THQ - Bottom Fishing: 2 Big Yields For February

Summary

• Do you love snagging things on sale? I know my wife does!
• Often in the market, investors eschew great opportunities simply because other investors have put them on sale.
• You can preserve capital, and grow it by buying on sale income.

Co-produced with Treading Softly.

When it comes to buying groceries, my wife loves to snag things on sale. Locally, we have Publix and their buy-one-get-one section is always filled with individuals looking to stretch their dollar as far as possible. Aldi is also a hotspot for frugal shoppers looking for the best value for their dollar.

Interestingly, when it comes to the stock market, investors frequently play the opposite cards. When an investment becomes cheaper compared to its fundamental value, they sell it out of their holdings or refuse to buy it simply because it has dropped in price.

It's on sale and they think it's bad. Often this is done in the name of "preserving capital" but instead they've actively destroyed some and rejected the opportunity to grow their capital.

It's like buying overpriced pasta instead of the buy-one-get-one because it's not on sale. The one on sale must be inherently bad because it's on sale.

Curious right?

January is historically a strong month for average stock market performance and this year:

Yet even in a market that is trending higher, many investments are still trending on the low side of their prior prices. This means we can be avid opportunists and pick those income generators up at great prices before they climb higher.

Let's look at two such opportunities to capitalize on.

Pick #1: THQ - Yield 6.8%

Tekla Healthcare Opportunities Fund ( THQ ) is a closed-end fund ("CEF") that focuses on healthcare stocks. THQ invests in pharmaceutical companies, providers, medical equipment companies, medical technology, and even real estate. If you see your doctor, THQ has a financial interest in every aspect. Source .

The medical sector became part of the COVID bubble. Speculators were quick to bid up companies that might have a vaccine, COVID test, or otherwise benefit from the massive amount of government money that poured into the sector. Given that the world's focus was on a health problem, it isn't surprising that healthcare had plenty of enthusiasm. We saw this COVID-era enthusiasm in other places like Zoom ( ZM ), Teladoc Health ( TDOC ), Peloton ( PTON ), and even crypto. These investments have since crashed, as the COVID speculators disappeared as quickly as they arrived.

THQ hasn't been completely immune, it is down about 22% from its peak. Yet the healthcare sector held up much better than others that were touched by COVID speculators.

The reason is simple: Healthcare has strong fundamentals that transcend the immediate economic benefits of COVID. While the urgency to create a COVID vaccine is gone, the virus is still mutating, and there will now be new COVID vaccines created every year. The research put into the COVID vaccine will be adapted to other vaccines.

Let's not forget about the immense amount of business that healthcare companies do that has nothing to do with COVID. We didn't magically stop all other ailments! The population is aging, and one side effect of aging is a greater need for numerous medical services, pharmaceuticals, and equipment.

The bottom line is that the healthcare sectors had very strong fundamentals before COVID, with growing demand and limited supply. So while many of the COVID-era stars have fallen as their demand was significantly linked to the shutdowns, the healthcare sector dipped with the broader market but has not seen a massive decline in demand.

The healthcare sector benefits from being recession-resistant. The healthcare sector held up better than the markets during the Dot-Com bust:

And again during the Great Financial Crisis – falling less and recovering more quickly:

With the risk of a recession on the horizon, we want exposure to the healthcare sector. THQ is an option to translate healthcare exposure into a high yield while also trading at a very attractive 11% discount to NAV.

Sister fund THW has a similar portfolio and pays a higher yield. However, it is currently trading at a large premium to NAV. At current prices, we prefer THQ.

Pick #2: EPR Preferreds, Up to 7.7% Yields

EPR Properties ( EPR ) is a high-quality net lease real estate investment trust ("REIT") with a unique focus on experiential properties. EPR’s portfolio has 356 fun locations with over 200 tenants in 44 American states & Canada. ( Source: EPR Website . )

The issue creating anxiety among investors is that EPR is heavily allocated to theaters and that one of EPR’s core tenants - Cineworld - has filed for bankruptcy.

