Co-produced with Treading Softly
I often get asked about my Income Method. For many, the theory behind the practice can trip them up. They see the results – which speak for themselves as cash pours into one’s brokerage account at levels never seen by them before. However, they struggle to sum up the Income Method into a pithy statement.
It’s similar to when someone asks what you do for a living. Your job title isn’t always the most helpful, especially if you’re called an “analyst,” since that covers such a wide berth of possibilities.
So what is the boiled down, distilled, and purified version of the Income Method? We are “Buying income today to enjoy tomorrow.” The Income Method covers the who, what, where, when, and how. The “why” is unique for each investor.
Why do you invest? for retirement? Financial security? To take care of a loved one who needs help? To travel the world? Save for a child’s college?
We have many reasons for what we do, and each is as unique as you are.
So whatever your reason is, we use our Income Method with its varied rules – like The Rule of 42 – and its various situational guides – like The Tax Loss Survival Guide – to help investors like yourself discover income investing and thrive from its impacts and outcomes .
Let’s look at two picks that allow us to buy income now and enjoy it for years to come.
Pick #1: ECC – Yield 14.5%
Eagle Point Credit Company Inc. (ECC) is a CEF (Closed-End Fund) that specializes in buying positions in CLOs (Collateralized Loan Obligations). As investors, I believe it is important for us to help out those who have problems. After all, a free-market economy is very much about solving various problems in a profitable way. ECC has a number of “problems” which are: too much income, not enough defaults, and rising rates that threaten to drive profits higher.
Is there such a thing as “too much income”? Well, if you’re running a CEF there is. You see, CEFs are required to distribute the majority of their taxable income. If they don’t, they have to pay an excise tax and they have to distribute 100% of their taxable income. I love investments that have this “problem,” and ECC is one of them. Despite raising its dividend twice in 2021, a 50% hike in the regular monthly dividend, and then paying out a special dividend of $0.50 (more than they paid out in the entire first half), ECC still failed to distribute enough with approximately $1.25 in undistributed net investment income.
For 2022, ECC will have to distribute 100% of taxable income, plus that $1.25. It will do so through a combination of regular monthly dividends and very likely, a special dividend at year-end to clear out any remaining obligation.
This brings up “problem” number two. Borrowers keep paying their loans! ECC already has a “problem” with having “too much” taxable income. They’re in the business of owning debt and have a “first loss” position. So when a borrower fails to pay as agreed, ECC is right there, first in line to write the loss off on their taxes. Yet borrowers are paying as agreed as defaults declined to historic lows.
Historically, the average default rate for leveraged loans is 2.82%. Excluding recessions, it is usually in the 1.75%-2.00% range.
Coming into 2022, Fitch projected default rates below average, at 1.5%, and that estimate was viewed as bullish for CLOs. So far, it appears to have been a conservative estimate.
The third “problem”? The loans held by CLOs are floating rates. The structure is floating rate assets funded with floating rate debt tranches. As interest rates rise, CLOs benefit in two ways.
First, demand for CLOs and leveraged loans goes up as institutions look to invest in floating-rate assets. Even as most debt investments have declined, the S&P Leveraged Loan Index is essentially flat year-to-date.
Second, higher rates lead to higher cash flows for the “equity” tranches. The equity tranches get “whatever is left” after the required payments are made to the debt tranches. The higher interest rates go, the higher “whatever is left” will be even higher than it already is. ECC’s recurring cash flow already grew to $1.32/quarter. With rising rates, it could get even higher and since ECC already has a “problem” with not distributing enough, it could be forced to raise the dividend yet again.
ECC most recently hiked its dividend from $0.12/month to $0.14/month for Q2, its third dividend hike in 12 months. Now ECC is approaching the time frame where it has been announcing Q3 dividends. We can’t guarantee another hike but it is a notable possibility. ECC will reassess its taxable income, and determine if another hike is needed.
We’re happy to live with “only” a 14% yield, but if ECC continues to have problems with too much taxable income, the humanitarian thing to do is to help our fellow man and collect more dividends. Do the charitable thing, and help ECC out with its “problems” by collecting more dividends!
Pick #2: CSWC – Yield 9.4%
Capital Southwest (CSWC) is a BDC (Business Development Company) that focuses on the “lower middle market.”
We often generalize BDCs saying they invest in “small to medium-sized” businesses. Yet when you look at some BDCs like Ares Capital Corporation (ARCC) that is investing in companies with annual EBITDA averaging +$150 million, they are not companies most would consider “small.” We love ARCC for its predictability and its consistent performance over the years. Such investments, that can be relied on for regular recurring dividends, are crucial for an income portfolio. ARCC’s scale, and the size of the companies it invests in, provide that stability.
