The more frequent the profits, the stronger the growth
by Steve SelengutMr. Selengut is a private investor and a contributing editor to Advisor Magazine. 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 (MCIM) was developed in the 1970s, at a time when individual equities were the most popular game in town. There were no «self directed» IRAs or 401ks and trusteed pension and profit sharing plans ruled the corporate benefits roost. There were no Money Market Funds, ETFs, or Index Mutual Funds, very little attention from the media, and no discount brokerage firms or on-line anything. Those who were lucky enough to have a trusteed defined contribution plan were limited to a choice of asset allocation… equity and fixed income.
Trustee benefit program managers were governed by a «Prudent Man Rule,» which had no room at all for speculation. Today›s MPT adjusted «Prudent Man Rule» encourages all manner of speculation, and most individual stock market «investors» feed only on mutual funds, ETFs, and index derivatives. The $16.8 Billion Vanguard Target Retirement Income Fund (VTINX), for example, does not contain one individual common stock or corporate bond… nada. It holds five Vanguard Index Funds and generates less than 2.25% in spending money.
The bulk of private “self directed” stock market involvement is channeled through derivative products, and this means that much more “buy” and “sell” decision making is in the hands of non-financial professionals than ever before. In the face of extreme fear or greed, Wall Street equity securities become managed by “the mob” of derivative product holders… fundamentals be damned. This creates an emotional risk environment way outside the MCIM comfort zone.
The Velocity Of Money
In economic theory, the “velocity of money” is the rate at which money is exchanged in an economy. For MCIM portfolios, where individual positions are treated like merchandise in a department store, the velocity of money is defined differently:
The “velocity of money” is the rate at which new working capital is created by dividend and capital gain reinvestment. The more frequent the profits, the stronger the growth in both “base income” and working capital. Market volatility and changing interest rate expectations increase velocity.
That said, the evolution of MCIM into the steroidal income generating machine it is today becomes much easier to understand. Owning individual securities positions based solely on price parameters and economic fundamentals has become much more “speculative”. Investors buying sectors, indices, and futures haven’t a clue about corporate P/E or “Quick” ratios… making safety in numbers a potent risk minimizer on its own.
Most of the equities in my 1970’s defined contribution plan were high quality, well known, dividend paying, NYSE companies… household names that we all grew up with. The plan was well diversified in every way, and it became the equity selection model used to grow the very first MCIM portfolio. The first “income purpose” securities in that portfolio were preferred stocks, corporate and municipal bonds, and US Treasury securities.
Quality, Diversification & Income
The QDI principals (quality, diversification, and income) and the foundations of Investment Grade Value Stock investing were “in there”, for sure, but many important things were missing… not the least of which was any form of profit taking discipline.
MCIM was able to resolve all of the plan’s issues while implementing a trading model that embraced both the volatility of financial markets and the power of compound earnings. If you were disciplined in following the guidelines, you were prepared for the markets› (equity and fixed income) directional changes.
- Allocation and diversification decisions based on Working Capital (cost basis), not market value
- Growth or income purpose driven allocation based on individual goals, not market prognostication
- Every security produces income and is always for sale at reasonable profit targets. No profit of 10% or $1,000 ever goes unrealized
- Profit “reasonableness” is a function of the availability of replacement securities with similar income production, profit potential, or both
- Cash resides in the equity (growth) bucket; the income bucket is always as fully invested as possible
- The “present value” of money vs. money due a year from now, and all the wonders of compound earnings are the primary thoughts influencing trading decisions. Trading produces higher “velocity of money” within MCIM portfolios
The six classic MCIM “bullets” above have not changed, evolved, or been adapted to new Wall Street mutual fund, index derivatives, ETFs, etc. They remain the foundation principals of MCIM… still solid, still productive, and still capable of producing reasonable growth in both “base income» and working capital, regardless of what is happening in the general marketplace.
But, the securities contained in MCIM portfolios have changed considerably in response to an eleven year, upward only stock market and historically low interest rates; the shrinking IGVS selection universe and the discontinuance of the S & P Monthly Stock Guide created a need for tactical change.
Profit taking targets have been adjusted lower for risk minimization purposes in a less quality controlled environment, and in appreciation of the smaller trading range within a higher yielding, size stable, selection universe.
How the «Growth Purpose Bucket» has changed
Over the past eleven years, the number of Investment Grade Value Stocks falling within MCIM price parameters has shrunken to the point where it makes more sense to avoid them than to purchase them. The sophisticated “watch list” replacement program developed to mimic the S & P selection parameters corroborated these feelings.
Since about 2012, with money market rates near zero, MCIM portfolio exposure to professionally managed equity closed end fund portfolios has been growing steadily. Minimal money market rates have pretty much killed the “smart cash” ideas discussed in “Brainwashing”. This move has produced broader equity diversification, and multiplied the dependable income from “growth purpose” investments. The “quality” of the 78 Equity CEFs in MCIM portfolios is measured by yield, operational experience, management approach, and trading range.
