Editors' Note: This article covers stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.
Since I started writing on Seeking Alpha, I have revealed the entirety of my personal portfolio. The start of 2014 marks an excellent time to once again share my positions going into the new year. We will begin with a review of REITs' performance in 2013 along with my portfolio's performance and follow with my 2014 positioning and portfolio strategies. While readers are welcome to use portions or all of the portfolio, it is highly recommended that each investor do his/her own research. It should also be noted that I am a frequent trader with fairly high risk tolerance, so this portfolio is certainly not for everyone.
2013 year in review
When contrasted with the S&Ps greater than 30% return, 2013 was a difficult year for REITs with the MSCI REIT index (RMS) returning only 2.47% including dividends. Much of the REIT underperformance occurred in the 2nd half of the year consequent to taper talk and rising interest rates. Amidst all this underperformance, however, there remained some stellar REIT opportunities.
With a value oriented portfolio, I was fortunate to have owned many of these opportunities. In particular, CapLease (LSE), Ashford Hospitality (AHT), Northstar Realty Finance (NRF), RAIT Financial (RAS), and Sotherly Hotels (SOHO) drove my returns.
Overall, my portfolio returned 37.1% in 2013 which brought in 3,463 basis points of outperformance over the REIT index and 471 basis points of outperformance over the S&P 500. I will attempt to outperform again in 2014 and I believe the following portfolio is positioned to do so.
My 2014 Diversified REIT Portfolio
Below is my consolidated account positions statement with absolute values removed for confidentiality. It shows relative weighting in the %MV column.
This article will detail why I am in each of the positions, but first, I would like to describe some of the strategic aspects.
While I consider myself to be a bottom-up investor, I do pay attention to asset allocation in terms of risk exposure. Some would argue that having nearly 100% of my assets in REITs is overexposure, but in my opinion, REIT is not an asset class and if you look at the underlying businesses, this portfolio is fairly diversified. The following table shows a breakdown of the portfolio's exposure to various industries.
VTR, OHI, IMUC, MPW
AHT, SOHO, INN
CBL, WSR, ARCP, GOOD
NRF, RAS, NRF-B, FUR
5.98% long and 4.60% short
Breaking it down by sub-industry would reveal further diversification. For example, within healthcare, OHI, VTR and MPW in aggregate provide a fairly even exposure to each of SNFs, senior housing, and hospitals. That being said, I do have rather substantial overweights in healthcare, hotels, retail, and specialty finance. Each of these overweights is intentional for the reasons detailed below
Healthcare REITs have plummeted on fears of regulation changes and rising interest rates. By our analysis, neither poses a real threat to their underlying fundamentals. Consequently, the industry has become quite a value relative to its market pricing. (more on this as we talk about the individual stocks)
Hotel REITs trade at substantially lower FFO multiples than other REITs and the market in general. Admittedly, they should trade at a lower multiple as the business is inherently volatile. However, I believe this risk is overstated in the market pricing due to the recent history of hotels which were decimated by the travel shut-down following September 11th and hit again by the financial crisis. Further, the market seems to be anticipating a cyclical peak for hotels in the near-term as ADR and occupancy approach (and in some cases surpass) the highs of the previous cycle.
We do not believe the former cycle's peak to be a good proxy for the current cycle for 2 reasons.
- Demand growth has substantially outpaced supply growth
- The previous cycle was shortened by the back to back recessions
The superior sector fundamentals along with a potentially longer time horizon will allow this cycle's peak to be substantially higher. Given the currently cheap market pricing, we do not believe the upside is priced in, making hotels opportunistic.
The market prices of many retail stocks have become depressed based on fears of online competition. While this fear may be rational for the sector in general there are certain portions of it that are less susceptible yet have sustained the same price decline. For example, the triple-net REITs with retail exposure will not feel weak sales as their contracts are generally not tied to performance. As long as the contracted tenants can avoid bankruptcy, triple net REIT cashflows should remain strong.
We believe mall REITs such as CBL are also somewhat sheltered from online competition. Unlike their stand-alone brick and mortar peers, malls provide a shopping experience that cannot be simulated online. Consequently, the selected batch of retail stocks seem poised to outperform relative to their substantially depressed market prices.
The recovering economy creates a substantial demand for capital as businesses take on new ventures. Unfortunately, more stringent regulation of banks since the financial crisis prevents them from filling some of the higher risk loans. This is where the specialty finance REITs come in.
