From Slide Rules To Spread Sheets: Coping With 'Analytic Overload'
- When I started in the financial business, calculators were few and far between, and pencil and paper were our primary analytical tools. Forget about computers and spreadsheets.
- Now we have a plethora of tools and data. But the basic questions - what is important? and what does it mean? - haven't changed.
- I cut through the "analytic overload" to focus on what is most important to me.
- Here are the factors I look at most carefully in evaluating closed-end funds as candidates for my Inside the Income Factory® portfolios.
- Pretty basic stuff: What are the fund's objectives? Does it meet them? How does it do it? Can we count on it continuing to do so? Price and discount attractive?
- I do much more than just articles at Inside the Income Factory: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »
From Pencil & Paper to Analytic Overload
When I started working at the Bank of Boston many decades ago, we used to "spread statements" by hand, transposing balance sheet and income data from a corporation's annual reports onto forms that were then typed onto sheets in the company's credit file, which was the "bible" containing the life story of the borrower's financial history and its relationship with the bank over sometimes many decades. Calculators were usually rudimentary "adding machines" of the sort used by the green-eye-shaded clerk in the Bailey Brothers Savings & Loan in the movie It's A Wonderful Life.
Like Sherlock Holmes, we would pore over the financial statements for clues about what was really going on with the company. Without spreadsheets and other computerized assistance, credit analysis was a labor-intensive process, so it was critical to figure out what data and insights were truly important to our decision-making, and zero in on those.
Fast forward fifty years
Today we have the opposite situation where data, spreadsheets and other analytical tools are so available it can be overwhelming. Here on Seeking Alpha, we have a wealth of analysis on funds, stocks and other potential investments, including the closed-end funds that my Inside the Income Factory members, other followers, and I myself tend to focus on.
I'll be the first to admit that I can hardly keep up with all the analysis that crosses my computer screen just on the funds already on my radar scope as holdings or candidates for my Income Factory model portfolios, or for my own personal portfolio. Nor do I have the talent, time, resources or energy to personally produce the highly detailed, data-rich and chart-filled analyses that I often see other SA authors prepare on closed-end funds, ETFs, stocks and other securities.
OK, so what do you do?
I see myself as more of a portfolio manager than an analyst. I jokingly have referred to the rest of the SA authors as my "analytical team" but in many ways that is true. I rely on fellow contributors to do a lot of heavy analytical lifting, and my job is to integrate it with my own more focused analysis, and convert all of it into actionable conclusions that I can utilize myself and share with Inside the Income Factory members, and other followers and readers.
To arrive at those "actionable conclusions" about specific closed-end funds, I focus primarily on the following key factors and/or variables, most of which I can obtain and evaluate very quickly from readily available sources:
1. What does the fund say it expects to do?
Many funds say they "seek a high level of current income, and capital appreciation as a secondary objective." Some state it more cautiously, that they try to "maximize current income while preserving capital." Meanwhile, some are more ambitious and say they plan to "provide a high level of total return from dividend income and capital appreciation."
This may seem like mere boilerplate, but it can provide a clue as to whether the particular fund can be expected to provide (1) a distribution and nothing more in the way of capital appreciation, (2) a distribution plus some capital appreciation along with it, or (3) a distribution that overstates the actual return of the fund because you then give some of it up in price erosion over time. In other words, can we anticipate the fund to be primarily an "income-only" fund, a "growth and income" fund, or an "annuity" that pays an income stream while depleting its capital base over time.
2. What is its total return history over time?
Having seen what the fund says it plans to do, now we check what it has actually done. What are its recent, 5-year, 10-year and, if available, its "since inception" total returns on an annual basis. Then we compare these total returns with its distribution yield. This shows us at a glance (1) whether it has delivered on its plan to deliver the high level of income or whatever else it promised in its self-description, and (2) how much of the total return has consisted of "current income" and/or "capital appreciation."
