Seeking Alpha

Let's Learn About CEFs: Don't Be Dumb Money - Develop Standards Of CEF Quality

by: David Van Knapp
Summary

Most CEFs are sold to retail investors, not "smart money" institutional investors.

Nevertheless, retail investors can develop standards that steer them to quality CEFs.

We create standards on several metrics and use them to create Quality Snapshots.

Do CEFs Represent Dumb Money?

In a recent article, an investment writer said that the CEF marketplace can be used as a contrarian indicator. That is not a compliment.

A contrarian indicator is a metric that, when it indicates bullishness, indicates that the smart thing to do is to run in the other direction. The term is often applied to “dumb money,” meaning retail investors.

CEFs are mostly focused on paying high yields, which makes them popular and mostly-used by retail investors rather than institutional “smart money”. Weird things happen in this market, in other words….

I know from first-hand experience that dividend-focused keywords do very well for search traffic. In addition, Seeking Alpha’s service marketplace has a disproportionate number of high-dividend services, including the most popular one there. In a world of negative-yielding or low-yielding bonds, people are willing to take on substantial risk in search of yield. We have yield euphoria, folks….

It’s useful to keep an eye on the weird CEF market to see what retail investors are piling into, because it’s a useful contrarian indicator.

I’m a Retail Investor, But I’m Not Dumb Money

The most-read articles that I have written on Seeking Alpha have been about finding quality in my investments.

Along with many other dividend growth investors, I put an emphasis on quality in nearly every purchase I make. Quality often trumps every other metric associated with dividend growth investing – including high yields and fast dividend growth rates.

I focus on quality, because when I buy a stock, my intention is to hold it for a long time – years or decades, not weeks or months. Therefore, I want to own investments with established enduring qualities that are likely to endure. Once I push the Buy button, I may be living with a stock for a long time.

In this article, I am going to begin defining quality for CEFs. Fair warning: This topic is subjective, and I will be using my own biases. Not everyone will agree with my concepts about what “quality” is in a CEF.

That’s OK. This is a community educational series, and the idea is to identify aspects of quality that investors can debate and hopefully stimulate discussion around the subject. Everyone is different, and one investor’s ideal CEF might be one that another investor would not touch. That’s what makes a market.

What Am I Looking for in a CEF?

My definition of “quality” in a CEF logically proceeds from my own goals. In my equity investing, I want to receive income that is “enough” (for me), reliable, growing, and sustainable.

I have successfully reached those goals through 11+ years of dividend growth investing. My quest here is to see whether CEFs can help reach the same goals.

Please note that I separate quality from valuation. With stocks, a company can be a high-quality company, but priced too high to be a good investment. Since CEFs trade on open markets, the same thing is true about CEFs.

Therefore, in this article about quality in CEFs, I will ignore valuations. At this stage, I am just trying to identify the better CEFs. Whether they are priced attractively to buy is a topic for another day.

Let’s go through those goals again, because they provide the framework for how I will grade CEF quality.

Income is “enough.” This is not really a quality factor. A high-quality investment might yield less than what I want. They often do. But most CEFs yield quite a bit, so I don’t expect to eliminate many CEFs on the basis of their low yields.

Income is reliable. While past performance is no guarantee of future results, I’ll be looking for CEFs with track records of maintaining their distributions. Recent cuts will be disqualifying. Survival of payout rates through the Great Recession will earn extra credit.

Income is growing. Most CEFs don’t grow their distributions regularly the way dividend stocks grow their dividends. So a lack of distribution growth won’t be a disqualifying factor. Within one’s portfolio, income growth with most CEFs comes from reinvesting the distributions (which is a behavior of the investor, not of the CEF itself).

Income is sustainable. This will get us into the realm of distribution safety and sustainability, and finding ways to measure or estimate those qualities.

Third-Party Rankings

Over the years in analyzing DG stocks, I have identified several third-party ratings from information providers that I trust. I put them together to create Quality Snapshots, like this one for JP Morgan Chase (JPM):

Unfortunately, similar independent analyst quality ratings for CEFs are hard to find. If Value Line has Safety or Financial Strength grades for CEFs, they are not in my subscription. I found no credit ratings for CEFs. Simply Safe Dividends does not rate the safety of CEF distributions.

For example, here is the analyst lineup from E-Trade regarding the fund that I am using to illustrate principles, DNP Select Income (DNP).

The one report that is available, Market Edge, is based on technical price-trend analysis, not on fundamental research about the fund’s quality or the sustainability of its business model.

Schwab does offer a “Report Card” for CEFs, but its information is very basic (like the top 10 holdings, absurdly carried out to 10-one-thousandths of a percent), or it is based on past performance (such as total returns over various time frames). This is no fundamental analysis about how a CEF works.

Morningstar does offer star ratings for CEFs, but if you are familiar with Morningstar, you know that its ratings for funds are based on past performance, not fundamental analysis.

One will find, of course, articles about individual funds (including author recommendations), and features like this 2016 Forbes article purporting to rate the best CEFs. Even those, however, often focus on past performance or valuation rather than the fundamentals of how a fund operates.

Some Promising Sources

But all is not lost. I identified some sources that may be useful in zeroing in on ratings or data points that can be used in constructing a Quality Snapshot for CEFs.

Morningstar

To its premium subscribers, Morningstar provides for CEFs its moat ratings for the stocks held in equity CEFs, along with a few other possible metrics.

I contacted Morningstar to learn more. I was told that the grades for Financial Health, Profitability, and Growth pertain to the stocks in the CEF, not to the CEF itself.

