Are we in a REIT bubble?

Low rates have made investors hungry for yield. As a result, traditional higher yielding investments such as utilities and real estate investment trusts are getting bid up by investors. If this madness continues, the possibility that many investors will get burned down the road increases exponentially.

Real estate investment trusts (REIT) are required by law to distribute at least 90% of their taxable income to shareholders. The REITs I own typically distribute somewhere close to 80 – 90% of their Funds From Operations (FFO) to shareholders. FFO is a commonly accepted tool to measure profitability for REITs, and is a more accurate indicator than earnings per share. FFO adds back for certain non-cash items such as depreciation, in order to determine the amount of profits that are available. Most REITs that I follow tend to have a FFO payout ratio between 80% - 90%. I own shares of Realty Income (O), Omega Healthcare Investors (OHI), Digital Realty Trust (DLR) and American Realty Capital Properties (ARCP).

As a result, I find it safe to assume that for REITs a low yield usually shows a stock that is overvalued, whereas a higher yield usually shows an attractively valued stock. I define a low yielding REIT in the current environment as a REITs that yields somewhere close to 4% or lower. A higher yielding REIT is one that yields at least 5%. This generalization only includes REITs whose primary business is to own physical real estate.

Some investors believe that current lower than historical yields on REITs are justified by record low interest rates. For example, yields on US 30 year Treasuries are close to 3%. These investors believe that today is the new normal, as low interest rates justify REIT valuations. The mentality that the this time it’s different might be costly to your portfolio.

Investors who purchase a REIT yielding 3% are generally receiving 80 – 90% of cashflows. In contrast, an investor in a typical dividend champion such as Procter & Gamble (PG) or Johnson & Johnson (JNJ) who gets a 3% yield today also gets a 5%- 6% earnings yield.

Even in the current environment however, there are reasonably priced opportunities for investors who are on the lookout for bargains. I have been able to use the weakness in Digital Realty Trust (DLR) to acquire a decent position in the stock. In addition, the following low yielding REITs seem to have very low FFO payout ratios:

Low yields could be justified by the expectation for higher distribution growth down the road. If your REIT slashed distributions to the bone during the 2007 – 2009 recession, they could not yield much today, but could have the potential to yield twice as much in a few years. In addition, REITs in different sectors have different yields. A healthcare REIT that might be overvalued at a yield of 4%, even though a 4% yield would be considered fair for other types of REITs.

Many REITs are able to sell ten year bonds at yields as low as 3-4%. They have particularly benefited from falling interest rates in the past five years. If you re-finance debt that used to cost 6%-7% with debt that costs half of that, the FFO bottom line will be instantly improved. However, the problem that REITs might get to in a decade is if interest rates are substantially higher than interest rates today. Many investors believe that rates will go up, which could be costly to real estate trusts that want to refinance debt a decade from now.

Another risk that we might see is if REITs bid up assets they purchase to yield below 6-7 percent. If the low cost of capital drives REITs to compete aggressively for new assets to purchase, without any regards to quality or future possibilities, this could spell disaster for REIT investors. If rates increase over next decade, this could result in reductions in FFO. This could mean trouble for REIT investors one decade down the road - low property returns relative to high interest rates in 10 years. The mitigating factor here is that interest rates might increase gradually, once they start increasing in 2- 3 years. As a result, REITs will have plenty of time to adjust their debt costs. In addition, many REITs would be able to raise rents if inflation increases alongside with interest rates.

In my personal portfolio, I have replaced National Retail Properties (NNN) with American Realty Capital Properties (ARCP). Check my analysis of National Retail Properties.  I used the fact that investors pushed yields on National Retail Properties below 4% to exit my position. I did not like the slow growth in FFO/share, as well as the slow growth in distributions. The slow growth over the past decade did not justify current valuations. Buying National Retail Properties was justified up until 2010, after which I simply held on and cashed the dividends along the way. In all reality, this REIT could probably go as high as yielding 3%, which translates to $52/share.

