These companies are known as Business Development Companies (BDC) and, when publicly listed, are roughly akin to closed end funds. Ares and Apollo represent the most typical style of BDC – those which provide financing through debt and equity instruments to middle-market companies. Typically speaking, the deals that these types of BDCs invest in are leveraged buyout transactions sponsored by a whos who of middle market private equity firms – GTCR, Audax, Apax, etc.

In order to classify as a BDC, the companies must follow two very particular guidelines. First, they must maintain leverage no greater than 200% their net assets. Second, they must distribute 90% of their income. This generally means that BDCs are slow moving, high yielding stocks and well suited for income-oriented investors.

Over the past year, BDCs have fallen out of favor and their stocks have nose-dived. Declining investor appetite towards debt investments as well as forced sales in debt and equity securities have taken a toll on the market value of BDC investmnts. Two of the most well known BDCs – American Capital Strategies (ACAS) and Allied Investments (ALD) – have fallen on hard times and are in the process of deleveraging through forced sales on their portfolio. In the case of BDCs, the 200% of net assets rule can turn into shackles despite the company’s modest leverage (versus other financial institutions).

BDC stocks, however, have fallen at an even greater rate than their net asset value.  Before the “Great Recession of 2008-2009,” BDCs, much like closed-end funds, almost always traded near or above net asset value. Today, very few trade at even 90% of NAV.  Instead, analysts believe that the funds are now priced on dividend yield with investors demanding significantly higher returns for the perceived risk. Could the recent success of capital raising activities by Apollo and Ares be a sign that investor appetite for private equity originated securities be returning? If so, BDC shares could benefit both by a rebound in portfolio market prices as well as a return to “closed end fund-like” valuations.

Interested in potentially investing in this space? A “related companies” search on Google Finance pulls up nearly every participant of note. A word of caution, while these businesses provide access to investments in private equity companies, it is often difficult to get much information outside of the names and market values of each portfolio company through public filings. Furthermore, since very few are trading at market caps representative of the book value of their investments, it is advisable to spend time reading each Company’s 10Q before taking a dive into this space.  I would suggest looking for BDCs with time left on debt commitments, net asset value to debt <1.9x and as much liquidity as possible.

Full Disclosure: Author does not have a position in any of the stocks listed in this article.

What are Hotel REITs?
Hotel REITs are a subcategory of Real Estate Investment Trusts. These are businesses which invest and (usually) operate income producing real estate. The benefit of this classification is that qualifying REITs do not need to pay corporate taxes on income which they distribute to shareholders in the form of dividends. As a result, there’s a particular incentive for these businesses to remit 100% of their earnings in the form of dividends.  Hotel REITS focus on the purchase and operation of hotel (and other lodging) properties. 

Any special considerations?
Researching in Hotel REITs is a significantly different animal than looking at more typical stock investments. Hotel REITs derive value in two ways – appreciation in the value of their underlying property and the cash flow/earnings power of the properties they operate. Which valuation dominates public market trading depends on the real estate market, consumer appetites with respect to travel and lodging, and a whole host of other things. With real estate market in shambles, the focus for Hotel REITs is increasingly placed on their cash flow power. 

To assess this, get comfortable with two “novel” financial measurements often used by analysts and the companies themselves. Funds from Operations (FFO) or Adjusted Funds from Operations (AFFO) and RevPAR.

Funds from operations is a statistic which attempts to correct for issues that arise from GAAP accounting (specifically, historical cost depreciation) and provide a “clean” number representing exactly the earnings power of a business stripping out depreciation costs (which, for these businesses, are more of a representation of investment). In simplest terms, basically net income minus depreciation. Adjusted funds from operations takes this one step further and subtracts capital expenditures. This allows you to get to a number which is closer to that of the Company’s distributable net income because the Company must allocate some of its earnings to pay for maintenance of its properties or invest in new ones. 

RevPAR stands for Revenue per Available Room. This is the fundamental driver of operating cash flow/earnings at a hotel. It is basically a hotel’s occupancy rate multiplied by its average daily room rate which provides a metric for how well a Company is monetizing its rooms. Furthermore, this metric allows you to compare operational performance across different hotel operators which may charge differing average daily rates or have significantly different physical capacity. 

Overall Perspective
Admittedly, this industry/asset class has done exceedingly well in the last month, but prices of several of stocks in this category remain greater than 50% below their 52-week highs. Many, despite reducing dividends to conserve capital during this unprecedented credit crisis, continue to pay significant dividends. A few particularly interesting stocks in the category might include: Hersha Hospitality Trust (HT), Starwood Hotels & Resorts (HOT), Ashford Hospitality Trust (AHT), and Sunstone Hotel Investors (SHO). These stocks all offer significant dividends and continue to trade at relative discounts and could be prime pickings when the current rally eventually corrects.