Yet sometimes we want a little spice, too. We want a company that is going to surprise us with sizable dividend raises and large special dividends. With CSWC, you never really know how much you’re going to get paid this year. In 2021, they raised the regular dividend four times and paid a $0.10 supplement and a year-end dividend of $0.50. So, when we were buying a year ago, assuming we would get $2.08 in dividends for the year, we actually got $2.56. †source: Investor Presentation February 2022†
Now we come into 2022, and our base assumption was that the $0.48 dividend was all we were going to get. $1.92 is what we expected; after all, CSWC just paid a large dividend to reduce its undistributed income. Here we are in April, and CSWC announces a $0.15 special dividend! As the market bleeds red around us, not only are we getting the income we anticipated, but we’re also getting more!
Why does CSWC pay out more frequent supplements and special dividends than many other BDCs? CSWC invests in companies that are actually quite small. Their core target is companies with EBITDA in the $3 to $20 million range. When you are investing in a large company, doubling is hard. It is much harder for a company with $100 million in EBITDA to double than it is for a company with $10 million in EBITDA, small companies grow faster!
Like most BDCs, CSWC makes combination debt and equity investments. A portion of their investment will be first-lien debt, secured by substantially all of the assets of the borrower. Then, CSWC will often get an equity position or warrants. So CSWC’s return is comprised of predictable cash flow from the debt positions, plus they hold equity which can be worth anywhere from absolutely nothing, to a lot. Valuing private companies is a bit of an art form and greatly depends on the bidder. These equity positions typically represent a small portion of CSWC’s investment as reflected in book value, but when the company has a liquidity event like being acquired by a peer, a public IPO, or recapitalized, and the investors decide to buy out CSWC, the returns can be huge.
Last quarter, CSWC sold out of an equity position in Danforth Advisors LLC for $6.5 million. They realized a gain of $5.6 million. In investing terms, CSWC had a 7-bagger with an IRR of 99%! In per/share terms, that is a gain of $0.23/share. As a BDC, CSWC is required to distribute most of its taxable gains. These types of equity gains are what drive supplemental and special dividends. The recurring “regular” dividend is generally covered by the more predictable cash flow from their debt investments.
As you can see from CSWC’s history, they have a track record of having these gains and paying special or supplemental dividends frequently. Currently, equity positions make up 8% of CSWC’s investments across 39 portfolio companies.
That is 8% relying on GAAP book value, which takes a very conservative approach to value equity. The actual value won’t be known until a liquidity event happens. The uncertainty of these equity monetizations in terms of timing and size is why we can’t predict how much in dividends CSWC might pay out over the next year. However, we can be confident that the surprises will be good ones. My wife never knows when flowers will arrive, or what kind they will be, but the surprise is always a good one. That’s why she is still invested in me. Someday, she might figure out that the flowers are tied to special dividends… That is why I’m still invested in CSWC!
With ECC and CSWC, I have been getting regular cash dividends, plus special dividends to boot! This aligns well with my “buy income today and enjoy it tomorrow” mindset. If you’re not retired yet, letting your shares DRIP until you hit your desired allocation can be an easy way to grow your holdings in these securities rapidly.
For retirees, I suggest taking the income you need and reinvesting the rest. Treat your dividend income exactly like you treated your paychecks when working. You’ve had a lifetime of practice living within your means, and since you have a portfolio, you are capable of saving a portion for the future. Even when you are retired, you still have a future!
I love nothing more than hearing from long-time followers who have taken the path of the Income Method. I love when they tell me their portfolio income stream is now bigger than the paychecks they received from their employers! In retirement, they actually got a raise! Imagine that!
For many, facing retirement is scary because it is so different. They have a portfolio, and the retirement advice they get is to sell off shares. But how much can they take out? Growth stocks are down about 20% year to date. Does that mean they should take out 20% less? What if the market sells off more? What if it doesn’t recover soon? Should you wait to sell? Should you sell extra right now before it gets worse? All these concerns that focus on the central fear: Will my portfolio survive long enough?
Retirement doesn’t have to be different. You don’t have to guess how much income you can take out. You don’t have to play day-trader trying to time the market. You can put your capital to work generating an income so that you know exactly how much you have, just like when you received a paycheck. You’ll know what you have to live on, and how much you can reinvest to grow your income higher in the future.
This is the peace of mind that comes with income investing. While I’d argue that investing for dividends is superior for getting total returns, the peace that comes with knowing your income, knowing your budget and knowing that your portfolio will continue indefinitely is priceless. The sooner you change your mindset and portfolio, the greater your long-term results will be.