Looking For Alternatives

11/12/2012


Past results are no guarantee of future returns.

Why lead with this disclaimer? Because we can't count on the next 15 years unfolding like the last 15.

If you had put $1,000 in the S&P 1500 Index at the end of October 1997 and reinvested the dividends, over the next 15 years your stake would have grown to $1,852. But what if you'd instead looked at alternative investments with higher yields? A $1,000 investment in the MSCI U.S. REIT Index would have grown to $3,533, an annualized return of 8.8%. The Alerian MLP Index, which invests in energy master limited partnerships, performed even better, delivering an annualized return of 15.4% — and turning $1,000 into $8,615.

While the returns are real, we didn't advise investors to sink all their cash into real estate investment trusts, MLPs, or other income-oriented alternatives like royalty trusts 15 years ago, and we can't do it now, for at least three reasons:

Industry concentration: As asset classes, MLPs, trusts, and REITs offer some diversification benefits in a portfolio of traditional stocks, and the average MLP or royalty trust is less volatile than the average for energy stocks or stocks in the S&P 1500 Index. But while these investments don't always move with the market, they frequently move with each other. Most MLPs and royalty trusts hold energy assets, and investors who load up on REITs, MLPs, or trusts are making a big bet on a small sliver of the market.

Royalty trusts tend to focus on production, while more than half of the MLPs in our Quadrix universe own storage and transportation assets, so investors can diversify somewhat within the energy sector. REIT investors can partially hedge their bets by focusing on different types of property (retail versus office, etc.) and different regions of the country. But the strategies above won't protect against a broad slowdown in real estate or energy.

Difficult analysis: We calculate Quadrix scores for 166 REITs, 93 MLPs, and 17 royalty trusts. Our Quadrix system considers more than 80 statistics. Many trusts, MLPs, and REITs don't report all of the numbers, and some of the metrics are not particularly useful for assessing investment appeal in those groups.

Historically, Quadrix hasn't worked very well for REITs, and we have not tested it for MLPs and trusts. We can dig into these investments and draw some conclusions, but we will never be as confident in our Quadrix scores or our analysis as we are with traditional companies.

Odd structure: Technically, REITs and royalty trusts are unit investment trusts, not stocks, while MLP investors own partnership units. Because they must distribute most of their cash flows to investors, REITs and trusts receive favorable tax treatment — and if you own them, you might have to take a few extra steps at tax time.

MLPs also receive special tax treatment, though it depends on how the partnership generates its cash flows, not how much it distributes. Last month, the Internal Revenue Service opened up the tax-preferenced MLP structure to some energy and chemical businesses not previously allowed to form MLPs.

In some cases, investors must pay ordinary-income tax rates on distributions. And some distributions are treated as returns of principal that lower the cost basis of the units. Subscribers interested in MLPs and royalty trusts should consider how the investments will affect their own tax situation, consulting with a tax expert if necessary.

Aggressive shareholder distributions limit the ability of REITs, MLPs, and royalty trusts to invest in future growth without external funding; royalty trusts can't even issue new units or debt to fund acquisitions. Because of their yields and tax structure, REITs, MLPs, and royalty trusts are often tossed into the same high-income bin by investors. Don't make that mistake, because the three are quite different, as shown in the table below.

