Income Factory: Philosophy, Strategy, And Opportunity

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Includes: CEN, DSE, ECC, EMO, FEN, FGB, FMO, FOF, JMLP, KYN, OXLC
by: Steven Bavaria
Summary

The "market" has told me recently that it thinks my portfolio should be "discounted" at a higher rate, so it has reduced the market price of our Income Factory accordingly.

Since our income hasn't changed (actually it has grown), the price reduction has raised the distribution yield from about 11.6% in September to 14.8% now.

If I thought that reflected a real increase in the risk represented by my Income Factory investments, then I'd be seriously worried.

But I think it actually represents the increased level of stress and angst throughout the geopolitical, economic, and financial worlds due to a host of issues and challenges creating a year-end "perfect storm" for investors.

So, we hang on, reinvest, compound and try to be alert.

In sharing my "Income Factory" philosophy, I have often emphasized how our income stream grows faster when market prices are dropping than when they are rising. That's because we are reinvesting and compounding at lower prices, and therefore, higher yields than prevailed before the market drop.

But even so, severe market price drops like the current one can be unnerving, to say the least.

Although the year has not yet ended and this is not our formal quarterly review, given the amount of angst many readers and followers are probably experiencing, I wanted to share briefly some thoughts about both strategy and opportunity.

Here is my current situation:

  • Like many of you, I have "paper losses" up the wazoo, with a negative total return (cash return plus paper gains or losses) of -14%.
  • My cash return for the year to date has been about 11%, which means my paper loss ("unrealized depreciation") has been about 25%, almost all of it since the end of September.
  • As a result of the drop in market prices, my current overall portfolio distribution yield is up to an almost breathtaking 14.8%.
  • If I were to reinvest in the identical portfolio assets I currently hold, that would be my re-investment rate as well, one that would double and re-double its income every 5 years.
  • I am not suggesting that will happen, because (1) I am up to my limit in some holdings and unlikely to increase my exposure regardless of how tempting the yields become, and (2) I do not expect the current market price and distribution yield levels to remain where they are indefinitely.
  • So, I merely mention the current yield levels to emphasize what unusual opportunities our current situation presents.
  • As readers and followers would expect, I have remained and plan to remain fully invested, although I continue to tweak the portfolio, typically looking for funds that may represent better relative value or have been unduly beaten up compared to others.

Philosophy

An economist named John Burr Williams wrote a book in 1938 called The Theory of Investment Value in which he introduced the idea (radical for its time, pretty obvious now) that the intrinsic value of a security was the discounted present value of all the future cash payments to investors that it would generate; i.e. all the dividends it would generate and pay as long as you owned it, plus any proceeds or terminal value if it were sold or liquidated. When you combined Williams's ideas with those of Benjamin Graham and David Dodd, published a few years earlier in their landmark work, Security Analysis, about using fundamental analysis to help determine what a company's earnings would likely be, you had the basic framework for the evolution of financial markets from the casino mentality of the 1920s to one where most investors apply a more rational approach to assessing long-term value.

Essential to the idea of discounting a stream of future cash payments in order to establish a present value is the discount rate you use in your calculation. Obviously, that discount rate will reflect the risk the market applies to your particular investment, so it is totally appropriate that the market perceives a higher risk and therefore applies a higher discount rate (i.e. demands a higher yield and/or total return) to certain kinds of assets and asset classes than it does to others.

Sometimes, the market applies a higher discount rate to a particular investment because it perceives the investment is riskier and therefore investors deserve to be paid more. That applies all the time to particular stocks or industry groups whose prospects are expected to suffer from some specific event or trend, whether specific to the company or industry itself or to the overall environment in which they compete. It can also happen to an entire stock or financial market if economic or other conditions change in a way that investors in general began to feel antsy or uncomfortable about their current return expectations. As investors pull their money out or shift to lower risk investments, the drop in market price levels automatically raises the yields on the stocks or other securities affected, in effect raising the discount rate at which the future cash flows of those investments are being valued.

As stated earlier, the current distribution yield on my Income Factory portfolio is 14.8%, which is 27% higher than the yield at the end of September. My cash stream of payments (the "output from my Factory") is the same as it was in September (actually a bit more as I have reinvested and compounded distributions since then, expanding the Factory each month), so one way to view what has happened is that the market now values my Factory's future income stream as being worth about 25% less than it did 3 months ago. "Mr. Market," as Benjamin Graham called it, has raised the rate at which it discounts my future Factory output, in effect saying, "I want to be paid about 25% more to hold your assets and take your investment risk than I did three months ago."

