Tag Archives: portfolio

Source Capital: Big Change Is Coming At This Closed-End Fund

SOR has a long and solid history. But the long-time portfolio manager has retired. The portfolio remake in the wake of his retirement changes everything. Source Capital (NYSE: SOR ) is one of the old timers in the closed-end fund, or CEF, world. Over the long haul it’s done pretty well, using a focused portfolio to opportunistically invest in small- and mid-cap companies with high returns on equity. But now that the manager is has retired, throw that history out. Source Capital’s advisor, FPA Group, is changing everything . Out with the old Source Capital’s now-retired manager was Eric Ende. He had been with FPA since 1984 and worked closely with the fund’s previous manager. He took over the fund in 1996 and basically kept running the fund the same way it had been run previously. But Ende has now retired. SOR data by YCharts Unlike the last manager transition, which was nearly 20 years ago, there’s no smooth hand off planned. FPA is taking an entirely new approach with the fund. That’s big news that current investors shouldn’t ignore. For starters, the fund will shift from an all-equity portfolio to a balanced portfolio that mixes stocks and bonds. Stocks will vary from 50% to 70% of assets and bonds will live in the range of 30% to 50%. This, in and of itself, isn’t a bad thing. But it is a vast change from the previous all-stock focus and shareholders need to be aware of the remake. Moreover, Source will no longer be keyed in on small- and mid-cap stocks. Over the next year or so the closed-end fund will be shifted to a globally diversified large-cap focus. Again, not a bad thing, per se, but a big change from what the fund had been doing for decades. There’s also a not-so subtle shift from what was more of a growth bias to a value approach that’s going to be part of this transition. There’s a couple of take aways here. The first is that the closed-end fund’s historical performance isn’t a useful guide anymore. That performance was built on an investment approach that no longer exists. So, for all intents and purposes, Source Capital should be looked at as a new fund. Second, the changes taking place will have a major impact on shareholders financially. For example, FPA expects 100% of the fund to turnover next year. Thus, every stock holding is set to be sold as it resets the portfolio to a new baseline. That will increase trading costs, but, more important, will lead to as much as $39 a share in distributions in 2016, according to FPA. Source Capital’s NAV was recently around $76 a share, so this is a really big event. And expect every penny to be taxable. Source is also going to initiate a stock repurchase program with the aim of reducing the closed-end fund’s discount to it net asset value. That discount is only around 10% right now, so it’s not a huge discrepancy. In fact, a 10% discount is the trigger for the buyback and about the average discount over the trailing three years. So this probably won’t be a big change. But combined with the portfolio remake and expected capital gains distributions, this has the potential to further shrink Source Capital over time. That could lead to higher expenses as there’s fewer assets over which to spread the costs of running the fund-which will now be run by a team of five managers. What should you do? If you’ve owned Source Capital for years, you need to rethink your commitment to the fund. It is no longer the same animal. Moreover, there’s no track record to go on anymore for this CEF and the next year is going to be one of material portfolio change. That, in turn, will lead to a large tax bill. If you like the idea of owning a balanced CEF, you might want to give the new approach some time to prove itself. But don’t look at the next year or so as the start of the new approach-the management team will need around a year to get the fund repositioned. You’ll need to sit through the transition and then start examining performance, perhaps using January 2017 as a “start” date for tracking the new approach. In other words, for a year or so, there’s no way to really know what you own here. If you don’t like the new approach or don’t want to sit through the portfolio makeover, then you might want to sell sooner rather than later. In the end, this is a big change and if you don’t buy in to it for any reason, you should get out. Yes, that could have significant tax implications for your portfolio, but the makeover is going to lead to a tax hit anyway.

