RVT - Value Investing Made Easy: Earn 8% With RVT

2023-10-24 07:35:00 ET

Summary

• Everything in life doesn't have to be complicated and difficult.
• Earn a livable income from an outperforming fund.
• Royce Value Trust focuses on Value stocks, and we explain what that means.

Co-authored by Treading Softly.

Have you ever heard the saying, "birds of a feather flock together?"

I understood the concept of this long before I ever had a flock of my own, that similar types of personalities, or people with similar habits, would naturally gravitate towards one another because of those similarities. It wasn't until I owned my own flock of chickens with various breeds that I recognized that those birds with so many similarities - the same diet, the same habitat, the same access to water - would still gravitate towards other chickens of the exact same feather pattern or breed, even though there were no other identifiable marks on the outside of them. I could have two birds that looked similar to one another and were different breeds, and they would still flock with their own breed, even if they looked less like them.

When looking at something as large as the stock market, it is often useful to create different groups that have a certain similarity. We can look at a particular stock and sometimes get so zoomed in, that we can't see the forest. Often, the performance of a specific stock might have less to do with the company and more to do with macroeconomic trends. So, by grouping stocks that have something in common, it is easier to spot these broader trends.

There are numerous ways to dissect the market into groups. One common way is "Growth" and "Value" stocks.

Growth stocks are stocks that the market is valuing based on future earnings. They might have very low or even negative earnings today, but investors are buying because the company has promise for future growth. How much a Growth stock is expected to earn in the future is more important to the share price than how much it is going to earn next quarter.

Value stocks are the opposite. They are companies where the market expects slow or even no growth in earnings. These are often mature businesses with well-established business models that produce cash flows that are somewhat predictable. You find a lot of Value stocks in sectors like finance, real estate, utilities, etc. Value stocks are valued based on the earnings they are producing today.

Breaking the market into these two groups, we can see that Growth stocks are trading at a higher price/earnings ratio than they were from the mid-2000s through 2019. Meanwhile, Value stocks are trading at a P/E ratio that isn't too far removed from what we saw in the mid-2010s. Source .

Another way to group stocks is by market capitalization. When we do this, we can see that there is a huge valuation gap between large to MegaCap and small to MidCap companies.

Today, the larger a company is, the higher its valuation. It is important to note that large and MegaCaps are expensive relative to smaller companies and relative to their own history. Meanwhile, small to Mid-Cap companies are trading at valuations that are very low and only traded significantly lower during the March 2020 selloff and at the bottom of the GFC since 1998.

What does this information tell us? It tells us that Growth stocks and large to Mega-Cap companies are trading at valuations above their historical averages, while Value and small to Mid-Cap stocks are trading at valuations below their historical averages.

We don't know what the future will bring; we could see the prices of large-cap growth stocks go up more, and both have traded at higher valuations in the past. Personally, I prefer to buy stocks when they are cheap, and when we look at groups, the cheap companies right now are most likely going to fall into the category of being Small to Mid-Cap Value stocks.

A Top-Notch Value Fund

Royce Value Trust ( RVT ), yielding 8.5%, is a CEF (Closed-End Fund) that focuses on Small-Cap stocks. It has outperformed the Russell 2000 index since inception in 1986. We see a lot of fund managers outperform over short periods, but there aren't as many that have outperformed over 36 years as RVT has. Source .

Of course, like any investment strategy, RVT has had periods of significant outperformance and periods of underperformance. Since RVT focuses on Small-Cap companies, how well the Small-Cap group does is going to have a significant impact on RVT's performance. Fortunately, RVT has a long history, so we can look at prior experience from conditions most similar to today.

The valuation difference between Large-Cap and Small-Cap stocks is the largest it has been since 2001.

At the same time, we are seeing high interest rates, a strong job market, and moderate inflation - very similar to what we saw in 2001. In January 2001, the 10-year Treasury Rate (US10Y) was near 5%, CPI was 3.39%, and the Fed's target rate was 6%. Today, the 10-year Treasury Rate is near 4.8%, CPI is 3.67%, and the Fed's target rate is 5.5%.

Against that backdrop, how did RVT perform?

History doesn't repeat, but it sure does rhyme. When you buy stocks that are trading at low valuations, good things tend to happen. Especially when those stocks are trading at low valuations in large groups, as opposed to a single company that might not recover.

RVT has a proven history of success in the Small-Cap space with a value focus. When we combine that with conditions where Small-Cap and value stocks are trading at low valuations, while large-cap and growth stocks are at relatively high valuations, RVT is a fund we want to have in our portfolio.

For the dividend, RVT pays a variable distribution that is adjusted quarterly based on NAV at the end of the trailing four quarters. This means that the dividend rises and falls with RVT's NAV, but since it is using an average of the past four quarters, changes in the dividend are gradual. Since RVT is trading at a 14% discount to NAV, we are able to enjoy a higher yield on our investment.

Conclusion

With RVT, you can have an index of beating returns over the long haul, as well as a dividend that will vary as needed to keep the fund running. This means that my income will be stronger in the years that the fund outperforms, and potentially be weaker in years if the sector of small caps struggles.

The stock market, just like a flock of chickens, can be subdivided in many different ways. Yet, understanding the impact on a single chicken can be better understood by knowing what its breed is and how the entire breed can be impacted by something, not just trying to zero in on the specific bird. Likewise, a company can be impacted in sympathy along with their entire sector, even if that company is doing nothing wrong or has no issues in its performance.

We've all lived long enough to recognize that some companies sell off in sympathy with others. Recently, we saw that the entire utility sector was selling off as well as individual utilities (even though individual utilities were performing excellently fundamentally) simply because the entire sector was selling off.

When it comes to your retirement, sometimes it's good to have holdings that cover a subsector of the market in its entirety without having to play the game of picking individual stocks. This allows you to leverage the expertise of a portfolio manager and provide you with strong income. All you have to do is own the shares.

One beautiful thing about the Income Method is how easy it is to follow. It's not a complicated method with 100 different dials and switches that you need to worry about twisting and flipping at the right time to get the perfect outcome. Instead, it's meant to be as simple, as vanilla, as possible - no options trading, no swing trades from momentum trades, no need to try and buy and sell securities after they've moved just a couple of pennies in share price to try and get the most value squeezed out of the market. Instead, we hold wonderful companies that pay us excellent dividends so we can then go out and buy food that we need or the gas to drive our cars. Life becomes a whole lot more affordable when the market is paying for it, and you're not stressing about every single dollar that is being spent. Financial freedom is not being unfathomably wealthy or unbelievably rich. It's about having the comfort of knowing that you're able to pay your bills and pay your expenses without running out of the funds that you need. Income investing can give you that.

That's the beauty of my Income Method. That's the beauty of income investing.

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