In the markets for thinly traded preferred stocks, it's not uncommon to see small pricing deviations for pari passu (essentially identical) issues. A company routinely has an 8.0% A series that is $25.00 at market close concurrent to the 8.0% B Series' $24.625 close; the astute investor interested in these issues, obviously, buys the discounted series for its higher yield and cost basis advantage.
In real market dynamics of the last few years however, the skews have been exaggerated. When fear supplants reason or true financial analysis, compromised shareholders might have to sell into a void. They need or want liquidity in a dearth of buyers…prices plunge.
This was the trading tape for 3rd and 4th quarter 2008 and for the first 70 days of 2009. We saw it again in August, September and the first days of October 2011. What I'd like to address now is a subtler, stranger phenomenon. One that will recur, year to year, and provide predictable opportunities for profit.
The investor demographic for new preferred equity offerings is both individual and institutional investor, but, because that's where the money is, it's mostly institutional. The behavior in the aftermarket of each type of investor is different. The mutual fund holder of preferred shares that have no market for sellers may have to sell to satisfy redemption requests, regardless of pricing. Too often, the individual investor will convince himself that the further the price declines, the stronger the reason to get out while he can. Both lose.
The example, and possible opportunity, I introduce is Hersha Hospitality Trust (HT). Hersha Hospitality is a Real Estate Investment Trust (REIT) that owns and operates hotels in many major East Coast markets….New York, Washington D.C., Philadelphia. Like all hotel companies, during the recession they suffered declines in average occupancy and Revenue Per Available Room (REVPAR). In the second quarter of 2009 Hersha slashed the quarterly dividend on its common shares by 72% from $0.18 to $0.05 to conserve cash, but the lodging sector is recovering and in the second quarter of 2011 Hersha raised the common's quarterly dividend from $0.05 to $0.06.
Also in the second quarter of 2011, Hersha issued 4,600,000 shares of Series B Preferred stock (HT-B). The company already had a Series A Preferred (HT-A) for which it issued 2,400,000 shares in August 2005. Both Series, A & B, are 8.00% cumulative, redeemable preferred. They each have a $25.00 redemption preference. They each pay $2.00/share/annum. They each sit just senior to the common shares in Hersha's capital structure. Pari passu.
It seems the shares of two nearly identical issues from the same company, trading on the same exchanges would price nearly identically in day-to-day trading, but in the last half of 2011 the Hersha issues diverged. From the time of its May issuance, HT-B initially bounced around trading at prices within a couple percent of its $25 nominal value; just about where HT-A was trading. But by early August heightening awareness of the looming trouble in European Sovereign debt, the downgrade of U.S. credit ratings, sustainingly high unemployment, and the disappointingly slow economic recovery combined to create market hysterias reminiscent of the 2008 financial crisis.
Historically, during times of investor panic, thinly traded, small-cap issues (e.g. REIT preferred shares), can sustain the most damage. On August 5th, on volume of just 11,400 shares, HT-A opened at $24.50 then plunged to $16.60 before closing at $23.63 for a decline of 3.8% from the prior session's close. That same day, on 43,000 shares volume, HT-B opened at $24.03, fell to a low of $22.16, and closed at $22.53, down 6.2% for the day. In subsequent days the markets calmed a bit and by August 15, HT-A again traded north of $24. HT-B, on the other hand, never fully regained its footing; it hit a low of $18.55 on August 11 and meandered between $20.50 and $23.50 for the remainder of the year. HT-B closed 2011 at $22.10.
Markets were generally in a recovery mode in December 2011, so you have to ponder what factors are depressing certain issues that don't respond to market trends. REITs in general performed well last year with the MSCI US REIT Index (RMS) posting a total return of 8.69%, so HT-B's downturn doesn't jibe with sector trends. Instead, I suspect HT-B was a new issue, forgotten, cut loose and cast adrift in last August 's financial markets turmoil. When things stabilized, very few remembered the birth or existence of this little $100 million issue. As the year came to a close, investors found more value in HT-B as a current year tax-loss sale than they did as a high yielding long position. They sold into a market with very few buyers and those buyers were offering only $22.
HT-B closed 2011 at $22.10, 7.8% below the $23.97 closing price of its identical twin HT-A and a stunning 11.6% discount to its $25 par value. HT-B's $22 price delivers an impressive 9.05% yield against purchase price in this environment of the sub 2.0% 10 year Treasury. A thorough analysis of Hersha's capital structure should detail that payment of the rising dividend on HT's common stock is subordinate to payment of its preferred dividends; the preferred dividend has some cushion. If sufficient calm soon returns to equity markets and HT-B regains the $25 normalized price of its twin, HT-A, December 30th purchasers can tack on more than 13% capital appreciation for a 2012 total return in excess of 22%.
In the first four weeks of 2012 we approached a normalized market; on January 30 HT-A closed at $24.96 (up 4.1%) and HT-B closed at $23.99 (up 8.5%). Both issues and the common will declare the next dividend in March and, if investor panic has abated, the share prices should rise to the occasion.
The above described pricing anomalies are surprisingly common and they are caused by a variety of factors. More than 200 issues exist in the realm of REIT preferreds. Study the issuing companies' capital structures. Familiarize yourself with each company's operations and those of their sector peers. Stay current with each company's financial performance. Examine historical pricing for given issues in both calm and volatile markets. Fully prepared in this fashion, you can wait and watch for opportunity.
Investors should always consider risks of liquidity and pricing and total loss of capital before taking a position in any security.
Disclosure: 2nd Market Capital Advisory and its affiliated accounts are long HT-B at the time of this writing.
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