Portfolio Manager Chris Sandys recently had an article published on Seeking Alpha: Yield Trap: The PIMCO High Income Fund Is Too Good To Be True. He specializes in closed end funds and the article provides some important insight into closed end fund investing.
Here is a story with a potentially sad ending. It may conclude with thousands of small investors losing a lot of money, as their hunger (greed?) for high yield collides with a leveraged, too-good-to-be true investment.
About two weeks ago, Barron’s published an article on the PIMCO High Income Fund (PHK). The summary of the article was that this closed-end fund was trading at a tremendous 70% premium, and that its assets are leveraged. Any sort of disruption, like a distribution cut, could mean trouble for investors.
I have been watching this fund for several years, but… Click to Read – Yield Trap: The PIMCO High Income Fund Is Too Good To Be True
Disclosure: The author does not currently hold PHK.
Last Wednesday (7 July 2010) the market reversed its down-trend and was strongly positive, so the new talk of the financial news stations was the “summer rally.” Never mind that the Dow was exactly where it was 1 week prior, because the recent history is actually ancient history. Or at least that seems to be the conventional wisdom of the 24-hour news cycle.
Calling a rally on short-term direction of the market is preposterous. I understand the reason behind the positive action: 10 trading days of stocks lower. Every now and then the market takes a breather. I am totally uninterested in what the market does in a single week, let alone one day. I am more interested in what is going to happen through the remainder of the year, and a few more beyond that.
I see only a couple of obvious reasons to invest in equities right now. Large American companies are cheap by historical standards. This is a fundamental analysis, meaning we are looking at the price of the stock and comparing it to the company’s earnings. Remember though, earnings do not occur in a vacuum. There are a lot things going on that can disrupt earnings and send the market lower, despite yesterday’s summer rally kick-off. The other reason is positive employment statistics from Canada, proving that some parts of the globe are effectively repairing their economy.
With little to be optimistic about in the market, it makes investing tricky. This is the first in a series that is going to describe the investing environment, and what we are doing to exploit opportunities while avoiding traps. Each piece of this series will build on the next, and will focus on a discrete topic. I will state the topic early; so that if you feel you are well-versed you can save your time.
The piece is going to focus on sovereign and state debt, and their pending impact on you.
So we hear about sovereign debt on the television and radio all the time, but what is it? Simply stated, sovereign debt is government debt. In the United States you would know it as our National Debt, i.e. the total outstanding debt the US Government owes to its bond holders (US Treasury securities and Savings Bonds). The US isn’t the only country carrying a debt. Scores of developed and emerging countries also issue debt to cover the shortfalls in their national budget.
Debt is not necessarily a bad thing. If managed properly a country, like an individual, can use debt to invest in the future and work its way through tight times. Debt becomes a problem when it starts to exceed the capability of the issuer to service the debt, i.e. make the principal and interest payments. How does this happen? Let’s use an example of an individual first, something we clearly understand, and compare that to sovereignty.
A person has access to debt through a variety of means, including credit cards, mortgages, and margin accounts. Let’s look at an example of Mr. Smith using his credit card. He makes $80,000 per year and has a total credit card limit of $50,000. Years ago both his credit limit and annual income were lower, but they have increased in tandem.
Mr. Smith starts using his credit relatively responsibly. He is paid monthly, and sometimes he needs a little extra liquidity to make it to the next paycheck. At first he was always diligent about paying off his cards in full each month, but eventually he starts carrying a balance. His interest rates are so low, that it makes financial sense to use this cheap money. As time goes on, Mr. Smith continues to grow the balance on his cards, because his income is increasing. At one time it would have been difficult to pay $200/month to a creditor, but now he can easily pay $600. Also with time, and familiarity, he starts using his credit for more than just monthly liquidity. Luxury items and vacations start to accumulate on his credit balance, but at this point it’s not a big deal. He can still cover the monthly payments plus a little extra, and the interest rate is low.
After a few years Mr. Smith finds himself in the unfortunate position of being unemployed. This was unexpected, so he never established an emergency fund. But initially it is not a problem, because he still has $20,000 left on his credit limit; that is equivalent to 3 months of his former salary, or so he thinks. Not considering that each month he was augmenting his lifestyle with some borrowed funds from credit, he doesn’t immediately curtail his usual expenses.
As the weeks pass the job situation becomes to look bleak, and he is going through his credit more quickly than anticipated. Fortunately, he is always receiving offers in the mail for new credit cards, so he applies for a couple and is able to establish another $20,000 worth of credit. Since his outstanding balance is approaching his annual salary, his interest rates are not as attractive on his new cards. He is being viewed as a potential risk.
As a few more months pass he has still not found a job. A couple of weeks ago he received offers for new credit cards, but their rate was exorbitant—he is viewed as a high-risk borrower. Now, he receives no new offers. He has been late on payments, and he has borrowed nearly the amount he used to earn annually when he was employed. He is no longer high-risk; he is credit ineligible. He has recently started to cut back on his lifestyle, but he did so too late. No amount of austerity measures is going to enable him to make ends meet.