Based on FFO/share of $1.77 and annualized dividend of $1.58/share, the forward FFO payout for National Retail Properties comes out to roughly 89%, which is rather high. For American Realty Capital Properties, FFO is expected to be in the range of 91 - 95 cents/share in 2013, and $1.06 - $1.10 share by 2014. The annual dividend is 91 cents/share, which could make up for a forward FFO Payout of 95.80 - 100% in 2013. It looks high, but in reality the company just recently completed the acquisition of American Realty Capital Trust III, which will probably distort how financials look like this year.

I liked the fact that American Realty Capital Properties (ARCP) is a REIT that is trying to make strategic accretive acquisitions in order to expand and increase FFO/share. I view ARCP as a company that could potentially become the next Realty Income (O). Since this REIT has only been publicly traded for less than 2 years, it trades at a premium to more established REITs such as Realty Income (O) and National Retail Properties (NNN).

I also put Realty Income (O) on my watchlist for potential trimming of my position there. I believe that Realty Income is a fine buy at 43/share, which translates to a 5% yield. However, if it trades above 54 it is richly valued. At current valuations, I will consider selling some at the $62-$72/share zone. This is equivalent to a yield of 3% - 3.50%. In the meantime, I will be sitting tight and reinvesting my dividends in other stocks.

I do like the fact that the REIT has managed to maintain and grow distributions. I also like the diversified nature of the tenant base, and stability and quality of cash flows. I believe that Realty Income is the Coca-Cola of REITs, but at yields below 4% it looks overvalued. At yields below 3.50% I am going to start trimming my position in it. My last purchase was in 2011, when my entry yield of 5% made me afraid that I am purchasing at the top. The REIT has managed to boost FFO substantially since then, which is why a valuation in the low 40s is fair.

Full Disclosure: Long O, DLR, ARCP, OHI

Relevant Articles:

- National Retail Properties (NNN) Dividend Stock Analysis
- Five Things to Look For in a Real Estate Investment Trusts
- The Case for owning Digital Realty Trust (DLR): When Hedge Funds Don't Know What They Are Talking About
- Realty Income (O) – The Monthly Dividend Company

Clorox Hikes Dividends, but is it a buy at current levels?

One aspect of dividend investing that is very appealing to me is the consistency of dividend increases for many of the dividend champions I own. I realize how I take these raises for granted, in the rare event when a stock I own freezes or cuts distributions.

Over the past week, Clorox (CLX) boosted dividends by 10.90% to 71 cents/share. This marked the 36th consecutive annual dividend increase for this dividend champion. Between 2002 and 2012, annual dividends have increased by 11.30% per year. Earnings per share increased by 11.60%/year. Check my analysis of Clorox.

The current yield increased to 3.20%, which is higher than the 2.88% which 30 year US Treasury Bonds offer right now. An investor in a company like Clorox today will likely earn much more in income over the next 30 years, compared to a 30 year US Treasury Bond.  As a result, fixed income allocation might not make sense for investors who look for current income. This would be driven by increases in profits over time, which would likely also result in much higher stock prices. If we experience an annual inflation of 3% over the next 30 years, an investment in Clorox with its rising dividends would essentially provide shareholders with a source of income that is relatively protected against inflation.

It is no surprise that investors are rushing to purchase quality dividend stocks right now, which is pushing valuations to overvalued levels.

The average estimate for 2013 earnings per share for Clorox is $4.30. The estimate for 2014 is $4.63. Based on these estimates however, I would not think it is reasonable to pay more than $86/share. For those investors who have owned Clorox for several years, such as myself however, holding on to this fine consumer goods company is a very good idea that will pay dividends for a long time. In the company’s Centennial Strategy, it targets 3 – 5% revenue growth, and profits above the rate of revenue growth. Given the company’s propensity to repurchase shares, I could easily see earnings per share growth in the high single digits for the foreseeable future. Given that the international segment is only approximately 20% of sales, I see this as a growth opportunity to expand the brand further outside the US.

One concerning factor is the high dividend payout ratio of 66% for 2013. If we use 2014 forward earnings however, the dividend payout falls to 61%, which is borderline high.

