Tag Archives: income

Building A Dividend Stream With The Best U.S. REIT ETF

Summary The uncertainty around the interest rate hike was not resolved in September. The high level of volatility is expected to continue in the coming months as well. Take advantage of the occasional dips to build a position in an income stream ETF. Back in June, after the second quarter of high volatility in the REIT sector, I wrote about the opportunity in U.S. REITs. The latest dip was marked during the first half of September towards the Fed’s decision when we saw both the REITs and utilities dropping dramatically. Since the Fed announced that it is essentially pushing out its decision to a later date, there is no reason to believe that the high volatility is behind us and that we will not see high levels of anxiety towards the Fed’s announcements, the one in October or in December. The volatility in REITs is well seen in this Vanguard REIT Index ETF (NYSEARCA: VNQ ) graph. The ETF hit $72 just after Yellen’s announcement, but in the following couple of weeks, it rallied pretty nicely, closing at $75 on September 25. (click to enlarge) Is it still the best U.S. REIT ETF? The next table compares VNQ to the other 15 ETFs that are focused on U.S. REITs. I marked the top five in each of the categories of dividend yield, management fees and the total return during the last 3 and 5 years in green. (click to enlarge) VNQ was favorable in all of the categories, delivering more than 4% yearly yield at only 0.12% yearly management fees with an impressive 72% return during the recent five years. Throughout 2015, through times of uncertainty and concerns, not only has VNQ continued to pay uninterrupted dividends, but also on top of that it grew its dividends by ~10% compared to the year before. The next graph shows VNQ’s quarterly dividends starting Q1’10 until the recent Q3’15. For Q4’15, I have plugged a $1.1 dividend, which is equal to the one paid back in Q4’14. While the other three dividends this year went up by 10%, it would be very hard to believe that the forth one will not grow, but I always like to be conservative: (click to enlarge) How can we model it forward? The 2015 dividend per share is estimated at $3.13, growing 10% year over year. An investor who wants to build a position during the next 10 years can generate some interesting strategies assuming they are willing to invest in VNQ regularly. What can one expect from this type of investment? First thing, let’s examine the dividend growth rate. Nothing can grow forever at the level of 10%. Moreover, this sector like any other sector is exposed to risks. REIT risks are associated with macroeconomic slowdown, space overflow and rental pricing. For a long-term model, let’s judge the growth rate to be 4-5% per year for the next decade. Model Assumptions Dividend rate: The current VNQ dividend rate is 4.2%. Let’s use it in the first year. Dividend growth rate: If we should pick a number between 4% and 5%, let’s go with 4.5%. Tax rate: Since not every investment can be tax free, let’s assume a 25% tax rate on the dividends. Investment: $1,000 invested per month or $12,000 yearly investment across a time period of ten years. The dividends, net of taxes, are assumed to be reinvested as well. VNQ’s price: The ETF price across the years is highly unknown. In order to mitigate that, let’s look at two scenarios. Scenario 1: VNQ’s yearly prices change at the same pace as the dividend per share. That means that in this scenario the ETF price will go up by 4.5% every year. Scenario 2: VNQ’s price remains at $75, or in other words the investment and reinvestment are taking place through the time of dips in the ETF pricing. Scenario 1 results In this case, where the ETF prices are growing alongside the dividend per share, after ten years, the investor has accumulated a holding of 2,093 VNQ shares. This holding has the potential to generate $9,739 in dividends per year. The investor invested $120,000 and therefore can expect 8.1% return on his investment in the tenth year. An income stream that potentially will continue to grow afterwards. Scenario 2 results In this scenario of flat ETF prices through the ten-year horizon, the amount of accumulated shares is ~30% higher than in scenario 1. The holding is getting to a total of 2,783 shares. It has the potential to generate a yearly income stream of $12,946 per year pre-tax. The following year, if we’re maintaining the same assumptions of reinvestment, the income stream after taxes is expected to exceed the $12,000 threshold. After ten years, the investor had invested $120,000 and expects to receive 10.8% in annual dividend return on his investment. Conclusions The anxiety regarding the interest rate will accompany us in the coming months and years. This will generate great opportunities for the long-term investor who is pursuing an income stream. The REIT sector is expected to grow even if the interest rate will rise. I find VNQ to be the best ETF that focuses on U.S. REITs. The patient investor has the potential to gain significant returns by setting their investment strategy straight. As there is no way to best optimize the entry or time the market, the investor should build a position through several purchases. And lastly, an investor should take advantage of the days of panic. These will be the days that will serve them well in the long run.

