Saut: Warming to Pharma Shares, REIT Preferred Securities

Excerpt from Raymond James strategist Jeffrey Saut's latest essay:

Our recent “warming” to pharma shares is driven by the fact that they are cheap relative to the equity markets, cheap relative unto themselves, and cheap on their respective dividend yields. Moreover, even though we continue to think the U.S. economy will avoid a recession, it is worth considering that in the past four recessions consumer staples, healthcare, and materials have shown the best returns six months prior to the start of the recession, while financials, IT, and telecom have fared the worst.

We began our foray into pharma by recommending Johnson & Johnson (JNJ) and Pfizer (PFE). So far, two scale “in” purchases (or tranches) have been made and we are about at a break even point on these two names. More recently, we recommended Schering Plough (SGP) given the common shares’ 45% price concession on what we consider to be a “one-off” event. In this case, however, we used Schering Plough’s 7%+ yielding convertible preferred “B” shares (terms should be checked before purchase).

Last week we “warmed” to Wyeth (WYE) when our pharma analyst upgraded the shares to a Strong Buy as concern about the fate of Pristiq, an antidepressant awaiting U.S. approval, left WYE shares at a discount to our estimated breakup value. Even without Pristiq, WYE shares are probably worth at least $51.00. Wyeth’s free cash flow yield of 8.6% is superior the group’s 6.0% and is likely to surge once the company finishes making liability payments for its diet drugs.

Excluding those payments, free cash flow yield in the 12 months ended September is about 9.9%. The most immediate threat to our recommendation is a potential rejection of Pristiq. Regulators are likely to decide by the end of this month. Our price target of $51.00 represents our estimated breakup value. Further, our estimate assigns no value to a pipeline that includes treatments for Alzheimer’s disease and osteoporosis. And there, ladies and gentlemen, could be the real gem, for certain savvy seers suggest Wyeth’s Alzheimer’s drug actually works...

Along this “income” theme, while the REIT preferreds don’t necessarily increase their respective dividends, they do afford “outsized” yields. REIT preferreds have rallied from the lows of December, with some issues up 15-20%, yet we still see select situations as an attractive opportunity. Credit risk is minimal based on REIT balance sheets and the relatively healthy state of the commercial real estate market. REIT preferred yields have not followed the falling yield of the 10-year Treasury over the past three months, but rather spreads have widened and now are trading on a level comparable to junk bond yields.

The implied risk profile for these cash flows seems unjustified, and thus we recommend investors consider REIT preferred shares as part of their asset allocation. Although there are unique liquidity/trading characteristics and call provisions across almost all of the REIT preferred securities, we believe that they make attractive income plays for investors seeking above-average yield and minimal default risk. Two names for your consideration are Corporate Office Properties (OFC) using the 8%-yielding preferred “G” shares, as well as LaSalle Hotels’ (LHO) 7%-yielding preferred “G” shares (for more ideas see our REIT Preferred Report dated 2/13/08).