Harness the power of synthesis with time-tested CEF

Co-authored with “Hidden Opportunity.”

In middle school physics, we learned about simple machines, basic mechanical devices that apply force and perform work. Think about one of the most important inventions in human history: the wheel and axle. Simply As it is, we wouldn’t survive without it. Cars, trains and almost all factory equipment would cease to exist. We will carry the load or use sleds or animal backs to move it.

Pulleys, wedges, and ramps are all examples of simple machines that help us in our daily lives, simplifying tasks that would otherwise be difficult to complete. The engineer in me can’t stop appreciating and talking about the simple tools and technologies that make our lives easier. Let’s go back to discuss some simple techniques to brighten your retirement life.

dividends The simple machines of finance are the ones that simplify the complexities of retirement life by regularly pumping cash into our accounts. No matter what the market does each day, I know that certain dividends will be credited to my account. This feeling is priceless.

They say the first million is the most difficult. This is because once a certain level of wealth is achieved, the power of compound interest plays an important role. When investments pay dividends and those dividends are reinvested, you can accelerate wealth building, making it easier (and more automated) to achieve millions in the future.

“Compound interest is the 8th wonder of the world. Those who understand it make money… and those who don’t… pay compound interest.” – Albert Einstein.

Like a simple machine that moves a complex machine, simple dividends combined with the power of compound interest are the secret to my healthy retirement. So that’s enough physics for today. Let’s look at two choices to make money.

Choice #1: RVT – 7.5% return

Financial markets ended fiscal 2023 with value stocks historically cheaper than any other type of security. The small cap value category has an average price/fair value ratio of 0.84%, implying a 16% discount, while large gap growth stocks have traded at a whopping 15% premium. The various recoveries from the 2022 bear market can be clearly seen in the chart below, with investors overpaying for growth stocks at a time when our economy is sliding into a recession. source.

A Goldman Sachs study found that the Russell 2000 has outperformed the S&P 500 in 80% of election years since 1984. source.

2024 is expected to mark a major change in the Federal Reserve’s interest rate policy, coinciding with an election year, and interest rate normalization will likely trigger a valuation reset, fueling a small-cap recovery in 2024.

Royce Value Trust (RVT) is a small-cap closed-end fund (CEF) managed by the same portfolio manager, Chuck Royce, since its founding in 1986. Although Mr. Royce will step down from his position as Senior Portfolio Manager effective 2022, the Royce Funds continue to benefit from his oversight and experience.

RVT It has a large diversification across 486 holdings, which is a very necessary requirement as small caps tend to be a riskier type of investment. The CEF is actively managed with a 2022 portfolio turnover of 60%. This means your holdings will remain in your portfolio for approximately 20 months. So it’s not surprising that a significant portion of RVT’s distributions over the past decade have come from long-term capital gains.

Industrial and manufacturing companies can benefit significantly from government incentives and initiatives to strengthen domestic manufacturing capabilities. This sector is RVT’s largest holding, accounting for approximately 24% of the CEF’s assets. The next largest sector is financials (about 19%), which continues to be at a large discount due to several bank failures and is expected to see a strong recovery from 2024 onwards with the normalization of interest rates.

RVT does not utilize leverage in its investment strategy and maintains a variable allocation that is adjusted quarterly based on NAV at the end of the trailing four quarters. This means that the distribution rises and falls depending on RVT’s NAV, but since it is calculated using the average of the last four quarters, the change in payment is gradual.

RVT’s management fee structure reveals a rare feature among CEFs, indicating significant incentives for management alignment with shareholder interests.

• Advisory fees may increase or decrease based on the fund’s performance relative to the S&P 600 SmallCap Index benchmark.

• Fund managers lose fees for any months in the past 36 months in which the fund has had negative performance.

At a discount of approximately 11% to NAV, RVT offers an excellent discount that could drive the recovery of the small-cap sector. Small-cap stocks are well-positioned for a strong recovery in 2024, and RVT is one of the best income-focused funds to ride that recovery. Backed by a time-tested proactive management strategy and a management team that cooks for itself, this CEF pays 7.5% to await a big valuation reset.

Choice #2: BTO – Yield 9.1%

It’s been 10 1/2 months since the FDIC closed Silicon Valley Bank, making it the third-largest bank failure in the United States. Mr. Market was afraid of the bank’s name and the local bank got the worst of his feelings.

