ETY: 10% Yielding CEF, But We Are Concerned About The Second Wave Of Coronavirus Infections (NYSE:ETY)

This time, we will present our readers with the Eaton Vance Tax-Managed Diversified Equity Income Fund (ETY), which was incorporated in November 2006. It is a closed-ended fund that is primarily focused on domestic and some international dividend-paying companies. In addition, this fund utilizes the writing of index call options to protect its portfolio in the case of a major market downturn. During normal market conditions, it also receives cash flows from underwritten options to enhance return for its shareholders. It pays a regular monthly distribution of $0.0843 per share and offers a 10.03% dividend yield as of April 24, 2020. This fund has recently experienced a market price decline of 42% in a month, as the result of the global financial market rout between the end of February – March 2020. In terms of the key bullish catalysts, we find the following (1), faster than expected U-shaped recovery of the US economy, primarily supported by the recent fiscal stimulus and expansionary monetary policy. (2) end or a rapid slowdown of the global outbreak of coronavirus crisis.

About the fund

“The Fund invests in a diversified portfolio of domestic and foreign common stocks with an emphasis on dividend paying stocks and writes (sells) S&P 500® Index call options with respect to a portion of the value of its common stock portfolio to generate current cash flow from the options premium received.”

(Source: Annual Report)

A particular combination of dividend-paying stocks and written S&P 500 Index call options can make up to only 80% of total assets. The fund can also invest at least 40% of its assets in common stocks from international issuers and cannot invest more than 5% of total assets in stocks of issuers located in emerging markets. The fund is also allowed to write index call options on other than S&P 500 domestic and foreign indices.

(Source: The Options Guide)

The Fund’s policy of using option based strategies enables the fund to earn an additional revenue stream while limiting the downside risk in the case of major market downturns. However, in times of major bull markets, a particular strategy of writing index call options results in a total portfolio loss. According to the figure above, loss only deepens if the stock market index reaches a double-digit annual return in a year like was the case in 2019 (S&P 500 was up 28.88%).

“As the market trended upward for much of the period, the Fund’s options strategy detracted from returns relative to the Index, as premium income was relatively low and written calls, overall, ended in losses during the period.”

(Source: Annual Report)

At the end of 2019, it had written call options for roughly 48% of its stock portfolio with average days to the expiration of 14 days. That basically means it is managing option-based strategy on a very short term basis, to minimize any kind of unexpected spikes in the underlying greeks. For instance, a very volatile year for the S&P 500 would definitely have a very strong impact on the implied volatility of an option with a longer-term maturity. That would result in a higher price of an option and consequently in a loss for the option writer. The fund can also use financial derivatives to minimize the general portfolio risk. It not using any kind of leverage at this point in time.

(Source: Seeking Alpha)

In terms of sector allocation, this fund has the highest exposure in the Financials (15.1%), Healthcare (12.6%), and Information technology (22.2%) industries. The largest exposure to IT doesn’t surprise us at all and we remain positive about the near-term outlook of the industry. In our view, IT-related businesses are well-positioned to acquire new clients from traditional businesses like travel or hospitality. For instance, major corporations will most likely reduce non-essential business travel which can easily amount to several thousand USD per employee. Instead, they can easily perform a video call using Zoom Video (ZM) or Google Meets (GOOG) and save on travel time as well as reduce the risk of coronavirus infection. There are also other general trends like a change of consumer behavior to purchase non-essential items like clothing or electronic appliances through Amazon(AMZN) rather than to go to a local retail store like JCPenney (JCP) and risk a potential coronavirus infection. In fact, JCPenney announced last week that it is on the verge of bankruptcy.

“J.C. Penney is at an advanced stage of discussions with Wells Fargo & Co. (NYSE: WFC), Bank of America Corp. (NYSE: BAC.PK) and JPMorgan Chase & Co. (NYSE: JPM) to secure funding to the tune of $800 million to $1 billion, through a debtor-in-possession loan.”

(Source: Finance Yahoo)

Our favorite sector within the IT industry is cybersecurity, as “work or stay home” requires highly sophisticated security systems of data and applications. In the worst-case scenario, employees can jeopardize the entire company because of a massive data breach leading to enormous costs and loss of a reputation.

We remain bullish about the financial industry over the mid-to-long run, primarily supported by strong balance sheets and liquidity ratios of major domestic financial institutions. In addition, some companies like JP Morgan (JPM) and Bank of America(BAC.PK) have already reported better than expected Q1 20 earnings. Even though all of them face headwinds coming from limited business activities due to a nationwide lockdown, they were still able to increase the number of deposits and loans leading to higher operating revenue in commercial banking businesses. One important contributor was an industry-wide trend of a rapid digitalization of core banking businesses over the last decade. For instance, clients can easily perform basic banking operations like signing up for a loan from home, while employees can use a well-protected IT system to work remotely.