I zeroed in on the Financial Health grade as a possible substitute for Value Line’s Financial Strength grade for stocks. Here is how Morningstar defines its Financial Health grade:

One of the three quantitative grades that Morningstar assigns to each stock as a quick way to get a handle on its fundamentals. To get a good grade in this area, a company should have low financial leverage (assets/equity), high cash-flow coverage (total cash flow/long-term debt), and a high cash position (cash/assets) relative to its sector.

I noticed Morningstar’s D/C (debt-to-capital) metric. I consider debt in a corporation to be a risk factor, and as we saw in an earlier article, debt magnifies both good and bad outcomes for CEFs. I realize that CEFs’ ability to use leverage is one of their charms, and they get credit for that when considering their yields. That said, the potential riskiness of debt should be recognized.

But Morningstar’s D/C ratio pertains to the underlying stocks, not to the CEF itself. My own bias (and you may see this issue differently) is that in trying to estimate the operational quality of a CEF, it is the debt load of the fund itself, not its underlying holdings, that is of interest.

CEF Connect

As we learned in the third article in this series, CEF leverage is measured by structural leverage and effective leverage of the fund itself. This information is easily obtained from CEF Connect and other sources.

Another metric of interest available from CEF Connect is the stability of a CEF’s NAV. You may recall from the last article that the impact of a fund’s trading activities shows up in its net asset value [NAV] over long time periods. It is obviously desirable to have a fund that does not destroy its own NAV by paying out more in distributions than it actually earns from dividends, interest, and the outcomes of trades.

In other words, NAV stability is a pretty good reference point by which to judge a CEF’s business model.

The following are illustrations of CEF Connect’s screener set up to capture:

  • U.S. equity funds
  • At least 10 years old
  • Showing their effective leverage and 5-year NAV performance

CEF Connect presents its screening results in a table that can be sorted by any column. Here I ran the above screens and sorted the results alphabetically by ticker just to make individual tickers easy to find. The screenshot below is from page 2 of the results. DNP is highlighted.

Seeking Alpha

Here’s our last category: How many years has it been since the fund cut its distribution? A big quality element that I am looking for is income stability, because I intend to reinvest distributions to provide income growth.

I could not find a way to use the CEF Connect screener to isolate this fundamental data point. As of now, I don’t see a better way to find this data than manually looking it up.

SA’s data seems to fill the bill. Here is DNP’s distribution history set to the longest it can be.

Clearly, there has been no cut since about 1993 (and probably not before then). Of course, the most accurate data would come from each fund’s website, but I’m looking for a fast, uniform way to find the data for all funds.

So that gives us five categories to construct a quality snapshot for equity CEFs:

  • Moats of the stocks it holds (from Morningstar)
  • Financial health of the stocks it holds (from Morningstar)
  • Leverage ratio (from CEF Connect)
  • NAV stability (from CEF Connect)
  • Distribution stability – no recent cuts (from Seeking Alpha)

A Modest Proposal for Quality Snapshots

When I construct grading systems, I usually use a 5-level approach: A-F. I assign points to each grade, from 5 points for A down to 1 for D and 0 for F.

Sometimes a metric does not lend itself to a five-level system, so some of the grades get skipped for that metric.

Here, then, are metrics that we can try for creating Quality Snapshot ratings for equity CEFs, using the sources identified above, and showing how I would grade them.

First, moat ratings:

To compute the moat score for a CEF, simply multiply the percentage of stocks with each level of moat by the corresponding number of points, add those numbers up, and divide by 100. DNP, for example, comes out with a score of 3.55.

Next, the financial health grades:

DNP gets a B+ from Morningstar, which is a B on my scale.

Third and fourth, leverage and NAV stability. I used CEF Connect’s range selections to construct these two grading scales.

From the screener output shown earlier, DNP gets a B for both its leverage and NAV stability.

Finally, the grade ranges for distribution continuity are based on my own judgement. I wouldn’t consider a CEF with less than 5 straight years of uncut dividends to be eligible for purchase.

The reason for the uneven break point between B and C is the Great Recession. To get a B, the CEF must not have cut its distribution during that recession. The recession started in 2007, so the break point between B and C is 13 years.

DNP hasn't reduced its distribution in more than 25 years, so it gets an A.

Two Examples of Quality Snapshots

Here’s what the quality snapshots look like when everything is pulled together. First, DNP:

Applying the points for each grade, DNP gets 21 out of a possible 25 points. It is a very high quality CEF.

For comparison to DNP, I’ll use Allianz GI NFJ Dividend, Interest & Premium Strategy Fund (NFJ), which I picked at random.

NFJ gets some good grades, but its NAV stability is treading water, and its dividend history is filled with cuts.

I know a lot of people would disagree with me, but I wouldn’t buy NFJ. That kind of volatile distribution payout is the opposite of what I am looking for in considering CEFs for a dividend growth strategy.

Summary

  • CEFs are sold mostly to retail investors, not to “smart money” institutions.
  • That doesn't mean, however, that retail investors can't identify high-quality CEFs.
  • How you measure quality in a CEF should be based on your own goals for investing in CEFs.
  • This article presents a fledgling system for creating Quality Snapshots of CEFs. I expect this will evolve as we identify more metrics of interest and additional sources of information.
  • Separate valuation from quality when evaluating CEFs. Don’t let a high yield or steep discount blind you to the possible unsustainability of a CEF’s business model or a poor management team that cannot execute well.
  • Don’t buy new CEFs, no matter how attractive they sound. Do your hunting among CEFs that have been around long enough to establish a track record.
  • Don’t push beyond your envelope. If a CEF doesn’t measure up to your quality requirements, don’t invest in it.

Please use the comment stream to evaluate my suggestions and to suggest other sources for CEF Quality Snapshots. In doing so, please do not mix in valuation suggestions, such as z-scores or where to find price discounts. Those will be topics of a separate article.

Thanks again for reading, and good luck in your investing.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.