As a DIY income investor and an ardent SA reader, I continually seek out opportunities to grow and secure my retirement income stream. In the process, I focus on the four major areas:
- Nominal income stream. That is, the income necessary to maintain my desired living standards.
- Reliability and safety of income and preservation of capital
- Growth of income to keep up with inflation
- Tax efficiencies.
Recently retired at age 66, I now rely on Social Security as the base of my nominal income, from which I must now look to other income producing investments as supplements to that base. I have spent the better part of the last year legging into my current positions within my investment accounts. My portfolio list, other than mutual funds, can be viewed here. The current allocation of this portfolio, based on the market close on 8/16/13, is as follows:
Master Limited Partnerships
Mutual Funds (Stocks/Bonds)
Options (Spreads & Positional)
Until this recent slide in the bond market which is clearly dragging equities down in its wake, it has been comparatively easy to make intelligent stock selections and buying decisions relying on my favorite and most reliable screening indicator for creating growing and sustainable income - free cash flow.
The signals seem clear that odds favor a sustained rise in long-term rates which will not bode well for bonds and their kissing cousins, preferred stocks. I am of the opinion that MLPs (Master Limited Partnerships) will also be pressured though not as much as bonds and preferreds due in part to the tax deferral advantages of MLP distributions. There are other fundamental factors that play into the MLP space which are well documented throughout the SA community, and not discussed here.
I learned a long time ago that there are two reasons for purchasing preferred stocks and neither one is capital appreciation. The two reasons, at least for me, are simply yield and safety. Capital appreciation is a bonus until it reaches or exceeds its par value, normally $25.00, and the optional call date for the issuer is within a year. This condition becomes a signal for the holder to consider selling at the higher market price, otherwise there is a strong probability that it will be "called" at the $25.00 price which will vaporize any price appreciation above par.
So the market's tough now, and unless one has the stomach to be a short seller, it is very difficult to stay the course. Sure, I could put on a portfolio hedge using put options on the SPY, but the bid/ask spreads are too wide and too much volatility is priced into the premiums. The index would have to plunge well below my strike price to make it profitable. Besides that, I have never been very good at calling market tops or bottoms. So, I'm batting down the hatches and staying the course. Currently the preferred stock portion of my portfolio is only 4 percent. Not long ago it was 5 percent, but the oversold market in preferreds (that is an opinion) made that happen. One of my largest preferred stock positions is comprised of two different series of Public Storage (PSA) issues, and it is about to get larger.
For anyone that may not be familiar with the company, Public Storage is a California based fully integrated and self-administered real estate trust that acquires, develops, owns and operates self-storage facilities. PSA is a member of the S&P 500. The self-storage industry is highly fragmented. The firm estimates that its 2,078 properties across 38 states comprise just 5% of the total U.S. self-storage industry, with its nearest four competitors comprising a combined 6%. The vast majority of self-storage facilities are owned by smaller, mom-and-pop or local operators. With that said, there is ample opportunity for further growth for PSA through accretive acquisitions.
Other than a small blip in 2010, the company has consistently increased top line revenue while increasing operating margins even faster to the current level of just under 50% for year-end 2012. Free cash flow for 2012 was $1.3 billion, from which $757 million was paid in dividends to common stock holders and $202 million to preferred stockholders, a payout ratio of 73% of free cash flow. For Q2 2013 revenue increased by 5% over Q2 2012, and net income margin increased to 53% compared to 43% over Q2 2012. At the close of Q2, the company only carried long term debt of $113 million. However, preferred stock on the balance sheet was listed at $3.4 billion, which in practical terms is more debt than equity. But even when converting the preferred stock to long-term debt, the result is a company with a long-term debt to equity ratio of a respectable 40%.
While the common stock may be a compelling buy with its current dividend of $5.00 a share and a current yield of 3.25%, I am more attracted to the preferred, series, T, U, V and W. All four of these are selling well south of the $25.00 par value and all have solid investment grade ratings of A3/BBB+. See the table below:
All of the above issues are callable at the issurer's option at $25.00 a share after the call date. Keep in mind that these are not maturity dates like bonds, and in fact, they may never be called. Prices will fluctuate and they will be throttled by interest rate factors.
I stated earlier that I consider purchasing preferred stocks for yield and safety. From a yield standpoint, I give the Public Storage preferred issues a grade of B+. However, from a safety standpoint, I give them an A+ for the following four reasons:
- The sponsoring company is profitable, well managed and growing
- The credit ratings are well within investment grade territory
- They are cumulative preferred which means that besides ranking senior to the common stock in a liquidation, the cumulative part means that if dividends are ever suspended, they accumulate and will be paid before any distributions are paid to the common shareholders.
- Given the REIT status and the fact that over $757 million are paid as common stock dividends compared to the $202 million on the preferred, there is a huge cushion of safety propping up the likelihood of uninterrupted payments on the preferred stock.