Tag Archives: Yields

Small Cap CEF Yields 7.7%, Deep Discount Of 9.2%, Outperformed The Index The Past 32 Years
July 4, 2018 6:32 pm|Comments (0)

This research report was jointly produced with High Dividend Opportunities authors Julian Lin and Philip Mause.

Royce Value Trust (RVT) is a legendary closed-end fund (‘CEF’) started by a giant fund manager in the small-cap investing world, “The Royce Funds”. In fact, RVT is the first small-cap CEF ever created 32 years ago.

RVT recently traded at $ 15.76 per share, representing a 9.2% discount to its net asset value (‘NAV’) of $ 17.80 and a 7.7% dividend yield based on its trailing 12 months distributions. RVT is a solid pick for those wanting exposure to both the high alpha small-cap space as well as a high dividend yield.

Small Caps Have A Little More Alpha

Stocks of small-cap companies are well known to potentially have higher return potential than their larger cap counterparts. This is generally due to the fact that smaller companies have more room to grow, they tend to grow more quickly, leading, of course, to share price appreciation.

In fact, from 1927 to 2009, small-cap stocks greatly outpaced large-cap stocks by a wide margin.

(Dimensional Fund Advisors)

In 2018, small-cap stocks are taking the leadership position compared to their large-cap counterpart with the small-cap Russell Index (IWM) returning 10.3% year-to-date compared to the S&P 500 index returning only 3.8% for the same period.

One Of The Best Time To Have Exposure To Small Caps

It is one of the best times to be invested in small-cap stocks. Small-cap companies will be the biggest beneficiaries of the recently enacted corporate tax cuts. Larger companies will also benefit, but not as much, because they usually hire expensive tax accountants and use complex strategies to reduce their effective tax rate down; so the biggest tax impact will be felt in smaller cap stocks. According to a recent Invesco study, the companies in the S&P 600 Small Cap Index had an average effective tax rate 4.3% higher than that of the S&P 500 companies. This means that small-cap stocks have been more positively impacted by the recent corporate tax cuts because they will be able to save more taxes.

U.S. stocks are set to strongly outperform their foreign counterparts. With the U.S. economy being the healthiest large economy on the globe, it provides a “safe haven” for investors. Small-cap stocks on average generate more than 78% of their revenues from the U.S. compared to 70.9% for the S&P 500 companies. Since their revenues are mainly generated domestically, they are set to grow faster.

Despite the recent rally, small-cap stocks continue to have PE ratios which are very attractive relative to the S&P 500.

At current ratio levels, the increased potential for growth inherent in small-cap stocks is not really “priced in.” As a result, in addition to earnings growth potential, there is also significant potential for multiple expansion – this is a recipe for strong shareholder returns. No wonder small-cap stocks are seeing such a strong outperformance.

Getting To Know RVT

RVT was the first small-cap closed-end fund ever at its inception in 1986, and its manager, Chuck Royce, has managed it for its 32 years of existence since inception. Royce is naturally known as a legend in the small-cap investing universe. The focus is on small-cap stocks generally with market capitalization up to $ 3 billion. The fund has about $ 1.46 billion in net assets and 437 total holdings, and employs a tiny bit of leverage, with its leverage ratio at around 3.7%. This is relatively modest for an equity CEF.

A Solid Management

The managers of RVT, “The Royce Funds”, are pioneers in small-cap investing. It’s been their specialty for 40+ years. What sets them apart is their depth of small-cap knowledge, experience, and a single focus in their area of expertise.

The core approach of management is to combine multiple investment themes through small-cap companies that are set to generate high returns on invested capital or those with strong fundamentals and/or prospects trading at what management believes are attractive valuations.

This strategy has paid off well over the years. RVT has seen 10.7% average yearly returns since inception (through March 31, 2018).

The Portfolio

Their top ten holdings are seen below (as of 3/31/2018):

RVT mainly focuses on U.S. based stocks with 87% invested domestically. It has 18.1% in international exposure out of which 7.7% in Canadian stocks. So, RVT has an overwhelmingly North American exposure.

(CEFConnect)

This Isn’t Just The Index

There are substantial differences in sector representation between RVT and the Russell 2000, the typical small-cap index. In particular, RVT has dramatically greater exposure to the industrial, materials, and information technology sectors and considerably lower exposure to health care and utilities:

In our opinion, this allocation makes a lot of sense in the current economic environment. We have previously discussed reasons for the industrials and materials sectors to outperform, namely in the form of a near-term catalyst in a large infrastructure bill in Washington, backed by long-term tailwinds of incessant demand for infrastructure spending. Furthermore, industrials and materials tend to do much better during periods of economic growth, inflation, and rising interest rates than other sectors such as utilities.