Occasionally, risky loans can be a win-win situation for finance REITs. If the borrower succeeds, the REIT receives full payment and if the borrower fails, the REIT can sometimes obtain the collateralizing property at a steep discount to its NAV. With a REIT structure and internal property management expertise, these companies can harvest more value out of a foreclosure than a bank can.
Despite the fundamental advantages of the sector, many of the companies still trade at low multiples which makes them opportunistic investments.
Beyond the asset, industry and sector weights, I would like to discuss the weights on individual securities.
Weighting of individual stocks
The individual stock weights in my portfolio range from 0.53% to 12.82%. Much of this difference has to do with 3 factors:
- Conviction: The more confidence I have in my thesis, the more money I feel safe allocating to it.
- Estimated magnitude of opportunity: Larger opportunities warrant greater allocation.
- Immediacy of relevant catalysts: positions with near-term catalysts are given greater positions such that upon fruition or failure the money can be reallocated to the next opportunity.
Generally, the stock weights are reflective of my relative estimates of opportunity, with the heavily weighted stock being the ones I view as most likely to succeed going into 2014. We will begin our description of the individual securities with these.
The cream of the crop
The 5 best positions for outperformance (in my opinion) are VTR, NRF-B, CBL, LAND short, and FUR. The elevator pitch for each is provided below
Ventas (VTR): Since May 21st, VTR's market price has fallen remarkably. Much of the drop seems to be consequent to fears of rising interest rates. However, Ventas has locked in cheap debt for the long term such that it would maintain its strong spreads even if interest rates rose substantially. Over the same period in which its price dropped, VTR has performed exceptionally on a fundamental basis, repeatedly beating earnings expectations, giving it room to comfortably raise its dividend. The disconnect between market pricing and fundamental performance has left VTR substantially undervalued at only 12X forward FFO despite blue chip quality and a strong outlook.
Northstar Realty Finance Preferred B (NRF-B): NRF-B has become a superior investment to other REIT preferreds and it could enjoy substantial capital appreciation as equilibrium is restored. At a market price of only $22.69, it has a current yield in excess of 9%. In today's environment, obtaining a 9% yield on a fixed income investment will generally require taking on material risk, but given the overwhelming success of the underlying company, Northstar Realty Finance, we believe the risk to the preferred is far less than a 9% yield would indicate. Its weak market pricing may have been consequent to tax-loss selling, exacerbated by poor liquidity. As the risk is reassessed and the equilibrium restored, NRF-B has the potential to provide meaningful capital appreciation to supplement the 9% yield.
CBL and Associates (CBL): Rather than being propelled by positive catalysts, we believe CBL's outperformance will be driven by the cessation of the negative catalysts holding it down: Specifically, the fears surrounding its exposure to J. C. Penney (JCP) and the threat of online competition. If and when these threats fail to materialize, CBL could return to a less anemic FFO multiple.
Gladstone Land (LAND) short: For the past year LAND's market price has been held up by an artificially high dividend consequent to REIT compliance. As a new REIT LAND has to pay out a certain portion of its accumulated earnings which it just finished doing with the December 16th dividend. We feel confident that upon the cessation of the oversized dividend, the market price will drop to a more fundamentally sound valuation.
Winthrop Realty (FUR): Obtaining valuation is difficult for a company like Winthrop as it has such a small pool of potential investors. With a market cap under $400mm it is not large enough to attract substantial institutional attention. It also fails to attract retail investors due to its complexity as it partakes in financially sophisticated transactions mostly through joint ventures which mask FUR's true exposure. While the small pool of potential investors could perpetually plague its market valuation, it has little bearing on its fundamental performance. At a price to FFO of only 7.6, it is deeply undervalued relative to its future earnings potential and unique capabilities.
The 5 stocks mentioned above have the highest expected returns (by my estimation) in the portfolio, but also carry a fair amount of volatility. In an effort to stabilize the return trajectory, I have included a batch of stocks with oversized dividends and strong fundamentals. While the market prices will fluctuate with exuberance and fear, the dividend income remains in line with the economic performance of the underlying companies.
Dividend Yield %
Omega Healthcare (OHI)
American Realty Capital (ARCP)
Gladstone Commercial (GOOD)
Whitestone REIT (WSR)
Sun Communities (SUI)
Medical Properties Trust (MPW)
*Data from SNL Financial
These companies lack immediate catalysts to have the supreme near-term return potential of the 5 "cream of the crop" stocks. However, they possess strong underlying fundamentals at opportunistic valuations which position them to provide steady, slightly above market, returns. The low price to FFO ratios also ensure conservative payout ratios such that the dividends are likely to be sustained or even grow. Although the picks mentioned thus far have been strictly bottom-up based on fundamental analysis, this portfolio also includes a sector bet.
