Estate and Consumer Staples at the fastest rate in years, stretching normal valuations and leaving more dynamic areas of the market gasping.
In our view this is less about a true flight to safety and more about investors around the world reaching for better income than what they can get in the Treasury market or in overseas bonds that pay negative interest. That’s an important distinction. No matter what you hear, we aren’t facing a lot of fear right now. We’re dealing with a species of greed.
Risk tolerances haven’t collapsed. Bond yields around the world have. And as money inches out of bonds in search of reasonable returns, yields in the stock market follow bond rates lower.
We’ve talked last week about the premium risk-averse investors are paying for relief from recession anxiety without having to accept the negative inflation-adjusted income they’d get from Treasury bonds. If prices are climbing 1.7% a year and the Fed won’t raise rates before inflation hits 2%, buying middle-term government debt will leave you with less purchasing power when those bonds mature than what you have now.
That’s only an acceptable strategy if you’ve abandoned hope for anything in the global markets doing better than breaking even. We’re naturally on the side of doing better. So are like most realistic investors who recognize that the world is a long way from the point where locking the doors against absolute disaster is the only move that makes sense.
However, some moves only make sense because every other option has a worse outcome. That’s where we think Utilities and Consumer Staples stocks are now. They’re not objectively bad as places to park cash ahead of an economic storm. But when you see better alternatives as we do, these sectors look bloated and on their way to outright bubble territory.
Utilities, for example, usually command a slight premium because their dividends are about as reliable as it gets, and people will pay extra for that kind of clarity. However, that premium has expanded a lot in the last few months. Three months ago, these stocks were available for 19.1X earnings against an 18.4X multiple for the S&P 500 as a whole. As of last week, the S&P 500 valuation hasn’t changed while Utilities are at the point where they cost 20.9X earnings to buy in.
Admittedly, Utilities still pay a 1% higher dividend yield than the S&P 500, but when you’re weighing whether to lock in 2.8% or 1.8% (before factoring in inflation) nobody is reaping huge windfalls here. That’s why we tend to skip the sector in order to focus on Real Estate, where yields remain higher, especially on the specific stocks we recommend.
But the real arbiter of value in a defensive portfolio is the amount of extra income investors can squeeze out of the stocks they pick while their money is parked. With Treasury debt, the rate you lock in is the interest you’ll receive. The odds of a default are as close to zero as it gets. Everywhere else, you’re accepting a little risk that a company will run out of cash and cut its dividend or skip a payment.
The higher the spread, the greater the perceived risk. Treasury rates have reached 1.35% so the bottom of the risk/return curve is almost as low as it gets right now. Five-year bonds bottomed out at 1.26% at the end of 2008, when it really looked like Wall Street’s world was ending and overnight lending rates were effectively zero. Back then, Utilities paid 4.2% to reflect the elevated risk that these companies would fail to meet their shareholder obligations. The spread naturally rose to roughly 3 percentage points. A lot of people were scared.
What happened, of course, is that the sector didn’t even blink. It would take a disaster greater than 2008 to interrupt the income investors receive here. And because the spread between Utilities and Treasury yields has narrowed to 1.5 percentage points (half what it was in 2008), the bond market is signaling that default risk has receded a lot over the past decade.
Likewise, we can track the spread between “defensive” yields and what investors get from the S&P 500 as a whole. Normally we expect Utilities to pay 2.4% more than the broad market. The spread is now barely 1 percentage point wide now. There just isn’t a lot of room left there for more money to crowd into the sector before the risk curve breaks. Back in 2008, for example, the yield spread between Utilities and the S&P 500 narrowed to barely 1.2 percentage point. We’re close to that historical limit now.
We’re lingering on this math to give you a better sense of how the current rush to defense is distorted in any reasonable historical context. If the world right now feels like it did at the end of 2008, then locking in these abnormally low yields and compressed risk spreads makes sense as the best way to sidestep any significant economic threat. Otherwise, the math doesn’t add up. The usual statistical indicators that accompany real fear in the market simply aren’t there.
To borrow a line from the Sherlock Holmes stories, the dog isn’t barking. Maybe there’s no dog.
