If you’ve followed my writing for any period of time, you probably know that I’m a stickler for valuation. That isn’t to say that I only own contrarian, deep value names; actually, I oftentimes find those investments too risky for my liking.
What it means is that fundamentals play a paramount role in my stock selection. I spend a lot of time looking at relative valuations, in terms of historical norms and industry/sector peers. I’m always on the lookout for a bargain.
In the past, I’ve covered high growth technology names here at Sure Dividend. Many of those names are expensive, especially if you ignore their growth potential. If those are the only pieces of mine that you’ve read you’re probably thinking to yourself, “This guy has got to be kidding, right?â€
No, not at all I have a small segment of my portfolio that I have earmarked for highly speculative and potentially disruptive investments like Amazon (AMZN) or NVIDIA (NVDA), but other than that, even if the high growth space, fundamental valuations are at the forefront of my mind when making capital allocation decisions. There is actually only one other set of stocks that I buy and sell based upon information other than the underlying fundamentals and that will be the topic of my article here this week.
The sub-group of stocks that I’m talking about are the high yield, interest rate sensitive names.
After last Friday’s (2/2/18) massive sell-off sparked by fears of rising rates, it seems like as good of a time as ever to talk about these names. We’re talking REITs, utilities, MLPs, BDCs, and to a certain, though lessor extent (in my opinion, anyway) telecom’s.
I view telecoms in a somewhat different light because of changes going on in that industry with regard to them looking for the same sort of content-oriented growth as big tech. I like this move away from the traditional content/information distribution business. This industry trend has given me a more bullish long-term growth outlook for major telecom players and because of this, I don’t necessarily look at them in a totally income-oriented light.
While fundamentals remain important for stocks in these industries/sub-industries, I tend to use yields as non-negotiable thresholds when setting entry and exit targets.
Why? Because companies operating in these spaces aren’t known for their growth. I wouldn’t invest in any of these types of companies if I was looking for quick and/or outsized capital gains. Instead, companies in these areas of the market typically attract investors with their reliable cash flows and shareholder returns. In certain cases, they’re obligated due to tax structure to pay a certain percentage of their earnings out to shareholders as a cash dividend/distribution. In other words, they’re income-oriented investments.
I like bolstering my income stream with the high yields offered by companies in these areas. But, because of their relative lack of growth prospects, I’m not willing to own these names unless the risk/reward scenario is tilted in my favorite with an acceptable yield.
What’s “acceptable†to me might not be acceptable to the next guy or gal. What’s more, “acceptable†yields remain on a fluctuating scale relative to the yields available in the fixed income space. Typically, I’m looking for yields in the equity space that are at least 200 basis points higher than the upper end of my near-term U.S. 10-year treasury note yield expectation.
This figure is admittedly arbitrary, but I feel comfortable with it and the defensible margin it gives me as a shareholder in the face of rising rates. Different investors will have different yield thresholds when it comes to rate sensitive companies like REITs. Really, it all comes down to understanding the relationship between the valuation premium that the market applies to equities based upon the perceived margin of safety between their current yields and the direction of U.S. Treasuries.
