by Travis Johnson, Stock Gumshoe | May 26, 2017 4:37 pm
Lots of folks have been asking me about Bitcoin and Ethereum and the other alt-currencies of late, for obvious reasons (well, it’s obvious why folks are curious about it — far less obvious why anyone would seek my wisdom on the subject)… so I’ve got an extended bit of blather about those currencies to share (if you find them completely uninteresting, or don’t care what I think, just scroll down a bit and I’ll start talking about REITs and interest rates to jazz things up).
The reason for interest is clear: The prices of most cryptocurrencies are soaring (though coming back in a little bit here as we close the week) — the total amount of cryptocurrencies/alt currencies in existence now exceeds $80 billion in value, according to CoinMarketCap.com, up from close to zero five years ago and about $10 billion just one year ago.
Close to half of that “value” is in bitcoin itself, which is the pioneer and still by far the largest, but the other alt-currencies are growing dramatically faster and being launched seemingly every day — the “ex bitcoin” alt currency market hit one billion dollars just over a year ago, in February of 2016, and has now topped $45 billion, with much of that gain from cryptocurrencies that didn’t even exist a year ago.
My initial reaction is “that’s crazy.”
And I’ve commented on it in the past few days to a few readers who have asked, but thought I would expand on those thoughts a bit for you today.
To me, this still has all the hallmarks of a mania… particularly with all the new currencies that are surging up to compete with bitcoin and ethereum and the other larger markets, with the reason for their existence seemingly (to a non-expert here, I should admit) being “hey, here’s another one that’s cheaper and might go up!”
But just because it’s a mania, doesn’t mean I have any idea when or how it stops — or any reason to be convinced that it’s actually a bubble (the key determinant of a “bubble,” of course, is that it pops — which you can’t generally be sure will happen until it has happened). The same “that’s crazy” reaction would have been perfectly reasonable when bitcoin went from a few cents to $10, then to $100, then to $1,000, and it seemed safe to write it off for a while as it fell back to $200… but now here it is at well over $2,000 per bitcoin.
I’ve shaved off profits from my cryptocurrency positions as they’ve surged over the past few months, since I don’t have any real confidence in them as a “store of value” if sentiment turns even slightly, but I sure don’t know where the top is and I still hold some bitcoin, ethereum and litecoin as I watch the fireworks.
It is a fascinating thing, to think about the evolution of money from something of physical durability and natural scarcity (gold and silver, among other things), to an idea backed by the “full faith and credit” of a nation as fiat currencies without “hard asset” convertibility took over the world 50 years ago, led by the US Dollar, to now this new idea supported by mechanically controlled scarcity and security, without any central authority, and without any implied promise beyond scarcity and security. And, frankly, still without a lot of practical use because of the limited number of users, the dozens of different cryptocurrencies, and the wildly volatile price (I could accept bitcoin for my business, for example, but just as a transactional convenience — I wouldn’t hold the rent money or other working capital in bitcoin for even a few weeks. I’d have to accept it and convert it back to dollars instantly for fear that it might fall 50% before I can pay my suppliers or employees, and would have to adjust prices in bitcoin constantly to have my revenue stay in some harmony with my expenses).
There’s a great article in the latest issue of Grant’s about bitcoin, with the apt headline “I own tulips at 40 cents a bulb” — Jim Grant is obviously skeptical, his feeling has always been that we should rebuild monetary stability off of gold, and I’m probably closer to his camp than I am to the true bitcoin believers, but he interviewed several folks who continue to speculate in bitcoin and several other cryptocurrencies because they think the almost unlimited potential is worth the risk of complete failure.
The most cogent argument in favor of the alt-currencies is along the lines of, “the global monetary system is in serious trouble, something has to change, maybe this will be the change” … and the biggest worry for bitcoin users (other than swings of sentiment) is likely regulation. Does bitcoin remain a small issue for governments to keep an eye on, with new tax policies being publicized to clear up how bitcoin trading will be treated by the IRS? Or does it become a large enough thing that it’s effectively a black market payment platform and a tax avoidance tool in the US and an avenue for capital flight in countries with much more repressive financial policies (like China)?
If it’s a small issue, you just report your gains and losses and pay your taxes and follow the rules, and the government smiles at your hobby… if it becomes a big issue, the US could require much more intrusive reporting and regulation, and China, if it wished, could effectively shut down bitcoin trading for their residents tomorrow and the price could fall by some massive percentage (other countries would have more of a challenge, of course, but China has a pretty tight handle on internet traffic, on which all alt currencies depend).
Marin Katusa also posted a diatribe against bitcoin about two weeks ago — which certainly doesn’t mean the price can’t go up (bitcoin is up almost 50% since he first tweeted that “sell bitcoin, buy gold” sentiment).
