David Stein (02:42):
A lot of the inputs in the fertilizer comes from Russia and with the sanctions that has shot up the price of fertilizer 12%. So in a lot of the developing world, they’re not planning as much because if you put more money into what’s going into the ground, the risk is higher. And so farmers will often not plant as much, just because they can’t afford the fertilizer and they don’t want to take the risk. So there’s the potential for that.
David Stein (03:05):
But, and I did an episode on this recently, the good news is there’s, well, prices have shot up for corn, for wheat, for many other grains. Prices for rice have actually fallen 20%. There is a surplus of rice in the world. And that really came out of 2008 when there was a rice shortage and governments, farmers got together and now there’s plenty of rice. And so I don’t spend a lot of time worrying about famine.
David Stein (03:31):
When you think about commodities, I just saw a report by BofA, where they interviewed well over 200 managers. This is a regular report that they do. So these managers collectively manage about $800 billion. What they found in that is the most crowded trade, the trade that people are most long is commodities.
David Stein (03:50):
And I know we’re going to talk a little bit about being contrarian, but when I think about commodities right now, that aspect, a true contrarian is going short commodities right now. They’re not expecting oil to double from here. They believe everybody’s bullish on commodities because of inflation. The time to have bought commodities was two years ago, not today.
Trey Lockerbie (04:10):
I think that’s a very interesting point. And similarly related, there’s a lot of talk around stagflation. You mentioned inflation being high and we’re facing potentially a recession. I mean, we saw the yield curve invert, which is sometimes a signal of that. Are you of the belief that we are going to face a stagflation scenario?
David Stein (04:31):
No, I think it’s a risk. You talk about the other trade that people … Or the consensus. The consensus is a recession is coming. Now, if you look at the data, you go back to the last eight tightening cycles that the fed did, six out of eight led to a recession. But just because the fed is tightening, those recessions weren’t necessarily caused by interest rates.
David Stein (04:55):
Think about 2020 recession, the fed had been raising its fed funds rate for 36 months. The economy was slowing into 2018, 2019. The fed was on the cusp of a soft landing, they were going to land the plane. The economy was going fine, and then we get the pandemic. And we had the worst global recession, albeit short, since the Great Recession. It had nothing to do with interest rates, it had everything to do with governments, businesses, and households voluntarily shutting down to help prevent the spread of the virus.
Trey Lockerbie (05:27):
Now, last time you were on our show, you discussed the chaos surrounding Evergrande with Stig, it was episode 384, and you were correct in pointing out that Evergrande was different from Lehman, that was a narrative at the time, in that it didn’t have as much contagion risk for the global economy, since it primarily dealt with Chinese real estate. Can you catch us up on what has happened with Evergrande in the last six months? And are they out of the woods now?
David Stein (05:54):
No, if anything, they’re deeper in the woods. This last month, they announced, it might have actually been earlier this month, that they were delaying the release of their financial statements, that Evergrande stock has stopped trading. China gave companies the opportunity to sue Evergrande in court to collect. This is a highly, highly indebted company. And so if you’re a creditor of Evergrande, you’re going through the workout hoping to get some money back. But in terms of contagion, we haven’t seen it.
David Stein (06:24):
China has way bigger problems than Evergrande right now with the spread of the virus, with the … I just saw this report yesterday reported in the Financial Times, the birth rate in China was down 30% from today compared to 2019. China has a huge demographic crisis where some experts are seeing potential population cut in half by the end of the century.
David Stein (06:46):
China’s always been this huge growth story and it’s fascinating why China gets all this publicity on that aspect, but this is a … Yeah, there’s a lot of people live in China, but the population is not growing and it’s makes up less than 3% of the global stock market, less than the UK. And so China gets a lot of press, but I’m not bullish on China just because it has some very big demographic headwinds.
Trey Lockerbie (07:14):
Right. But on that point, I mean, who doesn’t, right? I think Japan’s been declining in a similar fashion and also the US is even, I think at 1.8. I think you need 2.25 or 2.5 births just to maintain and grow a population and we’re well below that. So is this a global risk that all markets are facing maybe 20 years from now or even sooner?
David Stein (07:37):
Well, there are areas of the world where the prime population age, working age population is growing and that’s the key. India, for example, has much more favorable demographics than China, so I have a meaningful position in India. But you’re right, the other thing to consider though is evaluation.
David Stein (07:55):
So Japan, yes, has some demographic challenges, but their stock market earnings yield relative to the average is much cheaper compared to the US, or even compared to China. And so you always have to look at well, what is baked in to the valuation of equities or other assets relative to the economic trends.
David Stein (08:16):
And the other thing is even in China, so I have a position in some of our models in smaller cap Japanese stocks, which have been able to sustain their growth rates, and so you can find your niche. But I agree with you that there are some demographic challenges throughout the world.
Trey Lockerbie (08:32):
So you mentioned that China’s stock market makes up only about 3% of the global market. And one interesting fact about China you mentioned on our show before is that the stock market is much smaller than the country’s contribution to the global GDP. What does that tell you about the future prospects of China and how does it compare to say the US stock market compared to the global GDP ratio?
David Stein (08:56):
What makes me worried about the US, which makes up 61% of the global stock market, but only about 20% of global GDP and their percentage, US’s percentages is shrinking. China, yeah, the stock market, the market capitalization will probably grow, but in order to do that, it’s not going to come necessarily from demographics, growing population. It’s going to have to come from greater productivity from Chinese companies becoming more efficient, from being more innovative and that often comes from top down. Is there an environment for Chinese companies to do that?
