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This Unknown Canadian CEF Has A 10% Monthly Distribution

|Includes: Bank of America Corporation (BAC), FNV, WFC
Summary

The Canoe EIT Income Fund is an unknown (in the US), undervalued closed end fund.

EIT has a monthly distribution of 10% and could be a viable income investment.

For US investors, EIT offers geographical diversification to Canadian companies.

It is one of Canada’s largest closed-end funds and manages $1.2 billion in assets - yet it is very unknown in the US.


Main Thesis

The Canoe EIT Income Fund is an unknown (in the US), undervalued closed end fund and could be an attractive investment option at its current market price. The fund continues to trade at a (rounded) 3% discount to its NAV. However, this figure has been narrowing over the past two years may be going from “undervalued” to “just right”. ENDTF has a monthly distribution with a 10% yield, remaining at $0.10 per share for almost 10 years. Finally, while many CEFs focus on different industries or sub-indexes, the Canoe EIT Income Fund’s only goal is to “maximize monthly distributions and maximize net asset value, while maintaining and expanding a diversified investment portfolio.”

Fund Background

EIT is a closed-end investment trust established under the name EnerVest Diversified Income Trust. EIT (or “Canoe EIT Income Fund” or OTC:ENDTF or TSX:EIT.UN or EIT) was incepted on August 5, 1997 and renewed/amended its Credit Facility in 2007. The Canoe EIT Income Fund objective is to “maximize monthly distributions and maximize net asset value, while maintaining and expanding a diversified investment portfolio.” This means that buying into this CEF is much like buying into an index fund (in terms of diversification); you will be exposed to many different equity sectors.

For US investors this diversification extends geographically. ENDTF is a Canadian fund so it invests mainly in Canadian companies. As of the end of 2017, 52.2% of its assets were invested in Canadian equities, while 38.3% were invested in US equities. Another interesting thing to consider is that it is one of Canada’s largest closed-end funds and manages $1.2 billion in assets. This isn’t some basement operation - EIT is a 20 year old fund managed Canoe Financial LP, a reputable Canadian investment advisor. Canoe’s portfolio managers are proven performers in the most widely held mutual fund categories.

Currently the fund is trading on OTC Pink Sheets (penny stock exempt) in the US under ENDTF. The fund officially trades on the TSX under EIT.UN an EIT.UN-A (preferred). Please note that for the remainder of the article I will be discussing EIT (NAV, Mkt. Price, ect...) using Canadian Dollars (unless otherwise noted).

The Canoe EIT Income Fund currently has a net asset value of $12.067 CAD, while it trades on the TSX for $11.750 CAD. It pays a monthly distribution of $.10/share, which translates to an annual yield of about 10%.

NAV Discount

Buying a CEF with both a high yield and discount not only gives you the opportunity to capitalize from discount contraction, but you also get "free" alpha every time the distribution is paid out.

Some quick CEF principles: Buying a closed end fund with a high distribution and pairing that with a considerable discount gives you two advantageous opportunities. 1), you can capitalize on the discount contraction and more importantly, 2), you basically get free alpha everytime the fund pays out dividends. Why?

CEF’s make their money from four main sources:

  1. Interest payments on fixed-income portfolio holdings

  2. Dividends from equity holdings

  3. Realized capital gains

  4. Return of capital - there are three types; pass-through (from master limited partnership investments, primarily), constructive (from unrealized capital gains) and destructive (investors are literally receiving their own capital, minus expenses).

They are also tax-free - the funds themselves do not pay taxes. Instead, they must pass on to shareholders 90% or more of net investment income from dividends and interest payments and 98% or more of net realized capital gains. This “pass on” of money is referred to as a distribution and is what the fund pays you monthly. In EIT’s case, it has a distribution yield of 10%.

You get free alpha everytime the fund pays you because it isn’t getting its yield from its share price. Instead it is getting it from it’s holdings. Simply put; paying out a distribution is effectively the same as liquidating the fund at NAV and returning the capital to the unitholders.

With that in mind: the Canoe EIT Income Fund currently has a net asset value of $12.067 CAD, while it trades on the TSX for $11.750 CAD. That means that it’s current discount is (-)2.66%. While this isn’t a massive discount, it is still substantial. However, what’s even more important is the fact that the discount is contracting, meaning market price is getting closer the the NAV price.

