YMBC 2-Year Review - A Crazy High-Yield Portfolio

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Includes: BCRH, BDCL, CEFL, CPLP, DVHL, DVYL, EFC, EFF, FBC, FIG, GSBD, HDLV, HEDJ, HOML, LADR, LMLP, MAIN, MLPL, MMP, MORL, PFBI, RICK, RWXL, SDYL, SMHD, SPLX, TCPC, TPVG, YMLP
by: Darren McCammon

Summary

The YMBC portfolio has both been volatile and is currently in a bear market (lost more than 20% from most recent high).

A much higher level of correlation than expected from the portfolio components has been particularly disappointing.

An alternate trading portfolio made up of individual equities is introduced.

The YMBC (You Must Be Crazy) High Yield Portfolio utilizes primarily UBS leveraged 2x ETNs in order to formulate an easily managed, very high-yield portfolio. Many would consider the utilization of such a portfolio foolish, particularly in the face of increasing interest rates. As you will soon see, at least for the 2015 calendar year, they would be right. A one year 2014 review article, including a more thorough explanation of the goals, characteristics, and a risk analysis of the portfolio is available here.

For this update, it is assumed the reader has already read that article and thus is familiar with the goals, characteristics and the inherent risk involved.

As of the beginning of 2015, the YMBC portfolio stood as follows:

30% UBS ETRACS 2X Leveraged Long Wells Fargo Business Development Company ETN (NYSEARCA:BDCL) (overweight due to my call that it is cheap)

21% UBS ETRACS Monthly Pay 2x Leveraged Mortgage REIT ETN (NYSEARCA:MORL)

17% UBS ETRACS Monthly Pay 2xLeveraged Diversified High Income ETN (NYSEARCA:DVHL)

15% UBS ETRACS Monthly Pay 2x Leveraged S&P Dividend ETN (NYSEARCA:SDYL)

17% Eaton Vance Floating-Rate Income Plus Fund (NYSE:EFF)

0% UBS ETRACS Monthly Pay 2xLeveraged Closed - End Fund ETN (NYSEARCA:CEFL), UBS ETRACS 2x Leveraged Long Alerian MLP Infrastructure Index ETN (NYSEARCA:MLPL), UBS ETRACS Monthly Pay 2xLeveraged Wells Fargo MLP Ex - Energy ETN (NYSEARCA:LMLP), and ETRACS Monthly Pay 2xLeveraged U.S. Small Cap High Dividend ETN (NYSEARCA:SMHD)

0% Cash

Indicated Forward Yield: 14.2%

Changes:

In Q1 2015, all distributions were re-invested in SMHD, a new 2x leveraged UBS small cap, high dividend ETN which caught my eye. For more on my reasoning why please see the Q1 2015 portfolio review.

In Q2, I did the same, re-investing all distributions in SMHD. This has not been a good choice, particularly since small caps have been getting disproportionately hit all year.

In Q3, distributions were re-invested in Blue Capital Reinsurance Holdings (NYSE:BCRH), a company which provides catastrophe re-insurance against hurricanes, earthquakes and other major disasters (BCRH article). This was not done because I felt BCRH had the best investment prospects of any of the YMBC Portfolio components (BDCL still owned that position in my mind) but rather to further diversify the portfolio.

During Q4, no new investments were made, the proceeds from YMBC distributions were utilized to fund a Required Minimum Withdrawal with what little remained being left for re-investment during the annual Q1 re-allocation. As will be discussed later in the risk section, the components of YMBC have continued to show more correlation than I had hoped.

Going into Q4, the YMBC portfolio was allocated as follows:

26% BDCL (overweight due to my call that it is cheap)

17% MORL

15% DVHL

14% SDYL

5% SMHD

17% EFF

5% BCRH

0% CEFL, MLPL, LMLP, UBS ETRACS Monthly Pay 2X Leveraged Dow Jones International Real Estate ETN (NYSEARCA:RWXL), Etracs Monthly Reset 2xLeveraged ISE Exclusively Homebuilders ETN due March 13, 2045 (NYSEARCA:HOML), UBS ETRACS Monthly Reset 2xLeveraged S&P 500 total Return ETN (NYSEARCA:SPLX), UBS ETRACS Monthly Pay 2xLeveraged US High Dividend Low Volatility ETN (NYSEARCA:HDLV), and UBS ETRACS Monthly Pay 2x Leveraged Dow Jones Select Dividend Index ETN (NYSEARCA:DVYL).

