RISK OFF: Global Markets Tumbling Again

To cap a rough week, markets have fallen into “risk-off” mode once again this morning.

The S&P 500 is down 0.9%, completely erasing yesterday’s big rally. Asian exchanges were mostly closed Friday and European indices are getting hammered across the board.

…continue reading HERE

Business Development Companies (BDCs) are publicly traded private debt and equity funds. I know that description isn’t terribly sexy, but keep reading and you’ll find there’s a lot to be excited about.

BDCs provide financing to firms too small to seek traditional bank financing or to do an IPO, but at the same time are too advanced to interest the earliest-stage venture capitalist. These companies are often near or at profitability and just need extra cash to reach the next milestone. Filling this void, BDCs provide funds to target companies in exchange for interest payments and/or an equity stake.

BDCs earn their living by lending at interest rates higher than those at which they borrow. Conceptually, they act like banks or bond funds, but with access to yields unlike any you’ll see from a traditional bond fund. The interest rate spread—meaning the difference between their capital costs and interest they charge their clients—is a major component of their business.

Oftentimes, a BDC will increase its dividend when market interest rates have not changed. Like a bank, the more loans it has in force, the more it profits. Increasing its dividend payout will generally have a very positive effect on its share price.

Unlike banks or many other traditional financial institutions, however, BDCs are structured to pay out more than 90% of their net profits to the shareholders. In return, BDCs don’t pay any income tax. In essence, their profits flow through to the owners. Many investors like to own BDCs in an IRA to create tax-deferred or tax-free income. The opportunity to use them for tax planning purposes, access to diversified early-stage financing, and the impressive dividend yields they deliver make them a perfect fit for the Bulletproof Income strategy we employ at Miller’s Money Forever.

The Clients

As a business model, BDCs emerged in response to a particular need: early-stage companies needed funding but couldn’t do it publicly due to their small size. At the same time, these companies didn’t match the investment criteria of so-called angel investors or venture capital providers. Enter the Business Development Company.

BDC teams, through expertise and connections, select the most promising companies in their fields and provide funds in return for a debt or equity stake, expecting gains from a potential acquisition scenario and a flow of interest payments in the meantime. The ability to selectively lend money to the right startup companies is paramount. It makes little difference how much interest they charge if the client defaults on the loan.

With limited financing options, BDCs’ clients may incur strict terms regarding their debt arrangements. The debt often comes with a high interest rate, has senior-level status, and is often accompanied by deal sweeteners like warrants which add to the upside potential for those with a stake in the borrowing company.

In return for these stringent terms, the borrower can use the funds to:

•Increase its cash reserve for added security;

•Accelerate product development;

•Hire staff and purchase licenses necessary to advance R&D, etc.

•Invest in property, plant, and equipment to produce its product and bring it to market.

Turning to a BDC for funds allows a company to finance its development and minimize dilution of equity investors while reaching key value-adding milestones in the process.

What’s in It for Investors?

In addition to the unique opportunity to access early-stage financing, we like BDCs for their dividend policy and high yield. The Investment Act of 1940 requires vehicles such as BDCs to pay out a minimum of 90% of their earnings. In practice, they tend to pay out more than that, plus their short-term capital gains.

This often results in a high yield. Yields of 7-12% are common, which makes this vehicle unique in today’s low-yield environment. The risk is minimized by diversification—like a good bond fund, they spread their assets over many sectors. This rational approach and the resulting income make the right BDC(s) a great addition to our Bulletproof Income strategy.

BDCs and the Bulletproof Income Strategy

In short, BDCs serve our strategy by:

• Providing inflation protection in the form of high yields and dividend growth;
• Limiting our exposure to interest-rate risk, thereby adding a level of security (some BDCs borrow funds at variable rates, but not the ones we like);
• Maintaining low leverage, which BDCs are legally required to do;
• Distributing the vast majority of their income to shareholders, thereby creating an immediate link between the company’s operating success and the shareholders’ wellbeing… in other words, to keep their shareholders happy, BDCs have to perform well.

How Should You Pick a BDC?

Not every BDC out there qualifies as a sound investment. Here’s a list of qualities that make a BDC attractive.

