More Red Flags for Yield Hogs

The market loves "high yield" stocks, which used to mean cautiously picking a few real estate investment trusts with 10% yields, but now means loading up on those same names with 4 - 6% yields. Looking at energy sector stocks a few days ago, the most expensive stocks in the sector seemed to be Master Limited Partnership (MLP) assets with a 20 multiple (Price/Earnings ratio) versus traditional companies in the sector which regularly sport valuations half that level. The draw, of course, is that the MLP's pay out huge dividends, sometimes in excess of their true earnings power, while the traditional "C" Corporations have lower dividend yields. Today's post-Enron investors have learned not to trust earnings statements - which are frequently be re-stated back several years as a result of option dating scandals and other derivative-based shenanigans. Given the sad state of the corporate suite, where the CEO supported by his hand-picked directors is systematically looting the company, being skeptical about the true state of earnings is a lesson well learned. However, the notion that dividends are an infallible indicator of stock market opportunity is a stretch, to say the least.

Barron's "The New Math of Oil and Gas" article by Dimitra DeFotis gives a close look at Denver-based Forest Oil (FST). Commenting on the disparate valuations between the MLPs and traditional companies, DeFotis writes that, "in the limited partnership market, a company's daily energy production usually is valued at about $200,000 per barrel. But Forest Oil's production is valued at just $60,000 per barrel." The MLP's pay out all their earnings (and them some, at times) so investors don't mind paying more than 3 times the going rate for those assets. Overpaying in "market B" for assets that cost less than as third as much in "market A" is not a great strategy for making money, but investors chasing yield are taking that risk.

The real estate market is in a similar conundrum. Barron's Andrew Bary wrote "High-Risk Realty" about how the national REIT market has been bid up to interesting levels. Writing about the sector's most recent buyout - of Archstone-Smith (ASN), a national company with many tight-market apartment properties, the buyout group is buying properties with a yield of 4% on the real estate assets being acquired, and will be paying 6% on the debt used to acquire the properties. Negative cash flow is sometimes a fact of life in the world of real estate. It can be offset by price appreciation of the underlying assets. But in today's world of fast-growing foreclosure rates, rising residential housing inventories, and falling real estate valuations - such a leveraged bet on future price appreciation might not be a good deal. Chances are, the buyout group may have an idea of where they are going to lay off these properties and pay down that debt. In a recent Equity Office Properties buyout, some of the target properties were turned around and re-sold even prior to the EOP deal closing. Just hope that those Archstone apartment buildings aren't being turned around and sold to some private real estate syndicated deal that's going to end up in your portfolio, courtesy of your local bank or wirehouse broker, whose marketing departments are cooking up these "new" diversification strategies and plugging them into client portfolios just as the real estate market is beginning to turn down.

Keep your real estate deals local. Western Colorado is in the midst of an energy led boom that is contra-cyclical to the rest of the country.

And don't pay too much, just to chase a high-yielding security. Earnings yield is just a portion of the total return equation. Don't forget to keep a close eye on your principal as well!

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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