REITs: A Quality And Risk Analysis

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Includes: ADC, AHH, AMH, BPR, BRG, BRX, CDOR, CDR, COR, ESRT, FCPT, HIW, HT, IRET, JLL, LAMR, OLP, ORM, PDM, PEB, PEI, PK, REXR, RPT, SNH, SPG, STOR, TIER, UHT, UMH, VICI, VNQ, WPC
by: Roderick MacIver

Summary

Of the 212 REITs reviewed for this report, 139 have insufficient dividend coverage by free cash flow. The eighteen lowest-quality of those are reviewed in this report.

Forty-eight REITs were identified as having superior dividend coverage, profitability, balance sheet strength and overall financial statement trends.

The fourteen with the strongest dividend coverage and financial statement trends are named in this report.

Those fourteen had an average yield of 3.7% versus 5.4% for the REITs with insufficient coverage, and 5.0% for all REITs.

First, the context. This research focuses on the financial statement characteristics and trends of public companies (“moneyball investing”). It emphasizes two principles:

  • All companies, public or private, are either improving or deteriorating. Static doesn’t exist, although the majority of companies lack a clear, protectable competitive advantage and move back and forth between improving and deteriorating.
  • Companies with improving margins, improving asset turnover (revenues divided by assets) and declining debt outperform, over time, companies with the opposite characteristics.

For more on my methodology, scroll down to the bottom of this report.

To assist with the initial stages of identifying companies with inordinate risk or inordinate potential, we’ve developed credit analysis software that applies hundreds of ratios to a variety of time frames, and then compares each company against all public companies. We also use stock price momentum studies, read government filings (10Ks, 10Qs) and research reports by industry experts.

To prepare this report, we ranked all 212 REITs in either the Vanguard REIT ETF (VNQ) or in the NAREIT list of public REITs by strength or weakness of financial statement trends and characteristics.

Note – charts/tables provided by the author using company data.

Overall conclusions:

The following conclusions are based on five major considerations:

  • Dividend security or coverage by free cash flow.
  • Dividend growth
  • Financial statement trends (profitability, leverage, liquidity).
  • Ability to compound free cash flow (see below).
  • Financial strength (a company can be financially strong but experiencing deteriorating trends).

REITs with the best dividend coverage and strongest financial statement trends listed in order, best to not quite as good:

  • Jones Lang LaSalle (JLL)
  • Park Hotels & (PK)
  • VICI Properties Inc (VICI)
  • American Homes 4 (AMH)
  • Empire State Realty (ESRT)
  • Brixmor Property Group (BRX)
  • Four Corners Property (FCPT)
  • CoreSite Realty Corp (COR)
  • STORE Capital Corp (STOR)
  • Pebblebrook Hotel Trust (PEB)
  • Rexford Industrial Realty (REXR)
  • Lamar Advertising Co (LAMR)
  • Simon Property Group (SPG)
  • WP Carey Inc (WPC)

REITs with insecure dividends ranked in order from worst coverage to not quite as bad:

  • Bluerock Residential Growth (BRG)
  • Agree Realty Corp (ADC)
  • Armada Hoffler Properties (AHH)
  • Investors Real Estate (IRET)
  • One Liberty Properties (OLP)
  • Tier REIT Inc (TIER)
  • Hersha Hospitality Trust (HT)
  • Condor Hospitality Trust (CDOR)
  • Senior Housing Properties (SNH)
  • Ramco-Gershenson Properties Trust (RPT)
  • Piedmont Office Realty (PDM)
  • UMH Properties Inc (UMH)
  • Highwoods Properties Inc (HIW)
  • Cedar Realty Trust (CDR)
  • Pennsylvania Real Estate (PEI)
  • Universal Health Realty (UHT)
  • Owens Realty Mortgage (ORM)
  • Brookfield Property REIT (BPR)

A comparison of best and worst REITs versus all REITs and all 5,648 public companies in our database:

All REITS table

Conclusions:

  • The highest-quality REITs tend to follow a strategy or business model requiring low capital expenditures. As a result, they have less debt in relation to fixed capital than do REITs in general, and substantially less debt than do the worst REITs.
  • On average, the highest-quality REITs have lower current yields, but substantially higher yield growth, than the worst REITS or REITS in general.
  • Dividend coverage by free cash flow is below that of all public companies even for the best REITs, but the worst REITs come nowhere close to funding their dividend from operations. These REITs fund dividends in part out of increased debt and in part by continually issuing shares.