It is likely, given their broad diversification (over 190 positions per fund, on average) that a large number of IGVSI companies are inside. The average price of the equity CEF selection universe is just $13.50 per share with an average yield a scooch above 9%. 63% pay monthly dividends, the rest quarterly and the average CEF has been in operation just under twenty years. 72% have been in operation for more than 10 years, or longer than most ETFs; 70% trade at prices below NAV vs. zero in either mutual funds or ETFs.
There are 36 management companies represented in the selection universe, and more importantly for a trading process, there are always 78 CEFs to select from. This availability makes it much easier to employ defensive strategies during raging bull markets (i.e., taking smaller initial positions in preparation for buying more when prices move lower).
Equity CEFs are traded frequently because there is a constant supply of suitable replacement securities with similar yields and profit potential, and because profit taking is itself a powerful portfolio risk minimizer. But the most important reason for frequent trading is the compounding of profits and long term impact on growing both base income and working capital.
- Keep in mind that a profit of as little as 3% is 20% more than that generated by the multi-billion dollar VTINX in an entire year… while the “bucket» itself is generating roughly 9% in dividends
- MCIM IRA and 401k portfolios routinely generate more “base income» than required to meet both RMD and other fee requirements
- During rising markets, MCIM portfolios may generate more than enough net/net profits to cover all client management fees
How the “Income Purpose Bucket” has changed
Over the past thirty years or so, the purpose of most MCIM portfolios has changed from predominantly growth to mostly income, causing portfolio adjustments to a much higher income purpose allocation. Portfolio income holdings shifted from individual bonds, bills, and preferreds to Corporate Income Trusts, GNMAs, and Municipal Bond Trusts. Today’s MCIM income bucket is almost entirely CEFs, both Tax Free and Taxable.
More recently, the combination of historically low interest rates and tax code changes has caused tax free CEF managers to cut dividends sharply, while demand for the product itself was falling . There are now less than twenty municipal CEFs that pay as much as 5% while the selection universe of 105 experienced taxable CEFs continue to produce an average above 8.5%. The large number of diverse taxable portfolios has almost entirely replaced the individual and trust type income programs once included in MCIM portfolios.
The quality of income CEF portfolios is measured in the same way as the equity variety, but with additional attention to security holdings and issue concentration. The portfolios have an average price of $13.76 and average 15 years experience. They produce roughly 60% more income than income ETFs and mutual funds.
The average CEF portfolio contains more than 400 individual securities, and only 5 have less than 100… 70% sell at discounts to NAV. CEFs are the only investment product that allows you to buy a portfolio of illiquid securities at a discount, and without markup.
MCIM income CEFs are provided by 36 Management companies including: Blackrock, Wells Fargo, Western Asset, Eaton Vance, First Trust, Franklin, Hancock, Prudential, MFS, Nuveen, Pimco, Virtus, and Invesco. And, there are always 105 to select from, making all trading strategies (defensive buying and reasonable profit taking) much easier to implement.
Income CEFs are actively traded for both risk minimization and velocity of money acceleration. During lower interest expectation markets, income CEF portfolios may generate more than enough net/net profits to cover all client management fees.
Leverage and Return of Capital are NOT Four Letter Words
I hate to say that worries about either “leverage” or “Return of Capital” (ROC) are “Much Ado About Nothing», but experience using CEFs over the past twenty five years or more have pretty much proven that it is just that.
Do financial experts worry about the ROC included in mortgage or annuity payments? Do they concern themselves about how people finance their cars, homes, or even their life insurance premiums? Do they understand that individuals, economies, businesses, and governments all run on some portion of borrowed dollars?
- CEF leverage involves short term borrowing to finance purchases of higher yielding (generally longer term) securities… seems a bit safer than the types of leverage described above. If the manager can’t find higher yielding securities, she doesn’t borrow the money
- ROC reduces the cost basis of the CEFs that provide it, thus making profit taking opportunities appear sooner rather than later.. while also increasing investable cash flow. Most savvy (I really hate that expression), investors realize that it absolutely needs to be reinvested
CEFconnect.com, (a service of Nuveen Investments) provides historical charts for all forms of CEFs. Review the prices and dividend histories over the last twenty to twenty-five years. You’ll see the impact of the market cycle; you’ll see the impact of interest rate directional expectations; and you’ll see a history of high income levels that, when compounded, surpass the growth rate of the stock market over the same time period.
And when the head scratching stops, ask yourself where there have been more business failures, dividend omissions, and bankruptcies… in the CEF universe or in the stock market. And, with respect to bonds, just look inside a CEF and see the very same stuff your broker gets a 3% mark up on (in and out), just sitting there, in your CEF portfolio, free to trade in a liquid market, with no mark ups at all.
So just reinvest the ROC, understand the leverage, do the due diligence, and by all means take your reasonable profits willingly, actively, and with a very large smile on your face. There›s no such thing as a bad profit, even after taxes. ◊