Banks have become almost stock market outcasts as analysts of varying reputations and backgrounds attempt to predict the next “shoe to drop.” But the reality is that the Fed moved quickly and aggressively and there was no “contagion” in the sector, so to speak. Banks have recovered after their darkest days in 2023 but remain significantly undervalued.

Permanent rates are almost here, and historical market performance shows that banks perform better when interest rates peak or fall. This is because when interest rates fall, the market value of bonds rises, relieving pressure on banks and boosting their earnings and regulatory capital ratios.

RBC analysts point to two specific scenarios in which peak interest rates triggered a rise in the banking sector.

• 1994-95 interest rate cycle: The Federal Reserve planned a soft landing after raising interest rates from 3% to 6%. The interest rate hikes ended in February 1995, but stocks had bottomed a few months earlier and had rallied 55% in 1995-96.

• 2004-06 Interest Rate Cycle: The Federal Reserve, led by Chairman Alan Greenspan, kept interest rates rising from mid-2006 to the end of 2007. The stock rose until 2007, but then plummeted due to the global financial crisis, mainly due to credit problems.

Credit soundness was not a problem in 1994, but it became a critical problem for the financial sector in 2006, and the market results were very contrasting.

In today’s market, credit quality is closely monitored and sound. Banks have operated cautiously during QT, and their loss absorption capacity remains historically strong, demonstrating their readiness to manage an uncertain macroeconomic and regulatory environment. Average reserve coverage has increased to 2.2% for the seventh consecutive quarter, which compares favorably with pre-pandemic levels (1.6% in Q4 2019). Similarly, the bank’s CET1 ratio was above historical levels, averaging 11.4% compared to 10.9% at the end of fiscal 2022 and 10.8% at the end of fiscal 2019. Credit agency Fitch expects banks to continue to conserve capital amid ongoing regulatory uncertainty. Finalization of proposed capital rules. RBC Capital Management estimates that U.S. banks have set up enough provisions to cover credit losses and defaults in a scenario where unemployment is 5% (3.8% according to a December 2023 report).

Banks continue to recover from the March 2023 scare, both emotionally and fundamentally. We want to ride the recovery and get paid. John Hancock Financial Opportunity Fund (BTO) – CEF with up to 95% allocation to banks, capital markets and other financial services companies.

BTO’s distribution in 2023 was comprised of 62% long-term profits, 4% short-term profits, 17% net investment income, and 17% return on capital. We expect continued capital gains generation in 2024 as bank valuations improve.

BTO operates with ~18% leverage with a modest interest expense of 0.47%. This sets the fund up for increased returns along with the recovery of the banking sector.

BTO distributes $0.65 per share each quarter, reflecting an annualized return of 9.1%. Given the fund’s market tenure and demonstrated shareholder returns since inception, CEFs have always traded at a healthy premium to net asset value (often in the double digits). BTO is now trading at unprecedented prices.

In today’s report, we have discussed the past two record high interest rate (cuts) and the current banking sector parameters are similar to one. But market speculators tend to assume the worst in every scenario and only look for similarities in past troubled times. As an income investor, time spent in the market is money through sound distribution. BTO’s 9.1% yield provides a great way to drive the recovery of the banking sector.

conclusion

Tiny water droplets create a huge ocean. Retirement is a big ocean of worry and stress for everyone, but it can be simplified through multiple income streams. Our investment group maintains a model portfolio of +45 securities, targeting an overall return of +9%. We take pride in this diversification. No single source constitutes more than a single-digit percentage of our portfolio income.

We view dividends as a fundamental element of financial development and success. Combined with the power of compound interest, this can help you snowball your retirement income one dollar at a time. Starting early, investing regularly, reinvesting consistently, and making rational decisions are the keys to long-term wealth accumulation.

BTO and RVT are two time-tested CEFs that have successfully weathered numerous bear markets and recessions. Allocations to necessary but undervalued sectors, current yield levels and discounted valuations are attractive options for increasing portfolio income. All the complex equipment around us is built from simpler tools. We simplify complex retirement planning with simple, reliable dividends. In sickness and in health I get my share without any effort. That is the beauty of my income method and the extraordinary power of income investing.