Wednesday, May 8, 2013

Income Options (Part III)

Yesterday, I pretty well thought I had finished this series. I had at least one more income idea, foreign bonds issued by developing nations, but I concluded that was a little too risky to even discuss as a serious possibility. At the end of Part II, I mentioned that my GE Capital preferred that was paying over 6% was called back by the company at par. That happened in January, just in time for my retirement. If I was reading my article, I would want to know what happened to that money.

I never give specific investment advice. I’m not that smart. I will tell you what I have done that works and more importantly what I have done that didn’t work. Normally, I would wait until I had some results to report, but in this case I will make an exception. My GE Capital was generating some income that needed to be replaced. I found the same information that I reported in my two earlier posts. It is hard times for the income investor. Bargains are hard to come by.

Closed end funds are an old form of the mutual fund that is almost forgotten. These funds are bought and sold as “companies” on the stock exchange just like any other company. Unlike the more common open funds, closed end funds issue a set number of shares. That money is then used to purchase shares in other companies. Therefore, at least in theory, an investor could take the value of shares held in the fund divide it by the number of shares outstanding and come up with the true value of a share in the closed end fund.

For reasons that are not well understood, these funds can sell at prices that fluctuate, sometimes wildly, around their true value. Benjamin Graham, the godfather of value investing, claimed that an investor can hardly go wrong by buying such a fund with a 15% discount. (Wikipedia) In my research, I found one that was selling at an 11% discount, Black Rock Enhanced Dividend Achievers Trust (BDJ). At the time shares were paying out a 7.5% dividend. I thought that 7.5% with a margin of safety sounded like a pretty good deal. The price of a share has risen by about 5% since I bought them back in February. It is too early to know if this was a good idea or a bad idea, but at least I am off to a good start.

BDJ invests in just the kind of boring stuff I love. Here are the funds top 10 holdings. As you can see it doesn’t do much of anything for diversification since I already own some of these companies. However, it does expose me to some U.S. bank stocks I would normally tend to avoid.

JP Morgan Chase
Wells Fargo
General Electric
Home Depot
Exxon Mobil
Phillip Morris International

BDJ also writes covered calls to juice their returns. That is a subject for another day. However, I need to mention that different kinds of closed end funds can do more than buy and sell shares in other companies, including the use of leverage. They can gamble with borrowed money. If they plan of doing anything unusual with your money, they have to let you know. Wikipedia notes, “Because a closed-end fund is listed on the market, it must obey certain rules, such as filing reports with the listing authority and holding annual stockholder meetings. Thus stockholders can more easily find out about their fund and engage in shareholder activism, such as protest against poor management.”

Economists have a name for the forces we fighting in our quest for income and safety, the efficient market hypothesis. “In finance, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient". In consequence of this, one cannot consistently achieve returns in excess of average market returns on a risk-adjusted basis, given the information available at the time the investment is made.” (Wikipedia) Over the long run, I can’t really find a bargain because all the investors in the world and their computers are privy to the same information that I am using to make my decision. In the long run studies indicate that the efficient market hypothesis is very close to the Truth. However in short term performance, I side with the critics. There are things like insider information that isn’t generally known or factored into market pricing at a given moment in time. The efficient market hypothesis also fails to account for the temporary lunacy of crowds. Remember the dotcom bubble. Companies with no assets, no business plan, no sales, and no profits temporarily enjoyed total capitalization that was higher than well established responsible wealth producing corporations.

As Kenny Rogers Once Observed:

Now ev’ry gambler knows that the secret to survivin’
Is knowin’ what to throw away and knowing what to keep.
’cause ev’ry hand’s a winner and ev’ry hand’s a loser,
And the best that you can hope for is to die in your sleep.

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