1% Cash

Indicated Forward Yield: 14.4%

Returns:

Q4 2015 was not a complete disaster for the YMBC portfolio as it was up 2.98%; however, it under-performed both the S&P 500 (+6.45%) and the Russell 2000 (+4.39%). SMHD, MORL, and DVHL were losers for the quarter but the other components managed to remain flat or register small increases.

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For 2015, the YMBC portfolio was down a disappointing 12.7% versus a loss of 0.7% for the S&P 500 and a loss of 7.5% for the Russell 2000.

Starting in May of 2015 pass-through securities and other high yield assets fell out of favor. This May-July period represents the majority of the under-performance in the YMBC portfolio vs. the Russell 2000. In July, all small caps began following suit as expectations of interest rate hikes started to affect the broader market. The Fed did finally raise rates 1/4% at the end of 2015 in what I would call the culmination of a purposeful calculated effort to flatten the yield curve. The Fed in my opinion is attempting to force investment from carry trades into more main street uses (Why the Fed is raising interest rates article). The purpose is to hopefully increase the velocity of money (hopefully, without tanking the stock market or economy). Shortly, after the actual cut however, the unwanted but typical feedback loop occurred, at the beginning of the new year large cap equities began to follow the rest of the broader market down.

Currently, there continues to be significant fear of global recession with declining growth rates in China, Europe, Asia, Russia, and Brazil which may soon be imported into the US. Most countries (other than the US) continue to cut interest rates and devalue their currencies in a race to the bottom. This relative devaluation has made the US dollar expensive, positioned companies with mainly US based costs at a competitive disadvantage, and in effect is helping to import recession back into the US. Fear is rampant.

Meanwhile, the income flow produced by the YMBC portfolio continues to be re-invested at lower prices:

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Risk:

What is most surprising to me about 2015 is not the 13% loss, or even the much sharper loss since May; that sucks, but it is part of what I signed up for with a leveraged portfolio of high yield assets. In reality, a period of lower prices early on, IF followed by a period of higher prices later, is one of the better situations the YMBC portfolio can experience. YMBC was designed to take advantage of volatility and this kind of volatility could be very beneficial in the long run, again provided there is an eventual recovery.

Instead, what is more frustrating to me is that most of the YMBC components (excepting BCRH and maybe EFF) continue to show high correlation to each other, dropping in unison. This is likely because these components are all susceptible in various degrees to a flattening of the yield curve. They are dominated by small caps equities (except SDYL), and of course, everything starts to correlate when investors become fearful. The high correlation many of the components have exhibited so far has defeated much of the strategy behind the YMBC portfolio and is the main reason I consider this experiment to be a failure so far. However, I'm not quite yet ready to give up on it. So in Q1 2016, the YMBC portfolio continues to run and is allocated as follows:

17% BDCL

15% MORL

14% DVHL

19% SDYL

4% SMHD

7% Yorkville High Income MLP ETF (NYSEARCA:YMLP) (new entrant)

19% EFF

6% BCRH (dividends re-invested here in Q3)

0% CEFL, LMLP, RWXL, HOML, SPLX, HDLV, DVYL

<1% Cash

Indicated Forward Yield: 17.8%

We can only hope the Fed signals one and done, the curve becomes steeper, and the spread/carry trade investments in the YMBC portfolio respond well.

New Investment, YMLP:

After much questioning and encouragement in the comment sections of previous YMBC articles, I have finally made a direct investment in an MLP vehicle, YMLP. As readers of these previous article's comment sections will know, I have resisted an allocation to MLPL the last couple of years because I thought most of the pipeline MLPs dominating MLPL too expensive.

For a long time, investors were treating the US based pipeline companies as if they were bond-like, valuing them at 4% yields, which I felt inappropriate. Now that these companies have fallen in price, many have become decent buys. However, it is still the non-pipeline MLPs, which I find attractive. YMLP was chosen in part because it has a higher proportion of other non-pipeline MLPs in its assets and in part because UBS closed MLPL in Q1 2016.

Regarding that closing, while it is unfortunate that investors took such sharp losses and UBS decided to close the ETN, I am encouraged to see the amount paid to the investors on closing was the indicated value. They do not appear to have been taken advantage of by the closing rules which is somewhat reassuring should a similar fate befall one of the UBS 2x ETNs in the portfolio.