I still think bitcoin and its fellow cryptocurrencies are probably the most “pure” expressions of sentiment and investor psychology in existence, given the fact that I think their only real objective value is some combination of “mass adoption” and “controlled scarcity”… and having a substantial amount of your portfolio in something that is the embodiment of sentiment is frightening. That’s true when your portfolio is dominated by business-less stocks like Pets.com in 2000, and also true when your portfolio is dominated by a stateless and impractical “foreign” currency whose value has surged by 1,000% in a year for no obvious fundamental reason other than “more people want some now.”
I fear there’s a non-trivial chance that this ends up like the Beanie Baby craze, only without you having a little stuffed elephant to snuggle at the end. Nobody needs bitcoin, they want it — either because they have strong feelings about the technology or their government’s handling of their currency, because they’re trying to operate outside the view of their government, or simply because “it’s going up” or “it’s the future.” I appreciate the reasons why a global, controlled and secure digital currency would be appealing… but I don’t think governments will accept a real cryptocurrency if it grows large enough to threaten their franchise in moneyprinting. And if it’s not going to become a really viable medium of exchange… well, what’s the point?
If it’s just “something scarce that’s not controlled by a government” that you’re seeking, I’d put more faith in gold in the long run (really long), and I still have probably 10X more precious metals exposure than I do cryptocurrency exposure in my portfolio, though that ratio has shrunk as the price of bitcoin and ethereum have soared. Governments could and have controlled gold, of course, but they’ve done so with laws — the same thing could absolutely be done with cryptocurrencies, governments could seize them or make them illegal or otherwise drive them underground (as gold trading was a black market thing in the US for decades, for example). You can hide bitcoin, it probably wouldn’t disappear under government pressure, and some networks are beyond the reach of any one government, but is bitcoin really going to be popular and expensive if the government actively tries to shut it down or slow it down or makes it somehow illegal? I guess you could sew a memory stick into your hem the same way families smuggled gold coins out of Europe in the face of the Nazi advance, but somehow it seems different.
On the other hand, gold is very unlikely to go up by 1,000% in a year, as many of the cryptocurrencies have done. The market for gold is mature and physical and relatively high-friction.
There’s some substance and backing to gold that could provide a real foundation, mostly because of its long history in human society. Gold has been used and coveted by humans for thousands of years now, almost long enough to become a part of the evolution of our species. I exaggerate a little there, evolution is unfortunately far slower than technological advancement (otherwise we’d be much better investors and make more rational decisions more often), but to some extent gold is hard-wired into the brains of many of the largest societies of humans on the Earth as a valuable asset. I’d be quite confident that gold will have similar purchasing power in 50 years as it does today, because that general trend has held true for centuries, but it’s not a constant and has certainly lost value for decades in the past, even for lifetimes. I’m not necessarily confident that gold will hold its value at any given point in one year, or even five or ten years.
The whole alt-currency market is still quite small and inconsequential on the global scale, so it might be that it has to grow for years before it becomes big enough that governments are truly concerned about either their own currencies or laws or, paternally, that their citizens are being taken advantage of. I have no idea.
The price of bitcoin and ethereum and all the others is based on constant trading, so probably the chartists and technicians will have more insight into where these trends might tend to break or shift, but it’s all sentiment. Trading that is based on sentiment and excitement can reverse quickly, as we have all seen with bubbles across history. If faith is lost in the currency, and there is no one to step in and force you to use the currency (like the US can with the dollar — you can’t pay your taxes in bitcoin), or to say soothing things to keep people from panicking, or promise solutions, things can snowball quickly.
The “full faith and credit” in bitcoin (and the others) is really just that it’s not controlled by a government (yet) and people have faith in the blockchain coding, it’s not going to be inflated away (though it’s suffering from massive deflation now, as prices of all things drop in bitcoin terms), and it’s expected to be anonymous and secure. Each of those things are valued in the mind of traders and investors who buy bitcoin, and it snowballs as each new buyer builds that faith in the currency and perhaps puts some away for a rainy day with confidence that it will still be valued when the rains come… but they are not unique to any one cryptocurrency (or, arguably, to cryptocurrencies in general — banks are active in developing new financial technologies and systems, too, and lots of blockchain-like technologies are being adopted for use with regular old currencies like the dollar). Therefore you can’t make any kind of fundamental argument about the valuation of any of the cryptocurrencies beyond “this is a big idea” and “everyone’s buying it.” That’s true with national currencies too, but those have a much, much deeper well of faith to pull on than does any cryptocurrency (and, of course, national currencies have to be used by the vast majority of human beings every single day).
No one should be claiming with a straight face that the entirety of the bitcoin in existence should be worth $1 billion, or $10 billion, or $100 billion, or $1 trillion — there is no number that makes sense. Today, it all depends on whether there’s someone (probably in China or Japan) jumping in to buy bitcoin tomorrow at a higher price than you paid last week.
