As part of work done for Investing Daily’s Utility Forecaster, where I am a senior analyst, I developed an Early Warning System for the utility sector to ascertain threats to the dividend and identify investment opportunities. 

The model also works well with all types of income investments in addition to utilities, such as the REITs, banks, and telecoms. That’s why I regularly use the Early Warning System to monitor Global Income Edge portfolio companies.

In the subscriber section, we’ll share the results of the model and discuss which companies, if any, have shown weakness or strength, and what actions we might take as a result. 

This Early Warning System deconstructs a company’s return on equity (ROE) into its individual components, which allows for greater ease in analyzing what’s actually driving growth.

In addition to identifying promising investments, this system alerts us to declining margins and rising leverage. The System’s red and green flash alerts notify us when trends in percentage changes in ROE exceed or fall short of preset criteria. The system then displays customized breakdowns of each company’s fundamentals, offering a snapshot of a firm’s true financial health.

The System, also referred to as the DuPont Hybrid Model, originates from the original DuPont model that was developed in 1919 by a finance executive at EI du Pont de Nemours and Co, and was then used by many other companies to evaluate the critical components that contribute to ROE and so shareholder value. ROE is still considered a key measure when comparing companies against their peers and is used by many of the world’s top investors, including Warren Buffett.

According to a study conducted by Charles Schwab, ROE also appears closely correlated with the safety and sustainability of a company’s payout. Schwab reviewed the characteristics of dividend payers among the top 3,200 stocks by market capitalization, over the period from 1990 through February 2009, and found that companies with higher ROEs were less likely to have cut their dividend.

Furthermore, many utilities’ cash flows are cyclical in nature, as they’re highly sensitive to weather-related events, as are many other businesses in the GIE portfolios. A precipitous, short-term drop in ROE in one quarter may not necessarily indicate that a company’s financials are unraveling. As such, the early-warning system will evaluate trends in ROE across multiple quarters prior to recommending any action with regard to an existing holding or a new opportunity.

The most surprising result of running the early warning system on Global Income Edge portfolios was in what great shape our Real Estate Investment Trust holdings are in. This confirms suspicions that the recent selloff in the sector has been more investor overreaction to a possible rate increase by the Federal Reserve than on the fundamentals. 

And we have long argued that income investments such as REITs will remain competitive with Treasuries for some time as Fed rate increases are expected to be gradual.

The majority of REITs in our portfolio maintained their previous quarter’s return on equity (ROE) levels, one increased its ROE and profitability, while two companies showed potential weakness. We highlight them here, though two negative ROE quarters are required before we would make a ratings change.      

Portfolio Safety Update

Starwood Property Trust’s (NYSE: STWD) ROE actually increased from 2.37% to 3.12% in the last quarter as net profit margin improved. STWD is a Buy up to $32.

But REIT Portfolio #1 Best Buy HCP (NYSE: HCP) has been experiencing headwinds as of late as a result of one of its major clients, HCR ManorCare, which is having trouble paying its rent. This situation clearly explains a 2.34% drop in return on equity, where the firm’s profitability has fallen, and it has taken on more leverage.

HCR ManorCare represents a quarter of HCP’s business and is being investigated by the Justice Department for its billing practices. HCP has taken steps to reduce its exposure, reporting in the first quarter of 2015 a 4% decrease in exposure to the nursing segment.

According to news reports, the firms have been working together to resolve the issue, and “they have agreed to sell 50 non-core, underperforming nursing homes, provide a rent reduction, and a five-year extension of the lease term.”

Given the firm’s stellar management, its 30-year history of paying an increasing dividend and its moves to shore up its position, we continue to support the stock with a Buy up to $44. However, another quarter of weakness in ROE and we may revisit the rating.

Government Properties (NYSE: GOV) was the other REIT suffering a drop in ROE  as a result of declining margins (the company had a loss of $33.4 million in the last quarter) and leverage increased as its rental rates declined.

According to news reports, 83K of space for either new or renewed leases were entered during the quarter, with average rental rates 6.2% lower than prior rents. As noted prior, one bad quarter can be forgiven but two consecutive quarters of negative ROE will require us to revisit the rating. GOV is a Buy up to $33.

That being said, we’re pleased to report that none of our portfolio holdings has suffered two quarters of negative ROE, with various firms showing a boost.

GlaxoSmithKline (NYSE: GSK), Huaneng Power International (NYSE: HNP) and Novartis (NYSE NVS) all experienced jumps in return on equity in the last quarter as a result of improved profitability. GSK is a Buy up to $54, HNP is a Buy up to $55 and NVS is a Buy up to $100.