The Optimum In Business Quality: Compounders

Compounders are companies that consistently, year after year, generate more in free cash flow than they did the prior year without increasing debt. Only about 5% of all companies are capable of that. Here’s an interesting comment on this subject by John Huber of Saber Capital Management:

Fastenal (FAST). FAST sells nuts and bolts, sounds basic enough… but the returns are far from basic. The company averages around 20% returns on capital and produces very consistent results. 25 years ago, the stock traded for a split adjusted $0.32. Today, it trades at $44, or 138x the price in 1989. The stock has averaged 21.8% annualized returns not including dividends. This long-term result nearly matches the company’s average return on capital over time.

Fastenal earned roughly $3 million in 1988, and a buyer of FAST paid somewhere around 25 times earnings for FAST in 1989. But a buyer could have paid 50 times earnings for FAST in 1989 (or roughly $0.65 per share) and the compounded annual return would have only decreased from 21.8% to 18.4%…. a big difference over time, but certainly still a splendid result.

Again, I cannot emphasize enough that valuation is more important over shorter time periods, quality is more important over long time periods (10-15 years or longer). The longer you hold a stock, the more important the quality of that company is, as your long-term returns will approximate the company’s internal returns on capital over time.

- John Huber, Base Hit Investing, Importance of ROIC Part 2: Compounders and Cheap Stocks, POSTED JUNE 4, 2014

Compounders are easily identifiable with graphs of their free cash flow per share. For comparison purposes, here is the Alphabet (GOOG) graph.Not a perfect up slope but pretty good.

GOOG FCF Table

And here is the FCF chart of one of the better REITs, CoreSite Realty (COR). Not as good as Google – Google is in the top 1% of all public companies in this and most other regards – but good.

COR FCF Graph

Compare that to a graph of the free cash flow of Investors Real Estate Trust (IRET), one of the worst REIT compounders. It failed to generate positive free cash flow from operations in any year since 2002. It appears to finance its business by selling assets and a revolving line of credit.

IRET Compounder

More compound free cash flow graphs and comments below.

Summary comments, best REITs:

Jones Lang LaSalle (JLL)

Overall neutral trends. Current Yield: 0.6%. Yield coverage by free cash flow: 22.69 times. Profitability trend neutral, leverage trend positive, liquidity trend slightly negative. Above average growth. Financial strength strong. Quality of earnings average. Dividend secure and growing. Fairly Valued.

Five-year trends:

JLL Five Year Table

Comment:

  • Conservatively financed, stable.
  • Margins have deteriorated, asset turnover improved, resulting in a stable return on assets.
  • Interest coverage by free cash flow an exceptional 11 times.

Park Hotels & Resorts (PK)

Overall improving. Current Yield: 6.5%. Yield coverage by free cash flow: 4.7 times. Profitability trend slightly positive, leverage trend very positive, liquidity trend exceptionally positive. Strong growth. Financial strength strong. Quality of earnings good. Dividend secure and growing. Undervalued.

Price Versus Intrinsic Value:

PK Value Graph

Comment:

  • The REIT seems to be creating value faster than the stock price is appreciating.

VICI Properties Inc (VICI)

Overall improving. Current Yield: 1.9%. Yield coverage by free cash flow: 4.2 times. Profitability trend exceptionally positive, insufficient data to determine leverage trend, insufficient data to determine liquidity trend, Exceptional growth. Financial strength average. Quality of earnings exceptional. Dividend secure and growing. Fairly Valued.

American Homes 4 Rent (AMH)

Overall improving. Current Yield: 0.9%. Yield coverage by free cash flow: 4.01 times. Profitability trend positive, leverage trend very positive, liquidity trend neutral. Strong growth. Financial strength above average. Quality of earnings very good. Dividend secure. Fairly Valued.

