by Travis Johnson, Stock Gumshoe | December 13, 2013 5:32 pm
I have a hard time jumping up and down and urging anyone to buy anything at this particular point in time — the market is not cheap, stocks with any kind of top line sales growth are expensive, real estate is being propped up by low interest rates that are likely to ease, and commodities are faltering in some cases (oil, natural gas) and completely collapsing in others (gold). The only stocks that look like real bargains are commodity-related in one way or another, and I probably already cover those sorts of stocks too often already — in addition to being overweight them in my own accounts.
I’m a long-term investor, and I usually buy stocks intending to hold them through both up and down cycles as long as my confidence in their business and their future growth remains strong, respecting the power of compounding income (especially compounding dividends) and the inability of any of us to accurately predict future stock movements to any degree of specificity. But there are definitely times when I want to hold more cash in my accounts and wait for bargains. This feels like one of those times.
And that’s a problem for me. I don’t like to hold cash. It’s one of the few things that I know for sure will be less valuable in a decade than it is today. Of course, I’ll still be able to pay my mortgage and buy groceries with it next month or next year, but over the long term the value of the dollar versus hard assets or other currencies is in a usually steady and slow decline. That’s how it’s designed, that’s the point of inflation — to make people feel good about rising incomes and keep money flowing so that you won’t hoard it. Hyperinflation is obviously terrible for most people and most asset classes, but a nice mild 2-3% inflation like the Fed would like to have is just what the American economy thrives on. And assuming we get back to that, savings will gradually erode in value and we ought to be doing something productive with our money — buying a business, buying income-producing assets, helping someone else. Money that’s just sitting is the bane of our economy … and though inaction is often the best choice for an investor in uncertain times and pricey markets, it’s not a natural one.
So this month I can tell you about what I’ve done with my money lately — I’ve added some income-producing real estate in the form of shares of REITs, both a hospital REIT (MPW) and a data center REIT (COR), both of which I wrote about in passing recently, and I picked up some shares just today of one of the floating rate closed-end bank funds (EFR). I won’t put all my cash to work, but when pretty solid assets are yielding 6% and are near their lows because of (probably overdone) fears about interest rate rises, I’m willing to trickle some more cash into those assets. More on that in a moment.
I’ve also sampled a couple Bitcoins to see what that “Virtual currency” is all about, which is definitely not a fundamentally justifiable move that I’d suggest to anyone else — Bitcoin is an interesting money exchange technology and at least a nice exercise in creating currency scarcity through controlled creation (as opposed to the dollar’s mostly uncontrolled potential inflation through fractional reserve banking), but it’s too crazy to be a currency for transactions (value per coin has ranged from $650 to $1100 in the week I’ve owned Bitcoins) and it’s too young to be a “store of value” so I’m mostly owning it so I can learn more and watch it — and I suspect virtually everyone who owns it today is either a day trader or a speculator.
I used Coinbase, by the way, as the “virtual wallet” through which to buy my coins, I’d stay away from the big Japanese exchange Mt. Gox and avoid relying much on its pricing if you’re in the US, they’ve had some dollar-exchange restrictions that have inflated their pricing and they’ve also had lots of lags and downtime and, despite what you hear about Bitcoin being a freer system with cheaper transfers, there’s still a fair amount of friction in fees involved for most folks when it comes to moving your money between exchanges or from dollars to Bitcoins and back. I don’t know that Coinbase is the best, but they’re well-funded and they were the easiest one to get started with, and my experience with them has been good so far (and they just raised $25 million from some smart VC firms, so there’s a bit of institutional endorsement there as well). If you want to try it out, you can use my referral code and get $5 back from them (I’ll get $5, too). For tracking general pricing movements, I found the most useful site to be BitcoinAverage.com
I see Michael Robinson going bonkers promoting Bitcoin to his potential subscribers lately, so this is really getting into the investment newsletter mainstream, but I definitely wouldn’t urge you to mess around with Bitcoin with anything other than “play money” right now. Bitcoin could easily fall dramatically, like 90% dramatically, if there’s real regulatory pressure in the US or China, and though it’s roughly where it was when I bought around $850+, it has since also seen $1,100 and $600 and it’s only been a week. No one is using it to buy or sell, it’s all being traded and hoarded, and as we’ve seen with daytraded and promoted stocks that don’t necessarily have a fundamental base value the crowd psychology can move quickly if lots of folks suddenly think it’s time to get out (that’s not to say Bitcoin as an idea has no value — but it is just an idea and a self-limiting money exchange coding system, any assessment of what that value is has to have huge guesses incorporated). It’s also a very murky and unregulated world still that I don’t trust entirely, with unpredictable downtime and delays at the trading exchanges and with more nefarious problems always a possibility. Play and learn if you like, that’s what I’m doing and I’ll share more about my experiences in the future … but don’t plan on it replacing the dollar or gold anytime soon.