Over the past 30 years, investors in Clorox have done very well. The key to success had been investing at P/E ratios below 20, and holding on the position. Selling even after gains of 1000% would have been a mistake, as the company kept earning more income and kept raising dividends. While the next 30 years might not look the same as the past 30 years, this chart illustrates the power of selecting just a few quality stocks like Clorox for your dividend portfolio and then holding them for as long as possible. The data for 2013 assumes two payments at the new rate and two dividend payments at the old rate; it also assumes forward EPS projections for 2013 fiscal year.

Full Disclosure: Long CLX

Relevant Articles:

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Should you invest in Wells Fargo (WFC)?

In order to identify attractively valued dividend stocks, I follow a monthly screening process, where I go through the list of dividend champions and dividend achievers to look for bargains. In addition, I often stumble upon quality income stocks during my review of the dividend raises for the week or on an ad hoc basis through interactions with other dividend investors.

Some investors that I know have been purchasing Wells Fargo (WFC), which is one of the best run large banks in the country. The most prominent buyer of Wells Fargo is Warren Buffett, who has been accumulating the stock for the past four – five years in his personal portfolio and for Berkshire Hathaway (BRK.B). Buffett finds that the key competitive advantage for Wells Fargo is its low cost of funds. The bank took out 25 billion from TARP, and as a result had to slash its dividend and acquire Wachovia.

I had heard only great things about Wells Fargo, which increased my interest in the bank. As a result, I took a look at the financials over the past years.

The financial included Wachovia since 2009. The thing that I noticed was that there was no growth over past four years in revenues. The amounts from non-interest fees have held steady, while the net interest revenues have decreased slightly. Since 2009 however, expenses have decreased from $70.688 billion all the way to $57.615 billion in 2012. The main driver behind the decrease in expenses was due to decrease in the Provision for credit losses from $21.668 billion in 2009 all the way to $7.217 billion in 2012.

At the same time earnings per share increased from $1.75 in 2009 to $3.36 in 2012, while annual dividends increased from 49 cents/share to 88 cents/share. The forward annual dividend payment is $1.20/share. Wells Fargo also increased the number of shares each year since 2009 to 5.351 billion. Since the main reason behind growth has been the reduction in the Provision for credit losses, it seems that future growth would be limited, unless the company either earned more from loans or more from fees.

Actually, net interest income has been declining, while the amount of loans has been slightly up from $783 billion in 2009 to $800 billion in 2012. Securities available for sale have increased dramatically however to $235 billion, up from $173 billion in 2009. At the same time, deposits have increased from $781 billion to $946 billion. The main problem behind lending these days is that it is much tougher to loan money, and interest rates are dropping at the loan rate level. At the deposit rate level, interest rates are essentially zero. As a result, in order to compensate for the decrease in the net interest rate margins, Wells Fargo would have to ramp up its lending. With interest rates projected to be low for the next three years, increasing lending will be the only way out to profit growth in this segment, without sacrificing credit quality however.

The issue with ramping up credit right now however is that when interest rates go up in five - seven years, Wells Fargo might end up owning assets such as 30 year loans at 4% ( I made this number up), when its cost of capital is close to or above 4%.

The mitigating factor however is that the average maturity of loans is under 30 years, and also a portion of Wells Fargo’s loans are floating rate. The company will have almost $300 billion in loans mature within the next five years. Over half of these loans were floating rate ones. New loans will generate more income however.

I like the fact that the company also has a substantial amount of non interest based revenues, which account for half of Wells Fargo’s revenues. Total trust and investment fees and total mortgage activities accounted for over half of those non-interest revenues. The portion of fee income is approximately 59%, with the rest derived from mortgage origination, other, insurance and gains from trading. It is good to hear that the company is able to generate diverse income streams to fall back on. The company is able to cross-sell products to customers who enjoy their banking relationship with it.

One positive could be that the company has a record $945 billion in deposits, and has attracted over $200 billion since 2008. While not all of the funds are allocated to loans, this could be a good indicator going forward, because it means more banking relationships over time. A customer can open a checking account today, then decide to take a mortgage, open a brokerage account or do other business with Wells Fargo. The customer relationship piece is an intangible part of the business, but nevertheless could yield dividends down the road. In addition, with record low interest rates, these deposits are almost not costing anything to Wells Fargo.