CHARACTERISTICS OF ALTERNATIVE INCOME INVESTMENTS
Dividend
Frequency
Average
Stock-
Market
Value
($Mil.)
Owns
Assets
Required
To Pay
Out 90%
Of Income
Investors
Receive
K1-Form
For Taxes
No. Of
Units In
Quadrix
Universe
Average
Quadrix Scores
Average
Dividend
Yield
(%)
Value
Overall
Master limited partnerships
(MLPs)
7
Quarterly
3,783
Yes
No
Yes
93
38
44
MLPs are publicly traded partnerships, not corporate entities. To qualify for tax breaks, MLPs must derive 90% of cash flows from "qualifying sources," which for the most part limit them to natural resources, commodities, real estate, or in some cases chemicals. Nearly three-fourths of MLPs operate in the energy sector, mostly in midstream businesses where results hinge more on volume than on commodity prices. MLPs are not required to distribute the bulk of their income, but most do in an effort to attract investors. 
Royalty trusts
8.3
Varies **
392
No
Yes
Yes
17
63
54
Royalty trusts don't own assets but are entitled to cash flows from production assets owned by others. Trusts are not perpetual, operating for a preset period of time or until the assets deplete. Sales and profits often depend heavily on commodity prices, which can lead to volatile dividend streams. Investors should research an individual trust's terms and maturity date before investing. 
Real estate investment
trusts (REITs)
5.3
Quarterly
3,538
Yes
Yes
No
166
30
34
REITs allow investors to participate in an asset class too expensive and illiquid for most to purchase directly. Equity REITs own property and generate revenue from rents or sale proceeds. Mortgage REITs own loans and generate income from interest and principal payments on the loans. Some, but not all, REIT dividends are taxed at the capital-gains rate. The REITs in our Quadrix universe average Value scores of 30 and Overall scores of 34. The tiniest REITs tend to earn the highest Value scores, so the selection of midcap and large-cap REITs presented on page 5 average even lower Value scores than the industry average.
** Some pay monthly, some quarterly. Note: Quadrix scores are percentile ranks, with 100 the best.

 

Our buy lists contain no REITs or MLPs, though you can find two partnerships — Plains All American Pipeline ($47; PAA) and Sunoco Logistics Partners ($52; SXL) — in our Top 15 Utilities Portfolio. However, investment appeal aside, we can't deny the lure of the stocks' income. The average REIT in our coverage universe yields 5.3%, while MLPs and royalty trusts average 7.0% and 8.3%, respectively.

With that income in mind, today we will begin monitoring 33 REITs and 25 MLPs, assigning them ratings of A (above average), B (average), or C (below average). We'll present the Alternative Income Watch List in this space twice annually, and you can find it at www.DowTheory.com/Go/Alt. We limited our coverage to stocks with market values above $2 billion and sufficient data to give us some confidence in the Quadrix score. No royalty trusts satisfied those criteria.

Notice the scarcity of A ratings. That's not an accident. REITs and MLPs tend to score poorly in Quadrix, carry a lot of debt, and trade at high valuations. Investors' thirst for income has driven up the price of many of these investments, and we wouldn't touch most of them. However, the market changes over time. When the Quadrix scores and valuations improve, perhaps an MLP or REIT will make it onto our buy lists. Until then, be selective.

In the MLP group, Plains All American Pipeline ($47; PAA) and Sunoco Logistics Partners ($52; SXL) stand out from the crowd. Both companies enjoy solid operating momentum. Analysts expect profits for both companies to fall in 2013, but estimates are on the rise. With the economy improving and demand for oil likely to rise, both companies seem capable of exceeding expectations.

Among REITs, only American Tower ($74; AMT) and Extra Space Storage ($35; EXR) earn A ratings.

ALTERNATIVE INCOME WATCH LIST

The Forecasts divides alternative income stocks into three categories: A (above average), B (average), and C (below average). Ratings reflect Quadrix scores, competitive conditions, valuation, growth potential, and various other factors. The paucity of A ratings reflects two chief issues:

First, many of the REITs and MLPs look a lot alike, making it unusually difficult to ascertain whether one has more investment appeal than another. Second, the average REIT and MLP don't look very good, and in these groups, "above average" does not always equate to "attractive."

Some of the names look better than others, but we are reluctant to provide many A ratings. Investors should realize that not one of these stocks — even those with A ratings — qualifies for our buy lists.

