Stock Exchange: Realty Income’s Near-Term Momentum, Long-Term Risks

The Stock Exchange is all about trading. Each week we do the following:

• discuss an important issue for traders;
• highlight several technical trading methods, including current ideas;
• feature advice from top traders and writers; and
• provide a few (minority) reactions from fundamental analysts.

We also have some fun. We welcome comments, links, and ideas to help us improve this resource for traders. If you have some ideas, please join in!

Review: Do You Trade Big Or Trade Small?

Our previous stock exchange asked the question: Do You Trade Big Or Trade Small? We noted how many market participants draw the sharp distinction between trading and investing, whereby the main difference is time frame (i.e. investors often have a much longer holding period than traders). We cited specific big versus small trading considerations including position sizing, macro versus micro considerations and cash levels, to name a few.

This Week: Near-Term Momentum Versus Long-Term Fundamentals

So far, we are seeing a rare “v-shaped” market decline and then recovery since the start of the fourth quarter through this week, as shown in the following chart.

We started by saying “so far” because we may still actually still be in the middle of another bear market rally, as described here: How to Invest in a Rising Market.

But what’s interesting is the decline and recovery hasn’t been exactly indiscriminate across sectors. For example, real estate investment trusts (aka “REITS”) declined less than the market on the way down, and they have risen more than the rest of the market on the way back up. You can see this phenomenon in the following graph, and it has been particularly pronounced for many popular big-dividend REITs in particular, such as monthly dividend payer Realty Income (O).

What’s causing the noticeable non-conforming strong momentum for REITs? For starters…

REITS are a “risk-off” sector. This means when the market sells off, REITs often act as a safe haven investment thereby selling off less than the market due to their larger than average steady dividend payments and their generally low market betas. And this is a good explanation for what happened in Q4. As the market sold-off, investors piled into REITs thereby creating some strong near-term momentum for the sector. However that’s not all that happened…

The Fed got less hawkish on interest rates. Because REITs are generally required to pay out 90% of their income as dividends for tax purposes, that means they rely heavily on the capital markets (e.g. issuing debt or new shares) to fund growth. And when the fed gets more dovish (less hawkish) that generally mean they don’t expect to raise interest rates as much or as quickly as previously expected. And that’s a good thing for REITs because it means their expected cost of future borrowing has gone down. For a little perspective, here is a look at what has happened to future interest rate expectation over the next year, as measured by the CME FedWatch Tool (i.e. interest rate increase expectations have decreased).

As you can see in the above chart, the Fed got much less hawkish in December, and that is a very good thing for REITs. In fact, it was a double dose of near-term momentum for the sector when you consider it in combination with the risk-off phenomenon that was also happening in the market.

But how do you interpret this strong near-term momentum compared to long-term fundamentals? Your interpretation likely depends, at least in part, on whether you are an investor (long-term focused) or a trader (near-term focused). Perhaps you have a long-term thesis that prevents you from participating in near-term trades. On the other hand, you may have little interest in the longer-term market dynamics if you are focused exclusively on near-term trading. We will have more to say about this dynamic later in this report, particularly with regards to monthly dividend paying REIT Realty Income (which currently yields 3.9%). But first…

Model Performance:

We are sharing the performance of our proprietary trading models, as our readers have requested. For reference, the models are still only 1/3 invested (the rest is in cash–for risk management purposes). And regarding the 1/3 invested amount, here is an article describing a well-know formula for determining your optimal “bet size:” Edge Over Odds.

Controlling Risk:

We find that blending a trend-following / momentum model (Athena) with a mean reversion / dip-buying model (Holmes) provides two strategies, effective in their own right, that are not correlated with each other or with the overall market. By combining the two, we can get more diversity, lower risk, and a smoother string of returns.

Since many clients combine the trading models with our long-term fundamental methods, they have additional diversity of methods without the need for short-term timing.

For more information about our trading models (and their specific trading processes), click through at the bottom of this post for more information. Also, readers are invited to write to main at newarc dot com for our free, brief description of how we created the Stock Exchange models.

Expert Picks From The Models:

Note: This week’s Stock Exchange report is being moderated by Blue Harbinger, a source for independent investment ideas.

Felix: As you know, I am computer-based momentum trading model. I typically hold for as long as one year or more (I have the longest holding period among all of our trading models). For this week’s Stock Exchange report, I ran the stocks of the Russell 1000 (US large caps) through my trading model, and my top 20 rankings are included in the list below. Do you see any momentum ideas on my list that strike your fancy, Blue Harbinger?

Blue Harbinger: Well I am not a near-term trader (per se), I am a long-term investor, but I do pay close attention to technical trading indicators as one input into my investment process, and I love your stuff, Felix. In particular, I notice this week Realty Income (O) made your list. We can see the near-term momentum you are talking about very clearly in the chart we shared earlier in this report, but aren’t you worried about the long-term fundamentals, Felix?

Felix: First of all, I am not a human, I am a trading model, so no I am not “worried” as you say. I am completely objective in my decision making process, and that is one of my advantages over you emotional and irrational humans. You are prone to behavioral mistakes. For example, you all thought the world was ending in December, and fear mongers were selling everything. Now that the market is rallying this year, you all think the world is peaches and cream.

BH: That is not entirely true, and your language is interesting for a technical trading model, Felix, but your point is well taken. By the way, here is an interesting article about how Artificial Intelligence can help to prevent the spread of disinformation. The market could have used a little bit of that type of disinformation spread (read “fear mongering) prevention in December when the market was selling off and it seemed every viral stock market article suggested the sky was falling.

Felix: And since we’re swapping information, what is your longer-term thesis on Realty Income, and how does it contrast the near-term technical momentum it has been experiencing?