So the risks are all certainly there — that should not surprise anyone. Things don’t surge 1,000% in a year without risk, and we should all be fully aware that an asset that surges 1,000% in a matter of months can also fall by 99% just as quickly (or more so). I have no way of knowing how risky the alt currencies are, but I’m pretty sure that if China cracked down further on bitcoin or if a couple major exchanges had giant thefts again or froze accounts for an extended period (as has happened in the past), there would be a decent chance that we’d see a selling panic. Markets that are driven by sentiment and rumor and simple momentum chasing can collapse much faster than they rise, and the alt-currency markets have risen in crazy hockey stick j-curves.
It doesn’t mean they will fall this week or next month (or ever), but it means that these alt currencies that I put a tiny bit of money into over the past few years are now about as valuable, at least as of this moment, as my holdings in Ventas (VTR) or PCSB Financial (PCSCB), about 2% of my portfolio, and that feels nutty. If they were stocks, Ethereum would be about 1% of my portfolio, Bitcoin about 0.5%, and Litecoin about 0.4%. Crazier still, they could be 5% of my portfolio in a month if this crazy growth continues (which it might or might not, I have absolutely no idea — momentum shifted a bit over the past day and prices came down, but you’d need better tea leaves than I have to know why).
So I don’t mind enjoying the ride with my small position even as I remain mindful of the fact that I can’t tell from up here whether I’m sitting on a rocketship, a mountain peak, a soap bubble, or a helium balloon. I won’t lose any sleep if they go to zero, but I also can’t claim that I have a rational reason why Bitcoin should be worth $2,800 or $400 or something far higher or far lower than that ($2,800 is close to the current price, it was below $400 a year ago). Which means I’ll just continue to let it ride, I suppose — I’ve taken profits here and there along the way, so my cost basis in cryptocurrencies as an “asset class” is negative, and I’ll probably continue to take little profits now and then if it climbs dramatically higher once again, but I’ll try not to let logic or fundamentals interfere too much with a global thrill ride.
And now… back to the world of fiat currencies that are, at least partially, controlled by humans, in all their ham-fisted glory. I want to take a look at REITs and interest rates, so get ready for some blather.
The value of the dollar and the level of interest rates are connected — paying higher interest rates attracts more money to a currency, which raises the value of the currency compared to other currencies, and both have big impacts on “income investments” in general and on Real Estate Investment Trusts (REITs) specifically, so I want to take a look at that relationship to think through what might happen as (and if) rates continue to “normalize” to some higher level this year.
REITs are just ways to own property, really, and they are tax advantaged and are designed to generate income for shareholders. The basic idea is that REITs who have the vast majority of their business in real estate or some related activity do not pay corporate taxes, but instead pay out at least 90% of their income to shareholders in the form of dividends, and the government gets its tax bite from those individual shareholders. They are required to pay out most of their income to shareholders, but those payments are still dividends — not contractual interest payments — and they can fluctuate significantly, falling if business is bad or the company loses money, rising (as is more typical) as whatever real estate-related business it owns grows and becomes more profitable. I have generally been unafraid of the impact of possible interest rate increases over the past few years, mostly because my expectation has been that rates will rise gradually as the economy improves, and an improving economy will boost the operating performance of many REITs.
But it’s been a while since I looked at the connection between REITs and interest rates, and REIT dividend yields in general are rising and seemingly getting more attractive, so I’ve been thinking about whether we might have a buy opportunity here, or soon, thanks to the general level of concern about rising rates.
If that sounds like gobbledygook to you, the conventional wisdom is that REITs fall when interest rates rise. That’s because most investors buy REITs for current income (the dividend yield), and if they could get that income at lower risk from a bond (which guarantees the coupon payment, and which sits atop the pile of creditors and claimants if the company falls into trouble), then they would take the bond over the REIT.
There’s also some impact on operations, since essentially all REITs are levered (like all other real estate investments, they use both debt and equity to buy or develop properties), and that means their cost of doing business rises (and therefore profits potentially fall) when their borrowing costs go up thanks to rising interest rates.
There has been plenty of research about the long-term attractiveness of REITs even in rising interest rate environments, but it’s also true that every period of rising rates is different — so we should be somewhat circumspect in just jumping straight to “no worry!” when we see charts like this one from NAREIT (the National Association of REITs):
That implies that REITs will go up sharply even if the Fed Funds rate goes from 1% to 5%, as it did from 2004-2006 (it’s at about 1% now)… but, of course, even beyond the fact that this data is reported by an industry booster group, which should bring some skepticism (NAREIT’s job, in part, is to get the world to want to buy more REITs), it’s also just one time period. If you need no other reason to be somewhat skeptical of that single chart, remember how much everyone talked about real estate in 2005 and 2006 as the bubble was building — REITs benefitted from that fascination with “safe” real estate, if not to quite the same extent that single family home prices did.