Then one day as he examining his tattered finances, searching for an escape hatch, he receives correspondence from one of his creditors. Perhaps it is the credit increase he requested. Unfortunately, the news is not positive. Upon considering his request for additional credit, the lending company saw that he was over 30 days late paying on 4 different cards. They are revoking all his remaining credit. After 5 months of unemployment, he is dead in the water.
Who is Mr. Smith? He is Greece, a few months ago. The main difference being that the European Economic Community has no interest in saving Mr. Smith. His future will consist of misery, austerity, and bankruptcy.
Who could be a future Mr. Smith? Well, the most immediate countries that come to mind are Spain, Portugal, Ireland, and Italy. He may be the United Kingdom, but they have started to cut their spending significantly. He is more likely the United States, in about 10-20 years. But these two countries have one more trick up their sleeves that Smith could not access.
Let’s look at how the United States is similar to Mr. Smith, and where the differences are. First off, the United States has lost its job. Unemployment is through the roof, and it has not improved over the last year. Unemployed or under-employed citizens pay either no or less taxes. Tax receipts for the Federal and State governments have dropped and none of the governments that I am aware of, other than New Jersey, have curtailed their lifestyle. The Federal Government has actually increased its deficit spending (comparable to a credit card). “By how much,” you may ask? They are increasing the debt at an astronomical rate. According to the US Treasury, on 1 January 2009 the entire debt was $10,699,804,864,612.13. As of 9 July 2010 it was $13,181,991,714,131.18. That is an increase of over 23% in the last 18 months.
How are the next 12 months looking? Well, that’s a tough one to answer, since Congress refused to pass a budget this year. It seems that a direct vote on a budget would have cost many congressmen their jobs. So instead they attached $1.3 trillion worth of spending to the Emergency War Supplemental Bill. The people spending your money in DC are afraid to look you in face and admit the degree of their spree. To what degree this will be a deficit (i.e. in excess of tax revenues) is uncertain, but it will likely be high, and there is good reason to believe that even more spending will be attached to other bills.
If the United States were Mr. Smith, there would be a happy ending. Credit would be revoked, medium-term pain would ensue, but eventually recovery would occur. Hopefully with a new system and awareness that prevents reckless spending. But we are not so lucky, because the US government has another line of credit that Smith, nor Greece, ever did. The United States has the ability to issue its own currency.
Here is an elementary explanation of how this monetary system works. The United States needs to fund their operations, but they have no money. They hold an auction for Treasury Securities (bills, notes, and bonds), and people and institutions buy these bonds through an auction, setting the lending rate in the process. Now where does the money come from to pay the interest and principal on these bonds if it doesn’t exist? Simple, they print it. And in the process, they debase (dilute) the value of the current dollar. Eventually, what used to cost $1 will cost $2, because the money will be worth half as much. This is called inflation. No one talks about inflation now, because we are in a deflationary recession, but it will likely happen.
Now I used the word “likely.” What could help stave off inflation? Well, there are 3 measures. The first is to cut services. Using our previous example, this would be like Mr. Smith eating rice and beans at home, and using a fan instead of an air conditioner. These are the austerity measures that Greece is in the process of employing. There are no austerity measures, or even talk of them, in DC today. Rather, all the talk and action is of increased spending. Your representatives are trying to spend their way out debt. Perhaps there is logic to this Keynesian Economic theory, but the luxury of being able to experiment with it is an opportunity lost on other budget items. The new socialized-private healthcare model will likely pile massive deficits to the already failing budget. This is money that could have been used for the so-called “shovel ready projects” needed for economic stimulus (if you believe that theory). So of the 3, eliminate the first one. It is not happening. Few politicians get reelected by showing fiscal restraint.
The second fiscal measure is to raise taxes. This will definitely happen. At first it will target certain groups of people, primarily the “rich.” It will spread to include things like tanning salons, and perhaps even a VAT tax, which will not replace the current sales tax but will multiply it. This is the only reason the US is still able to borrow money. Lenders look at you, the US citizen, and figure that a lot more money can be squeezed out of you. I am not making this up; it is the absolute truth. Your taxes are going up. If not yours, your children’s taxes will increase. That will be legacy of the Baby Boomers.
The third measure is a recovering economy. As more people and businesses are productive, there is more income to tax. There is a problem with this measure though. No one knows when the economy will recover. It could take years. Things could get a lot worse before they get better. We can hope things improve, but this is ineffective planning tool. Further, it is not enough. No amount of growth will be able to fill this gap. Scratch the third measure as viable. The only one we can count on is an increase of taxes.
The summary of all this is that the US Government is spending at an unprecedented rate. The economy is in poor shape. Unemployment is high, and not improving. The most conservative projections call for sustained deficits extending over a decade of over $1 trillion per year. The Fed is continuing to debase the dollar, which will lead to inflation. But this is only the Federal Government, what about the states?
Last week there was an article in the New York Times describing the state of disarray of finances in Illinois. Illinois is running a rather extreme budget deficit. The deficit is so bad that they have been late paying their account receivables—10 months late in some instances. The impact of this is, of course, to drive private enterprises out of business. These small businesses provide services to the government and do not receive payment. The Illinois government is literally destroying Illinois businesses.
