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Summary CEFs are great at paying distributions for those seeking income. That said, some CEFs appear to be “too good” at this increasingly desirable trait. What is a sustainable distribution and when should you worry? Try this case study on for size. Closed-end funds, or CEFs, are great at providing investors income, something that most other pooled investment vehicles don’t do as well. However, there’s a fine line between providing investors a nice yield and drawing down net asset value, or NAV, to sustain what might really be an unsustainable distribution. If you are looking to buy and hold a CEF, at what point should you worry about the yield? A tale of two managed distributions How much is too much? That’s a tough question to answer across the entire closed-end fund universe because CEFs do so many different things in so many different ways. For example, a high-yield bond CEF’s distribution is inherently different from a short-term municipal bond CEF’s distribution. And both are different from a stock CEF’s distribution. So, the first thing to consider when looking at CEFs is to make sure you are comparing apples to apples. And that includes taking into consideration such things as leverage and option strategies. That said, let’s look at two funds that are exactly the same in all respects. Fund One has a 10% managed distribution policy, whereby it pays out 2.5% of its NAV every quarter. Fund Two has a 6% managed distribution policy, paying 1.5% of its NAV every quarter. What do the distributions look like? Over a four-year period in a generally rising market, Fund One’s NAV started out at $9.13 a share and ended at $8.07 a share. Over that span, it paid $0.15 a share from income it received, $2.85 from capital gains, and $0.54 from return of capital. Despite the fact that the broader market was heading generally higher over the span, Fund One lost over $1.00 a share in NAV. True, it paid investors handsomely via distributions, but its distribution policy was leading to a shrinking NAV. Fund Two, meanwhile, over a four-year span with a generally rising market, watched its NAV rise from $4.21 a share to $5.35. Over the four years it paid out $0.84 in distributions from income, nothing from capital gains, and $0.44 in return of capital. But, the NAV increased by a touch over $1.00 a share. Note that the market was moving generally higher through both four-year spans. In other words, Fund Two was able to grow its NAV at a time when you would expect it to be growing its NAV – something that Fund One didn’t achieve. The big reveal! The biggest difference between Fund One and Fund Two was their distribution policies, because both funds are the Liberty All-Star Equity Fund (NYSE: USA ). The first set of data came from January 2004 to December 2007, when it had a 10% distribution policy in place. The second set of data came from January 2009 to December 2012 when the fund had shifted to a 6% distribution policy. That move took place in early 2009 . USA data by YCharts USA data by YCharts I chose those end dates specifically because I wanted to track generally rising markets and avoid the disastrous performance the fund had in 2008. In that year, the fund’s NAV fell from $8.07 a share to $4.21. Distributions in 2008 were $0.07 from income and $0.58 from return of capital. Essentially, almost 90% of that year’s distribution was return of capital. It was a rough year for almost all investors and investments, to be sure. And Liberty All-Star Equity Fund wasn’t alone in dipping into capital to maintain its distribution. However, it isn’t a coincidence that the managed distribution plan was adjusted a year later in 2009. According to the fund’s board of directors, The change was adopted primarily to better align the Fund’s distribution rate with historical equity market returns. What does that mean? Historically, the stock market has returned roughly 10% or so a year, on average. If a CEF pays out 10% of its NAV every year, it is, essentially, returning everything that an investor might reasonably expect it to make – every year. That requires the CEF to beat the market in order to increase NAV. Fall short and the NAV will fall, which is pretty much what happened for “Fund One.” If, instead, the target is 6%, the CEF has a cushion. It can fall short of the market’s long-term average return and not eat into NAV when it pays distributions. Moreover, if it does better than 6%, it can actually grow its NAV over time. This is the benefit that “Fund Two” enjoyed above. To be fair, the markets in both periods were very different. And the fund uses a collection of outside mangers, which change over time. So there are factors beyond the distribution policy that impacted performance in both periods. However, this is as close as I think you can get to apples and apples in the investing world. It depends Of course this is just one example from what is, generally speaking, an unremarkable fund. For example, Liberty All-Star Equity Fund underperformed the S&P 500 Index by roughly three percentage points over each of the trailing 3-, 5-, and 10-year periods through year end 2014 on a total return basis (which includes distributions), according to Morningstar. But, it provides food for thought when looking at CEFs with big yields. You need to ask yourself if the level is sustainable over time. That’s particularly true for distributions that are at the complete discretion of the board of directors. In fact, target percentages are easier to deal with in some ways because they will, inherently, adjust up and down as the fund’s NAV and performance change over time. Good years you’ll get more, bad years you’ll get less. A static distribution based on what is, essentially, the board’s whim, will result in increasingly larger yields when the market is heading south and can set up dividend cuts. Of course, there are a host of other factors involved in deciding what CEFs to buy and which ones to avoid. Premiums and discounts, asset class, investment policy, etc. But, if you are looking for income, Liberty All-Star Equity Fund is a good case study in the difference that distribution choices can have on NAV. When all is said and done, the moral of the story is to think long and hard before you simply chase a yield in CEF land.