The information technology sector, despite the recent rally, is still quite attractively priced because of the potential for growth and major innovations. The recent tax reform which has allowed companies (especially large-cap tech companies) to repatriate foreign cash at lower tax rates greatly increases the potential Merger & Acquisition activity. Small-cap companies, such as the ones that RVT holds, have market caps which look like mere “pocket change” to companies like Apple (AAPL) which has over $ 200 billion in cash.

The weighted average price to earnings (‘P/E’) multiple of RVT portfolio companies was 22 and the price to book ratio (‘P/B’) was 2.2, versus 20.4 and 2.3, respectively, for the Russell 2000. The slight premium in valuation reflects management’s decision to emphasize positions with strong growth potential:

Share Price Performance

RVT has outperformed the Russell 2000 over almost every time frame, including by over 50 basis points since inception 32 years ago.

In addition to producing superior returns over time, RVT has also had less volatility (‘risk’) as well.

This management team clearly has a long track record of outperformance and also has the experience of managing through multiple economic cycles.

Low Expense Ratio

Whereas many CEFs have high expense ratios around 1.5% of assets, RVT is different and in a good way. RVT has an expense ratio of only 0.65% of net assets. This includes 0.54% in inclusive management expenses plus 0.11% in interest expenses. This low expense ratio is a significant plus because high expense ratios tend to eat away at shareholder returns over time and are considered an important reason why many funds underperform indices over the long run.

Dividend Policy

RVT uses a “managed distribution policy” in which they pay quarterly distributions at an “annual rate of 7% of the average of the prior 4 quarter-end “net asset values”, with the 4th quarter being the greater of these annualized rates or the distribution required by IRS regulations.”

RVT last paid an average of $ 0.305 in quarterly dividends and for the past 4 quarters paid a total of $ 1.22 per share in dividends, for an annualized yield of 7.7%. The fund has historically distributed dividends out of long-term capital gains and dividend income.

(Chart by Author)

While it is definitely a plus that RVT has rarely had to give distributions in form of “return of capital” (‘ROC’), we would like to remind readers that ROC is not necessarily a bad thing when it comes to equity CEFs. While ROC for fixed income CEFs is usually always destructive, in the case of equity CEFs, this is not always the case. Often, equity CEFs decide to distribute ROC as a tax advantaged way to return capital to shareholders.

Valuation

Aside from trading at a 7.7% dividend yield, RVT also trades at a 9.2% discount to its NAV of $ 16.24 per share. With a 1-year Z-Score of 0, RVT is currently trading within its normal NAV discount. Note that during the bull market of 2002 through 2007, RVT traded mostly at a Premium to NAV.

(CEFConnect)

We would not be surprised if RVT will start trading again at its NAV or a premium to NAV in the current bull market cycle. In all cases, the shares do not deserve such a steep discount to NAV considering management’s track record to outperform the index.

Risks To Consider

  • Small-cap stocks tend to carry a higher risk and price volatility than their large counterparts. That said, this risk is mitigated by RVT through a high diversification among both sectors and companies through 437 stock holdings. While there may be some losers in the mix, these have been more than offset by very big winners.
  • In the event of a market downturn, RVT, like all equity funds, will see its price decline. However, it has very low leverage which may make it comparatively stable. In addition, there are many reasons to believe that the outlook for equities is positive, considering the extra firepower for growth-related capital expenditures and investments being afforded as a result of corporate tax cuts.

Bottom Line

RVT is possibly the best equity CEF with a focus on small-cap stocks. It has a proven track record of outperformance through its 32 years of existence. Because of its exposure to value small-cap stocks with growth potential, the fund is set to strongly outperform in the current economic cycle. RVT is recommended for income investors who are looking for a portfolio diversification in addition to a generous yield which is currently at 7.7%. RVT has also the potential to also generate a high level of capital appreciation. We rate RVT as a strong buy.

If you enjoyed this article and wish to receive updates on our latest research, click “Follow” next to my name at the top of this article.

Note: All images/tables above were extracted from the Fund’s website unless otherwise stated.

Disclosure: I am/we are long RVT.

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.

