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VNQ Share Fall, Yields On REITs Rise As Treasury Yields Fall

Summary The Vanguard REIT Index ETF appears to be on sale. Despite falling treasury yields and rising prices for utilities, equity REITs are showing weakness. I believe we are seeing a flight to quality as investors angle for more conservative assets. For investors that believe the markets are reasonably efficient, it makes sense to hold a large position in a low fee ETF like the Vanguard REIT Index ETF (NYSEARCA: VNQ ). I believe the markets are reasonably efficient, but I also believe that fear and greed occasionally overpower rational analysis and we see movements that fail to make adequate sense. On June 29th, it appears that fear was the emotion of the day and VNQ was becoming even more attractive. The Fear If you haven’t heard already, there are some issues in Greece. The Greek banks and their stock market are closed for the day and there are expectations of a payment due to the IMF to be missed. There was a nice little piece on it in the SA news feed earlier in the day . The piece there contains a little more information for readers that are interested. Rather than repeat the issues with Greece, I want to focus on the irony in the interest rate market. Let us begin with a look at a yield chart I pulled from Yahoo: (click to enlarge) The yields fell sharply lower today. If an investor is simply interested in what level of yield they can get on their investment, this should indicate that too many people are buying bonds and that they should be less attractive. By comparison, other sources of income should be more attractive. They should see prices increases and yields fall. However, that is precisely not what we saw with the Vanguard REIT Index ETF. I put together a quick chart from Google showing the price movements for VNQ and the Utilities Select Sector SPDR ETF (NYSEARCA: XLU ). (click to enlarge) As you can see, the movements previously were relatively similar and this morning they both jumped higher, but since then VNQ has been trading down while XLU has maintained part of the gain. My Take I’m seeing yields falling on treasury securities as investors have a “flight to quality”. Since the treasury securities are seen as the most reliable investment available, that is where the money is being placed. We see the same logic over the course of the day as investors are picking XLU over VNQ. The theory may be that if economic conditions worsen, the utilities will still have safe profit margins. Renters can move in with their parents and stop renting an apartment, but they won’t stop consuming electricity. The logic makes sense in the context of a flight to quality, but it ignores everything else about the business. I’d Rather Have REITs Owning a piece of the utility companies is a reasonable choice for portfolio diversification and very reasonable for investors focused on dividend yields. However, REITs remain an extremely attractive investment for the tax advantaged accounts. In my opinion, VNQ is a screaming buy relative to the 10 year treasury. The yield on VNQ just broke 4%. It is offering investors substantially higher levels of income than the Treasury, though I will grant it is also a significantly riskier security. The reason the risk is worth it can be viewed in the long term context. When we focus on investing and buying yield rather than on short term price movements, it is reasonable to say that an investor buying a bond should expect to achieve roughly the yield to maturity if they hold the security to maturity. In the event of a zero coupon bond (no reinvestment risk), we would expect precisely that yield absent any brokerage costs. When it comes to income, the investor in VNQ would need to see future dividends fall by over 40% before they would receive less in their yield on VNQ than they would on investing in the treasury security. It could happen, at least theoretically equity REITs could find themselves forced to reduce dividends if the economic environment worsens and revenues decline, however I have yet to see any plausible argument for a 40% reduction across the industry. The worst year for VNQ when measured in dividends paid out was 2010. The total dividend payment was $1.89. Compared to the current share price, that would still result in a 2.52% yield. Acceptable Capital Losses If we assume that dividends will average roughly the same level they are at now over the next ten years, then we have superior performance by about 1.7% per year. Using simple math, the premium in yield would compound to just over 18% in ten years. So long as VNQ ended the period with the share price falling by less than 18%, the shares would have delivered a superior total return. The most logical case for VNQ to underperform treasury investments would be a substantial cut in dividends that matches a substantial decline in share price as investors would continue to expect a reasonable yield on new investments. In that manner, if dividends were cut to less than $2.00 per share, I would expect capital losses to easily surpass the acceptable levels. I find that scenario to be very improbable. On the other hand, since late 2004 through early June VNQ delivered a CAGR (compound annual growth rate) counting reinvested dividends of 8.75% per year. Over the next decade I’m expecting the dividends to grow on average by 4% to 5% per year and I’m expecting share price to grow at a slightly slower rate as higher interest rates on bonds will require higher yields from other income securities. Conclusion I’m long VNQ and I have a buy-limit order to add to my REIT holdings. I’m hoping to see the major REIT index funds decline more over the next year so I can keep adding to my positions at prices I consider attractive. I’m not just rebalancing into more REIT investments; I’m increasing my exposure to equity REITs because I see attractive long term investment opportunities. The situation right now resembles a falling knife, but I see it as a falling knife of gold. I may get cut several times as I keep buying into the REIT sector, but the long term expected returns at these yield levels are enough to keep me happily buying more. Disclosure: I am/we are long VNQ. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

Will UNG Resume Its Descent?