One would think that this would serve as a wake-up call for them, but that would be to not understand the politics of states like Illinois, New York, and California (the two right on the heels of Illinois). They are refusing to cut their budget (measure #1). They are raising their taxes (measure #2). Unfortunately for them, they will learn the extent to which people, especially wealthy people, are portable in American society. When taxes are too high, people leave for a different state. When Illinois wants too much, move to Florida. The weather is better and there are no income taxes. Illinois does not have the capability to print their own money, but if they are wise they are studying the Greece playbook right now.
Just like the EEC perceived an interest in bailing out the excess of Greece, the Federal Government will likely perceive a political interest in bailing out the excesses of Illinois. Simply stated, you, the citizen of anywhere but Illinois, will pay for the excessive benefits of the programs and pensions enjoyed by the citizens and municipal workers of Illinois. You can sleep well at night knowing your money is paying for someone else’s retirement benefit 1,000 miles away. Again, I am not making this up.
The only other evident path is the state of Illinois defaulting on their bonds. They have already started an internal default by late-paying businesses for their services. The next internal default would be to statutorily decrease defined benefits. It’s unlikely they will do that (again – Illinois politics), so the only other option would be to delay or skip payments to their lenders, who happen to be people that own Illinois municipal bonds. This is the least undesirable course of action for Illinois, since these bonds are the source of income for rich Illinois retirees.
I am using Illinois as the example here, but California and New York are right behind them. They all have the same political makeup, and they all have the same, limited options.
Hopefully this has served as a primer as to what sovereign debt is, and why it will impact you. Beyond inflation and higher taxes these issues will impact certain investments more than others. Some investments take on an increased risk in this environment, while others actually may benefit from these issues.
Over the next several months I will be writing installments that explain investments, and I will often refer to concepts discussed here.
I realize that there are many statements I made that are controversial, and if you disagree I would sincerely like to hear from you. I welcome questions also. Please use the comment function, so that we can politely discuss them in public, in a joint-learning environment.
DISCLOSURE: Certain Belray clients own municipal bonds of numerous states and Treasury securities.
Recently I had an article published on SeekingAlpha.com regarding British Petroleum. In my view the situation is much worse than BP has admitted and the situation is not likely to improve anytime soon. – Chris Sandys
We have received a lot of questions recently about BP.
Is BP oversold?
Will there be a short-squeeze?
Is the cost of the disaster accounted for in the stock price?
Is now the time to buy, since everyone is running scared?
Is this a wonderful, investment opportunity, or is BP going down faster than a burning rig? In order to assess the potential we’ll take a look at the true scope of the catastrophe, and to do that we need to put it into terms that we understand. We’ll take a look at the two key players’ responses, the government’s and BP’s. Finally, we will pull it together with last Thursday’s Congressional hearings, to see how this looks as an investment. Read more
We have received a lot of questions recently about BP [NYSE: BP].
- Is BP oversold?
- Will there be a short-squeeze?
- Is the cost of the disaster accounted for in the stock price?
- Is now the time to buy, since everyone is running scared?
Is this a wonderful, investment opportunity, or is BP going down faster than a burning rig? In order to asses the potential we’ll take a look at the true scope of the catastrophe, and to do that we need to put it into terms that we understand. We’ll take a look at the two key players’ responses, the government’s and BP’s. Finally, we will pull it together with yesterday’s Congressional hearings, to see how this looks as an investment.
Deepwater Horizon rig blew on 20 April, killing 11 people. By now, the absolute breakdown of procedure and leadership is not questioned. BP failed miserably. Not to be insensitive to the loss of human life, but that liability is a known quantity and was immediately priced into the stock. But just how large is the gusher, and what are the potential liabilities associated with its lawsuits and clean-up?
As of this penning (18 June 2010), the well blew 59 days ago. The initial flow rate of petroleum was estimated by BP at a farcical 1,000 barrels (BBL) per day. Since then, the estimate has been revised to the latest number of 65,000 BBL per day, but I believe the rate is even greater. My opinions aside, we’ll use the official estimate.
There are 42 US gallons per BBL of oil. At 65,000 BBL per day, oil is flooding into the Gulf of Mexico at a rate of 2,730,000 gallons per day, or 10,920,000 quarts/day. I am converting this to quarts so we can grasp this flow. The average automobile requires 5 quarts per oil change. Most cars drive 12,000 miles per year, and, if you are maintaining your car properly, will require an oil change every 3,000 miles. That is 4 oil changes per year, or 20 quarts of lubricant per car per year. The gusher, at 10,920,000 quarts per day, is dumping as much oil as 546,000 worth of annual oil changes per day. Since it has been going for 59 days, it has dumped as much as 32,214,000 worth of annual changes into the Gulf.
The most populous state is California, with a current population of about 37 million. At current flow estimates in the Gulf, in less than 9 days the gusher will have spilled as much oil as every man, woman, and child in California owning a car and changing its oil for a year. Can you picture that? Think about every person in the entire state of California owing a car, changing its oil 4 times per year, and dumping that spent oil into their front yard. To put a little more perspective on this, if you were to dump 20 quarts of used motor oil into your yard your property would officially be a hazmat site. You would likely need to spend between $250,000-500,000 to recover it. I chose California for this thought experiment. If I would have chosen Texas, the second most populous state, we wouldn’t be waiting 8.7 days to hit this mark, it would have happened two weeks ago.