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Safe Preferred Stock Yields 10.4%, Opportunistic Buy, 25% Return Potential
April 15, 2018 6:01 pm|Comments (0)

This research report was jointly produced by High Dividend Opportunities research team and Seeking Alpha author Julian Lin.

CBL & Associates Properties (CBL) is the most experienced operator of B mall properties. As their common share price continues to struggle, they have also seen their preferred stock drop considerably. Preferred dividends must be paid before those of the common, making their distributions inherently safer. In spite of tremendous cash flow coverage, their preferred shares nonetheless trade at a very opportunistic 10.4% yield. Shares have 25% upside, including dividends. The following are the two Preferred Shares of CBL:

  1. CBL & Associates Properties, 7.375% Series D Cumulative Redeemable Preferred (CBL-D) – Last price $ 17.80 (Annual Dividend $ 1.84375, Yield 10.36%).
  2. CBL & Associates Properties, 6.625% Series E Cumulative Redeemable Preferred (CBL-E) – Last Price $ 16.60 (Annual Dividend $ 1.65625, Yield 9.98%)

Note that your investment broker may list the preferred stock as CBL-PD and CBL-PE instead of CBL-D and CBL-E. Some other brokers such as IB list them as (CBL PRD) and (CBL PRE).

https://static.seekingalpha.com/uploads/2018/4/10/16392-15233592227347343.png

Business Overview: A Story Of Stability And Transformation

CBL owns 119 properties including 63 malls in the United States:
https://static.seekingalpha.com/uploads/2018/4/7/16392-15231070206341395.png

This is a portfolio which has undergone an impressive transformation. After the 2008 recession, management has reduced debt to EBITDA from 8.5 times to 6.7 times. Since 2013, CBL has disposed of 20 underperforming properties, increasing their net operating income (‘NOI’) exposure to Tier 1 & Tier 2 malls from 78% to 86%. This has also led to increases of tenant sales per square foot:

https://static.seekingalpha.com/uploads/2018/4/7/16392-15231070223152802.png

In spite of the headlines that malls are dying, CBL has maintained very stable mall occupancy rates, indicating the strong demand for leasing space in B malls:

https://static.seekingalpha.com/uploads/2018/4/7/16392-15231070238920171.png

CBL has managed to dramatically improve their balance sheet, notably reducing leverage and borrowing costs:
https://static.seekingalpha.com/uploads/2018/4/7/16392-15231070257576435.png

This shows that strong management matters in this tough retail environment. It is not enough to have the best properties – only the strong operators will survive. This is a management team that endured the 2008 recession and adapted by cleaning up the balance sheet.

Valuation

With their common stock trading at around $ 4.40 per share, this is a multiple of 2.5 times 2018 funds from operations (‘FFO’) and an 18% dividend yield, which is dirt cheap. With such a low valuation, future rent concessions appear to have been more or less priced in. We are reiterating our strong buy rating for the CBL common shares. This article, however, focuses on the preferred stock issues, which are also attractive, recently yielding 10.4%. These preferred shares have fallen considerably after trading near par for quite some time:
https://static.seekingalpha.com/uploads/2018/4/7/16392-1523107027130035.png

(Yahoo Finance)

Preferred stock, in comparison to their common counterparts, is usually less volatile due to their more secured dividend payouts. This is a unique opportunity to take advantage of unexpected volatility.

Free Cash Flow Coverage

Using the midpoint of 2018 guidance, CBL will have approximately $ 350 million in funds from operations and $ 167 million in common dividends. CBL has guided for $ 75-125 million of annual redevelopment spending along with $ 90 million of annual capital expenditures and $ 50 million of annual debt principal repayment. As we can see, the majority of redevelopment spending is likely to be internally funded.

Using FFO, the $ 44.9 million in total preferred dividends are handily covered at 7.8 times. After recurring capital expenditures (including amortization), the preferred dividends are covered 4.68 times. This is also known as “free cash flow” coverage.

And finally, even after accounting for redevelopment expense, they are still covered at ~2 times. We can see the cash flow coverage laid out below:
https://lh4.googleusercontent.com/XqkYrd4e77uq7a593Mx1eiSwOYb8D9oyDMxeJX_fCtWV_20SOLe29kHWJzZbg6XmLTbCVXZ3IUKvHKWx8hzjoPkBbgIBhSewzlB8_MjSCUR4pg1TYasqc5YEG8uxr1EAd4UroQx7


(Chart by Author)

Anyway you put it, the preferred stock dividends are very well covered and appear to be very safe.

