Buy These 2 Preferred Stocks, And Say Bye To These Others

Book with page about preferred stock. Trading concept.

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Co-produced with Preferred Stock Trader

Introduction

In the last several weeks we have seen a big rally in Treasury Bonds which has led to a large rally in the prices of preferred stocks. In order to outperform the market going forward, we have been searching for preferred stocks that have lagged the rally for no fundamental reason with the expectation that they will play catch-up and move higher in price. Preferred stocks that have lagged the rally also often have oversized yields relative to their peers who have rallied providing a significant opportunity to achieve high total returns.

In our research, we have found what we believe are the two biggest laggards which are quite undervalued relative to the rest of the preferred stock market and offer large upside price potential. Those stock symbols are EPR-E and RLJ-A.

Buy EPR Properties Preferred “E” and Sell Their Preferred “G” Stock

EPR Properties (EPR) is a property REIT that owns experiential properties like movie theaters, Top Golf locations, and other recreational properties. These were the hardest hit properties during the COVID lockdowns, but EPR managed through it due to a good balance sheet and long-term leases. Now EPR is on the rise with growing earnings and a strong common stock dividend. Most of their properties are on triple-net leases which provide more safety than traditional leases and currently they have cash in the amount of $168 million so their liquidity is good.

EPR Properties has 3 preferred stocks. Two are convertible preferred stocks:

  • EPR-C 5.75% Series C Cumulative Convertible Preferred Shares (EPR.PC)
  • EPR-E 9.00% Series E Cumulative Convertible Preferred Shares (EPR.PE)

They also have a traditional fixed-rate preferred stock:

  • EPR-G 5.75% Series G Cumulative Redeemable Preferred Shares (EPR.PG)

EPR-E has been a huge laggard during the last several weeks that the market has been rallying. Here is an 8-week price comparison of the three EPR preferred stocks. The preferred stock rally began around the week starting on June 20th. The graph below shows the price action since then.

graph

Yahoo! Finance

EPR-E has lagged EPR-G by 12% and EPR-C by 7%. If EPR-E had just kept up with EPR-C, it would be trading at $34.20 and if it had kept up with EPR-G, it would be trading at $35.85. And even at a price of $35.85, EPR-E would still have a higher yield than the other two.

Not only has EPR-E significantly lagged the recent price action, for no apparent reason given the action in the other EPR preferreds, but its current yield is much better than its two peers:

  • EPR-E 7.1%
  • EPR-C 5.8%
  • EPR-G 6.1%

So if EPR-E simply traded at the same yield as EPR-G, it would trade at $37.00. But there is even more. EPR-E is not callable while EPR-G is callable at $25. Thus, EPR-E has more upside price potential. And add to that the fact that EPR-E is a convertible preferred stock so you also get a call option on EPR. That should add another $2.00 per share of value to EPR-E versus EPR-G. So relative to EPR-G, EPR-E must be one of the most undervalued preferred stocks in the market in terms of relative value versus its peer stock.

One year ago, EPR-E traded as high as $38.05, and relative to EPR-G it should trade over $38.00 now. Given that EPR-G looks overvalued here, I would put relative fair value of EPR-E at $36.00 and EPR-G at $22.00. At $36.00, EPR-E will still have a better yield than EPR-C, the other EPR convertible preferred stock.

So we have EPR-E as a strong buy and EPR-G as a strong sell. We also recommend selling EPR-C and buying EPR-E. Why accept a 6.1% yield from EPR-G when you can get a 6.3% yield from something like AAM-B (AAM.PB) which has a strong investment-grade rating and pays a qualified dividend?

Note – We are not going to get into the conversion rates of convertible preferreds EPR-E and EPR-C because they are not much of a factor with EPR trading where it is today.

Buy RLJ-A and Sell the Preferred Stocks of Pebblebrook Hotels

RLJ Lodging Trust (RLJ) is a property REIT that owns hotels. Since RLJ-A (RLJ.PA) is the only preferred stock issued by RLJ, we cannot do the same type of comparison that we did with EPR-E. But unlike EPR-E (which has no peer companies with similar properties) there are several other hotel REITs that can be used for comparison. This allows us to assess the valuation of RLJ-A in relation to other preferred stocks from hotel REITs and also document how the price of RLJ-A has extraordinarily lagged its peers. The closest peer to RLJ is Pebblebrook Hotel Trust (PEB) which has four preferred stocks.