So I was thinking about a few different ideas for you this week — I’m getting more and more comfortable with the Africa Opportunity Fund (AOF in London, AROFF on the pink sheets) as a publicly traded value investing hedge fund for that continent, but it’s not at a huge discount to net asset value at the moment so there’s no reason to jump immediately … and it’s kind of hard to trade for most folks. And I’ve also been looking at Linc Energy (LNCGY) now that it’s been beaten down, is moving from the Aussie exchange to Singapore, and is spinning off its coal division and maybe even spinning off its us oil and gas division to focus on coal seam gas and, eventually, on that huge shale oil deposit in the Arckaringa basin that Dr. Moors was teasing a year ago. But there seems no great rush on Linc, either, so it’s largely a speculation right now on whether or not they’ll get a big partner on board to fund the shale oil exploration campaign (it’s taking longer than investors thought it would, but that’s not unusual) and on what the value of the coal spinoff will be — along with, of course, some uncertainty about how it will trade in Singapore. I think there’s a chance for a really substantial boom in those shares, particularly if they get a big shale exploration deal and fracking gets a real stamp of approval in Australia — but those are open questions when you’re drilling beneath the biggest aquifer on the driest continent, so it’s really tough for me to value right now. I admit to being tempted to speculate on this one myself, based on potential that the coal spinoff will really unlock value and the possibility that they really will get a partner to commit several hundred million bucks to drill and flow test under Coober Pedy, but it would just be a speculation at this point and I haven’t bitten yet.
So to be frank, I was finding it hard to build up a head of steam for any topics for our “Idea of the Month” this time around. Which is when we got what I think is a little gift from some dips in the prices of a few picks that I think are reasonable “gradually rising rates” plays — particularly Medical Properties Trust (MPW), which fortuitously dipped a bit below $12 to give us a 7% yield.
A sign from above? Well, probably not — but at a yield of better than 7% and with substantial growth in their cash flow quite possible thanks to their spread over their borrowing costs and their recent acquisitions I think this recent purchase of mine is an attractive idea. So we’ll focus on Medical Properties Trust this month.
Folks have been gradually waking up to the realization that the bull market in bonds is over and that recent retirees or near-retirees can’t just move more money into bonds each year and expect their income yields and portfolio stability to improve gradually. We’re done. Bonds are going to go up in yield at some point (they can’t go down much), and bond prices move in the opposite direction so most bonds, instead of buttressing a portfolio, will make portfolio levels fall as interest rates rise.
Now, interest rates may not jump right back to 5% on the 10-year bond anytime soon — and probably won’t be re-testing those 1980 highs of 12-14% — but they’re not going to stay down here in the 2.5% range forever and they will probably not spend a lot more time at less than 2% unless a giant crater opens up somewhere in the global economy. So if bonds are flat, you get a lousy yield from here … but if bond rates rise as the economy recovers or as someone finally manages to create some inflation, bonds will lose value. A lot of value. If you consider just the 10-year bond, think about what happens if you bought one this year for $1,000 that carried a 2.5% yield. You’re guaranteed to get that $25 per year coupon for ten years, and to get your $1,000 back at the end of the ten years, but there are no other guarantees about the price at which you can sell the bond in the interim. If next year the 10-year bond carries a 3.5% coupon (which would be a sharp rise, but certainly is within the realm of possibility — there have been bigger jumps this year), then anyone you try to sell your bond to next year is going to want to earn $35 for each $1,000 they invest. That $10 a year doesn’t sound like a big difference, but it dramatically impacts the price at which you could sell your bond — if you had to sell your bond, you’d end up having to take roughly a 10% haircut and sell it for $900(ish). That’s a rough approximation, but it serves as an example of what worries bond investors now.
