Sure, who wouldn’t like the market to show its true bottom and start a new climb to the stars? However, it’s not happening now. So, are there any lemonade recipes out there for the lemons we’re drowning in?
Good recipes usually have their roots in the concoctions of the master chefs. One of the aromas emanating from Chez Buffett lately has been preference shares. Now I’m as eager to follow him (and as battered by the Dow) as the next person, so I considered the idea of following his lead. But how? Picture the reaction from Goldman Sachs to my offer to invest $5,000 of my precious IRA in these preferred shares paying 15% per year. Yeah, right.
Sometimes small can be good, though. Bear with me as I share how I discovered where even better returns are to be had by ordinary investors who follow Chef Buffett’s cuisine nouveau. In my case, it started with the advice of that other icon of the small-time investor, Peter Lynch: invest in what you know and understand. It so happens that our company services the hotel industry. Not necessarily the most glamorous, but it’s what pays our rent (and gets us free vacations in Jamaica and Barbados) and therefore the one that’s most familiar. A good place to start, therefore.
As a normal part of our company’s due diligence, we keep track of our publicly traded customers’ fortunes. For those not familiar with how the hotel business works, there are three parties to a typical hotel: the owner, the manager and the brand. The Hilton you last stayed at is typically owned by an insurance company, REIT or some kind of institutional investor. The property likely is managed by Interstate Hotels (IHR) or a professional management company like it. Hilton’s only stake in the property is its branding. Of course, this is a generalization – the major brands (Marriott, Hilton, etc.) typically own a few flagship hotels in major centers, and manage those (and a few more) as operators. The party buying stuff usually is the owner, and the owners most likely to have a publicly traded presence are REITs. Therefore, we routinely monitor the earnings releases of publicly traded hospitality REITs every quarter.
It’s no news that the lodging industry suffered the last quarter of 2008. The outlook for 2009 is equally grim, grim enough that many common dividends have been suspended. Given that REITs have to distribute all their earnings as dividends, that is not a trivial indication of concern. A new refrain is emerging, and it goes something like this. “We’re suspending common dividends. We can meet our obligation to pay dividends by paying no more than our preferred dividends.”
That is when the aforementioned Buffett menu shift came to mind. What are these preferred dividends that HAVE to be paid, at the expense of the common dividend? In the past, preferred shares always had a connotation of boring, staid and uninteresting. They never go up and therefore they hold no interest to any red blooded investor. But in these trying times they seem to have something of value: a dividend regarded as holy. Holy and safe, because as a percentage of total cash flow, preferred dividends tend to be small and therefore much easier to maintain than the common dividend.
Safe is good, so my next question was, how much of a dividend are we talking about? At first, I had the hardest time tracking down these infernal preferred shares. None of the web sites I use respond to “preferred” or any known abbreviation. No stock screener seems to have a variable for stock type, and even when I specify a dividend yield as low as 0.1%, no preferred shares show up on the list. Most stock screeners seem to regard only common stocks.
There had to be another way to track these pesky and shy stocks down. We were just wrapping up a small job for LaSalle (LHO), so I looked to see if they had any preferred stock. A quick glance at their latest 10-Q showed they indeed do, four separate series’ worth, in fact. So I used the symbol lookup feature of my friendly online stock broker to see what would pop up under LaSalle. Sure enough, there they were, all four series of preferred stocks.
Now I was curious to see what the dividend yield was. My eyes popped open when I saw a yield of over 20%! Isn’t Warren Buffett’s benchmark 20% per year? At the risk of sounding like those late night television commercials: but wait, there’s more. For whatever reason, most preferred shares are issued at $25 per share, and that’s pretty much where they stay, year after year after year. However, these LHO preferreds were trading around $10, meaning that, when order is restored to the market, these stock prices will go back to their normal trading range around $25. That means not only does one get a 20% yield, but in a few years the price more than doubles on top of that. Sounds like the Buffett zone all right! Accessible by any patient investor, regardless of size.
Surely this was too good to be true. So I embarked upon a long and tedious study of all of the hotel REIT preferred stocks, and when that was done I looked at a few other similar stocks. Almost all seem to have the same variables, i.e., a $25 issue/redemption price, a dividend around $2 per share and almost all appear to be cumulative, meaning that if the company skips the dividend, it goes on the tab, and they can’t pay out any dividends to anyone else before clearing the tab. And if they make any money, they have to distribute it as dividends, so sooner or later those dividends are all going to get paid.
In normal times, that’s not too bad, but not too exciting, either. When the stock price goes down, though, that’s when the numbers become downright generous. I observed a hierarchy among the hotel REIT ranks, with some stocks more depressed than others, the logical explanation appearing to be the relative risk. The biggest risks, of course, are (a) a skipped dividend and (b) the company going under. Dividend payment comes from EBITDA, as does the interest payment (which has to be paid before preferred dividends). So I tabulated the EBITDA coverage of both the interest and pref. dividends (in other words, how many times the company can afford to pay both interest and preferred dividends).
At the secure end of the spectrum, Host (HST), the granddaddy of hotel REITs, has a bulletproof forward looking (2009) coverage of over 2.5 times. The yield on their Series E prefs is “only” 15% per year and the stock, trading below $15, has an upside of “only” 50%. Not bad for a fairly risk-proof investment.
At the risky end of the spectrum lies Strategic Hotels and Resorts (BEE) with forward looking coverage of around 1.0. They have three series of preferreds, all priced under $3, and all therefore yielding over 60% per year, plus capital appreciation of over 700% (that’s gain, because the “normal” $25 price is 8 times the current price). However, they’ve already started skipping the preferred dividend.
Between these two extremes there are several alternative risk/return scenarios, all yielding more than 15% in cash per year, plus the prospect of a juicy price increase.
In order to gain perspective, let’s run the numbers for three years. Let’s assume that some semblance of order is restored in the market after three years and that the prices all return to $20, which is less than the normal $25, but let’s just be safe. Let’s further assume we don’t reinvest any dividends at all (a conservative assumption, but it makes comparisons simpler). In other words, we can take the numbers below and regard them as the very low end of return, assuming that all the companies survive (which is a separate exercise). The returns are simple average, over three years, assuming no returns on dividends received. (I know, how conservative can you get?):
These are rough numbers, but hopefully consistent. Everyone will please draw their own conclusions and do their own homework to refine the numbers. (Please share any improvements.)
From my knowledge of LaSalle and how they operate, I judged their risk as low enough for me to make their preferreds the cornerstone of my IRA portfolio. Of course, it may take more than three years for the stock prices to reach their normal level, but there are worse options than making 25% per year while waiting. There are bound to be good opportunities to invest those dividends somewhere in the meantime for an even better ultimate return. We also do business with Felcor (FCH) and I went out on a bit of limb, buying some in the belief that they have a good plan to weather an extended recession (for example, no significant debt maturities in 2009).
Is this bulletproof? Of course not. However, to assume that each and every hotel REIT is going to go under is not realistic, either. So sticking to the safe end of the spectrum sounds like an acceptable way to pass the time waiting for Mr. Bull to show.
The purpose of this exercise is to point out a segment of the market, often overlooked, where it’s possible for mere mortals to also breathe the great chef’s aroma of double digit cash returns while we wait, patiently (as he admonishes) for the rally’s inevitable arrival. America is indeed on sale.
Disclosure: Author holds long positions in LHO, AHT and FCH preferreds.