Here is a table from another NAREIT article that goes back a bit further in time to look at past rising rate periods — though, again, all of those periods of rising rates were small aberrations during a 30-year period of falling interest rates and bond yields that arguably helped to power all income-focused investments:
Despite the fact that this is all colored by a very long bull market for bonds (rising bond prices, falling bond yields, most of the time, from the early 1980s to the present), that chart and the arguments from the NAREIT folks in general are fairly compelling. Real estate values keep up with inflation pretty well over long periods of time, so REIT values shouldn’t crash if interest rates are rising just to keep inflation in check… and real estate also is a business of market-based rents and occupancy, so if rates are going up because the economy is doing well, then that means there will be more stores and more workers demanding more office space and apartments and generally better occupancy for the buildings that REITs own, along with stronger rents because of that increasing demand.
If you get into sectors and specific stocks, you can easily build up a wall of worry — shopping malls are clearly in serious trouble in a lot of areas, for example, as department stores shut down and teen fashion retailers sink into bankruptcy or shut their stores or go online, and there are other specific market dynamics that undoubtedly hurt other specific REITs. But what about the whole sector? How has the sector reacted, what do yields look like, and can we isolate any opportunities or inflection points by comparing REIT yields to interest rates or bond yields?
There are, after all, a huge number of investors — perhaps including you — who need some kind of current income from their investments. The group that comes to mind are the baby boomers, of course, who are retiring in large numbers now and are likely to be gradually shifting their portfolios to be more yield-focused, but there are also massive, massive pension funds that depend on more secure and predictable bond yields to meet their actuarial obligations, and falling interest rates have hurt them as well as they try to face their obligations in 2025 and 2040 and 2060, forcing them out the “quality” curve as everyone looks to get higher income by taking more risks.
So I thought it would be useful to compare the coupon yield from the highest level of “junk bonds” to the dividend yield from REITs, and see if that shows anything. I charted the dividend yield for the longest-lived REIT ETF, the SPDR Dow Jones REIT ETF (RWR), divided by the effective yield of BB-rated high yield corporate bonds (BB’s are the highest rated junk bonds — the best credit ratings among companies that are not quite good enough to be “investment grade”).
We can go back almost 15 years with this data, which does not bring us to a bear market for bonds (you have to go back 30+ years for that), but it does encompass that rising rate period of 2004-2006, the crash of 2008, and the (slow) rise in interest rate expectations over the past year or so.
This basically tells you that the average trailing dividend yield for that particular REIT index has gotten up almost as high as the effective yield of top-rated junk bonds three times in the past 15 years — in 2005, which was followed by two years of surging returns for REITs; in 2009, which was followed by eight years of surging returns for pretty much everything; and, well, now, starting in February and continuing this week.
Does that mean REITs are a better bet than corporate bonds right now? Well, they still don’t have the certainty of bonds (as any bond newsletter teaser pitch will tell you, bond coupon payments are Guaranteed By Law!)… but by this perspective they may represent a compelling opportunity because REITs have tended most of the time to be significantly discounted compared to junk bonds on a yield basis.
Why is that? Well, I suppose it’s partly because low-rated bonds often haven’t gotten much respect, and many investors have avoided then even during times when the default rate (and therefore the perceived risk) was relatively low, but I expect it’s also partly because of the fixed nature of bond coupons. Fixed coupon payments sound great when interest rates are falling, as they have been for much of the past 30 years, but if interest rates start rising the value of your bonds drops — the $1,000 bond you bought with a 5% yield seems fine and pays you $50 a year, but that bond loses value if someone’s offering the same thing with a 7% yield ($70 annual coupon payment) a year later. You can still hold to maturity and get your $1,000 back, but if you have to sell you’ll sell for less than $1,000 — a turnaround from the long term trend that has had bonds steadily rising in value for decades.
Inflation, therefore, has a horrifying impact on bonds — something many investors have likely forgotten, or perhaps never knew if they weren’t worrying about a bond portfolio back in the early 1980s. If you get 5% inflation, which is high but certainly not shockingly high, then a 6% coupon means you’re only making 1% over the rate of inflation, barely enough to make sure you don’t lose purchasing power when you get your principal back (since the principal will be worth less in a few years than it is today).
Let me illustrate a little bit, in case that helps folks who are new to bond investing: If you bought a 10-year BB-rated bond with a 7% coupon when it was new to the market in 2011 at par, which would have been $1,000 per bond at the offering, you would begin receiving annual coupon payments of $70 per bond. If rates for similar bonds drop to 5% in a couple years, then someone would be willing to buy that bond from you for a “yield to maturity” of about 5% a year, which would increase the market price of that bond by as much as 15-20%. So you can get a nice capital gain if you sell, a big bonus on top of the 7% a year you were counting on. The flip side is more painful, of course, if the market determines that it will insist on 9% yields, then your bond immediately becomes worth much less.
