Wild January Could Have Inflicted More Harm than it Did
By: Tim McPartland,
January was a wild month, not only in common stocks, but also in preferred issues and “baby bonds.”
But when the month came to a close, our holdings outperformed the S&P 500 by a wide margin as they combined to dip only slightly more than 1% for the month. There has been a shift in the preferred stock and baby bond sectors during the last 2-3 months whereby high quality issues have performed much better than low quality, unrated ones.
While many unrated issues have gyrated in a relatively wide range, the investment grade issues of banks, insurance companies and high quality real estate investment trusts (REITs), such as Public Storage (NYSE:PSA), have held firm and, in many cases, risen in price. Conservative income-seeking investors, have chosen a safe dividend instead of the higher current yields of unrated and lower quality issues.
The wholesale selling by investors presented a number of opportunities for investors with a somewhat higher tolerance for risk to pick up some apparent bargains and we took the opportunity to make numerous purchases during the month.
The REIT sector held its own during January. Similar to preferred stocks, higher quality issues performed better than those that were marginal. It would appear that investors are concerned with the overall economy in the United States and they are choosing to move to the safest issues. Super safe issues such as Realty Income (NYSE:O) had stellar gains during January with Realty Income up near 15%. Lower quality but higher-yielding issues, such apartment owner Independence Realty Trust (NYSE:IRT), took a 10% loss.
As one would expect, Master Limited Partnerships (MLPs) continued to be smashed downward as crude oil and natural gas prices remain extremely low. Originally, it was primarily upstream energy companies taking the brunt of the pain. But now, virtually all sectors have undergone painful setbacks. No doubt there are bargains, but to dabble in the energy patch now would be foolhardy as we believe bankruptcies in 2016 will be more prevalent than they were in 2015.
As we look over our portfolios, we can report we survived January with only minor blemishes. This is true of the model portfolios, as well as our own personal accounts. Unfortunately, we are more fearful of the future than of the past as we stare down the barrel of a potential recession. Below we review some of the actions taken during January in the Model Income Portfolios.
For the month of January, we made one sale in the Blended Income Model Portfolio, but we made six purchases. These moves took our cash position in the portfolio down to 10%, which we consider adequate cash from which to make purchases in the month ahead if additional bargains become available (and we have no doubt that bargains will appear). We sold theGeneral Finance 8.125% Senior Notes (NASDAQ:GFNSL), which had been knocked lower because of their dependence on the oil and gas industry. General Finance (NASDAQ:GFN) earnings are trending lower fast and there is little likelihood that the company will recover anytime soon and there is a chance, depending on energy prices, that the company will eventually go bankrupt (not soon, but in the next 24 months). High yields are meaningless if the issuer fades to Chapter 7.
We purchased common shares in lodging REIT DiamondRock Hospitality (NYSE:DRH) and water utility Aqua America (NYSE:WTR). The shares of DRH have performed poorly since purchase, while WTR has been stellar as the water issues in Flint, Michigan, highlighted the poor condition of the infrastructure in the United States.
Additionally, we purchased the term preferred shares of REIT Gladstone Commercial (NASDAQ:GOOD). This purchase is the 7.125% issue (NASDAQ:GOODN) which has a mandatory redemption date of January 31, 2017. We purchased these preferred shares for just above par, so we have locked in a return of 6.125% for the next 12 months. This was a large purchase and meant to use some of our cash to lock in a fairly safe return for the next 12 months which we expect to be difficult for all investors. Additionally, we purchased term preferred shares in business development company (BDC) Gladstone Capital (NASDAQ:GLAD) as the shares went “on sale” when the market panicked because the company has a modest exposure to the energy patch. We were able to pick up shares of the 6.75% 2021 term preferreds (NASDAQ:GLADO) at the bargain price of $20.90/share and they now are trading at $22.50. Investors figured out that GLAD is covered by the leverage rules (GLAD must maintain 200% asset coverage on senior securities) which brings a nice level of safety to the issue.
In the same vein as the GLAD purchase above, we purchased the 9% perpetual preferred shares of REIT Ashford Hospitality (NYSE:AHT-E) as shares were knocked lower as the company battles activist investors. We were able to purchase shares at $18.65/share and those shares are now trading in the $23.56 area. You might recall that while we avoided “perpetual preferreds” in 2015, we tweaked our investing strategy to include a few perpetual preferreds as it appears that higher interest rates are very far away. Additionally, we are focusing a bit more on current income versus being so totally focused on capital preservation.
Lastly, we purchased the 6.25% baby bonds of Prospect Capital (NYSE:PBB) as they went on sale at $19.50. They currently trade at $21.78. Prospect Capital (NYSE:PSEC) is a business development company which has been under pressure because of high management fees and poor performance. But since it is a large company and its bonds are investment grade, the yield of 8% it offers is a fairly lucrative investment.
As we look ahead to the next month or two months, we believe that all markets will remain volatile. While the United States had slight growth during the last quarter of 2015, the rest of the world continues to struggle mightily. Japan went to negative interest rates in January as the country continues to fight an aging demographic trend. Unfortunately, this move will likely be in vain as you simply can’t make consumers spend when they don’t want to spend. China continues to slow and there is no reason to believe that the Chinese government has the means to any longer juice their economy. Europe is being overrun and resources over taxed by millions of refugees. The contagion from the oil patch has been decimating but there are likely many more dominos to fall before this story is finished — remember that the United States’ largest single trading partner is Canada and the economy to the north is in shambles. We believe that the United States is heading toward recession — we can find no silver bullet (economically speaking) that will bail out the economy.
For February, we expect markets to rise and fall sharply as investors vacillate between the notion of a pending recession or an economy that continues to muddle along. Interest rates are going nowhere (or if anywhere they will trend lower). It is a scary time — one in which we will sit tight — probably not buying or selling while trying to divine the economic tea leaves. The fear of the unknown is as high as it has been at any time since 2008. But the economic releases in the last month have not been absolutely terrible, so maybe we will muddle through. Maybe this is simply going to be a “goldilocks” time for income investors. We hope so.