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Preferred Shares From Flaherty & Crumrine: 1 To Buy And 1 To Sell

Summary Flaherty & Crumrine is a preferred stock specialist offering five leveraged and hedged closed-end funds. There has been a strong trend of investment money moving into preferred stock CEFs as the high-yield credit market has faltered. FFC now holds a premium over 8%. Flaherty & Crumrine’s Preferred Stock CEFs There are categories of closed-end funds where I consider that a single sponsor offers a range of funds that make it the best in its class. For taxable fixed-income CEFs, my vote goes to PIMCO. Other fund sponsors offer some excellent competitors, but PIMCO’s full lineup is demonstrably the best in its category. For unleveraged equity-income CEFs, it’s hard to beat Eaton Vance’s array of option income funds. It would be hard to make a case that any other fund sponsor has the across-the-board strength in this category that Eaton Vance’s funds have. I’ve written about each of these recently ( How Safe Are The Distributions For PIMCO CEFs…? and Comparing The Option-Income CEFs From Eaton Vance ) where I give some rationale for those choices. I also have a comparable pick for preferred shares; it’s Flaherty & Crumrine. F&C offers five closed-end funds for the investor in preferred securities: Flaherty & Crumrine Dynamic Preferred & Income Fund Inc (NYSE: DFP ) Flaherty & Crumrine Preferred Securities Income Fund Inc (NYSE: FFC ) Flaherty & Crumrine Total Return Fund Inc (NYSE: FLC ) Flaherty & Crumrine Preferred Income Fund Inc (NYSE: PFD ) Flaherty & Crumrine Preferred Income Opportunity Fund Inc (NYSE: PFO ) We’ll have a look at them individually shortly, but first a few words on the category and asset class. Why Preferreds and Why CEFS? Preferred shares should be a core component of any income investor’s portfolio. They offer stable income with much less price volatility than common stock. They are, of course, interest-rate sensitive as are all income investments, but I am more concerned about volatility in common stocks than I am about volatility from interest-rate moves at this time. I fully expect the Fed will be true to its stated goal of gradual interest rate increases, and I further expect that experienced management can prosper under those circumstances. On the other hand, I am anticipating a difficult year for common stock, and those who have followed my thinking are aware that I am not usually found at the bears’ end of the spectrum. With that in mind, I continue to seek out more defensive positions in my portfolios. Thus, I consider a portfolio shift that reduces exposure to dividend-paying common shares and increases exposure to preferred stocks to be a prudent move. Note that I say “reduces,” a very different thing from “eliminates.” I will still carry a strong position in common shares, but I will also be increasing my allocation to preferreds. One can hold preferred shares in individual equities or ETFs, but it is my preference to look for exposure to this asset class in closed-end funds. It is one of the three areas where I feel CEFs offer the greatest opportunities for income-investors. Let’s explore why. Presently, the median distribution yield for the 17 CEFs that aggregator sites list for the category is 8.32%. Compare that with the two largest preferred stock ETFs, the iShares U.S. Preferred Stock ETF (NYSEARCA: PFF ) and the PowerShares Preferred ETF (NYSEARCA: PGX ); these both have a distribution yield of 5.92%. Furthermore, I suspect investors holding a portfolio of individual preferreds will be averaging something fairly close to that yield percentage as well. So if 6% is the prevailing bar for preferred stock yields, where do the CEFs find those extra two and a third points? First, they use leverage. Median leverage for the 17 CEFs is 33.58%. Notice that if we apply that 1.33x leverage factor to the ETFs’ 5.92% yields, it works out to 7.91%. While this is still under the CEFs’ median yield to their investors, it is nearly identical to the CEFs’ median yield on NAV which is 7.86%. So, it seems that the CEFs along with the ETFs and individual share holdings are all generating close to the same level of yield. The CEFs get an added kick that pushes them to even higher yields from their discounts. The median discount stands at -7.11%. This generates an additional 41bps to the market yield over the NAV yield and illustrates the importance of buying CEFs at a discount. It is the combination of leverage and discount that drives the enhanced yields for CEFs over the EFTs. Of course, leverage adds risk, primarily as a multiplier of volatility. Leverage also adds to interest-rate risk as rising rates will make leverage more costly. Why Flaherty & Crumrine? Flaherty & Crumrine has been focused on the preferred shares market for over 30 years. The firm formed in 1983 as a manager of portfolios of preferred securities for institutional investors. It introduced its first leveraged and hedged preferred securities funds in 1991. Through its experience in the preferred securities markets, Flaherty & Crumrine has developed expertise to implement portfolio- and interest-rate management strategies to obtain consistently high levels of sustainable income. This expertise is key to functioning effectively in what the firm describes as a ” wonderfully inefficient market .” When appropriate, the F&C funds employ hedging strategies designed to moderate interest-rate risk. These are designed to increase in value when long-term interest rates rise significantly, from either a rise in yields of Treasury securities or interest-rate swap yields. In general these are used when interest rates are expected to rise. From the current literature I reviewed, it is unclear the extent to which these hedging strategies are currently employed. The Funds Each of the five funds is leveraged near 33%, which is consistent with the category. Each is invested in at least 93% preferred stocks. All but DFP are wholly domestic; DFP is 77.2% domestic with the remainder of the portfolio holding positions from U.K., Bermuda, Western Europe and Australia. F&C’s funds tend to be more tax efficient than many other preferred shares CEFs. For the 2014 tax year qualified dividend income ranged from about 62 to 70% of total distributions. (click to enlarge) I have not reviewed the category for this metric, which is significant in a taxable account, but previous analyses showed other sponsors’ funds with levels of QDI generally under 50% reflecting, in part, greater exposures to REIT preferreds. Portfolios Portfolio compositions are quite similar among them. Each is most heavily invested in financials (ex. REITs) which comprise greater than three-quarters of their portfolios in a roughly 2:1 ratio for banks:insurance. (click to enlarge) PFD and PFO do not list energy or REITs separately; instead they are lumped into “other” sectors. A cursory perusal of the published portfolios indicates a significant fraction of “other” does include energy, but I have not attempted to sort out actual percentages. DFP has the largest energy holdings of the other three funds. Utilities comprise about a ninth of the portfolios of FFC, FLC, PFD and PFO, but only 2.76% of DFP’s holdings. Performance Total return for one year is shown in the next chart. (click to enlarge) And, for the past 3 months: (click to enlarge) As we can see here, there has been a strong flow into the preferred shares funds over the past quarter driving price up relative to NAV. As a consequence, discounts have shrunk and in the case of FFC, valuation has grown to a premium. (click to enlarge) The rising prices relative to NAV for the funds is shown in the 3, 6 and 12 month Z-scores which are positive except for PFD and PFO 12 month values. (click to enlarge) The discounts and Z-scores show that bargain hunters will find little to take advantage of at this time. This has been a trend across the preferred shares category which has median Z-Scores of 0.89, 1.31 and 0.14 for 3, 6 and 12 months, respectively. The shrinking discounts mean that distribution yields are somewhat lower than when I last looked at preferred CEFs in early autumn. Distributions range from 8.06 to 8.5%, in line with the category median of 8.32%. (click to enlarge) Conclusions FFC has been a favorite of mine in the recent past and it is a fund I have held for some time, adding to my position as recently as last September. But at this time its 8% premium makes it an unattractive purchase. Indeed, anyone holding the fund may want to consider trading out of it to capture that premium which I suspect is near a peak value. This is what I have done. FLC is, in my view, the most attractive of the remaining funds. It has a distribution yield better than the category median. Its -4.0% discount is less favorable than the category median of -7.1% but is the deepest discount of the fully domestic F&C funds. Total return on NAV for the past year is stronger than FFC, even as FFC’s growing premium has driving its return on market price appreciably higher. And the exposure to energy preferreds is the lowest of the three funds where that is explicitly listed. DFP, with the same yield and a deeper discount is less appealing to me. The relatively high level of energy-sector preferreds is potentially problematic for one thing. In addition, there has been a stronger trend to discount reduction relative to FLC. If one is attracted to international exposure in preferred stock CEFs, it might be worthwhile to look more closely at the First Trust Intermediate Duration Preferred & Income Fund (NYSE: FPF ) rather than DFP. Preferred shares look increasingly to present a timely alternative to the troubled high-yield credit market for income investors. Flaherty & Crumrine offers the preferred shares investor nearly three decades of experience and five funds with strong long-term records. The firm uses hedging strategies to moderate interest-rate risk, potentially an important approach in the coming year. Money flow has been moving out of high-yield bond funds; it seems that some of that flow has been moving into preferred share funds. This has meant discount reductions for the category and, in some case, such as for FFC, premiums to NAV. One might want to take advantage of the rising valuations and trade out of fund like FFC which is unlikely to sustain its premium valuation, while retaining a position in F&C’s hedged and leveraged preferred share funds by opening a position in FLC instead. While I do, as stated, like F&C in the preferred shares CEF arena, there are other funds that should be competitive. I shall be looking at a few of those shortly.

