SPY - GAB: A Solid CEF That Beat The Market Last Year But An Expensive One

2023-04-24 09:33:02 ET

Summary

• Investors are in desperate need of income.
• GAB invests in a portfolio of equities and pays out a percentage of its assets annually, regardless of the performance of the portfolio.
• The fund is invested primarily in relatively conservative stocks that should outperform during periods of market weakness.
• The fund failed to cover its distributions last year and its assets declined accordingly.
• The fund is extremely expensive, as evidenced by its very large premium.

It seems unlikely to be a point of contention that one of the biggest problems facing the average American today is the incredibly high rate of inflation that has permeated the economy over the past eighteen months or so. This is evident by looking at the consumer price index, which has increased by at least 6% year-over-year during eleven of the past twelve months:

While many investors and policymakers have become optimistic that the Federal Reserve has finally managed to get inflation under control, there is a very real chance that a near-term revival of energy prices will once again cause the prices of numerous goods and services to begin to spiral out of control. This will bring pain to numerous households that have been forced to take on second jobs or enter the gig economy just to obtain the extra money that they need to pay their bills and keep themselves fed.

As investors, we are certainly not immune to the rising cost of living since we also have bills to pay and need to eat. However, we do have alternative methods that we can employ in order to obtain the extra money that we need to maintain our lifestyles in the current inflationary environment. After all, we have the ability to put our money to work for us to earn money. One of the best ways to accomplish this is to purchase shares of a closed-end fund that specializes in the generation of income. These funds are unfortunately not very well-followed in the investment media, nor are most financial advisors familiar with them. As such, it can be difficult to obtain the information that we would really like to have prior to making an investment decision. This is quite unfortunate as many of these funds have a number of advantages over open-end and exchange-traded funds, such as the ability to employ certain strategies that allow them to provide much higher yields than pretty much anything else in the market.

In this article, we will look at the Gabelli Equity Trust ( GAB ), which is a fund that can be purchased by people seeking an income. This fund is certainly not what one would expect an income fund to look like, but it has a few advantages over other income-focused funds that invest in fixed-income securities such as bonds. In particular, the Gabelli Equity Trust has some built-in protection against inflation. I have discussed this fund before, but two years have passed since that time so obviously a great many things have changed. This article will focus specifically on those changes, as well as provide an updated analysis of the fund’s financial condition. Let us investigate and see if this fund could be a good addition to your portfolio today.

About The Fund

According to the fund’s webpage , the Gabelli Equity Trust has the stated objective of providing its investors with long-term growth of capital, although it has income as a secondary objective. This is not altogether unusual for a fund like this since, as the name implies, the Gabelli Equity Trust is an equity fund. As of the time of writing, the fund is almost entirely invested in common stock, although it does possess an allocation to common stock:

The reason why the fund’s investment objective is not unexpected is that it appears to be investing in common stocks for the same reasons as any other investor. The primary reasons why people purchase common stocks are to realize an income through the dividends that the stocks pay out as well as to benefit from the growth and prosperity of the issuing company as the dividends increase along with the value of the company itself. Unfortunately, over the last ten years or so, it has become very difficult to earn an income from most stocks as the Federal Reserve’s free money policy basically pushed the value of everything to bubble levels and suppressed yields. Even today, the U.S. utility index ( IDU ), which has long been considered a safe bet for income seekers, only yields 2.43%. That is far less than even a money market fund, which could very easily be a sign that stocks are still not really a great vehicle to use to earn an income from a portfolio.

With that said, the Gabelli Equity Trust is able to use certain strategies that allow it to boast a much higher yield than the issuing stock actually does. One of these is a managed distribution. The way it works is that the fund has committed to pay out 10% of the value of its assets every year. We have already seen that the yield that the fund receives from the stocks in its portfolio is almost certainly nowhere close to that. However, the fund does not need the yield to be that high, as long as the total return that it gets is that high. After all, it could always sell off stocks, borrow money against its stock holdings, or something like that to get the difference between its portfolio income and the required 10%. As long as the portfolio returns 10% annually, this should be sustainable indefinitely. The S&P 500 Index ( SPY ) has delivered a total annual return of 11.88% on average since its inception in 1957, so achieving a 10% total return with a stock portfolio should be possible during most years. However, it is certainly not always guaranteed to be successful, as the S&P 500 Index was down in 2022 along with this fund. In fact, the Gabelli Equity Trust was down 19.15% over the past year:

The fund seemingly underperformed the index, but the difference is not as much as might be thought at first glance. This is because the fund paid out a distribution over the past year that will not be captured in the market price performance. Over the course of the calendar year 2022, the Gabelli Equity Trust had a total return of –11.17%, which is quite a bit better than the S&P 500 Index over the same period. It is still a loss, naturally, but very few equity closed-end funds managed to deliver a positive return in 2022, which is probably because energy and healthcare were the only sectors (apart from specialty sectors like military contractors) that delivered positive returns in 2022:

Thus, the Gabelli Equity Trust paid out 10% of its assets, despite the fact that it actually took a loss. This is perhaps the biggest problem with the fund’s managed distribution. However, it should be pointed out that retirees have the same problem due to the required minimum distributions that must be pulled out of a retirement account even if the account suffered a loss during a given year. The goal is to earn sufficient returns during positive years to offset the bad years.

