2023-05-30 07:35:00 ET
Summary
- The market is a lot like high school - there are cliques everywhere.
- Sometimes, going against the grain provides you large sums of income.
- It's better to approach the market with an understanding mindset rather than one looking for a quick and easy answer.
Co-authored with Treading Softly.
Do you remember your high school days? For most of us, those were decades ago, and for some of us, probably the worst years of our lives. For others, they peaked in high school, they were part of the popular or cool crowd, and they enjoyed unprecedented popularity.
I'll be honest with myself; I wasn't one of the cool kids. I wouldn't skip my high school years and have many fond memories from them, but they weren't easy. So why am I bringing up high school? Well, in every high school back then, there was always a group of misfits, often simply misunderstood individuals with unique talents or interests that others can't relate to, and therefore push them out.
The stock market is no different.
You've got popular kids like Netflix, Amazon, and Microsoft; everyone loves to say that they're "part of them," and then you've got other misunderstood and maligned corners of the market that people are part of but don't openly like to admit it.
Today, I want to look at two market misfits that offer high-yield income, but we need to take a moment to understand why and how.
Let's dive in!
Pick #1: EPR - Yield 8%
EPR Properties ( EPR ) is a company that is primarily known for owning movie theaters – a property class that has historically been known for being extraordinarily stable. Since 1998, EPR has collected rent and experienced 98%+ occupancy in its movie theaters for decades – a distinction that isn't shared by other types of properties.
Then COVID hit, and theaters were among the hardest hit properties. From a sentiment standpoint, theaters went from being premium assets for landlords to garbage. The reality is likely somewhere in the middle.
The main news item for EPR today is the bankruptcy proceedings of Cineworld Group plc (CNNWQ), the parent company of Regal Entertainment Group. Regal is EPR's third largest tenant, accounting for 12.8% of revenues. Source .
When a major tenant files for bankruptcy, it is common for the landlord to experience sympathy pains. On the one hand, the tenant has the right to abandon properties in bankruptcy. For example, the Sears bankruptcy did have a material negative impact on malls as the leases were abandoned and the malls had large vacant spaces that needed to be backfilled. That process was hampered by the inconvenient timing of COVID.
On the other hand, such large liquidations of companies are the exception. The most common result of bankruptcy filings is that the company is reorganized, ownership changes, and the new company continues operating. The new company needs the real estate and assumes the lease. The landlord keeps collecting rent, and the reorganized tenant is usually better capitalized and has lower risk than before the bankruptcy.
In this situation, Regal did not pay rent in September 2022 but has paid rent every month since, including back rent due from COVID deferrals. It filed motions to reject the leases on three of EPR's 57 Regal properties but so far has decided not to proceed with those rejections. The various parties have reached a restructuring agreement, and it is expected that Cineworld will emerge from bankruptcy in Q2 as an operating company. EPR is continuing to defer providing annual guidance as bankruptcy agreements can change, and there is still a possibility that leases are rejected. However, it is looking increasingly likely that the total impact on EPR will be the loss of September 2022 rent and rental payments will otherwise continue as before.
Meanwhile, EPR's AFFO continues to climb. It was $1.30/share for Q1, up 12% over the past year and 2.3% from last quarter. Additionally, EPR's payout ratio has declined from 68% in Q4 2021 to 63% last quarter.
EPR was previously raising the dividend to keep the payout around 68%. Since Cineworld filed for bankruptcy, they have declined to hike the dividend, likely due to the uncertainty. As things sit today, if the current restructuring agreement is approved and Cineworld exits bankruptcy this quarter, we could expect a dividend hike. Even if the Cineworld bankruptcy takes a dark turn, EPR's current dividend is likely conservative enough to withstand the impact.
The "experiential" real estate business, which requires large groups of people, was the hardest hit by COVID. Great management is demonstrated at the difficult times, not the easy ones. EPR's management stepped up and navigated those very difficult times. EPR absorbed a massive overnight decrease in revenues without materially increasing outstanding debt while decreasing the number of shares outstanding. In Q2 2020, EPR collected only 21% of pre-COVID rents. How many other companies can absorb an overnight crash of nearly 80% of revenue without taking on tons of debt or diluting shareholders?
