The market crisis of 2008 created an unprecedented situation in which preferreds traded massively below liquidation preference. Some could be had for under 20% of par value and generated yields over 40%. At this same time many common shares had completely stopped paying dividends. Subsequently the preferreds produced strong capital appreciation as the prices began to return toward par all the while delivering outrageous yields. These past few years offered extraordinary opportunity for the astute investor but the market is approaching normalcy. With the redemption of higher-yielding preferreds and many common share dividend increases, common shares once again are beginning to have higher yields. As the market conditions change we must reevaluate our positions.
Once a portfolio manager decides a company is worth investing in, it becomes advantageous to choose the best option offered. Many companies, particularly REITs, will offer a plethora of equity shares. Common shares tend to get far more attention than their respective preferreds, yet in some cases the preferred is a superior choice. Using a very simple set of tools we can make intra-company comparisons to decide which one to buy.
Entrance Criteria: Once we purchase a stock we are at the mercy of the market. By establishing entrance criteria we can give ourselves a better foundation from which to work. Know an issue well and understand its intrinsic value. Research of a company is never wasted even if the end result is that it is not worth buying presently. Each company has a price at which it becomes a good buy. Establish through your analysis what this price is for any given issue and simply watch for it to become a viable purchase. Stocks will not always dip to this value, but by having established entrance prices across an array of stocks chances are that one of them will.
Percent Yield: The price to dividend ratio will often vary drastically within the spectrum of equities by a given issuer as well as over time. By watching for dips in price one can often obtain a position with much higher yield than it typically offers.
Seniority: As we know, preferreds have superiority over common stock in the capital structure, which can have a significant affect with companies struggling to pay debt. It is easy to overlook the effect of seniority in a strong company but we must remember that market downturns are often unexpected so it really serves as a form of damage mitigation.
Growth potential: Common shares will generally have far more volatility while the growth of a preferred is somewhat limited by the liquidation price (particularly as the call date approaches). In the past many preferreds could be had well under their liquidation preference allowing for both extra yield and capital appreciation, but today a vast majority trade near their liquidation price.
Type of dividend: Preferreds usually have a fixed coupon so the % yield can only be influenced by the price at which it is purchased while common dividends can be increased. For those owning a common stock at the time of a dividend increase, the benefits are twofold. In addition to getting a larger dividend, the announcement of the increase tends to drive up the price of the stock creating capital appreciation.
Liquidity: Securities with low trading volumes are both difficult to obtain and to sell. Be aware that entrance into some thinly traded stocks will result in potentially slow liquidation or having to take losses to liquefy. This poor liquidity can in certain circumstances create great opportunities for the perceptive buyer. As many smaller issues of preferreds are largely owned by only a few individuals or trading institutions, circumstances unique to one of these investors can drive the price well below a rational value.
Peer Comparison: In addition to the intra-company comparison on the above factors, we should compare performance with the rest of the sector. Particularly useful parameters here are price/ffo, EBITDA/interest expenses, and relative dividend yields.
The value of issues and ultimately the superior choice is also influenced by the goals of the investor, but the following analysis will be with the goal of maximizing overall expected returns (both capital appreciation and dividends).
Recent Market Price
Annual Dividend per Share $
% Yield at Recent Price
Hospitality Properties (HPT) is a hotel REIT with over $6 billion invested throughout North America. HPT recently (02/13/12) redeemed all 3,450,000 shares of the 8.875% series B preferred. This followed shortly after the issuance of 11,600,000 shares of the new 7.125% Series D Preferred. Since the removal of the high coupon Series B, the disparity between the yields of the common and the preferreds is quite small. Additionally, the preferreds have virtually no room for growth as HPT-C is redeemable presently and trading above par, and HPT-D, while not redeemable until 1/15/17 is already significantly above par. The common, however, has room for growth both in capital appreciation and dividend increases. With an estimated price/FFO of 8.4 it trades well below the sector average. An estimated EBITDA/debt interest of 4.3 provides stability of dividend coverage as well as the potential for dividend increases. Taking both yield and capital appreciation into account, Hospitality Properties' common provides more overall return potential.
That being said, I would not recommend the purchase of HPT at its current price as it is significantly above what I would consider its viable entrance price of $26.31. This price roughly equates to a price/ffo of 8 and a yield of 6.84%. Keep in mind that any established entrance price is not fixed and relies upon the strength of the company remaining on track. So the price deviation to reach said entrance price would have to be due to normal fluctuations and not a response to adversity. After deciding that purchase at this price generates sufficient returns, we can look at the plausibility of this opportunity actually occurring. Through most of 2012 HPT traded between 7 and 8 price to FFO, and it wasn't until late in March that it traded consistently higher. Additionally, some upcoming events could generate some volatility: On May 7, HPT is scheduled to release its first-quarter earnings report and host the related conference call. By diligently watching the erratic behavior that sometimes precedes and follows such an event we may have the opportunity to pick up some HPT at a discount. Buying HPT at a price of $26.31 would net 6.84% annual yield and allow for growth as the price normalizes.
As preferreds across all sectors are trending toward lower coupons, the high annual yield of HPT's common will in some ways set its minimum price. Excluding adverse events, which significantly harm HPT and force it to reduce or remove the dividend on the common, a price floor is set by the dividend and enforced by rational market behavior. In the present market situation, where annual yields over 7% are fairly rare and high yielding preferreds are being redeemed, it stands to reason that rational market behavior will hold the price of HPT common at or above the point of 7% annual yield. With $1.80 in annual dividends this practical yet imaginary price floor rests at $25.71. Of course this will not prevent damage from a major sell-off (company or market), but it can serve to mitigate risk due to ordinary vicissitudes.
Unfortunately, the normalizing market presents fewer opportunities for the massive returns than we have enjoyed in the past few years. As such we must streamline stock acquisitions to outperform the market. Setting up entrance criteria across the market is a way to recognize and capitalize on opportunities as they arise.