I briefly mentioned before that I do not agree with the new, official flow estimate. Without getting too deep into it, the scientists that I trust are estimating the flow to 85,000 BBL/day. The total population of the United States is 307,000,000. At the flow rate that I think is more accurate, it is equivalent to every person (not every household, but every person) in the entire United States dumping over 2.6 quarts of oil in their front yard (as of today, and there is no stop anywhere in sight). If you were caught dumping 3 quarts of oil on the beach, what would the fine be? $1,000 perhaps? Well take that and multiply it by 307 million. That equals $307 billion.
These numbers are astonishing, aren’t they? The true enormity is masked behind units of measurement we do not associate (Barrels), huge numbers (tens of thousands per day) and also some more insidious tricks and lies.
I believe the most sinister lie to date has been BP’s initial flow estimate: 1,000 BBL/day. That flow rate is equal to 42,000 gallons/day. That number is so small it would be laughable if this were a joking matter. For comparison, I have an 85 gallon fish tank in my living room. 85 gallons is a large one, but for fish-tank-aficionados it is consider moderately small. The circulation pump I have on my tank is capable of moving 86,400 gallons per day. This pump can be held in one hand, it uses 180 watts of electricity, runs cool, and is whisper silent. Yet, somehow BP was claiming that my fish tank pump was moving double the fluid of their 25,000-feet deep oil reserve.
It is clearly evident that BP is attempting to hide and obfuscate the reality. We know how bad the situation is at this moment, but are they also hiding the direness of a solution? To answer that, we need to take a look at the environment in which they are working. What is the pressure like at 5,000 feet? I do not even know how to articulate that in everyday terms. I can tell you that the strongest military submarine in the world, the titanium-hulled Soviet K-278, hits its crush depth at 4,500 feet below see level. It would not even be able to get close to the wellhead, which is 5,000 feet below the surface. Keep in mind that the deposit is another 20,000 feet below the wellhead.
This very well may be the worst case scenario: a damaged down hole 5,000 feet below the sea. That means they will never cap it. Never. They are not even trying any longer. The flow from this is too high to capture. You are probably witnessing the greatest environmental disaster in mankind’s history.
The enormity of this disaster and the alarming brazenness of BP’s cover-up brings into focus the other key player, the US Federal Government. We can talk ad infinitum about who is culpable in not helping prevent this, but once it did happen, why was the government allowing BP to put out such a whopper of a cover story? Didn’t they realize that BP has so many motivations to attempt to minimize the perception of the impact? The only thing I can conclude from this is that government has not a single, intelligent “expert” with any influence within this administration. Like the night of the blowout, we are witnessing, real time, utter failure of leadership. I am indifferent as to whether President Obama is mad or empathizing with the people of the Gulf coast, but I would like an official acknowledgement of the severity; some honest, intelligent communication; and centralized, streamlined crisis management. These people (government) are the ones that are supposed to be protecting your interests in the face of conflict with BP. You’re in trouble deeper than the gusher.
Let’s take a look at the Congressional hearing yesterday. The CEO of BP, Tony Hayward, essentially asserted his 5th Amendment Rights against self incrimination. This seemed to be irksome particularly to the chairman of the House Committee on Energy and Commerce, Henry Waxman. Did anyone let Waxman know that Hayward is under investigation by the Attorney General Eric Holder in addition to at least 4 state attorney generals for criminal negligence? I am going to go out on a limb here and guess that Waxman grasped this obvious fact, and that the entire dog-and-pony show yesterday was nothing more than a smoke screen for the good people back home. Meanwhile, the Coast Guard is detaining oil skimming barges for 24 hours, as they check to make sure there are life jackets and fire extinguishers on board.
Let’s return to our original questions about BP as an investment, now that we can somewhat grasp the magnitude of this disaster. BP is lying to you, and they have proven 100% incapable of taming the beast they have released. The only thing BP has shown competence in with regards to this disaster is controlling the Administration and the message. To hold BP accountable could mean seizure of decades of their profits. If you consider it unlikely that the Administration, Congress, and Courts will be unable to hold BP culpable, then this may be value investment some months from now.
I don’t feel comfortable betting that a company will be able to wreak mass destruction and not suffer the accountability. I also think this calamity will develop to a massive scale not yet officially communicated. For those reasons, I am giving this company a wide berth.
Disclosure: As of June 18th the adviser’s clients do not have long nor short positions in BP. Certain Belray clients do have a long position in BP.
Last night I watched the 1964 animated classic “Rudolph the Red-Nosed Reindeer” with my son. There is a scene where the prospector, Yukon Cornelius, sings of his search for Silver and Gold. Cornelius, where have you been? We found it.
RiverSource Precious Metals and Mining Fund [Ticker: INPMX]
Market Vectors Gold Miners [Ticker: GDX]
Coeur d’Alene Mines Corporation [Ticker: CDE]
Silver Standard Resources Inc. [Ticker: SSRI]
These positions are notable for a reason—they are investments in precious metal mining companies.
