Embracing Market-Cycle Investment Management

What’s in your mattress?

by Steve Selengut

Mr. Selengut is a private investor and a contributing editor to LIFE&Health Advisor. He is the author of the book ‘The Brainwashing of the American Investor: The book that Wall Street does not want you to read.’ He can be reached at [email protected]

Market Cycle Investment Management portfolios are different from any others you may be analyzing, and all investors analyze their portfolios most intently when their “bottom line” market values begin to crumble. This focus on market value is part of Wall Street’s Brainwashing of the American Investor.

MCIM investing is more realistic. It recognizes that investment markets (both equity and income) are cyclical. Rarely do portfolio market values trend upward as long as they have since March of 2009. Most equity investors have forgotten the five month, 22%, mini-correction that ran from May through September 2011. Will this one be the real deal?

MCIM focuses on “working capital”, a measure of the total cost basis of the securities and cash contained in an investment portfolio. Managed properly, this measure should grow in all market, economic, and interest rate environments, irrespective of changes in “market value”… really.

MCIM portfolios always include an “income purpose” element of at least 30% of “Working Capital” and never own an equity that is not an “Investment Grade Value Stock”. This translates into a portfolio of high quality securities, each of which contributes to a realized “base income” higher than that contained in the most popular stock market only averages.

Embracing the cycles, MCIM portfolios strive to grow both total Working Capital and portfolio “Base Income” steadily, regardless of what is going on in the investment markets, in either direction. (Understand Working Capital? Base Income?)

Portfolio “Working Capital” is up roughly 8% since the equity and income markets peaked (together) in 2012; “base income” has risen proportionately in every individual portfolio where cash flow has remained positive for the entire period.

Follow the CEFs

Income Closed End Fund (CEF) prices have been moving lower since November 2012; the decline accelerated in May; the WCMSI index has now declined roughly 16% in just seven months — but with barely any change in total income generated. Back in November you’ll recall, many CEFs were selling at premiums to NAV. The premiums are now gone, taking a whole lot of market value with them… but with no change in income.

Stock market numbers have been much stronger, falling just 6% or so from peaks achieved toward the end of May. This divergence between equity and income security prices is quite normal; weakness in income security prices often signal upcoming stock market corrections.

The vast majority of income CEFs are now selling at significant discounts to the Net Asset Value of the security portfolios inside. The vast majority of income CEFs are selling at significant discounts to the market value of the securities they contain. (repetition intended)

Income Closed End Fund (CEF) prices have been moving lower since November 2012; the decline accelerated in May; the WCMSI index has now declined roughly 16% in just seven months --- but with barely any change in total income generate

A selection universe of ninety-one taxable income CEFs and sixty-nine tax free income CEFs is used in constructing MCIM portfolios. Over the five years since the depths of the financial crisis, and in spite of the lowest across the board interest rates in history, the vast majority of these CEFs have maintained (perhaps increased) their regular payouts to shareholders.

Historically, in “normal” interest rate environments, income increases have been more prevalent than income reductions. Overall, income CEF managers coped well with the lowest interest rates ever…. how have they been dealing with the specter of higher rates? Keep in mind that no actual interest rate change has yet occurred.
After five consecutive years of artificially low market interest rates, just 28% percent have reduced their payouts over the past 6 months or so, and nominally… except for two that have made significant dividend cuts.

Now the interesting part: at current prices, the average dividend yield on the 44 CEFs that have cut their payout is approximately 7.5%.

Nine CEFs (5.6%) have raised their payouts while 67% (107) have made no changes at all. The current yields on the MCIM CEF Universe is in the 7% neighborhood for tax free  income and 8% for taxable income.

So, just how did CEFs perform?

I believe that the vast majority of these CEFs made their regular scheduled distributions throughout the financial crisis; how could a rising interest rate environment be any worse than that?

Here’s how the professional CEF managers do it:

  • Each CEF portfolio contains hundreds of individual issues with varying qualities, maturities, call provisions, etc. The average duration is between 7 and 8 years
  • Managers use short term borrowing to purchase additional securities; nothing forces them to borrow at higher rates if they can’t still invest profitably
  • Managers capitalize on profit-taking opportunities
  • CEF share prices are completely “uncoupled” from NAV; shareholders are investing in the investment company as opposed to owning a piece of the investment portfolio itself.

Nuveen Asset Managers seem to agree that the fall in CEF prices is “technical” in nature, as bond fundamentals remain strong.

As I see it, and this is no prediction or recommendation of any specific course of action, CEFs provide investors with the opportunity to take advantage of irrational price dislocations in the income securities market — an opportunity that is difficult for the average investor to capitalize upon using individual securities.

By adding to existing CEFs positions, investors can increase overall portfolio yield, increase yield on specific holdings, and reduce their per share cost basis in the process.

Thus, even if some reduced payouts are experienced, the overall level of income is likely to be at least stable, and possibly higher — unless there have been more than the usual withdrawals.

The expectation of higher interest rates is probably the main force driving Closed End Fund prices lower; eventually, actual higher interest rates will provide higher yielding securities for fund managers to purchase. In the meantime, associated weakness in the stock market may cause investors to seek out higher yielding and safer-than-the-mattress opportunities….

Like those we believe are afforded by the MCIM universe of CEFs. What’s in your mattress!