RVT - 2 Great Dividends To Retire In Style And Splendor

2023-08-08 07:35:00 ET

Summary

• What does "safe" mean to you?
• I don't want a retirement built on hopes that I can sell my shares for more than what I bought them for.
• These two funds can provide you with plenty of income to help you to achieve financial independence.

Co-authored with Treading Softly.

One question I frequently get asked is a question about safety. In the financial planning world or the investment world, the term "safe" is a loaded word.

The reason is that almost every investment has some level of risk, and if there's any risk at all, it's no longer safe. For many, the only safe investments that they consider completely safe are certificates of deposits, CDs, and Treasury notes. The reason is that if you have a CD at a bank that is under FDIC insurance coverage, there's no real risk of loss there. If it's over the limit, then there is risk, and it's no longer safe. As long as you have trust in "the full faith and credit", the U.S. government is going to pay their bills, Treasuries are a source of safety. However, it is important to recognize that these investments only guarantee your return if you hold until maturity. You can lose a lot of money buying and selling Treasuries.

So even when you are choosing very "safe" investments, you still have to account for risks like when you need money, changing interest rates, and inflation. Most of all, you need to address the risk of whether you will have enough cash flow to cover the rest of your life.

Being a wise investor is not about avoiding risk. It is about understanding the risks that you take and taking steps to manage them. One of the greatest risks that I see investors take, is that they plan their retirements around the idea that they will be able to sell their stocks at a higher price in the future. Yet the history of the stock market is filled with very "safe" companies that have seen significant sell-offs of their share price.

What I can tell you is this, if your retirement is built on hope – the hope that you can sell shares at a premium to what you paid for them, then the level of safety is lower. Instead of hoping that someone else will buy your shares at a higher price and you pay for your retirement – essentially using the greater fool phenomenon as your funding method – I want to suggest that there's a better way to retire with a higher degree of safety and an even higher degree of splendor. That would be through income investing.

Millions of retail or novice investors who received a lump sum from their 401K are now forced to make decisions on their own and find it extremely stressful to try to follow the traditional ways of index investing or gradually liquidate their life savings to pay for retirement. Yet, many of them would benefit by investing in companies that pay them to be a shareholder, allowing them to take that money and live on it. It's no longer required to wait for a bigger fool to pay more for what you purchased; instead, you can be an active part of the economy – that sounds better to me!

Today. I want to take a look at two funds that provide you with a wide range of exposure to a large number of companies that pay you to be a shareholder, and you can use these funds to pay for your retirement.

Let's dive in!

Pick #1: RVT - Yield 7.5%*

In my Market Outlooks, I have been covering the substantial valuation gap between mega-caps, large-caps, and small to mid-cap stocks. In today's market, there is a very strong correlation between the market capitalization of a company and the valuation multiple it is trading at. Mega-caps are trading at over 30x price/earnings, large-caps at nearly 20x, while small and mid-caps are closer to 14x. This is the largest valuation gap between small-cap and large-cap stocks since early 2000. From 2004 through 2019, small-caps traded at a higher valuation than large-caps.

Royce Value Trust ( RVT ) is a Closed-End Fund ("CEF") that focuses on small-cap companies. RVT is an old CEF and has been outperforming its benchmark since 1986. Source .

Outperforming the market for 1, 5, or 10 years is an achievement many funds have had, whereas outperforming for nearly 37 years is something special. The period from 2000 through 2003 was especially good for RVT, as it saw a positive return even as the S&P 500 ETF ( SPY ) declined.

History doesn't repeat, but it sure rhymes. In 1999-2000, the valuations of large-cap stocks were extremely high, averaging in the mid-20x P/E, while small-cap stocks were in the mid-teens. Today, there is a very similar situation, and it is very unlikely that such a large gap in valuations will persist. We want exposure to small to mid-cap stocks, which RVT provides.

