Tag Archives: function

Rising Rates Are Good For PHK, Part II

Summary PHK pays out 19.2% of its NAV in dividends to shareholders. This distribution is unsustainable, as the fund’s managers have increasingly relied on active investment in bonds, currencies, and derivatives to sustain payouts with minimal return of capital, thus increasing risk. If interest rates rise, PHK is likely to become less reliant on this riskier approach as its NII will increase. The greatest concern regarding Pimco High Income Fund (NYSE: PHK ) is its payout to NAV ratio. With NAV of $7.62 as of July 2nd and annual dividend payouts of $1.46256, the fund needs to get a 19.2% return to sustain its dividend. Bears argue that this is impossible, and that the fund has to return capital and deplete its NAV to maintain the unsustainable dividend. However, according to CEF Connect , PHK has not paid a Return of Capital in over a year. On top of that, PHK’s history of funding distributions through ROC is moderate. While 1.71% of distributions came from ROC last year, that is down from the prior two years: Also significant: the fund has not resorted to ROC to fund distributions in years of rising rates — years of ROC distributions coincide with times of heightened economic crisis (2008, 2009, 2010) for the most part, although the reliance of ROC during 2012, 2013, and 2014 indicates the fund has had some difficulty in covering distributions from income along. However, the consistent decline in ROC and the absence of ROC so far for 2015 suggests that the fund has been able to wean itself off this stop-gap. There is still a fear that the fund will need to resort to ROC soon, since the average coupon of the fund, according to its most recent holdings report , is 5.165%. Even with leverage, which has fallen to 29% in recent months, it seems there is no way the fund can return 19%. So how can PHK continue to cover dividends when it is paying out 19% on NAV? Clipping Coupons To understand this, we first need to take a step back and remind ourselves that the income a bond holder receives is not necessarily the same as the coupon rate. Bonds are frequently bought at a discount, particularly by institutional investors who have greater access to a market that is much less liquid than equities. Since PHK does not reveal the price it has paid for its holdings, and we can only infer how long it keeps certain holdings in its portfolio, coupon rates are useless in determining the sustainability of the dividend or the fund’s ability to earn a 19% return on NAV. Additionally, the fund’s use of derivatives, its arbitrage and hedging from shorting, and its currency trades make it impossible to know exactly how well operations can fund distributions to shareholders. A better way to understand the return it is getting from its portfolio is to compare its net investment income to its NAV. If we look at these, we see that the fund is now earning about a 12.4% return: This is nowhere near the 19% return that is necessary to sustain the dividend in perpetuity, but is much better than the coupon rates suggest. However, this might become the wrong way to look at this fund if rates rise sufficiently. A Better Investment on Rising Rates While it is undeniable that the low interest rate environment hurts PHK’s NII and its ability to sustain its dividend, the sustainability of those payouts improves considerably in times of higher rates, as the above chart suggests. NII has fallen 43% from 2006 to 2015 due to lower interest rates, and its NII is likely to rise if rates rise and the fund is able to purchase discounted issues with a higher coupon rate. The fund’s recent decline in leverage might indicate its managers are anticipating a rise in rates and are positioning themselves accordingly by freeing up access to capital. Much more crucially: a rise in rates will also help the fund cover dividends, as its NII-to-Dividend Ratio remained well over 100% until the Global Financial Crisis in 2008: Surprisingly, the fund’s NII-to-Dividend ratio remained strong in 2009, when its NAV plummeted to less than $3 at its lowest point. At that time, and for several years since then, the fund has been able to more than cover dividends through investment operations — the kind of arbitrage, churn, and derivative trading that investors pay for. (The significant exception, in 2012, was during Bill Gross’s tenure as manager of the fund. He is no longer with the fund or PIMCO.) The fact that the fund has relied on this kind of active speculation more than before 2008 suggests that there is considerably greater risk in the fund than there was then, but it may also suggest that the fund will become less reliant on such tactics when rates rise. While it is true that the total capital PHK has to invest is much less than in 2005-2008, making it a riskier investment than it was then, its access to higher-yielding bond opportunities in a rising