By Simon Lack
Barron's ran an interesting article on places to go for higher income than high-grade bonds. The writer pointed out quite accurately that ten-year treasury bonds do not provide sufficient income to preserve after-tax real purchasing power. The Federal government doesn't believe its creditors should earn a real return, and has adopted a policy to prevent that. The thinking investor's response is to look elsewhere and to keep more money in cash waiting for better opportunities.
Closed end funds, which Barron's highlights in their article "How to Get Safe Annual Payouts of 7%" can be interesting if they trade at a discount. However, much of the market is characterized by funds that pay distributions in excess of their earnings in order to maintain a high "distribution yield," even though they are in part giving investors back their own money. Closed end funds are best owned if they're mispriced, in combination with a hedge to neutralize the NAV movements. We have owned Boulder Total Return Fund (BTF) for some time. The fund has a substantial holding in Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), and its second biggest holding is Yum Brands (NYSE:YUM). BTF doesn't pay a distribution, an omission that has caused traditional closed end fund investors to shun the stock. Consequently, it trades at a 21% discount to NAV. The PM and affiliates own over a third of the shares. One day they may reinstate the distribution or engage is some other value-creating exercise. In the meantime, it represents attractively-priced exposure to BRK or can be hedged to focus on the discount narrowing.
Another area we like is Master Limited Parterships. Six per cent tax-deferred distributions with a reasonable expectation of 4-5% distribution growth. MLPs have historically outperformed stocks, bonds and REITS but remain an under-invested asset class. K-1's deter many potential investors. But MLPs, particularly the midstream firms that invest in pipelines, storage facilities and refineries have only modest exposure to energy prices and toll-based fee models that create earnings stability. We think of MLPs as a good substitute for high yield bonds. Historically similar levels of price volatility but more attractive return profile.
Many high-dividend stocks are attractive. In some cases large companies with stable earnings growth offer dividends higher than their own debt. Johnson & Johnson (NYSE:JNJ) and Pepsi (NYSE:PEP) are both examples, and are names that we own in our Hedged Dividend Capture Strategy, where a diversified portfolio of such names is combined with an equity market hedge seeking to profit from dividends with reduced market volatility.
The "Fracturing of Pennsylvania" was another in a series of articles the New York Times has been running on shale gas and potential environmental damage from its extraction. We like natural gas E&P names - shale gas represents an enormous source of fuel for the U.S. in the years ahead. It's far cheaper than oil on a BTU-equivalent basis and it's here in the politically stable U.S. But it needs to be mined safely. The issue of toxins leaking into drinking water remains a vexing one. So far the science strongly suggests that the risks are extremely low. But the number of stories of undrinkable water and high levels of metals in residents' bloodstreams is growing. The evidence that fracking is to blame is inconclusive at best, but it's not an issue to ignore for investors or the landowners who sell drilling rights to their land. Range Resources (NYSE:RRC) appears to have reacted professionally, which doesn't shock me at all having met the management. We continue to like the company but believe the stock is expensive. We prefer Devon Energy (NYSE:DVN), which trades closer to the value of its proven reserves.