Full Disclosure: Author is long shares of GE, VLO, LINE, and MO at the time of writing. No positions in the Hotel REITs mentioned, though positions may change at any time.

For example, if you own an S&P 500 index fund, buying additional US large caps will really only add to the exposure you already have. Furthermore, since the index is market value weighted, the largest companies (and usually most popularly held by at-home investors) in the US like Citigroup, ConocoPhillips, and Microsoft already make up 3.95% of a market weighted ETF’s assets. Apple, a Curious Investor favorite, also makes up an additional 1.09% of assets.

So, for those of you taking notes, don’t forget that owning an ETF is very much like gaining exposure to all the stocks represented by the ETF’s underlying index. If you do choose to use them, then think twice about redundantly buying individual shares of similar companies. Instead, use the time you’ve freed up by buying an ETF to research stocks in other sectors and really gain the benefits of diversification and ease of use that ETFs can offer.  

We’ve already discussed a few interesting defensive strategies which can be employed by the use of ETFs – hedging, indexing, and asset allocation. Basically, the goal is to diversify your risk exposure and try to limit the effects of event, asset class and industry specific risks.

Generally, if your domestic market is falling, the goal is to increase your allocations in the most uncorrelated or as negatively correlated securities as possible. This will help your portfolio to weather the storm in the intermediate term by decreasing volatility within your own portfolio and allowing you to be patient with the securities within your domestic market that you decided to hold on to.

But, where exactly should we be looking if we’re going to attempt a more diversified allocation? Well, for one we could look globally. Yes, many markets around the world are highly volatile and likely not the best for a defensive portfolio. But, there are also many undervalued, under appreciated economies which provide steady, consistent returns. Look towards modernized countries that have rather mature industries – Australia, The Netherlands, Sweden, and Japan are great examples. For a great article highlighting some ETFs which are particularly interesting, read this article from SeekingAlpha. These investments are particularly interesting as the growth of ETFs and increased international investing has turned these countries’ markets into a sort of “global value” play. You can be sure, as people realize that prices have been bid up to ridiculous levels in popular, high-flying emergin markets, capital will begin flowing out of those markets and into these ignored and relatively cheap markets.

Outside of equities markets, you can look at so-called “safe haven” assets. These are typically assets which are tangible and have long-term track records for maintaining value. These can include treasury bonds, gold, or real estate. Unfortunately, real estate in the United States is less than attractive given that it is weakness in real estate which is hurting the markets. But, that’s not to say that global property is not still a good play. Increased liquidity and wealth around the world has created booms in most property markets and governments around the world are starting to employ REIT structures for real estate companies to spread the wealth. iShares offers several broadbased real estate funds which will allow you to get access to FTSE (Europe) and the World ex-US. It also offers an ETF which tracks the COMEX Gold index (symbol: IAU). Gold is more a diversifier (uncorrelated) than a truly negatively correlated investment but in times of turmoil like a major decline in the markets or a global upheaval, it has historically done very well. Though, as with most things, there are exceptions as gold has not quite performed as a good hedge against the US markets over the last few weeks.

An inverse ETF works a little bit differently than a straight short. And, this answers the question of why an inverse ETF will not typically go to zero, unless something absolutely unprecedented like a 50% or 100% appreciation in the underlying index happens. If you read an inverse ETF’s investment goal carefully it mentions that it hopes to replicate -100% or -200% of an underlying index’s daily percentage gain. This matters because over a period of time, this will mean that you won’t get exactly the performance of a short.

For example, if the underlying index is trading at $1000 and appreciates to $1200 and then to $1440. This represents two days of 20% gains. An inverse ETF would thus lose 20% each day. If you had $100 invested, assuming perfect tracking, your portfolio would be worth 80 and then 64. In the end, the first portfolio has a 44% gain, but your portfolio only has a 36% loss. This also works in reverse. If the index falls 20% two days in a row starting at $1000, you have 800 and then 640 representing a 36% loss. Your investment will gain 20% each day and thus return 44%. Does this mean that an inverse ETF will always magnify your gains and limit your losses when you’d like to be short? Not at all. If there are a mix of up and down days, your expected returns change a lot. For example, in a simple two day period, if an index is up 10% each day for a 21% gain over two days, the inverse ETF will lose 10% each day for a lost of 19%. In the same two day period, if the index is up 21% and then

All-in-all, using inverse ETFs as part of a paired trading/market neutral technique is not an optimal choice. They still work to hedge and pairing them will likely work to hedge some risk, but they aren’t the win-win I painted them to be yesterday. For those without the ability to short, inverse ETFs will likely work as you will be getting exposure similar to what you expect from a short, but it won’t be exact and as a result is less predictable.