A Stock Picker's Market - Part II

 |  Includes: EDR, VER
by: Bret Jensen

"Strategy without tactics is the slowest route to victory. Tactics without strategy is the noise before defeat." - Sun Tzu

Yesterday I penned an article postulating that 2014 was likely to be very different year than 2013 or for that matter 2012. Both of those years showered investors with great returns with very little volatility. However, most of the gains in equities in those years were driven by multiple expansion and not by underlying earnings gains.

Investors bid up the market on the anticipation of accelerating economic growth finally in 2014. The last two quarterly GDP reports have been strong with 4.1% growth in Q32013 and 3.2% in Q42013. However, I believe this is as good as it gets and 2014 will prove to be yet another false economic start ala the 'Summer of Recovery'.

The main drivers of my pessimism are that investors are underestimating the likely impacts of the Federal Reserve starting to unwind its liquidity providing operations…AKA, the 'taper'. The other is that emerging markets are starting to fall apart. Turkey, India, Hungary, Argentina, Brazil are just some of the names that are seeing slowing economic growth, rising rates as well as increasing inflation.

Even China seems to slowing down at a concerning rate looking at their last couple of economic reports. If emerging markets were starting to decline before the 'taper', how will they react as the Federal Reserve starts to withdraw liquidity from the markets at an accelerating rate?

I would be shocked if equities provided double digit returns in this sort of environment and my own forecast calls for returns between -5% to +5% for the year as we consolidate the last couple of years of gains and get used to the market's 'training wheels' being removed by the Federal Reserve.

One of the big surprises early in the New Year is the decline in interest rates. The yield on ten-year treasuries has moved from ~3% to begin the year to a current 2.7%. This flies in the face of most pundits' predictions calling for higher interest rates in 2014.

The high-yield sectors that significantly underperformed the overall market in the back half of 2013 on rising rates are now outperforming equities overall. Given my outlook for the market and growth in 2014, I think this continues and I am increasing allocation to my income portfolio on these market dips in the New Year. Included in the increase in allocation to my income portfolio are two high-yielding REITs insiders are also buying recently.

Education Realty Trust (NYSE:EDR) is one of America's largest owners, developers and managers of collegiate housing. The real estate investment trust (REIT) owns or manages 71 communities in 24 states with ~40,000 beds. The shares seemed to have bottomed at ~$8.50 a share and are down some 20% from their highs in May before the Federal Reserve started their 'taper' talk.

Insiders were consistent buyers during the decline which is a nice vote of confidence in the company's long-term prospects. The shares yield a healthy 4.9% and the company increased its payout by 10% earlier this summer. Fall 2013 same-community pre-leasing occupancy was 93.6%, a 290-basis point improvement over the prior year. It also saw 3% to 5% rent increases across the communities it owns and manages.

Organic growth and new development drove over 25% revenue gains this fiscal year and current analyst projections call for almost a 20% increase in FY2014. The company has a solid balance sheet, has more than doubled operating cash flow since the end of FY2010 and the stock provides a low beta which investors should appreciate if market turmoil continues to rise.

I also like and continue to add in my position in American Realty Capital Properties (ARCP). This REIT owns and operates mainly single-tenant retail properties, and the company has a presence in almost all 50 states. It is one of the few REITs I have in the retail space as I believe the sector is vulnerable to the acceleration of the vulnerability of being 'Amazoned' in the retail sector.

However, American Realty is digesting a major acquisition that will give it more substantial heft and economies of scale -- nearly at the size that market leaders Realty Income (NYSE:O) and National Retail Properties (NYSE:NNN) command. American Realty is selling at an approximately 20% discount to these bigger brethren based on forward FFO (Funds from Operations). I believe this discount will disappear over time as the firm integrates its recent acquisition.

American Realty provides a 7.1% dividend yield, much higher than its bigger brethren. ARCP has a reasonable valuation of 12.5x forward FFO. Like Education Realty Trust, insiders have been frequent buyers of the shares over the past six months and the REIT is also down some 20% from its highs in May.

Disclosure: I am long ARCP, EDR. 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.