If you are a client, the RiverSource fund may look familiar. You have had a position since November 2008, and (depending on the exact entry date) the position has a gain of anywhere between 80% and 110%. If you are a newer client, the RiverSource fund was one of your fist investments, and you will notice that it has outperformed virtually all other investments and indices.
Within the past three weeks you have seen the addition of one of the other three securities to your portfolio. Market Vectors Gold Miners overlaps the RiverSource Fund to a degree, but adds additional companies. Its purpose is to add concentration in the mining sector, with further diversification.
Coeur d’ Alene Mines and Silver Standard are not funds; they are individual companies. Neither of them is part of the portfolio of the aforementioned funds. There are several interesting characteristics of these two companies. Firstly, they are “junior” miners, i.e. they are small compared to the major players. Many “juniors” do not have productive mines, but these two do. Silver Standard is strictly a silver miner. Coeur mines both silver and gold, and it is the only junior to do so. Being smaller companies, their capability to grow is greatly enhanced. They are a riskier investment, but circumstances are aligning in their favor.
Okay, that is all fine, but why the all the attention to mining companies? Furthermore, why the addition to this sector when it has already doubled in value over the past year? Has this train run its course, and the ride is over? Don’t fret, there is still a lot of mileage left in this three-legged trip. We were saying that as gold broke a $1,000/ounce, and we’re saying it now.
The first leg was powered by fear, brought on by the credit crisis. In times of uncertainty people seek stability, and nothing is secure if not gold. Its practical uses are very limited, but it is still one of the most sought after commodities in the history of man. Wars are waged, empires are built, and the [New] world is divided over it, just ask the Spaniards or the Portuguese. Its purpose is simple: currency, storage of wealth. It is no coincidence that people preparing for disasters do not stockpile Dollars or Euros, they stockpile gold. Did you know that the entire supply of gold extracted throughout human history could fit into 2 Olympic-sized swimming pools? It is indeed a rare metal.
The second leg of this trip has just started to leave the station, but the whistle has been screeching “All Aboard!” for an entire year. This, of course, is the weakening of the US Dollar (USD). Gold is priced in USD. As the Dollar gets weaker, the price of gold increases. Think of it this way. $1,213 buys an ounce of gold, today. If tomorrow the dollar becomes weaker as a currency, the gold seller will require more of the weaker currency to buy the same troy ounce of gold. After all, the dollar just doesn’t go as far as it used to. This Administration and Congress are going to do everything in their authority and beyond to guarantee that our dollar continues to weaken. We’re going to take that to the bank, since this message has been extremely clear, and the obvious is now coming to fruition. Those of you that remember 1982, standby, things are going to get a lot more expensive.
The final portion of the gold trip is not as certain, but has potential. Leveraged, producing companies have recovered well over the past 10 months. Commodities have also recovered, but not to the same degree. If the economy is truly working out of a slump, then real assets will resume their secular bull market that was curtailed by the credit crisis. There is a lot of potential waiting to advance, but we need confirmation beyond the Beltway. Either way, the path for precious metals is smoothly paved. If the recovery is real, commodities recover, silver (the industrial precious metal) is in demand, and all is well. If the recovery pans, then fear resumes, the Fed prints money, more lose jobs, inflation ensues, and gold advances, as does silver. Not a pretty economic picture, but we’re prepared.
Precious metal miners are included in your portfolio under the category I describe as “aggressive growth.” Their volatility is extreme. At the end of this past October they lost 11.5% in a single week (your investment dived that much in 7 days—and a couple of clients took note!), only to climb over 25% in the following 5 weeks. Being so volatile, the portion of the portfolio we invest here needs to be prudently limited. As a portfolio manager, I reserve 5% of the portfolio for “niche opportunities,” and this is one of them—right now. The argument to load-the-boat is compelling, but I am cautious of the unanticipated, and we have an adherence to investing discipline. Watch for gains in your mining stocks over the following quarters, but also be aware that they will not come without volatility.
As a little teaser: perhaps another individual stock will be added to your portfolio (under the “niche opportunity” category) within the coming days as I conclude research.
Disclosure: Belray clients are long INPMX, GDX, CDE, and SSRI.
There are many benefits to being a dividend hog. Within your portfolio you have securities that pay a cash dividend, which is also referred to as a distribution in some cases (I will use the terms “company,” “fund,” and “stocks” interchangeably in this article when referring to securities). A dividend is cash that is distributed to owners (shareholders) that is usually a portion of profits. I say “usually,” because that is not always the case. In some instances there are companies that are paying a dividend while they are losing money. A notorious example of this was last year, when Citigroup (NYSE: C) was paying a dividend to common share holders, while receiving an influx of taxpayer dollars. They were taking taxpayer dollars and transferring them directly to Citigroup shareholders.
There are a couple of reasons a company will continue to distribute cash as usual, even when their operating profit has turned negative. The first reason is window dressing. Reliable dividend payments are seen as a sign of strength. Cutting or canceling dividends is a clear indication that a company is retrenching, which is often the responsible business decision. Responsible or not, it gets everyone’s attention, and selling usually follows.
