GCV - ECF: Attractive Discount And Improving Income-Generation

2023-07-24 03:58:37 ET

Summary

• Ellsworth Growth and Income Fund's net investment income has significantly increased, which could provide better coverage of its distribution.
• ECF continues to trade at an attractive discount, making it a strong investment choice in the convertible space with some equity exposure as well.
• The fund has also not had to contend with higher interest rates in terms of seeing their borrowing costs rise as they have fixed-rate preferred for their leverage.

Written by Nick Ackerman, co-produced by Stanford Chemist.

Ellsworth Growth and Income Fund ( ECF ) recently published its latest semi-annual report . This was for the six months ended March 31st, 2023. The report showed that net investment income for the fund had risen quite materially from the last report. That's encouraging when capital gains can be an unpredictable source in an uncertain market.

Since our last update , the discount has narrowed slightly. That helped provide a boost to the returns we've seen since that time.

That said, the fund is also continuing to trade at an attractive discount, making it an appealing investment choice for putting capital to work in the convertible space.

The Basics

• 1-Year Z-score: -0.03
• Discount: 12.72%
• Distribution Yield: 6.16%
• Expense Ratio: 0.99%
• Leverage: 28.29%
• Managed Assets: $187.5 million
• Structure: Perpetual

ECF's objective is quite simple "... providing income and the potential for capital appreciation; which objectives the Fund considers to be relatively equal, over the long term, due to the nature of the securities in which it invests." They attempt to achieve this by simply "primarily investing in convertible securities and common stocks.

When including leverage expenses, the total expense ratio comes to 1.39%. That was an increase from the last annual report. Fortunately for investors in this fund, they are protected against the rising rates increasing borrowing costs. This is because ECF utilizes fixed-rate preferred shares for their leverage through a publicly traded 5.25% Cumulative Series A ( ECF.PA ) and private placement of 4.4% Series B. That kept the expenses from being impacted even further, as we've seen other leveraged funds now struggling because of borrowing costs increasing.

While that has been a positive for this fund, it should be noted that Series B is puttable on June 26th, 2023 and June 26th, 2024. They've also redeemed some of the Series A in the latest period.

The Board has authorized the repurchase of the Series A Preferred in the open market at prices less than the $25 liquidation value per share. During the six months ended March 31, 2023, and the fiscal year ended September 30, 2022, the Fund repurchased and retired 31,113 and 1,572 Series A Preferred, at investments of $699,557 and $36,725 at average discounts of approximately 10.10% and 6.59%, from its liquidation value.

On July 1, 2022, the Fund issued 2,503,000 shares of Series B 4.40% Cumulative Preferred Shares (Series B Preferred) receiving $24,887,500 million after the deduction of estimated offering expenses of $142,500. The Series B Preferred shares have a liquidation value of $10 per share and an annual dividend rate of 4.40%. The Series B Preferred Shares are puttable on June 26, 2023 and June 26, 2024 and are callable after June 26, 2024.

They also have the ability to make buyback their common shares when trading at a wider than 10% discount.

The Fund is authorized to issue an unlimited number of common shares of beneficial interest (par value $0.01). The Board has authorized the repurchase of the Fund's common shares on the open market when the shares are trading at a discount of 10% or more (or such other percentage as the Board may determine from time to time) from the NAV of the shares. During the six months ended March 31, 2023 and the fiscal year ended September 30, 2022, the Fund repurchased and retired 2,400 and 222,248 of its common shares at an investment of $19,910 and $2,068,339, respectively, at average discounts of approximately 13.82% and 13.42% from NAV.

Redeeming some fixed-rate preferred might seem unusual at first, but when doing so in the open market under the liquidation value is accretive to the fund. That's the same when repurchasing common shares at a discount.

It should be noted that this fund also issues shares at a discount for its dividend reinvestment plan. Not all funds do this, but there are a select few. That means they are simply negating some of the dilution that comes from that issuance. To be fair, the dilution over the years hasn't been too impactful overall.

The fund isn't that large, and that can lead to fairly limited trading volume. An investor with a larger portfolio or a tactical investor should note that before potentially considering a position.

Performance - Attractive Discount

In my last couple of updates, I've touched on the opportunity for ECF to invest in its sister fund, the Gabelli Convertible & Income Securities Fund ( GCV ). The original idea was presented publicly on July 17th, 2022 . That makes it nearly a year ago now; there has been a clear winner. That made my title "A Clear Choice" quite aptly named in hindsight.

I also believed there was potentially more of this to play out in my last update. For investors who took advantage of the valuation difference for a swap on April 13th, 2023, that would have still worked out in ECF's favor.

Based on the absolute valuations, ECF still makes more sense. However, based on averages, it's more of a toss-up at this time.

I still favor ECF, but I think a swap going forward doesn't make the most sense anymore. This is simply because the distribution rate (whether it's earned or not) is higher for GCV, and that's likely to drive interest from investors and keep the downside limited. That is, as long as that distribution is maintained.

Distribution - Managed 5% Minimum Distribution Plan

Speaking of the distribution rate, ECF pays a modest rate which is likely why it doesn't garner more interest like its GCV sister. They've been paying a $0.13 quarterly distribution for several years now as their regular payout. However, they also have a 5% minimum distribution plan in place where if they don't top out over this level, they will top it off at the year-end. This is also required due to being a regulated investment company, where they must pay out most of their earnings or pay an excise tax.

Last year didn't require a year-end to meet their target, nor having to do so to hit regulatory requirements. This year is also looking similar, as the NAV rate is currently at 5.38%. What could push them would be the RIC status because they did take some healthy realized gains in the first half of their fiscal year.