David Stein (09:30):
And we talked last time when I was on the show that China was sort of going in the opposite direction, making it more difficult for Chinese companies to innovate, but China’s backed off on that a little bit and China’s actually doing a great deal of investing in the startup world, trying to fund startups all around the country with government funds in order to try to get more and more innovation within China itself, as opposed to technology transfers from other countries.
David Stein (09:58):
So we’ll see. I mean, China’s a fascinating story, but it’s again, just one country, a very small percentage of assets with some capital controls. As an allocator, there are many other areas of the markets that are more fascinating, at least to me.
Trey Lockerbie (10:15):
You mentioned China kind of relinquishing a little bit on their control with some aspects to the capitalism there in that country and one of the more curious trades over the last six months has been Alibaba and Charlie Munger. Obviously he’s one of the billionaires we study most on this show.
Trey Lockerbie (10:31):
The stock had been declining since China was reminding markets of their ability to affect business decisions at the company, which in one way creates a lot of third party risk. It dropped in Q4 after missing top line, bottom line expectations. But Charlie came in and doubled his position in 2021 and increased the position to 72 million, which left a lot of people, myself included, scratching their heads.
Trey Lockerbie (10:56):
And China’s regulators recently made concessions and said they would allow, say Chinese auditors to share audit papers with Public Company Accounting Oversight Board, which is basically this precondition to keep ADR shares of Chinese companies listed in the US. And Baba was bouncing around quite a bit, but then it popped 40% in one day after some news about upping their share repurchases.
Trey Lockerbie (11:18):
And then at that point you saw Charlie sell half of his position, and so that left people scratching their heads once again. So with all of that, I’m just curious if you have any general thoughts on why Munger would’ve made such a bipolar trade, it would seem?
David Stein (11:34):
No idea, but I think it’s a great example of how challenging investing can be. So Alibaba is now trading at a level it was in 2016. We’re seeing Netflix today fall 40%. One of the challenges when investing in stocks, when you’re buying individual stocks is the underlying assumption is the market’s wrong that the stock is mispriced.
David Stein (11:56):
So we don’t own Netflix because we think it’s a great growth company. The company has to grow faster than everybody already expects. And what you see time and time again, with many of these well publicized growth companies, at some point they disappoint because the compounded growth that they need to continue to sustain very high P/Es, just isn’t sustainable.
David Stein (12:17):
Now, clearly there are exceptions, but most of the time a company will disappoint and you’ll see it fall 40%. And so now you have a growth stock, was a growth stock like Netflix, what’s their growth strategy? Their growth strategy, according to their press release is to come after their users that are sharing passwords so that they can crack down on their customers. That doesn’t sound like a growth company to me.
David Stein (12:40):
And so, I don’t spend a whole lot of time, really any time investing in individual stocks because there’s so many other opportunities in other asset classes. But one reason is I spent 17 years interviewing, meeting with hedge fund managers, long-only stock managers. Our firm would meet well over 700 managers a year.
David Stein (13:00):
And you meet with so many managers and you see how disappointing that is when they can’t outperform a benchmark or one of their stocks blows up and you realize, well, if they can’t do it, if they can’t get an informational edge and it’s their full-time job, how am I going to do it on a part-time basis?
Trey Lockerbie (13:17):
I think that’s a fair point. And you brought up Netflix, so I have to ask, say we’re not investing in individual stocks, but say an ETF like QQQ, it’s down 14% or so from its high over the last 52 weeks. Do we think what’s happened just now with Netflix, do we think Netflix is a canary in the coal mine for the other basket of high flying tech stocks, given rates are increasing and as you mentioned, the P/Es need to be sustained and how unrealistic that might be? Do you think there’s further to fall for the basket of stocks say within QQQ?
David Stein (13:50):
I think there’s more pressure on growth stocks, like in QQQ, just because interest rates are increasing. And given those earnings are the inherent or intrinsic value of a stock because it’s future earnings, as interest rates go up, you’re discounting those earnings and they’re more impacted than a valued company that’s paying dividends.
David Stein (14:09):
And so I’ve been overweight value now just because it’s more attractive, it’s been the right move over the last year and the valuation’s have gotten so high for some of those growth companies. Now that doesn’t mean growth doesn’t work. I mean, momentum is an academically proven approach to investing that works very well, but it’s very hard to do if you’re just picking a couple momentum stocks. I’d rather own a basket of momentum stocks knowing some will blow up, but most will do just fine.
Trey Lockerbie (14:39):
I’d like to get your opinions on what it means to be a contrarian. So this is what makes investing so hard, right, because you see Netflix drop like a rock today in today’s market. We’re recording this April 20th of 2022. And it’s always that thing about is now the time to be greedy when others are fearful? Are we supposed to back up the truck, so to speak, when you see a performing, a company with, I think, fairly strong fundamentals and a good growth rate, just get so crushed by the market in something like today? Just out of curiosity, is this an example of when it might be a good time to be a contrarian?
David Stein (15:14):
Not for Netflix. The time to have been a contrarian for Netflix … And for me, a contrarian is somebody that’s going against the consensus, there’s usually a value component to it, but also some momentum. So the best time to be a contrarian is when you see an extreme, when there’s heavy pessimism, but then you start to see a reversal, so you get some momentum aspect to it.
David Stein (15:35):
So I point out Netflix because it is one of those stocks that I should have bought, thought about buying five or six years ago, it might even have been longer ago, when Netflix got killed because of the DVDs they were sending out. That was their business, they were transitioning to streaming. They missed earnings estimates as stock got crushed. But it seemed logical that streaming was coming on board.