Ride The Coming 4th Wave Of Wealth Creation With This ETF

Summary Rising yields generally mean the economy is improving, which should benefit companies that depend on corporate and consumer spending. Technology is at the edge of another transformative wave. The acceleration of global population aging is going to drive demand across the biotech sector. Ride the coming transformative wave with this unique ETF that targets both technology and biotech and has consistently outperformed the broader market by a wide margin. Michio Kaku is a world-renowned, American futurist and theoretical physicist. He is a Professor of Theoretical Physics at the City College of New York (CUNY). Kaku has written several books about physics and related topics and has made frequent appearances on radio, television, and film. I recently had the pleasure of listening to him speak at an event in Boston. During his talk, he described the past three waves of wealth generation and shared his vision of how technology will shape the future. The question today is: what is the fourth wave? The first wave was steam power, the second wave was electricity, the third wave was high technology – all of it unleashed by physicists. What is the fourth wave of wealth generation? It’s going to be on the molecular level: nanotech, biotech and artificial intelligence . – Michio Kaku. According to Kaku, we’re at the edge of another wave of technological transformation. The world is growing increasingly dependent on technology. Products and services based upon or enhanced by information technology have revolutionized nearly every aspect of human life. The use of IT and its new applications has been extraordinarily rapid across all industries and an IT-Biotech convergence is already well underway. The acceleration of global population aging and technological breakthroughs are going to drive demand across the biotech sector. Longer life spans and increasing rates of chronic conditions will continue to fuel demand for new products and services. Nanotech breakthroughs will spur innovations across a wide range of applications in biotech and healthcare, potentially curing human illness. Multiple platform technologies working in combination – nanotechnology, biotech/genomics, artificial intelligence, robotic and ubiquitous connectivity – are going to lead to increasing profits for the dominant players utilizing these technologies. Many ETF issuers are coming up with innovative concepts targeting these technological transformative areas. The iShares Exponential Technologies ETF (NYSEARCA: XT ), with an annual expense ratio of 0.30%, attempts to track the developed and emerging market companies which create or use exponential technologies such as big data and analytics, nanotechnology, medicine and neuroscience, networks and computer systems, energy and environmental systems, robotics, 3-D printing, bioinformatics, and financial services innovation. (click to enlarge) There are funds targeting cloud computing such as the First Trust ISE Cloud Computing Index Fund (NASDAQ: SKYY ), which has annual expense ratio of 0.60%. The Robo-Stox Global Robotics and Automation Index ETF (NASDAQ: ROBO ), with an annual expense ratio of 0.95%, targets the robotics industry or you could own the Purefunds ISE Cyber Security ETF (NYSEARCA: HACK ), for 0.75% per year, which holds a portfolio of companies in the cyber security space. SKYY and HACK both follow the technology sector solely while ROBO and XT follow multiple sectors. Although many of these ETFs hold a few well-known, large-cap companies, most are fairly expensive and have so far proven to be more volatile than the broader technology sector. Because they have a short history, and until many of the smaller Exponential Technology companies achieve consistent profit growth, I prefer to ride the coming tech-biotech transformative wave with a portfolio of large, high-quality companies – market leaders within their respective industries, with a history of delivering consistent revenue growth. These large-cap market leaders are, no doubt, aware of how emerging technologies might bring them new customers or force them to defend their existing bases or even inspire them to invent new strategic business models. Many successful small-cap companies with disruptive technologies will eventually become dominant large-cap players. In fact, the NASDAQ’s dominant