A Star in the Yield Sky

 | May 13, 2013 | 1:00 PM EDT
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In my first column for Real Money, and I will deviate from my nom de stock The Portfolio Guru, but I will not deviate from my core principles of income investing. Our philosophy is simple: buy high-yielding securities and reinvest the interest/dividends into more high-yielding securities.

The PG's model portfolio is yielding 14%, a level attained through extensively researching individual companies to find securities that are underfollowed, misunderstood and mispriced, yielding a lot more than they should.

How do we find those individual securities? Sometimes, it's as easy as following the yield.

When I the model porftolio in October 2011, the yields in the financial sector were appealing. Europe was a huge worry and investors were preoccupied with stress tests. There were opportunities in bonds/preferreds of Bank of America (BAC), PNC (PNC) and Wells Fargo (WFC), among others. Those opportunities disappeared as banks redeemed those securities to issue new debt at lower interest rates. 

Simply put, the financial sector is not attractive from a fixed-income standpoint now. But while investors have micro-analyzed each central bank machination, the energy industry has reinvented itself.

Horizontal drilling of shale formations using hydraulic fracturing -- fracking -- has opened unexplored areas to exploration and allowed for further exploitation of previously drilled reservoirs.

There lies the opportunity for the income investor. CFOs of companies with shorter track records -- those exploiting new horizontal drilling techniques -- choose preferreds because they do not have the restrictive covenants found in bond indentures. Lack of operating history is a risk and commodity prices are important, although these companies actively hedge commodity exposure, and these two factors create attractive yields.

A prime example is Gastar Exploration (GST). Gastar preferred shares pay an annual coupon of $8.625% and are not callable until June 2014. GST-A closed trading Friday at $23.27, below face value of $25, offering a current yield of 9.3%. 

Gastar recently settled litigation with Chesapeake (CHK) regarding a 2005 land deal and, as a result, will repurchase Chesapeake's 10% interest in Gastar and buy 157,000 acres from Chesapeake in Oklahoma. This property adjoins existing Gastar acreage and offers access to the Hunton Limestone shale formation. This is a very attractive oil play and Gastar's results from its own Oklahoma oil wells have exceeded expectations, while Chesapeake's properties were barely exploited. 

Gastar is now completely focused on the Hunton oil play and existing natural gas assets in the Marcellus shale in West Virginia. To finance this, Gastar privately placed $200 million of debt Friday, with a coupon of 8.625%. So, we can buy the preferreds for a higher interest rate than the big boys, though they are senior in the capital structure to preferred shareholders.

Are we safe? In 1Q 2013 Gastar produced $13.5 million in cash flow from operations. With the new high-yield debt, Gastar's quarterly interest/dividend bill will be about $6.5 million, so that's more than 2x coverage. Gastar is projecting a 30% sequential increase in Marcellus production in 2Q2013 as pipeline issues are resolved, so cash flow will increase there, and Gastar is soliciting JV partners for the newly acquired Oklahoma acreage, which will reduce net leverage.

The removal of the overhang from the Chesapeake litigation has driven GST's common shares to $3.07 from $0.90 in November and GST-A to $23.27 from $16.00 in the same period. But Gastar's preferreds are STILL trading below par and still yielding 9.3% vs. the 10-year Treasury yield of 1.92% and the ML High-Yield index of 4.98%.

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