Most investors are familiar with the acronym, TINA, which stands for the “There Is No Alternative” environment we lived in for over a decade. Meanwhile, the 10-year Treasury yield has hovered around all lows, generally rising from 1.5% to 2.5% over this period.
This has had a big effect on the stock market’s momentum, as the market applies the “risk-free” Treasury rate as a discount rate on a company’s future cash flows. As one can imagine, a lower discount rate (i.e. the cash rate) results in a higher net present value for the value of the business, translating into a higher stock price raised. Many high-tech valuations have been buoyed by this phenomenon.
All of that has changed since the start of this year, as the 10-year treasury bill rate has trended higher, now sitting at 3.45%. This had a disastrous effect on tech valuations, as investors in Ark Innovation ETF (ARKK) witnessed. As shown below, ARKK is down 64% over the past 12 months.
Given the dynamics of higher rates, I think the era of TINA is over, as investors have plenty of choice besides pouring more and more money into stocks at unsustainable valuations. For those who want to stay invested in the stock market, I’m highlighting various income sectors that present great options for higher and growing income, so let’s get started.
Goodbye TINA – Hello back
One of the asset classes that I like are REITs. However, not all REIT sectors are created equal, with some being more vulnerable to an inflationary environment. Net lease REITs are seen as the most vulnerable to inflation, due to their long-term weighted average lease terms. It may have been STORE Capital (STOR) that recently agreed to be acquired by GIC and Blue Owl, as I recently highlighted here.
As such, investors may want to consider REIT categories with shorter lease terms, which puts them in a better position to increase rents as rates rise. Self-storage and apartment REITs come to mind first, as they have the lowest rental terms among REITs.
Public Storage (PSA) is the 800-pound gorilla in self-service storage space and is down 11% so far this year. It trades at a reasonable forward P/FFO of 20x and pays a dividend yield of 2.6% well covered by a payout ratio of 68%. Additionally, it has an A-rated balance sheet and analysts expect FFO/share growth of 21% this year, followed by 8.5% growth next year.
For those looking for a higher return, AvalonBay Communities (AVB) may be a better choice. Its stock price has fallen 20% since the start of the year. It boasts a higher dividend yield of 3.2%, protected by an A-rated balance sheet and an estimated payout ratio of 65% (based on a forward FFO per share of $9.86). Like PSA, analysts also estimate robust growth in FFO per share of 19% this year and 10% next year.
Finally on the REIT segment, I favor Simon Property Group (SPG) for its very high dividend yield of 7%. SPG is well positioned for an inflationary environment as its leases are typically 5 years or less. Over the past 2 years, SPG has taken on more short-term leases as tenants test the waters in a post-pandemic era.
This gives SPG greater ability to increase rents as renewals come due. Like AVB, SPG also sports an A-rated balance sheet. Its dividend is on track to reach the pre-pandemic level and comes with a safe payout ratio of 60% based on a forward FFO/share of 11, $66. As shown below, SPG is trading at a blended P/FFO of 8.8, well below its normal P/FFO of 13.8 over the past 10 years.
Outside of the REIT segment, I see value in BDCs because they offer the best of both words – high yield with low valuations, while being ready to benefit from a rising rate environment. This is because most BDCs have high exposure to floating rate debt investments while having comparatively lower exposure to floating rate balance sheet debt, as in the case of New Mountain Finance Corp (NMFC) , as noted here.
A top pick in this sector is Main Street Capital (MAIN), which is again trading below $40. It has the lowest operating cost structure among its peers and boasts an attractive dividend yield of 6.6%. MAIN comes with a reasonable PE of 13.2, given its sustainable track record of shareholder returns, and with analysts expecting EPS growth of 13.5% this year, followed by EPS of 5.5 %. As shown below, MAIN has an impressive track record of shareholder returns through both increased net asset value and dividends.
Those looking for a higher yield can consider Ares Capital (ARCC), which is backed by leading asset manager, Ares Management (ARES). The ARCC comes with a much higher efficiency of 9% while carrying a lower PE of 10.1. Some of its discount from MAIN is deserved, given that ARCC is externally managed with a higher cost structure.
However, I believe ARCC deserves a higher valuation given the higher interest rate environment it is expected to enjoy. Analysts on the sell side have a strong buy consensus rating with an average price target of $21.54, implying a potential total return of 23% over one year, including dividends. ARCC also carries a Strong Buy rating from the Quant system, with strong ratings for valuation, profitability and analyst upgrades, as noted below.
Last but not least, the MLP pipeline segment remains an attractive asset class for tax-deferred returns (note that they issue K-1 schedules to investors for tax purposes). They are also well positioned to deal with rising fares, as they are able to raise fares in line with inflation. Enterprise Products Partners (EPD) is the quality player in the sector with its focus on natural gas.
The EPD is currently yielding 7.2% and posted an impressive 1.9x payout coverage ratio in the second quarter. Management has a strong alignment of interests with unitholders, owning approximately 32% of outstanding units and appears committed to return of capital, including two distribution increases this year, putting it on track for 23 consecutive years distribution increases.
For those looking for a higher yield, Magellan Midstream Partners (MMP) presents a solid option, with an 8.1% payout yield protected by a 1.25x hedge ratio. MMP has lower distribution coverage than EPD. However, it also lacks capital-intensive projects to invest in, as it focuses on transportation of oil and refined liquids, a mature and longer-growing sector.
MMP’s asset base enjoys one of the highest returns on invested capital among MPL’s peers and faces little to no competition in its geographies. This monopoly type business model allows MMP to deploy capital returns more quickly to unitholders. As shown below, MMP has redeemed 3.6% of its outstanding shares this year alone, making it an attractive pick for total returns.
Key takeaway for investors
With the TINA environment of the past 10 years behind us, it is prudent for investors to look to segments that stand to benefit from rising rates. I think the stocks and segments above offer investors exactly that. While I expect the market to remain turbulent for at least the short term, I believe these stocks are well positioned for potential above-market returns over the next 3-5 years, and beyond.