rate environment may make it a less risky investment than it has been since 2008 and throughout the 7 years that the fund maintained its monthly dividend payouts. Conclusion PHK is not without its risks. Its reliance on derivatives and investment operations, particularly since 2009, means greater volatility in dividend coverage and a greater risk in a decline in NAV, as we have seen in four of the last 8 years since the Global Financial Crisis, including this year. At the same time, the fund’s ability to earn higher rates of income in periods of rising rates means that a sell-off due to rising rates is unwarranted. Most significantly, if rates do rise later this year or next year, PHK may find it easier to earn income from the high yield market and become less reliant on derivatives and active trading to boost returns. Disclosure: I am/we are long PHK. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The Philosophy Of Value Investing – Reject ‘New Paradigm’ Thinking

By David Foulke Every few years, people start to question whether value investing is dead. A recent Google search along these lines generated 3.1 million results: Likewise, people sometimes question whether the size effect is permanently going away. For instance, during the dotcom craze in the late 90s, large-cap growth investors made small-cap value investors look foolish. People jumped on the bandwagon, and embraced the “new paradigm” for investing. In “New Paradigm or Same Old Hype in Equity Investing?” Chan, Karceski, and Lakonishok (a copy is here ) examine equity returns across the growth/value and large-cap/small-cap spectrum during this era. I went ahead and cherry-picked some key data that illustrates the big picture trends explored by the authors. In the academic world, market returns during the 1970s and particularly in the 1980s were fertile grounds for researchers studying the cross-section of market returns, and variables that explained them. For instance, as can be seen from the panel below (from the paper, as are the other data below), during the 80s, value stocks earned more across the board than growth stocks, and small-cap value stocks beat small-cap growth stocks by 9% per year. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. This 1980s sample period was influential in the establishment of the “size anomaly” and the “value premium.” The evidence seemed clear – you should go forth and buy small-cap value stocks. But then something strange happened – Both of these anomalies seemed to show elements of reversal! 1. First, large-cap began to outperform. Note below how from 1984 through 1998, large cap beats small cap: The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. And the large-cap trend only accelerated in the late 90s: The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. 2. Second, growth also seemed to outperform value, particularly for large-caps. From 1990-1998, large-cap growth beat large-cap value: And again, as with the large-cap outperformance above in #1, by the late 90s the trend in growth also appeared to accelerate: The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Indeed, in general, growth began to look like the better overall bet than value. Based on value weightings, growth stocks beat value stocks by 1.1% from 1990-1998 (although small and mid cap value still beat growth over the period). Particularly in the late 90s, large-cap growth just hammered small-cap value. In 1998, for example, large cap growth earned 41%, while small cap value earned -1.2% . Value investors began to look like idiots. During this period, even the king of value investors – Warren Buffett – began to feel the pain. In their paper, “Buffett’s Alpha,” (a copy is here ) Frazzini et al. observe that from June 30, 1998 to February 29, 2000, Berkshire Hathaway (NYSE: BRK.A ) (NYSE: BRK.B ) lost 44% of its value while the overall stock market gained 32%. Thus, over this ~1.5 year period, Warren Buffett underperformed the market by an astonishing 76% . At the tail end of this stretch, Barron’s published a piece entitled, “What’s Wrong, Warren?” From the article: After more than 30 years of unrivaled investment success, Warren Buffett may be losing his magic touch. Huh? What was going on here? Was Warren Buffett no longer a guru, was value investing dead, and had the small-cap premium disappeared forever? Some seemed to think so. Yet, if this were the case, how could you explain why these anomalies would do a 180 degree turn, and perform in a way that was the opposite of how they had performed previously? The paper examines three potential explanations for why this could be the case: Rational Asset Pricing Under this view, the outperformance of large-cap growth was driven by a series of unexpected positive shocks for large caps, and negative shocks for small caps, perhaps due to new technology, or investor expectations. If this were true, then the performance edge of