I use to like REITs and Utilities for Income, but not anymore.
Most are expensive! I wrote once again last week about the valuation problems that the Utility, REIT, and Blue-chip dividend paying stocks were facing. I gave specific examples of profitable sells that I had made in early July, particularly in the REIT sector.
Amongst the numerous comments that my article received, many challenged me to give some specific examples of the new areas of the market that I was pivoting to in order to find income.
Well, here you go…
First, I want to review the facts that led me to the conclusion that many dividend paying sectors in the market were extremely expensive right now. I wrote about that back on July 5th.
I did not just drop off of the turnip truck as it relates to valuations. This is my third decade as a professional money manager. I spent several years visiting companies around America and writing up research reports on them, valuation is the biggest part of that exercise.
What is the bottom line of a research report? It comes down to the potential earnings of the company going forward, and how much are those earnings worth?
It is obviously not quite as simple as that, but almost. Then, once I would arrive at a potential future valuation of the company, I would compare it with the current price. At any given time, a stock is undervalued, fully valued, or overvalued.
I like to compute 5-year valuations. They fit nicely with the five-year growth rates that are common in the industry. In fact, you can look up my target prices on thousands of stocks each and every day in my Best Stocks Now database.
I do not like to buy stocks unless I can make a reasonable valuation case for them. As valuations get stretched, risk to reward ratios rise. One way you can mitigate risk in a portfolio is by mitigating valuation risk. It is not a good idea to have a portfolio of expensive stocks.
It is hard to make the case for buy and hold to an investor like me that pays attention to valuations. Why would I continue to hold on to a stock that has become stretched way beyond historic norms as it relates to valuation? This makes little sense.
Let's first check in on the current valuations of the utilities. Pick a utility, any utility. How about NextEra Energy (NYSE:NEE)? Why not? It is the biggest holding in the iShares U.S. Utilities ETF (NYSEARCA:IDU) which tracks the U.S. utilities index. The company provides electricity to about 5 million folks in Florida every days.
Over the last ten years, the P/E ratio for NextEra has ranged between a low of 11 and a high of 23. I use Morningstar.com as my source. The ten-year average P/E ratio has been somewhere in the 15X range. The current P/E ratio is 22X. This is obviously a very stretched valuation from a P/E ratio point of view.
Let's next look at the price to sales ratio of NextEra. It has ranged between a low of 1.2 to a high of 3.4 over the last ten years. The average price to sales ratio has been in the 2X area. The current price to sales ratio is 3.4. This too is obviously a very stretched valuation.
How about price to book value? It is yet another flavor of valuation. The range over the last ten years has been between 1.7 and 2.6. The current price to book ratio is 2.6. One would have to see continued multiple expansion way beyond their historic norms to be able to justify today's valuation ratios. That is a bet that I am not willing to take.
The price to cash flow multiple is also stretched to the max. No matter what flavor of value that you like best, they are all currently way too rich.
You could make the argument that NextEra's dividend yield of 2.8% looks pretty attractive in today's low yield environment. That dividend yield can get eaten up, and then some, rather quickly by a 10-20% valuation correction in the stock, however.
The five-year chart of NextEra still looks good, but does the risk to reward ratio currently favor the investor from a valuation point of view? I don't think so. It is time to look elsewhere. I sold my positions in utilities back in early July.
NextEra has corrected by about 8% since its July high. In my opinion, there are much greener pastures elsewhere, for income seeking investors right now. More on that in a bit.
NextEra is just one utility, but it is a pretty good proxy for the industry. You can do the same valuation exercise that I did on NEE and come up with similar results on countless other utilities. The bottom line is this: I warned a few months back about the utility sector. I said that it was time to take profits and I did. I reiterated my warning in my article once again last week.
Next let's look at the real estate investment trust sector (REITs).
In early July, I voiced and penned a similar warning about the REITs. They had the same valuation issues that the utilities had, s-t-r-e-t-c-h-e-d valuations. Let me give a specific example.
Over the years, Realty Income (NYSE:O) has been one of my favorite REITs. It is headquartered in my neck of the woods in San Diego, Ca., and it is a member of the S&P 500. It should be a fairly good proxy for the rest of the sector.
Realty Income has the same valuation issues, if not worse, than the NextEra has. Over the last ten years, the P/E ratio of Realty Income has ranged between 25X and 60X. Where is it currently trading? You got it - 60X!
From time to time, I hear the argument that REITs should be evaluated by their FFO (funds from operations) ratios, however. While that is correct, you cannot ignore price to earnings ratios. In addition to this, historic FFO ratios are hard to find, but they would be very similar to price to cash flow ratios.
So, let's look at Realty Income from a price to cash flow perspective. Over the last ten years, the price to cash flow ratio of Realty Income has ranged between 8.5X and 22.4X. Where is it trading now? At the extreme high of the range, 22.4X! I don't know about you, but this makes me extremely nervous. Not only would I NOT buy it at this level, I would seriously consider cashing in for now. In fact, early July was a better time to do so.
