2023-08-24 07:35:00 ET
Summary
- Every earnings season is like a new season of a TV show. You get all the information you're going to get for that season.
- This is the perfect time to spot-check your portfolio and make sure your income is as strong as you expect it to be.
- Don't let the tidbit of news that's blown up out of proportion between quarterly updates derail your mental thinking.
Co-authored by Treading Softly
I can remember when I used to have to watch a new episode of my favorite show every week. I can then remember when streaming became popular, and you could binge watch an entire season in a night or two. Ironically, the tables have turned. TV producers have realized that you can get more buzz and more word of mouth by dragging the episodes out one week after another, instead of just unloading them and making a big splash. So now, many streamable shows that are releasing new episodes force you to watch one a week. You could be patient and wait until the whole season is over to binge watch it, but many of us likely tune in week after week because we want to catch the newest content.
It's part of human nature to want to be in the know. Few of us choose to be willingly ignorant or out of the loop for very long. There's another group that has capitalized on this - the financial news. Interestingly they have to fill up 24 hours a day, seven days a week, of news content, even though the market only updates you about every three months on how companies are doing. What this means is that every tiny tidbit of potential news is exploded to massive size and outlandish proportions. This creates a lot of unstable sentiment throughout the quarter. We, then, get these punctuated periods of vastly important information - earnings season.
Today, I want to take a look at two opportunities that have recently released their earnings that I think are outstanding yields to be loading up on.
Let's dive in!
Pick #1: CSWC - Yield 10.7%
Capital Southwest ( CSWC ) is a business development company with a focus on small businesses. This quarter, CSWC announced yet another dividend raise, increasing its regular quarterly dividend 3.7% to $0.56.
For BDCs, the "regular" dividend is what management believes will be sustainable as the economy changes. CSWC has a great history of increasing the regular dividend consistently. CSWC also announced a "supplemental" dividend of $0.06, up from $0.05 last quarter. The supplemental dividend is excess cash flow that might not be sustainable. Looking at CSWC's history, we can see that supplemental and special dividends have been frequent, but inconsistent. Source
The current supplemental dividend is primarily driven by high interest rates. The business model that CSWC follows is to borrow at a fixed rate and lend at a floating rate. The high rate environment has been a boon for many BDCs, including CSWC. We can expect the supplement to continue as long as interest rates remain high. If the Fed pivots, we would expect the supplement to decline. However, we expect the regular dividend still has room to grow. CSWC has grown its net investment income and grown its portfolio from $1.1 billion to $1.3 billion over the past year while decreasing its leverage.
CSWC August Investor Presentation
CSWC is currently operating at a very modest 0.87x debt-to-equity leverage ratio. On the credit quality side, CSWC continues to see stability, and currently has no holdings in the highest risk category.
CSWC August Investor Presentation
The bottom line is that the current environment is fantastic for CSWC. CSWC has maximized the opportunity, providing investors with a supplemental dividend. At the same time, CSWC has expanded its portfolio, allowing it to grow its base earnings which has allowed the regular dividend to grow as well. Since 2020, CSWC has grown its assets from under $600 million to over $1.3 billion, while also reducing leverage. As shareholders, we've benefited from a growing dividend, frequent supplements, and stable book value.
We were active buyers of CSWC when it was undervalued and out of favor in the market. Recently it surged above our buy-under price as the market is seeing the value we saw all along. We will sit back and let this winner run, collecting our dividends.
Pick #2: HR - Yield 7.4%
Healthcare Realty Trust Inc. ( HR ) had a negative headline in earnings. FFO guidance was reduced from $1.60-$1.65 to $1.57-$1.60. While only a 3% reduction, a reduction in guidance is usually a negative for share price. The company is going to make less in 2023 than previously anticipated. Perhaps adding fuel to the fire, the dividend payout under new guidance will not be covered by FAD (funds available for distribution), which inevitably brings up a concern about the dividend.
HR addressed this concern head on, noting that it realizes the payout ratio will likely exceed 100%, but that they are confident that it will come back below 100% through same-store NOI (net operating income) growth. In the Q&A period, management described the dividend as "sustainable."
HR has been seeing renewal contracts increasing an average of 3% on a GAAP basis, which is a main driver of their expectations of 3%-4% NOI growth on a GAAP basis, and 4%-6% NOI growth on a cash basis in 2024. Source
HR Q2 2023 Earnings Supplement
Traditionally, most MOB leases have fixed escalators, as opposed to escalators tied to inflation. As a result, when inflation is high, the landlord has to wait until renewal to make up the difference between the fixed annual escalator and the experienced inflation.
Management pointed to three things that drove guidance lower:
- Inflation is moderating, but not as fast as expected, pressuring operating margins. HR recovers approximately 65% of expenses from tenants, which leaves them exposed to inflation in 35% of property-level expenses.
- Interest rates are staying higher for longer than assumed in prior guidance. About 15% of HR's debt is floating. HR does intend on reducing debt using cash from asset dispositions.
- Disposition guidance was increased with HR having another $300 million in properties under contract at an average cap-rate in the mid 6%s. Acquisitions are expected to be under $100 million, so the portfolio will shrink in size. HR expects to use excess proceeds for debt repayment and repurchase common shares.
Much of the story for HR is that they're absorbing a very large merger. Management described their asset sales as "cleaning up" the portfolio. HR is selling off properties that have lower growth opportunities. HR has made it clear that it sees the best opportunities using its "cluster" strategy, where it owns multiple buildings in close proximity. Being close to other medical offices is beneficial for leasing potential, while also making it easier and cheaper for HR to manage the property. So HR is selling off the properties it has acquired through the merger that are isolated and do not have the potential to develop future buildings.
HR is selling properties at a 6.5% cap-rate, and would have to pay about the same rate to buy properties. Meanwhile, HR expects to achieve a 6.5-8% cap rate from new developments, while being able to get a 9-12% yield from redevelopments.
HR Q2 2023 Earnings Supplement
This is a much more profitable strategy, so HR is focused on selling assets that are not candidates for redevelopment or for having new developments nearby. Rather than trying to force growth when it's difficult, HR is willing to sell off its least attractive assets to deleverage and improve the balance sheet. This will put it in a position to expand profitably when its cost of capital is lower.
In the meantime, management spoke bluntly in favor of maintaining the current dividend, so we can enjoy collecting a nice income while we wait for HR's plan to bear fruit.
Conclusion
With CSWC and HR, I don't have to worry about crazy potential worries between quarterly updates. The reason is that both management teams are very clear about their goals and objectives, and everyone else's suppositions and beliefs are just that - beliefs that they have created for themselves that may lead them to make foolish choices because they're not using new information - they're using fantasies.
When it comes to my retirement, I want a portfolio that pays me strong income quarter after quarter, month after month, and year after year. Owning companies like these two allows me to have that strength of income in my portfolio. The only thing I have left to do then, while my portfolio pours in dividends, is to fantasize about what hobbies I want to pick up or where I want to travel and take my vacations. As a professional income investor, money creates opportunities, opportunities are boundless, and having boundless opportunities because you're not restricted by your money is the definition of financial security.
That's the beauty of my Income Method. That's the beauty of income investing.
For further details see:
I Am Loading Up These 2 Big Yields