Seeking Alpha

My 2019 Adventure In Preferred Stocks

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Includes: AHT, CBL, DSX, GLOP, GMRE, GNL, HT, QTS, SB, TGP, TNP
by: R. Paul Drake
R. Paul Drake
Portfolio strategy, dividend investing, REITs, closed-end funds
Summary

In early 2019 I invested in a basket of preferred stocks, seeking income and appreciation.

This article shows how the strategy ended up doing well enough overall.

I discuss my disappointment in my thinking about CBL-E through my portfolio changes.

I had some fun and made some money with preferred stocks during 2019. I bought a basket of them in January and February and sold nearly all of them in August through October, and one more recently.

Perhaps I should have sold the other one too. It is CBL-E, and they just suspended dividend payments on their preferred stocks.

Reflecting on my decisions about that case may help me generate clearer thought in the future. I’m OK with the outcome; I just don’t like my clarity of thought at the time.

In early 2019, for reasons that don’t matter here, I had about 20% of my investment portfolio available for some use, in the hope of making a profit.

In retrospect, I could have done better this year in an S&P 500 index fund, and indeed I made some money that way. But this year the S&P 500 was a hot investment. I know from years of experience and observation that trying to pick the hot investment of the moment is a good approach to generating cold returns.

As it happened, when Mr. Market decided to run away from common stocks through the latter part of 2018, he ran away from preferred stocks too. Many of them dropped in price to an unreasonable degree.

I was slow on the uptake. That was not about investments but rather about my unexpected transition to a place where clearly, for health reasons, in was time to head into retirement. I had expected to work another five years; my failure to do so generated a need to pay a lot more attention to generating returns with the funds I did have.

As it happened, preferred stocks in general took a couple of months, or more, to recover from their severe downward move though December 2018. This made it sensible to invest, even starting in mid-January.

What Preferred Stocks Are

If you are new to preferred stocks, I provide a description and a link to additional information here. REIT preferred stocks pay rates well above Treasury rates. Figure 1 shows that, since the Great Recession, the average difference is above 400 basis points (4%).

Figure 1. REIT preferred stocks have paid significantly more than Treasury bonds. Source.

Why Preferred Stocks Got Cheaper

In the fourth quarter of 2018 Mr. Market soured on common stocks in general, as Figure 2 illustrates. Recession fears, trade war fears, and fear of fear fed on itself, leading as usual to a stock market correction.

Tax-loss selling near year end exacerbated the market decline, taking prices to the edge of the usual threshold for a bear market. But the thing about Mr. Market is that he does not think well in emotional times.

If you like sports and watch sports TV, you can see this behavior a lot. Whichever team won yesterday is the greatest of the year. Whichever game seems like a good one this year is the game of the century. ESPN’s Mike Greenberg often describes himself as a “professional over-reactor”.

Mr. Market can give Mr. Greenberg a run for his money. Mr. Market almost invariably reacts as though today’s bad news presages larger and worse follow-ons.

More to the point here, Mr. Market is a deep expert in guilt by association. When oil prices drop, the price of every company connected with oil drops, whether or not they are actually affected by oil prices. When a small fraction of retail stores fail, Mr. Market reacts as though a large fraction of them are headed into bankruptcy.

ChartData by YCharts

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Figure 2. This behavior of the S&P 500 in the fall of 2018 drove Mr. Market to panic about preferred stocks. Source: YCharts

As a natural result of Mr. Market’s personality, preferred stocks in general were beaten down beyond all reason in late 2018. Even Barron’s noticed. This presented a good opportunity for those seeking total return combined with good income.

The Strategy and What I Bought

I decided to invest in a basket of preferred stocks paying relatively high rates. Both aspects of this choice deserve some explanation.

To my mind, you cannot expect to predict well the fortunes of a single company. Too many factors are beyond your knowledge or control.

In this context, I favor buying a basket of securities in some sector that I believe is undervalued by Mr. Market. Amongst others, preferred stocks were in this category at the end of 2018.

I chose to seek relatively high-yield stocks, accepting the associated additional risk. This reflected a perspective I still hold, that one sensible approach to retirement spending is to be unafraid of failures while spending down a very widely diversified and comparatively high-yield portfolio. I modeled this and published the idea in early 2019.

The strategy was to buy a basket of undervalued preferred stocks with attractive yields, and then to reap the income and enjoy their return to full value until such time as I decided to sell. I considered it possible that I would not sell, but instead let them be called in due course.

Tables 1 and 2 show what I bought, with the average size of a full position normalized to about $10,000. Table 1 shows the collection of REIT preferred stocks.

Table 1. My collection of REIT preferred stocks, as of mid-October. Those in yellow are discussed further in the text. Source: author

I focused on diversifying across REIT sectors, as indicated. I avoided companies I did not find convincing. I was deliberately overweight the mall sector, which has three of the 12 positions. This reflected my conviction, then and now, that the myth of the retail apocalypse was overdone.