This is an extremely durable real estate investment trust, or REIT, that is on the path to recovery. The movie industry is dealing with the weight of the debt it had to take on to get through 2020. Yet, as demonstrated by Regal, lenders are not interested in closing a bunch of locations – especially the high-quality locations held by EPR.
EPR Properties is currently yielding 8%, a bargain price for a high-quality management team, with great potential for a dividend increase later this year.
Pick #2: NLY - Yield 14%
Annaly Capital Management, Inc. ( NLY ) is a mortgage REIT (mREIT) that is primarily focused on residential mortgage-backed securities ((MBS)). NLY recently reported Q1 EAD , Earnings Available for Distribution, of $0.81. This is down from the $0.89 in Q4, which was telegraphed by management. What is somewhat surprising is that the book value was $20.77/share, compared to $20.79 at the end of Q4. This is a great performance compared to its largest peer AGNC Investment Corp. ( AGNC ), which saw a 4.4% decline in book value for the quarter.
This is why we diversify. AGNC and NLY are taking slightly different approaches; sometimes, one will outperform the other. For Q1, NLY did better. What happens next quarter? Nobody knows.
NLY is choosing to be more aggressive than AGNC and has started buying meaningful amounts of agency MBS, increasing its portfolio by 7% in just one quarter. Source .
Note that these agency MBS are still trading at a significant discount to book value. As of the end of the quarter, NLY's agency portfolio was trading at a $1.9 billion discount to par. Source .
Since the agencies guarantee agency MBS, that is $1.9 billion that NLY will receive in the future as long as they don't sell the MBS. NLY is also seeing huge discounts on its non-agency portfolio. While those assets are subject to credit loss, it is likely that the current fair values at a 10-20% discount to face value likely overestimate the loss rates.
Agency MBS is trading at very attractive levels, with spreads at levels that are most similar to the GFC. The headwind for agency mREITs is the high cost of short-term rates. They borrow 30-90 day money to own assets expected to last 5-10 years. NLY hedges this cash-flow risk with interest rate swaps, which currently lock-in an interest rate of 2.13% on $64.7 billion.
You can see that NLY has a lot of runway with an average maturity of five years from now. This is a risk, but it is one that NLY has managed and hedged.
Agency MBS has historically performed best during recessions. NLY has been through the dot-com bust and the GFC. In both cases, the period heading into, during, and immediately following were their highest performance years. The reason is that agency MBS has no credit risk. It is an asset that investors flock to when the economy is poor.
During these periods, NLY saw a rising price and a skyrocketing dividend.
Our outlook includes a high probability of a recession starting within a year. We want to have exposure to agency MBS to protect our portfolio from that possibility.
Conclusion
I always thought movie theaters were cool when I was a kid. I'm still prone today to go see a movie in theaters and find it interesting enough. I saw Top Gun: Maverick three times in theaters because different friend groups wanted to go, but I was happy to watch it again and again.
I also know everyone who has a mortgage is still doing everything possible they can to pay it. Overwhelmingly, the vast majority of mortgages that make up MBS are currently all from the period when interest rates were near 0%. The most significant factor for MBS pricing now is depressed prices due to the Federal Reserve no longer buying and high interest rates.
While the market has labeled both of these companies as misfits, I find them to be welcome companions in my income portfolio.
At the end of the day, your retirement success is solely based on your decision-making:
If you make bad choices, you'll have a bad retirement.
If you make good choices, you'll have a great retirement.
Every time I write and publish an article, my goal is to help you decide what is the best choice for you. I provide the information, and you make the decisions. I have helped thousands of investors turn into professional income investors through education, experience, and providing them with a unique insight on the market, as well as helping them craft a way to see that insight for themselves as well.
I'm not looking to make a crowd of petulant-dependent children. I want to help each investor turn into a full-fledged standing adult who is going to make their own decisions and know what's going on in the market. This means I have less of a "follow me" mentality and more of a "come alongside me and learn" mentality.
Thank you to everyone who reads our articles and finds value in them. We find it highly encouraging to see those who began making comments without understanding mature into strong, stable investors.
That's the beauty of our Income Method. That's the beauty of income investing.
For further details see:
Earn Up To 14% From Market Misfits