Buffett’s words should be heeded concerning Southern Company: “Price is what you pay. Value is what you get”. Compared to 5-yr average fundamentals, Southern Company looks expensive. While not a seller, I would not be a buyer either. However, investors should evaluate their dividend reinvestment position. Many readers know I have been bullish on Southern Company (NYSE: SO ) for some time. Over the previous two years, I have written eight articles focused on SO. With the recent spike in price to the $53 range, SO is now overvalued. At its current price, while I would not be a seller, I would not be a buyer either. “Price is what you pay. Value is what you get,” says Warren Buffett. While SO is a strong utility with a bright future, the value investors are buying is not as attractive as a few months ago. Below is a comparison of current valuations vs SO 5-yr average. The corresponding price is the valuation of SO at each of these 5-yr averages. As shown, these fundamentals indicate SO is overvalued compared to its averages since 2009. Source: Morningstar, MyInvestmentNavigator.com Earnings have been reduced recently due to write-offs of cost overruns at their Kemper project. There are questions being raised as to first $900 million cost overruns on the Vogtle power plants as the resolution has now been passed to the courts. The consensus belief is SO will win these lawsuits based on the terms of their contract. However, delays from the planned fourth-quarter 2017 and fourth-quarter 2018 start dates seem inevitable, and could lead to future charges against earnings. Southern Company still has several very positive trends that should continue to reward shareholders. The regulatory environment is quite favorable in its service territory. Return on invested capital ROIC is one of the best in the business at a 5-yr average of 6.75%, even after a dismal 2013 at barely over 5%. Unlike many of its peers, SO’s ROIC is above its weighted average cost of capital WACC of 4.2%. Southern Company has earned an A- rating by S&P Capital IQ for 10-year consistency in earnings and dividend growth. The rating puts SO in the top 3.3% of all companies reviewed by S&P and in the top five management teams for the entire utility sector. These are very admirable qualities for long-term investors. Concerning distributed generation, CEO Fanning is on record as embracing this potentially disruptive power trend. In an interview last year, he is quoted, Fanning touts efforts by Southern subsidiary Georgia Power to promote both utility-scale solar as well as distributed generation. “If somebody wants to buy distributed generation, I want to sell it to ’em. I’m completely happy to do that.” To support that effort, rate structures will have to be redesigned, something Fanning thinks state regulators will be “constructive” about supporting. “You need to do it fairly. There are three components of that. One is revenue , which should be done at avoided cost. Second — it is not net metering; that is a flawed concept. Second is a fair charge for connection to the network, and third is a fair charge for the backup generation and the energy when the wind is not blowing and the sun does not shine. As long as you do that right, we’re 100 percent in,” Fanning said. “This is something where we’ve got to play offense.” Morningstar rates SO with only 2 Stars, not a very compelling value. Their unique Bulls and Bears comments from the latest update in early Dec are: Bulls Say: Southern operates in the business-friendly Southeast, where its traditionally low power prices and sterling reputation help to foster a constructive and stable regulatory atmosphere. As of mid-November, Southern’s dividend yield was 4.5%, well above its peers’ [Author’s note: with the recent run-up in prices, yield is 4.0%]. With a stronger business model and premium returns, the yield premium is appealing in an otherwise overvalued sector. Business investment continues to head to the Southeast, which bodes well for the region’s economy and Southern’s customer base even though residential demand has remained tepid. Bears Say: Southern burns a lot of coal, so complying with carbon emissions and coal ash regulations could require significant investments that would raise customer bills, discourage usage. We include $500 million of potential cost overruns at Vogtle that we project Southern will not be able to recoup in rates and $200 million in extra owners’ costs. These figures could go much higher in a worst-case scenario. Utilities suffer in times of inflation and rising interest rates. Inflation erodes the value of the rate base on which a utility’s allowed returns are calculated. This is where an automatic dividend reinvestment program becomes a bit dicey. Although I wrote a book on DRIPs in 2001 for McGraw Hill, All About DRIPs and DSPs , reinvesting dividends in SO at the current price seems a bit risky. Accumulating the dividend in a cash account for reinvestment in other income stocks may be preferred until SO’s fundamentals improve. While Southern Company is replacing its coal generating capacity with low-cost nuclear, has one of the best management teams in generating Net ROIC, is in a growing service territory with friendly regulators, and is embracing distributed solar generation, the current share valuation leaves much to be desired. Waiting for a better valuation would be prudent. Author’s Note: Please review disclosure in Author’s profile.