Chairman and CEO Jamie Dimon stated the following:

“We lent over $500 million to small businesses in the month and we’re now actively supporting the SBA’s Paycheck Protection Program. We continued to support our wholesale clients throughout this challenging period, as they drew over $50 billion on their existing lines. We also provided over $25 billion of new credit extensions in March for companies most impacted by the crisis and helped our clients execute record Investment Grade bond issuances this quarter. In Commercial Banking, we partnered closely with clients on their liquidity needs, increasing loans $25 billion and deposits $40 billion in the quarter.”

(Source: JP Morgan – Earnings Release)

In addition, Chairman and CEO Brian Moynihan stated the following:

“We remain a source of strength – our customers trusted us with $149 billion in additional deposits since year-end, which enabled us to provide liquidity to people, small business owners and corporate clients.

(Source: Bank of America – Earnings Release)

In addition, the sales&trading business division performed exceptionally well because of the unprecedented volatility in the financial markets leading to a higher amount of transaction and advisory fees. Our readers can find our opinion about the financial industry in our previous article on Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund (ETO) here.

On the bottom half, the fund has the lowest exposure in Energy(3.46%), Basic Materials (2.36%), and Real Estate (2.56%). Particular industries are under enormous pressure because of a coronavirus crisis, especially the oil industry. Following this week’s crackdown of the price of crude oil in the futures market, investors could even get paid as high as $40 per barrel to pick up physical crude oil from hubs in Oklahoma as current full storage capacities outweigh the industrial demand. Therefore we like the fact that the portfolio management team was able to have low exposure to the energy industry before the escalation of the crisis in early March.

The fund has a total of 55 equity holdings in its portfolio, and we can find the top 10 individual stocks below.(Source: Seeking Alpha)

In our view, most of the companies in the top 10 list should be resilient enough to weather the coronavirus crisis over the coming months. They are some of the largest companies in their underlying industries, which are all supported by positive underlying industry trends, which we have described before in the case of financials and IT. Furthermore, Visa (V) is a payment processing leader, which should benefit because of a higher number of digital transactions. On the other hand, Vertex Pharmaceuticals (VRTX) and Danaher (DHR) are both involved in the healthcare industry, which is definitely the crucial factor of the global fight against the coronavirus. In terms of portfolio structure, we like the fact that all of the companies in the top 10 except Microsoft have a weight of less than 5%. Given that this fund has total equity holdings of approximately 55, that makes up on average a weight of less than 2% per individual stock. In our view, that is quite a reasonable diversification for an actively managed fund, which is trying to beat its benchmark. Nevertheless, if investors would prefer to track stock market indexes over the long run then we definitely recommend the largest ETFs from Vanguard, Blackrock, or State Street in the field, which come at a significantly lower management fee.

Based on our analysis of the industry and individual stock specifics of this fund, we find the key risk of a potential major downturn of the entire US stock market in the case of a worsening of the coronavirus crisis. One of the triggers might be a prolonged lockdown that could trigger a massive wave of defaults of small-to-mid-sized businesses leading to a depression type unemployment rate. Another one is that it still persists a reasonable risk of a higher-than-expected number of new COVID-19 infections over the coming months.

One of the most famous investors in our era Howard Marks has recently made a very interesting remark.

“We’re only down 15% from the all-time high of February 19,” the investor said, referring to the S&P 500. “It seems to me the world is more than 15% screwed up.”

(Source: Markets Insider)

Our readers should keep in mind that we are now facing very unique health and economic crisis over the last 100 years, and the NASDAQ is down less than 5% YTD.

Performance

According to the figure above, both market price and NAV have been negatively impacted by the spread of coronavirus in the US in March 2020. In fact, the biggest drawdown occurred when the NAV and market price have declined by 31% and 42%, respectively, between February 23 – March 23, 2020. Nonetheless, both market metrics have managed to recover over the last month, primarily supported by the massive stimulus programs for SMBs and expansionary monetary policy by the FED to soften the impact of the coronavirus crisis on the domestic economy.

According to the figure above, the S&P 500 benchmark index has achieved a higher annualized return on a 3-year and 5-year basis for 290bps and 160bps, respectively. Further, ETY has even failed to outperform its benchmark by roughly 380 bps over the last 10 years.

