Charles Sizemore Economy and MarketsOn a team full of momentum traders, I’m something of an odd man out at Dent Research. I’m a value investor. Some might even call me a dumpster diver. I like buying stocks that are cheap… dirt cheap… or even better, left for dead.

But there’s a little problem with that these days. There just isn’t a whole lot out there that can credibly be called “cheap” at today’s prices.

The S&P 500 trades at a cyclically adjusted price/earnings ratio (“CAPE”) of 26.5.

That places it about 59% higher than its average over the past 135 years, and implies that annual returns, including dividends, will actually be negative over the next eight years.

And bonds? The 10-Year Treasury yields a whopping 1.8% right now, and bonds and bills of shorter maturities yield even less.

As Harry pointed out yesterday, a 1.8% yield is barely positive at all after inflation has been taken into account. So in a bit of irony, the risk-free rate has become a return-free risk.

There are some pockets of value out there, however.

Today, I’m going to jump into two of my favorite asset classes at today’s prices: equity real estate investment trusts (REITs) and mortgage REITs, both which we’ve been buying of late in Boom & Bust.

I’ll start with equity REITs.

Equity REITs hold assorted real estate properties covering everything under the sun: apartments, office buildings, hospitals, mini storage… you name it, and chances are good that there is a REIT or two that owns it.

Today, equity REITs as an asset class sport dividend yields just shy of 4%.

Now, that might not sound wildly impressive. But when measured as a spread over the 10-Year Treasury, it’s one of the widest spreads in nearly 40 years.

REITs were cheaper relative to Treasurys briefly during the 2008 meltdown and for a stretch during the early 2000s. But otherwise, at least relative to Treasurys, this is close to as cheap as equity REITs have ever been… in their entire history as an asset class.

Equity REITs are also in a nice sweet spot when it comes to inflation.

We’re of the opinion here at Dent Research that deflation – or at least very significant disinflation – is a lot more likely than inflation over the next few years.

Well, deflation is wonderful news for safe, income-producing assets. In a world of falling prices, cash – and the investments that produce it – is king.

But let’s say we’re wrong. Let’s say that the world’s central banks manage to finally stoke inflation and somehow overpower our demographic models.

Fortunately, real estate is a natural inflation hedge. A move by investors away from “paper” assets and into hard assets should benefit commodities, precious metals and… you got it… equity REITs.

Moving on, mortgage REITs are a very different animal than their cousins, equity REITs.

Apart from sharing a common business structure and tax classification, these two couldn’t be any more different. Equity REITs hold property; mortgage REITs hold mortgages and mortgage securities like Fannie Mae bonds.

Despite their differences, they actually do have one more thing in common – both present a nice opportunity in an otherwise overpriced market.

Mortgage REITs regularly have to report their net asset values, which is the market value of their investment portfolios minus any debt used to finance them.

Well, across the board, mortgage REITs are worth more dead than alive at current prices.

One that we recently added to our Boom & Bust portfolio currently trades at an 11% discount to its net asset value, meaning that we’re getting a high-quality mortgage portfolio for 89 cents on the dollar.

But that’s just the start of it. Many of the other names in this space trade at discounts of around 20%.

Again, these are real book values. These net asset values are based on the prices of real, marketable securities. If you had deep enough pockets, you could literally buy up the entire company, sell if off for spare parts, and walk away with a pretty substantial profit.

Pricing anomalies like this don’t last forever. Eventually, investors take note of the 80-cent dollars they see lying around, and prices move to something more sensible.

And already, we’re starting to see mergers and acquisitions in the space, as some of the larger mortgage REITs find it cheaper to simply buy their competitors than to buy the securities their competitors own.

But while we’re waiting for that to play out, we can sit back and collect the fat, double-digit dividend yields currently on offer. Across the sector, you can find plenty of mortgage REITs yielding 10% – 12%.

Now, I should be clear. Mortgage REIT dividends are not as safe as equity dividends. They can be – and often are – cut when interest rate spreads are less favorable. But today, when you can buy these things for 80 or 90 cents on the dollar, that’s a risk worth taking.

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Charles Sizemore
Editor, Dent 401k Advisor

Charles Sizemore
Charles Sizemore is the editor of Peak Income, a monthly newsletter focusing on income and retirement strategies.