This is very important. "Total return" is what really matters in an investment's performance, and it consists of two elements: (1) the cash dividend or distribution you receive during a particular period (quarter, year, etc.), and (2) the appreciation or depreciation in price over that same period.
A fund that pays us a 7% distribution and goes up in price by 2% over the same period is generating a 9% total return (i.e., 7% plus 2%). A fund that pays us 9% a year but drops in price by 2% is only generating a 7% return. If that pattern continues indefinitely, any investor who happily pockets the 9% distribution will actually find him/herself owning an "annuity" with a principal that shrinks in value each year, generating less and less income over time. (Here is a recent example of that.)
3. How does the fund earn that total return?
Closed-end funds earn income in three basic ways:
- Direct interest, dividends or other cash distributions from their investments (this is the familiar "net investment income" or "NII")
- Capital appreciation from trading assets, or from buying bonds, loans, etc. at below par and collecting them at par at maturity, etc.
- Other income, like option and covered call premiums, hedging income, etc.
NII is the most steady, predictable income. A fund that owns bonds, loans, stocks, and other securities that make regular payments of 3, 4, 5% or more can pretty predictably be counted on to pass along distributions of that amount, minus whatever administrative expenses the fund incurs. In fact, most funds can pay more than the "natural" yield of the assets they hold because they can buy additional assets (up to 50% of the fund's total NAV) by leveraging themselves with cheap institutionally-priced debt. This can add an extra 1 or 2% or more to what they could pay shareholders with an un-leveraged portfolio, depending on what sort of assets the fund holds (e.g., low- yielding investment grade bonds or high-yield bonds and loans, etc.) and how big the spread is between the cost of leverage and the yield on those assets.
Finally, shareholders can sometimes buy the fund at a discount of 5 or 10%, which means the actual yield on the amount they invest would be even higher than the fund's yield calculated on its par value (i.e. on its NAV). Check out this article for more details on how the "alchemy" of closed-end funds allows them to pay higher yields than the natural yields on the assets they own.
4. What is the fund's "earnings coverage" or "distribution coverage?"
This is the very straightforward calculation of how much the fund's distribution is covered by its NII. If the distribution is fully covered by the actual dividends, interest and other cash flowing into the fund from its own investment portfolio, that makes it pretty much a "no-brainer" as far as our being sure the distribution is covered, at least in the short run.
If it's reported as less than 100% coverage, it still doesn't really mean that it's NOT covered, it just means it's not covered by NII, and therefore the fund managers have to do more than just clip their coupons and hand the money over to shareholders in order to make their current distributions. It means they have to generate income from the other, more "heroic" activities mentioned up above: capital gains and/or option or covered call premiums or whatever other tricks they have up their sleeves.
5. How dependent is the fund on such "heroic" income, beyond its NII, for its historical total return as well as its cash distribution, and can we depend on its continuing to successfully generate that?
So we look at the fund's operating statements to see how much of its total return and distribution is dependent on other income (capital gains, etc.) over and above its net investment income.
As we said, if distribution coverage is 100% or more, then the fund's portfolio income itself - dividends and interest - covers the distribution and there is little reliance on achieving capital gains to do so. Examples of this among funds we currently own are KKR Income Opportunities Fund (KIO) with a 117% coverage ratio and Barings Corporate Investors (MCI) with 194% coverage (per CEF Data).
However, if the fund's total return has exceeded its distribution over time, and we hope and expect it will continue to do so, then even if the distribution is covered from normal fund cashflow (i.e., NII), we are still counting on the fund achieving additional income from capital gains or other sources in order to maintain its historical level of total return. An example is Apollo Tactical Income Fund (AIF), another one of our holdings, whose distribution is 6% and well covered by NII at 108%; but whose total return has averaged 10% for the past five years. That would suggest that AIF's managers are not just sitting around passively collecting interest at 6% and paying it across to fund shareholders, but are actively managing the portfolio in order to generate - on average - that additional 4%, most likely in capital gains. It may not necessarily be 4% every year, as market conditions change and capital gains come and go. But as a long-term holder, it's the fund's ability to maintain its average total return I care about, along with the ability to cover the distribution on a current basis.