Overall I like the fact that Wells Fargo is trading at 10.80 times earnings, yields over 3% and has a sustainable dividend payment. The company has a solid asset base, which will pay dividends for years. However, I am not certain where future growth will come from. The increase in the company’s profit since 2009 has been mostly due to the reduction in the provision for loan losses. At the same time revenues have been flat. Unfortunately, a company cannot grow shareholder value without growing revenues. You can only cut so much expenses. If Wells Fargo were to start loaning out more funds, it would possibly translate into more revenue, as long as borrower quality is maintained and the net interest margin does not drop from here. There is a margin of safety in today’s valuation, but until I can see revenues increasing, I am going to sit this one out on the sidelines.

At the same time, I am a big fan of the five largest Canadian banks. These companies have a dominant position in the Canadian market, and earn very good amount of fees from customers. At the same time they have been able to grow interest and non-interest income, increase number of branches and expand by buying US bank assets. Back in early 2013 I purchased shares in Bank of Montreal (BMO), Bank of Nova Scotia (BNS), Royal Bank of Canada (RY), Toronto-Dominion Bank (TD), Canadian Imperial Bank of Commerce (CM).

Of course, if Canada’s housing market softens, these big five banks would likely perform worse than the likes of Wells Fargo. The table above shows the Net Interest and Non Interest Income trends for Toronto - Dominion Bank (TD). It also shows the trends in the provision for credit losses as well. Canada adopted IFRS accounting standards recently, which is why information for prior to 2011 is under Canadian GAAP. Either way however, the trend in the three pieces of information would be similar under both accounting methods. The trend over the past few years in both interest and non-interest income for the big five Canadian banks is positive. They have been expanding domestically and internationally, which makes seeing where growth will come much easier.

Full Disclosure: Long BMO, BNS, RY, TD, CM

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Why would I not sell dividend stocks even after a 1000% gain?

In a previous article I wrote on when to sell dividend stocks, many investors were absolutely furious that I would not even think about selling after a stock I own goes up 1000% in value. The reality is that this would depend on the circumstances, but since I am a long-term investor, I expect that at least some of the stocks I purchase today would become tenbaggers over the next 30 years or so.

In order to add shares in companies to my portfolio, I go through a quantitative screening process, followed by a qualitative review of the business. The qualitative portion is the most subjective one, and is based on my experiences consulting companies, using products or discussing products with company’s clients etc. As a result, I try to enter companies which I believe would be there for at least 20 – 30 years, when their shares trade at fair prices. If they are undervalued, that makes investing in them much easier. For example, based on my prior experience I would much rather purchase an oil company like Chevron (CVX) or ConocoPhillips (COP), than an individual US oil and gas trust that will be worth zero in a few decades. I could probably write an article about that.

Dividend growth stocks follow a natural progression of slowly increasing earnings and dividends over time. They almost always look fairly valued, which is why the biggest benefit is earned by long-term holders. If I purchase a stock like Chevron today while the annual dividend is $4/share, the current yield is at 3.30%. Chances are that one decade from now, the yield would be close to 3% again. However, the dividend and the share price would have probably doubled along the way.  I say probably in regards to the dividend growth, because things never progress in a linear fashion of course. Using the inputs above however of dividends doubling every decade, and stock prices yielding somewhere close to 3%, it would not be unheard of if an investor in Chevron sits on an 800% – 1000% gain in 30 years. If there isn’t a tectonic shift that would take the world off of oil and gas, chances are that this growth is a very likely scenario that would continue for several more decades.

As a result of focusing on quality companies, there are few things that can make me sell. I view myself as a part owner of a business, and as a result the business fundamentals such as returns on equity, earnings per share and dividends per share are more important than share price fluctuations.