Valuation:

To help explain why I find most pipeline MLPs relatively less attractive than other types of MLPs, I will give an example. Again, just as an example, I do not understand why investors continue to prefer something like Magellan Midstream Partners, L.P. (NYSE:MMP) over something like Capital Product Partners L.P. (NASDAQ:CPLP). Nothing against MMP in particular (I just picked a pipeline company which is still highly valued) but they are a fixed point pipeline company servicing customers who are not only currently decreasing production volume, but are also in significant danger of going bankrupt.

CPLP admittedly has similar counterparty risk (HMM could go bankrupt and is actively negotiating for a 30% reduction on the existing leases from CPLP) but that risk is not greater than MMP. At least CPLP's assets (CPLP article) can easily be moved to service another customer should the current one no longer be viable; MMP cannot say as much, their assets would likely be stranded. In both cases, we are talking potential for a meaningful decline in revenue due to counterparty risk (counterparties breaking or defaulting on contracts) but at least with CPLP there are alternatives which earn some cash.

Even more important than this specific risk in my mind, is that both leverage (risk) and CAD yield (reward) seem to favor CPLP over MMP. If you are going to invest in something undergoing tumultuous counterparty risk, why would you choose the one with 3x the leverage and offering 1/3 the CAD yield of another? MMP has 3x the debt/equity ratio of CPLP and is currently earning 1/3 the CAD yield, yet investors seem to prefer it.

So, while I'm not convinced YMLP is the best choice to represent the MLP class, I do like that it is not completely dominated by US based pipeline MLPs and have decided it is what I'm going with for now. (Side Note - if you are invested in MMP, I'm not saying it is a bad investment. I'm just saying in comparison, CPLP seems a better choice.)

The fact that SDYL and EFF have slightly higher allocations than BDCL, MORL and DVHL should not be interpreted to mean that I think them better values. Rather, I wanted to put an allocation into MLPs so selling some BDCL and buying some YMLP was the easiest choice. I would have liked to have also raised the allocation to BCRH to 10%; however, it did not seem worthwhile doing a bunch of trades shaving a couple of % off other components in order to do it. In hindsight, this was probably a mistake and I was being lazy. I will probably fix it by using future portfolio dividends to bring up the BCRH allocation.

If I were to choose one component which I think the best value, it remains BDCL. You can see the valuation section of my last YMBC article for why (not much point in repeating my reasoning here).

Introduction of an alternate portfolio comprised primarily of individual equities (YMBCi, WAGNFN, McCammon small cap value?):

As I have alluded to in a few comments, I have been toying with the idea of introducing a portfolio comprised of individual equities. The reason is, while the YMBC articles have provided a decent forum to discuss investment analysis and philosophy, and sparked some interesting discussions which I have learned from, the YMBC portfolio is not representative of the way I actually invest the majority of my portfolio. YMBC was always no more than a live test of what I thought may be a useful and interesting strategy utilizing a small IRA account I inherited from my dad (<5% of my total assets). In real life, I invest the vast majority of my assets in individual securities chosen utilizing a few different specific methods (including many pass-through securities). The strategies vary somewhat; however, they do have a few things in common.

For one, when picking individual equities, I tend towards domestic small cap value*. Domestic because I don't have as much access to useful information for foreign equities and in some cases don't trust the information that is available. Small cap because in general I feel unable to add any meaningful insight on large caps that millions of others haven't already seen and therefore priced in. Value because only rarely do I come across a fantastic new product or business everyone else doesn't already know about, plus I just don't have the personality to buy hot stocks**. My portfolio can also at times have high amounts of cash (because I can't find anything good, or market indicators are flashing warnings, or I'm on an extended vacation). I should also mention this alternate portfolio will probably have less than 20 stocks in it at any one time (because again I just don't have that many good ideas).

(side notes:

* When I do invest in foreign, large cap, and/or hyper growth, paradigm shift story type assets, I tend to buy a cheap ETF or otherwise hire someone to do it for me.

** In the 90s, I actually passed on at the time relatively unknown startups Cisco (NASDAQ:CSCO) because, "no company is worth a 50+ P/E," and eBay (NASDAQ:EBAY) because, "it's nothing more than an online garage sale." I wish I could pick those game changers, but I can't seem to do it. I'm just too cheap. Even today, deep down, I think people invested long in such promising names such as Tesla (NASDAQ:TSLA), Amazon (NASDAQ:AMZN) or Facebook (NASDAQ:FB) are crazy.)