BH: Well, in a nutshell, I think Realty Income’s valuation is getting a little rich, and the share price may be getting ahead of itself because of the powerful near-term momentum factors we discussed earlier that have been driving the share price much higher (i.e. a less hawkish fed and a lingering “flight to quality” among risk-averse investors–meaning fearful investor are still hiding out in REITs, particularly the popular ones like Realty Income).

Felix: That’s an interesting narrative, but if I was looking for story time I’d go to the children’s library. Do you have any objective data to support your view?

BH: For a non-human trading model, it sure does seem like you’re getting a little smart with me, Felix. Anyway, per the following valuation summary table, Realty Income is currently trading above it industry peers and its own historical valuation in term of price to AFFO (that’s an industry metric meaning Adjusted Funds From Operations), price to book value and EV to EBITDA. Not to mention its dividend yield is lower than usual, which also suggests to me that the price is getting a little ahead of itself.

Felix: That’s just one opinion–yours BH.

BH: Here is the opinion of the 18 Wall Street analysts covering Realty Income. They believe it’s overpriced too.

Felix: What else have you got?

BH: According to Kevin Brown, an analyst at Morningstar:

“The value of Realty Income’s long-term leases, which altogether exhibit minimal built-in rent growth, are particularly susceptible to rising interest rates and inflation.”

He also notes that:

“Rising interest rates reduce the spread between acquisition cap rates and financing costs, sapping management of its ability to create value through continued external growth.”

As you can see in our earlier graphic, the implied cap rate for Realty Income is only 4.96.

Felix: So are you saying Realty Income’s dividend is in jeopardy?

BH: No, nothing like that. The dividend is actually quite safe. The company has plenty of liquidity, and a very healthy, above average “A-” credit rating from S&P.

I am just a little concerned that it’s becoming increasingly difficult for Realty Income to keep growing in the future as fast as it has been in the past because it’s starting to get pretty big (they’ll need larger and larger acquisitions to move the needle considering its market cap is now over $21 billion–it was much easier to grow when they were smaller), the valuation is a little rich, and if the overall stock market keeps going up then the fed will get more hawkish on interest rates and the “flight to quality” trade that has benefited Realty Income will quickly work against it if/when the market moves back to a more “risk on” environment.

Felix: Alrighty then, BH. Thanks for that information. And just so you know, just because something makes onto my top 20 list during a particular week, that doesn’t necessarily mean I am buying it. There are more factors involved.

Holmes: While you two keep arguing over whatever it is you’re arguing about (near-term technicals versus long-term fundamentals?) I’ll share a trade. This week I purchased Five Below (FIVE).

BH: I know Five Below. They sell a variety of things for $5 or less, such as sporting goods, games, fashion accessories and jewelry, hobbies and collectibles, bath and body, candy and snacks, room decor and storage, stationery and school supplies, video game accessories, books, dvds, iPhone accessories, novelty and gag, and seasonal items.

Holmes: Thanks for regurgitating that list of items from whatever internet source you copied it from, BH. Good overview. As you know, I am another technical trading model. I am the resident “dip buyer” and I typically keep my trades on for around 6-weeks. Here is a look at the recent price action on Five Below. You can see the “dip.”

BH: I do see the dip, Holmes. That stock has been very strong from a fundamental standpoint, and we may well see a strong bounce off those moving average prices you’ve shared in the chart. Here is a look at some fundamental data on Five Below in the following Fast Graph, which is always helpful, in my view.

Holmes: I suppose it’s helpful if you are a long-term fundamental investor, but I am a technical trading model, and I typically hold for only around 6-weeks, as I’ve already told you.

BH: Ok, thanks. And how about you Road Runner–any trades to share this week?

Road Runner: I bought HubSpot. (HUBS). They offer a cloud-based marketing and sales software platform that enables businesses to deliver an inbound experience. As you know, I am a momentum trader, I typically hold for around 6-weeks, and I like to buy things in the lower end of a rising channel, as you can see in the following chart.

BH: As a general theme, I like cloud software solutions because I think migration to the cloud is a giant secular trend that is no where near over. Here is a look at the Fast Graph for HubSpot.

Athena: This week I sold my shares of Westinghouse Air Brake Technologies (WAB). As you know, I am also a momentum trader, and my typical holding period is around 17-weeks. I run a “king of the mountain” type strategy, and it takes a lot to get into my “best ideas” portfolio.

BH: Looks like you took advantage of a nice jump in the share price this week to sell. Thanks for sharing. As I assume you are aware, Westinghouse sells equipment, systems, and value-added services for the rail industry. Here is a look at the Fast Graph, if you are curious.

Oscar: I have some ETF rankings to share. As our resident sector/ETF rotation model, this week I ran our comprehensive and diverse ETF universe through my model, and my top 20 are ranked in the following list.

Conclusion:

Depending on what type of market participant you are, you may prefer to consider near-term technical momentum over long-term fundamental metrics. These two viewpoints can often seem at odds with each other, such as Realty Income’s near-term technical strength (arguably thanks to the Fed’s decreased hawkishness and the lingering “flight to quality” trade) versus its growing long-term fundamental valuation risks (even if the dividend is very safe, the valuation seems a little rich). We find a variety of near-term technical factors can be helpful considerations for long-term fundamental investors, but they can be very valuable trading metrics in their own right.

Getting Updates:

Readers are welcome to suggest individual stocks and/or ETFs to be added to our model lists. We keep a running list of all securities our readers recommend, and we share the results within this weekly “Stock Exchange” series when feasible. Send your ideas to “etf at newarc dot com.” Also, we will share additional information about the models, including test data, with those interested in investing. Suggestions and comments about this weekly “Stock Exchange” report are welcome. Your can also access background information on the “Stock Exchange” here.

Trade alongside Jeff Miller: Learn more.