NIE - NIE: Short-Term Pain In This Current Environment

2023-10-31 11:01:57 ET

Summary

• Virtus Equity & Convertible Income Fund drops nearly 4% amidst broader market selloff.
• NIE relies on capital gains to cover its 10% annual distribution rate, which is challenging in the current high interest rate environment.
• NIE has outperformed the Morningstar US Moderate Aggressive Target Allocation benchmark but has not fully captured gains of its equity exposure.

The broader selloff seen in the recent days has also hit shares of the Virtus Equity & Convertible Income Fund ( NIE ), which dropped nearly 4% over this period, as investors continued to digest mixed earnings results and new macroeconomic indicators.

The fund's tilt to growth stocks makes it certainly more volatile in a risk-averse environment. Meanwhile, it is fair to say that NIE is still delivering a total return of nearly 11% year-to-date.

The flip side of it is that NIE relies mostly on capital gains to cover its annual distribution rate of roughly 10%. While stock appreciation in the fund's portfolio is likely to support such a distribution in the long run, the short-term outlook is challenging, as the high interest rate environment poses a challenge to growth stocks and current geopolitical tensions are certainly not helping for the time being.

Fund Description & Highlights

Having as the benchmarks the Russell 1000 Growth Index and the ICE BofA US Convertible Index, with a 60% / 40% allocation respectively, NIE is essentially a blended fund with investments in equities and convertible securities. Consistent with its growth-oriented equity exposure, the fund is largely focused on obtaining total return through capital appreciation and, to a lower extent, income from convertible securities and dividends.

That is not to say that NIE does not offer a juicy distribution, on the contrary, NIE's annual distribution has yielded in the range of 6% to 8% over the last decade, and since 2022 distributions have been above 10% annually, without any distribution cuts over this period.

This has a lot to do with the allocation strategy of the fund, as its overweight on higher growth companies have been quite favorable to the performance, since so-called growth stocks have largely outperformed the broader market during this time span.

Nearly 61% of the fund was invested in equities as of September 29th, 2023. From the sector allocation perspective, the equity portfolio of NIE looks relatively close to the S&P 500 index, with information technology accounting for nearly 28.0% of total equities, consumer discretionary 17.7%, financials, 11.9%, healthcare 10.0%, industrials 9.5%, communication services 9.4%, energy 4.9%, utilities 3.5%, Materials 2.2%, Real Estate 1.6% and consumer staples 1.3%.

The relevant distinctions relative to S&P 500 are the NIE's overweight allocation on consumer discretionary (+7.0%) and underweight exposure to healthcare (-3.4%) and consumer staples (-5.3%).

Relative to the Russell 1000 Growth index though, NIE has a much more diversified allocation strategy, as the former is heavily concentrated on technology (51.0%) and has little exposure to financials (2.6%) and communication services (0.7%).

As a result, S&P 500 seems a more appropriate benchmark for NIE, at least in terms of sector allocation.

Looking at individual stocks' exposure, NIE's top six constituents are basically as same as S&P 500 and Russel 1000 Growth indexes (Alphabet (GOOG), (GOOGL), Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Tesla (TSLA), Nvidia (NVDA)). On the other hand, NIE's top ten holdings account for nearly 40% of the equity side of the fund, while these top ten represent just 30% for S&P 500, but as much as 51% for Russell 1000 Growth index, due to its higher concentration on technology stocks.

Overall, such differences in the stock exposure give the equity portion of NIE a compounded P/E Forward valuation at nearly 20.5 as of Sep 29th, 2023, compared to S&P 500's P/E Forward of 18 and Russell 1000 Growth index's P/E Forward of roughly 25.

Of course, growth stocks are expected to trade at higher multiples, and the large exposure of Russell 1000 Growth index to the technology sector largely explains its higher P/E multiple. On the other hand, NIE's higher valuation relative to S&P 500 is consistent with NIE's overweight on consumer discretionary stocks, combined with its lower exposure to consumer staples, as discretionary stocks typically trade at higher multiples than consumer staples.

