These REITs Have the Right Fundamentals

 | Oct 21, 2016 | 4:00 PM EDT
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Stock quotes in this article:

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I have spent a lot of time on F-scores this week. The nine-point fundamental scoring system developed by Joseph Piotroski has proven to be an excellent way to measure financial strength, and I have used it with other valuation metrics with lots of success over the years.

In one sector, in particular, it can be utilized by itself to find stocks and manage your portfolio with a great deal of success. I have discovered that you can buy REITs with F-scores of 7 or higher and handily beat the market, as measured by the S&P 500, over time. This year it is doing so by more than a 2-to-1 margin.

I rebalance this portfolio every quarter, so any REIT with slipping fundamentals is immediately sold. The turnover is moderate, but combined with the flow of dividends, there will be a lot of taxable income and gains from this approach, so the strategy is probably best used in an IRA. I have said for some time that most investors have far too little real estate exposure, so I would not be afraid to have a significant portion of my portfolio is a REIT F-score strategy.

I ran the portfolio this morning, and there are 37 REITs that qualify for the portfolio. That is up from 28 when I ran it back in June of this year, so REIT fundamentals are continuing to improve, even in a slow growth economy.

The first thing I did was look to see if any of my holdings made the list. Equity Commonwealth (EQC) is one of my big-three real estate holdings that I hope to never sell. It doesn't pay a dividend at this time, but it is managed by Sam Zell and his team -- so I am confident that the long-term results will be outstanding. They have been selling properties and are sitting on almost $2 billion in cash to put to work when they decide the price is right.

I have owned shares of Cedar Realty Trust (CDR) for more than five years now, and it has quietly turned in double-digit average annual returns over that time. The REIT invests in supermarket-anchored shopping centers in the Northeast and Mid-Atlantic, and results have been steady -- with earnings growth averaging about 18% a year.

Silver Bay Realty (SBY) has been a ho-hum performer so far, but I have high expectations. The stock price has not done much, but the value of the single-family homes they own has been steadily appreciating. The shares trade below the 2012 IPO price -- in spite of the price appreciation on single family homes in its markets. The company appears to believe the stock is undervalued -- it has been buying back stock this year. I am getting paid 3% while I wait for the value to be reflected in the price, and we should see steady dividend increases as rents rise in the future.

I have mentioned Apple Hospitality (APLE) as a REIT on my "hope the price falls" list of stocks trading near book value. They have a fantastic portfolio of hotel properties around the United States, and the recent merger with Apple 10 should add to the bottom line going forward. Apple Hospitality shares yield 6.58%, which is very attractive in a low-interest-rate world.

Host Hotels and Resorts (HST) is not only the largest hotel REIT, but it is also the REIT with the highest F-scores -- earning a perfect 9. The firm owns 89 properties in the U.S. and nine properties internationally -- totalling approximately 54,500 rooms. It also has joint ventures in Europe and Asia. The shares yield a little over 5%, and the REIT has been buying back stock, so management is decidedly shareholder friendly.

Owning high-quality real estate has been the underpinning of several fortunes, and I think this strategy can help individual investors achieve outstanding long-term results. It is not as valuation-sensitive as my usual deep-value methodology, but it is hard to argue with the results.

National Association of Real Estate Investment Trusts (NAREIT) studies have shown that REITs outperform stocks over the long run, and a portfolio of REITs with the best fundamentals should do even better than the equity REIT Indexes. I have included a spreadsheet, below, showing all 37 stocks -- for those of you how to wish to investigate the F-score REIT approach a little further.

Strong REITs

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