players have changed drastically in the last 15 years and probably will look much different in the future. You can capture this large-cap dynamic dominance with one of our favorite, can’t miss ETFs, the tech-heavy PowerShares QQQ ETF (NASDAQ: QQQ ), a unique fund that targets both technology and biotech and has outperformed the broader market by a wide margin for more than a decade. (click to enlarge) The QQQ is an ETF based on the NASDAQ 100 Index. The Index includes 100 of the largest domestic and international non-financial companies listed on the Nasdaq Stock Market based on market capitalization. The fund is rebalanced quarterly and reconstituted annually. Besides being a 5-Star Morningstar-rated ETF with an expense ratio of just 0.20%, QQQ has delivered consistently superior returns during most time periods over the last decade. QQQ Sector Allocation: (click to enlarge) The top 10 holdings of QQQ consist primarily of U.S. technology, and also include Gilead Sciences (NASDAQ: GILD ), a major biotechnology firm, Amazon (NASDAQ: AMZN ), an e-commerce retailer and Comcast (NASDAQ: CMCSA ), a media/entertainment giant. QQQ Top 10 Holdings: (click to enlarge) In addition to the technology names in the above graphic, the QQQ holds another 36 big-tech firms including Qualcomm (NASDAQ: QCOM ), Texas Instruments (NASDAQ: TXN ) and Baidu (NASDAQ: BIDU ) to name a few. Besides Amazon and Comcast , there are 31 additional Consumer Discretionary names including Netflix (NASDAQ: NFLX ), Tesla (NASDAQ: TSLA ) and Priceline (NASDAQ: PCLN ). And besides Gilead, the QQQ’s biotech holdings consist of 15 more companies including Celegene (NASDAQ: CELG ), Amgen (NASDAQ: AMGN ) and Biogen (NASDAQ: BIIB ). Over 55% of the QQQ is tech. Technology is a cyclical industry. When the economy gets stronger, cyclical sectors like technology have tended to generate higher revenues from increased consumer and corporate spending. So its relative performance tends to rise and fall with the strength, or lack thereof, of the economy. However, a number of technological innovations – from nanotech applications to cloud computing to mobile connectivity – are spurring migration to new technologies. This migration may continue regardless of the overall condition of the global economy. Some solid, pure technology funds include the Technology Select Sector SPDR ETF (NYSEARCA: XLK ), the iShares U.S. Technology ETF (NYSEARCA: IYW ), the Vanguard Information Technology ETF (NYSEARCA: VGT ) and the Fidelity Select IT Services Portfolio (MUTF: FBSOX ). However, the aforementioned funds are primarily all tech and not the unique mix of the QQQ. The world’s dependence on technology and the acceleration of global population aging are two megatrends that should drive performance for years to come. Seventy percent of the QQQ’s holdings focus on well-established, high-quality technology and biotech companies. The fund’s consumer discretionary stocks should also benefit from an improving economy while the fund’s consumer staples stocks add a defensive component to the mix. Let’s take a look at how the QQQ has performed over various time frames. The newer Exponential Technology ETFs don’t have a long-term performance record so they cannot be included in this comparison. As you can see in the table below, the QQQ, with its unique structure of one-half tech, one-fifth consumer discretionary and one-seventh biotech, has outperformed the S&P 500 and just about every other large-cap technology fund during most time periods over the past decade, including the iShares S&P 500 Growth ETF (NYSEARCA: IVW ), which holds the fastest growing half of the S&P 500 stocks. QQQ is a kind of quirky fund, but it works. It delivers a unique combination of tech-biotech, growth and large-cap exposure. 10-Year Performance: (click to enlarge) Conclusion Rising yields generally mean that the economy is improving, which should be good for technology and growth companies that depend on corporate and consumer spending. Big tech and biotech companies have the potential to capitalize on two mega-trends for years to come – the increasing global dependence on technology and the acceleration of global population aging. QQQ is in a strong position to benefit from these favorable trends. As Michio Kaku says, “Don’t bet against technology. Be a surfer. Ride the wave of technology, see the wave coming, get on the wave”.

