MSFT - EOI: Offering A Rare Discount But Questions About The Distribution

2023-03-27 09:40:19 ET

Summary

• Eaton Vance Enhanced Equity Income Fund invests in a portfolio of companies and employs a covered call writing strategy to generate a high level of income for investors.
• The EOI closed-end fund is heavily weighted toward a few large technology companies, which delivered a poor performance last year.
• The CEF underperformed similar funds that have a more diversified portfolio last year, but it is somewhat well-positioned for a near-term recession.
• The distribution is okay for now, but management is going to have a challenge maintaining it going forward.
• The fund is trading at a discount, which is rare.

It is unlikely to come as a surprise to anyone reading this that one of the biggest problems that have been plaguing most Americans over the past eighteen months or so is the incredibly high level of inflation in the economy. In fact, there has not been a single month over the past year in which the consumer price index went up by less than 6% year-over-year:

This has, naturally, has a very negative effect on the number of goods and services that we can purchase with a given level of income. As such, people have become ever more desperate to secure higher levels of income simply to maintain their lifestyles.

We have certainly not been unaffected by this as the Federal Reserve's attempt to fight inflation has caused the market to decline, which means that we have fewer assets that can be invested and generate the returns that we need to cover our own expenses. In addition to this, our bills have also gone up as a result of inflation. Thus, investors are in need of more income just like everyone else. However, we do not have to resort to things such as taking on a second job in order to obtain this extra income. This is because we can put our money to work for us to generate this income. One of the best ways to do that is to invest in a closed-end fund, or CEF, that specializes in the generation of income. These funds are not exactly very well discussed or followed in the investment media, but they offer a lot of benefits for anyone that is seeking income. In particular, these funds offer an easy way to obtain a portfolio of assets that can usually generate a higher yield than any of the underlying assets possesses.

In this article, we will discuss the Eaton Vance Enhanced Equity Income Fund ( EOI ), which currently yields an impressive 8.78% at the current price. This is certainly a high enough level of income to satisfy any investor that is in need of income. I have discussed this fund before but was rather disappointed with its portfolio. The fund's strategy is certainly a reasonable way to get income, though, so it is a good idea to revisit it today. This is especially true since several months have passed since we last looked at the fund and obviously a few things have changed, including the release of a more recent financial report. This article will therefore focus specifically on those changes.

About The Fund

According to the fund's webpage , the Eaton Vance Enhanced Equity Income Fund has the objective of providing its investors with a high level of current income. This is, to put it mildly, a strange objective for a common equity fund. Indeed, this is a common equity fund, as 99.22% of the fund's assets are invested in common equity:

The reason why this objective is strange is that common equity is not generally considered to be an income instrument. After all, the S&P 500 Index (SP500) currently yields a scant 1.63%. In fact, there are very few common equities outside of the fossil fuel sector that has a higher yield than a money market fund today. This makes a certain amount of sense, since common stocks are generally a total return vehicle since they are purchased primarily for capital gains and only to a lesser degree for the income that they provide through dividends.

With that said, the Eaton Vance Enhanced Equity Income Fund does not simply use a buy-and-hold strategy like we commonly see with equity funds. Rather, this fund makes heavy use of an options strategy to produce the income that it targets. As I mentioned in my previous article on this fund, it writes call options against the equities in its portfolio, which is a common way to generate income. This is because the fund will receive an upfront payment when it sells the option. In a sense, this is like a synthetic dividend, since the objective is for the stock price to be below the strike price of the option at maturity. In such a situation, the option will not be exercised, and the fund can keep the stock to write a new option against and repeat the process. The risk here is that it essentially caps the fund's capital gains from the stock position since the option will be exercised if the price of the stock is above the stock price. In a flat or bear market though, the odds that the option will be exercised against the fund are pretty slim, so the strategy works pretty well in such environments. This is precisely the kind of market that we have today, making a fund like this appealing.

The same factor that makes the fund a good holding during flat and bear markets helps the fund outperform the index in such environments. After all, it will still have the option premium income offsetting some of the losses during a bear market. This happened during 2022 as the fund's portfolio delivered a -17.91% total return as compared to -18.11% for the S&P 500 Index. This is, admittedly, not as good as it should have been able to deliver with a covered call strategy. As I mentioned in my last article on the fund, this is because the fund is heavily weighted to the mega-cap technology companies. That is quite obvious by looking at the largest positions in the fund. Here they are:

As we can clearly see, Microsoft ( MSFT ), Apple ( AAPL ), Alphabet ( GOOG ), and Amazon ( AMZN ) account for a sizable portion of this fund's portfolio. These four companies, along with Meta Platforms ( META ), all significantly underperformed the S&P 500 Index in 2022. I discussed this in a blog post earlier this year. The heavy weighting assigned to these companies caused the fund's stock positions to underperform the market, and the option premium profits helped to offset some of these losses. The BlackRock Enhanced Capital & Income Fund ( CII ), which uses a similar strategy, only lost 10.95% in 2022 because it is a bit better diversified than the Eaton Vance Enhanced Equity Income Fund.

With that said, the fund's allocation to each individual sector is not particularly out of line with the market. In fact, only real estate, utilities, and consumer discretionary have substantially different weightings than the S&P 500 Index:

The difference between this fund and the index comes largely from the fact that the fund's weighting to a few companies is substantially different from the index as a whole. The Eaton Vance Enhanced Equity Income Fund only has 68 common stock positions, which is much less than the index as a whole. As I pointed out in the past, an outsized percentage of the total returns of the index over the past came from just a handful of companies, which are the ones that collapsed in 2022 when the bubble popped. This fund, like most of Eaton Vance's funds, happened to be overallocated to these companies. This differs from peers that had more diversification and so performed much better.