• Dividend distributions come from earnings. This may sound like common sense, but it’s worth reiterating. A successful BDC should generate enough quarterly income to pay off its dividend obligations. If it doesn’t, it will have to go to the market for funds and either issue equity or borrow—or deplete cash reserves it would otherwise use to fund future investments. An equity issuance would result in share dilution; debt would increase leverage with no imminent potential to generate gains; and a lower cash reserve is no good either. We prefer stocks that balance their commitments to the shareholders with a long-term growth strategy.
• The dividends are growing. This is another characteristic of a solid income pick, BDC or otherwise. Ideally, the dividend growth would outpace inflation, in addition to the yield itself being higher than the official CPI numbers. This growth can come from increasing the interest rate spread and also having more loans on the books.
• Yields should be realistic. We’d be cautious about a BDC that pays more than 12% of its income in dividends. Remember, gains come from the interest it receives from the borrowers. Higher interest indicates higher-risk debt on a BDC’s balance sheet, which should be monitored regularly.
• Fixed-rate liabilities are preferred. We need our BDC to be able to cover its obligations if interest rates rise. Fixed rates are more predictable than floating rates; we like the more conservative approach.
• Their betas should be (way) below 1. We don’t want our investment to move together with the broad market or be too interest-rate sensitive. Keeping our betas as low as possible provides additional opportunities to reduce risk, which is a critical part of our strategy.
• They are diversified across many sectors. A BDC that has 100 tech companies in its portfolio is not as well diversified as a one with 50 firms scattered across a dozen sectors, including aerospace, defense, packaging, pharmaceuticals, and others. Review a company’s SEC filings to see how many baskets its eggs are in.

Wrap-up

Right now, BDCs look very interesting to income-seeking investors. They provide excellent yields, diversification opportunities, and access to early-stage companies that previously only institutions enjoyed. They also fit in with Miller Money Forever‘sBulletproof Income strategy, the purpose of which is to provide seniors and savers with real returns, while offering maximum safety and diversification.

Catching a peek our Bulletproof portfolio is risk-free if you try today. Access it now by subscribing to Miller’s Money Forever, with a 90-day money-back guarantee. If you don’t like it, simply return the subscription within those first three months and we’ll refund your payment, no questions asked. And the knowledge you gain in those months will be yours to keep forever.

In the spring of 1982 we were glued to the TV. Not to reruns of “Hogan’s Heroes” or “M*A*S*H,” but to a real, live war. 

Argentine dictator General Leopoldo Galtieri believed Argentines needed a little patriotic diversion from the grim stories of murder, mayhem and economic mismanagement that plagued his leadership. 

Britain had ruled the Falkland Islands (Spanish: Islas Malvinas) since 1883. But undefended… and perhaps not worth defending… Argentina had been claiming sovereignty over the tiny islands ever since the days of Juan Perón. 

After negotiations between Buenos Aires and London over the sovereignty of the islands collapsed… on April 2, 1982, Galtieri sent in troops to claim them for Argentina. This triggered the Falklands War (what many Argentines still refer to bitterly as the Guerra de las Islas Malvinas). 

The world watched. We believed the US would intervene and broker a settlement between the Thatcher government and the Argentines. The islands (current population about 3,000 souls) were not worth bloodshed. 

But instead of negotiating, Britain’s “Iron Lady,” Margaret Thatcher, decided to strike back… with the not inconsiderable might of the British Navy. Britain prepared a task force under Admiral Sir John Fieldhouse. And its fleet sailed with the tide for the southern seas.

US investors watched the news and sold stocks. The outbreak of war tends to raise doubts and lower stock prices. The Dow duly fell. It continued to fall even after the last shots were fired, in June. Finally, in August, the Dow dropped to 776. 

That was the bottom of a bear market that had begun 16 years earlier. In inflation-adjusted terms, a generation of capital gains had vanished. 

But it was in this unhappy and barren ground that the seeds of the greatest bull market of all time were planted. Including yesterday’s 189-point loss, the Dow is still ahead by about 15,000 points. 

But that was a nominal gain, not an inflation-adjusted one. It comes to us in a gust of other facts and figures, all of them similarly swept aloft in a great blinding blizzard of misinformation. 

Each measure – from inflation to unemployment – is a snowflake of detailed and intricate workmanship. But each one melts away as soon as you put a lamp on it to have a good look. 

How much is the Dow worth when properly adjusted for inflation? How much of the GDP is useful output? How many of those 15,000 points of Dow gain will be left when the big reckoning finally comes? 

Answers to these questions were easier to give when Maggie’s battleships were under full steam in 1982. Compared to today, the figures were simpler. They told a story that made more sense. 

GDP showed a sure and steady increase since the end of World War II. Wages, too, showed substantial gains. Household net worth confirmed the trends: Real output, wages, and wealth were all going the right way. Total debt remained steady – at about 150% of GDP. 

The typical American was probably far more worried about the rise in consumer prices in the US than about war in the South Atlantic. He had made gains – more or less – for the last three decades. 

We baby boomers are especially fond of those years. We found jobs easily. Houses were cheap. Even after the “oil shocks” of the 1970s, gasoline was still inexpensive. 