NextEra Energy Still Not Worth Buying, More Questions Emerge In Hawaii

Summary Hawaii Electric looks less likely to close by the end of the year than in our previous analysis. NextEra still doesn’t appear worth more than the mid-$90s. NextEra is doing really well in Florida and profits are higher than expected. Today, we will to take a refreshed look at NextEra Energy (NYSE: NEE ). We first looked at the company in late February and followed that with an update in June . When we started our analysis in February, we argued for some correction. We then reiterated that valuation was too rich in June. YTD, the company is now down 5% and has not shown much ability to add more value. We noted we would be interested at the 90-level. Our main thesis was that, while the company’s health and catalysts were strong, valuations were pricing in a best-case scenario of 6% revenue growth and 22% operating margins consistently moving forward. In the June update, we continued to be worried about margin compression from the Hawaii Energy (NYSE: HE ) deal. Today, we want to revisit our catalysts in the wake of the last set of earnings as well as other developments that have occurred. Additionally, we will take another look at our pricing model to update that given this analysis. 2015 Catalysts Revisited Economic Moat Strength For me, the key strength for NEE has always been its economic moat that exists from non-competitive agreements that the company has with many municipalities. Non-comp agreements exist in many of the relationships the company has where it negotiates a “fair price” deal with a town/city/county that limits competition but keeps prices in check for citizens. As we noted before, NEE is very attractive because about 80% of its business is in the regulated arena, where profitability is strongest. This image from Market Realist tells the tale: (click to enlarge) (click to enlarge) The company benefits strongly from these regulated industries as it can establish infrastructure, keep consistent revenue/earnings flowing, and doesn’t have to worry about competition. As long as the company can maintain this strong mix, it will be attractive for income, long-term investors. To me, the real catalyst, though, is the company’s ability to have success in Hawaii. Hawaii – Another Regulated Market to Add Shareholder Value In 2014, NextEra bought Hawaiian Electric ( HE ) for north of $4B. The move was a chance to come into a new market that was in need of cost savings and be able to combine a regulated market with the company’s practice of making efficient utility deliveries. Further, NEE wanted to be able to bring its ability and knowledge of scaling renewable energy in an area that is burdened by extreme energy costs. Between the company’s initiatives in solar energy and knowledge of other sources, NEE stands to be able to generate a very strong value proposition for Hawaii while also continuing to promote its economic moat. So, how have things been moving since the last time we looked at the company… The last time we looked at the HE/NEE deal, the main aspect of the deal was just to get it done and approved. In April, HE’s CEO came out saying he was confident that the deal would be completed within a year, and the Hawaiian House of Representatives put a resolution in place to complete the deal by June 2016. Given the market is regulated, it is a major decision for Hawaii, consumers, etc. In the company’s latest earnings, here was the company’s comments on the HE deal: Steven Fleishman – Wolfe Research Yes, hi good morning and congrats. The couple things that I guess you didn’t mentioned, first is any kind of thoughts on the Hawaiian deal and just, there does seem to opposition in your ability to get that done? James L. Robo – Chairman and Chief Executive Officer Steve this is Jim, obviously the state filed a testimony ten days ago saying that they opposed the deal in its current form and the Governor held a press release where he, press conference where he said he opposed the deal in its current form. I think the key, the keywords there in its current form, they also, the state also listed several conditions that would be, I think just positive for them to think about changing their view. And we are in the process of responding to that testimony and we think we have a very strong case to put forward to the Commission around the benefits to customers, the benefits to customers were actually pretty compelling and I think we’re going be able to