That impact is big, particularly because people buy bonds for security… but it is much more dramatic for perpetual securities, like stocks or REITs, than it is for bonds, because bonds have a maturity date on which you will get back your principal (so you get that $1,000 back in ten years, even if the market price rises or falls in the interim). You can see from this chart from an AAII article that bonds with fixed coupon payments are impacted by interest rate changes… but that the impact is dramatically higher at longer maturities, where you have to wait 20 or 30 years to get that full principal returned. If you hold a ten year bond and the rates on such bonds rise by 2 percentage points, then the value of your bond drops by 14.9%. If it’s a bond that’s just about to mature, the impact is far smaller because you’re about to get your full principal back — so if interest rates rise 2%, your one-year bond really just loses 2% of its value.
REITs and high-yielding stocks are subject to the vicissitudes of their operating businesses, but in some ways you can also think of them as perpetual income securities — you’re never promised that you will have your principal returned, there’s no maturity date, so the value of the stock can move far more dramatically than the value of a similar-yielding bond, all else being equal. If you spend $100 a share to buy a REIT that pays a flat and solid yield of 5% that the market is pretty confident will stay flat, paying out that $5 in dividends every year, then what happens when the market insists on 9% yields from similar investments? Suddenly the market price of that REIT you paid $100 for is $55. Ouch.
On the flip side, REITs are rarely “static” dividend payers. The power of REITs and similar investments, in comparison to bonds, is that their dividends can (and usually do) rise — if there’s real inflation, for example, then REITs should be able to charge higher rents (many REITs have annual inflation adjustments in their lease agreements), and pass along higher dividends to their shareholders.
So you’ll see that a lot of REITS have been able to increase their per-share dividends far more rapidly than the consumer price index has been growing — the Consumer Price Index (CPI) is up by about 5% over the past five years or so, a time during which we often fretted about deflation and falling prices, but Realty Income (O) has been able to increase its per-share dividend by about 35% during that time period.
That’s just one example, I used it because Realty Income is pretty solid and predictable in its steady dividend increases, and because it’s in a fairly steady and non-faddish business (triple-net leases to stand-alone retail establishments, like pharmacies and gas stations and fast food restaurants), not because it has particularly massive dividend increases. On the more dramatic end of the spectrum, CoreSite (COR), for example, my favorite data center REIT, has increased its dividend by almost 200% during that same time period, and Public Storage (PSA), another hot REIT, has increased its dividend by 65%.
Here’s how that works, and why people typically pay more for dividend growth than they pay for static coupon yields or flat dividends: If you bought CoreSite shares in 2012, you were getting 72 cents a year per share for a dividend yield of about 3-4%. If you buy Coresite shares today, you’re getting $3.20 per share, and the stock has risen a couple hundred percent as the dividend has climbed, so you’re still getting about a 3% yield. But if you happen to have been fortunate enough to buy it at $25 five years ago, your “yield on cost” is now up to almost 13% a year even if you didn’t compound the past five years of dividends by reinvesting them into new shares. That’s why dividend growth is more powerful than current yield, and why investors are usually willing to pay more for growing dividends than they are for junk bonds.
Sometimes that calculus shifts, as we’ve seen, and the price people will pay for high-yield bond coupons rises so much (or the price people will pay for REIT dividends falls so much) that the two come much closer to one another. Over the past 20 years, those windows have been buying opportunities for REITs and selling opportunities for high-yield bonds. I think we might be at one of those points again today, but it could also be that it’s simply junk bonds that have gotten goofy because of the thirst for guaranteed yield.
Going back in time, the data gets pretty muddy — REITs were created in the early 1960s as tax-advantaged investments, and gradually began to proliferate and become listed on the public markets over the decade following that, but they also had a huge drop in the early 1980s when the first version of MLPs was created with huge tax advantages and drew a lot of real estate cash away from REITs (that was corrected when the “tax shelter” MLPs were culled out). It wasn’t really until the mid-1980s that there started to be some meaningful real estate-focused funds for individual investors.
That was followed by a dramatic downturn in real estate in the late 1980s/early 1990s, heading into that mini-recession (that was the recession that hit as I was graduating from college, so it didn’t seem “mini” to a 20-year-old job hunter, but it certainly paled in comparison to the more recent recessions). That opened the door for what you’d probably call the “modern” REIT era, with lots of REITs that exist as market leaders today being launched in the early 1990s, like Kimco and Simon Property Group, and the universe gradually expanded (the first timber REIT, Plum Creek, hit the market in 1999, for example), and then the first ETFs for real estate hit the market around 2000. So comparing those eras pre-2000 is a bit of a challenge, even beyond the challenge that REITs barely existed the last time we had a sustained period of raising rates or really dramatic inflation.