And in that scenario, money will soon flow back out of overcrowded yield stocks into what are now underrated areas of the market. Our High Technology and Aggressive portfolios are already rebounding and unlike a lot of defensive stocks, have a lot of room to continue their rally. We know how high these companies can go when Wall Street is in an optimistic mood and as fast as their fundamentals are expanding, the ceiling keeps rising.
After all, the thing about locking in a yield is that you’re also locking out a lot of upside. We’re willing to do it with Real Estate and Big Pharma because those companies are dynamic enough to generate additional cash from year to year. That cash then feeds into additional dividends or gives investors a reason to buy the stocks at ever-higher levels. In our view, they’re in the sweet spot between a strong defense and enough offense to stay open to ambient economic growth.
However, locking in less than 3% elsewhere in the market right now locks out a lot of upside. How high can Utilities go, for example, when earnings in the sector are inching up 2% a year? If the stocks rally much faster than that, already-stretched valuations get even more extreme until finally there just isn’t any justification to keep buying.
The market as a whole, meanwhile, tends to beat Utilities by at least 2 percentage points a year. Our stocks do even better. The slow years aren’t great but the fast years more than make up for them, while our own high yield recommendations provide a cushion to encourage patience through the rough spots in the economic cycle.
Knowing that a portion of our universe is paying 5% (the REIT portfolio) to 7% (the High Yield recommendations) gives us that cushion and that patience.
Equity Residential (EQR: $87, up 1%)
With market jitters impacting most stocks and fears of a recession looming, now is the perfect time to focus our attention on our REIT portfolio, which serves as an excellent defensive play during moments just like this. We think the fears are overblown, but it's good to check the foundations long before any storm hits.
First up is Equity Residential. The company is one of the most prominent Residential Real Estate companies in the world. Equity Residential develops and manages premium apartment complexes in major urban centers across the country, and caters to upwardly-mobile 30- and 40-somethings. That’s a terrific market to focus on, primarily because these folks have disposable income and are therefore capable of splurging on lavish apartments, plus the fact that Americans are getting married much later in life, which means they are renting for longer periods. This increases the life-cycle of the typical Equity customer.
Equity had a strong 2Q19. The company posted $670 million in revenue, for a 5% YoY increase. FFO – a true measure of a REITs health, because it excludes depreciation, which many REITs manipulate to avoid paying out distributions to shareholders – came in at $0.86, or a penny higher than consensus expectations. The company also boosted its full-year FFO/share guidance to $3.46. Consensus estimates were at $3.40.
Management announced its expectations for full-year same-store net operating income growth of around 3.2%. The market had been expected to report in the mid-2% range, so this comes a nice surprise. Occupancy rates remain above 96%, which is extremely healthy for a nationwide portfolio.
BMR Take: Equity has strategically targeted the right demographic at the exact right time. While much of the citizenry may be stagnant in terms of wage growth, the upwardly-mobile Millennial crowd – many of whom work in Tech and Finance – continue to see incomes rise and can therefore spend lavishly on living conditions. It should come as no surprise then that the stock is up 34% YTD. This is a fabulous company in a strong sector. And the 2.6% annual yield only makes the pot that much sweeter.
Office Properties Income Trust (OPI: $30, down 2%)
Office Properties Income Trust hasn’t been having as great a year as Equity Residential, but the stock is still up a healthy 16% YTD. It yields an attractive 7.3% per year, which puts our return in double digits.
Office Properties is reducing its debt exposure and selling off underperforming properties. The company recently sold three assets for $25 million, which reduces the debt load going forward. This comes on the heels of a $220 million sale of four properties. Management is clearly focused on shoring up the balance sheet, which is nice to see given that interest rates are lowering – meaning management can always take on more debt to fuel future purchases at a lower borrowing cost than it previously attained.
The company had a strong 2Q19, posting $176 million in revenue for a 63% YoY improvement, and FFO of $1.65 which beat the market estimates by $0.27. While same-store net operating income did fall 3% YoY, the aforementioned sales of underperforming assets should help that metric going forward.
BMR Take: Total growth for the Commercial Real Estate (CRE) market will be 2-2.5% for the year, which is decent, not spectacular. But during jittery macroeconomic times, decent looks spectacular. CRE is a solid defensive play, and Office Properties offers a dependable 7.3% annual yield. The stock is an excellent place to park some money and ride out any oncoming storm.
