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What are we looking for?

In a volatile market, securities in a top-performing sector that may be candidates for selling – or shorting.

The screen

Canada’s trade balance for September, announced on Nov. 2, was a disappointing $420-million deficit. Economists, according to the Reuters Poll, had predicted a $150-million surplus. Furthermore, August’s trade balance, originally announced as a $530-million surplus, was revised down to a $550-million deficit. This massive revision was largely owing to three icebreakers imported from Sweden that were previously unaccounted for.

All this to say, it appears Canada’s economy may be slowing. Hawkish commentary from the Bank of Canada suggests that monetary policy will be an added headwind for growth. Trading in interest-rate futures indicates the market expects three 25-basis-point rate hikes in the next 12 months. Investors may be justifiably hesitant to increase their exposure to Canadian shares. Cautious investors may look to sell stocks that have performed well and take profit. More aggressive speculators might look to go short and take an active bet on stock prices falling.

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Over the past 10 years, the S&P/TSX Composite Index’s best-performing sectors have been industrials and real estate, posting total returns of 292 per cent and 289 per cent, respectively, (more than double the index as a whole). Considering the rising interest-rate environment, we will focus on real estate (owing to the amount of leverage applied in this sector) and specifically real estate investment trusts, to find a potential sale or short target.

Within the S&P/TSX, we look at REITs that are overvalued relative to earnings. Rather than the more traditional forward price-to-earnings ratio, however, we will look at forward funds-from-operations (FFO) – a real estate-specific earnings measure defined by the U.S.-based National Association of Real Estate Investment Trusts. We look for companies whose price-to-FFO is at least 12 times.

Next, we consider how over- or undervalued the stock price of the REIT is relative to the net asset value, or NAV, of the underlying real estate. The threshold set is at least a 3.5-per-cent premium.

Finally, we look at the REIT’s StarMine Earnings Quality Score – an indication of how sustainable reported earnings are – and look for those with a percentile score of less than 40, that is, in the bottom 40 per cent for Canada.

More about Refinitiv

Refinitiv (refinitiv.com), formerly the financial and risk business of Thomson Reuters, is one of the world’s largest providers of financial markets data and infrastructure, serving more than 40,000 institutions in over 190 countries.

What we found

The screen yields five REITs, and InterRent appears the most overvalued on both criteria considered. Its stock has performed very well recently, posting a 21-per-cent return over the past six months while the S&P/TSX Composite has lost 6 per cent in the same period.

It also has the lowest earnings-quality score, driven in part by more than a 25-per-cent increase in what are being classified as “other non-current assets" on its third-quarter balance sheet compared with a year ago.

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For those who are fearful the market will continue downward, this would be a great candidate for a stock to sell in order to lock in a profit. And if investors want to offset the capital gains, losses in other parts of their portfolio probably won’t be hard to find after the recent stock market correction.

Investors are strongly advised to do further research before investing in or otherwise trading any of the securities shown here.

Selected Canadian real estate investment trusts

Company Ticker Market Cap ($Mil) Price/FFO (NTM) Premium/NAV (%) Earnings Quality Score 1Yr Return (%) Recent Close ($) Div. Yield (%)
InterRent REIT IIP-UN-T                              1,373.8  26x 10.0 16 60.7                        12.98  2.1
Boardwalk REIT BEI-UN-T                              2,252.7  19x 3.8 19 23.7                        48.78  2.1
Allied Properties REIT AP-UN-T                              4,417.1  18x 6.0 33 6.5                        42.53  3.7
Killam Apartment REIT KMP-UN-T                              1,394.2  16x 8.7 25 26.4                        16.35  3.8
Northview Apartment REIT NVU-UN-T                              1,425.9  12x 10.0 38 14.1                        25.38  6.4

      
Source: Refinitiv

Hugh Smith, CFA, MBA, investment management specialist at Refinitiv.

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