Between realized gains and the fund's net investment income, they generated around $5.485 million against the $3.573 million paid to common holders. They paid another $1.316 to preferred shareholders for a total of nearly $4.9 million. Of course, it remains to be seen what happens with the latter half of the rest of their fiscal year that will determine whether a special will be required or not.

I'm an income investor and love distributions and dividends just as much as the next income investor. However, I am also patient with a long-term view. Personally, I hope they don't pay a special. After we've had a tough 2022, finding a way to retain these assets and keep them invested for future potential returns could be a better result. Alternatively, I could simply reinvest the distribution on my own to get the same effect.

Quite impressively is the fact that NII increased quite substantially from the prior fiscal year. If we annualize the latest figure, it works out to an increase of 167%. The fund had previously gone from a negative NII after the preferred dividends were paid out in the prior year to now a positive NII even after the preferred shareholders were paid. While the fund is still going to require capital gains to fund shareholders' payouts, this shift can be important. It can provide more predictability and less selling off of portfolio positions in the future.

On a per-share basis, it was similar at an increase of $0.09 to $0.12 but annualized to $0.24 if they can maintain this pace. In the same period a year ago, they posted NII per share of $0.04, so some of this appears to be an income generation increase rather than payment timing alone.

One of the reasons for an increase could be portfolio positioning. With a turnover rate of 20%, they've been fairly active in the last six months. However, higher rates could also impact what yields they are picking up now.

In a previous post , Calamos noted that they are seeing convertibles starting to pay more and being issued at lower conversion premiums. On top of that, they even see some higher-quality companies issue convertibles to keep their borrowing expenses in check during this rising rate environment. That's positive news for convertible investors across the board. With ECF having their borrowing costs fixed, they are in a better position to take advantage of this shift as well.

ECF's Portfolio

The fund carries a large weighting of 62.4% to convertible corporate bonds and another 3.8% to mandatory convertible securities. All of this is based on the last semi-annual report breakdown. However, this fund also mixes in a fairly large allocation to common stocks as well at 19.3%.

The fund had also carried a substantial weighting to U.S. Government Obligations at 14.5%. While the fund should be investing this capital, it certainly doesn't hurt too much to sit on cash these days. Unlike most of the last decade, they are earning between 4.547% to 5.040% in these T-Bills. In fact, this was for the period ended March 31st, 2023. So they are very likely earning even more at this point.

I noted this in a prior update as well when we took a look at their annual report. Then, the weighting was 13.3% of the portfolio. I was a bit critical of this weighting too.

However, another large piece of their pie is allocated to U.S. Government obligations at 13.3%. In particular, these are U.S. T-Bills earning between 2.272% and 3.297%. This makes up the second-largest allocation in terms of sector weighting of the fund at the end of the fiscal year.

Essentially, this is a cash position, and thankfully, these cash positions pay something these days. Because the first thing I think of is $24.2 million is allocated to 'cash,' and they are paying 4.4% on a Series B they just issued. That math still doesn't work out, but if they are waiting for a more opportune time to put this capital to work, then that is something I can understand.

However, we are now earning or at least very close to earning above their leverage costs in super-safe Treasuries. So I'm going to be less critical, only slightly less critical though.

Because if we factor in the expense ratio, it's still a net loss, but to a lesser degree than it was. It also means they missed out on the rally in the six months during this period. We know they maintained at least some of this sizeable weighting through the six months because of their N-PORT filing. For the period ending December 30th, 2022 , that filing showed roughly 18.25% allocated to U.S. T-Bills. That's an opportunity cost of sitting in cash equivalents rather than staying invested because you never know when the market will rally.

What portion of their portfolio that is invested is fairly diverse but, as usual with convertible funds, favors the more tech-related industries. This can be common because by being growth-oriented, there could be a better opportunity for investors could realize gains from the convertible feature of these securities in the first place.

In more recent data, they provide an update of their top ten holdings as of the end of June 29th, 2023.

The Eli Lilly ( LLY ) position, as well as the Microsoft ( MSFT ), Equinix ( EQIX ) and Broadcom ( AVGO ), are all examples of their common stock holdings. MSFT and AVGO are examples of tech investments. They appropriately categorize MSFT as "computer software and services" and AVGO as "semiconductors." However, EQIX is listed as a real estate investment trust. As a data center REIT, they will be impacted by not only the trends of the REIT sector broadly but the tech industry too.

On a YTD basis, these positions have been working hard in ECF's portfolio. Even EQIX, despite its REIT structure and the threats that come with a higher interest rate environment, is enjoying some strong results this year.

i3 Verticals ( IIIV ) is an example of one of their convertible positions . This was also an example of one of their low-yielding convertible positions, as it comes with a 1% coupon. As of their last report, the principal amount was $2.59 million. Their cost was $2.524 million, but the market value at that time was $2.402 million. That means should they simply hold this position to maturity in February 2025, there will be some upside here, even if redeemed at par. That is, as long as the company doesn't go bankrupt. Even some capital gains will be realized as it's above their cost basis.

The equity positions and the IIIV convertible notes have been regular holdings in this fund for quite a while now. In fact, they were positions listed a year ago, as noted in one of our previous updates.

Conclusion

ECF is trading at an attractive discount. The fund's distribution rate might not be the most exciting in some years, but there is always the potential for a higher year-end payment if one is required. If one is looking for convertible exposure with a bit of common equity as well, ECF represents one of the more attractive options at this time in the space.

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