Service Properties Trust (SVC: $25, down 2%)
Service Properties Trust – formerly Hospitality Properties Trust (HPT) – is the owner and operator of prominent branded hotels and travel centers (truck stops). Names like Radisson, Wyndham and Sonesta are all under the Service Properties umbrella.
The company recently acquired a retail service portfolio from Spirit MTA REIT for $2.4 billion, which led to the name change and new ticker symbol. Hospitality funded the purchase with a previous $1.7 billion notes offering, as well as tapping its revolving credit facility. This is a major diversification move for the company. The travel industry REIT now has AMC Theaters, Carmax and Academy Sports retail locations in its portfolio. That helps ease any headwinds that might come from a dwindling travel industry should a recession strike.
The stock has been on a bumpy ride of late, as one might expect given that the travel industry is extremely reliant on the broader economy. If a recession does occur, hotels and travel centers get hit pretty hard, as both businesses and individuals cut back on their travel expenses (which is what makes the Spirit acquisition all the more significant). That said, with the Fed juicing interest rates and the economy humming along at a moderate pace, there is no fundamental sign of a recession looming – we only have the anxieties of investors who are worried that it’s been over a decade since the last one.
BMR Take: Despite those anxieties, Service Properties is up 3% YTD, and the stock yields 8.5% annually. This is never going to be our biggest winner, and it isn’t meant to be. Service Properties, with a $4 billion market cap, is a fundamentally strong REIT with an attractive yield – those are the exact qualities investors should be searching for as they seek to buttress their portfolios against the potential of an oncoming market downturn.
JBG Smith (JBGS: $39, down 1%)
When it comes to managing office properties, there’s perhaps no better tenant in the world than Amazon. Which is why JBG Smith is in such great shape going forward.
The company is a regional CRE operator that manages a portfolio in Washington, D.C. After Amazon announced part of its HQ2 would be housed in the district, JBG Smith scooped up tenancy, as Amazon wanted to be in the historic National Landing section of our nation’s capital. And National Landing just happens to be mostly-owned by JBG Smith.
Not only does the Amazon deal bring direct revenue to the company, but it also boosts the Real Estate value of the entire surrounding area. That’s why JBG Smith just submitted plans to redevelop six properties adjacent to National Landing, including five multi-family properties and one office building. All six are within half a mile of Amazon’s new headquarters. The company has already announced two redevelopments in the area, as well as a pair of entirely new developments.
JBG Smith knows an opportunity when it sees one. That’s why it landed the Amazon deal, and is now capitalizing on that agreement as much as possible with all of this development activity. We love this company because they are already a major regional player, but have yet to go national. We expect management to turn its eyes outward in 2020 and 2021 and look to conquer other major CRE markets across the country. That’s when JBG Smith will transform from a strong regional company into a dominant one.
BMR Take: As one might expect with the Amazon announcement, this has been a strong year for JBG’s stock, which is up 12% YTD and then the 2.3% annual yield is the icing on the cake. Given that the stock was trading above $40 earlier this year, we’re expecting even more price appreciation here as the year ticks on. There is a true growth story emerging with JBG Smith, which is something you can’t say about most REITs. Such is the power of having Amazon as your tenant.
Ventas (VTR: $75, up 3%, including the $0.79 dividend)
Turning now to Healthcare REITs, Ventas is a RIDEA-structured REIT that owns and operates a diverse portfolio of Healthcare facilities. RIDEA means the company actively manages its portfolio, as opposed to being a passive landlord issuing triple-net leases. So Ventas can invest in CapEx and managerial upgrades to maintain a high quality portfolio.
The company has over 700 senior housing communities, 360 medical office / outpatient facilities, and 34 research centers. And the company just completed a $1.8 billion investment in a Canadian senior housing facility. The deal should represent 8% of Ventas’ net operating income going forward, and provides even more diversification for the company.
Healthcare REITs are riding strong industry tailwinds, as Baby Boomers retire at the rate of 10,000 per day, every single day for the next 19 years. With Americans living longer than ever before and spending more of their income on Healthcare costs, Healthcare REITs like Ventas are primed to benefit. The company’s $950 million of 2Q19 revenue – up 1% YoY – helps illustrate the growth story. FFO of $0.97 also beat market expectations by two pennies.