Anyone who buys or replicates my portfolio at this point will get the benefit of Mr. Market's decision because they can buy it for 25% less than they could three months ago and therefore get the benefit of the 25% increase (approximately) in cash yield on the investment. For me, and others who already hold it, we get the benefit of higher reinvestment rates in the future, but at the cost of the "paper loss" we have suffered on our existing portfolio. Whether that "paper loss" is temporary or permanent remains to be seen.

How to think about this? Is my portfolio actually 25% riskier than it was previously, and is the paper loss a permanent impairment?

  • Worst case: The market drop represents a realistic assessment of the increased risk in my portfolio, which means the distribution has a real likelihood of dropping by 25% or so and therefore deserves the 25% haircut the market has given it.
  • Realistic case: All the uncertainties facing our economy and our geopolitics represent an increased macro-risk environment for all sorts of financial and other business investments, so some haircutting across the board is probably appropriate. In this case, we recognize that there is currently a "perfect storm" of issues, events and challenges that would lead many investors, regardless of their personal political persuasions, to see a higher level of uncertainty and to demand, via "Mr. Market," a higher level of return for whatever risks they are taking. The perfect storm might include: (1) the loss of the typical "shared understanding" between Washington players and parties of the norms of constitutional government, rule of law, checks and balances, transparency, independence of the judicial, criminal justice and monetary policy authorities, and other basic tenets (written and unwritten) of how politics and government should function; (2) the impact of the Mueller investigation and related cases and whether that will lead to a Constitutional crisis of some sort; (3) the fraying of some international alliances and the uncertainty that creates in foreign markets; (4) end of year tax selling; (5) concerns and disagreements about the desire for or impact of higher interest rates; (6) international trade and tariff issues; (7) concerns about whether the bull market has run its course; (8) questions about where we are in the credit cycle and whether we are facing some sort of "bust" or just routine cyclical fluctuations. Our "realistic" case expects that these issues are serious and will take some time to work themselves out, but assumes that ultimately the "center will hold," as they say, and the market will slowly bring risk premiums and discounts back down to more normal levels. I've probably missed some issues in my list, but you get the idea. The government shutdown is another recent issue that didn't cause the drop but adds to the national angst. I've tried to present this as neutrally as possible, since investors of all political persuasions can still be concerned about these issues, regardless of which individuals or parties they may blame for them.
  • Optimistic Case: In this case, we see all the issues just mentioned, but - in part because it is such a "perfect storm" - we assume Mr. Market has over-reacted and that the market will bounce back strongly once the end of year factors are behind us and we get more evidence (hopefully) that the country and the economy will muddle through. One issue that may help tip the scales between the optimistic case and the realistic case will be the government shutdown and whether it gets handled/ended in a way that portends more or less cooperation between the parties in Washington going forward.

Personally, I am somewhat indifferent - as an investor - to whether it is the middle ("realistic") case or the optimistic one. In both cases, it is macro factors that are the concern, and not some fundamental flaw in my portfolio that suggests its actual economic value has depreciated. So, the difference between the two cases is mostly between how long I'll have to wait for my paper loss to shrink while I'm collecting (and reinvesting) my abnormally high distribution yields. As a voter and citizen, of course, I am hoping for an earlier resolution of all the issues that are bothering the markets, because these same issues are causing angst and worse to people across our nation and around the world.

Strategy and Opportunity

As mentioned earlier, I remain fully invested for a number of reasons:

  • I need the money. I cannot afford to forego cash income at a rate of over 14% in order to move money to the sidelines in the hope that I would time my re-entry later on at the "bottom." It is too great an opportunity cost to give up 14% (the same would be true if it were 9 or 10%) and also take the risk that if I got off the investment train at this level and missed getting back on when it started up again (as so many investors have done in previous downturns), I would (1) turn paper losses into real ones, and (2) make those losses permanent.
  • The investment opportunity at these current levels is substantial for long-term income investors. I will publish our updated portfolio as part of our quarterly review in a couple weeks, but it doesn't change much from quarter to quarter so if you want to look for opportunities, you might want to check my most recently published Income Factory portfolio (link here) and look at the funds' current distribution and discount levels on CEFConnect. I will also mention some specific favorites.
  • Finally, as I have said in a number of comments to various articles by others in recent weeks, I think the concerns about some sort of credit market crash are overblown. Credit cycles have their ups and downs and CLO managers and other credit investors build into their models' assumptions for expected defaults and losses that have been pretty predictable and consistent throughout history, including through the great crash of ten years ago.