David Stein (15:59):
But again, in that case, I didn’t do it because I didn’t know what the consensus was, what was already priced into that stock. But it would’ve been a better time to buy than today when the growth strategy is to crack down on your customers for sharing passwords and user IDs.
David Stein (16:13):
And so from a contrarian standpoint, we always want to understand what the consensus is or what are people thinking about that, and if there’s a heavy deal of pessimism, like we’re seeing today where most people think a recession is coming, the pessimistic trader, the contrarian trade is take on more credit risk. Assume the economy is not going to enter into a recession in the next three months.
David Stein (16:36):
You mentioned the inverted yield curve. Why is the yield curve inverting? Well, the yield curve’s inverting because one reason is the fed is raising their interest rate, their policy rate. So that gets reflected in the 2 year. At the same time, the 10 year hasn’t shot up. Maybe it isn’t because there’s an expectation for a recession, maybe it’s because the market believes the fed will get inflation under control, and so there’s less inflation assumptions embedded into the 10 year treasury bond.
David Stein (17:04):
And so an inversion, just an inversion itself, isn’t enough for a recession call. You want to look at multiple time periods, the 1 year or the 3 month versus the 10 year, or the 2 year versus the 10 year and understand what’s driving it. It isn’t a simple rule, it needs some context.
Trey Lockerbie (17:22):
You mentioned a great contrarian that would be shorting commodities, which is such an interesting point. Is there a way to do that, if one wanted to do that? I know there’s for example, an ETF that shorts the S&P 500. Is there something similar for a basket of commodities or is there another way to play that if you were interested in doing so?
David Stein (17:40):
Oh yeah, there are ETFs that will go short commodities. And in some ways going short, an asset class like in futures, not to get into the nitty gritty on futures, but when you’re long, let’s say you’re long VIX or volatility, or some of these other asset classes, again, with any type of futures contract, you’re competing against all the other speculators. And if they think, for example, commodities are going to go up in price, and you saw this in oil, and then in order to make money in going long oil, it has to go up more than what’s already priced into the futures contracts.
David Stein (18:16):
And oftentimes what you’ll see is because there’s an upward sloping future curve, every time you roll over that futures contract, it actually is costing money. And so you get what’s called a negative roll yield with futures. And so in some ways like shorting VIX is actually can be a beneficial strategy, going back to volatility because of this, but then you get the positive roll yield.
David Stein (18:37):
So if everybody’s on one side of the trade and is very excited about it, oftentimes it’s embedded into a very steep futures curve, and so then commodities have to do better than what everybody thinks. And so I’m not shorting commodities because commodities is a zero sum game. Now I own gold as a hedge, but I think there’s better ways to invest than trying to speculate on commodities.
Trey Lockerbie (19:02):
Great point. You mentioned the fed is raising rates because they’re trying to quell inflation and there’s a lot of speculation around how much they can do so. And until we have to start doing something like, potentially, yield curve control, we’re seeing that happen right now in Japan. They came out announcing that the Bank of Japan was willing to buy an “unlimited,” quote-unquote, amount of 10 year bonds, just to keep that fixed rate. Do you see that kind of playbook from our own fed down the road? Is that the path we’re on, in your opinion?
David Stein (19:34):
The fed would only do yield curve control if they felt the 10 year had just got completely out of whack. So when you think about interest rates, what makes up that 10 year treasury bond yield? You have the expectations based on what the fed will do in terms of setting its policy rate, going out one year, two year, three years.
David Stein (19:53):
So right now, basically it’s assuming by 2024, that fed funds rate could be close to two and a half, 3%. So that’s a big component and that’s one reason you’ve seen interest rates go up, but you also have the inflation expectations embedded into that yield.
David Stein (20:08):
But there’s a third component that’s called the term premium, and a term premium represents just additional compensation that investors demand for uncertainty regarding the fed or uncertainty regarding inflation. And one of the interesting things, which is why we have eight and a half percent inflation yet the 10 year treasury is less than 3%. What we don’t have is a positive term premium. It’s basically been flat to negative, whereas back in the ’80s, you had a term premium of 4 or 5%.
David Stein (20:35):
And so if investors lost faith in the federal reserve in central banks in general and term premiums shot up because they felt like they would not be able to get control of inflation, then you might see a yield curve control because then the fed realize, okay, this is all we got is just our ability to create money out of thin air and to buy bonds. And we’ll see.
David Stein (20:56):
So there’s definitely been pressure in Japan, but the yield’s at zero. I mean, that’s the bogie, that they’re implementing yield curve control. They could allow it to go up a little bit just because of the inflationary pressure, but things seem like they’ve settled down. So the central bank can step in, they can change their wording, they can buy more, and oftentimes trust gets restored and things settle down.
David Stein (21:20):
And markets tend to be very narrative driven and they go from one narrative to the other and they lose interest in one story to worry about, and then things settle down and we see that a lot.
Trey Lockerbie (21:31):
They can definitely change the narrative and they can definitely change the numbers, it would seem. For example, the 1980s way to define inflation apparently would calculate it closer to 20%, but here we are sitting at eight and a half percent. When people talk about yield curve control, sometimes I wonder what would happen first, would they just manipulate the CPI number down just to say their quelling inflation before they have to implement something like that?
David Stein (21:54):
No, I don’t think so. Calculating CPI and inflation is inherently difficult. You have this reference basket of items, hundreds and hundreds of different items, and it’s based on consumer preferences. Well, one thing you see with inflation, as certain things go up in price, other things fall in price, those preferences change, we can substitute.