The following chart shows the difference between NAV and Mkt. Price for EIT.

[Source]

Notice how for the past two years, NAV and Mkt. Price have been getting closer and closer. This means that investors who have been long in ENDTF since then have been benefiting from the two situations discussed above; capitalizing on the discount contraction, and receiving free alpha.

Incoming investors can still capitalize on these two benefits. Realize that while the discount has been shrinking, it is still discounted (especially when compared to other funds with the same objectives).

10% Distribution

As we touched upon in the first section, the Canoe EIT Income Fund has a 10% distribution yield. Where does this 10% come from? Recall the four sources of CEF income. In EIT’s case, distributions come from income generated from “the securities of publicly traded REITs, qualified limited partnerships, corporations and similar issuers, corporate debt, convertible debentures an preferred shares of issuers engaged in businesses in various industries and geographic regions.”

In a recent distribution, about 32.5% came from dividends. 66.8% came from return of capital, and the remainder came from net investment income. In EIT’s case, return of capital results mainly from capital gains, so it is constructive. Excess capital gains in one period may be used to support distributions in a subsequent weaker period, while maintaining a sustainable distribution and protecting net asset value.

However, because most of these distributions are coming from the sale of securities, investors should take note. Most stocks in the fund pay dividends of 4 or 5%, which make up part of the distribution. Then a certain amount of holdings are sold each year to make up the difference. 

This allows the fund to pay $0.100 CAD per share in monthly distributions. This rate has remained the same since 2009. Approximately seventy percent of total distributions are reinvested in the fund.

A Quick Look At Holdings

The Canoe EIT Income Fund is a highly diversified fund, exposed to many industries. Its top two sectors are Financials (34.1) and Energy (21.8), an has assets in healthcare, industrials, IT, materials and more.

EITs top 3 holdings are Wells Fargo (WFC), Bank Of America (BAC) and Franco-Nevada Corp (FNV). It also holds Canadian Natural Resources, Brookfield Asset Management, Intact Financial and Sun Life Financial (all Canadian Companies). The funds top 10 holdings make up approximately 36% of its total holdings.

Geographically, it is a Canadian fund, so as expected 52.9% of its assets are Canadian. 38.0% are from the US and 7.1% are Foreign. EIT consists of about 97% equities and 1-2% Canadian fixed income, and is structured for the long-term given its ‘balance of high-quality Canadian and U.S. dividend-paying securities with sustainable growth characteristics and defensible business models.’ (Rob Taylor, Q4 ‘17 Commentary)

Returns

The Canoe EIT Income Fund is an income fund. This means that while it will try achieve returns in NAV and market price, its first priority is to provide a stable monthly distribution to shareholders. As a result, returns may suffer.

With that out of the way, the fund has seen some good returns, and kept in pace with the S&P 500 as well as the S&P/TSX.

[Note that this chart is from the 2017 Annual Report. It will be updated when the 2018 Annual Report is published.]

This is the total return from Morningstar. You can see that the fund outperforms Morningstar's index in the YTD, 1-year, 3-year, 5-year and 10-year (by a lot).

Now let’s look at the most practical (in my opinion) return measurement - hypothetical return of a $10,000 investment.

This is the 1-year return:

You would have made a whopping $305. This seems pretty lackluster until you remember the 10% distribution. For every share you own, you’re making $0.10 a month. That's about $850.

Here is the return for 5 years. Pretty good, considering that you’d invest in this fund mainly for income.

Now, the most commonly used “growth of $10,000” metric. This growth rivals some Vanguard funds. Now pair that with the monthly distributions, and EIT becomes pretty appetizing.

[“Growth of $10,000” charts sourced from company website]

Management

Like most CEFs, EIT is an actively managed fund. When buying into actively managed funds it is extremely important to know and trust the ‘person behind the money’.

Robert Taylor, CA, CFA is the sole portfolio manager of EIT. He was directly responsible for managing more than $4 billion in his previous position as Vice President and Portfolio Manager, Canadian Equities at BMO Global Asset Management, and is very experienced in the industry.