Stocks were bargains, too. At the 1982 bottom, you could buy almost any company in the country for five to eight times reported earnings. You could have bought the 30 Dow Industrial components for an ounce of gold. (This, in retrospect, would have been the Trade of the Century.) 

But something important happened in the early 1980s. The healthy economy of the postwar period split in two – one real… one unreal. 

In one, people got rich. No special knowledge or skills were required. You just had to buy US stocks and wait. If you put in $100,000 in 1982, you’d have about $1,500,000 today (not accounting for compounding). 

Or you could have made about the same amount from the bond market. Again, no sweat. 

But better even than buying stocks and bonds – much better – was selling them. This created a new class of rich people. A financial elite who got MBAs or degrees in math and finance and then went to work for Goldman Sachs, JPMorgan, Merrill Lynch and other Wall Street firms. Soon, these folks were earning salaries and bonuses that made your jaw drop.

“Bankers’ Stock Awards Jet Higher,” declared a Wall Street Journal headline last week. “Goldman Sachs employees are sitting on more than $600 million in extra bonus money, for the past year alone.” (We did not feel the need to underline the word “extra.”) 

Today, you can go to Aspen or the Hamptons and see the results. Bankers, stock brokers and hedge-fund managers now live in the mansions that used to be owned by families who made things. 

But most people did not make it into this unreal economy. Most stayed in the old economy. This was the economy of real things… and real wages… 

…and it sucked. 

More tomorrow… 

Regards,

Bill

From the desk of Chris Hunter, Editor-in-Chief, Bonner & Partners

One of the knotty questions we’ve been trying to untangle over the past few days is the extent to which convulsions in the emerging markets might affect the US stock market. 

As I told members of Bonner & Partners Family Office yesterday: 

About 15% of S&P 500 revenues comes from the emerging world (10% if you exclude China). But capital flight from the emerging markets could have the effect of sending inflows into US assets, making up for a drop in corporate revenues coming from the emerging markets. 

Meanwhile, US exports to the emerging markets make up just over 3% of US GDP. So, I don’t see the US economy suffering too much as a result of turbulence in the emerging world.

Although the current turbulence in the emerging markets is not quite at the levels we saw during the Asian crisis in 1997-98, comparisons between then and now are nevertheless illuminating. 

Throughout the upheaval in Asia during this time, real US GDP growth averaged 4%… and the US unemployment rate fell to 4% from 4.5%. 

The big wobble came in 1998, after the blowup of Long-Term Capital Management – an event triggered by the 1998 ruble crisis. US credit markets froze… and a 20% correction in the US stock market ensued. 

Today, there is little evidence that the mini-crises in Turkey, India, South Africa, Thailand, Ukraine, Brazil and Argentina are having any major effects on the US economy. 

One indicator to keep an eye on is the Cleveland Fed’s Financial Distress Index. This incorporates information from 16 metrics across credit markets, equity markets, foreign exchange markets and interbank markets to track US financial system stress.

As you can see from the chart above, the level of financial risk in the US economy, as measured by the Cleveland Fed, is lower today than it’s been since 1992. 

This doesn’t mean stress in the US financial system won’t build. Or that US stocks will continue to rally. But there are no signs just yet that we’re anywhere near a repeat of the Long-Term Capital Management and Russian ruble crisis.

One tradition the bond and equity markets tend to maintain is the testing of the resolve of a new Fed chairman relatively early in the first term.  Normally, there is a little bit of a honeymoon period, but current circumstances appear to have accelerated things.

The spike in volatility and the crisis in Emerging Markets were not enough at this point to get a reaction from the Fed yesterday during their every-six-weeks FOMC meeting.  Even though Janet Yellen did not interfere with the current QE Taper schedule, we still don’t know for sure whether there will, or will not be, a “Yellen Put”, just as there was a “Bernanke Put” and a “Greenspan Put.”

The markets have become accustomed to dovish central bankers coming to the rescue at almost any sign of trouble.  Given Yellen’s past, we know that she is very dovish.  However, she might want to prove that she is a little different that we think.  If the markets sense this, things could get very volatile over the next couple of months to see just how much resolve she has.

The opinions expressed in this report are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP Limited or its affiliates. Assumptions, opinions and estimates constitute the author’s judgment as of the date of this material and are subject to change without notice. We do not warrant the completeness or accuracy of this material, and it should not be relied upon as such. Before acting on any recommendation, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice. Past performance is not indicative of future results. 

Richardson GMP Limited, Member Canadian Investor Protection Fund.

Richardson is a trade-mark of James Richardson & Sons, Limited. GMP is a registered trade-mark of GMP Securities L.P. Both used under license by Richardson GMP Limited.