The main threat would be violation of any of their debt covenants, but even here CBL is still very strong:

https://static.seekingalpha.com/uploads/2018/4/7/16392-15231070291720068.png

Impact of Moody’s and S&P Downgrade

In February 2018, Moody’s downgraded CBL’s unsecured credit rating to Ba1, down from Baa3. This comes after S&P had downgraded the corporate credit rating (note the distinction) to BB+ from BBB-. They did maintain their BBB- unsecured credit rating. As stated in their 2017 10-K, CBL has elected to use their unsecured credit rating to determine the interest rates on three unsecured credit facilities and two unsecured term loans. As of December 31, 2017, the “three unsecured credit facilities bear interest at LIBOR plus 120 basis points and our unsecured term loans bear interest at LIBOR plus 135 and 150 basis points, respectively.” If they were to receive a downgrade from Standard and Poor’s (S&P) on their unsecured credit rating, then the unsecured credit facilities “would bear interest at LIBOR plus 155 basis points and the interest rate on our two unsecured term loans would bear interest at LIBOR plus 175 basis points and 200 basis points, respectively.”

The approximate impact to interest expense related to these unsecured credit facilities and unsecured term loans is shown below. Again, S&P has not yet downgraded the unsecured credit rating, thus, this is only a projected impact (in 000’s, only showing credit-rating sensitive loans):

https://static.seekingalpha.com/uploads/2018/4/7/16392-1523107017796898.png

(Chart by Author, data from 2017 10-K)

As we can see, the net near-term impact to interest expense would be just over $ 4 million, which is not very significant considering the approximately $ 350 million in funds from operations. Further, we anticipate that CBL will be able to regain their investment grade rating from Moody’s as their redevelopments begin to bear fruit.

Which Preferred Issue Is Better?
CBL has two preferred issues, as seen below:

https://lh6.googleusercontent.com/eOZbEpWNdV6SfBEY09YZ9JC3rfbZXgZZkjIUBj8Jkm3XxR9sMVWaXSrrkQXEGfetqoF4I8xvZ2frFcmKltEzgIlqT_c2JCL2wd83sAr8C81dzWJ951VOFxQ-Nj2z6V6OMC9mZhoB

(Chart by Author)

Both issues are cumulative, meaning any unpaid preferred dividends would accumulate until they are paid in full in the future. Both issues also are currently callable. Preferred shares have a natural cap on the upside around call value (or par value) of $ 25/share. For example, in general, investors do not like to buy preferred stocks at above par their value of $ 25/share plus accrued interest. A trade-off is that the preferred D shares have significantly greater liquidity, with 1.815 million shares outstanding versus 0.69 million outstanding E shares. Both issues are strong buys at the current prices.

Comparison With Peers

Mall REIT peers Washington Prime Group (WPG) and Pennsylvania Real Estate Investment Trust (PEI) both also have preferred stock, but these are yielding around 8.5%, considerably lower than what is seen at CBL. We believe that this discount is undeserved as in comparison with these two peers, CBL will be able to fund the majority of their redevelopment expense with cash flow alone. The tremendous cash flow coverage of the CBL preferred shares also makes them comparably less risky than those from these two peers.

Price Target

Our short-term price target is $ 20.50 per CBL-D share or $ 18.40 per CBL-E share for a 9% yield. Including dividends, this would be a 25% total return in a period of 12 months. We believe that both issues have more upside potential if held for longer than 1 year.

Risks

The biggest risk to the preferred issues is if CBL suffers a liquidity crisis and would need to dilute preferred shareholders in order to redeem debt maturities. This, however, does not seem likely due to the currently low leverage of their balance sheet. These also have a significant cash flow cushion and the common dividend must be cut first before any suspension to the preferred dividend. This does look to be a distorted risk to the reward proposition.

Bottom Line

CBL is investing heavily into redeveloping their mall properties. The market is not giving them any credit for their ability to internally fund these value-enhancing capital expenditures, and this pessimism has reached their preferred stock. The CBL preferred stocks are not only safe but too cheap to pass up at 10.4% yields. These have the greatest cash flow coverage compared to peers and are unlikely to remain this cheap for long.

If you enjoyed this article and wish to receive updates on our latest research, click “Follow” next to my name at the top of this article.

Note: All images/tables above were extracted from the Company’s website unless otherwise stated.

Disclosure: I am/we are long CBL, WPG.

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.

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