small-cap value should reappear in the future. New Paradigm Popularized during the dotcom bubble, this view argues that technology and the dynamics of large companies have altered the investing landscape. Technology will allow huge long-run returns, with high growth rates persisting in the future, and large-caps have sustainable advantages based on their scale and international presence. Therefore, the old paradigm, in which firms were priced based on historical returns, no longer applies, and new valuations might be low given the new high expected growth rates under these new-paradigm conditions. If this is true, then small-cap value may continue to lag large-cap growth for a long time. Behavioral/Institutional This view argues that investors overreacted to the growth potential of technological innovation, and prices became disconnected from underlying fundamentals. Additionally, as markets continued to march higher, and large cap growth continued to outperform, the trend was self-reinforcing. If this view is right, then small-cap value will in the future exhibit return patterns consistent with its historical performance. We can test these explanations. Did large-caps experience excess profitability and small-caps experience depressed profitability? If this were true, that would support the rational pricing and new paradigm interpretations. If we failed to see this evidence, that might support the behavioral interpretation. So what does the evidence say? The authors examined performance data based on four accounting metrics: net sales revenue, operating income before depreciation, income, and cash dividends. We’re going focus on sales only since, as the authors point out, this data has no negative values, and is “smoother” (although you can read the paper to confirm that the other accounting metrics exhibited similar characteristics). The authors examined the price-to-sales ratio of the various asset classes and found something surprising: The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Note the extreme multiple expansion for price-to-sales that occurred for large-cap growth from 1997 through 1999. This expansion was obviously not duplicated by the other asset classes. Yet was this expanded multiple justified by the fundamentals? No. Note below how 1996-98 sales growth for large-cap growth was nothing special at 6%. In fact, growth badly lagged the 29 year average for large-cap sales growth of 10.3%. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request. Meanwhile, sales growth for small-cap and mid-cap showed no particular weakness; in fact, small-cap sales growth from 96-98 was 12.7%, versus its long term (70-98) average of 8.1% – much stronger than historically! While we have only reviewed price-to-sales versus sales growth in detail here, again, the other profitability metrics reviewed in the paper are consistent with these observations. We therefore have a reasonable basis for rejecting the rational asset pricing argument, since we observed no unexpected fundamental shocks. Sales growth trends actually showed the opposite: it was weak for large-cap growth, and strong for small-cap value. Similarly, we can (mostly) reject the new paradigm argument, since we weren’t able to identify any emerging trends in sales growth that would justify higher valuations. It’s possible that these dramatically higher growth rates would show up farther in the future, but again, you would expect to see at least some evidence that this was occurring. Accordingly, it seems reasonable to embrace the third argument: behavioral/institutional. That is to say, the very high valuations of large-cap growth became disconnected from any reasonable assessment of future growth prospects, and this was driven by human bias, as investors overreacted to new technology and wild extrapolations of internet growth, and they chased anticipated returns. Taking a Step Back This observation is not especially revolutionary, in hindsight. By now, it’s obvious to everyone that during the dotcom years investors were caught up in “irrational exuberance” and bid up large-cap growth stocks to unsustainable highs. Yet it is still remarkable to see the actual fundamental data laid out so starkly and juxtaposed with equity prices. One observation that emerges from this analysis is how broader trends and market distortions can cause certain historical patterns and relationships, such as the size anomaly the value premium, to break down. Yet, once these behaviorally-driven market trends recede, and internet fever subsides, it seems reasonable to think longer-term value and small-cap effect will take hold once again. Of course, during this period in the 90s, people began to question value and size effects. As was demonstrated, Warren Buffett lagged the market by 76%! And people questioned him and his methods. Now that is the kind underperformance that can give you plenty of cover to argue that Buffett has lost his touch, that value investing is dead, and that only suckers believe in the size anomaly. Yet we have a long history of returns that gives us confidence that value and size effects are persistent. So we should be realistic and recognize too that they are not consistent. That is, there are prolonged periods, such as this stretch in the late 90s, when large-cap growth looks like the smart way to bet going forward. So when you see a broad reversal, say when large-cap growth has a stretch of outperformance, don’t be fooled. Consider that it’s pretty likely that you are getting fooled by “new paradigm” thinking that prevailed in the 90s. Original Post