AMH Free Cash Flow Graph:

AMH FCF Graph

Empire State Realty (ESRT)

Overall improving. Current Yield: 2.7%. Yield coverage by free cash flow: 2.95 times. Profitability trend slightly positive, leverage trend positive, liquidity trend neutral. Above average growth. Financial strength strong. Quality of earnings good. Dividend secure. Undervalued.

ESRT 5 Year Table

Comment:

  • On a 176% increase in revenues, operating free cash flow is up 239%.
  • Margins declined; asset turnover improved resulting in a slightly improved return on assets.

Price In Relation To Intrinsic Value

  • After the stock price decline, it now appears undervalued.

Empire State Value Graph

Brixmor Property Group (BRX)

Overall improving. Current Yield: 7%. Yield coverage by free cash flow: 2.8 times. Profitability trend very positive, leverage trend positive, liquidity trend exceptionally negative. Average growth. Financial strength below average. Quality of earnings good. Dividend secure. Undervalued.

Free cash flow trend graph:

BRX FCF Trend Comment:

  • Free cash flow has not grown since 2014.

Price In Relation To Intrinsic Value:

BRX Intrinsic Value

Four Corners Property (FCPT)

Overall improving. Current Yield: 4.1%. Yield coverage by free cash flow: 2.6 times. Profitability trend positive, leverage trend very negative, liquidity trend neutral. Exceptional growth. Financial strength above average. Quality of earnings excellent. Dividend secure. Fairly Valued.

CoreSite Realty Corp (COR)

Overall improving. Current Yield: 3.2%. Yield coverage by free cash flow: 2.5 times. Profitability trend positive, leverage trend slightly negative, liquidity trend exceptionally positive. Strong growth. Financial strength strong. Quality of earnings very good. Dividend secure. Fairly Valued.

Five-year financial statement trends:

COR Financial Statement Trends

Comment:

  • Recent significant increase in debt versus equity: equity now 28% of debt versus 73% a year ago.
  • Exceptional return on assets of 14% versus 2.9% five years ago.
  • Free cash flow per share up 636% over the five and a half years and a 157% increase in revenues. See free cash flow graph above.

Financial strength trends: still positive despite recent increase in debt.

COR Financial Strength

CoreSite Price Versus Intrinsic Value: The recent significant increase in intrinsic value has now caught up with the stock price.

COR Price vs Intrinsic Value

STORE Capital Corp (STOR)

Overall improving. Current Yield: 4.3%. Yield coverage by free cash flow: 2.1 times. Profitability trend slightly negative, leverage trend positive, liquidity trend exceptionally positive. Strong growth. Financial strength above average. Quality of earnings good. Dividend security stable. Fairly Valued.

Pebblebrook Hotel Trust (PEB)

Overall improving. Current Yield: 4.6%. Yield coverage by free cash flow: 2 times. Profitability trend positive, leverage trend slightly positive, liquidity trend exceptionally negative. Above average growth. Financial strength above average. Quality of earnings very good. Dividend secure. Undervalued.

Pebblebrook free cash flow graph: excellent though volatile.

PEB FCF Graph

Rexford Industrial Realty (REXR)

Overall improving. Current Yield: 2%. Yield coverage by free cash flow: 1.85 times. Profitability trend neutral, leverage trend slightly positive, liquidity trend neutral. Strong growth. Financial strength average. Quality of earnings good. Dividend security stable. Somewhat overvalued.

Summary graph: stock price versus free cash flow and financial strength. Conclusion: significant increase in financial strength over the last five years.

REXR Summary Graph

Lamar Advertising Co (LAMR)

Overall improving. Current Yield: 4.8%. Yield coverage by free cash flow: 1.8 times. Profitability trend very positive, leverage trend slightly negative, liquidity trend slightly positive. Average growth. Financial strength average. Quality of earnings good. Dividend secure. Fairly Valued.

LAMR Summary Chart

Simon Property Group (SPG)

Overall improving. Current Yield: 3.2%. Yield coverage by free cash flow: 1.75 times. Profitability trend very positive, leverage trend slightly positive, liquidity trend neutral. Average growth. Financial strength average. Quality of earnings good. Dividend secure. Somewhat overvalued.