David Stein (22:17):
At the same time, you have innovation and technology. These different analysts that look at inflation and say, “Well, the basket should never change. We should still have landline phones in that basket comparing what AT&T charge for landline today versus back in the 1940s.” That’s not what inflation measures. Inflation measures cost of living. How we live changes over time, and so we have to change what we measure. We can’t keep the basket the same.
David Stein (22:45):
At the same time, you do have to take into account quality improvements. Computers are better today than they were, automobiles are better today than we were, and that should be reflected in the inflation number. And we just have to recognize that there’s some judgment, there’s subjectivity in the inflation number. But inflation is high. If they were hiding it, now would be the time and they’re not. It’s just the process of estimating inflation, that cost of living is incredibly subjective.
Trey Lockerbie (23:12):
In our last discussion, you touched on how often you were using earnings yield to compare investment opportunities and with the inflation over 8%, I’m wondering how that compares to the S&P today. Its earnings yield is 4.15%, which is not as high as inflation, but also much higher than bonds. So what are the latest numbers telling you on how our market is priced?
David Stein (23:37):
Our market, if it’s the US market is too expensive, so the latest year at month end, March, earnings yield for the US, looking at the previous yields earnings. And earnings yield is just an inverse of the price to earnings ratio. I like to use earnings yield because I compare it to bonds. So the earnings yield is 4.3% in the US. The average earnings yield going back to 1969 is 6.8%. And so the market is still pricey, despite interest rates going up.
David Stein (24:04):
And so that’s why I’m underweight US. I’m not completely out of the US, but I wouldn’t put 61% of my equity portfolio in the US because there are many other areas of the world that are much cheaper. If we look at Japan, it’s earning yield is actually is 6.9%. Europe’s at 6.5%. UK’s at 7%. Emerging markets at 7.1%. And so when you look at the All Country World Index, it’s at 5.2%, basically at its long term average, going back to 1995. But if we exclude the US and look at the world ex US, we’re at 6.4%. So most of the world is cheaper than the US.
David Stein (24:42):
And let’s go back to Japan. Japan has significantly trailed the US stock market over the past decade, going back to 2012. Most of that under performance, even if we adjust for different sector rates is due to the US getting more expensive than Japan. So it wasn’t earnings, it wasn’t dividend, it’s just people are paying more for the US versus the rest of the world. And if you buy an asset that’s higher priced, you should expect a lower return than if you buy something similar that’s at a cheaper price.
Trey Lockerbie (25:14):
You also reference standard deviations to find relative strength between indices. With the contraction that we’ve had in the US as of late, even though it’s not that big, I’m curious how it compares to its average, now that it’s come down a little bit.
David Stein (25:29):
Yeah, it’s come down a little bit. So the latest Shiller P/E, or cyclically adjusted price to earnings ratio, so in this case, we’re taking the price divided by the average earnings over the past decade, it’s at 33.8. The average going back to 1980 is 21.3. So we’re still one and a half standard deviations above average. And the standard deviation really is, it’s measuring the range of a particular point relative to that average over time.
David Stein (25:57):
And so, one of the ways that I look at the financial markets is, and we look at it in our membership community, we look at all the different asset classes and we want to know what is their standard deviation, like is this an extreme valuation. And the US remains the most expensive stock market in the world and maybe it’ll continue to outperform in order to do so.
David Stein (26:18):
It’ll either have to buy back a boatload more stock, significantly increase earnings growth, or it’s going to get more expensive to where we’re looking a decade from now and the Shiller P/E is over 40. That’s not an investment that I would have a lot of confidence in. And as a contrarian, I’d rather be overweight other areas of the market, while keeping 30 to 40% in US in terms of my overall equity allocation, just because you never know.
Trey Lockerbie (26:47):
So buying back a ton of shares is interesting because there’s a lot of narrative out there around how one of the reasons we might be running into trouble is that CEOs of companies have bought back a ton of shares instead of, for example, investing in future prospects of the business or investing in CapEx needed to increase production. And obviously the market’s valuation comes from increasing earnings over time, increasing revenues over time. Is buyback shares to a degree, does it go against the longer term advantage of the market?
David Stein (27:21):
Well, as a CEO, it’s the easiest thing to do because CEOs are measured, not on total earnings, they’re measured on earnings per share. And so if they can goose the earnings per share by buying back stock, then they do it. It’s a sure thing versus trying to invest in some project 10 years down the road. And given the turnover in CEOs, they tend to be short-term focused, and so they’re going to continue to buy back shares.
David Stein (27:45):
It’s an interesting thing, because if you look at what drives the stock market over time, it’s the dividend, it’s the earnings growth, and it’s what investors are paying for those cash flows. And historically across the country, the overall earnings has been basically most of the time only keeps up with the per capita GDP, so 3, 4%. And so when we saw what’s happened in the past decade where you’ve seen earnings compound at 7, 8%, that has helped, but it isn’t overall earnings, it’s the earnings per share because there’s less shares outstanding.
David Stein (28:20):
That is what has driven the stock market and they do it because it’s the easiest thing to do. But it does go against, if you really want to be innovative, then you’re going to invest in long term projects. But CEOs aren’t measured on that, they’re measured on did they beat the earnings estimate in the most recent quarter.
Trey Lockerbie (28:39):
All right. So I’d like to shift gears a little bit and talk about the meat of the discussion for today, which is around different assets that resale investors may or may not be familiar with. So for example, a lot of people might assume that the New York Stock Exchange exchanges stocks in companies, which they do and that’s mostly right, but there’s also a lot of different assets that trade on the New York Stock Exchange. I’m curious, what are some of the overlooked assets that investors should consider?