make that case as we go forward. So, this was not necessarily a surprise to me that the state filed a kind of testimony that they did and we are going to continued to move forward on laying out our arguments and we look forward to the hearings we’re going to have in December to make our case. As we can see, things aren’t progressing as well as the company has hoped. In the last report, the company had noted that they expected the deal to be done by the end of the year. Now, the company is not quite as positive. Waiting till December to answer testimony is much different than getting approval then. The state of Hawaii published testimony in July, and the Governor came out against the deal: Gov. David Ige said Tuesday he doesn’t support the sale of Hawaiian Electric to Florida-based NextEra Energy. The sale was approved by Hawaiian Electric’s shareholders in June but still needs approval from the state Public Utilities Commission. Ige said he supports capital investment in Hawaii, but he joined critics saying he’s concerned that NextEra may not be able to fulfill Hawaii’s goal that its utilities use 100 percent renewable energy by 2045. This news was not exactly the type of “positive” news that the company had hoped for. Since that comment in July, the Governor has said the process was still very early, and that he is looking forward to the company’s responses to testimony it presented. While we all expected some snags, the process continues to move quite slow and questions the long-term prospects of being able to have this deal work well for all parties. Overall, though, we believe this deal is very important to NextEra Energy. As we noted previously: The company brings the expertise of how to apply a mix of renewable energy and create consistent returns. With the prices that Hawaii is used to paying, the company should reduce costs for Hawaiians yet also make a strong profit. The company’s mix, though, of more green energy plays has not been as profitable. The company still makes its bread and butter in Florida where it uses a majority natural gas. So, the question will be if they can return the type of 20% operating margin in Hawaii? The nice thing that is baked into the cake for them is that Hawaiians are used to paying more than most Americans, so they will be able to invest more easily. We will continue to monitor this situation, but for now, the company is starting to look like they are getting off track. Current Pricing Next, we want to update our current pricing model for NextEra. The latest earnings for NEE were pretty solid in the latest quarter. EPS came in at 1.56 versus 1.50 expectations as well as a beat for revenue as well. The company’s strength continues to be seen in Florida, where revenues/earnings continue to rise. The company’s results were helped by an improving Florida economy that led to more additions as well as a lot of strength in NextEra Energy Resources, which saw a 21% increase in revenue. The NEER division is the renewable contracted part of the business, and that type of growth shows just how in demand renewable energy is becoming. In this section, we will want to take a look at our last pricing analysis, update it, and determine what we believe is a fair value price for NEE. In order to price the company, we need to make certain assumptions. In our last two articles, we modeled revenue growth to continue at a clip of 4-5% per year, and we believe that level will maintain for the next several years. The gains we noted in our last article were not sustainable in NEER, and the results have already seen a 50% reduction QoQ. Most analysts are only modeling for 1% growth still for this year, but we are using an annualized figure. Utility revenue is fairly consistent. The key to the company is definitely margins. Operating margins are key to our DCF analysis. The coming has forecast that they will come in at the 22-23% in 2015, but I imagine this number will dip some with the onslaught of Hawaiian Electric when it is approved. In Q2, the company’s operating margins came in strong at 26% after 28% in Q1. For 2015, we believe 22-23% is a bit light, and we will increase our expectation to 25%. As for the HE deal, it should add roughly $4.5B in sales in 2016, but the company operates with a 10% operating margin. The deal is really essentially to take what is a tough market for making money, revolutionize it, and improve it. This plan, though, will take several years. Therefore, margins will drop in 2016 but