The price of UNG is up for the month on account of stronger demand in the power sector. Despite warmer weather, the cooling degree days are expected to reach normal levels this week. The normal cooling degree days could suggest the demand for natural gas in the power sector will cool down. The recent natural gas report showed the injection to storage was 75 Bcf, which was slightly lower than market expectations. Moreover, the latest buildup was below the 5-year average and last year’s injection. This news has provided a short-term boost for the shares of the United States Natural Gas ETF (NYSEARCA: UNG ) during last week. The price of UNG is slightly up for the month, but it will require a stronger demand for natural gas to bring UNG further up. For now, this scenario doesn’t seem likely. Before reviewing the latest developments in the natural gas market, shares of UNG continue to underperform natural gas prices: The impact of the roll decay on the price of UNG is demonstrated in the chart below (the prices are normalized to the end of last month). As you can see, the price of UNG rose by only 3.5% during June, while the Henry Hub by nearly 5%, i.e. a 1.5 percentage point difference. (click to enlarge) Source of data taken from EIA and Google finance According to the weekly EIA report , this week’s injection was the first time for this season to be below the 5-year average buildup. As of last week, the storage was 38% higher than the level recorded last year and 1.4% above the 5-year average. (click to enlarge) Source of data taken from EIA From the supply side, production picked up – it rose by 1%, week over week. And it’s up by 5.5% compared to last year. Based on the latest update by Baker Hughes , the number of gas rigs slightly rose by 5 to 228 rigs. Nonetheless, U.S. consumption also grew by 2.4% last week and was up by 8.5% for the year. Most of the growth in demand came in the power sector – 6.1%. This gain was partly offset by lower consumption in the industrial and residential/commercial sectors. Looking forward towards the next two weeks, the weather is expected to heat up mostly in the coastal line, including West, Northeast and South Atlantic, but the temperatures are projected to be lower than normal for this time of the year in parts of the Midwest. Despite the expected higher than normal temperatures in parts of the U.S., the cooling degree days are estimated to be only slightly higher than normal – this could suggest the rise in consumption in the power sector will slowdown. This could explain why the markets estimate this week’s injection will be close to the 5-year average buildup of 75 Bcf. The natural gas market slightly heated up in the past few weeks, but over the short run the power sector isn’t expected to heat up. Thus, the demand isn’t likely to pressure up the price of natural gas. For UNG, this could mean another pullback in its price. For more see: On the Contango in Natural Gas Market Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