Current opportunities include:

  • Lots of MLP funds, for those who think that no matter what happens, there will still be a demand for pipelines and storage facilities to transport and contain gas and oil products. I currently own closed-end funds CenterCoast Brookfield MLP (CEN), ClearBridge Energy MLP (EMO), First Trust Energy (FEN), Nuveen AllCap Energy MLP (JMLP), Kayne Anderson MLP (KYN), Duff & Phelps Select Energy (DSE) and Fiduciary Claymore MLP (FMO). All have double-digit distributions and are selling at discounts, with DSE, EMO, and JMLP at particularly big discounts. I also own the InfraCap ETF AMZA (AMZA), but it is - for me - somewhat harder to understand and evaluate, so with the great values currently offered by more straightforward and transparent closed end funds, I have shifted some but far from all of my AMZA exposure to the other MLP funds listed.
  • First Trust Specialty Finance (FGB) is a personal favorite and my largest holding. Invests primarily in BDCs which have been hit hard by panic selling. Has a great long-term record and currently pays almost 14%.
  • Of course, our old favorites Eagle Point Credit (ECC) and Oxford Lane Credit (OXLC) are both selling at bargain prices, paying distributions of 17% (ECC) and 19% (OXLC). Both buy collateralized loan obligations (CLOs) which are leveraged pools of senior secured corporate loans. (A CLO is like a virtual bank.) CLOs often get confused with their legal cousins, collateralized debt obligations (CDOs) which held sub-standard, often fraudulently originated home mortgage loans and helped precipitate the great crash of 2007-2008, but CLOs are a whole different animal (far simpler and more transparent) and actually came through the crash with flying colors for their buy-and-hold institutional investors. I don't pay much attention to movements in their NAVs, which mostly reflect guesstimates and estimates rather than actual trades. Traditionally, institutional investors bought and held CLOs based on their cash flows, parking them away and not even attempting to "mark them to market."
  • Finally, one old favorite I would like to mention. Cohen & Steers Closed End Opportunity Fund (FOF), about which I wrote a few years ago (link here), looks particularly attractive right now. This fund of funds holds other closed end funds and currently sports a distribution yield of 10%, highest in my memory. When I wrote the article just mentioned, it was only yielding 8.3%. The great dynamic in the FOF value proposition is that it can buy closed end funds at discounts, and then it in turn often sells at a discount, so you get discounts on discounts. (Think of "double coupons.") While 10% is not as high a distribution yield as the ones we just discussed, FOF represents - I think - a very different risk, given its broad diversification, professional management and solid history. I hold it in a number of friend and family portfolios and, at its bargain price and generous distribution yield, plan to buy it back into my Income Factory portfolio with my year end dividends next week.
  • Currently, FOF sells at a 6.86% discount, with a net asset value of $11.22 that we can buy for $10.45. But FOF's net asset value reflects the market prices of the funds that it owns, many of which are at discounts to the NAVs of those funds. I calculated the discounts on FOF's 15 largest holdings, which account for 48% of its total holdings, and they have a weighted average discount of 4.3%. If we assume that is representative of FOF's portfolio as a whole, then the underlying assets that FOF holds and which are priced at $11.22 per FOF share, actually have a market value of $11.72. In other words, FOF's NAV represents a 4.3% discount from the actual underlying value of its assets per share, which is $11.72.
  • Put it all together and you are paying $10.45 per FOF share for underlying shares of closed end funds whose NAV is $11.72. Divide 10.45 by 11.72 and we see that we are paying 89.1% of the real NAV value. That's a total discount of almost 11%.
  • With closed end fund prices deep in the "bargain bin" to begin with, FOF's additional 11% "coupon" looks pretty attractive to me.

I hope that is interesting and/or useful. Thanks for all the interest and support you have shown over the past year. Happy Holidays!

Steven Bavaria, a former executive of Bank of Boston and Standard & Poor's, writes extensively about his high yield "Income Factory" investment strategy. You can "follow" him and/or check out his book and other writings on his personal profile page here on Seeking Alpha (link: Steven Bavaria's Articles).

Disclosure: I am/we are long OXLC, ECC, FOF, FGB, FMO, EMO, JMLP, FEN,, CEN, DSE, KYN. 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.