At that time, the stock from CBL & Associates (CBL) was the highest yield and highest risk stock in the basket. Leaving aside the mall REITs, some of the other companies I chose have issues that make the preferreds perhaps a better choice than the commons.

Examples of this include preferred stocks from the hotel REITs Ashford Hospitality Trust (AHT) and Hersha Hospitality Trust (HT), notoriously vulnerable in recessions and Global Net Lease REIT (GNL), notorious for its dilutive issuance of equity. Global Medical REIT (GMRE) is at risk from its small size, while QTS Realty Trust (QTS) lives in the shadow of Amazon Web Services and other big players in data.

As I became increasingly attracted to investment in REITs, I joined High Yield Landlord in March. I was pleased to find substantial overlap between my collection of preferreds and those chosen there.

Table 2 shows my collection of shipping and energy preferred stocks. Here again, I sought to diversify across sectors and to avoid companies I did not find convincing. For dry bulk shipping, I could not decide between Diana Shipping (DSX) and Safe Bulkers (SB), so I split that position.

Table 2. My collection of shipping and energy preferred stocks. Source: author

Things to like as a preferred stock investor in shipping stocks include long call dates [2027 for GasLog Partners (GLOP), Teekay LNG Partners (TGP), and Tsakos Energy Navigation (TNP)]. In addition, I tried to choose companies that pay serious attention to supply and demand cycles, hoarding cash and not overbuilding in good times.

My overall basket had 19 positions. It paid a yield on cost of 8.4%, with the individual yields varying from 6.3% to 13%.

When and Why I Sold

I reaped the anticipated gains through the spring as the prices on these stocks went back up toward par. I also collected the dividends.

By August, after a good bit of further study, I had decided to establish a basket of mall REIT investments and a taxable basket of midstream MLPs. Here again, my point of view was that Mr. Market was significantly undervaluing these categories of security.

For reasons unimportant here, my only option was to use funds from the preferred stocks. One of them had been called in July. I sold out 8 of the remaining 18 positions August and another 8 positions in October.

In October I also chose to establish a basket of shipping stocks. I did this from a similar perspective that the sector was undervalued. I had become convinced that there seems to be a supply and demand imbalance that will persist for a while and drive income and valuations upward.

This left me with 2 positions, AHT-I and CBL-E. I did not need the funds from these, but sold AHT-I in December after collecting their Q4 dividend. This made additional funds available for year-end investing.

By mid-October, my preferred-stock strategy was essentially complete, with results shown in Table 3. Valuing the remaining securities as-of mid-October, the strategy generated an annualized rate of return of just over 14%.

Table 3. Results of the 2019 preferred stock strategy. Source: author

That total return is satisfying. The strategy was a success. I also don’t mind having held on to the AHT-I, which is and was a good place to park some cash.

The lower line in Table 3 shows the preferred-stock results as of early December. The human held onto the CBL-E and it has recently lost a few $k in value following suspension of its dividend. I next consider why I held on to the CBL-E and what kind of investment it is now.

Thinking About CBL-E

In the context of the preferred stock strategy, I am surprised that I held onto the CBL-E in October.

I don’t believe in hanging onto losers. I’ve sold them before. Holding onto them is a well-known way that individual investors tend to underperform.

My best guess is that I would have sold CBL-E if it had not been a mall REIT. One never really knows, though, does one?

As it happened, I had been putting a lot of energy into understanding the mall REITs. I am bullish on all of them, even CBL, for reasons well described in recent articles by Marel and by Dane Bowler.

But CBL has clearly been a challenged company, with regard to both their operating profitability and their debt structure. My investment in CBL common is quite underweight compared to the other mall REITs. More importantly, I consider the investment in CBL common to be in my “Las Vegas” bucket, not in my mall REIT basket.

What bothers me in retrospect is that, upon selling out of the preferred stock portfolio, I did not ask what the role of CBL-E was in my portfolio going forward.

Did I expect a high reward from holding it? Perhaps, though not with high odds. Did I expect the dividend cut that came? No, but perhaps I knew it could happen.

What’s clear today is that CBL-E is in the Las Vegas bucket along with CBL common. Thinking about its status in October might have led me to book the loss to date with the preferred strategy and ask how large I wanted the Las Vegas bucket to be. Perhaps I would have sold some; perhaps not.

What I want to do better at next time is to ask the question and to think it through.

Portfolio Implications

Preferred stocks, especially in passthrough entities like REITs, are a good way to find steady income. They make sense as part of most portfolios. For the next couple of decades, they will keep making a lot of sense relative to most bonds, as I discussed here.

When Mr. Market throws a tantrum, you can at times pick up preferred stocks at an unreasonably low price. Doing so then is a good idea.

As your strategy or circumstances evolve, it is worthwhile to consider again the role that each security has in your portfolio.

Disclosure: I am/we are long WPG, TCO, MAC, PEI, WPG, CBL, AND SKT, TGP, GLOG, AND TNK. 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.

Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.