gradually improve again through 2020. Taxes have averaged roughly 25% for the past five years, and it’s likely this will stay around 28%-30% over the next several years. We may see it jump even a bit more beyond 2016 when more solar credits are expected to expire. Depreciation will continue to grow at about the same rate as revenue growth. Capex should come down in 2015 to around $6B and again in 2016 to $4B.The $4B rate, though, is pretty standard for the company. Our WACC rate is 5% for discounting. When we use this math in our five-year DCF analysis, we were looking at a low-90s number. We have made some positive adjustments, and here is our projections:   PROJECTIONS   1 2 3 4 5   2015 2016 2017 2018 2019 Income from Operations 4350 3654 3990 4347.2 4726.73 Income Taxes 1218 1023.1 1117.2 1217.2 1323.48 Net Op. Profit After Taxes 3132 2630.9 2872.8 3130 3403.25             Plus: Depreciation 2600 2700 2800 2900 3000 Less: Capex -3600 -3900 -4000 -4100 -4200 Less: Increase in W/C -100 -100 -100 -100 -100 Available Cash Flow 2,232 1,531 1,773 2,030 2,303 We don’t see any major change from our last model, so we are keeping our price target at $96. Margin drops in HE and getting regulations approved are key to this model. Additionally, if Florida and NEER stay very strong, the company could outperform our expectation for the current FY. Conclusion NextEra has interesting catalysts to 2015, but after a tremendous run in 2014, the company looks like its upside may be limited in the near-term. Recent issues in Hawaii Electric ( HE ) make me nervous, but the rest of the company’s business is extremely intriguing and strong, which neutralizes my fears there. Yet, we still don’t see the reason to buy when we are at sitting at 2.5+ times sales and the company has question marks outstanding.

Lower Risk Versions Of A Dual Momentum Fixed Income Strategy

Summary This article presents the performance and risk of Lower Risk Versions (LRVs) of a dual momentum fixed income strategy as compared to a High Risk Version (HRV) presented previously. The difference between the LRVs and HRV is the number of assets per month; the HRV selects one asset per month, while the LRVs select multiple assets per month. The LRV-3 (3 assets per month), backtested to 1994 using mutual fund proxies, has a CAGR of 10.2%, a standard deviation of 6.3%, and a maximum drawdown of -6.1%. The minimum annual return of LRV-3 is -2.4% in 1994. All other annual returns are positive. The LRVs are more robust than the HRV, and should be used by more conservative investors, who desire reasonable growth with less volatility and drawdown. In a recent article on Seeking Alpha, I discussed a simple tactical bond ETF strategy employing relative strength momentum. This strategy is explained in detail here . I will call the original strategy the High Risk Version (HRV) of the fixed income strategy, since only one ETF is selected each month (out of a basket of five ETFs). This article presents Lower Risk Versions (LRVs) of the same momentum strategy. For LRVs, a multiple number of ETFs are selected each month in order to reduce volatility and drawdown compared to the HRV, while still maintaining a CAGR greater than an equalweight portfolio holding all five assets. My basic objectives of the LRVs are: 1. A CAGR > 10%; 2. A standard deviation (SD) that is less than the SD of an equalweight portfolio of all assets; 3. No negative years of return; and 4. A maximum drawdown based on monthly returns of less than 7%. I started out by making a slight modification to the original HRV strategy in order to turn the strategy into a dual momentum strategy. The original methodology only used relative strength (no absolute momentum) to determine what asset to select. But, in a way, the original HRV that selected only one asset each month was really a dual momentum strategy, because a short-term treasury was included in the basket of assets. In order to determine the effect of selecting multiple assets each month rather than just one asset, I needed to use a true dual momentum approach instead of a relative strength strategy. So I have switched to the dual momentum technique in this study. Dual momentum strategies have been popularized by Gary Antonacci and are well-known to many investors. Dual momentum means relative strength momentum is first used to select the top-ranked asset(s) each month, and then the top-ranked asset(s) have to pass an additional absolute momentum test (must have positive momentum) in