BMR Take: Broadly speaking, Real Estate is a defensive play, and Healthcare Real Estate is an even more specific defensive play. Investors can take advantage of both sectors at once, and at the same time capture the company’s stable 4.4% annual yield. Even though the stock is up 29% YTD, we’re expecting more gains throughout 4Q19.
Welltower (WELL: $91, flat)
The other RIDEA Healthcare REIT in our portfolio is Welltower. The firm has about 1,400 properties in the United States, Canada, and the United Kingdom with most of the properties in Canada and the United Kingdom located close to Toronto and London respectively. It’s a big firm, tipping the scales at a market cap of $#6 billion. Like Ventas, Welltower makes CapEx and managerial improvements to its slate of properties. The company is also known for targeting large urban centers with lots of elderly citizens who have disposable income, so that gives the company a strong pipeline of future customers.
Welltower is riding the same industry tailwinds as Ventas. And management is extremely forward-looking. Welltower just announced a partnership with CareMore Health, to integrate CareMore’s clinical programs into Welltower’s properties. This is an example of a RIDEA REIT being actively managed. The company is looking at ways to innovate and differentiate its product line. CareMore offers teams of nurses, doctors, behavioral health specialists, case managers and clinicians which will help improve the health and wellness of Welltower’s customers. All of this means a better product, which will lead to higher customer retention rates and increasing revenue for the company over time.
And Welltower’s revenue continues to increase. The company posted $1.3 billion of 2Q19 revenue, for a 17% YoY gain. FFO of $1.05 beat consensus estimates by a penny. Earlier this year, the company completed a major acquisition – a $1.25 billion purchase of 55 medical buildings from CNL Health Properties. Like Ventas, management is growing by all means, which is what we want to see in an industry with strong tailwinds.
BMR Take: Both Welltower and Ventas are well-positioned to take full advantage of ‘the graying of America.’ Both are well-managed, and each has their eye on growth through expansion and product improvement. Welltower in particular is making some truly innovative moves in the space. The stock is up 37% YTD not counting the 3.9% annual yield. As with Ventas, we’re expecting even more price appreciation by the end of the year.
The High Yield Investor
By John Freund
VP of High Yield
The Bull Market Report
With all of the macroeconomic headwinds at play – China, the inverted yield curve, the potential for a recession on the horizon – the name of the game right now is defense. That said, ‘defense’ covers a pretty wide range of options. There are lots of different ways to play defense, and if investors play the wrong way, they could be leaving significant gains on the table (or worse, suffer unnecessary losses).
Right now, Treasuries are yielding zilch (when factoring in inflation). So owning a Treasury bond is only slightly better than keeping your cash under the mattress. Looking across the spectrum of investments, utilities are returning under 3% at the moment, REITS are averaging around 3% (ours are much higher, as outlined above). The SPDR S&P 500 Trust ETF (SPY), which tracks the S&P 500, is returning 1.9%. These aren’t terrific options for parking money long-term.
The Federal Reserve is going to continue their interest rate reduction, at least until inflation reaches 2%. For the trailing 12 months ending June 30, the inflation rate was recently revised down from 1.8% to 1.6%. So inflation is lower than what we previously thought. In other words, don’t expect the Fed to stop their rate cutting any time soon. Inflation has to increase by 25% before they will consider changing pace.
While the Fed juicing the economy is great for many companies, including many of our BMR picks, here at The High Yield Investor we’re all about capturing yield. We want to know where we can lock in the highest fixed income dividends – with the caveat that those dividends are safe and dependable. Of course, everything is relative. In times of 2% or 3% inflation, a ‘high yield’ might be something above 6% or 7%. But when inflation is at a measly 1.6%, and investment in other sectors of the market in general only yields at most a hundred basis points more than that, then the definition of what constitutes ‘high yield’ changes. Suddenly, earning 4% per year on your money doesn’t look so bad.
Our REITs and High Yield stocks pay much higher yields than 4%. And the stocks we recommend have safe and dependable dividends. They are excellent vehicles for investing your money when adopting a defensive position. Many have experienced significant price appreciation over the past year as well, so there has been some real upside in addition the annual yield.
Take Ares Capital (ARCC: $18.27, down 3%, Yield = 8.8%). Ares is the largest middle-market direct lender in the country. Ares is so big, in fact, it has occasionally made loans that qualify as large-cap ($500 million and up).