There is some data going back further, some was put together by Dow Jones in a paper about the impact of rising interest rates on REITs back to the mid-1970s — this misses the really, really terrible early years, when the newly created REIT index from NAREIT started out with close to a 50% loss in the early 70s, but it’s also true that REITs were quite different and much more marginal back then. You can read the analysis here, but they sum up their findings thusly:
“Ultimately, whether interest rates are rising or falling does not seem to be the key driver of REIT performance over medium- and long-term periods. Rather, the more important dynamics to address are the underlying factors that drive rates higher. If interest rates are rising due to strength in the underlying economy and inflationary activity, stronger REIT fundamentals may very well outweigh any negative impact caused by rising rates.”
The impact of swift or “surprise” changes to rate expectations on REITs is clear over the past few years — as with the “taper tantrum” in 2013, and the paper mentions that as well:
“When expectations about future interest rates change suddenly, REITs (as well as other asset classes) have often experienced high volatility and rapid price changes. This phenomenon was evident in May 2013, when Fed Chairman Ben Bernanke suggested that the QE taper could start earlier than most market participants expected. The Chairman’s comments led to a sharp selloff of REITs and of some other asset classes, such as emerging market equities, which were viewed as reliant on “easy money” from the Fed. The Dow Jones U.S. Select REIT Index dropped 15.8% from its peak on May 21, 2013 (the day preceding the Fed comments), to its 2013 low on June 22, 2013. However, as markets calmed, the index recovered most of its losses by mid-July 2013 and has subsequently reached new highs in both 2014 and 2015.”
And this is the chart of the performance during those rising rate periods, finally going back a bit further to before the 30-year bull market in bonds:
So what’s going to happen this year? It’s widely expected that the Fed will raise rates again next month, and it’s at least 50/50 odds that they’ll raise at least one more time this year and bring the Fed Funds rate up to roughly 1.5%. The Fed Funds rate is just the basement, though, that’s the level that might increase money market rates and savings account rates… but it’s not a very direct driver of rates that are more important to investors, like the rates on the 10-year Treasury Note that effectively drive most commercial interest rates in the US. The 10-year note has fluctuated quite a bit over the past year, from 1.5% to 2.5%, roughly speaking, but it is also, at about 2.25%, very close to the average level we’ve seen for that key rate over the past five years.
Over the past couple months, the yield curve has gradually been flattening, meaning that the difference between the yields demanded by investors for short-term bonds and long-term bonds has been shrinking. Which indicates to me that we’re still not seeing the important long-term interest rates spiking higher, or even a fear of rates spiking much higher, which makes me think that the risks to REITs might be overstated in their recent decline.
The Vanguard REIT index ETF (VNQ), my favorite ETF for the sector (and one of the larger ones), currently has a yield that amounts to roughly $3.65 per share on an annualized basis, a 4.4% yield on an $83 share price.
If that dividend grows by 4% over the next year, which seems like a reasonable expectation, it will be at about $3.80 per VNQ share. What will the yield on the ETF be? If it falls all the way to 3%, because investors value the growth and inflation protection over the safety of whatever bonds are paying at the time, then that ETF would soar to $126 from the current $83… if the market yield drops just a bit to 4%, the ETF should hit $95. If it’s still about 4.4%, as it is today, then the ETF goes to $86 or $87 to reflect the rise in the dividend payment.
On the other side, if investors start to demand MORE yield from the REITs, instead of accepting less, then the price of the ETF should fall considerably — with a $3.80 dividend, a 5% yield price would be $76 a share, and a 6% yield would mean the ETF drops to $63.
Much of this is a mental exercise as I think through the possible outcomes, but I decided to place a small bet on it as well. I placed a little bet on VNQ January 2018 options, speculating that investors might rush to the REITs for a safe and growing yield and drive the yield down below 4% by January. That would send the ETF into the mid-$90s, and the call options for that going out just seven months are cheap because the market thinks that’s an extremely unlikely outcome, so it seemed an intriguing bet. For most of 2015 and 2016, VNQ had a trailing dividend yield that ranged from 2.6% to 3.8%.
And I paired that with a bet on rising rates that means I’m also putting a bit of a bet on the other side of my idea that the Junk bond/REIT yield differential has gotten too small: I bet against high yield corporate bonds during that same time period by buying puts on the iShares iBoxx High Yield Corporate Bond ETF (HYG). That ETF tracks junk bonds, though it’s not as specific as the BB bond rate I noted above (I used that BB yield to chart comparisons above because it goes back further than HYG, though HYG’s average credit rating is a step below BB and the yield is therefore a bit higher).
Any short, sharp crisis in interest rates could have similar impacts on both REITs and junk bonds, but over time I expect the yield on REITs to become substantially lower than the yield on junk bonds again, whether that’s because the yield on VNQ comes down further from the recent post-crisis high or because HYG’s yield rises from the current all-time low (or both).