It is critical to understand that RLJ-A cannot be called. This means that there is no limit as to how high in price RLJ-A can trade. Just as EPR-E trades at $32 per share because it is not callable, potentially RLJ-A can also trade over $30.00 per share.

Since July 1st, a number of hotel REIT preferreds, like PEB-E (PEB.PE), have taken off like a rocket. But one has not, and for no discernible reason – and that preferred stock is RLJ-A.

PEB-E Price Chart Since July 1st

chart

Author’s graph

As you can see, PEB-E is up $4.00 per share just since July 1st.

RLJ-A Price Chart Since July 1st

graph

Author’s graph

The price chart above shows that RLJ-A has barely participated in this rally at all, up just 24 cents since July 1st. So RLJ-A has lagged PEB-E by around $3.75 per share. If RLJ-A had followed suit, it would be trading at $30.00. And here is a price comparison chart between the preferred stocks of hotel REIT Sunstone Hotel Investors (SHO) and RLJ-A since July 1st.

graph

Yahoo! Finance

RLJ-A is up less than 2% during this huge hotel REIT rally we have had since July 1st while SHO-I (SHO.PI) is up 12% and SHO-H (SHO.PH) is 17%. If RLJ-A had simply kept pace with the slower rising of the SHO-I preferred, it would trade at $29.25. If it had kept pace with SHO-H, it would be trading at $30.55.

And let’s look at yield comparisons between the preferred stocks of the quality hotel REIT preferred stocks of RLJ, PEB, SHO, and DRH (DRH).

table

Author’s calculations

The PEB preferred stocks are the best comparison. Although RLJ-A has a better balance sheet, with over $500 million in cash versus only $32 million for PEB, the companies are similar in size and quality (in my opinion). The 7.5% yield on RLJ-A provides a yield that is 15% higher than the 6.5% offered by PEB-E. So RLJ-A is clearly much better than the PEB preferred stocks on yield alone, and that doesn’t include the fact that RLJ-A can’t be called and thus has more price upside. Based on yield alone, RLJ-A is around 12% undervalued ($3.15 per share undervalued) relative to similar preferred stocks.

SHO does have a better balance sheet than RLJ-A, but I still much prefer RLJ-A as its higher yield and unlimited price upside make it significantly more attractive.

So RLJ-A is a strong buy at current prices. If you own DRH-A (DRH.PA), the SHO preferred stocks, and especially the PEB preferred stocks, I would definitely look at selling them and moving the money into RLJ-A. This will both increase the yield of your portfolio and give you much better upside price potential.

And don’t forget that the preferred stock dividends from EPR-E and RLJ-A receive a tax benefit such that 20% of your dividends are tax-free.

Summary

After the recent strong rally in preferred stocks that have raised the price of many preferred stocks by $2.00 to $4.00 per share, we are focused on those preferred stocks that have hardly budged for no fundamental reason – stocks that have been ignored, providing us with great total return potential. Not only are their yields oversized relative to preferred stocks that have rallied, but they have much more capital gains potential.

One of those laggards is preferred stock EPR-E. While EPR-C and EPR-G have rallied strongly, EPR-E has seen a much smaller price move. If EPR-E had simply followed the move higher of its sister preferred stocks, or traded at similar yields to its sister preferreds, EPR-E would be several dollars per share higher in price.

We have fair value of EPR-E at $36.00 per share, while EPR-G, which has rallied much too strongly (in our opinion), has a relative fair value of $22.00. Thus, we believe that EPR-E is one of the strongest buys in this market, while EPR-G is one of the best preferred stocks to be sold.

RLJ-A is our other favorite laggard. While preferred stocks from other hotel REITs have rallied as much as $4.00 per share, RLJ-A has not budged, and there is no fundamental reason to explain this. RLJ-A now has a much better current yield than all the quality hotel REIT preferred stocks as well as much more price upside, especially given that RLJ-A cannot be called and thus can trade several dollars higher. This is simply a great opportunity to sell your other hotel REIT preferred stocks, especially PEB-E and other PEB preferreds, and buy RLJ-A which should provide a much higher total return going forward.

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