The Private Equity (PE) and Private Credit (PC) sectors (Ares is a Private Credit company) have received a major boost from the implosion of the hedge fund world. Hedge funds haven’t kept apace with the broader market, and this has led to a flight of institutional capital away from the space into PE and PC. Many of the larger PE funds, which dabble in PC – firms like Blackstone and Carlyle (both BMR picks) – are raising record amounts of capital and as a result focusing their efforts on larger deals. That in turn has created a gap for middle-market lenders like Ares to operate in. And since Ares is the largest middle-market lender, the company secures favorable financing terms which help it dominate the space.
Ares has a track record of investing in strong portfolio companies with low default rates. That’s especially important during times like these, when investors should be thinking defensively. Ares doesn’t take unnecessary risk with its portfolio. What’s more, no single company makes up more than 6% of the total portfolio. Ares is all about diversification. This defensive play looks more defensive when you check under the hood.
2Q19 was another strong quarter for the company. Net investment income rose 28% YoY to $208 million, and EPS came in at $0.49 – a nickel above consensus estimates and a 25% YoY gain. The company made $1.8 billion of new investment commitments during the quarter. 50% of those were first-lien senior secured – the most stable kind of loans. Only 30% were second-lien senior secured, and the rest were subordinate and convertible/equity loans.
The stock is up 17% YTD not counting dividends, and has more than made up the ground it lost during 4Q18. This is a fundamentally sound company that pays a stable 8.8% yield – far more than you’ll get from most investments. An investment in Ares is an investment in middle-market lending, which is currently experiencing a boom. So there are industry tailwinds at work here as well. We believe in investing money in an 8.8% yielding stock, especially when that stock is on the upswing. Ares has too much going for it for investors to remain on the sidelines, especially given the current market conditions.
One other stock we want to mention this week comes straight out of our Special Opportunities portfolio. But as noted above, given the current market conditions, it’s technically a High Yield Investment at the moment. We’re talking about iShares U.S. Energy ETF (IYE: $30.79, down 1%, Yield = 3.4%). While it may seem odd to highlight a 3.4%-yielding stock as ‘High Yield,’ compared to the rest of the market – and indeed the Treasury market – locking in 3.4% on your money isn’t such a bad proposition at the moment.
U.S. Energy is a diversification play for High Yield Investors. If you’re already exposed to several (or all) of our recommended REITs, as well as the other High Yield stocks we recommend in this newsletter every week, then tossing in some Oil & Gas exposure will add some much-needed diversification.
Oil will always be a strong defensive play because it has several floors under it. First, there’s the geopolitical threat. Iran recently launched a drone attack via a rebel group in Saudi Arabia on one of the world’s major oil infrastructures. That chopped Saudi Arabia’s oil output in half, and lowered global supply by 5%. Iran happens to control the most important oil infrastructure in the world – the Strait of Hormuz. If Saudi Arabia (or the United States, by proxy) were to strike back at Iran in any meaningful way, oil prices will undoubtedly skyrocket.
The simmering tension in the Middle East is enough to prop up prices. Iran is currently under pressure from tough sanctions from the U.S., and doesn’t want to cut oil supply. Saudi Arabia, however, has pushed for steep OPEC cuts. Currently, Iran is exempt from the latest round of OPEC cuts. But if Saudi Arabia wants to retaliate for the drone strike, they can remove that exemption, which would impact Iran’s oil output (and could lead to greater tension in the region).
And of course, oil is always a safe haven in distressed economic times. Oil is getting a nice boost from investor rotation lately. Again, that 3.4% yield is small in most years, but today looks positively rosy.
Oil also serves as a hedge against inflation. Of course, we don’t see that happening for some time. It is worth mentioning, as some investors are worried about inflation, hence they will continue to make their way into the sector to protect against any inflationary spike.
As we stated earlier, the name of the game here is defense. Ares and U.S. Energy both provide some solid defensive positioning. Ares has the stable yield and the industry tailwinds, making it an excellent short and long-term investment, while U.S. Energy is more of a stalwart defensive play that adds diversification to the portfolio while also providing the potential for a big pop should geopolitical tensions heat up in the Middle East.
Todd Shaver, Founder and CEO
The Bull Market Report