Consolidated Edison – An Unsettling Look At Shareholder Yield

In a prior commentary I looked at the “shareholder yield,” that is dividends and share repurchases, for Coca-Cola and Exxon Mobil. In both instances the shareholder yield was greater than the dividend yield. Alternatively, a company like Consolidated Edison has a shareholder yield that has been routinely lower than its dividend yield. In a previous article I compared the “shareholder yield” of both Coca-Cola (NYSE: KO ) and Exxon Mobil (NYSE: XOM ). The idea was to take it a step further than simply looking at dividend yield, and instead focus on funds used for both dividends and share repurchases. As a part owner, share repurchases are commonplace. Yet if you owned the entire business, there would be no need to repurchase shares and thus these funds could be diverted elsewhere. For Coca-Cola and Exxon Mobil, this meant that the “shareholder yield” – dividends plus buybacks – was reasonably higher than the ordinary dividend yield that you commonly see quoted. Exxon Mobil turned out to have a higher shareholder yield than Coca-Cola (it’s share repurchase program has more room and a lower valuation of purchased shares) but the takeaway was that both companies had the ability to send away more cash without impairing the business. Which brings us to a company like Consolidated Edison (NYSE: ED ). Unlike Coca-Cola or Exxon Mobil or any number of well-known dividend paying companies, Consolidated Edison’s share count has been increasing over the years rather than decreasing. Thus conversely the shareholder yield tends to be lower than the quoted dividend yield. Let’s look at the past decade to see what I mean: Year Divs Sh Re Shares Total / Sh Price Sh Yield 2005 $518 -$78 245 $1.79 $46.33 3.9% 2006 $533 -$510 257 $0.09 $48.07 0.2% 2007 $582 -$685 272 -$0.38 $48.85 -0.8% 2008 $618 -$51 274 $2.07 $38.93 5.3% 2009 $612 -$257 281 $1.26 $45.43 2.8% 2010 $640 -$439 292 $0.69 $49.57 1.4% 2011 $704 -$31 293 $2.30 $62.03 3.7% 2012 $712 $0 293 $2.43 $55.54 4.4% 2013 $721 $0 293 $2.46 $55.28 4.5% 2014 $739 $0 293 $2.52 $66.01 3.8% The first three numerical columns are in millions, while the next two represent a per share basis. On the dividend front we can see that Consolidated Edison has been paying more and more total dividends, as to be expected from a company with a long history of regularly increasing its payout . What’s not readily obvious until you take a closer look is that the company had been issuing a good amount shares during the 2005 through 2011 period. This makes sense when think about it – the business is inherently capital intensive – but it might not be something that you would instantly notice. As such, the share count has been increasing. The company had 245 million shares outstanding in 2005, which has now become 293 million. This makes a difference when you’re thinking like an owner rather than a small shareholder. Here’s a comparison of the shareholder yield and the dividend yield over the years: Year Div Yield Sh Yield Difference 2005 4.6% 3.9% 0.7% 2006 4.3% 0.2% 4.1% 2007 4.4% -0.8% 5.2% 2008 5.8% 5.3% 0.5% 2009 4.8% 2.8% 2.0% 2010 4.4% 1.4% 3.0% 2011 3.9% 3.7% 0.2% 2012 4.4% 4.4% 0.0% 2013 4.5% 4.5% 0.0% 2014 3.8% 3.8% 0.0% The first number is what you’re accustomed to seeing quoted on any financial website – a dividend yield in the 3.5% to 5% range. The next column – shareholder yield – illustrates what magnitude of cash is actually being returned to shareholders. Consolidated Edison was indeed paying the full dividend, but it was also receiving cash back from shareholders to increase the share count. If you owned Coca-Cola or Exxon Mobil or any number of other firms in their entirety, the amount of cash that would be available to you would likely be greater than the current dividend yield. When a company both pays a dividend and buys back shares, the shareholder yield is greater than the dividend yield. With Consolidated Edison you have the opposite effect take place. The amount of cash that can be extracted from utility-like business models (without impairment) is lessened when you think about owning the entire thing. Issuing shares is common practice in the utility world (and other worlds for that matter) but it likely wouldn’t be occurring if there was just one owner. (You wouldn’t buy more shares yourself, or you could, but that would simply be inputting more capital). Thus you have a couple other options: issue more debt or reduce the dividend payment. The second option