That might not happen this year, of course, in which case my gamble will not pay off — but it’s a relatively cheap gamble as the yield differential between HYG and VNQ is near its all time high (HYG only goes back to 2008, so that’s not a long time, but still). This is the ratio between VNQ’s dividend yield and HYG’s yield, for what it’s worth:
More sensibly, for those who don’t like making shorter-term wagers with high risk of 100% loss like this, I do think that if we assume the world is not going to end, and that interest rate changes will be economically sensitive and not necessarily punitive, that this is probably a good time to nibble on favored REITs.
Or, frankly, even to just nibble on the VNQ ETF with a 4.4% yield… For those looking at individual stocks I’d mix it up a bit but focus on REITs that have meaningful yields that are at least as high as the VNQ average, and a record of well-above-inflation dividend growth rates — on the safer end of the spectrum, the ones I’ve been looking at recently include Ventas (VTR) in health care, which I own, or Realty Income (O) and National Retail Properties (NNN), which I don’t, and on the riskier end I still think Medical Properties Trust (MPW), also in my portfolio already, is underpriced because of fears of hospital trouble as the insurance market changes (assuming it does change). I expect I’ll continue to look at others as well if and when the market continues to soften for REITs… but for now, I’ll stick with my little option bet and track it in my Real Money Portfolio — this is not a recommendation that anyone follow my specific notions here, but if you want the details I went long VNQ January 2018 $96 calls and HYG January 2018 $80 puts. Both are widely out of the money, so have a very high risk of a 100% loss — this is a gamble, not an investment.
Dammit, just when Berkshire Hathaway (BRK-B) was finally drifting lower after the annual meeting… Barron’s did a gushing piece about Berkshire’s potential for 15-20% gains through next year, including one analyst’s note that it looks attractive at 1.4X book value with expected 9-10% growth in book value per share over the next couple years.
This is Barron’s conclusion:
“With a combination of offensive and defensive qualities, Berkshire is a good bet to top the S&P 500 in the coming years—although the gap is apt to be closer to one or two percentage points, which has been the experience over the past 10 and 20 years, than the staggering 11-point advantage over Buffett’s 52-year tenure. Berkshire doesn’t need Buffett to remain a good investment.”
I don’t disagree, but I’m still digging in my heels a bit and hoping to buy when someone finally writes an article about Warren Buffett doing something stupid. Or when the market collapses and Berkshire finally comes down closer to the price that is shorthand for “good value” for me with this stock, 1.3X book value (as of last quarter, that’s about $156 a share).
Fingers crossed that the stock gets cheap again, and that I’m waiting with plenty of cash in my portfolio when that happens… but it might not happen anytime soon. The talk at the annual meeting this year was partly about Berkshire’s need to start buying back stock or paying a dividend if Buffett can’t find a good way to use his $100 billion or so in available cash, so we might not ever get to a cheap valuation.
Once investors started to believe that Buffett was serious about doing buybacks at 1.2X book value or below, that established a real floor — but it also took a little time, the stock did swoon to below 1.2X book value very briefly in 2013, after the buyback threshold had already been established, and it certainly traded down briefly to book value or slightly below a few times before Buffett spoke publicly about buybacks, during the crash and in some of the bleak times after that in 2009 and 2011. So I hold out some hope.
It is tempting to say that Berkshire is a buy even now, given the limited downside relative to the broad market (I expect BRK-B shares to fall less than the S&P 500 if we have a meaningful bear market… especially if that bear market is led by crashes in the huge tech stocks that I also own, which is why I like the balance of owning large positions in both Berkshire and Facebook)… but since there’s no viable scenario where Berkshire Hathaway shares run away from you and double in six months, I think it makes more sense to wait for your pitch. Which is, of course, probably what Warren Buffett would say, too.
Incidentally, I’m in the same grumpy “hope it gets cheaper” frame of mind when it comes to Markel (MKL), too — I updated my thoughts on that stock a little bit yesterday in response to a Nicholas Vardy teaser pitch that hinted at the potential of Markel shares, so I’ve talked myself into raising my “buy up to” level for Markel shares to 1.35 times book value, since that’s the average ratio Markel has traded at over the past decade… but with the stock at almost 1.6X book, we’ve still quite a ways to go (that puts the “buy” price up to $837 if you’re being a stickler for specifics… that would mean a dip in the shares of about 14% would be required to get me reaching for my wallet).
Remember Cannabis Wheaton (CBW.V, KWFLF), the stock teased by Jimmy Mengel about three weeks ago for his Marijuana Manifesto newsletter? I thought it was ridiculously valued given its lack of cash and need to raise capital, and they did finally announce a capital raise this week. It looks like they tried to do it without obvious dilution, which is a little silly for a company at this stage of development — they’re selling convertible bonds and warrants instead of stock, which makes things look better on the income statement for a while but could provide some negative pressure in the future.