That’s why everyone is afraid of long-term bonds and telling you to stick with short-duration stuff that matures in a few years or less, and why investors have scooched out the yield curve in search of higher yields, which mostly means taking on more credit risk (that is, the risk that you won’t be paid back instead of the risk that interest rates might rise). Generally, the longer the bond’s term and the lower the rate, the more sensitive it is to increasing rates.
If you’re going to be taking on considerable credit risk anyway to get a decent yield, I think it’s better to take on credit risk in a security that can raise its coupon — which usually means buying equity in a company that can make more money as rates rise. And I think Medical Properties Trust fits the bill on this front, but I do think it’s also worth noting that we’ve also finally seen the prices of floating rate funds come down a bit too and those are starting to look a bit appealing — the Eaton Vance Senior Floating-Rate Fund (EFR) is my favorite in that group and the one I bought recently, and, like Medical Properties Trust, it’s tickling around near the 52-week low. 52-week low, inflation protection, rising rate protection, and a yield of between 6-7%? That all sounds like a recipe I want a little taste of — I bought a little bit of EFR for the first time this morning, and I also added a few more shares of MPW to average down on that position.
There’s a lot of fear floating around regarding REITs and most other income-focused investments — that’s because our credit markets are still so artificially suppressed, with interest rates so low, and there’s a fear that rising rates will hurt REITs. They might, particularly in the short term, but it’s worth remembering that unlike bonds, REITs as a broad asset class have proven their resilience in times of raising rates and inflation — the folks at Cohen and Steers are certainly biased toward real estate (they run a bunch of real estate funds), but they’re not lying or making up numbers when they say that REITs have outperformed stocks substantially both when the 10-year rate has been rising and when the Fed Funds rate has been rising over the last 35 years or so (they put out a report on that earlier this year).
We don’t even think much about the Fed Funds rate anymore, it’s been effectively at zero so long, but it will rise again someday (though Wall Streeters aren’t allowed to think about “someday” — they have to worry about December and January first and whether the Fed’s bond buying program “extraordinary measures” and quantitative easing will come to an end in December or in January or in March or whenever). But as individual investors we can enjoy the benefit of being focused on the long term and being rational — over time, owning valuable real estate works. That doesn’t mean you can pay any price for that real estate and have it work out, so there’s always some fear that low interest rates have distorted the prices of these assets and forced companies to pay too much, but I’m not particularly worried about that in the case of Medical Properties Trust and most of my other REIT investments.
So … why Medical Properties Trust (MPW)?
This is the biggest hospital-focused REIT — there are several other real estate investment trusts in the health care sector, like Ventas, Health Care REpit, and Healthcare Realty Trust, but they are all focused on other segments — mostly senior housing, skilled nursing care, or medical office buildings. Medical Properties Trust is focused on acute care hospitals, rehab hospitals, and long-term acute care hospitals — more specialized properties that require expertise but are also a little bit more profitable.
They have grown fairly quickly in the past decade, from fewer than 20 facilities in their first years to more than 80 now, and I think the company gets underlooked for a few reasons: They have no history of dividend increases because they cut the dividend during the early days of the 2008 crisis and then froze the dividend for about five years, and they have not been a rapid grower because they failed to execute many deals in 2008-2011 when funding was scarce. Just as the company started heating up with more deals and acquisitions, showing substantial revenue growth, the market started to panic about interest rates about six months ago and helped to drive the shares down again.
I think that’s a mistake. I think this is a growth company hiding inside a flat-yielding REIT — and actually, I think the dividend is likely to increase in the future as well (the first sign of that was the one-cent rise this past quarter, which is what flagged me to the stock and got me to buy shares for the first time). I like that the company is the go-to for hospitals as a financing partner, since they can provide much greater financing than a bank and do so more quickly and flexibly, and I like the company’s focus on increasing diversification in their portfolios — not only moving beyond their core comfort zone with the few hospital chains they started with, but getting into other regions of the country and expanding internationally with their first foray into Germany.
How stable is the value of their portfolio? Hospitals are particularly valuable, critical to communities, and hard to close or move — that doesn’t mean they can’t have losing deals or see tenants leave when their leases expire, but these are specialized and expensive physical plants and hospitals rarely move within a community. And very few of them go out of business in any given year.
