In my First-Half Portfolio Review article, I stated that I had Lorillard (LO) under surveillance:
Currently I have one stock under special watch. Reynolds American (RAI) has floated a proposal to purchase Lorillard. I have a 63% paper profit in LO (it is a small position). RAI has never been a Top 40 stock, so I may sell LO at some point, although I will investigate RAI with the idea of just keeping it if and when they acquire LO. There is plenty of time to make this decision.
This past Friday, the two companies issued a press release reiterating that their merger talks are progressing. LO’s shares spurted upward on the news.
I now had a 67% gain after owning LO for 16 months.
My proceeds (after commission) were $1618.
Not bad for a stock position that I started with a simple $1000 reinvestment of dividends in March, 2013.
I could have just let RAI buy LO from me and replace it with their own shares.
There are four reasons that I did not do that.
• RAI has never been a Top 40 Dividend Growth Stock. I use the Top 40 stocks as my shopping list each year. A stock not on the list is not eligible to be purchased. That is how I leverage the work that goes into selecting the Top 40 each year.
• RAI’s valuation is poor according to both FASTGraphs and Morningstar. (See “DGI Lesson 11: Valuation” for a complete discussion of how I value stocks.)
• RAI’s credit rating according to S&P is BBB-, which is below “investment grade.” One of my preferences is to own investment-grade companies.
• There is no telling what RAI will do with its dividend after the merger.
So the decision not just to accept RAI shares in place of LO’s shares was pretty easy.
Picking a Replacement
Next up, I had to decide what to replace Lorillard with. Here is my process:
1. Purchase new stock or more of an existing holding? Because I am on a mission to increase the diversification in my Dividend Growth Portfolio, I decided to replace LO with a new position rather than buy more shares of a stock I already own. That eliminated 17 stocks from consideration. (Hover over the “Dividend Growth Investing” tab at the top of this page, and then hit the link to “Dave Van Knapp’s Dividend Growth Portfolio” to see the 17 stocks that I already own after LO is removed.)
2. Good valuation. I consulted my Top 40 stocks on both FASTGraphs and Morningstar to update all their current valuations, skipping over the stocks that I already own. I made a list of the stocks that have Fair or better valuations.
3. Sufficient yield. I eliminated stocks with yields less than 2.7%, which is the minimum I allow in this portfolio. That left 12 candidates.
4. Due diligence. I considered each candidate’s yield, dividend growth history, credit rating, Story, other fundamentals, and how it would fit in the portfolio.
The stock that I selected is HCP Inc. (HCP), a healthcare REIT (Real Estate Investment Trust).
HCP is the first healthcare REIT selected to the S&P 500, and it is the only REIT included in S&P’s Dividend Aristocrats Index. The company has compiled a record of 29 consecutive years of dividend increases.
The company acquires, develops, leases, sells, and manages real estate in the healthcare sector of the economy. HCP is diversified across 5 healthcare segments, with a total of about $22 Billion in assets under management, distributed as follows:
• Senior housing (36%)
• Post-acute care / skilled nursing (28%)
• Life science (17%)
• Medical offices (16%)
• Hospitals (3%)
The company is also diversified geographically.
The dark green shade in California, for example, indicates that HCP owns upwards of 160 properties there, with high concentrations in Texas, Florida, and Illinois as well. As you can see, the company holds properties in practically every state across the country.
HCP’s strategy is to focus on opportunities with the best risk/reward profiles. The majority of its interests are traditional long-term triple-net leases with annual rent escalators, under which the tenants operate the facilities. The company tries to maintain a conservative balance sheet by actively managing debt-to-equity levels and selecting from the most appropriate sources of money, including revolving lines of credit, capital markets, and secured debt. Debt is primarily fixed-rate (which reduces the impact of rising interest rates).
My only major concern about HCP’s business plan is tenant concentration. Its top 5 tenants represent more than 60% of its revenue. I expect that as HCP grows, that concentration will become more diversified.
HCP is in roughly the same business as Ventas (VTR), a company that I added to the portfolio earlier this year and wrote about in “I Just Bought this Stock for My Real Money Portfolio.” You might want to check that article too, as the demographic trends favoring healthcare REITs discussed there apply to HCP as well.
In addition to being a member of S&P’s Dividend Aristocrats club, the company is a Dividend Champion, as seen from this extract from “David Fish’s Dividend Champions, Contenders, and Challengers,” which you can also see by hovering over the link under the “Dividend Growth Investing” label at the top of this page.
We can see that, with a yield of 5.2%, HCP will actually produce more annual income than Lorillard was producing.
The picture looks good on the valuation front too. Lorillard was overvalued – this is typical when an acquisition offer is made for a company. The market runs its price up close to what the buyout price is expected to be, and acquisition offers almost always are made at a premium to the prior market price. This often takes the price into overvalued territory, which is exactly what happened with Lorillard.
HCP, on the other hand, is undervalued. Here is Morningstar’s rating:
The 4 stars (on a 5-star system) indicate undervaluation. FASTGraphs suggests a fair valuation:
The price (black line) is slightly beneath the orange fair-value line. To the right (5 lines from the bottom), we see the BBB+ credit rating that I referred to earlier. HCP is a slow grower (notice “Estimated FFO Growth 3.3%”), but with a higher yielding company like HCP, slower growth becomes acceptable.
I was happy with Lorillard until the acquisition offer became public. Once that news was out, however, a reexamination was in order. What I found was that I owned a company that had now become overvalued that was probably going to be acquired by a company that I have never rated highly.
So by selling Lorillard, I was able to replace it with a company that I have rated highly, and that has a higher dividend yield, better credit rating, and better valuation.
This, to me, is an example of standard portfolio management in dividend growth investing. A merger announcement creates an opportunity. Investigating that opportunity sometimes leads to a decision to make a change that can improve the portfolio. That’s what I did here.
Please note that the acquisition cannot be completed without regulatory approval, which could take months and is not guaranteed. Both RAI’s and LO’s prices have shown significant volatility this week By selling last week, I avoided that volatility and any damaging emotions that might have been associated with it.
Dave Van Knapp
Author of Top 40 Dividend Growth Stocks