David Stein (29:09):
Sure. So my favorite investment vehicle that trades on the New York Stock Exchange are closed-end funds and closed-end funds are the oldest mutual fund out there. They were there before open-end mutual funds. So an open-end mutual fund is what’s in your 401k plan, for example, where at the end of the day, the fund sponsor strikes a net asset value. It looks at that value of all the assets it owns, divides it by the number of shares and comes up with the price per share. And that’s what you buy that mutual fund for, that open-end mutual fund.
David Stein (29:42):
Closed-end funds are more like exchange traded funds as they trade throughout the day and because of that, you can see the price of the fund, it can differ from the net to asset value. In theory, it can for ETFs also, we’ve talked about in the past flash crashes for ETFs. So that’s where there can be a disconnect between the price of the ETF and its net asset value.
David Stein (30:06):
But there are what are known as authorized participants that are always trading the underlying holdings of the ETFs called the reference basket, the shares of the ETFs. And so there’s all this trading activity around that to make sure the price of the ETF equals the net asset value.
David Stein (30:20):
Closed-end funds by design have never been able to do that because there isn’t an outside entity that can get enough to close that discount. So if you go to a website like CEFConnect that list out the 500 or so closed-end funds in the US, it’s about $300 billion of assets, you can rank them by discount to net asset value and see these vehicles that are selling for 10, 15%, 20% discount to the value of what it owns.
David Stein (30:52):
And to me, that’s a great deal. If I can buy an asset at a 15% discount, a 10% discount and it’s an attractive asset in an area that I’m interested in. For example, right now a recent closed-end fund I bought is the BlackRock Debt Strategies Fund, the ticker’s DSU. This fund invest in bank loans, so syndicated, non-investment grade bank loans. It fell to greater than a 10% discount. These bank loans are variable rates, so you protect against rising interest rates. And you’re seeing these yields go up before these bank loans. As the fed raises its policy rate, the yields on bank loans goes up.
David Stein (31:30):
What these have is credit risk. So we talk about being contrarian, instead of buying commodities, maybe you take more credit risk currently thinking that, well, the recession might not be out. It might be two or three years away or it might not come at all.
David Stein (31:44):
And so what a closed-end fund does is basically … And any time I invest, I always want to ask who’s on the other side of the trade, who am I competing with? When I buy commodity futures, I’m competing against bots, institutions, algorithms, hedge funds. That’s who’s selling it to me.
David Stein (32:01):
When I buy a close-end fund, I’m competing against retail investors that tend to panic when markets fall and they start dumping their closed-end funds, which aren’t terribly liquid. And then you’d see discounts widen. Anytime there’s a sell off, you see discounts widen and that’s where it becomes more of an opportunity to get an asset class that typically they use leverage.
David Stein (32:23):
Most closed-end funds are more income oriented. The sponsor uses leverage that they can get very cheaply. So this Debt Strategies Fund, DSU, is able to borrow at LIBOR plus 80 basis points. And then it’s investing in loans that have an interest rates of four and a half to 5%. So it’s able to keep that spread.
David Stein (32:44):
The expense ratios tend to be higher, but ultimately this is a way to compound at a much higher … Much better than just owning something like the Vanguard Total Bond Index Fund, BND, because this has leverage, the distribution rates tend to be higher. So DSU for example, has a distribution rate of 7% and you’re getting it at a discount to its net asset value.
Trey Lockerbie (33:06):
Now are all closed-end funds a basket of credit products?
David Stein (33:11):
No. So there’s equity closed-end funds. There are closed-end funds to do more option strategies, some do master limited partnerships, utilities, but because most of the investors tend to be retail-oriented investors, it’s just an area that has tended to gravitate more toward leveraged fixed income-type income products. So there’s equity REITs, there’s convertible bonds, there’s all different types. But I typically don’t, for example, buy straight equity-type closed-end funds. I prefer something a little more predictable on the bond or some other type of income strategy side.
Trey Lockerbie (33:48):
I like the credit investment aspect of it. It’s not something I’ve really experimented with at all, but it’s sort of like betting on a horse to just finish the race, whereas equity investments are like betting on the horse to win or at least place in the show. Is that how you see it? I mean, when you’re investing in credit products, the company just has to essentially survive long enough to pay back the principle and interest. And is there a way to audit the basket of the CEF and monitor the companies and get a feel for, if you think that horse is going to finish the race?
David Stein (34:19):
Well, you buy, for example, DSU, has 1,200 different credits in it. And BlackRock has been in the bond business for decades and they have huge quantitative strengths. They’re very, very good at analyzing bonds, much better than any of us would ever be. So I’d rather have a professional management team selecting which of these bank loans to purchase.
David Stein (34:43):
We talk about equity is winning the race, well, what is the race? When you’re buying a stock, the race is I think the price is wrong. And so it has some surprise to the upside. That’s actually more challenging than just getting your money back from a bond. And then you have the structural leverage built into the close-end funds and you’re buying it at a discount to the net asset value, which means you’re getting a $100 worth of assets for 90 bucks. And so that’s what makes it attractive to me.
David Stein (35:13):
And recognizing these can be used as trading vehicles. For example, DSU, once that discount narrows, I’ll potentially exit depending on where we are with the economy at that point. So there’s just a lot of different tools you can use when it comes to close-end funds versus just buying a straight up equity.