Another example is a covered call fund I own, Eaton Vance Tax-Managed Global Diversified Equity Income Fund (EXG). EXG sports a puny distribution coverage ratio of only 6%, even though it has a pretty stable distribution of about 7.7%, and a total return averaging 12% for the past 5 years and 9% for the past 10 years. So it's obviously covering its distribution, and then some.
As a covered call fund, NII is relatively less important, since EXG generates most of its income from the premium received from writing the calls, which covers its distribution and leaves a bit extra to generate some additional total return. That's why covered call funds tend to generate dependable "steady Eddie" returns, as they usually own high-quality stocks and then write covered calls that essentially trade away much of the profit to be made if the stocks appreciate, in return for premium income they get to keep regardless of what stock prices do. Therefore, we shouldn't let the low NII coverage scare us off.
Regular equity funds are another matter, especially if the fund owns mostly growth funds with low dividend rates. Clough Global Opportunities Fund (GLO), which I wrote about recently, is a good example. With a distribution yield of 10%, and a 5-year average annual return of 19%, and 10% for 10 years, fund management must be doing something right. Mostly generating capital appreciation. But the coverage ratio is listed as 0%, meaning all of the funding of its dividend recently has come from current and past capital gains. That doesn't make the distributions or the total return any less real, it just means it is less predictable than it would be if it came from net investment income or even from a covered call program.
6. How can I tell if an equity fund, dependent on capital gains as opposed to more stable, predictable income or covered call premiums, will continue generating capital gains in the future?
That's the key question, and a difficult one. For me, it comes down to judging the overall professional experience and competence of the fund company and the team that manages the specific fund. In fact, it's a judgment we have to make about every fund we buy, regardless of whether it manages equity, credit or other asset classes.
Some fund companies have great records and inspire confidence in investors over a long period of time: Cohen & Steers, John Hancock, Eaton Vance, BlackRock, Nuveen, PIMCO, and Calamos. Certain other funds have risen to prominence and gained enormous respect even though they may not be part of major fund companies, with Reaves Utility Income Fund (UTG) being probably the best example of that. Similarly with fund companies that focus on particular asset classes, like Ares and KKR in the high-yield credit field, or Eagle Point (ECC), Oxford Lane (OXLC) and XA Investments/Octagon (XFLT) in the collateralized loan obligation space.
With equity funds in particular, where total returns depend so much on capital gains as opposed to more predictable NII, we really have to judge mostly on past performance. For that I rely on the numbers, reports (annual, semi-annual, quarterly commentary, etc.) and other data that are readily accessible on CEF Connect, CEF Data, and the funds' own websites. But I also like to see what other analysts think about the funds, how they assess their records, and the expectations they have about their future. Here is where I think the analytical bench strength of other Seeking Alpha contributors can be valuable, especially those (and we all know who you are, and greatly appreciate your efforts!) that have gained a level of credibility over the years.
7. How is the fund priced? What does it pay as a distribution yield? Is there a discount that provides a margin of error?
If I think the distribution yield is probably covered and is reasonably close to being an "equity yield" that I would be satisfied earning over the long term, even if there were no or very little additional capital appreciation, then that reduces the downside risk. Even if I can't be assured that capital gains achieved in the past will necessarily be repeated.
Meanwhile, if there is a discount, it reduces my risk by providing me with more assets "working for me" than I had to pay for.
For example, suppose I can buy a fund at an 8% discount from its net asset value. That means I have $100 of assets working for me that I only paid $92 for. If I get an $8 distribution from the fund, which is 8% on its net asset value, I'm actually collecting an 8.7% return on my invested capital of $92. Normally you'd have to take more risk if you bought a bond or other security that paid 8.7% than if you buy one that pays only 8%. In this case I'm getting that 8.7% yield but only taking the risk of holding an 8% asset. Spread across a whole portfolio and over many years, that small advantage - sort of tipping the risk-reward scale in our favor - makes a big difference.