KKR Income Opportunities: Good Entry Point For A 10% Yielder

Summary KKR Income Opportunities is a closed-end fund that invests in high-yield debt. A weak market in 2015 pressured the stock price and caused the discount to NAV to widen. Broad diversification, a large discount to NAV and a 10% yield make the current price a very compelling entry point. KKR Income Opportunities Fund (NYSE: KIO ) is a name that I have been watching with interest over the last few months. In this article I’m going to provide an analysis of the portfolio of this closed-end fund and explain why I think it is an interesting buying opportunity for income focused investors. What is KIO? KIO is a closed-end fund that provides a high level of current income by investing in a portfolio of loans and fixed income securities in the high-yield space. The fund makes use of leverage in order to enhance its yield and has a credit facility in place for this purpose – at the moment leverage stands at 32%. The company invests predominantly in BB – B – CCC rated securities and is almost evenly split between high yield bonds and leveraged loans, as you can see in their latest factsheet : The portfolio As we enter 2016 a characteristic that I search in a fixed income portfolio is a low exposure to interest rate risk. The portfolio’s duration is 3.4 years even though the average maturity is eight years. This low duration is achieved thanks to the allocation to leveraged loans, which generally offer a spread on top of the LIBOR rate and therefore have limited interest risk exposure. I believe the portfolio also is reasonably diversified, with a total of 95 positions and a concentration in the top 10 names of 32% of NAV. Sector concentration is a bit higher (44% for the top five industries) but what I particularly like is the absence in the top five of the energy sector. Considering how much money energy companies raised in the last few years and the weight of energy in high yield benchmarks (around 12%) I’m very pleased to see that exposure to this sector is below 6%. Credit to the management for that! As of the end of September the yield to maturity in the portfolio was 15.6% while the average coupon stood at 10.6%. As mentioned earlier the portfolio is leveraged with a loan to value of 32%. As of April 30th (date of the latest semi-annual report ) a credit facility was in place for a total of 145 mln at LIBOR + 0.825%. This facility expired on August 28th. I could not find the terms of the new facility but I suspect there must have been some worsening in the spread. The publication of the Annual Report (fiscal year ends on October 31st) will give some insight on this. One last thing that deserves to be mentioned is the management fee: KKR manages the fund and receives a fee of 1.1% of the Fund’s average daily managed assets. That means that also all the assets acquired thanks to the credit facility will pay the management fee. At the current 32% loan to value that means the fee is roughly 1.6% of net asset value. Investment thesis KIO currently trades around $14.4, a 13.9% discount to the most recent NAV. That compares with an average discount since the 2013 inception of 8.9%. I believe closed-end funds should trade at a discount to NAV given the often elevated fees and expenses associated but I believe such a discount should be between 5% and 10%. A 13.9% discount certainly has some appeal. Other two elements make that discount even more appealing to me: This is an income distribution fund: the yield currently stands at 10.45% and dividends are paid monthly. That means that you get a significant portion of your investment back at NAV even though you are investing at a large discount. The discount is close to peak in a disappointing year for high-yield securities. That means you are entering into a market that became cheaper during the year and you are doing so at a larger than usual discount. My biggest concern as I look at this investment is the possibility that the weakness in high yield/leveraged loans is not over yet. If we look at the S&P Leveraged Loans Total Return Index we see a peak to trough of 2.8% this year over six months. That compares with a 5.5% decline in 2011 over one month – in that occasion the decline was completely re-absorbed within six months. For the purpose of giving a complete picture I also have to add 2008: in that case the peak to trough was a massive 29% over six months. Although we can’t exclude a repeat of 2008 I have to say that I find it extremely unlikely. Credit conditions certainly relaxed over the past few years but they are not at the level of pre 2008 and, more importantly, banks have much higher capital cushions and are not as involved in the high-yield space as they used to be. In any case even in the dramatic situation of 2008 the S&P Leveraged Loans Total Return Index re-absorbed all losses within 11 months. Conclusions I believe the quality of the portfolio (measured in terms of diversification, exposure to the now “toxic” energy sector and duration) makes me comfortable in getting long KIO. However I can’t rule out further weakness in the months to come. As a result I’m starting a new position with an amount equal to 50% of my target allocation. The objective is to add to the position over the next few months in case of further weakness or keep it at current levels in case the decline in the market is over.