Mr. Taylor’s investment philosophy is very realist. He expects heightened volatility and muted returns going forward, therefore “stock selection will become increasingly important”.

In his recent commentary on Q4 2017, Mr. Taylor gave good insights into his management style and investment philosophy.

“We believe that we are in the early stages of a late cycle market, and there is still money to be made in cyclical areas (e.g., energy, materials, industrials, financials, and technology stocks) - where we should see further earnings growth in the coming 12 to 18 months. With tax reform only recently introduced, commodity prices threatening to break out of multiyear downtrends, interest rates closing in on their highs, and defensive sectors (e.g., consumer staples, utilities, telecommunications, and real estate stocks) breaking below their uptrends, the backdrop for further cyclical leadership is there.”

He feels that we are currently in a transition to a lower return oscillating market where active management will become increasingly important.

Mr. Taylor ends his commentary with a statement that all investors should take note of, especially in the current market environment:

The best course of action is to stay balanced, stick to quality, stay disciplined, and remain flexible. There will continue to be opportunities for patient investors going forward.

Mr. Taylor is an extremely capable financial professional with a good approach to investing. He has managed the fund since 2013.

To Non US Investors

Unfortunately US investors cannot benefit from a unique benefit to this fund, called DRIP. DRIP (or a “dividend/distribution reinvestment plan ”) isn’t exactly proprietary to EIT, but Canoe does offer some interesting additions.

Unitholders of the Canoe EIT Income Fund can choose to have their monthly cash distributions automatically reinvested into new units of the Fund at 95% of the market price, or receive 102% of the monthly cash distribution via the Premium DRIP™ component of the plan. Participants in both of these plans do not pay any costs associated with these features.

So again, for those ‘seeking alpha’, here it is. In the long run this plan could really boost returns when comparing it to similar funds, so be sure to take the DRIP (especially the premium plan) into consideration.

To US Investors

Without having to trade internationally, you can buy into the Canoe EIT Income Fund with OTC Pink Sheets - ticker: ENDTF. For a pink sheet fund, ENDTF is fairly liquid with a normal volume of about 18,000 shares changing hands per day.

Share price mimics the market price of EITs Canadian listing - EIT.UN - which recently traded for $11.750 CAD. ENDTF traded for $9.18 USD or $11.76 on the same day.

US investors cannot partake in the DRIP plan meaning that they will miss out on the opportunity reinvest their distributions in new units at a discount of about 5% to the average market price.

In addition, there are tax implications to think about. Canadian domestic law requires 25% tax to be withheld on payments made to non-residents. In certain circumstances this 25% withholding rate may be reduced by Canada’s bilateral tax treaties for certain kinds of payments to residents of those countries with a bilateral tax treaty. Investment advisors are responsible for assessing the withholding tax requirements on distributions from the funds based upon the residency of the recipient.

Risks And Considerations

As with all investments, reward comes paired with risks. First off, consider the fact that you (if you are a US investor) will be trading OTC shares with a liquidity of under 20,000 shares per day. For large investors, this will be very limiting.

The fund is also heavily invested in the financial sector (almost 40%), so any volatility in this sector will be reflected over onto the fund.

For US investors, understand that this is not a US fund. It is heavily focused on Canadian investments, so any Canadian policy changes, influences or other events within the country will effect this fund. While it offers the prospect of geographical diversification, investors must be aware of international events to be informed on their investments.

Remember the tax implications. If the 25% withholding figure applies to you, you could lose ¼ of your monthly payment.

Also consider the management fees. EIT is an actively managed fund which is good for cyclical, volatile markets. However because it is active, the Management Expense Ratio is high. EIT has a MER of 1.50% excluding issue costs and interest, while many comparable funds run around 1%. This is high, and may do a number on your long term (10, 20 year) returns.

Bottom Line

The Canoe EIT Income Fund is an unknown (in the US), undervalued closed end fund and is an attractive investment option at its current market price.

The fund has seen some nice returns in the past years, as well as a high distribution of 10%, but US investors need to consider the tax implications and other factors.

In conclusion, the Canoe EIT Income Fund could be a great investment both to US and international investors. It trades at a discount, allows geographical diversification, is great for income and has holdings in many sectors. However, weigh the pros and cons before investing and understand if it would be a good investment choice for you.

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.