Market Commentary | January 24, 2024
Present and Ready
Last Thursday and Friday CPI and PPI reports were encouraging in demonstrating that inflation is moderating, but the battle against inflation continues. Inflation is our perpetual enemy because it erodes consumer purchasing power. Week to week we feel the costs of rising grocery prices; over the course of a three-decade retirement, 5.0% annual increases in healthcare costs are demonstration that inflation is always a formidable foe. As investors, we always strive to achieve total returns that exceed inflation so that we can maintain our financial well-being.
In calculating total investment returns, we must consider that return on investment is comprised of many components and its calculation is multidimensional in measure. Total return is generally measured as a combination of dividend income and capital appreciation. A third, dimensional, component would be a measure of pace or time.
Over the last few years with overriding concerns of the pandemic, pandemic recession, high inflation, rising interest rates to combat inflation, a potentially slowing economy which could bring falling interest rates and a new recession, the financial markets have been on a rollercoaster on which we have ridden at least two circuits around the track. During this tumult, our efforts have been squarely focused on optimizing our positions and total return.
Rising interest rates are anathema to market price performance for rate sensitive sectors like Utilities and Real Estate. If 10-year treasury yields rise from 1.3% to 4.8% over 18 months, treasury prices fall along with share prices for Utilities, REITs, or any other stock that had a previously attractive dividend yield of 3.0% to 3.5%. Fully aware of this correlation, we proactively reallocated capital to discounted, fixed income, senior securities (think preferred stocks) to boost portfolio income and capture capital appreciation potential. The result is that our real dollar portfolio dividend income increased by mid-teens percentage points in both 2022 and 2023. We are not simply talking about an improvement in % yield here, we are describing real growth in portfolio income and an enhancement of purchasing power over inflation. Though the markets beat us down, our earnings engine became more robust.
At 2nd Market Capital we analyze and track the operational and market performance of more than 130 companies and 250 equities in our investment universe. We meet with, agree, and argue with as many of these companies’ executives as we can, every year. A prime example that has been in each of our portfolios over the years is Gladstone Commercial (GOOD). GOOD is a triple-net lease REIT whose portfolio is currently comprised of about 60% industrial/logistics and 40% suburban office (their aim is to be 100% industrial). Gladstone Commercial has 1 common stock and 2 fixed yield preferred issues (GOODN, GOODO).
In the 4th quarter of 2022, a price/yield inversion occurred between the common (GOOD) and the preferreds (GOODN, GOODO); GOOD, trading at ~$19.20/share offered a 7.5% dividend yield while the senior preferreds share prices had fallen to $18.00, offered an 8.4% dividend yield and had a $25.00 liquidation preference (potential capital appreciation). If a GOOD common holder was looking to move up the capital stack, raise dividend income, and create new capital appreciation potential, he could have sold GOOD, plowed proceeds into the higher yielding, discounted preferreds and never broke stride in our collection of dividends from the same fully vetted issuer. As the market played out, that swap would have proved fortuitous.
We continually try to identify and execute capital stack arbitrage opportunities.
Beyond an individual company’s capital stack, these analytical and trading tools can be applied comparatively to components of whole sectors.
Throughout late 2022 and 2023, the retail real estate sector has reported strong rent and occupancy growth due to surging demand and limited supply. We knew we wanted to participate here with some new capital, we just had to narrow the target to issues with low price to FFO ratios, modest debt, and strong rent growth. By mid-November 2023 we had decided that Kite Realty Group (KRG) presented the sector’s best opportunity. Surprisingly, one-week later KRG shares were up 8% while the rest of the sector was flattish and another candidate’s (Slate Grocery REIT (SRRTF)) share price had cratered 15%. SRRTF is a Toronto-based REIT that, like KRG, owns grocery store anchored shopping centers across the US. Three weeks later, SRRTF shares had surged 15% and KRG had fallen about 8% from their early December highs.
If knowledgeable investors are nimble and can manage extraneous considerations like taxation, they might dramatically enhance their total return by actively trading in the targeted sector. Issues from different companies within the same sector are not fungible, but they rhyme macroeconomically in their objectives.
The lesson of these two examples is that if you perform sound analysis and remain forever present in the markets, you can take your positions, book your gains, and retain the knowledge necessary to seize opportunity when it presents itself, again.
Notes and Disclosure
Articles are provided for informational purposes only. They are not recommendations to buy or sell any security and are strictly the opinion of the writer. The information contained in these articles is impersonal and not tailored to the investment needs of any particular person. It does not constitute a recommendation that any particular security or strategy is suitable for a specific person.
Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. The reader must determine whether any investment is suitable and accepts responsibility for their investment decisions.
Commentary may contain forward-looking statements that are by definition uncertain. Actual results may differ materially from our forecasts or estimations, and 2MCAC and its affiliates cannot be held liable for the use of and reliance upon the opinions, estimates, forecasts, and findings in this article.
Past performance does not guarantee future results. Investing in publicly held securities is speculative and involves risk, including the possible loss of principal. Historical returns should not be used as the primary basis for investment decisions. Although the statements of fact and data in this report have been obtained from sources believed to be reliable, 2MCAC does not guarantee their accuracy and assumes no liability or responsibility for any omissions/errors.
We routinely own and trade the same securities purchased or sold for advisory clients of 2MCAC. This circumstance is communicated to clients on an ongoing basis. As fiduciaries, we prioritize our clients’ interests above those of our corporate and personal accounts to avoid conflict and adverse selection in trading these commonly held interests.
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