Noisy Market Hypothesis: Tilt Your Portfolio To Achieve Superior Returns (Part 1)

Summary In previous articles, we’ve shown how maintaining a diversified portfolio “beats the average retail investor”. In this articles, we will raise the bar and review the ways of “beating the market”. Initial building blocks (i.e. list of ETFs) for Satellite Portfolio are presented. This is the third article in the series that aims to develop portfolio investment approach that “beats the market”. The goal is to equip readers both with “knowledge about the path” and “confidence to stay on the path”. In the previous two articles, we’ve reviewed the ways of “beating the average retail investor”: These two articles serve as a practical guide to structuring core portfolio. We now move to the next step – satellite portfolio. We are raising the bar We saw what it takes to “beat average investor” and that doing so is pretty easy. All you need to do is maintain a diversified allocation to various asset classes. The key word is “maintain”; in other words, an investor should choose consistency over chasing the next “hot” stock or industry. As a reminder, please see the graph below; I hope that it will serve as a motivation: (click to enlarge) Source: J.P. Morgan and Dalbar Inc. Of course, managing emotions and staying the course is easier said than done. Especially, if your approach performed poorly for few years while your friend keeps on bragging about “that great stock” which made him a small fortune. How astonishing it is to see that few years of performance guide our long-term decisions. Just take a look at reactions that the second article in this series stirred up. It is true that commodities had very poor performance during last 4-5 years (and so did emerging market stocks). However, I wonder if half a decade performance warrants calling the commodities inappropriate for the portfolio [1]. History of the stock market is full with examples when the stock market pundits would conclude that some asset classes are no longer appropriate for portfolio, e.g. “stocks are dead” (typically, at the bottom of the market), just to observe market come back with a vengeance and prove all naysayers wrong. Putting short-termism aside, let’s go back to our long-term perspective. Commodity futures deliver equity-like returns (and risks as well) and have less than perfect correlation with stocks (i.e. provides diversification benefit). However, the focus of this article is not commodity futures, not even “Core Portfolio”. Our focus is “Satellite Portfolio” and how we can achieve even better returns through employing proven strategies. Our focus is on raising the bar. Noisy Market Hypothesis (NHM) and how to “beat the market” NHM provides a more realistic depiction of stock market dynamics when compared to Efficient Market Hypothesis (EMH). EMH claims that stock prices at every point in time represent the unbiased estimate of the true value of the firm. Such claims would have been true in ideal worlds where investors and speculators would not face liquidity constraints, tax considerations, institutional limitations, and many other externalities. Add to this list “popular delusions and madness of crowds” and you start questioning whether the even weak form of EMH is possible. I’m not suggesting to discard EMH. In the long term, information gets embedded in stock prices, but it may take a while. Quoting the “father of value investing” (Benjamin Graham): “In the short run, the market is a voting machine, but in the long run, it is a weighing machine.” In other words, in the short term, market “noise” might drive prices of particular stocks or even group of stocks significantly away from its intrinsic value and keep it there for a while. Just think of any stock market bubble. Unfortunately, taking advantage of such cases of mispricing is not easy. John Maynard Keynes reminds us that “the market can stay irrational longer than you can stay solvent.” As such one should expect that no trading strategy will consistently produce superior returns. This is one of the main implications of NMH. However, no need to despair. Based on academic research, Jeremy Siegel (father of NMH) concludes that over the long term it is possible to achieve better risk-adjusted return than holding very broadly diversified a portfolio. Jeremy Siegel mentions that taking advantage of “noise” might be achieved through “fundamental indexation” (i.e. weighting your holdings based on “fundamental factors”) instead of capitalization-weighted indexation. In other words, if the investor is able to stomach underperformance of his/her portfolio in short- and medium-term (which would be years), they might be well compensated in the long term for taking advantage of “fundamental factors”. We will discuss two of such fundamental factors – size (small caps) and style (value stocks) – in this article. Why value stocks and small capitalization stocks “beat the market”? Efficient Market Hypothesis (EMH) implies that strategy achieving higher absolute return is likely to be higher risk strategy. In other words, investors are compensated for taking the risk (only systematic risk, according to MPT) and, therefore, high risk equals potentially high return. As such, EMH advocates would claim that long-term outperformance of small caps and value stocks is due to higher risk. One can see why small caps would be a riskier proposition, however, value stocks are already selling at discount – how can they represent increased risk? One would expect that high-flying “hot” stocks with high multiples would expose investors to larger potential crash in price, compared to already “cheap” value stocks. However, EMH advocates would remind us about “value” trap. It’s when value stock continues to remain cheap for years and potentially keeps on getting worse. Instead of presenting you with arguments and counterarguments of various schools of thought, let me present you my version of why value and small-caps outperform. Small caps: Are riskier: typically higher volatility, higher chance to experience financial troubles (i.e. small to secure stable funding sources or access markets