PPL Corp. – Early Birds Catch The Worm

PPL has changed their business strategy to focus on a niche market. It is now a regulated utility focused on transmission and distribution assets. The company’s risk profile has been reduced. PPL could become a takeover target. PPL Corp. (NYSE: PPL ) is beginning to look attractive. In early June, PPL spun off their fleet of merchant power plants to a new company called Talen Energy (Pending: TLN ). By spinning off one part of their business, PPL changed its profile from a hybrid to a niche utility. The new PPL is a regulated utility. It is no longer exposed to the volatility associated with nation’s new deregulated power markets. It is no longer exposed to financial and political risks associated with U.S. Environmental Protection Agency or Nuclear Regulatory Commission actions. Instead, most of their revenues will be regulated and their earnings will become stable. PPL’s potential value is understood in the context of industry trends. Until recently, large utilities hedged their bets by spreading their positions along the utility value chain. Most wanted to diversify their portfolio of assets by owning power plants, transmission lines, pipelines, distribution wires, metering systems and energy service companies. They wanted to own regulated assets. They also wanted to own deregulated assets. For those utilities who tried owning everything, it did not work out well. Some were burned by the market. Others were overwhelmed with indirect expenses. A few saw their bond ratings limited as investors assessed their risks. Today, utilities are adopting a new strategy. One by one, the nation’s largest utilities are shifting their portfolios. One example is Duke Energy (NYSE: DUK ). Last April, Duke sold two deregulated businesses to Dynegy (NYSE: DYN ) for $2.8 billion in cash. One business was Duke’s fleet of deregulated power plants. The other was their deregulated energy services business. Today, most of Duke’s assets are regulated. Another example is Dominion Resources (NYSE: D ). Dominion sold a fleet of deregulated power plants and prematurely retired a nuclear plant. They also sold their deregulated energy services business to NRG Energy (NYSE: NRG ). While they still own a merchant nuclear facility, most of Dominion’s assets are regulated. Some utilities are unable to sell disaffected assets. Instead, they decided to do the next best thing. They decided to change the percentage of assets within their portfolio. To change their portfolio to more favorable emphases, they buy more of one asset and reduce numbers of other assets. Today, two large utilities are attempting to change their portfolios by acquiring distribution-only utilities. One example is NextEra Energy (NYSE: NEE ). NextEra is attempting to acquire Hawaiian Electric Industries’ (NYSE: HE ) utility. They are also attempting to acquire OnCore Electric Delivery (the Texas-based electric distribution utility owned by bankrupt Energy Future Holdings Corp.). By acquiring more distribution utilities, NextEra increases their footprint, reduces their reliance on one state’s regulator and de-emphasizes their generating profile. Another is example Exelon (NYSE: EXC ). They cannot easily sell their huge fleet of merchant power plants, which is mostly nuclear. They can adjust their profile by acquiring a wires-only utility, which is one reason why they are in the process of acquiring Pepco Holdings (NYSE: POM ). Pepco is mostly a regulated wires-only utility. If Exelon’s acquisition is successful, Exelon will become more of a regulated utility and less of a merchant utility. As a result, their access to capital is improved and their cost of capital is reduced. These examples are relevant to the new PPL. Now that PPL is mostly a wires-only utility, the company has become a niche player. This change in strategy should be attractive to investors. It could also be attractive to other utilities who might want to expand their footprint or alter their profiles. To be clear, the new PPL could be an attractive takeover target. If another utility attempts to buy PPL, shareholders could be rewarded. It may take time. It may not happen overnight. However, PPL is paying a stock dividend. That dividend could help buy shareholder patience. However, investors should be careful. There is a reason PPL’s dividend is attractive. It is possible PPL’s management could lower the dividend. The possibility seems remote. In their February conference call , PPL’s chairman and CEO addressed the complany’s dividend plans: But as we’ve said, post spin, our intent is to continue to maintain the same level of dividend prior to the spin. And we’ll look at opportunities where appropriate to grow it if we can. So that’s kind of still the game plan going forward. There appears to be equivocation. We can see why in their May conference call . In that call, PPL’s CFO addressed the dividend issue again: We recognize that the domestic payout ratio to fund our dividend was over 100% beginning in 2016. With our ability to dividend between $300 million and $500 million a year from WPD over the next few years, we would target to get the domestic payout ratio back under 100% for 2016 and continue to lower that domestic payout ratio in 2017 and 2018. Today, forward ratios appear to support PPL’s dividend goals. If everything goes as planned, the dividend should remain intact and possibly grow. However, PPL owns WPD utility system. WPD serves end-users in Wales and England. It has several subsidiaries operating in Wales and England. Over 40% of PPL’s assets are owned by their WPD subsidiaries. Approximately 33% of PPL’s forward revenues are derived from WPD subsidiaries. With billions of dollars in another country, PPL is exposed to United Kingdom’s economy and currency. They are also exposed to U.S. taxes on repatriated funds. If any unforeseen event takes place, there is risk PPL’s dividend may require adjustment. As a reminder, Exelon surprised their shareholders by cutting their dividend . Prior to acquiring Constellation Energy, Exelon’s management suggested dividends could be maintained. A few months after they completed their Constellation acquisition, Exelon’s dividends were cut. The stock tumbled. For PPL investors, the challenge is the company’s fundamentals. It is difficult to reference a baseline when the baseline suddenly shifts. In PPL’s case, when they spun off their generating company, it became difficult to reference past performance. As a result, it may take several quarters for investors to digest the full effects PPL’s spin-off. Nevertheless, speculators may want to accept management’s guidance and jump in. As uncertain as they may be, some ratios look attractive. PPL’s current yield is about 5%. Its price/earnings ratio is below 11, its forward earnings appear healthy, and its risk/reward suggests buying now — even if some critical facts are largely unknown. Fundamental investors may want to wait. PPL’s management has aggressive capex plans. They may attempt to buy a competitor and expand their wires business. There could be some dilution. Ratios could be adjusted. Then again, a hungry utility may want to jump in, pay a premium and buy PPL. In that case, ratios and earnings estimates are largely academic. Those who bought early may catch the worm. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.