There is a second reason an unprofitable company will pay dividends. Many people have dividend securities in their portfolio to provide for a needed cash flow. An example of this is a retiree that depends on dividends to meet financial obligations on a timely basis. A company may decide that it is in the best interest of their owners to bleed cash, on a temporary basis, in order to avoid disrupting shareholders’ needed cash flow.
Let’s examine a hypothetical example of that scenario to understand that situation better. Imagine a hypothetical fund has a distribution rate of 12% annually, paid out at 1% per month. If a person owns $100,000 of this investment, they can count on a distribution of $1,000 per month, which they use to pay monthly expenses. Now let’s suppose this fund hits difficult market conditions, and it cannot generate 1% monthly. The fund has two options.
The first option is to cut its dividend. In that case, the person who needed the $1,000 per month for expenses will need to raise cash another way, often by selling a portion of the investment. Their selling will create downward pressure on the fund price, hurting themselves and fellow investors. It will also cost the investor a commission, and may create an unfavorable, taxable event.
The other option is for the fund to establish a “level distribution policy.” A level distribution policy means that the fund will distribute a fixed ratio, e.g. 1% monthly, regardless of the performance of the fund. For the people that need the cash flow, they do not need to worry about continually monitoring their dividend rate, nor will they need to raise cash through sales and all the associated disadvantages. When the fund distributes cash in excess of its profits, it is actually returning a portion of the investor’s principal to them. On the tax form 1099-DIV this is clearly identified as a return of investor’s principal, and it is not taxed.
A level distribution policy makes dividend investing cleaner and easier for all investors, but do not forget the key, operative word: temporary. When a portion of fund distributions are returned principal, the fund is bleeding money. If this situation is permanent, the fund will eventually have no money left. The investment essentially took your money, and paid it back to you over a period of time. That is not a good investment.
Let’s look at an investment in your portfolio that touches on this topic, the Calamos Strategic Total Return Fund (NYSE: CSQ).
As of today, CSQ has a level distribution of 6.25 cents per share, paid monthly. That roughly equates to 8.5% per year. For the month of August 2009, of the 6.25 cents, 2.37 cents was actually a return of investor capital. For this month, September 2009, the dividend is still level at 6.25 cents, but 100% of this distribution is from investing profits, i.e. none of it is a return of principal. The partial return of principal was temporary.
From the perspective of a portfolio manager, I do not want funds that are merely returning capital. If the fund continued on its August trajectory, the real dividend rate would have been 5.45%, instead of 8.5%. For the risk profile of this investment, 5.45% is not acceptable, but there is another important factor to consider, and that is the market growth of the fund.
Over the past 3 months CSQ has paid its level distribution. A portion of that was actually a return of principal. Over that same period, the fund has grown in market value by 21%. This particular fund has an investment objective of total return, which means it is a combination of current income (distributions) and capital growth. In this situation, I was happy to take the distribution, albeit a portion of it being return of principal, because the capital growth was very rewarding.
A very similar investment may be in your portfolio, which is the Calamos Global Total Return Fund (NYSE: CGO). This fund has a level distribution rate of 10 cents per month, 100% of it being investment income (no return of principal). Based on the current security price that is an annual yield of 8.5%. That is an attractive yield, but even more attractive has been the capital growth. CGO is up 24.5% over the past 3 months. Again, the objective of this fund is total return, a combination of dividends and growth.
Regardless of whether the distribution is a partial or whole return of principal, or investing profits, it presents the investor with a decision. One may automatically reinvest the distributions into the fund (without incurring a commission), or they may take them as cash, and allocate them to the broader portfolio.
Automatic dividend reinvestment does have a couple of advantages. First, there are no commissions to reinvest the funds. Second, in some cases (Calamos is one of them), the dividend reinvestment plan will purchase at a slight discount to the underlying value of the fund. Third, this is a form of cost averaging. The funds are automatically being reinvested, on a regular monthly schedule, regardless of the market price.
Despite those advantages, I typically prefer to take the distributions as cash, and not automatically reinvest them. The market is tenuous, but with opportunities always arising. Having cash on hand allows me to take positions at favorable times. As you see new securities in your portfolio, realize that they were funded in part by the dividends in your portfolio. These dividends also pay for investing costs, like commissions, margin, and manager fees. Some clients have cash flow requirements, and the dividends fulfill that need.
Further, I do not automatically assume that continually increasing the size of dividend securities is a solid strategy. As an example, convertible securities funds do well in a rising market, but if the market shows weakness, those funds, and all the reinvested distributions, will drop quickly. Some of these funds utilize leverage, which can exacerbate a drop in market value. I am a hands-on manager, and taking cash is never a bad thing. We manage the entire portfolio on a total return basis.
None of my clients own Citigroup. Belray clients do own CGO and CSQ.
With one trading day left, this has been a great week for the stock markets. Primarily fueled by investment banking profits, the financial institution benchmark is up over 5% from last Friday. Goldman Sachs [NYSE: GS] started things off by accelerating its earning by 65%. JP Morgan [NYSE: JPM] followed with second quarter profits that were up 36% over last year. All this is great news if you are an investment bank. Also, with the financials on the mend, credit should free-up, and the economy could be on its way to a recovery. At least that’s a logic, but not one with which I agree.