MDY’s 2015 2nd-Quarter Performance And Seasonality

Summary The SPDR S&P MidCap 400 ETF in the first half ranked No. 1 among the three most popular exchange-traded funds based on the S&P Composite 1500’s constituent indexes. In the second quarter, the ETF’s adjusted closing daily share price dipped by -1.12 percent. And in June, the fund’s share price dropped by -1.28 percent. The SPDR S&P MidCap 400 ETF (NYSEARCA: MDY ) during 2015’s first half was first by return among the three most popular ETFs based on the S&P Composite 1500’s constituent indexes: It expanded to $273.24 from $262.52, an increase of $10.72, or 4.08 percent. Over the same period, MDY behaved better than the iShares Core S&P Small-Cap ETF (NYSEARCA: IJR ) by 6 basis points and the SPDR S&P 500 ETF (NYSEARCA: SPY ) by 2.91 percentage points. In contrast, MDY last quarter performed worse than SPY and IJR by -1.34 and -1.29 percentage points, in that order. Most recently, MDY last month lagged IJR by -2.34 percentage points and led SPY by 73 basis points. Comparisons of changes by percentages in SPY, MDY, IJR, the small-capitalization iShares Russell 2000 ETF (NYSEARCA: IWM ) and the large-cap PowerShares QQQ (NASDAQ: QQQ ) during the first half, over Q2 and in June can be found in charts published in “SPY’s 2015 2nd-Quarter Performance And Seasonality.” Figure 1: S&P 400 EPS , 2010-2014 Actual And 2015 Projected (click to enlarge) Notes: (1) Estimates are employed for the 2015 data. (2) The EPS scale is on the left, and the change-in-EPS scale is on the right. Source: This J.J.’s Risky Business chart is based on analyses of data in the S&P 500 Earnings and Estimate Report released June 30. MDY may have behaved OK in the first half, but the ETF might have a hard time performing OK in the second half. As Howard Silverblatt, senior index analyst at S&P Dow Jones Indices, indicated in the S&P 500 Earnings and Estimate Report series this year, the analysts’ average earnings-per-share estimate for the S&P 400 index underlying MDY for 2015 slipped to $71.31 June 30 from $75.06 March 26 (Figure 1). And I believe this EPS estimate continues to be highly unrealistic, as it would require growth of 21.13 percent over last year. As a result, I think there will be more downward revisions in this estimate, which collectively will not constitute an MDY tailwind. Figure 2: MDY Monthly Change, 2015 Vs. 1996-2014 Mean (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing monthly share prices at Yahoo Finance . MDY behaved worse in the first half of this year than it did during the comparable periods in its initial 19 full years of existence based on the monthly means calculated by employing data associated with that historical time frame (Figure 2). The same data set shows the average year’s strongest quarter was the fourth, with an absolutely large positive return, and its weakest quarter was the third, with an absolutely small negative return. Figure 3: MDY Monthly Change, 2015 Vs. 1996-2014 Median (click to enlarge) Source: This J.J.’s Risky Business chart is based on analyses of adjusted closing monthly share prices at Yahoo Finance. MDY also performed worse in the first half of this year than it did during the comparable periods in its initial 19 full years of existence based on the monthly medians calculated by using data associated with that historical time frame (Figure 3). The same data set shows the average year’s strongest quarter was the fourth, with an absolutely large positive return, and its weakest quarter was the third, with an absolutely small negative return. Disclaimer: The opinions expressed herein by the author do not constitute an investment recommendation, and they are unsuitable for employment in the making of investment decisions. The opinions expressed herein address only certain aspects of potential investment in any securities and cannot substitute for comprehensive investment analysis. The opinions expressed herein are based on an incomplete set of information, illustrative in nature, and limited in scope. In addition, the opinions expressed herein reflect the author’s best judgment as of the date of publication, and they are subject to change without notice. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.