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Eaton Vance’s Enhanced Equity Income Fund II (EOS) is a Closed-End Fund that, like many option-income funds, has taken it on the chin recently. A combination of its income strategy falling out of favor in a more bullish market environment, and a recent dividend cut for all of the Eaton Vance option-income funds, has combined to bring EOS and many of the option-income CEFs down to significantly undervalued market prices compared to their Net Asset Values (NAV).

However, I believe EOS' NAV is better-positioned now than at any point in the last two years to take advantage of a continued up cycle in the information technology sector, while still offering some downside protection with its option strategy. Combined with EOS' historically large discount price to its NAV, I believe the fund offers a compelling market price valuation once again after a 2-year wait.

First, the basics:

Eaton Vance Enhanced Equity Income Fund II

Inception date: January 26, 2005
Inception NAV price: $19.10
Current NAV price (1/31/11): $12.93
Current Market Price (1/31/11): $12.04
Premium/Discount: -6.88%
Current Yield: 9.2%
Dividend Cycle: Monthly
Income Strategy: Option-Income
Market Cap: $625 million

EOS, along with its sister fund EOI, is a rarity among the option-income funds in that it generates its income by writing covered-call options on individual stock positions in its portfolio rather than on indexes. Some might argue that this is a disadvantage because your winners can get called away, but it also puts less emphasis on the portfolio managers to own securities that will outperform their correlating indices. Nonetheless, EOS owns an impressive list of technology stocks and writes call options on approximately 69% of the notional value of its holdings, leaving the rest of its positions to appreciate or depreciate unencumbered.

EOS had been one of the darlings of the option-income funds, rising to a 10%+ premium level during the fall of 2009, and earning the highest valuation of all the Eaton Vance option-income funds. Part of that may have been due to its monthly pay dividend cycle, which is more attractive to investors than most option-income CEFs, which pay quarterly, and part of it may have been due to EOS’ large sector exposure to information technology stocks as well as a low exposure to financials. The fund owns approximately 110 large and mid cap equity positions in a well diversified portfolio with no leverage and no fixed income securities. The fund’s Top 10 holdings and top sectors are shown below.

(click to enlarge charts)

Over the past two years, EOS’ NAV performance has lagged that of the S&P 500, which is not unusual for an option-income fund to do during strong market periods. In fact, EOS was about middle of the pack in terms of NAV performance for the option-income funds, appreciating 18% in 2009 vs. the S&P 500 at 21% and 11% in 2010 vs. the S&P 500 at 15% (percentages include dividends). In general, lower market volatility means less option premium for option-income funds and options that were written in the face of a rising market are often closed-out at a loss and re-established at higher strike prices. All of this takes a toll on the NAV of option-income funds and accounts for their underperformance. Such is the price an investor pays for owning a defensive high-yielding security.

In an effort to allow the fund’s NAV to capture more upside in a strong market, Eaton Vance announced a dividend cut for all their option-income funds on December 14, 2010. This was the second dividend reduction Eaton Vance had announced, the first being in January of 2010 to align its fund’s income and distributions with a lower volatility environment. Whereas virtually all equity-based high-yielding CEFs have cut their dividends 1 to 3 times over the past few years due to the market fallout from late 2007 to early 2009, funds that used a leveraged strategy or a dividend capture strategy really had no other choice as their NAVs were deteriorating faster than the overall market. On the other hand, for option-income funds, it really becomes more of a strategy decision by the portfolio managers to cut the dividend and emphasize NAV appreciation over double-digit yields.

Though EOS could have comfortably paid its dividend even before the last dividend cut by adjusting their option strategy to include a higher coverage or to write call options more ‘in-the-money’, the portfolio managers at EOS decided that NAV appreciation in a strong market would take precedence over yield. Though many investors may malign a fund for doing this and may believe this is an indication of a more fundamental problem, I don’t believe this is the case and I do not anticipate any more dividend adjustments for the foreseeable future, i.e. 2013 at least.

I would rather a fund manager be pro-active in balancing its income with distributions as opposed to maintaining a high dividend and allowing its NAV to lag or even deteriorate like a lot of other CEF fund families do. Even with the dividend cut, the current yield on EOS is now higher than at inception. Combine that with a near zero money market yield and a 9% yield today is equivalent to a 12%-14% yield just a few years ago.

News of the dividend cuts last month for all of Eaton Vance’s option-income funds was not well received and the fund’s market prices have continued to languish even though NAV performance has improved in a continued up market. Should the markets start to stall out, then we can expect the option-income funds' NAVs to start outperforming the broader market. It’s interesting to note than even with a 3%-5% annual performance lag with the S&P 500 over the past two years, EOS’ NAV is essentially at its 2-year high.

NOTE: The red line represents the NAV of EOS while the blue line represents market price. Both graphs include reductions for dividend payments.

EOS’ market price discount at -6.88% has not been this attractive since the spring of 2009 when most CEFs were recovering from the market lows. Though discounts became irrationally wide during the lows of the market in late 2008 and early 2009, this had more to do with forced liquidations causing short-term spikes down rather than any fundamental reason. In fact, the discounts looked even worse during this period because the NAVs of the option-income funds were holding up far better than the broader market. Even with this anomaly, EOS’ premium/discount average historically has been just about at par over the past 1, 3 and 5 years, so a -6.88% discount is a significant undervaluation in the current market environment.

I believe EOS offers a compelling valuation no matter where the market goes from here. If the market continues to appreciate, EOS is better-positioned to capture more upside of the market with its reduced payout and heavy information technology exposure. If the market starts to stall out, then EOS offers some downside protection with its option strategy, a historically wide discount price and a sustainable 9.2% yield paid monthly to investors while they wait.

Source: Enhanced Equity Income Fund II: Compelling Valuation Again After a Two Year Wait