Taking a closer look at where profits were made within the banks shows the picture a little more clearly. Goldman made the majority of its profits through investing, not through consumer lending. In the case of JP Morgan, investment banking profits were to credit for the positive results. On the earnings conference call today, JP Morgan CEO Jamie Dimon commented on the current status of CIT Group. He postulated that the continued deterioration of the commercial real estate market could be “a big deal” for regional banks. (It is possible that CIT Group may file for bankruptcy protection as soon as tomorrow.) He also stated that the underwriting profits offset the rising defaults on consumer lines of credit and mortgages. The key concept being consumer defaults are on the rise.
That should come as no surprise. When the large banks were about to fail, TARP monies came to the rescue, and very quickly. In the case of the individual, there is no TARP. There is a $790 billion stimulus act, and you will recall that this bill was drafted and passed to law at break neck speed, before anyone, Congress included, could read it. The argument was that in order to provide immediate aide, and prevent a depression, it was imperative to move with extreme haste. If it was good enough for the banks, then it’s good enough for the individual.
A very troubling problem has now been exposed; only 10% of the stimulus money has been spent. The rush to immediately get to “shovel ready” projects prevented any debate or examination of the bill. We are now learning that the only money spent thus far has been for wealth transfer programs and closing gaps on state budgets. Capital expenditure projects, the classic Keynesian spending, have not yet begun, and they are spaced over years.
Furthermore, several state governments are considering not even accepting the stimulus funds. Not for ideological grounds, as has been suggested by some. Acceptance of stimulus funds mandate expansion of baseline entitlement budgets. The local governments know that they will be strapped with the expanded budgets long after the stimulus well has run dry. If you wonder what this landscape could look like, view the current state of California. Add to this that a depression has not materialized, despite the lack of capital spending. It is no wonder certain states are cautiously weighing the long-term consequences of taking the stimulus money.
Only a clairvoyant can predict if the eventual capital spending will fulfill its promise, so we cannot rely on that elusive aide in formulating an investment strategy. We can, with a much higher level of certainty, factor costs of the stimulus: inflation and higher taxes. Congress is showing no reticence in proposing tax hikes, so that particular consequence is highly likely.
So what is the current state of the economy? We lost close to another half million jobs in June. Officially, unemployment has risen to 9.5%, but that only tells a small part of the story. What the official number does not include are the underemployed.
I will give you an example. I have a friend that is a human resources manager at a major, industrial conglomerate. So far this year he has had two, mandatory, 1-week vacations. He will have another two, mandatory, 1-week vacations before the year is over. He is not on the unemployment role, but his pay has been effectively cut by 7.7% through the use of the mandatory vacations. That 7.7% will be deducted from any discretionary spending his family formerly did. His employment status will not be reflected on unemployment numbers, but his decreased spending will be reflected in the GDP numbers.
I count him as fortunate, though. His firm has already dismissed 10% of their workforce. I know earnings estimates are not optimistic, and there will definitely be more job losses before the year is complete. They are not engaged in a fringe business; they are in industrial power management. They are an infrastructure company.
In addition to the job losses and mandatory vacations, the company has suspended 401k matching contributions. Right now, when the market is near its lows (perhaps?), employees are less capable of investing in their retirement. Even if the company were maintaining its 401k match, for many, retirement savings are viewed as subordinate to current needs, i.e. they will not contribute to retirement when they are having issues making ends meet right now. I could not locate any statistics on this, but I strongly suspect that many people are actually tapping into their “retirement” funds, early, to meet needs now. These consequences will not be felt for decades, but they building a future crisis.
This is a true story of a single company in Ohio, but theirs is in no way unique. I work with a lot of executives of publicly traded companies, and I hear similar stories. It is happening across America. The Bureau of Labor Statistics is reporting a 9.5% unemployment rate. The rate is trending up. Neither of those are good news. It only gets worse as you dig beyond their numbers.
So what does this mean for us?
First, do not get excited about a quick recovery, mistaking this as the beginning of the end of the crisis. A lot of things are continuing to happen in the economy, and many of them are not positive. The financial industry, primarily on the East Coast, received a bailout from the government. It looks like it worked, as reflected in earnings this week. That is good news, but the national economy does not necessarily go the way of the investment banks. If you are living a thousand miles from DC or New York, continue to wait. Your bailout money may arrive sometime in the future. That portion of the market does not report this week, but I fear that when it does the current market enthusiasm could seriously wane.
Second, I am ensuring that we are not too exposed to some of the more volatile asset classes, e.g. common equity. I will continue to increase our exposure to more stable cash flow products. We already have exposure to bonds and commodities, and I will be increasing the former. I am still very bullish on Senior Bank Notes and Convertibles.
Third, you may have noted that we recently cut our petroleum positions. Some of that will be held in cash, and some of it is being applied to a hedge fund replication product known as the ING Alternative Beta [NASDAQ: IABAX]. A common misunderstanding of hedge funds is that they are a high risk investment. To the contrary, the typical hedge fund investor looks for steady, vanilla returns. Our goal here is to not lose money, while still pulling in a decent return.