order to be selected in any given month. I selected a basket of five fixed income assets that have relatively low correlation to each other. A major challenge in developing fixed income strategies is the short history of fixed income ETFs. This results in rather limited backtesting for the ETFs. To extend the backtesting, mutual fund proxies are used that have longer histories; this permits backtesting of the strategy to the 1990s. Shown below are the assets in the basket, both the ETF and the mutual fund proxy. Convertible Bonds: SPDR Barclays Capital Convertible Bond ETF (NYSEARCA: CWB ) – Vanguard Convertible Securities Fund (MUTF: VCVSX ) High Yield Bonds: SPDR Barclays Capital High Yield Bond ETF (NYSEARCA: JNK ) – Fidelity Advisor High Income Advantage Fund (MUTF: FAHDX ) Long Term Treasury: iShares 20+ Year Treasury Bond ETF (NYSEARCA: TLT ) – Vanguard Long Term Treasury Fund (MUTF: VUSTX ) Short Term Treasury: iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) – Vanguard Short Term Treasury Fund (MUTF: VFISX ) Emerging Market Bonds: PowerShares Emerging Markets Sovereign Debt Portfolio ETF (NYSEARCA: PCY ) – Fidelity New Markets Income Fund (MUTF: FNMIX ) In the original article, I used CNSAX as proxy for CWB and PREMX as proxy for PCY. But based on comments by EquityCurve in the original article, in order to get backtesting to 1994 instead of 1998, I changed to VCVSX instead of CNSAX and FNMIX instead of PREMX. So backtesting of the mutual funds now goes back to 1994. 1994 turns out to be a difficult year for bonds and I’m glad I could include it in the analysis. (All of this work was performed using the free Portfolio Visualizer software. Any investor can go online and trade the strategies in this article without any cost.) It turns out that the dual momentum strategy using this basket of assets is very robust, and good results are seen if one, two, three, four or all five ETFs are selected each month. There is the usual tradeoff between growth and drawdown depending on the number of assets selected each month. The greater the number of assets selected, the less the risk and growth. I will now present the results of the HRV that selects only one asset each month. These results are similar to the results presented in the original article, and are presented here just to be consistent with the results of the LRVs shown later in this article. The basket of mutual funds is used, and the backtesting timeframe is 1994-present. Two relative strength timing periods are employed to rank the funds: 4-months and 2-months. A 51% weighting on the 4-month ranking and a 49% weighting on the 2-month ranking is used. The 51%/49% weighting split is a good way to ensure that the 4-month timing period determines the better-ranking asset if there is a tie. The total return curves of the HRV, the equalweight portfolio (buy and hold all five assets, rebalanced annually), and the S&P 500 are shown below, together with a table of their relevant parameters and annual returns. Total Return Curve of HRV: (click to enlarge) Tabular Summary of HRV Results: (click to enlarge) Annual Returns: (click to enlarge) It can be seen that the HRV has a CAGR of 15.0%, an SD of 10.4%, and a maximum drawdown (based on monthly returns) of -13.0%. In terms of a risk-adjusted return on investment, the CAGR/SD is 1.44. This compares with holding an equalweight portfolio that has a CAGR of 7.8%, an SD of 7.0%, a maximum drawdown of -17.6%, and a CAGR/SD of 1.11. It can be seen that the HRV substantially increases growth at the expense of volatility (standard deviation). Yet the maximum drawdown is actually better for the HRV than the equalweight portfolio holding all five assets. For the LRVs, I systematically looked at various combinations of timing periods and number of assets selected each month. Overall, when two or more assets are selected each month, the strategy tends to be very robust in terms of what timing periods are used for relative strength ranking. This means the strategy works well for various sets of timing periods and results do not change dramatically when timing periods are varied slightly. With some flexibility in what timing periods to choose, I decided to use the same timing periods that I employed for the HRV in my previous article, namely 4-months and 2-months. I first show graphical results when one, two, three, four and five assets are selected each month. A logarithmic scale of total return is employed. One asset (HRV): (click to