In most cases their facilities are on 20 year leases, a few shorter and some longer, so there are fewer than 2% of their leases maturing in any given year until we get into the 2020s. When leases mature, the hospital has a repurchase option or can extend for five years at pre-set escalations in rent, or they can vacate the hospital but they’ll typically have obligations to transition the business to a new operator if that’s the case. In 10 years MPW has had five operator failures for total losses of $12 million (that’s out of $3.5 billion in investments, and out of 115 deals) — none of those properties are sitting vacant or worthless now, the $12 million is just the total losses they absorbed in selling those properties, getting new operators, or redeveloping the properties — the $12 million in losses came from MPW investments that had totaled almost $300 million, so they were far from total losses.
MPW, as a company that’s as much health care focused as it is real-estate focused, also concentrates on doing deals with the best operators — the goal is not to just get their value recouped by the value of the property if the deal goes bad, but to make deals with strong operators who have good and stable reimbursement rates (from Medicare and private insurance) and are in critical areas where demand will remain high (urban and suburban areas, not many rural hospitals). Many of their deals to increase the size of the portfolio have been from helping existing customers to expand, so they really act as a specialized banker for hospitals and rehab centers. Health care is a growing part of the economy, but many health care operators have a hard time raising funds to do needed expansions or bring on new staff or new equipment — MPW can help with that by offering up front cash in exchange for a 20-year triple net lease.
And how about inflation protection? Well, MPW is not going to offer quite as robust a response to inflation as the more cyclical REITs will — apartment and hotel REITs can raise rents almost instantly when inflation hits, office owners often take a little longer, but companies like MPW that offer up triple net leases generally have long-term leases so the rates can’t skyrocket in any given year like they could for an apartment in a hot urban area. They do, however, have inflation protection written into their leases in the form of annual escalations or adjustments. Almost 80% of their investments have CPI-based annual increases (about half are just to match CPI, the other half have a collar and can go up between 1-5% or so), and the rest have fixed annual increases that average 2.5% per year.
The risk comes, generally, if MPW sees their net margins decrease because their borrowing costs (they are roughly 50/50 capitalized by debt and equity) catch up with their lease income. They are not reliant on constant turnover of short-term debt, though, so it’s not as if a bad year of interest rates will markedly change their business — they have undrawn credit lines now and about $300 million in debt maturing over the next two or three years, but then most of their larger maturities go out to 2020 or later. Aside from one mortgage that matures in 2018, their debt is all unsecured. Debt is about 5X EBITDA, which is their target, and their dividend payout ratio is currently just a hair above th eir target range of 75-80%, so they have some flexibility and excellent long-term cash flow.
Medical Properties Trust is likely to continue growing with new deals, they’ve got $350 million available to invest now (including their credit line) and they’ve stepped up acquisition quite substantially in the low interest rate environment of the past couple years. I’m encouraged that they’ve expanded into Europe, but I think hospitals in the United States will be in excellent shape financially with a substantially smaller number of uninsured patients, and I expect many hospitals will see the need to raise cash to deal with modernization or with regulatory requirements, and that will send more of them to MPW for financing. The underlying truths of the health care business, that there will simply be dramatically more customers as populations age in the US and in Western Europe, mean that a good operator should be able to show solid growth — and I think MPW looks like a good operator with a unique financing niche in their specialized corner of the market.
They’re not perfect, the stock can definitely go down, but I think we will see a slowly rising dividend — and if you are able to buy it at $12 or less for a 7% current yield you might be able to enjoy some very substantial compounding benefits as they enjoy the fruits of their current and anticipated expansion. If you think the next crisis is likely to be like the last one, with a freezing up of the debt markets, then MPW will take a big hit if that happens — and they’ll also see their shares fall if we get instant hyperinflation and rates are at 10% in two years … but I tend to believe our next crisis is unlikely to be like the last one, and I think owning high-quality hospitals with good operators and long-term CPI-adjusting leases will work out very well. They are likely to earn $1 in Funds from Operations (FFO, the term REITS usually use instead of earnings) this year and probably on the order of $1.10 next year, so the current valuation is attractive and there should be room for more small dividend raises in future years as they make accretive acquisitions, the interest-rate sensitivity is probably overstated, and if you buy now you get that 7% yield plus you get to pay less than I did and less than Louis Navellier did for these shares. I plan to hold this one for a while.
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