I have given just two specific examples to back my belief that these two sectors have been exploited to the max by investors chasing dividend yields. I could give many more, however.
I have also witnessed the same Fed-induced feeding frenzy in dividend paying stocks like Johnson & Johnson (NYSE:JNJ) - all for a lousy 3% dividend yield. Let's look at what is under the hood of that dividend yield, however.
JNJ has had an average P/E ratio of about 16-18 over the last ten years. Right now it is stretched way beyond that average with a current P/E ratio of 22X. How much multiple expansion juice do you think is left in this dividend yielding fruit? You can argue and try to justify more, but to me it has been wrung dry.
You can also look to other flavors of valuation for JNJ and see the same stretched valuations numbers. From my perspective, Johnson and Johnson is also very representative of most large-cap, blue-chip dividend payers. This sector has also been overbought by the dividend seeking crowd. You will find the same valuation problems amongst popular dividend stocks like Kimberly Clark (NYSE:KMB), AT&T (NYSE:T), Verizon (NYSE:VZ), etc. etc. etc.
Before we move on to some possible solutions to the aforementioned problems, let's also not forget that we have a Fed out there, especially Stanley Fischer, that is rattling its rate-hike sabers right now. This also would not be good for these sectors, as it would cause already stretched multiples to contract even more quickly.
Now let's look at some possible solutions to the income seeking investor's current conundrum. CDs pay next to nothing, U.S treasuries just a little bit better than that, meanwhile all of the usual neighborhoods for dividends have become pricey.
In the income portfolios that I manage, I have had to pivot to some areas of the market that have not been exploited yet, and still offer some fancy yields. It is an eclectic and diversified mix of stocks, ETFs, and closed-end funds, but overall I find this approach much more lucrative potentially than the traditional areas of the market.
I currently hold 26 positions in this portfolio. Here are just a few examples from it:
I sold out of the energy patch back in the summer of 2014. Oil prices began to fall, and just a little bit of technical analysis showed trouble looming for the energy stocks. I started buying back into the energy sector earlier this year after its washout in January.
I don't really care for the individual MLPs because of the partnership returns that need to be filed along with them. MLP exchange-traded funds get around this issue. The ALPS Alerian MLP ETF (NYSEARCA:AMLP) went down 54% from its high in the summer of 2014 to its low early this year. I hope that you were not chasing yield all the way down! This is another strategy, along with buy and hold that makes little sense to me.
I got back into AMLP on May 16th of this year when it sported a dividend yield of 9.9%. It would seem to me that the energy supply/demand issue continues to work its way out, and in my opinion, the energy patch now offers more upside potential than any other sector in the market.
In addition to this, just in case the Fed starts to get hawkish on us, the energy sector is not quite as interest rate sensitive as other sectors are. MLPs are tied more to the price of oil. In fact, a little higher rates and a little bit of inflation could be beneficial to the sector.
I also like many individual energy stocks. I own several in both my growth portfolios and in my income and growth portfolios
I added British Petroleum (NYSE:BP) to my income portfolio back on June 21 st of this year. At the time, it was yielding 7%. In my opinion, it also offered much more upside capital appreciation potential, along with the fatter yield, than the utilities and the REITs offered at the time. I also like many British stocks right now. I don't think that the Brits will be raising their rates any time soon, and a weakening pound makes their goods more attractive on the world markets.
That is one of the main reasons that I also recently added HSBC Bank (NYSE:HSBC) to my income portfolio.
It currently sports a dividend yield of 6.6%, and if you believe Morgan Stanley, they said on Wednesday that they find the dividend to be safe. I featured the stock on my national radio show on that same day.
I also find the business development companies (BDCs) to be attractive right now. Valuations are still fairly reasonable and dividend yields are attractive. I purchased Ares Capital (NASDAQ:ARCC) back on April 15th of this year. It sported a yield of 10.2% at the time. You can see from the chart below how the stock is currently breaking out to new 52-week highs. I am happy with my BDC positions so far. I like income and capital appreciation if I can get it.
If you want to take a walk in the wild side, there is an ETF that is leveraged 2X on the Wells Fargo BDC index. I have a position in it also. It had a crazy 16% dividend yield when I bought it. I am happy so far. Buy and hold? I don't think so. This one needs a tight leash on it.
These are the only cards in my hand that I am going to show you right now. I have 21 more similar, slightly eclectic positions in my current income portfolio. As you can probably tell by now, I am not an average buy and hold asset allocator. The economy has cycles, the market has cycles, interest rates have cycles, inflation has cycles, sectors have cycles, and individual stocks have cycles. I want to do my best to be on the right side of those cycles.
In my opinion, the traditional asset allocation model that is being peddled by most advisory houses and advisors in my industry today is in big danger of blowing up when interest rates begin to normalize once again.
Remember, since the Roman Empire interest rates have averaged between 6-10%. Does a seventy-year-old really want to have 70% of his eggs in the bond basket when the chickens start to come home to roost? I don't thinks so…
It is time to think outside of the basket!
Disclosure: I am/we are long AMLP, BP, HSBC, ARCC, BDCL.
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.