Free cash flow and other profitability trends:

SPG Profitability Graphs

WP Carey Inc (WPC)

Overall improving. Current Yield: 6.1%. Yield coverage by free cash flow: 1.5 times. Profitability trend positive, leverage trend positive, liquidity trend neutral. Below average growth. Financial strength above average. Quality of earnings very good. Dividend security stable. Fairly Valued.

Summary graph: though erratic, the free cash flow trend has been strong. Financial strength less so, but still more than adequate.

WP Summary Chart

REITs with insecure dividends in order of worst coverage to not quite as bad:

Bluerock Residential Growth (BRG)

Overall deteriorating. Current Yield: 10%. Yield coverage by free cash flow: negative 11.3 times. Profitability trend slightly negative, leverage trend exceptionally negative, liquidity trend exceptionally negative. Weak growth. Financial strength very poor. Quality of earnings very poor. Dividend not secure. Somewhat overvalued.

Summary chart:

BRG Summary Graph

Agree Realty Corp (ADC)

Overall deteriorating. Current Yield: 2.8%. Yield coverage by free cash flow: negative 5 times. Profitability trend exceptionally negative, leverage trend very negative, liquidity trend neutral. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Somewhat overvalued.

This is probably the most controversial conclusion in this report. Rarely do a company’s financial statement trends so starkly contrast its stock price history.

ADC Summary Graph

Five-year table:

ADC 5 Year

Comment:

  • On a 302% increase in revenues, operating free cash flow fell over one thousand percent.
  • Margins and asset turnover are all weak.
  • Debt increased 284% however equity increased 440%.
  • Interest coverage fell 23% however remains at an adequate 3.1 times.
  • The REIT is funding itself primarily by issuing shares. Net income increased 240% over the almost six years but earnings per share increase 19%.

Armada Hoffler Properties (AHH)

Overall deteriorating. Current Yield: 5.2%. Yield coverage by free cash flow: negative 4.2 times. Profitability trend exceptionally negative, leverage trend negative, liquidity trend exceptionally negative. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Undervalued.

AHH Financial Strength Trends

Investors Real Estate (IRET)

Overall deteriorating. Current Yield: 5.25%. Yield coverage by free cash flow: negative 3.7 times. Profitability trend slightly negative, leverage trend negative, liquidity trend exceptionally negative. Below average growth. Financial strength very poor. Quality of earnings very poor. Dividend not secure. Stock has no intrinsic value

IRET Financial Strength Graph

One Liberty Properties (OLP)

Overall deteriorating. Current Yield: 7%. Yield coverage by free cash flow: negative 3 times. Profitability trend very negative, leverage trend negative, liquidity trend neutral. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Somewhat overvalued.

OLP Summary Chart

Tier REIT Inc (TIER)

Overall deteriorating. Current Yield: 3.3%. Yield coverage by free cash flow: negative 2.1 times. Profitability trend very negative, leverage trend very negative, liquidity trend exceptionally negative. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Somewhat overvalued.

TIER FCF Graph

Summary:

Overall deteriorating. Profitability slightly negative, leverage trends positive, liquidity exceptionally negative. Financial strength poor. Overvalued. Dividend not secure.

Tier RIET 5 Year Trends

Observations:

  • On a 26% decline in revenues, operating free cash flow is down 115%; free cash flow per share down 484%.
  • Margins and profitability are highly volatile.
  • TIER doesn’t cover its interest income from operating free cash flow.

Tier’s financial strength trends.

TIER Financial Strength

Hersha Hospitality Trust (HT)

Overall deteriorating. Current Yield: 4.8%. Yield coverage by free cash flow: negative 1.4 times. Profitability trend very negative, leverage trend negative, liquidity trend neutral. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Undervalued.

Hersha’s financial strength trends:

Hersha Financial Strength

Hersha’s profitability trends:

Hersha

Condor Hospitality Trust (CDOR)

Overall deteriorating. Current Yield: 7.5%. Yield coverage by free cash flow: negative 1.3 times. Profitability trend exceptionally negative, leverage trend very negative, liquidity trend negative. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Overvalued.