Company (Price; Ticker)
Div.
($)
Yield
($)
Market
Value
($Bil.)
Quadrix
Overall
Score
Rating
Real Estate Investment Trusts
American Campus ($46; ACC)
1.35
2.9
4.1
33
B
Amer. Cap. Agency ($32; AGNC)
5.00
15.8
10.5
33
B
American Tower ($74; AMT)
0.92
1.2
29.5
62
A
Annaly Capital Mgmt. ($15; NLY)
2.00
13.1
15.3
26
C
AvalonBay ($137; AVB)
3.88
2.8
13.3
35
B
Boston Properties ($107; BXP)
2.20
2.1
16.3
15
C
Camden Property Trust ($67; CPT)
2.24
3.3
5.8
21
C
CBL & Associates ($23; CBL)
0.88
3.9
3.6
23
B
Digital Realty Trust ($61; DLR)
2.92
4.8
7.4
34
C
Duke Realty ($14; DRE)
0.68
4.8
3.8
6
C
Equity Residential ($59; EQR)
1.35
2.3
18.7
45
B
Essex Property Trust ($146; ESS)
4.40
3.0
5.2
32
B
Extra Space Storage ($35; EXR)
0.80
2.3
3.8
71
A
Federal REIT ($104; FRT)
2.92
2.8
6.7
36
B
General Growth ($19; GGP)
0.40
2.1
17.8
14
C
HCP ($44; HCP)
2.00
4.5
18.9
45
B
Health Care REIT ($59; HCN)
2.96
5.0
13.3
26
C
Home Properties ($61; HME)
2.64
4.3
3.1
34
B
Host Hotels & Resorts ($15; HST)
0.32
2.2
10.6
26
B
Kimco Realty ($19; KIM)
0.76
3.9
7.9
25
B
Macerich ($57; MAC)
2.20
3.8
7.7
22
C
Plum Creek Timber ($44; PCL)
1.68
3.9
7.1
28
C
ProLogis ($34; PLD)
1.12
3.3
15.8
29
C
Public Storage ($141; PSA)
4.40
3.1
24.2
37
B
Rayonier ($49; RYN)
1.76
3.6
6.4
38
B
Simon Property Group ($155; SPG)
4.20
2.7
47.3
39
B
SL Green Realty ($77; SLG)
1.00
1.3
7.2
32
C
Taubman Centers ($79; TCO)
1.85
2.3
4.9
42
B
UDR ($24; UDR)
0.88
3.6
6.1
22
C
Ventas ($64; VTR)
2.48
3.9
19.0
25
C
Vornado Realty Trust ($80; VNO)
2.76
3.4
15.0
16
C
Weingarten Realty ($28; WRI)
1.16
4.2
3.4
31
B
Weyerhaeuser ($27; WY)
0.60
2.2
14.9
23
B
Master Limited Partnerships
Access Midstream ($35; ACMP)
1.68
4.8
5.2
56
B
Alliance Holdings ($50; AHGP)
2.79
5.6
3.0
73
B
Alliance Resource ($64; ARLP)
4.25
6.7
2.3
77
A
Blackstone Group ($15; BX)
0.40
2.6
8.3
63
B
Boardwalk Pipeline ($25; BWP)
2.13
8.4
5.5
41
C
Buckeye Partners ($49; BPL)
4.15
8.5
4.8
19
C
El Paso Pipeline Ptnrs. ($37; EPB)
2.20
6.0
7.7
71
A
Enbridge Equity Ptnrs. ($30; EEP)
2.17
7.4
8.6
20
C
Energy Transfer Equity ($45; ETE)
2.50
5.6
12.6
26
C
Energy Transfer Ptnrs. ($42; ETP)
3.57
8.6
9.6
54
B
Enterprise Prods. Ptnrs. ($54; EPD)
2.54
4.7
47.7
38
B
Genesis Energy ($34; GEL)
1.84
5.5
2.7
47
B
Kinder Morgan Energy ($84; KMP)
4.92
5.9
29.8
41
B
Linn Energy ($41; LINE)
2.90
7.0
8.1
7
C
Magellan Midstream ($44; MMP)
1.88
4.3
9.9
37
B
MarkWest Energy ($53; MWE)
3.16
5.9
6.8
34
B
Natural Resource ($21; NRP)
2.20
10.4
2.2
35
B
Oneok Partners ($60; OKS)
2.64
4.4
13.2
44
B
Plains All American ($47; PAA)
2.13
4.6
15.5
59
A
Spectra Energy Ptnrs. ($29; SEP)
1.94
6.6
2.8
43
B
Sunoco Logistics ($52; SXL)
1.71
3.3
5.4
93
A
Targa Resources ($43; NGLS)
2.57
6.0
3.8
44
B
Teekay LNG Partners ($38; TGP)
2.70
7.1
2.5
47
B
Western Gas Partners ($51; WES)
1.92
3.8
4.9
32
C
Williams Partners ($53; WPZ)
3.17
6.0
18.6
31
C
Note: Quadrix scores are percentile ranks, with 100 the best.

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