The CEO of Public Storage (PSA) likes to say that the fundamentals of demand for the company’s product (storage units) are driven by the four D’s; Divorce, Death, Downsizing, and Dislocation. That may sound a little depressing on the surface, but in this market investors have to deal with reality and we might as well try to profit from economic disruptions while we are at it.
PSA is a solid fundamental performer and the long-term trend of the stock has been inspiring over the last several years. After the financial crash PSA was trading for $40 per share and is now near $158 for a 295% holding period yield based on the dividend adjusted stock price. However, PSA is a REIT so it is popular among income investors, which means they are very sensitive to higher yields.
For example, when yields on Treasury bonds began to rise in May, PSA dropped quickly from $165 to $145 per share as its dividend yield looked less attractive compared to higher yielding bonds. The same dynamic hurt utilities and consumer staples stocks as well. I wouldn’t expect that relationship to change very much. In the next chart you can see that PSA has an imperfect but strong inverse relationship to the yield on 10-year Treasury bonds.
PSA looks like an interesting buy right now as it hits trendline support, but since so many of May’s losses have been restored it pays to wait for confirmation of a bounce to trigger a new entry. Establishing an entry order that gets you into the stock as its price rises can be done manually or in advance with a buy stop order.
Using Preferred Stock to Grow
PSA is interesting among similar REITs in that it primarily uses preferred shares to finance growth instead of debt. Preferred stock exists in a weird limbo between debt and common equity. Despite many disadvantages, some investors like preferred shares because they pay a higher yield on average than the common equity. For example, PSA’s preferred shares are paying nearly 6% yields right now and the dividend is cumulative.
However, PSA doesn’t have to ever redeem those preferred shares. If rates rise, they can keep those preferred shares outstanding while they fall further in value. The rise in interest rates in May dropped some of PSA’s preferred series 25% and, unlike the stock, they haven’t recovered. If interest rates fall, preferred shares have fewer potential gains as they start trading above par value.
The reason is that PSA has the ability to redeem preferred shares in the future if they want to. If rates fall and they can buy back their preferred shares and issue new shares at a lower yield then they will. In fact, last year they redeemed almost three fourths as much value in preferred shares as they issued.
All of this places preferred share buyers at a disadvantage over common shareholders who can benefit from equity growth and bond holders who have a maturity date on their debt. As you can imagine, not every company can use preferred shares like this, which is one of the reasons we like PSA’s potential in the short term as we expect interest rates to trend in their favor.
Not all preferred stock is like this, but unfortunately for individual traders, many preferred share issuers are in a powerful position right now with interest rates as low as they are. Because PSA is in a strong position compared to its preferred shareholders, their common shareholders stand to benefit from falling interest rates in two ways.
- Lower rates increases the attractiveness of the dividend on common shares and should drive the price higher. Based on a divided growth model, the current “fair” value of the shares is $180 per share. We think the stock is significantly undervalued at this point.
- Lower rates means the company is more likely to buy back its highest yielding preferred shares. That should set expectations for PSA that their cost of capital is likely to fall in the near term. Lower cost of capital means more earnings available to common shareholders as dividends.
Setting Up the Trade
PSA reported earnings on October 31 and beat expectations across the board. However, after an initial pop in price, sellers emerged and have pushed the stock lower as yields have been rising again. After meeting trendline support on November 12 and forming a nice bullish engulfing pattern on the 13, the stock reversed unexpectedly and is sitting at support again.
These kinds of false-buying signals are unavoidable but not necessarily a signal that the initial bullishness was wrong in the intermediate term. We recommend waiting for a break above the highs established following the bullish engulfing pattern for a more conservative entry. That may not appear and we would suggest that orders be cancelled if the stock breaks and stays below support for more than a few trading sessions.
Recommendation: Buy PSA on a break above the recent $164 high for a $175 profit target. Cancel your order if the stock stays below support.
Option traders may want to use an at the money call option on the stock for additional leverage. However, if you go that route don’t be distracted by the price differential in the puts versus the calls. Big dividend payers typically have much higher put premiums that call premiums but because option traders don’t get (or pay) the dividend it evens out in the end.
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InvestorPlace advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
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