Trey Lockerbie (35:33):
It kind of reminds me of being an allocator as you were with endowments, et cetera. You could look at it like building a fund of funds, right, where you’ve got the Blackstone, as you mentioned, but Oaktree has another promising CEF as well. And obviously people know of Howard Marks and how well he’s done in the credit markets over time and could consider Oaktree a great manager for that fund or for that product. Is that how you look at it where you’re building a basket of these baskets of funds?
David Stein (36:01):
Yeah. I mean, you can do that. In fact, there’s an ETF, the Amplify High Income Fund, the ticker is YYY. It is tracking the ISE High Income Index, which is an index comprised of 30 closed-end funds that are ranked based on their yield, based on their discount to the net asset value, based on liquidity.
David Stein (36:20):
But yeah, as an investor, I’m an allocator. That’s what I did in managing assets for endowments and foundations. If my portfolio, which I share with my members at Money for the Rest of Us, it’s an allocation portfolio with over a dozen different asset classes, mainly because that’s how I’m most comfortable investing and because it’s how I have invested.
David Stein (36:42):
Now that’s not the only way to invest. To me, it’s an asset garden approach where we just want a diversified mix of different assets, just like you have a garden, you’ve got a diversified mix of vegetables and flowers, different return drivers.
David Stein (36:56):
And so as retail investors, we have some advantages and one of those advantages is hedge funds can’t buy closed-end funds. They’re not liquid enough. The market’s too small. So there’s some niche assets that we can participate in where we’re not competing against hedge funds who are on the other side of the trade.
Trey Lockerbie (37:16):
So that discount to NAV opportunity, so to speak, is really interesting. My only experience with something like that is investing in the Grayscale Bitcoin Trust and that has had a negative discount to NAV for, I mean, a year now and it’s around 21% today, which can be very frustrating, right, to see that discount not catch up to the NAV. Is that not as common in these CEFs, for example? Do you ever see a situation where that gap is not closing?
David Stein (37:45):
Oh, it usually doesn’t close. So that’s the other thing with close-end funds is if you go to a site like CEFConnect, it calculates a Z-score, which is a statistical measure, looking at the current discount relative to the average discount, and then it factors in the volatility of that discount over time. And so generally I tell people, look for a Z-score of greater than negative three, which means the discount is wider than it typically is.
David Stein (38:12):
And you can see price charts, see, well, where is that discount relative to historically. But yeah, oftentimes the discount never narrows. Other times it becomes a premium and the premium never narrows. And that’s how you know this is an inefficient asset class, when you can see a closed-end fund consistently selling for a 20% premium, and that never closes.
David Stein (38:33):
In a case like the Grayscale Bitcoin Trust that was at a premium a year or so ago. Now it’s at a discount mainly because it has more competition with lower expense ratios. And so I’m not sure the Grayscale Bitcoin Trust, if you’ll see the discount narrow, as long as other products keep coming out with lower fees in order to get access to Bitcoin.
Trey Lockerbie (38:54):
Part of that discount could be also because of how thinly traded they are. How thinly traded are we talking with these CEFs? You mentioned they’re only a $300 billion market. How does that compare to the rest of the assets on the New York Stock Exchange? And give us an idea of the volume differential.
David Stein (39:11):
Well, for an individual CEF, I mean, as a retail investor, you can get in. It’s not like the gap between the bid ask spread is super huge. I mean, it’s similar to an ETF, and so there’re market makers. You can get in.
David Stein (39:24):
The thing about CEFs, in some ways they shouldn’t even exist because what happens is a sponsor comes along and says it wants to do a new fund and it goes to the broker community and there’s a 5% load invested in that and the IPO price is at the net asset value. And then immediately you’ll see the thing sell off to become a 10% discount. Anybody that buys a closed-end fund at the IPO has gotten ripped off, because you know it’s going to fall in price. And so we always want to buy these things in the secondary market.
Trey Lockerbie (39:59):
Is that what you would say is the biggest risk of owning a CEF?
David Stein (40:04):
The biggest risk is because it is a market that is primarily retail oriented, the biggest risk is a major sell-down. So with the pandemic selloff, you saw some closed-end funds sell off 40, 50% and you have to be able to stomach that volatility. But because they’re leveraged, at some point … And you saw this in the master limited partnership space.
David Stein (40:28):
So these are energy infrastructure assets that are invested in oil pipelines, natural gas pipelines. A number of those closed-end funds were 30 to 40% levered, and then you saw MLPs sell off 60%. So then the closed-end fund is getting margin calls on its debt, and so they’re having to sell assets, and so that’s a risk. Any leveraged asset is risky when the asset itself that it owns, that’s been levered up, falls. And so that’s a risk with close-end funds.
David Stein (40:57):
So with any investment, you have to understand, you just don’t go buy them blindly say, oh, it’s at a 20% discount. You have to say, well, what is the asset that it’s invested in? What is the leverage? What is the fees? And really understand what it is. And what is your investment thesis? When will you exit? It’s a vehicle is what a closed-end fund is, just like a mutual fund. An open-end mutual fund is a vehicle. We want to understand what’s under the hood that’s driving the performance of that particular investment vehicle.
Trey Lockerbie (41:27):
And what’s under the hood, I’m curious, it doesn’t seem to turn over very much. So for example, if you look at, say the price performance of a CEF, let’s say MCI, for example, and you compare it to the S&P 500, I mean, it looks like it’s just getting crushed. The S&P say over the last five years is up 105%. MCI is negative 1.18%, but that’s just the price differential. So that could be a mistake that some investors make when they look at how did these things compare. So how should we look at how they compare to the S&P 500? And is it true that the underlying assets don’t turn over very often?