during rough patches). Are less liquid: low float, low trading volume, and higher bid-ask spreads. Are “under the radar”: not enough analyst coverage and institutional limitations (big asset managers or speculators might find it hard to establish meaningful exposure to single small-cap stock due to the limited amount of available issuance; at the end of the day, we are talking about small-cap stock). Value stocks: Might experience “value trap” (we will discuss how to address this concern in our next article). Are not “hot” names: typically boring names with seemingly mediocre stories. In “Stocks For the Long Run”, Jeremy Siegel presents information regarding the historical performance of small caps and value stocks from 1926-2012. For more details, please refer to his book; here, I’ve provided relevant excerpts: (click to enlarge) Source: Jeremy Siegel (click to enlarge) Source: Jeremy Siegel How do I know that small caps and value stocks will continue outperforming? Past performance is not a guarantee of future performance, isn’t it? “History does not repeat itself, but it often rhymes”. And, I think that’s the blessing for those who will follow the recommendations in these articles consistently and disregard short-term market gyrations. Just because history does not exactly repeat itself, investors tend to lose confidence in proven strategy after few years of underperformance. Some of the main reasons are thought to be human nature and memory. It is only human to throw away proven strategies and jump on the bandwagon as they face “this time it’s different” environment. This was the case during tulip mania of early 1600s and in recent history (just recall peak of the dot-com bubble in 2000). How many of such cases of mass disillusionment were experienced during these 400 years? And what lessons we learned? It either we believe that ” this time it’s different” or memories faded away since the last roller-coaster. Or, perhaps, we remember that experience vividly and will try to outsmart the market this time, by jumping off the train just before it falls into the abyss. There is, of course, an argument that market participants realized the existence of small cap and value phenomenon and traded up these stocks. Supporters of such arguments claim that due to “arbitraging away” these opportunities – small caps do not offer any alpha, it’s purely higher beta play and value stocks correctly reflect the valuation of less than stellar companies (again, no alpha here). We will review if such arguments are warranted in the future articles when we finalize our proposed allocations for a satellite portfolio. Before we discuss execution, let us draw a preliminary conclusion. As a group of investors continue jumping from one bandwagon to another in search of alpha, another more passive investors might benefit from staying put. Unless, you have a crystal ball, it’s advisable to identify portfolio allocation and don’t deviate materially from these target allocations. In the long term, tilting your portfolio in the direction of small caps and value stocks is expected to lead to superior returns. However, it might take years before you achieve superior return; markets might favor large caps and/or growth stocks for long stretches of time. List of ETFs For core portfolio, recommended allocations are presented in previous two articles. For satellite portfolio, I suggest tilting portfolio to small-cap stocks and value stocks. Following are ETFs that I recommend to achieve this goal: (click to enlarge) Source: Vanguard, and my own recommendations As you can notice, all four are Vanguard ETFs. I recommend Vanguard ETFs mainly because of their low fees (I am not affiliated with Vanguard and do not receive any compensation for recommending its products). There are other low-cost ETFs as well; typically, I use other ETFs for very specific tax reason. I will plan to cover this topic in my book (expected to publish in Amazon in December 2015 or January 2016) or potentially in the future Seeking Alpha articles. Following table provides a brief summary about the recommended ETFs: (click to enlarge) Source: Vanguard Size (i.e. small cap) and style (i.e. value) are not the only factors that historically proved to generate superior returns. We will discuss “other” factors in the next articles and determine sensible allocation to various factors. At that point, I will present detailed execution plan (i.e. the list of all ETFs and allocations to each). To conclude, the superior performance of small cap and value stocks (and some other factors that we will discuss in the next article) has been identified decades ago. However, the opportunity is still there. Maybe sometime in the future large portions of stock investors develop longer-term approach, bid up the prices, and bring systematic alpha of small cap and value stocks to zero. That “sometime in the future” could be a so distant phenomenon that might not even happen during my lifetime. To quote from John Maynard Keynes: “In the long run we are all dead.” In a meantime, I don’t mind additional 2-4% return compounding for decades. References/Bibliography Jeremy Siegel, The Noisy Market Hypothesis , Wall Street Journal, June 14, 2006 Jeremy Siegel, The Future for Investors: Why the Tried and the True Triumph Over the Bold , 2005 Jeremy Siegel, Stocks for the Long Run 5/E: The Definitive Guide to Financial Market Returns & Long-Term Investment Strategies , 2014 Next article: Noisy Market Hypothesis: Tilt Your Portfolio to Achieve Superior Returns (Part 2) Disclaimer: I’m not a tax advisor, please consult your tax advisor for any tax related matters. ETFs covered: The Vanguard Mega Cap Value ETF (NYSEARCA: MGV ), the Vanguard Value ETF (NYSEARCA: VTV ), the Vanguard Mid-Cap Value ETF (NYSEARCA: VOE ), the Vanguard Small Cap Value ETF (NYSEARCA: VBR ), the Vanguard Small Cap ETF (NYSEARCA: VB ) and the Vanguard Small Cap Growth ETF (NYSEARCA: VBK ) [1] Once again, I would like to highlight that I’m not supporter of buying spot commodities (e.g. gold bars, silver coins) – I suggest using commodity futures. I will plan to write an article on this topic in the future.