One thing that is nice to see is that this fund is underweighted in the consumer discretionary sector right now. That could be an advantage because we are seeing some signs that the American consumer is tapped out. In December of 2022, consumer credit growth fell significantly month-over-month and continued this trend in January of 2023:

This is a clear sign that the American consumer cannot afford to keep maintaining spending at previous levels. This is probably due to the steep increases in food and energy costs over the last eighteen months. While consumers were able to keep up with these rising expenses and keep spending money on discretionary items by spending down their savings and building balances on their credit cards, their ability to do that may have reached its limit. If that is correct, consumer spending may be about to slow down. That will have a negative effect on the consumer discretionary sector, so it is nice to see that the fund's management may be getting ahead of this by underweighting the sector.

Distribution Analysis

As stated earlier in this article, the primary objective of the Eaton Vance Enhanced Equity Income Fund is to provide its investors with a high level of current income. In order to accomplish this, it utilizes a covered call writing strategy, which does generally work pretty well to generate a high level of income due to the premiums received from the option sales. As such, we can assume that the fund has a fairly high yield. That is certainly the case as the fund currently pays a monthly distribution of $0.1095 per share ($1.314 per share annually), which gives it an 8.78% yield at the current price. That is certainly a reasonably high yield that should provide a nice source of additional income. The fund's distribution history has also been better than some of Eaton Vance's other option-income funds as it has steadily increased over the past decade:

The fund's overall consistency with its distribution over the past ten years will likely appeal to those investors that are seeking a safe and secure source of income to use to pay their bills and cover other expenses. As is always the case though, we want to ensure that the fund can actually afford the distribution that it pays out. After all, we do not want to be the victims of a distribution cut since that would both reduce our incomes and most likely cause the fund's share price to decline.

Fortunately, we do have a very recent document that we can consult for this purpose. The fund's most recent financial report corresponds to the full-year period that ended on September 30, 2022. Although this report will not include any information about the fund's performance over the past six months, it is still a much newer report than we had available to us the last time that we discussed this fund, and it should give us a pretty good idea of how well the fund weathered the challenging market conditions that occurred once the Federal Reserve started raising interest rates in earnest in March 2022. During the full-year period, the Eaton Vance Enhanced Equity Income Fund received a total of $10,491,652 in dividends and strangely no interest from the assets in its portfolio. It paid its expenses out of this amount, which left it with $2,860,839 available for the shareholders. As we might be able to guess, that was nowhere close to enough to cover the $52,372,375 that the fund actually paid out during the same period. At first glance, this is something that could be concerning as the fund's net investment income was nowhere close to enough to cover its needs.

However, it is important to remember that there are a lot of things that result in the fund receiving money but are not considered investment income. For example, premiums received from options strategies are considered to be either a return of capital or capital gains depending on the situation. In addition, capital gains themselves are not considered to be investment income. Fortunately, the fund did do much better when we look at these things. The fund reported net realized gains of $52,831,651, but this was offset by $101,492,752 net unrealized losses. While the net unrealized losses are concerning, the fund's net investment income plus realized gains were enough to cover the distribution.

Overall, the fund's assets declined by $139,394,528 after accounting for all inflows and outflows though, so there are still some concerns here. This is because the fund issued several new shares during the year, which made the distribution more expensive going forward. When we combine that with the lower asset base, management will have a difficult task maintaining that distribution going forward because the required return is now much higher. I do not wish to sound the alarm yet, but I would not be surprised to see a distribution cut in the near future.

Valuation

It is always critical that we do not overpay for any asset in our portfolios. This is because overpaying for any asset is a surefire way to generate a suboptimal return on that asset. In the case of a closed-end fund like the Eaton Vance Enhanced Equity Income Fund, the usual way to value it is by looking at the fund's net asset value. The net asset value of a fund is the total current market value of the fund's assets minus any outstanding debt. It is therefore the amount that the shareholders would receive if the fund were immediately shut down and liquidated.

Ideally, we want to purchase shares of a fund when we can acquire them at a price that is less than the net asset value. This is because such a scenario implies that we are buying the fund's assets for less than they are actually worth. This is, fortunately, the case with this fund today. As of March 23, 2023 (the most recent date for which data is currently available), the Eaton Vance Enhanced Equity Income Fund had a net asset value of $15.03 per share but the shares only trade for $14.97 a piece. This gives the fund's shares a 0.40% discount to net asset value at the current price. This is much better than the 3.16% premium that the shares have averaged over the past month, so the price today is as good as we are likely to get for a while.

Conclusion

In conclusion, the Eaton Vance Enhanced Equity Income Fund uses a pretty good strategy to get a high level of income from a common stock portfolio. Unfortunately, the fund has substantial exposure to only a few large technology companies that have been delivering disappointing performance in the Federal Reserve's new monetary tightening regime. That has caused this fund to underperform some of its peers, although it is still likely to outperform the S&P 500 Index in a flat or bear market. The distribution was covered in the most recent period, but there are some concerns about how easily the fund can maintain it given the rising share count and smaller asset valuation. Fortunately, the EOI price today is better than normal, so someone that wants to buy Eaton Vance Enhanced Equity Income Fund would do well to make the purchase today.

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