In my view, NIE's overweight exposure to the consumer discretionary sector is a factor that can distinguish the fund from the broader S&P 500, as the consumer discretionary sector is expected to generate higher growth and share price returns to shareholders over time.

As of Sep 29th 2023, the remaining of NIE's portfolio is comprised of convertible securities (34.4%) and cash and equivalents (4.7%). The vast majority of convertibles invested by the fund have maturity below 5 years and coupons ranging from 0% to 4%, with more than half of them being lower than 2%. This will result in a weighted coupon of 1.81%, which is below the 3% average of the category.

Strong Performance In The Long Run

There is no question that both equity indexes and convertibles have delivered a great total return performance over the past ten years, as illustrated below:

As expected, NIE (blue line in the chart) is somewhere between the equity indexes and the convertible securities portfolio. For comparison purposes, the SPDR Bloomberg Convertible Securities ETF ( CWB ) was adopted as the benchmark for convertible securities.

The following table shows the total return in different timeframes for NIE, equity indexes and CWB, as well as a hypothetical portfolio comprised by 60% of each equity index and 40% of convertibles.

Despite the poor performance in the past month, we can see that NIE has outperformed the convertible securities benchmark, but has not been able to fully capture gains of the fund's equity exposure, as it has lagged the hypothetical 60/40 portfolio for both S&P 500 and Russell 100 Growth indexes, particularly over the 10-year period.

To me, it is less of a concern, as the past decade was marked by low interest rates and extraordinary returns for growth stocks, and chances are that the environment for the next ten years or so is not going to be the same, at least in terms of the underlying interest rates for the most important economies in the world.

However, overall, the combination of equities and securities applied by NIE has delivered consistent returns relative to another benchmark, the Morningstar US Moderate Aggressive Target Allocation NR USD, which seeks 77.5% exposure to global equity markets through a diversified mix of stocks and bonds. As we can see, NIE has handily outperformed the benchmark YTD and over the 10-year period as well.

A Challenging Environment For NIE's Distributions

Based on the dividend generated by equities of nearly 1.65% and the convertibles weighted coupon of 1.81%, the income produced by NIE's assets is somewhat modest for a fund with annual distributions of roughly 10%.

For context, over the first six months of 2023, the fund generated $2.117 million through interest and $3.361 million through dividends as investment income. After netting out $3.304 million relative to net expenses during the period, net investment income was $2.171 million. Meanwhile, net realized gains from investments came in at $9.912 million and written options also produced a gain of 609 million.

On the flip side, as the distribution in the period was $27.709 million, the fund had to cover it by returning capital to shareholders, using $15.017 million from unrealized appreciations. As these unrealized appreciations were $61.283 as of June 30th, 2023, it was not a major issue, and net assets increased by $46.266 or roughly $1.68 per common share.

In August, the fund management maintained the quarterly distribution of $0.50 per common share, and declared it as return of capital as well. While remaining unrealized appreciations at roughly $1.18 per common share can still support another quarterly distribution at the end of the year, it seems to me that a special year-end distribution in the neighborhood of $1.70 to $1.90, as we have seen in the previous two years, is quite unlikely.

As such, there is a good possibility that total distributions are limited to $0.50 per quarter, without any special distributions, until the stock market weakness persists, what will bring NIE's distribution rate back to the mid-single digit.

The Price/NAV Discount Has Widened

Following the recent broader market decline, the discount in shares of NIE over its Net Asset Value has just widened to 11.60%, a level that is reasonably below the 3-year average of -10.53%, reflecting the risk-off environment in the recent weeks. On the other hand, this discount is still above previous levels seen over the course of the year, when it dropped below -12%, as shown below.

And while the price/NAV discount starts to become appealing, my view is that shares of NIE should remain particularly vulnerable until we see an improvement in stock market sentiment, as the fund relies on gains in its equity portfolio to support distributions, and changes in the distribution policy may cause the price/NAV discount to widen further

That said, while I see NIE as an interesting fund to keep on the watchlist, as it combines equities and convertibles in just one investment vehicle, I rate NIE as a hold at the present moment due to current market environment and distribution headwinds.

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