8. Are professional investors putting their money where their mouth is with this fund?
I always like to see who else owns the funds I'm considering. Typical funds may have 10-15% ownership by institutional investors or insiders. When I see more than that, I usually consider it a real positive. It may mean that activist investors have targeted it and there will be specific actions being taken by the fund to ingratiate itself with its current investors to "fight off" the activists, or the activists will prevail and force the fund to take specific actions to increase its distribution or otherwise push up its price and close up its discount. But even if the higher ownership percentage does not represent activist involvement, it is still a very positive sign that professional investors like the fund.
Here is a representative sampling of funds and the percentage of their institutional and/or insider investors:
Reaves Utility Income (UTG): 10%
John Hancock Tax-Advantaged Dividend Income (HTD): 15%
Clough Global Opportunities (GLO): 27%
Barings Corporate Investors (MCI): 17%
Eaton Vance Tax-Managed Global Diversified Equity Income (EXG): 19%
KKR Income Opportunities Fund (KIO): 20%
Ares Dynamic Credit Allocation (ARDC): 38%
Apollo Tactical Income (AIF): 45%
Eagle Point Credit (ECC): 55%
As I said, the high participation of professional institutional investors to me is a plus, and merely confirms that this is a fund that others who invest people's money for a living have chosen to invest in. Would I invest solely on that basis? Probably not, but it is icing on the cake, once I've considered all the other factors listed.
So that's basically it. I try to determine what the fund itself says its purpose is and then look at its record to see whether it is achieving that successfully, how it is doing so, and whether it has a record of success.
I focus in particular on the quality of its total return and distribution. Is it actually earning its distribution? If so, where do its earnings come from? Are they sustainable? What does the fund's history tell us about what to expect in the future? Are the fund managers highly regarded in their own industry niche, be it high-yield credit, preferreds, convertibles, CLOs, utilities and infrastructure, covered call equities, or other specialized asset classes?
How do other analysts evaluate the fund? As investors are we in good company with institutional investors and insiders who've risked their money along with ours?
So those are the basic "ingredients" that go into our portfolio decision-making.
I launched Inside the Income Factory because many of my 11,500 followers and readers of my book The Income Factory® (McGraw-Hill, 2020) said they wanted more interactive dialogue than I could provide through public articles. It allows me to answer more member questions about how to use an Income Factory to earn "equity returns" from more predictable "non-equity" asset classes.
The great majority of those who have tried our FREE TWO WEEK INTRODUCTORY SUBSCRIPTION decide to stay with us.
So we must be doing something right. Why not give it a shot: click here to learn more.
This article was written by
Bavaria introduced the Income Factory® philosophy in his Seeking Alpha articles over the past 12 years, drawing on his fifty years experience in credit, investing, journalism and international banking. His earlier book "Too Greedy for Adam Smith: CEO Pay and the Demise of Capitalism" exposes the excesses in the CEO pay arena. Both books are available on Amazon.Bavaria began his career at the Bank of Boston, handling international credit workouts that included managing a fleet of ships, chasing a Vatican-owned bank in Switzerland, and leading the turnaround of troubled branches in Australia and Panama.
Then he did a stint as a journalist, writing about the financial markets for Investment Dealers Digest (IDD). There he wrote some of the first articles about novel securities, like CLOs, that have now become mainstream, and covered the early evolution of corporate loans to a public, tradable asset class.
Later he worked at Standard & Poor's, where he introduced credit ratings to the leveraged loan market, helping to open the loan asset class to pensions, mutual funds and specialized investment vehicles like CLOs.
Bavaria graduated from Georgetown University and New England School of Law. He lives in Ponte Vedra, Florida.
Analyst’s Disclosure: I am/we are long ALL THE FUNDS MENTIONED IN THE ARTICLE. 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.