RVT pays out a variable distribution, which is based on an annual rate of 7% of the rolling average of the prior four quarter-end NAVs. As a result, RVT's distribution changes with NAV, but it tends to shift slowly with the long-term trend. After steadily declining for the past five quarters, RVT's distribution will start rising again with the September payout. * Its clear distribution formula allows us to project the Q3 & Q4 payouts and calculate a 7.5% yield.

Note that RVT's distribution calculation is based on NAV, not the market price that shares are trading at. We have seen NAV recovering close to 52-week highs while the price remains relatively low.

RVT is currently trading at a 12% discount to NAV, allowing us to invest for a higher yield and enjoy some capital appreciation potential.

The massive valuation gap between small-cap and large-cap stocks will not last forever. Either large-caps need to fall in price, or small-caps need to rise in price, or a combination of both. Either way, small-caps is where we want our money invested. RVT provides us with exposure to small-cap stocks while paying us a healthy dividend while we wait.

Pick #2: BIZD - Yield 10.6%

Business Development Companies, or BDCs, follow an ideal business model for a rising interest rate environment. They generally borrow at fixed rates and lend at floating rates. This means that their interest expense remains relatively flat while the amount their borrowers pay them rises with interest rates.

Over the past several quarters, we have seen BDCs raising their dividends, paying out supplemental dividends, and achieving record earnings. For Q2 earnings, we expect this trend will continue.

Main Street Capital ( MAIN ) reported earnings of Net Investment Income ("NII") up 4% and NAV up 1.7% in Q2 over Q1. MAIN is covering its newly raised dividend by 160%. Capital Southwest ( CSWC ) similarly announced its estimates that NII was 1.5%-3% higher in Q2 than in Q1.

The bottom line is that BDCs are telegraphing another quarter of very strong earnings, beating Q1's record-breaking quarter. When I expect an entire sector to be very strong, owning an ETF is a great option to gain diversified exposure. I already own several individual BDCs, so an ETF is a way for me to "double down" on the strong sector without becoming too overweight on any individual pick.

VanEck BDC Income ETF ( BIZD ) is an ETF that follows the MVIS US Business Development Companies Index ((MVBDCTRG)). As a market-cap-weighted index, the investments are heavily weighted towards the ten largest BDCs. Source .

When BDCs do well, BIZD will do well – it is that simple.

One item that I am frequently asked about is BIZD's expense ratio, which is reported at 10.92%, which is very high for an ETF. This expense ratio is an artifact of government regulations. BDCs are technically considered "funds", so BIZD is required to report its own expenses, plus "acquired fund fees and expenses," which are the expenses that the underlying BDCs are paying.

BIZD breaks it down here: Source .

BIZD's fees are a 0.40% management fee and 0.01% in "other expenses." Those are the only expenses that are paid by the fund. The 10.51% are expenses that are paid by the BDCs. As operating businesses, 10%+ expense ratios are completely normal and expected. It is just another example of why the "expense ratio" is a useless metric for investors to rely on.

Conclusion

These two funds provide you with a very different exposure. One provides you with exposure to companies that are extremely undervalued and yet, have all the potential to soar. The other provides you with exposure to companies that are making hay while the sun shines. They're in a beautiful Goldilocks period where short-term rates are high, but the long-term rates, which they previously capitalized on, are low. What this means is that you can enjoy great income from both funds for decades to come while having exposure to two sectors that work in dynamically different ways.

So does that mean for you?

It gives you more free time. You no longer have to worry about fiddling with your portfolio to decide what shares to sell to pay for lunch; you can instead go to lunch and pay for it with the cash you received as dividends from these different funds and companies. You no longer have to worry at tax time about what shares to sell to try and claim losses or to pay for your tax bill; you can instead use the cash you receive from these companies to pay your tax bill comfortably. It means no longer having to stress about running out of money in your portfolio before you die, and instead, you can simply live off the cash flow that you receive and not have to stress about the portfolio balance daily. To me, retiring in style and splendor means retiring financially independent and free of financial woes and worries.

That's something that you can readily achieve.

That's the beauty of my Income Method. That's the beauty of income investing.

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