It looks like they intend to raise about C$80 million now, roughly half warrants and half convertible debentures (at 6% interest and with warrants attached), so they need to post a pretty high return on that capital to make this work as a financing company. The market cap should remain at close to C$200 million (at C$1.20, at least), and they’ll have close to C$80 million in cash to start to fund some of the streaming deals they’ve agreed to, so now perhaps they’re trading at “only” 2-3X book value if you don’t count the dilution of the warrants (the warrants are for two years, with a C$1.60 strike price).
I’ll be curious to see whether those warrants or convertible bonds get into the market for trading, the business still might make sense at some point — but I still don’t understand why you’d want to pay this much for it. There’s plenty of risk in their streaming deals as it is, counting on partner performance and on substantially rising prices for marijuana in a regulatory regime that may well have price controls as part of it (we won’t know the details of legalization for a while, right now everyone just expects “demand will skyrocket, so I can’t lose… which is a dangerous sentiment) — so I can’t see why you’d want to increase that risk by paying a huge premium to get access to those streaming deals. The stock was halted at the company’s request at mid-morning today, pending news, with no reason given for that as of the moment that I’m writing, so the story could change. I still like the general idea of being a financier in this market instead of a direct investor, but not at this price — maybe I’ll take another look when the dust settles, once they’ve got some actual cash on their books.
And for those of you who are curious about an oldie-but-goodie teaser pitch, the promotion from several newsletters over the past couple years that Energous (WATT) would have its wireless charging technology included in the next iPhone (first the 6S, then the 7), I beseech you: Please, please convince the newsletter flacks to start pushing this story again and driving Energous shares up to $20 in anticipation of the next iPhone release this Fall. I would really love to short Energous shares again if we get another low-probability prediction like that, but I’d rather do it after the shares spike up, and the surest way to get Energous shares to spike up is if a few huge newsletters start to talk up the shares and promise that long-rumored Apple unveiling.
I’m not a short seller, as a rule, but sometimes it’s so tempting — I did short Energous in the runup to the last iPhone release, and cover that short after (surprise surprise!) the iPhone turned out to NOT be using Energous’ WattUp wireless charging technology (or any wireless charging at all), and I think the Energous bulls could probably sell a better case this year than last year… but I haven’t seen the ads crop up again yet, nor have I seen the gushing press coverage that spreads more rumors of WattUp in the iPhone.
Last Summer, I shorted WATT but bought some out-of-the-money calls as protection to limit my losses (since WATT is a small cap stock, you never know when someone might step in and offer to buy them for a 100% premium — every big tech company has made dumb acquisitions), and covered that short for a nice short-term profit. In a market where obviously shortable stocks are in short supply, it would be nice to find a really irrational price spike in anticipation of a near-term positive catalyst that any rational person would say has low odds of actually happening. If you’ve got any situations like that in mind, please let us all know with a comment below.
Bull markets don’t die of old age, but they often do go out in a blaze of glory by exploding higher just when everyone is convinced that the peak is in, so despite the fact that the market is generally overvalued by historical measures, and despite the fact that lots of stocks trade at really optimistic valuations (including quite a few in my portfolio), we’re not at the point when I want to bet against stocks just because they “look expensive”… we are, however, at the point where I’d like to think about having at least a little short exposure in my portfolio, so if I can find some specific situations maybe I’ll finally open a position or two. We’ll see. Energous is not necessarily a great candidate right now, because short interest is already very high at 37% and the stock is not surging higher on rumors at the moment.
In other portfolio news, PCSB Financial (PCSB) added a third insider buyer a week or so ago — so that makes now three executives who not only maxed out in buying at the conversion at $10 a share, but have also come back since then and bought in the open market at prices from $16.26-$16.55 a share in just the month since the conversion and IPO. That remains compelling to me. I don’t know that I’ll add to this position, since it’s a relatively small bank and I have already built up a bit of a position, but if we see any weakness in the shares I’ll be tempted to come back to the trough again.
And my other “mutual conversion” stock, NI Holdings (NODK) just announced that they’ve authorized a share repurchase plan for up to $8 million — which is not very big, and may not be executed, but it’s a good signal that they were serious about creating long-term value per share for shareholders… they have a ton of cash after the mutual conversion (roughly $100 million more than they need, at a minimum), this is but a small portion, so it will be curious to see how they use it to try to grow. No real news on that yet, or reports of how they intend to invest in the business, but iff they did the full buyback today that would be about 2% of the shares outstanding. Not a big deal, but certainly not bad news… and NODK keeps trickling higher in the absence of actual news.
And that’s about all I’ve got left in my brain for you on this Friday afternoon… enjoy your weekend, dear reader.
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