One of the things that would make me sell is a dividend cut. My expectation is that a company would generate higher dividends over time, and thus the inability to do so is usually the last signal of deteriorating financials I am willing to take that shows trouble. I do expect to get a high yield on cost over time, although this indicator is not something i use when evaluating buy or sell decisions. If everything goes well for my investment, I would expect it to generate more dividends over time, which would increase yield on cost, which is an indicator of an increase in dividend income. This indicator always seems to confuse and anger investors for whatever reason. I would not sell a stock simply because it becomes overvalued. For a typical dividend growth stock, if it traded up to 30 times earnings it would be more of a temporary noise, especially if this is backed by serious growth.

Dividend investing is not a black and white strategy however, and as such, a P/E of 30 might cause me to sell some stocks but might lead me to hold on to other stocks. The nuances of holding on to overvalued companies that keep performing will vary for each individual situation. Even if I were to sell a stock with a P/E of 30, then I would have to pay a capital gain tax that would eat into my capital and find a security that is attractively valued. If we happen to have the stock market trading at all-time-highs, and all other quality companies are overvalued, I would have essentially shot myself in the foot.

As an individual dividend investor, I have a limited amount of time that would allow me to identify and invest in approximately 50 – 80 great stocks during my lifetime. Of those, probably 15 – 18 would perform to be once in a lifetime investments. The rest would get acquired, lose focus or outright fail. As a result, my goal is to run with the winners for as long as possible and get rid of the losers as soon as possible.

The number one reason why individual investors fail is because they tend to book small profits. At the same time they keep their losers hoping for a turnaround. Instead, they should focus on identifying quality companies, and then let fundamentals improve and simply hold on to these great ideas. It is difficult to be a long term investor when you are bombarded with stock market information everywhere you go. However if you do not embrace a long-term approach to investing, and do not see shares as ownership in real businesses, chances are dividend growth investing is not for you.

There is a lot of work involved in timing the movements of stocks, and selling a company that might be overvalued today to purchase another company. I have found that there are only so many quality dividend stocks I am willing to consider looking at. Finding the right company trading at the right price narrows the list down even further. Then there are things such as avoiding concentration to specific sectors as well as avoiding concentration in particular individual positions as well. As a result, I buy and hold on to stocks that fundamentally perform well. I could sell the stock and buy another one, but I might increase the risk that I am buying something that could be of lesser quality, despite the high price. For example, I could sell Johnson & Johnson (JNJ) today and purchase NuSkin enterprises (NUS), which have a much lower P/E. However as I mentioned in my analysis of NuSkin, I find it to be of lesser quality than a Johnson & Johnson.

As a dividend investor, I do monitor the positions I have regularly. However, from a psychological perspective I have found that a daily monitoring of my portfolio for major events might increase my chances of doing something stupid such as trading too often. In reality, as a part-owner of a business, there are not many events that would happen every day, which would materially affect the business. Again, this is more of a nuanced approach as opposed to a black and white strategy. I do want to see improving fundamentals over time, as well as catalysts that would bring more income. For example, Coca-Cola (KO) is a brand whose products would likely continue to quench the thirst of consumers, who would only drink the specific products sold by the company. I would never for example drink Pepsi, although I know some individuals who would always drink Pepsi and hate Coke. There are hundreds of millions of consumers who will be entering the middle class in developing markets in Asia, Latin America or Eastern Europe. If people in India and China eventually consume as many servings of Coke per year as Americans do, Coca-Cola will have a bright future ahead.

Back 1988, Warren Buffett began accumulating shares in Coca-Cola (KO) for his holding company Berkshire Hathaway (BRK.B). Currently, Berkshire owns 400 million shares at a cost of $3.2475/share. Berkshire’s stake has increased its value over 11 times over the past 25 years. At the same time, the company has been more valuable, as it has managed to increase profits and dividends. The stock price was overvalued in 1998, seeling as high as $45/share, and having a P/E of 48 by year end and an yield of 0.80%. EPS for 1998 were 71 cents/share. Buffett did not sell his stake, and earnings per share rose to $1.97/share by 2012. The issue was that Coca-Cola was consistently trading above 20 times earnings between 1992 -1998. Since 1995, Coca-Cola traded at a P/E of over 30 times earnings. The stock didn't become attractively valued until 2006. In hindsight, it’s easy to tell when to buy and sell. In reality, it ain’t so. Berkshire Hathaway currently is sitting on more than a 1000% gain in Coca-Cola. Chances are that it would keep on holding the stock, and since Coca-Cola regularly repurchases shares, Berkshire's stake in the company will keep increasing over time.