Secondly, my stock picking tends to rely heavily on numbers. Ratios and numbers speak to me (sometimes I even talk back); they tell me tales (many of which are even true). Fundamental ratios like CAD yield, P/B, PEG, Debt/Equity are things with substance which I can hold on to. Things I believe in. Thus, I utilize screens base on these kind of ratios to narrow down the investing universe into something more manageable. Something with few enough equities that I can then do more in depth fundamental analysis upon each one.

Next, because numbers are my friend, I pay some attention to technical analysis mumbo jumbo such as moving averages, relative strength, new highs and new lows. I'm not good enough with them to think I can use them exclusively to pick individual stocks, but I do think they can be useful for telling me WHEN to buy (or sell) stocks I already know I'd like to own.

Likewise, while I'm doubtful my skills at technical analysis will actually increase my overall returns, I do think I can use it to avoid a portion of the downturns. Maximizing total return is not my only goal (now you know for sure I'm over 50). Sometimes, I'm willing to trade a little of the upside in return for not experiencing quite as much of the downside.

You have got a general outline of the strategy I plan to utilize for this portfolio as well as the types of stocks that tend to result from it. This is really just an introduction, so I'm not going to go into more detail now and I am probably boring everyone. Recapping, there are different specific criteria for each strategy but in general the method is:

1.) Use basic market indicators to decide how much I should be in the market (if at all).

2.) Use screens to come up with equities with attractive value ratios.

3.) Do in depth fundamental analysis to get to know each stock and further cull the list.

4.) Be patient, wait until technical analysis tells you it is a good time to buy (or sell) a stock.

I'm going to devote a Roth IRA account that represents 25% of my overall portfolio to this project. Trading costs are expected to be small (fee = 1/10 of 1% per trade, E*Trade does a good job of bid/ask price spread improvement) and therefore not a consideration, also no tax considerations will be taken into account (since it's an IRA), and this is not a diversified buy and hold portfolio (tends to small cap value with less than 25 individual equities) but a trading portfolio. Also, I'm not particularly risk averse (now you know I'm under 65).

Here's the current holdings of the ________ portfolio:

4% Premier Financial Bancorp, Inc. (NASDAQ:PFBI)

4% Flagstar Bancorp, Inc. (NYSE:FBC)

4% Main Street Capital (NYSE:MAIN)

4% TCP Capital (NASDAQ:TCPC)

3% Ladder Capital Corp (NYSE:LADR)

3% PFX

3% EFC

3% Goldman Sachs BDC (NYSE:GSBD)

3% Fortress Investment Group LLC (NYSE:FIG)

3% TriplePoint Venture Growth (NYSE:TPVG)

3% WisdomTree Europe Hedged Equity ETF (NYSEARCA:HEDJ)

3% RCI Hospitality Holdings, Inc. (NASDAQ:RICK)

3% CPLP

56% Cash

Indicated Forward Yield (including cash): 2.5%

And the returns so far this year (admittedly too short a period of time to have any meaning whatsoever but I need to put a verifiable start date on it):

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I still need a name for this thing. Possibilities being toyed with include: YMBCi - You Must Be a Crazy Individual, McCammon Small Cap Value - boring but descriptive, NAMF - Numbers Are My Friend, RR! - Ratios Rule!, WAGNFN - We Ain't Got No Fr!cken Name. Feedback welcome.

Conclusion:

The YMBC portfolio has had a rough time of it but surprisingly is only down 1.3% since inception (1/1/2014-12/31/2015). During this same period of time, the S&P 500 returned a decent 10.6% but small cap stocks fared much worse. I find it remarkable that the portfolio is not down more despite 2x leveraged investment in heavily out of favor small cap, high-yield investments. In my opinion, this better than expected performance is probably due more to the power of reinvestment of very high dividends at ever lower prices, rather than either superior timing or asset selection. I look forward to reading your comments.

Disclosure: I am/we are long EVERY POSITION MENTIONED.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I say right there in the name, if you follow this portfolio YOU MUST BE CRAZY! I don't know who you are much less your particular situation; so how can I recommend this portfolio or for that matter any investment to you? Don't follow a crazy person, do your own due diligence.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.