Condor’s profitability trends:

CDOR Profitability Trends

Senior Housing Properties (SNH)

Overall improving. Current Yield: 9.5%. Yield coverage by free cash flow: negative 0.8 times. Profitability trend positive, leverage trend positive, liquidity trend exceptionally negative. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Undervalued.

SNH free cash flow trend (not good):

SNH FCF Trend

Five-year trend table:

SNH 5 Year Table

Comment: On a 73% increase in revenues over the almost six years:

  • Operating income went up only 2%.
  • Operating free cash flow went down substantially.
  • Debt went up 86%. Equity as a percent of debt went down 30%.
  • Return on assets went down 34%.

Ramco-Gershenson Properties Trust (RPT)

Overall improving. Current Yield: 6.8%. Yield coverage by free cash flow: negative 8.2 times. Profitability trend neutral, leverage trend very positive, liquidity trend neutral. Above average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Fairly Valued.

Free cash flow per share: the trend is positive, but still negative in absolute terms.

RPT FCF

RPT Annual

Observations:

  • Revenue is up 110% over the last almost 6 years, operating free cash flow declined from negative $2 million to negative $44 million.
  • Debt is rising faster than equity.
  • Doesn’t cover interest payments, let alone dividends, out of free cash flow.
  • Shares outstanding have grown from 18.5 to 79.5 million over the last ten years.

Piedmont Office Realty (PDM)

Overall deteriorating. Current Yield: 4.7%. Yield coverage by free cash flow: negative 0.77 times. Profitability trend negative, leverage trend negative, liquidity trend neutral. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Fairly Valued.

PDM profitability graph: Note how earnings, though volatile, are much better than actual cash earnings and returns.

PDM Realty

The poor free cash flow trends are reflected in declining financial strength:

PDM Financial Statement

UMH Properties Inc (UMH)

Overall deteriorating. Current Yield: 4.9%. Yield coverage by free cash flow: negative 0.66 times. Profitability trend very negative, leverage trend slightly negative, liquidity trend exceptionally positive. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Somewhat overvalued.

Five-year financial statement trends:

UMH 5 Year Table

On a 155% increase in revenues over the last five years:

  • Operating free cash flow is down 535%.
  • Earnings per share is down 591%.
  • Debt is up 266% versus a 164% increase in equity.

Highwoods Properties Inc (HIW)

Overall deteriorating. Current Yield: 3.2%. Yield coverage by free cash flow: negative 0.6 times. Profitability trend neutral, leverage trend negative, liquidity trend exceptionally negative. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Fairly Valued.

HIW Summary Chart

Cedar Realty Trust (CDR)

Overall deteriorating. Current Yield: 5%. Yield coverage by free cash flow: negative 0.4 times. Profitability trend positive, leverage trend positive, liquidity trend negative. Below average growth. Financial strength below average. Quality of earnings very poor. Dividend not secure. Undervalued.

CDR Summary

Value trend:

CDR Intrinsic Value

Pennsylvania Real Estate (PEI)

Overall deteriorating. Current Yield: 9.1%. Yield coverage by free cash flow: negative 0.08 times. Profitability trend positive, leverage trend negative, liquidity trend neutral. Weak growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Overvalued.

PEI Summary Chart

Universal Health Realty (UHT)

Overall deteriorating. Current Yield: 0.04. Yield coverage by free cash flow: negative 0.07 times. Profitability trend slightly negative, leverage trend negative, liquidity trend negative. Below average growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Somewhat overvalued.

UHT Summary Chart

Owens Realty Mortgage (ORM)

Overall deteriorating. Current Yield: 3.7. Yield coverage by free cash flow: 0.63 times. Profitability trend exceptionally negative, leverage trend very negative, liquidity trend positive. Weak growth. Financial strength poor. Quality of earnings very poor. Dividend not secure. Fairly Valued.