David Stein (42:03):
Well, what you don’t see is, because these are income oriented asset classes using leverage, and they’re trying to maximize their dividends, so basically pay out all the returns in the dividend. And as a result, you don’t see the net asset value of the CEF’s increase. And so if you look at a chart like that, basically you’re looking at a price return.
David Stein (42:24):
We want to look at the closed-end fund on a total return basis where the dividend is being received and reinvested. So that’s really key. But when you analyze closed-end fund, that’s important. So typically, so MCI, for example, it’s the Barings Corporate Investors fund, or it’s a debt fund.
David Stein (42:39):
They’re doing private debt lending in this case, it’s a closed-end fund that I own also. And it’s total return on the net asset value basis, it’s been 10% annualized over very much every time period, going over a decade, because they’re basically, what’s known as mezzanine debt.
David Stein (42:57):
So they’re lending to private companies, middle market companies. Oftentimes they’ll get in equity participation, so they’ll participate in the upside of providing some counseling and things of that sort. So because they’re providing that, they can get a higher yield on their debt on this private debt and that’s been that strategy. The key is that they don’t default.
David Stein (43:17):
But when you look at and when I look at buying MCI, you pull up the annual report and you look at all right, here’s the net investment income that was created. Is that enough to cover the dividend, or how are they paying for the dividend? Because some of these closed-end funds, they have what’s known as a managed distribution strategy where they try to keep the dividend the same, but in reality, one way they do that is the dividend’s too high, so they’re always basically returning capital, and then you see the net asset value drop over time.
David Stein (43:46):
So you don’t want to see the NAV consistently falling on a consistent basis because it means the manager’s basically taking assets, selling them, and they’re just giving it back to the shareholders and the shareholders think, oh, this is a really attractive dividend, but they’re getting their money back. And so in some ways close-end funds, I mean, it’s like analyzing an individual stock if you’re digging to the 10-K. So you need to understand how is that distribution being funded?
Trey Lockerbie (44:14):
Is this a strategy that might supplement for say someone who is looking for high dividend yielding equities in their portfolios, say if they’re getting older and they’re looking for just more of a dividend income for their return, is this somewhat of a supplemental option for someone like that?
David Stein (44:30):
Yeah, it certainly is an option. There’s a guy who goes … Steven Bavaria is his name. He wrote a book called The Income Factory, and it’s all about close-end funds. And his strategy, it’s all buy and hold. I’m going to buy the highest yield close-end funds, and I’m going to hold them through thick and thin, and as long term hold.
David Stein (44:47):
I tend to be a little more trader. I have some holdings that I’ll hold for a long time, but once that discount narrows to where it’s narrower than average, or even goes to a premium, I’ll often sell and then I’ll invest opportunistically when I see discounts widen. But it is a way to generate income. It’s a good portion of my bond allocation because the yields are 6, 7% as opposed to two and a half percent in the bond market. And so it can be used to generate income for retirement.
Trey Lockerbie (45:18):
Digging into closed-end funds a little bit more, there’s one type in particular that’s pretty interesting called business development companies. Walk us through why we might want to take some interest in business development companies and what they are.
David Stein (45:31):
Right. So business development companies are a little different. They fall under the regulatory structure for closed-end funds, but in this case, it’s not like a traditional closed-end fund. So if you go to CEFConnect, you won’t find business development companies. There’s only about 40 or 50 outstanding in the US, about 53 billion in capital. And this was created from the Small Business Investment Incentive Act back in the ’80s, and really as a way for middle market companies to get debt. So these are private companies.
David Stein (46:02):
So a BDC has money, they’ve raised money. They’re basically lending to private companies and they’re providing some additional counseling. Again, it’s sort of like a mezzanine strategy and as a result, they’ll often get some equity participation. They can charge higher interest rates, and so it’s very much a niche strategy.
David Stein (46:21):
It can be very concentrated, but a way to invest in BDCs is the VanEck BDC Income ETF. So the ticker is BIZD. It’s been around, it’s about 650 million in assets. It’s got just about a 10 year track record and it’s done decent. It’s returned 6 to 7% annualized just investing in 25 or 30 of these BDCs.
Trey Lockerbie (46:45):
Now, similar to the CEFs trading at a discount to NAV, do you see a similar thing happening with these BDCs?
David Stein (46:53):
In many regards, you see them selling at a premium to the net asset value. And what’s interesting is there isn’t a website where you can see and screen based on the discount, at least that I’m aware of. Maybe somebody should create one if there isn’t, but I think that the niche is so small.
David Stein (47:08):
But I, for example, had one of my members the other day ask about a couple BDCs that he owned in our member forum and once I looked at it and he didn’t realize it, that this BDC, it’s like, well, the performance has done well, it’s doing well. And then I looked at it, it’s selling at a 60% premium to the net asset value.
David Stein (47:25):
And I don’t give investment advice and I didn’t. Had it been mine, I would’ve sold it right then because I just am viscerally opposed to owning something at a premium, if there’s a chance it could fall. And so I much prefer discount because you have that margin of safety.
David Stein (47:41):
But you can, I mean, in a down market, because a risk of BDCs is like closed-end funds, they can sell off 50 to 60% in a down market. And at that point, potentially you are seeing them at a discount to the net asset value, but you have to go to the website of the particular BDC, go through and they’re sharing their net asset value.
David Stein (47:59):
Often though, because this is private debt, they’re not sharing it on a daily basis. It could be a quarterly release of the NAV. So you have to kind of estimate it, but it is an important component to look at.