As might be expected by the fact that the fund outperformed the S&P 500 Index last year in terms of total return, its portfolio is vastly different from the broader market index. We can easily see this by looking at the largest positions in the fund:

As I have pointed out in various previous articles, the technology sector was one of the worst-performing ones in the market during 2022. This sector tended to be overweighted in most closed-end funds, which resulted in some disappointments for investors, including the fact that several closed-end funds were forced to cut their distributions. We do not see anything like that in this fund. Rather, these are mostly conservative companies that should enjoy some insulation against macroeconomic problems. For example, we have a tobacco company, a payment processor, a waste disposal company, and a company that manufactures agricultural equipment. These companies never achieved the bubble valuations that we saw in technology and a few other sectors, so they held up much better when the Federal Reserve started raising interest rates. These companies also probably will not be significantly impacted by a recession as their products and services will always remain in demand. That is something that could be very important today considering that there are numerous signs that the United States will plunge into a recession during the second half of this year.

There have been surprisingly few changes to the fund’s largest positions list over the past two years. In fact, the only two changes were IDEX Corporation ( IEX ) and Honeywell International ( HON ) being replaced with Genuine Parts ( GPC ) and Republic Services ( RSG ). Other than this, we do see a number of weighting changes, but these could be explained by one stock outperforming another in the market. The fact that there were so few changes even over a two-year period could lead us to expect that this fund has a remarkably low turnover. That is certainly the case as the fund’s annual turnover in 2022 was 9.00%, which is the lowest that I have ever seen on a closed-end fund. The reason that this is important is that it costs money to trade stocks or other assets, which is billed directly to the shareholders. This creates a drag on the fund’s performance and makes management’s job more difficult. After all, the fund’s managers need to generate a sufficient return to cover these expenses as well as have enough left over to give the investors a satisfactory profit. There are very few management teams that manage to achieve this on a consistent basis, which tends to result in actively managed funds underperforming their benchmark indices. This one has a surprisingly low turnover though, which should help it minimize expenses.

Leverage

In the introduction to this article, I stated that closed-end funds like the Gabelli Equity Trust have the ability to employ certain tactics that have the effect of boosting their returns beyond that of any of the underlying assets. One of the strategies that is employed to accomplish that is the use of leverage. In short, the fund borrows money and then uses that borrowed money to purchase common stocks. As long as the purchased assets deliver a higher return than the interest rate that the fund needs to pay on the borrowed money, the strategy works pretty well to boost the effective yield of the portfolio. This fund is capable of borrowing at institutional rates, which are considerably lower than retail rates, so this will usually be the case.

However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not employing too much leverage since that would expose us to too much risk. I generally like to see a fund’s leverage remain under a third as a percentage of its assets for this reason. The Gabelli Equity Trust satisfies this requirement, fortunately. As of the time of writing, the fund’s levered assets comprise 21.55% of the portfolio, so it appears as though it is striking a reasonable balance between risk and reward. This is something that is nice to see, particularly considering that we are no longer in a raging bull market.

Distribution Analysis

As mentioned earlier in this article, the primary objective of the Gabelli Equity Trust is to provide its investors with long-term capital appreciation, although it does have a secondary focus on income. However, the fund also specifically states that it pays out 10% of its assets under management as distributions annually. Thus, we can expect that it will almost certainly boast a very attractive yield. That is indeed the case as the fund pays out a quarterly distribution of $0.15 per share ($0.60 per share annually), which gives it a 10.53% yield at the current price. It has been fairly consistent with its distribution in recent years, although it does sometimes make a special quarterly distribution at the end of the year. As is always the case though, we want to investigate the fund’s finances to determine whether or not it can sustain its payout comfortably.

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 December 31, 2022. As such, it is a much newer document than we had available the last time that we discussed this fund, and it should give us a very good idea of how well the fund navigated the challenging market environment of 2022. During the full-year period, the Gabelli Equity Trust received $30,948,084 in dividends and $788,372 in interest from the assets in its portfolio. This gives the fund a total income of $31,736,456 for the full-year period. It paid its expenses out of this amount, which left it with $7,428,571 available for investors. As might be expected, that was nowhere close to enough to cover the $175,996,560 that the fund actually paid out in distributions over the period. At first glance, this is certain to be concerning as the fund’s net investment income is nowhere close to enough to cover the distribution.

However, the fund does have other methods through which it can obtain the money that it needs to cover its distribution. For example, it might have capital gains as these are not considered to be investment income, but they do still result in money that can be used to pay the investors. The fund had mixed success at this, which might be expected from the conditions that dominated the market during 2022. The fund achieved net realized gains totaling $90,014,384 during the period, but these were more than offset by $296,535,384 net unrealized losses. Overall, the fund’s assets declined by $364,455,099 over the full-year period after accounting for all inflows and outflows. Thus, the fund failed to cover its distributions, but this is to be expected considering that it pays out a set percentage of its assets and so needs a positive return. The fund should be fine once we enter a bull market again, but it is uncertain when exactly that will occur.

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 Gabelli Equity Trust, 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 purchasing a fund’s assets for less than they are actually worth. This is unfortunately not the case today. As of April 21, 2023 (the most recent date for which data is available as of the time of writing), the Gabelli Equity Trust had a net asset value of $5.22 per share but the shares currently trade for $5.70 each. That is a 9.19% premium to net asset value, which is a fairly high price to pay for any closed-end fund. However, it is more attractive than the 10.81% premium that the shares have traded for on average over the past month. It seems unlikely that this fund will ever be acquired at a reasonable price since it usually trades at a premium. If you do genuinely want to buy it, it will probably be best to get it for as small a premium as possible.

Conclusion

In conclusion, the Gabelli Equity Trust is a fairly solid equity fund that should be able to provide investors with a high level of income to assist with their bills. As equities are theoretically a hedge against inflation, the fund should help to maintain the purchasing power of your money better than most income-focused funds. It also managed to beat the S&P 500 Index last year, which is an impressive feat. Unfortunately, it also failed to cover its distribution and is incredibly expensive.

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