Nonetheless, ETY was able to outperform options-based computed benchmark on the figure above. As a matter of fact, we recommend our readers definitely think about whether a CEF using covered calls on the S&P 500 suits their long-term financial goals. Despite the fact, it has failed to outperform the S&P 500 over the short and long run.

This chart indicates that the Fund has substantially outperformed its closest peers on the market – BlackRock Enhanced Capital and Income Fund (CII) and Nuveen S&P 500 BuyWrite Income Fund (BXMX) as it has generated an approximately lower total return of 10% and 18% respectively, over the last 5 years. Contrarily, the general Vanguard Total World Stock ETF (VTI) which basically tracks the performance of the US total stock market including low, mid and large-sized companies has achieved a slightly higher return of 4.5%. That clearly indicates that this CEF has been on the right path of tracking the performance of the US total stock market over the last 5 years. However, it fails to replicate the performance of the S&P 500 index.

Looking at a historical discount/premium to NAV, investors have recently missed a great opportunity to buy ETY at the lowest discount to NAV of roughly -18% in late March 2020. Even though the discount to NAV rebounded to -6% over the last month, we are still skeptical that now might be a great time to buy this CEF. For instance, our readers should still keep in mind that no one really knows when our daily lives can return back to normal. We anticipate that there is still a very high risk of the second wave of the coronavirus spread, especially later this year when it can strike together with the seasonal flu.

Even a very famous billionaire investor Carl Ichan has been very cautious lately:

“Icahn, who gave $200 million to the medical school at Mount Sinai Hospital in New York, said he’s been talking to “some of the smartest guys in this area” and formed an opinion of the virus that doesn’t leave him optimistic. He’s concerned about recurrences of infection and believes the economy will reopen in “spurts.”

(Source: Finance Yahoo)

Unfortunately, the second wave of infections would definitely prolong the recovery of the domestic and other international economies as well. We believe that it would most likely result in the sharp-selloff of the global financial markets and limit the effectiveness of recently announced fiscal stimulus packages to support SMBs.

Distributions

(Source: Seeking Alpha)

ETY has returned to its shareholders a stagnant monthly distribution of $0.0843 per share, since early 2013. Shareholders received an annual distribution of $1.01 in 2019, which makes up a distribution rate (market price) of 10.03% as of 04/24/2020. In comparison, ETY now offers 260 bps higher annual distribution yield (market price) compared to its closest peer CII. Nonetheless, given the high uncertainty surrounding the current coronavirus crisis we should definitely check whether this distribution rate can be sustainable over a longer period of time.

(Source: Annual Report)

According to the figure above, the fund reported a total investment income of $33.9 million in FY 19, while the total expenses were roughly 45% lower at $18.8 million. That makes up a net investment income of $15.06 million, which was slightly less than 15% of the total distributions paid to shareholders at $97.06 million. Nevertheless, distributions to shareholders were financed by net realized gain and change in unrealized appreciation both totaling approximately $138.3 million in FY 19. However, we are highly skeptical this fund will be able to maintain a current annual distribution rate of $1.01 per share.

(Source: CNBC)

According to the figure above, the US economic growth is expected to decline by more than 5% in 2020, while the global economy is expected to drop around 3%. In our view, economic growth is highly unlikely to rebound for the rest of 2020, as there is still a very high risk of prolonged coronavirus crisis with frequent lockdown restrictions of non-essential businesses.

Conclusion

Investing in this fund at this point in time comes at very high risk, therefore, we recommend our readers to wait for the end of the global coronavirus crisis. Maybe now might be a great buying opportunity but at a recent S&P forward PE ratio of 21, it doesn’t seem like the most favorable valuation at this moment. Nevertheless, we assign a NEUTRAL rating for this CEF over the next twelve months. Based on our analysis, we can conclude that this fund is highly exposed to the general performance of the domestic stock market indexes, as only 15% of total distributions to shareholders arrive from net investment income. Therefore, we are slightly concerned this fund will not be able to maintain its monthly dividend payment of $0.0843 over the next twelve months, especially in the case of the second wave of coronavirus infections. In terms of major risks, investors should consider any further deterioration of the global and domestic economy due to a coronavirus crisis, the second wave of coronavirus infections, or an excessive share dilution.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article does not constitute a bid or an invitation to bid for the purchase or sale of the financial instruments in question. Neither is it intended to provide any kind of personal investment advice, therefore, readers should conduct their own due diligence. Investing in financial instruments may always be associated with risk. Please contact your personal financial or investment advisor for any additional questions or materials regarding this article. We shall not be liable for any type of damage or loss arising from the use of the information contained in this article.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.

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