The hotel sector bet
For the reasons detailed in the section describing the reasons behind the hotel overweight, I believe hotel REITs represent a disproportionate and favorable risk/reward investment. Rather than using some sort of hotel index to bet on the sector, I believe one can extract more returns by buying a mix of the best opportunities within the sector: Ashford Hospitality Trust, Sotherly Hotels and Summit Hotels (INN).
Ashford recently spun-off a few of its higher-end hotels into Ashford Hospitality Prime (AHP). This was done through a special dividend in which the AHP shares were granted to AHT owners and the market price of AHT was adjusted to reflect the off-market trading price of AHP shares at the time. Based on the adjustment and initial valuations of the separated companies, AHT got a disproportionately small market capitalization relative to its FFO. Conversely, AHP received a disproportionately large market cap relative to its FFO which left AHT undervalued and AHP overvalued. Since becoming tradable, AHP has dropped 14% to reflect its overvaluation, but AHT's market price has yet to appreciate to reflect its undervaluation. Herein lies the opportunity.
Sotherly hotels sustained substantial damage over the financial crisis and was forced to issue an extremely high coupon preferred to stay afloat. Consequent to its dire circumstances, it has been slower to recover than its hotel REIT peers, but it is now poised to materially grow earnings going into 2014. The expensive preferred has been fully redeemed and SOHO is beginning to have sufficient liquidity to resume growth.
Summit Hotels: The strength of INN as part of a hotel portfolio is that it evades some of the most prominent headwinds. Analysts who are bearish on the sector will usually reference the following 2 difficulties:
- Washington DC weakness
- Poor group bookings
INN evades the first with 0 hotels in the DC MSA. It also has a mitigated exposure to the 2nd through its focus on beltway locations rather than gateway locations. Since most conference travel has historically been to the gateway cities, those are projected to be hurt most by the weak group bookings. Since both AHT and SOHO have substantial exposure to both Washington DC and gateway cities, INN seems to be a necessary compliment to mitigate these risks.
While I stand by each of the holdings discussed so far there are portions of the portfolio that are residual, questionable or speculative.
On the chopping block
Northstar Realty Finance is on the chopping block because it has performed so well. Originally, I had bought it because I believed it to be undervalued and misunderstood as detailed in the linked article. With 87.43% appreciation over the past 52 weeks it is no longer undervalued.
Rayonier (RYN) is also on the chopping block, but for a less desirable reason. Its disappointing 3Q earnings report sent its market price down nearly 14% in a single day. I bought at this point under the impression that the weak performance was transient and that the business fundamentals were unharmed. However, upon re-evaluation it appears as though there are legitimate supply and competition concerns based upon new entrants into cellulose specialties production. This could manifest in sustained price weakness and consequently lower profit margins for Rayonier.
Immunocellular therapeutics (IMUC) is a biotech firm researching a technique that teaches a patient's dendritic cells to recognize cancer stem cells as pathogens. While the results of the phase II trial were not statistically significant to the primary endpoint of the study, they were encouraging in terms of preventing recurrence. As the data mature, I believe it will reveal that the treatment has substantial benefits for mean survival duration as well.
While the thesis seems strong, biotech is so far out of my wheelhouse that I can only give it a speculative allocation which at the moment is 0.53% of the portfolio.
The brief descriptions of company specific investment theses given in this article are clearly insufficient. For more information on specific theses, please feel free to access my article archives which contain full length features on nearly every security in the portfolio. Alternatively, the company websites and presentations are great references.
Disclosure: Please note that this portfolio is not for everyone. Despite the prior year's success, there is absolutely no guarantee that this portfolio will outperform. This portfolio is my personal portfolio and does not necessarily reflect the holdings of 2nd Market Capital. My short position in LAND was closed out during the writing and there is a distinct possibility that I will initiate a new short position in LAND in the next 72 hours. This article is for informational purposes only. It is not a recommendation to buy or sell any security and is strictly the opinion of the writer.
Additional Disclosure: I am long ARCP, AHT, CBL, GOOD, IMUC, MPW, NRF, OHI, RAS, RYN, SOHO, INN, SUI, VTR, WSR, FUR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.