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Coffina: Investors' Rate-Hike Fears Overblown

Matthew Coffina, CFA
Jeremy Glaser

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Have concerns over the Fed raising short-term interest rates created any buying opportunities? I'm joined today by Matt Coffina--the editor of Morningstar StockInvestor newsletter--to find out.

Matt, thanks for joining me.

Matt Coffina: Thanks for having me.

Glaser: Let's talk about their short-term concerns first. Why do investors seem somewhat obsessed over when the Fed is going to raise interest rates? Does a 25-basis-point rise in that short-term rate really make a difference to the market?

Coffina: I don't think a 25-basis-point change really changes much one way or another, but I think investors have become very much focused on monetary policy over the last decade. We've had this very unusual period of zero interest rates for the past six years. I think a lot of investors think that that has propped up the stock market and maybe has been one of the main drivers of the bull market that we've had. So, I think investors are on edge about what it means when some of that stimulus is taken away.

Certainly, rates do affect the fair values of stocks, so you have direct effects--for example, your interest expense tends to go up with a higher interest rate. But then more importantly, you have indirect effects, such as your cost of equity also tending to go up. Investors demand a higher return, bonds become relatively more attractive, and so to invest in stocks, you need to be compensated even more so than before. Again, I don't think a 25-basis-point change makes a difference, but investors are worried about where rates are going over the long run and, more importantly, what this means for investor sentiment and how investors are going to see stocks relative to their alternatives.

Glaser: When you look at how Morningstar values stocks, what do we assume in terms of long-term rates? What's already priced in?

Coffina: We have an explicit assumption for the long-term Treasury yield in a normalized environment--and that's 4.5%. So, it's about double what the long-term Treasury is trading at right now. If the 10-year Treasury goes to 4.5%, it would meet our expectations. If it went higher than that, we might have to consider cutting fair value estimates; if it stayed lower than that indefinitely, we might have to consider raising fair value estimates. But as a base case, I think 4.5% is a reasonable number to keep in mind. We base that on about 2.25% over real return--and, by the way, bond investors haven't had any kind of real return in recent years--and then about 2.25% inflation in a more normal environment.

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Glaser: So, if this is maybe not something to be overly concerned about right now, has it created any pockets of opportunity? Have there been some sectors that maybe have sold off too much on these concerns?

Coffina: It's interesting because the bond market hasn't reacted all that much to concerns about the Fed raising rates. Ten-year Treasuries have been pretty steady. But stock investors seem to be really overreacting to the prospect of changes in rates. Certain rate-sensitive sectors, such as utilities and especially real estate investment trusts, have been very volatile in response to any kind of notion that the Federal Reserve might change its stance on monetary policy. We actually just recently bought a stock for the Hare portfolio based on our thesis that investors have overreacted to the concern of higher rates--Ventas (VTR).

Ventas is a healthcare REIT. When I bought it a couple of weeks ago, it was yielding 5.5%. The yield is down a little bit since then. The Fed held steady on rates, so REITs came back up a bit. But in any case, it's yielding around 5.5%. I think Ventas has internal-growth prospects at least in line with inflation, so already you have a much better total-return prospect than a long-term Treasury, 5.5% yield, and growth that's at least in line with inflation from the existing portfolio. And then what makes Ventas special, I think, is that management has done a very good job of acquiring assets over time and creating value for shareholders. And so their overall dividend-growth rate has been in the high single digits, and I think that's probably sustainable for at least a few more years; maybe eventually it will settle down to the mid-single digits. But either way, I'm expecting a double-digit total return from Ventas with significantly less risk than your typical stock.

Glaser: What do you like about Ventas compared with other healthcare REITs?

Coffina: We also own HCP (HCP) in our Tortoise portfolio. Those are two of the big three healthcare REITS; the other one is Health Care REIT (HCN) [which has recently changed its name to Welltower]. But again, Ventas has a few advantages over the others--especially relative to HCP. It has less tenant concentration. That's been a big concern for HCP; one of their tenants has not been in the best financial situation, and they actually just recently had to cut the rent for that tenant. Ventas doesn't have any tenants that are in any kind of immediate financial distress, and it also has less concentration, in general, than HCP.

The other big difference is that Ventas has a slightly lower payout ratio than its peers, so that creates a greater margin of safety around the dividend. It also allows them to retain more cash flow that they can reinvest in acquisitions or internal growth. But really, the biggest difference is that they have been better at acquisitions over time than their peers. Their CEO has been there for more than 15 years, so there's a lot of stability around the management team and around the strategy. I think that they can continue to do these value-accretive deals over time--their dividend growth has been double or triple what their peers' growth has been. I would expect that spread to probably compress over time, but I do think they can post superior dividend growth--and the valuation really isn't all that different relative to the big two peers.

Glaser: This is a high-uncertainty stock, though. What are some of the risks?

Coffina: The uncertainty, I'd say, is mostly on the upside with Ventas. If you look at our analyst's scenario analysis, his bear-case fair value estimate is basically right in line with the stock price--somewhere in the mid-$50s. But the bull case is much higher than that--$80 or $90 a share. The reason there is so much uncertainty on the upside has to do with their acquisition strategy. Healthcare real estate is a very fragmented market. Only about 15% of the real estate is in the hands of publicly traded REITs right now. So, if they can consolidate more of the market and if they can do it on attractive terms, that would create a lot more upside to the fair value estimate.

On the downside, there are certainly risks as well. The biggest one would be some kind of financial distress for a tenant. It's not on our radar right now, but it's always possible. Ventas also has greater exposure to senior-housing operating properties, so they are actually operating these properties. They are exposed to the underlying level of occupancy--the rental rates and whatnot--compared with a triple-net lease, where they are just taking on credit risk for whoever the tenant is. So, in a downturn, you could see occupancy decline somewhat or you might see rental rates decline somewhat, and that would make Ventas a little more cyclical in a triple-net-only REIT. But that said, we think that healthcare, in general, is a very defensive kind of business. Most 85-year-olds are not going to move out of their senior-housing facility just because the economy is weak in one year.

Glaser: Matt, I certainly appreciate your take on rates and on Ventas today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching. 

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