ORM Summary Chart

Brookfield Property REIT (BPR)

Overall deteriorating. Current Yield: 4.7%. Yield coverage by free cash flow: 0.8 times. Profitability trend very negative, leverage trend very negative, liquidity trend neutral. Below average growth. Financial strength poor. Quality of earnings below average. Dividend not secure. Overvalued.

BPR Summary Chart

Methodology

Risk Research Inc. focuses on risk and quality: identifying, quantifying and understanding degrees of risk and quality in client portfolios. We follow changes in the hundreds of financial statement trends that ultimately determine return on capital, leverage and liquidity. At the center of our process is an emphasis on free cash flow, or cash (rather than GAAP) earnings. Free cash flow is defined as net income (after deduction of one-time tax credits related to recent tax cuts) plus depreciation minus five-year average capital expenditures. For REITs growing at least 5% per year, we use five-year minimum capital expenditures rather than average. No adjustment is made for fluctuations in inventory or receivables, although those are the primary considerations in our quality of earnings assessment. Our approach assesses a premium to companies that can grow with disproportionately small capital expenditures.

Summarized, our risk/reward weighting:

  1. RISK
  • Stability: Free Cash Flow and Stock Price (25% weighting)
  • Balance Sheet Strength (25% weight)
  • Balance Sheet Trend (25% weight)
  • Quality of Earnings (25% weight)

To that total we increase the risk rating for overvaluation (in relation to historical trading range) as overvaluation adds to risk, and deduct for undervaluation (up to a total of 23% one way or another).

In addition to those criteria, we heavily penalize companies with three characteristics, regardless of balance sheet trend and strength:

  • Latest quarter free cash flow negative.
  • Two quarters return on capital decline from prior year, same quarter.
  • Trailing twelve months return on capital lower than prior twelve months.

(2) REWARD/UPSIDE POTENTIAL

  • Return on Capital (Equity for Financial Companies) (20% weight)
  • Balance Sheet Trend (20% weight)
  • Quality of Earnings (20% weight)
  • Return on Capital (Equity for Financial Companies) Improvement (20% weight)
  • Growth (20% weight)

There are overrides on some of these criteria. For instance, if Apple’s liquidity trends were adverse (they are), but the company still has more cash than total liabilities (it does), the relevant consideration is current position not trend when considering overall financial strength.

Price-To-Intrinsic Value

We reach an estimate of intrinsic using these criteria:

  • Based on average fifteen-year (if available, shorter period if not) price-to-free cash flow ratio. So, if a company had an average price to free cash flow of 30, and earned $1 over the last twelve months, the value indicated by this measure would be $30.
  • Free cash flow discounted at 6.67% (P/FCF ratio of 14.7), the value indicated by no growth companies in the current low interest rate environment. We include this conservative measure to reflect the possibility, even if small, that the subject company will experience no growth over the next year or two. A company earning $1 per share would, by this measure, be worth $15 per share.
  • PEG ratio applied to free cash flow. If a company is growing at 20% a year and earned $1 in free cash flow over the last twelve months, we would estimate value at $20 by this measure. If a company is growing at less than 14.7%, we use 14.7% as that is the long-term average ratio of the overall market, although the average growth of public companies is just under 10%.
  • Dividend value as indicated by current dividend yield divided by average dividend yield over the last fifteen years. If a company on average yielded 2% over the last fifteen years, and now pays an annual dividend of $0.50, we would estimate value at $25 by this measure.
  • Value based on fifteen-year average price to book times current book value. If a company is not currently earning money, we base value on the minimum price to book over the last fifteen years. For example, a company that lost $1 in the last twelve months, and had a minimum price to book of 1.7, and a book value of $15, would have an estimated value by this measure of $25.50.

To receive a free report on the financial statement trends of each of the 212 REITs, or to learn more about our methodology, and the influences underlying it, visit our website, www.risk-research-inc.com.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

Additional disclosure: This article assesses the financial statement trends, financial strength and dividend stability of publicly-traded REITs. It is designed to complement research and analysis rather than be a sole source. Before acting on this analysis, you should do your own due diligence, and consult your financial advisor who is familiar with your individual objectives and risk-tolerance.