enlarge) Two assets (LRV-2): (click to enlarge) Three assets (LRV-3): (click to enlarge) Four assets (LRV-4): (click to enlarge) Five assets (LRV-5): (click to enlarge) The results of LRV-5, compared to the equalweight portfolio, identify the effect of absolute momentum. It can be seen that absolute momentum mainly plays a role in reducing drawdown, and does not significantly affect growth in the years when drawdown does not occur. The beneficial effect of absolute momentum continues to be seen as the number of assets is reduced using relative strength. When the number of assets is reduced using relative strength, higher portfolio growth is seen as expected. The highest growth, of course, comes when only one asset is selected each month corresponding to the HRV. The tabular form of the overall results is shown below: (click to enlarge) The tradeoff between performance and risk is seen in the table above. Based on the objectives stated previously, the best LRV is LRV-3 (three assets each month). LRV-3 has a CAGR of 10.2%, an SD of 6.3%, a maximum drawdown of 6.1%, and CAGR/SD of 1.62. This compares well against the equalweight portfolio that has a CAGR of 7.8%, an SD of 7.0%, a maximum drawdown of -17.6%, and a CAGR/SD of 1.11. Thus, the LRV-3 has significantly higher CAGR, lower SD, and substantially lower drawdown and higher risk-adjusted return on investment than the equalweight portfolio. The equalweight portfolio also has three negative years: 1994 (-6.4%), 1998 (-0.3%), and 2008 (-11.6%), while the LRV-3 only has one year with negative returns: 1994 (-2.4%). In comparison to the HRV, the LRV-3 has lower growth (CAGR of 10.2% versus 15.0%), but the SD (6.3% versus 10.4%) and maximum drawdown (-6.1% versus -14.5%) are greatly improved. And the risk-adjusted return on investment of LRV-3 is significantly better (CAGR/SD of 1.62 versus 1.44). And for 1994, the LRV-3 has a -2.4% return, while the HRV has a -5.4% return. One negative aspect of the LRV-3 is that more trades are required each year compared to the HRV. However, the costs will still be minimal for an account value over $100K. Based on backtest results, the average number of annual trades (buys and sells) is approximately 20 for LRV-3. In a Schwab account, this amounts to a cost of 20 x $9 = $180 per year. So, the cost is about 0.18% for a $100K account. In addition, PCY and CWB are commission-free ETFs on Schwab (and the commission-free SCHO is a good substitute for VFISX). So, the commission costs of trading LRV-3 (neglecting any other costs) are quite minimal. A final step in this study is to ensure the ETF version of the strategy gives similar results as the mutual fund version. The ETF version can only be backtested to 2010, so the 2010-present timeframe is used for comparison. The backtest results for the ETFs and the mutual funds for LRV-3 are shown below. LRV-3 Results Using ETFs (2010 – Present) (click to enlarge) LRV-3 Results Using Mutual Funds (2010 – Present) (click to enlarge) Good agreement is seen between using ETFs and mutual funds. Using ETFs, the CAGR is 7.9%, the SD is 6.2%, and the maximum drawdown is -4.5%. Using mutual funds, the CAGR is 8.3%, the SD is 5.3%, and the maximum drawdown is -4.2%. It should be noted that the performance of the mutual funds from 2010-present is less than the performance between 1994-present. This is probably caused by the Federal Reserve holding short-term rates near zero from 2009-present. When short-term rates are increased, performance should eventually increase (after, perhaps, a short time of reduced performance). Also to be noted is that LRV-3 has gone to all cash (money market) since July 2015. So, for July, August and September, the top three assets based on relative strength have not passed the absolute momentum test. In summary, the LRV-3 should be used by more conservative investors, who desire solid growth (10%) with lower risk, while HRV should be used if more growth is desired (15%) at the expense of higher risk. For those investors, who desire even lower risk than LRV-3 as well as higher risk-adjusted return on investment, LRV-5 might be a better choice. For 1994-present, LRV-5 has a CAGR of 9.0%, a maximum drawdown of only -4.4%, and a CAGR/SD of 1.80. It should be mentioned that this strategy using fixed income ETFs is best employed in non taxable retirement accounts that avoid tax issues. I would also like to thank Terry Doherty for reading over this article and making a number of excellent suggestions.