SCD - SCD: Get 11% Yield On Cost From This Energy/Tech Total Return Fund

2023-10-16 05:24:39 ET

Summary

• LMP Capital and Income Fund is a unique fund offered by Franklin Templeton with a focus on total return and income.
• The fund's asset allocation includes a mix of MLPs, technology stocks, and fixed income securities.
• SCD has outperformed a mix of stocks and bonds and has a high yield income stream with a substantial discount to NAV.

I have been investing for a long time and I am not aware of any other fund quite like LMP Capital and Income Fund, Inc. ( SCD ). With an inception date of February 2004, SCD is offered by the Clearbridge Investments subsidiary of Franklin Templeton. According to the fund Prospectus, it started out as 29,700,000 shares of Salomon Brothers Capital & Income fund offered at $20 per share, raising about $566M in proceeds to the fund at inception. The fund's objective is total return with an emphasis on income. Perfect for my Income Compounder portfolio.

The fund's investment policy is to invest in at least 80% equity and fixed income securities from both US and foreign issuers. The fund uses about 20% leverage and includes a mix of MLPs, technology stocks, and fixed income securities from diversified sectors as illustrated in this chart from the fund's semi-annual report , dated May 31, 2023.

One thing to note is that the fund is actively managed, and you can clearly see how the fund managers have made some slight shifts in the asset allocation. Over the 6-month period from November 2022 to May 2023 there was a higher percentage allocated to Tech and Short-Term investments, and less allocated to Financials, Health Care, and Communication Services. Also, less was invested in underlying funds (down from 2.6% to 1.1%).

The asset allocation now looks like this (as of 9/30/23), according to the fund website.

The fund's top holdings, which make up more than a third of the total holdings (37.7% as of September 30), include well-known names that are high quality in each of the sectors they represent.

SCD has outperformed a 65/35 mix of stocks and bonds over the past 1, 3, and 5 years and has come close to matching the total return performance over the life of the fund as shown in this performance table from the fund website .

The mix of energy ((MLP)) holdings and technology stocks has worked well over the past 1 year and 3-year periods and since pre-Covid has kept pace with the energy sector over the past 5 years as shown in this 5-year total return chart of SCD and XLE.

With the recent upturn in energy and the pullback over the past couple of months in stocks the fund managers have to be nimble with their asset allocation strategies. One recent article from Clearbridge Investments talks about Taking the Long View . In that article, they make the following key points ( emphasis mine ) that I believe are relevant to today's income investors.

• We believe the toughest test for investors lies in the coming quarters as fiscal stimulus and consumer resilience fade while the lagged effects of monetary tightening take hold.
• Any tailwind from higher fiscal spending could be weakened or nonexistent should government spending caps go into effect. The other lever to stave off a slowdown, monetary easing, also appears to be off the table as the Fed remains hamstrung by inflation and a tight labor market.
• Unusually narrow market breadth and tepid small cap performance a year removed from recent market lows suggest the current rally could be short lived, leading us to favor growth and defensive equity positioning until more economic clarity emerges.

For the SCD fund the shift to more growth in the form of tech stocks such as Apple, Microsoft, and Broadcom, along with increasing allocations to defensive equities like MLPs makes a lot of sense to me. Clearbridge believes that the recession risk is even higher now than it was a year ago. This Exhibit from the same article displays their recession indicators now flashing red.

Midstream energy and MLPs tend to be defensive investments that generate high yield income during inflationary environments and are less impacted during a recession due to the long-term contract rates they typically enjoy. In my article from May of this year, Midstream Energy For Income - Not Your Grandfather's MLP | Seeking Alpha , I discussed the reasons why midstream energy holds up well during recessions and why income investors in particular should favor MLPs and midstream energy holdings as a diversified asset class to hold along with other income vehicles such as CEFs and HY bonds.

As of June 30, the fund fact sheet shows Total Net assets of about $250 million. At that time, the fund NAV was $14.81, and the market price was $12.81 resulting in a discount of -12.74%. The fund was paying a quarterly dividend of $0.26 which worked out to an annual yield based on market price of about 8%. Since that time, on August 3, the fund announced an increase to the quarterly dividend to $0.34, and a switch to monthly dividends starting in October.

Now, as of October 13, the fund still trades at a substantial discount to NAV of about -13.5% and offers an annual yield of over 11% based on the new monthly distribution of $0.113, effective October and November. Total net assets have declined slightly to about $241 million as of 9/30/23 (according to the fund website).

My assumption is that by switching to a monthly distribution, and increasing it as well, the fund managers are trying to stimulate buying to narrow the discount. The fund NAV has been relatively stable and has even risen by 20% over the past year, yet the discount has remained wide despite the positive indicators. I expect that at some point soon, investors will start to bid up the price to narrow the discount, unless the US economy does nosedive into a full-blown recession over the next few months.

Portfolio management is based on an experienced, active team with many years of combined experience and the backing of Clearbridge.

Summary

The SCD fund is one that offers a high yield income stream based on now monthly distributions that offer an annual yield exceeding 11% while trading at a substantial discount to NAV of -13.5%. The fund uses an actively managed blend of common stocks, MLPs, REITs, and other fixed income securities to generate income and capital appreciation. The NAV has risen by more than 20% over the past year and the distribution was raised in August from $0.26 per share quarterly to $0.34 per share, now based on a monthly dividend of $0.113.

The management team is experienced and has the backing of Clearbridge Investments, a Franklin Templeton subsidiary that also manages several other funds including the ClearBridge Energy Midstream Opportunity fund ( EMO ). With the mix of about 25% MLPs, along with common stock holdings in several high-quality tech names and a mix of other common stock and fixed income holdings that are somewhat defensive in nature, I believe that SCD offers a unique opportunity for long-term income investors to initiate a position or add to existing holdings while it trades at a wide discount.

The biggest risk is that the economy decides to take a significant downturn over the coming months and the fund managers are unable to shift the asset mix quickly enough to respond. If that were to happen, I could envision a potential future cut to the fund's distribution, but that is the worst-case scenario in my opinion and not likely to happen for at least the next 6 to 12 months.

I rate SCD a Buy and began purchasing shares in my Income Compounder portfolio.

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