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Our "Team Alpha" portfolio has gone through an overhaul this month. We decided to sell our positions in both Annaly Capital (NLY) and American Capital (AGNC), and several other stocks. The action was taken because of the Fed policy of an open ended promise to buy mortgage backed securities at the rate of $40 billion per month.

These two high yielding stocks added more dividends to our portfolio, but the risks outweighed the reward. We simply have no way of knowing what course of action the mREIT sector will take with the open checkbook of the Fed. Annaly decided to buy back $1.5 billion in shares over the course of 12 months, which is a very savvy move. Where else would it put the money to work if not buying back shares at a reduced price? As far as AGNC is concerned, it has used too much leverage and cannot do what NLY has done, as swiftly (if at all).

We just do not know whether this will work over the long term, even though its book value should increase with a rise in pre-payments. The question remains, what will the company do with the money? If it cannot make money, it will eventually need to reduce dividends. As it reduces dividends, investors will sell the stock. The uncertainty is not the friend of a retirement portfolio.

Replacing Yield With Yield

Recently, we began researching the world of business development companies, or BDCs. These equities are higher yielding stocks that have a rather unique role in our society. Basically, they lend money to businesses and new ventures, when banks will not.

They either take equity positions in the companies they lend to (or invest in), or they charge interest rates significantly higher than the "going" lending rate. So they borrow money cheaply, and lend it on the open market at higher rates. Sound somewhat familiar?

The reason that BDCs have become a growing business sector is due to the exact opposite reason that the mREIT business could struggle! With the Fed intervention policies, to keep interest rates ultra low, banks simply are reluctant to lend. Unless an established business has a pristine balance sheet and significant flows of income, a bank just will not take on the risk of lending with such a low reward.

When a window closes, sometimes a few doors are open. Enter the BDCs. In this recent article I went into detail about how BDCs actually work, and their business definition:

"BDCs are usually taxed as regulated investment companies (RIC) under the Internal Revenue Code. Like real estate investment trusts (REITs), as long as the RIC meets certain income, diversity, and distribution requirements, the company pays little or no corporate income tax. As a pass-through tax structure, RICs must distribute at least 90 percent of taxable income as dividends to investors. Most BDCs distribute 98 percent of their taxable income to avoid all corporate taxation. (RICs fall under section 851 of the Internal Revenue Code; REITS fall under section 856.)"

98% of a BDCs taxable income is distributed to investors. The minimum being 90%, as this could be a wonderful source of income for dividend seeking investors as well as retirees depending on which BDCs we decide to invest in.

Another definition from Investopedia adds to the understanding as well:

"To qualify as a BDC, companies must be registered in compliance with Section 54 of the Investment Company Act of 1940. A major difference between a BDC and a venture capital fund is that BDCs allow smaller, non-accredited investors to invest in start-up companies. Some of the reasons why BDCs have become popular is that they provide permanent capital to their management, allow investments by the general public and use mezzanine financing opportunities."

The IRS similarity between the REIT sector is obvious as well. Dividends paid out are taxable to the individual as regular income, not dividend income, and the companies themselves are not taxed at all as long as they follow the IRS guidelines. Most of the companies we researched actually pay out 98% of taxable income.

Mezzanine financing is interesting as well. For a great description of precisely what it is, read this from Investopedia:

"A hybrid of debt and equity financing that is typically used to finance the expansion of existing companies. Mezzanine financing is basically debt capital that gives the lender the rights to convert to an ownership or equity interest in the company if the loan is not paid back in time and in full. It is generally subordinated to debt provided by senior lenders such as banks and venture capital companies.

Since mezzanine financing is usually provided to the borrower very quickly with little due diligence on the part of the lender and little or no collateral on the part of the borrower, this type of financing is aggressively priced with the lender seeking a return in the 20-30% range.

"Mezzanine financing is advantageous because it is treated like equity on a company's balance sheet and may make it easier to obtain standard bank financing. To attract mezzanine financing, a company usually must demonstrate a track record in the industry with an established reputation and product, a history of profitability and a viable expansion plan for the business (e.g. expansions, acquisitions, IPO)."

We Are Adding 2 BDCs For More Yield

The two companies that have been decided upon, to add to our "Team Alpha" portfolio, are as follows:

BlackRock Kelso Capital (BKCC): Price: $9.96/share, Dividend Yield: 10.75%, ESS Rating: Neutral

  • A share price to book value of only 1.04.
  • An enterprise value of $1.15 billion.
  • A forward P/E ratio of 9.67.

KKR Financials (KFN): Price: $10.07/share, Dividend Yield: 8.50%, ESS Rating: Bullish

  • A share price to book value of only 1.02.
  • An extremely low payout ratio of under 60%.
  • An enterprise value of nearly $8 billion.
  • Profit margins of about 69% and operating margins nearly 73%.

The dividends that these stocks pay will just about replace the dividends from the mREITs we sold. That is the number one reason we are adding these stocks, but the potential for capital appreciation is rather attractive as well.

Normally, this sector does better when the economy is good, however, we have the unique wrinkle that the Fed has given us. They are doing everything possible to keep interest rates so low, that the banks will continue to shy away from taking on risk loans or investments.

Let's not forget that these 2 companies offer a sort of "back door" entry into Blackrock and KKR as well-- well managed and well funded enterprises in their own right. Yes, this is a small and not a key reason, but it is "out there". The recent performance of these 2 BDCs are intriguing to look at.

We should understand that these stocks are not dividend winners, they are dividend "opportunities". BKCC recently re-instated a dividend, and KFN has been increasing its dividends. Both of the share prices of the stocks have been trending up, from steep declines just a few years ago.

As the uncertainty grows within the mREIT sector, investors will search for yield. BDCs offer compelling yields as well as the potential for some capital appreciation as money begins to flow into these investments at a faster clip. We have added both of these stocks to the "Team Alpha" portfolio at almost the same price for each; $10.00/share.

Our Revamped "Team Alpha" Portfolio

Our portfolio now consists of Exxon Mobil (XOM), Johnson & Johnson (JNJ), AT&T (T), General Electric (GE), Blackrock Capital , KKR Financial , Procter & Gamble (PG), Intel (INTC), Realty Income (O), Coca-Cola (KO), Bank of America (BAC), Wal-Mart (WMT), Cisco (CSCO), Bristol-Myers Squibb (BMY), Healthcare Select Sector SPDR (XLV), and General Dynamics (GD).

Trades Made In October

shares

cost

Sold NLY for 17

200

3400

Paid 23 for GE

400

9200

sold AGNC for 35

150

5250

Paid 9 for BAC

300

2700

Paid 36 for T

150

5400

Paid 41 for O

50

2050

Paid 67 for JNJ

25

1500

sold SO for 46

100

4600

sold MMM for 95

50

4750

paid 33 for BMY

75

2475

sold NLY for 16

100

1600

Bought back JNJ Option for 3

100

300

Bought back XOM Option for 1

100

100

Paid 10 for BKCC

300

3000

Paid 10 for KFN

300

3000

Paid 65 for GD

100

6500

This new look reflects all of the changes made as we re-balanced and redeployed our cash reserves. Over the last 11 months, the portfolio out performed the S&P by 40%. It returned a gain of roughly 26% thus far (including dividends and option premiums). In 2 weeks we will announce our one year results.

Source: Retirement Strategy: Replacing Yield With More Yield