Trapping Value Positions For 2018: Navigating The Minefield Of High-Income Value Traps

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Includes: NPRUF
by: SA Editors
Summary

2018 will carry much more volatility.

Real estate is a great proxy for the economy but with a much higher degree of stability.

Northview Apartment REIT is the cheapest on a valuation basis in the Canadian apartment REIT sector.

Trapping Value, a value investor focused on REITs and other income-producing stocks and ETFs, is relatively new to Seeking Alpha, having been publishing articles since May of this year.

Trapping Value recently took some time to reflect on the past year and look forward to 2018. The author answers Seeking Alpha Editor Rebecca Corvino's questions below.

Rebecca Corvino: Let’s begin with an overview of your investment style/philosophy. Has anything changed for you in this regard in 2017?

Trapping Value: I generally look for high-income stocks that are deeply undervalued. This puts me squarely in the zone where there is a minefield of value traps. That is what led to the moniker “Trapping Value” in the first place. To navigate this minefield I use three important philosophies.

  1. There must be a pretty large margin of safety as bad market conditions can quickly erode small margins.
  2. It helps to create an even better price using put options. The combination of high fear and high dividend payouts results in very high values for at the money puts that “capture” expected dividends. Selling those significantly improves the final price I get on a stock.
  3. Finally, since no one can be right all the time, I keep all position sizes to a point where I can sleep at night without accessing Ambien.

I have gotten more defensive in 2017 and I have added close to 15 stocks to my portfolio, favouring better diversification over a more concentrated portfolio.

RC: In terms of asset allocation, how are you positioned heading into the new year?

TV: Real estate and energy. The way I see it this is late-cycle expansion and we will get significant inflation before we roll over. Both of those asset classes look best positioned for that. On the energy front, the crowd is significantly overestimating how quickly electric vehicles will stall or sap demand, and I think $80/barrel oil will be seen in 2018.

RC: What do you expect to be the key driver(s) of stock performance in 2018?

TV: We have had the longest period of extraordinary calm. It could go on, but I think 2018 will carry much more volatility. At an individual level, those who can embrace the coming volatility will do really well as this expansion cycle is nowhere close to being done. So buy extreme fear when it happens and you will do fine.

RC: What appeals to you about REIT investing, and what unique opportunities does the asset class offer?

TV: REITs make honest men and women out of CEOs. Just the fact that they have to distribute a significant chunk of their taxable income leaves them a lot less room for doing silly activities. If only the U.S. shale oil industry could have got REIT status we would have avoided a ton of bankruptcies.

Real estate is also a great proxy for the economy but with a much higher degree of stability. Leases typically run for several years while recessions last a lot less than that. This allows REITs to generally (2008-2009 was an exception) navigate recessions well, provided they have not done any silly antics like make large acquisitions near the peak.

RC: What advice would you have for investors new to REITs? What should they watch out for, both in terms of opportunities and in terms of risks?

TV: My advice to investors new to REITs would be “Step outside of your preconceived notions about this asset class.” There are tons of incorrect beliefs that have zero basis in reality. For example, I frequently hear:

  1. "REITs are to be avoided during rising interest rates," whereas the truth is that they have done well over all time frames and pretty much killed every other asset class during the late '70s when interest rates went vertical.
  2. "A REIT with no earnings is bad," which is focusing on a useless metric. Funds from operations is what should be looked at.
  3. "Yahoo shows their payout ratio to be more than 100%," which is also an irrelevant metric as REITs' ability to pay is assessed through funds flow and not earnings.

I do plan on writing a series on my process of evaluating REITs in 2018, which I hope will help investors as well.

RC: As a REIT investor and otherwise, what will you be paying attention to in 2018? Where will you be looking for opportunities?

TV: U.S. REITs are now getting into their latter innings of this cycle. Some sectors are still beaten down, such as retail and healthcare REITs, but in general there are many more opportunities in Europe. Prime properties in Europe are still trading at 6% CAP rates, and they can be financed with a fixed 10-year mortgage of under 2%. In case of panic selloffs in global markets, that is where I will be looking to buy.

RC: What is your highest-conviction pick (long or short) heading into 2018 and why?

TV: Northview Apartment REIT, which trades primarily on the TSX and OTC here in the US (OTC:NPRUF). It is currently the cheapest on a valuation basis in the Canadian apartment REIT sector, and its primary markets are showing very high rent increases. It returned over 30% in 2017, and I think 2018 should be very similar.

RC: Who will you be reading on Seeking Alpha in 2018?

TV: Dane Bowler and Jussi Askola. They are two REIT investors who come from the same philosophy that valuation matters a lot in establishing total return.

Disclosure: I am/we are long NPRUF.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.