Buffett did sell another one of his holdings, McDonald’s (MCD) in 1999, when the stock traded around $35 - $40/share. The stock fell as low as $12/share in 2003, before reaching $100 by 2011. The dividend increased each year during the period, although McDonald’s did have some operational issues in 2002 – 2003. In effect, Buffett missed out on this great investment idea.

Full Disclosure: Long CVX, COP, MCD, KO, JNJ, PEP,

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Attractively valued dividend stocks to consider today

With the stock market hitting all-time highs pretty much every day, there are not that many stocks that have low valuations today. Some of my favorite companies such as Coca-Cola (KO) are trading at over 22 times earnings, which is above what I am willing to pay for this otherwise excellent business.

As a result I focused on the list of dividend champions, and uncovered the following attractively valued companies with low p/e ratios. I tried to look for dividend champions with yields above 2%, payout ratios below 60% and P/E ratios around 16 or lower. Despite the fact that current yields on this list are low, these companies offer good values in today’s overheated market. With low dividend payout ratios and attractive dividend growth, these low valuations offer a great entry point for investors who have at least ten or twenty years to let the investment compound.

I also added Ameriprise Financial (AMP) to this list, because I was researching it for inclusion to my portfolio, despite the fact that the company has raised distributions for less than 25 years. As most of these companies yield less than 2.50%, I would monitor them and try to add on dips. For example, back in April, I initiated a position in IBM (IBM) when the stock market punished the stock below $200/share, thus locking a 2% yield for a low valuation business with excellent EPS growth potential. Early in 2013 I was able to add to positions in Yum! Brands (YUM) and Family Dollar (FDO) after investors punished the stocks as well. That is why any type of irrational weakness must be explored by the enterprising dividend investor. Despite the high P/E on Johnson & Johnson (JNJ) today, it looks like the company trades at a P/E of around 15 based on forward 2013 estimates, so it could be one company to check out. The ability to look beyond the numbers could uncover attractively valued stocks in todays market.

While I would not be adding to my positions in Coca-Cola (KO) or Colgate-Palmolive (CL) at current valuations, the 13 companies listed above will be the types of stocks to consider when adding new money to my portfolio on dips. This should be done of course only after thoroughly researching the business, and then paying an attractive entry price.

The traditional blue chip companies I have held on for so many years, such as Coca-Cola, Colgate-Palmolive and many others which have attracted my new capital contributions for the past five years are no longer making sense to buy. As a result, the overvalued markets have caused me to be more creative in uncovering successful businesses, that can deliver better performance in the future. I am willing to purchase a stock yielding 2% today, if the valuation is low at say 15 times earnings and if there are catalysts for future growth. At the end of the day, a company yielding 2%-2.50% that trades at a P/E of less 15 that grows dividends above 7%/year will be more valuable than a company yielding 3.00%, trading at a P/E of over 22 and growing at 7%.

I would try to avoid value traps during the individual analysis I perform. I would try to stay away from known problems that can be disastrous. As a result, I am avoiding technology stocks like Intel (INTC), which might not be able to grow earnings per share over the next decade per my analysis of the situation. In addition, I did not include Cardinal Health (CAH) on this list, because it has been losing customers such as Walgreens (WAG), and has contracts with CVS (CVS) up for renewal in June. That is despite the fact that Cardinal Health has raised dividends for 17 years, trades at a P/E of 13.60 and yields 2.60%

I would much rather avoid losing money, than miss out on the next hot stock. The importance is to focus on quality, which unfortunately usually lies in the eyes of the beholder. A small leak can sink a big ship. Companies which are losing customers, companies that have advantages which are not durable (such as tech companies), or companies which are cyclical are to be avoided. I am not interested in companies which look undervalued today, but whose profitability might suffer, thus making them overvalued in hindsight.

Full Disclosure: Long IBM, KO, CL, AFL, APD, CVX, MDT, UTX, WMT, WAG, AMP

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