is what is being illustrated in a “shareholder yield” way, but the first one is much more common. Incidentally, whether you own all of it or not, this is exactly what we have seen with Consolidated Edison in the past decade. Notice the difference in the 2005 through 2011 period and the 2012 through 2014 timeframe. In the first period you had an increasing dividend to go along with a good deal of shares being issued. In 2007 shareholders received $582 million in dividend payments, but gave back $685 million to add to the share count. You can call the dividend payment yield, but in the aggregate the company was actually a net beneficiary of cash received. The amount of funds available had been quite a bit lower than what the dividend yield alone would indicate. Notably, Consolidated Edison did not issue shares in 2012, 2013 or 2014. Which means that the shareholder yield was equal to the dividend yield in those periods. Yet there was still impairment during this time. The company had net debt issuances of $1.1 billion, $1.4 billion and $1.1 billion during those years. Instead of issuing shares, debt was used – much like what might be required if you owned the business in its entirety. The shareholder yield gives a reasonable gauge as to the type of cash flow that could be extracted from the business, but naturally it’s just a first step in the process. In this instance, it shows that while the dividend has been above average and increasing, the amount of cash than can be taken out of the business without impairment has been consistently lower than this yield. Warren Buffett had a particularly revealing commentary related to this concept (and incidentally Consolidated Edison itself) back in the 1970’s: “In recent years the electric-utility industry has had little or no dividend-paying capacity. Or, rather, it has had the power to pay dividends if investors agree to buy stock from them. In 1975 electric utilities paid common dividends of $3.3 billion and asked investors to return $3.4 billion. Of course, they mixed in a little solicit-Peter-to-pay-Paul technique so as not to acquire a Con Ed reputation. Con Ed, you will remember, was unwise enough in 1974 to simply tell its shareholders it didn’t have the money to pay the dividend. Candor was rewarded with calamity in the marketplace.” “The more sophisticated utility maintains – perhaps increases – the quarterly dividend and then ask shareholders (either old or new) to mail back the money. In other words, the company issues new stock. This procedure diverts massive amounts of capital to the tax collector and substantial sums to underwriters. Everyone, however, seems to remain in good spirits (particularly the underwriters).” Naturally today you can make a bevy of arguments (rock bottom interest rates, for one) that did not qualify back then. However, the concept is similar: the amount of money that can be taken out from owning the entire business is apt to be lower, not higher, than the stated dividend yield. Ideally you’d like to think in “owner’s earnings” terms, but the shareholder yield provides a short cut to get you started. Whereas a company that regularly repurchases shares has a bit of wiggle room (those repurchase funds could be diverted toward sustaining the dividend in dire times) a company issuing shares has the opposite effect occurring. A company that regularly issues shares has “negative” wiggle room. Now I’m not suggesting that Consolidated Edison is a poor business or that it’s bound for doom – far from it. Utilities tend to exist out of necessity and have been churning out cash for decades. However, looking at shareholder yield (and ultimately owner earnings) is a bit of a different way to think about it. If you owned all of Exxon Mobil you could pay yourself a 5% or 8% dividend in regular times and not put an added burden on the business. That is, the quoted dividend yield understates the amount of cash that could be extracted without impairing the company. With Consolidated Edison, this likely isn’t the case. If you owned all of Consolidated Edison, you’d be more likely to see a lower not higher percentage of cash being paid out. No longer would you be issuing shares and thus the focus would turn to added debt or a reduced payout. The debt could go on indefinitely, but the capital necessities are such that the current dividend payment coexists with other pressing requirements. When they say that you’re “buying it for the dividend” this could be even more applicable than it first appears.