By Ryan Vlastelica
NEW YORK, June 8 (Reuters) - Could prison stocks be poised for a breakout?
The small and controversial sector of for-profit prison companies, which operate as real estate investment trusts (REITs), have been under pressure this year, underperforming the broader REIT sector, which has itself lagged behind the general market.
The two main prison operators have been dogged by the prospect of new government regulations, with presidential candidates Hillary Clinton and Senator Rand Paul among those calling for criminal justice reform, an issue seen as a threat to the group.
While supporters argue that private prisons save taxpayer money, critics charge that the companies' for-profit model has led to excessive sentencing and poor conditions for inmates.
Corrections Corporation of America, which has a market capitalization of about $4.1 billion, is down 5.3 percent in 2015 while Geo Group is down 9.4 percent. The Vanguard REIT ETF, a popular way for investors to play the broader space, is down 4.9 percent.
Analysts say the year-to-date declines in prison stocks mean potential headwinds have been priced in, positioning them for gains even as the appeal of the overall REIT sector wanes. In an indication the selloff has been overdone, Corrections trades almost 16 percent under StarMine's measurement of intrinsic value, which looks at anticipated growth over the next decade.
"There is a lot of uncertainty surrounding reforms, causing prison REITs to trade at a discount to the REITs that aren't tied to government spending, but you've already seen them pull back, meaning that from here there's more upside than downside potential," said Eric Marshall, portfolio manager at the Hodges Funds in Dallas.
Marshall, who has a stake in Geo, also praised the high dividend yields of prison REITs, which surpass those for the sector at large. Corrections' yield is 6.25 percent while Geo's is 6.74 percent. Three of the biggest REITs by market cap - Simon Property Group, Public Storage and Equity Residential - have yields below 4 percent. The S&P's yield is 2.38 percent.
With interest rates near historic lows, dividends have long been a selling point for the broader REIT group. But investors have been rotating from defensive dividend payers to more growth-orientated names amid expectations that the U.S. Federal Reserve will raise rates later this year. The Vanguard ETF has seen outflows of $539.12 million this year, according to data from ETF.com.
"Higher interest rates represent a headwind to the sector, so while the group has enjoyed a really good run, the positives that helped fuel the advance are likely to slow," said Alan Gayle, senior investment strategist at RidgeWorth Investments in Atlanta.
Prison companies may be swept along in that trend, but their considerably higher yields relative to their peers could give them a margin of safety.
"Reforms can really only go so far, and so long as Geo continues to meet targets and raise its dividend, I think it is realistic to see it trading above $50 in the next year or so," said Marshall, giving a target price that implies upside of more than 30 percent from current levels.
(Editing by Linda Stern and Paul Simao)