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  1. Home
  2. / Investing
  3. / Energy

Those Overlooked, Red-Hot Preferreds

For myself, as an income-fund manager, validation is sweet.
By JIM COLLINS
Apr 12, 2014 | 10:30 AM EDT
Stocks quotes in this article: PFF, GRH-C, GST-A, MHR-C, MHR-D, MHR-E, EPM-A, MILL-C, MILL-D, ARR-A, IRC-A, GST-B

For the better part of the last year, it has been a tough time to be an income-fund manager. Seemingly every day the market would approach or hit new highs and, in my social encounters, it seemed every night someone would tell me how well his or her momentum-stock (Facebook (FB). Tesla (TSLA), Intuitive Surgical (ISRG) and so on) had been performing.

But now's our time. I believe the worm is turning, and for exactly the right reason: Earnings estimates are too high. My rant about bleak first-quarter estimates aside, there is always a tipping point -- a moment, as historians would say -- when the market "gets it." I have stated my belief that first-quarter earnings would be dire, and now the proof is unfolding. I believe, moreover, that this will continue as we move through the next three weeks. In short, fundamentals matter. With that in mind, watch for downbeat outlooks from companies in a variety of industries coupled with their "blah" first quarter-financials.

Still, as an active asset manager, it's not just enough to see someone else's strategy sputter. Yours needs to excel -- and, while this doesn't get 24/7 coverage on CNBC, the preferred-stock space has been red-hot thus far in 2014: The iShares US Preferred Stock (PFF) has risen 5.9% this year vs. the S&P 500's fall, which as of this writing stands at 1.6%. That's a great relative performance, and I believe these trends will persist. 

Meanwhile, my Portfolio Guru model portfolio -- composed entirely of income-securities, the vast majority of which are preferreds -- has risen 8.5% thus far in 2014. So I am raising my voice again at cocktail parties, and I can justify the general outperformance of preferreds as well as the outperformance of my fund vs. the overall preferred-share category.

On the outperformance of preferred shares: U.S. Treasury yields are not rising, nor do I think they will. The reasons are twofold. First, I believe the "flight to safety" trade will continue as the equity markets correct, and I don't believe the U.S. economy -- nor the global economy, for that matter -- is as strong as the raging equity bulls want you to believe. Second, the 10-year Treasury is the ultimate pricing benchmark for preferreds of U.S. companies, and as Treasury prices rise, assuming unchanged perception of credit risk, prices of preferreds should climb as well.

On my portfolio's outperformance against the general preferred category: My portfolio is heavily weighted toward preferred shares of companies in the energy sector. I look for preferreds of firms that can dramatically increase hydrocarbon production and, then the calculus is simple. More production equals more cash flow, which equals greater coverage of the preferred dividend, and that should equal a lower spread to Treasuries. That is exactly what is happening with my energy-sector preferreds.

At this week's Independent Petroleum Association of America's OGIS conference in New York, I spent time with the management teams of all of the energy-sector issuers in my model portfolio (much more to come on that in future columns). In each case I walked out of the meeting with increased conviction regarding the creditworthiness of that company.

I can't lie -- for me, as an income manager, it's a feeling that borders on ecstasy. With my investment style, I'll never experience the joy of selling someone a stock for 67x earnings that I bought for a mere 45x. But my core strategy of persistent reinvestment works, and if it takes a pullback in the momentum names to remind the investing public, then so be it.

So, not as an "I told you so" but in the spirit of idea-sharing and full disclosure, listed below are the preferreds that I own in the Portfolio Guru model portfolio, and for my clients. (I also own some straight debt, one high-yielding equity and one master limited partnership, but we'll focus on the preferreds.) I am still buying every single name on that list that isn't currently callable -- I only buy preferreds after first call date if they trade at a discount to par.

In short, I don't see any reason to alter my strategy anytime soon.

Energy Sector:

  • GreenHunter Resources Series C (GRH-C)
  • Gastar Exploration Series A (GST-A)
  • Gastar Exploration Series B (GST-B)
  • Magnum Hunter Resources Series C (MHR-C)
  • Magnum Hunter Resources Series D (MHR-D)
  • Magnum Hunter Resources Series E (MHR-E)
  • Evolution Petroleum Series A (EPM-A)
  • Miller Energy Resources Series C (MILL-C)
  • Miller Energy Resources Series D (MILL-D)

Other:

  • Armour Residential REIT Series A (ARR-A)
  • Inland Real Estate Series A (IRC-A)
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At the time of publication the author held positions in  GRH, GST, MHR, EPM, MILL, ARR, IRC.

TAGS: Investing | U.S. Equity | Energy

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