Notably, 41% of EPR’s EBITDA comes from theaters. EPR’s tenants in this sector include 19 operators with 173 properties. Cineworld has reached an agreement with its landlords and lenders, clearing the way for the company to borrow an additional $150 million and make a $1 billion debt repayment. The movie theater chain has made its October and November rent payments, and we are confident that the impact of the bankruptcy will be far less than the market fears. EPR is a core constituent of the HDO model portfolio, and we have shared several reports covering the investment thesis in this REIT.

Today, we will discuss a reduced-risk method of investing in this fun-filled REIT. EPR has three classes of preferred securities that have well-protected income streams and provide big yields with a high degree of safety. Considering EPR is in an excellent financial position, with no balance on its $1 billion revolver and no debt maturing until 2024, the preferreds are a low-risk investment.

• 5.75% Series C Cumulative Convertible Preferred Shares ( EPR.PC )

• 9.00% Series E Cumulative Convertible Preferred Shares ( EPR.PE )

• 5.75% Series G Cumulative Redeemable Preferred Shares ( EPR.PG )

• *EPR can force conversion of EPR-C and EPR-E if the common stock trades at 135% of $60.26 and 150% of $51.80 respectively
• This will provide EPR-C shareholders a conversion value of $33.70 and EPR-E shareholders a conversion value of $37.49.

YTD, EPR spent $18 million on preferred dividends and $114 million on interest expenses. After these expenses, EPR produced $285 million in AFFO to adequately cover its $198 million common dividend.

We see that the preferred dividends are well-covered. Now, let's review the three securities in detail.

1. EPR-C and EPR-E are convertible preferred. They are quite similar to a regular preferred, except that they don’t have a redemption date or maturity. The most significant difference is that they carry an option to convert into common stock, and the higher the common stock moves in price, the more valuable the security becomes. Hence, convertible preferreds act like a yield-producing option on the common stock.

2. EPR-G is a straightforward redeemable preferred that would have to be redeemed at a $25 par value (~23% upside from current price levels). EPR-G shareholders can expect a lesser overall correlation with EPR common stock and steady dividend payments for the foreseeable future.

The choice of preferred depends on your requirements. The dividends of all these preferreds are cumulative and well-covered. We like EPR’s business, its operating fundamentals, and the compatibility of its portfolio with the needs and tastes of the younger generation. As such, we hold EPR-C in our preferred portfolio, and we also like the prospects of EPR-C for a similar correlation with the common stock along with high-yield dividends.

EPR-C and EPR-E shareholders can convert their securities into common stock anytime. But it doesn’t make sense to pursue this conversion now. The table below shows the conversion value at various common stock prices.

Based on the calculations, we can see that EPR-C has higher upside prospects despite a slightly lower current yield.

EPR’s discounted preferreds are attractive income opportunities for risk-averse investors. Yields of up to 8% are available to you from the landlord of some of the most fun destinations in North America.

Conclusion

With the EPR preferreds and THQ, I can buy discounted income at great prices today and enjoy the income for the long haul. While enjoying that income, I can look forward to the higher price, building value and capital in my portfolio, and providing a cushion before the dreaded loss of potential capital may return.

When it comes to the market, it's important to evaluate a company's fundamental strengths, performance, and outlook. I do not look at the chart and price movement alone - if you do that, it is one sure way to miss opportunities and buy high and sell low - I look at the underlying "whys," this allows me to know if something is simply on sale or a bad company.

This way, when I buy income at a discount, I know I'm getting long-lasting and recurring income and not a dud into my portfolio.

My retirement will be filled with opportunities to explore hobbies, visit national parks, and hit the waters for another type of bottom fishing.

How do you want to spend your retirement? Forced to worry about your finances and the market's performance, or do you want to have the freedom to hit the lake without your phone and enjoy pure silence?

I like the quiet and calm in what is all too often a very busy life.

That's the serenity and beauty that income investing can unlock for you, the choice is yours if you want to embrace it.

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