Trey Lockerbie (48:12):
Should retail investors look at BDCs as an opportunity that, for example, may have used to be something you’d find it through private equity, but is now available as a product to retail investors, and that’s an advantage that they should consider?
David Stein (48:28):
It is. Right. It’s a way to basically invest in what in the private equity space is known as mezzanine debt. So somebody, a typical private equity investor, it’s mostly an equity investment, but there are mezzanine funds that are lending directly to the company and get some type of warrant option to participate in the upside, whereas a traditional venture capital or buy-out manager, it’s an equity investment. So there are some of these vehicles, BDCs, even closed-end funds that are sort of …
David Stein (48:59):
Because their advantage is there’s only a certain number of shares outstanding. So it can be a steady pool of capital that isn’t turnover. If it’s an open-end fund, you can’t have illiquid investments in an open-end mutual fund, or to some extent in an exchange traded fund, because there’s always a risk the shareholders want to exit.
David Stein (49:18):
But with a closed-end fund and even with BDCs, there’s a certain number of shares unless they do some type of follow up offering. And so the manager can hold private investments in that fund structure and this is a way for retail investors to participate in that.
Trey Lockerbie (49:34):
One peculiar thing about BDCs and CEFs is that they both seem to have these expense ratios that are pretty crazy high. You touched on it earlier, they do have this expected higher yield, but the costs seem relatively high. I’m curious, what is causing such a high cost for these types of funds?
David Stein (49:53):
With the BDCs since technically under the regulation, it’s a fund to fund. So you have the BDC and then it’s lending to individual companies. And so the SEC says, because of that, when you publish your expense ratio, you have to basically include all the fees, some of the operating fees for running the companies, there’s the incentive fees that are baked in there, there’s the interest expense. And so the way to look at a BDC or to look at a closed-end fund is look at what is the management fee. So what is vehicle charging to actually choose the underlying investment? So that’s of the base level.
David Stein (50:28):
So a closed-end fund, you can see, I’m in close end funds where the expense ratio, just the management fee is 75 basis points. But there are definitely closed-end funds where it’s one and a half percent. And so recognize that the overall, the expense ratios are higher than you’re going to see in ETFs and in an open-end mutual fund, which is another reason to buy them at a discount to net asset value, and that offsets some of the pain of the higher fee.
David Stein (50:53):
But always don’t just look at the expense ratio and say, oh, it’s really high understand, well, what are the components of the expense ratio, what’s included in that, because it needs to be an apples to apples comparison, if you’re looking at it relative to an ETF. The comparison is the actual management fee itself.
Trey Lockerbie (51:10):
So if you were a retail investor that was considering BDC, CEFs as part of the overall portfolio, what level of allocation … I mean, given there’s differences in sophistication and expertise, I know it’s hard to say, but roughly. You mentioned gold, for example, is this a similar allocation where it’s just a smaller part of a overall portfolio? And if so, how should retail investors think about allocating to things like CEFs or BDCs as part of an overall portfolio?
David Stein (51:41):
BDCs, they’re definitely a very niche strategy. So I mentioned that ETF, the VanEck BDC Income ETF, it only has 25 or 30 BDCs. And the draw down for these can be 50 or 60%, and so that should be single digit percentage allocation. Closed-end fund’s different, it just depends on what the overall allocation is for the particular investor.
David Stein (52:07):
The thing with closed-end funds though, because you have different layers, yes, it’s a bond fund, let’s say, but it’s leveraged and it trades on a stock exchange. So you can see volatility in your bond closed-end fund that looks like stocks. So you have to be comfortable with just the volatility of this particular vehicle. And that I think tends to keep investors for not making it a huge allocation.
David Stein (52:32):
But again, you have to understand that the CEF is just the vehicle, what’s the underlying strategy and how diversified in it? If I’m comfortable with my entire bank loan allocation, or most of it being in one closed-end fund, because BlackRock owns 1,200 underlying bank loans and they’re doing credit research. And so in that case, I’m more comfortable having a higher allocation recognizing it will be volatile and there’s a risk that the discount could widen further.
Trey Lockerbie (52:58):
Wow. Well, David, this was so interesting. I definitely learned a few things that were new. CEFs, BDCs are all assets that we’ve never explored on this show and I’m really thankful that you were able to bring them up and educate us on it.
Trey Lockerbie (53:11):
And I also love that we were able to just have a very wide ranging discussion, touching lots on different things and you brought such a wealth of knowledge to all of it, and it’s always a pleasure to have you on the show. I really enjoyed it.
Trey Lockerbie (53:22):
Before I let you go, I definitely want to give you the opportunity to hand off to our audience where they can learn more about you and your books, your podcast, any other resources you want to share.
David Stein (53:32):
Sure. So the website is moneyfortherestofus.com. There are a lot of free investment guides on there, one that covers closed-end funds, so you can check that out. The podcast is also Money for the Rest of Us, and you can learn more about there as well as some of the other courses and resources that we offer. So it’s all right there, moneyfortherestofus.com.
Trey Lockerbie (53:52):
Fantastic. Well again, thank you, David. And I hope we can do it again soon.
David Stein (53:56):
Yeah, it was great. Thanks, Trey.
Trey Lockerbie (53:58):
All right, everybody. That’s all we had for you this week. If you’re loving the show, don’t forget to follow us on your favorite podcast app. And if you’re looking to diversify into other markets around the world, definitely go to theinvestorspodcast.com, check out our investing resources for you there. We actually have a list of the best indices from every country, and it’s a great place to start. And with that, we will see you again next time.
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