Financial Planning Tip of the Month
This month we are going to talk to you about a couple of investment strategies that we have been employing off and on for several years. We saw some opportunities present themselves recently and we have taken advantage of them.
The strategies are as follows:
The first is what we like to call "Buying Assets at a Discount".
The second is "Getting Paid While You Wait".
Let me share some details in an attempt to help you understand these strategies.
First, "Buying Assets at a Discount".
Here is an example:
If I wanted to buy 100 shares of an XYZ exchange traded fund (ETF), I would place a trade and buy the shares at the next available Market Price available on a stock exchange. The Market Price is determined by supply and demand and the underlying fundamentals of whatever the ETF invests in.
If I wanted to buy $5,000 of my favorite mutual fund, I would place a trade and get the number of shares equal my investment amount divided by the next available Net Asset Value (NAV). If the NAV was $100, I would get 50 shares. Net Asset Value is simply the total of the values of all the investments in the fund divided by the total number of shares outstanding.
Now, let me introduce you to Closed End Funds (CEFs).
CEFs throw another wrinkle into the mix...CEFs have both a Market Price and a NAV.
If you pull up a quote on a CEF, what you are seeing is the Market Price. You need to dig a bit further and do some research to find the NAV. The important thing to understand here is that when you buy a CEF, you are buying at the Market Price NOT the NAV...much like the ETF example above. Now, here's the part we really like. If you carefully track the CEF market (as we do), you can find times when Market Prices fall significantly below the NAVs. This occurred from October into December when the stock market completely fell out of bed.
We found 2 CEFs that we have been following for years that hit historically high discounts to NAV and added then to our portfolios.
Since purchase in December, both have performed well.
Our strategy is to hold the funds until a reversion back to the NAV occurs (already starting) and then reassess. Once the discounts are reduced or eliminated, we typically will consider selling.
Please note: Most CEFs employ financial leverage. Leverage is borrowing for the purpose of additional investments and does have risks involved. Therefore, one must use caution when investing in CEFs. However, when used appropriately and at the right times, leverage can have a significant impact on the total return of a portfolio.
Next, we want to tell you "Getting Paid While You Wait".
We have seen ample opportunities to employ this strategy lately as well. Generally speaking, we have moved to a more defensive stance within our equity allocation focusing on dividends and income. This sort of falls into this category but we want to share a much better example.
Months ago, we exited almost all direct exposure to energy and fortunately missed a tremendous fall in the price of both oil and oil stocks.
We have been watching very closely for opportunities to present themselves.
Well, one did a couple of weeks ago and we jumped on it.
Master Limited Partnerships (MLPs) got absolutely hammered from September to December, losing anywhere from 25-40% of their value. Without getting into specifics and lots of legalese, we just need you to know that many oil and gas companies issue MLPs instead of corporate stock. MLPs are known for offering income-oriented investments related to oil and gas pipelines. Because they earn an income that is often based on long-term service contracts, MLPs are conducive to offering steady cash flows, which lead to consistent cash distributions. This enables MLPs to offer attractive income yields (often higher than the average dividend yield of equities).
When market prices fall, the income distributions do not necessarily follow; creating another anomaly that we like to call "Getting Paid While You Wait".
Here is an example to better explain:
As part of the major selloff in energy, MLPs dropped significantly in the fourth quarter of last year. Before the drop, the average MLP had a yield of approximately 6%. As an example, let's say the price of ABC MLP was $100 before the drop. A 6% yield would be $6 in annual income. Make sense? Now let's say this particular MLP dropped in price to $60 in the steep decline that occurred. Just because the price dropped does not mean the $6 in annual income changed (it is important to do research to gain confidence that the income will continue). So now our $60 ABC MLP is paying $6 equaling a 10% yield. You gotta love math tricks!
We felt the worst was likely over with the slide in energy prices. We felt comfortable knowing that even if there was a bit more downside, we were content to "GET PAID WHILE WE WAIT" for energy prices to recover. In other words, we will get a 10% yield as we own the MLP and wait for it to go back up to a price that we would consider selling at. Truth be told, we sold the exact MLP at $26.05 on October 12th and bought it back on December 20th at $19.28. It closed today at $23.69 and we will get a $0.655 quarterly dividend in February.
Please let us know if you have any feedback or questions.
We would love to hear from you !
We are looking forward to working with you to make 2019 a wonderful year.