A Way to be Greedy?
Warren Buffett (interviewed by Charlie Rose | transcript) recommends being “fearful when others are greedy and greedy when others are fearful.” Considering he hasn’t “seen this much economic fear” in his adult life, we should be greedier now than ever before.
I have heard that, following the S&L crisis, some investors locked in high yields (15-20 percent) on bonds, so I will be looking more closely into those.
When stocks take a dip, I generally do a quick search for high dividend yields. A company has little control over its stock price, but it does control its dividends. Companies try to keep dividends steady or rising. High yields hint at a number of things simultaneously: that the company’s financial health is good, that its stock price is low for no good reason, and that a good return on the investment is likely.
I heard about high-yield ETFs a couple of years ago, and kept them in a list of high-yield investments.
Recently, these instruments have begun to appear almost too good to be true, with cash distributions ranging from 15-20 percent annually. They appear to have a healthy margin of safety deriving from three sources.
- Such a fund invests, like a mutual fund, in a diversified portfolio of domestic and international stocks. One source of margin of safety comes from the fearful overreaction of the international stock market to the global financial crisis.
- Unlike a mutual fund, a closed-end fund can trade at a premium or discount to its net asset value. (Net Asset Value is the “book value” of the fund, the combined value of its portfolio). Currently, these funds are trading at the deepest discounts since their inception. Furthermore, the discounts are increasing, meaning the funds’ prices are declining faster than their net asset values. It is not clear why this happens. It may be because the funds are not well known. It may also be because they are traded by a distinct set of investors and for different reasons. In any case, this is another source of margin of safety.
- These closed-end funds have continued to make cash distributions at constant or nearly constant levels. This cash comes not just from the dividends yielded by the underlying stocks, but from the fund selling (covered) call options on the securities they hold. This strategy generates returns when the securities decrease in value as well as when they increase in value. (The only catch is that upside is limited.) An additional source of margin of safety derives from steady distributions from the funds.
After taking a closer look at the financial statements of one of these funds, I discovered that much of its cash distribution has been classified as “return of capital” for tax purposes. The fund advertises this as an advantage, because return of capital is not taxed until either
- it exceeds the original price you paid for shares in the fund, at which time it is treated as a capital gain or
- you sell shares, at which time your cost basis is reduced by the amount of capital returned
I initially suspected that the value of the fund may go down as capital is returned. If this is the case, then the yield would be diminished by the amount of capital returned. However, I have concluded that the value of the fund may not necessarily go down—the capital being “returned” is the capital put in when the fund was formed. It is only being “returned” to me because I now own the shares.
I have taken a position in some of these funds. If you believe my reasoning to be flawed or if my information is incomplete, then let me know.
| As of 9 October 2008 | ||
|---|---|---|
| Symbol | Distribution Rate | Discount from NAV |
| BDJ | 17.39% | 20.20% |
| CIF | 20.14% | 30.93% |
| EOI | 16.56% | 25.73% |
| ETW | 20.22% | 25.71% |
| JPG | 15.51% | 24.14% |
| NFJ | 15.51% | 24.14% |
| TSI | 10.32% | 19.03% |