I will also be allocating a portion of the portfolio to a buy-write fund. These funds sell options on an equity portfolio to generate current income. A covered call strategy is the most conservative of bullish option strategies. It caps your upside, maximizes the opportunity for a moderate gain, and provides a small buffer against losses. This, like the Alternative Beta, will allow us to remain in the market.
As of time of publishing Belray does not hold any positions in GS, JMP or CIT. Belray does hold positions in IABAX.
I recently heard an interview on Bloomberg Radio with John D. Spooner, money manager and author, and the topic was: 3 questions to ask your financial advisor. The first and third questions below are his, but I changed the middle question to one that is more useful. If your advisor cannot adequately answer the following questions, your financial future is in the hands of an amateur and chance, and success is apparently optional.
1. What is your investment philosophy?
2. How do you drive returns from an investment portfolio?
3. What is you favorite book?
My investment philosophy starts with identifying a client’s goals. These goals are then monetized. It is my job to maximize the opportunity of meeting the monetary portion of a goal.
Once goals are articulated, an investment plan is crafted. Regardless of the level of risk in a portfolio, all capital investments derive their returns from three factors: market timing, security selection, and asset allocation. All three of these factors are utilized in my portfolios.
The final portion of my philosophy involves a feedback examination of both the goals and the portfolio. If the goals or markets change, so must the portfolio. Never are either static.
It has been my experience that the overwhelming majority of financial advisors cannot articulate an investment philosophy. (Hint: An investment philosophy is not: “To manage risk to maximize returns regardless of market conditions.” That is a goal.) Nor do most advisors even understand the basic concept of what drives returns within a portfolio. The later deficiency is not only attributable to professional ignorance, but this fault is exacerbated by technical and policy limitations enforced by their employer.
To understand why this exists, one needs to know who a public corporation serves. Simply, it serves the share holders first, the employees second, and the clients third. Anything that cause liability for a share holder or an employee (or their manager) is counter productive to serving the two primary stakeholders. For example, an investment in a specific stock (security selection), at a specific time (market timing), may be in the best interest of the client. This investment, however, introduces liability to share holders and employees, therefore the client’s interest is trumped.
These liabilities are limited further by restricting the capability of an advisor to perform trades and to select securities. Considerable commissions are charged to discouraged clients from exposing the firm to risk. If an advisor tries to circumvent this risk management technique by discounting a commission, the firm will not pay the advisor for that trade.
The final strike against individual security positions is driven by technical issues. First, very rarely is an advisor allowed discretion within a client’s account (huge liability to the firm). Since the advisor does not have discretion, he must confirm with every single client all security transactions. This could take days to move in or out of a position. Furthermore, the advisor is not provided with an institutional trading platform. Every single order must be placed separately for every client position. This alone makes the task nearly impossible, and it guarantees that the market timing will be better for some clients than others. (Are you first on your advisor’s “call list” when he needs to make a change?)
Instead, advisors are told to develop asset allocations, and to “manage the managers.” This strategy involves trying to drive returns by only utilizing one of the three factors. The result is predictable: market performance, nothing more. Mediocre returns for a mediocre investment philosophy. Add the fees onto this plan, and the performance slips to sub-market.
Advisors are coached by the firm that they cannot compete on performance, therefore they need to maintain customer loyalty through a high level of personal service. Which would you prefer, a high level of friendly service, or the maximum opportunity to meet your financial goals? These do not need to be mutually exclusive, but at a publicly-traded wirehouse the performance aspect is excluded.
From the firm’s aspect, not dealing with performance issues has the added bonus of freeing up their advisors to be “asset gathers.” A scalable, vanilla investment procedure frees up the advisor to do their “real” job: sales. Indeed, advisors are given bonuses for enrolling new assets. Achievement levels (and advisor pay) within a firm are in no way tied to performance. They are tied to two things. One, how much money did you bring in this year? Two, how much money did you make for the firm?
Wirehouse advisors with the best intentions are working within a system that is designed to maximize profits for shareholders, while minimizing risk for the firm. Clients’ goals are not a concern. Firms will argue otherwise, but their incentive system for their representatives exposes, in crystal clarity, what they say versus what they do.
When someone asks me what my favorite book is, a few come to mind. The first is Atlas Shrugged, by Ayn Rand. Great Expectations, Wuthering Heights, the Great Gatsby, Moby Dick, and Lord of the Flies also make my short-list. If you’re interested, I can tell you why I appreciate each one of these.
To know why this question is applicable one needs to understand the barriers to entry in being a financial advisor. The barrier is: the FINRA Series 7 test. That’s it—nothing more. This is a 260 question test, and a 70% correct rate is required to pass. The test can be taken indefinitely, until a passing score is achieved. It is my guess that the average elementary school student could pass this test with less studying than is spent for the SAT.
Knowing that virtually anyone can be a financial advisor, it is important to know what experiences and level of mental acumen your advisor brings to the table. Knowing their favorite books will give you insight into the person that may not be reflected on a resume. If their favorite book is the latest pop-novel, you may wish to further exam the depth of the person with whom you trust your future.
Don’t be afraid to ask your current advisor these three questions. These questions are very easy to answer, and they should be non-confrontational. If the answers are hedged, inarticulate, or dodged, then you have a problem. That’s critical to acknowledge: the advisor does not have a problem—you do.