August 5, 2014
Investing in Start-ups
The Investment View from Prescott, Arizona
A Business Development Company (BDC) is an investment vehicle created to help grow small companies in the initial stages of their development and is similar to a venture capital fund.
BDCs are intriguing to investors for a couple of reasons. First, some BDCs provide attractive dividend yields. Secondly, BDCs have the allure of getting in on the ground floor of start-ups that have promise.
Until recently, BDC investing was limited to deep pocket hedge fund investors. Sensing a new market, Wall Street, over the last few years, has created dozens of closed-end funds and partnerships that focus on this investment niche.
Closed-end refers to the premise that no new shares are created or redeemed by the fund after the initial share offering. This means that if you want to sell your shares, you have to go to the stock market; and the price can be much more volatile than traditional open-end funds.
BDCs are often debt investments in growing small and mid-size U.S. businesses. When times are good, BDCs can perform well; but since new businesses often don’t have the cash flow to survive a bad year or two, they can be particularly vulnerable to business downturns. Just a hint of recession will have BDC prices heading south.
I track 29 BDCs in my database. During the 2007 to 2009 bear market, this group lost two-thirds of its value. In the summer of 2011, BDCs lost another 26 percent partially caused by the fear of government shut-downs. BDC investing is not for the faint of heart.
I cut my investment teeth as a municipal bond broker in the 1980s. One thing l learned during that time was that the majority of bond defaults occurred in new enterprises. BDCs invest exclusively in new enterprises, so investors beware. Junk bonds may have a lousy name; but compared to the untested businesses that most BDCs invest in, junk bonds look downright conservative.
If you have an interest in BDC investing, there are a couple of other items to consider. Some companies classified as BDCs actually provide mortgage financing which, in my mind, places those companies in another category. Fat dividends are the attraction, but use of leverage to deliver high dividends makes these particular BDCs very sensitive to rising interest rates. By sensitive I mean that when interest rates rise, these BDCs will lose a lot of their value.
Some BDCs deliver 1099s at tax time while others send out K1s. If you like to keep your tax preparation simple by avoiding pesky K1s, be sure to research this detail before you invest.
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A Slice of Life
The finishing touches of this newsletter are being added as I am sitting in my folding chair on the North Rim of the Grand Canyon, just watching the sky go by and marvelling at nature’s works.
The IMAX show at the South Rim has been running for many years now, and I vividly remember the awe I felt at the portrayal of the first conquistador coming through the trees and seeing the Grand Canyon unfold before him. You can share his reverence and wonder just by watching the movie.
If you haven’t been to the North Rim, it is worth the extra drive to get here. I was on a finger-like overlook that jutted out so that there was a 360° view of the canyon below. After a few minutes, everyone else had moved on; and I had the whole place to myself. The South Rim is spectacular, too; but you can’t really have a solitary experience there.
Bring your long johns because it’s cold up here at 9,000 feet. It’s in the 60s and damp today, just like a nice summer day in Anchorage. But compared to the heat in Phoenix, this is paradise.
How Are The Markets Doing?
The headline in Yahoo News on July 31 read “Sharp 1-Day Drop Wipes out Entire Gain for July.” Indeed, the Dow Jones Industrial Average** lost 300 points in one day, and the S&P 500 Index** lost an even two percent in one day, leaving both in the loss column for July. Small company stocks, represented by the Russell 2000 Index** fared the worst, losing 6.11 percent in July.
Until the morning of July 31, the stock markets looked quite stable. So what changed? I think liquidity changed.
As my friend and newsletter writer, Tom McClellan, says, “There are only two things that matter in the stock market: How much investor money is available, and if investors are willing to invest their money.” In fact, Tom’s work focuses on studying ripples in the liquidity pool, especially after the Fed cannonballs into it as they have the last few years.
The Federal Reserve Board has stated its intention not to add new money into the economy after October, and the rate of new money being added now is about one-quarter of what it was at its peak a year ago.
I believe that the market action we saw last week was due to the lower money flows into the market finally having an effect. I say this because the decline of the small cap Russell Index** has been so much worse than the large cap S&P** and Dow**.
One of McClellan’s more colorful analogies is that the money flow into the markets is like the milk in a big brood sow. One can’t easily see the milk, but the health of the piggies tells you how much milk there actually is. The biggest piggies (large company stocks) elbow aside the runts (small company stocks) until they have had their fill, then finally the runts can get some. If there isn’t enough liquidity in the market, the runts begin to starve. That is what July’s market action suggests.
And big institutions, like mutual funds, hedge funds and pension funds, can’t wait until the liquidity event in October is upon them. It takes them so long to reposition many billions of investment dollars that they must start early. I think the market action of July 31 is the beginning of institutional investors “front-running” the Feds closing of the liquidity spigot.
Interest rates have held firm as investors bailing out of stocks moved into bonds, but less rate-sensitive bonds did slide during July.
Gold prices are declining into the cyclical bottom that I have been looking for, but I don’t think they are finished going down.
What’s Going On In Your Portfolio?
Despite stubbornly high index values, I have been concerned over the past few weeks about signs of deteriorating strength in the markets which I mentioned in my “How are the Markets Doing?” segment of this newsletter. As a result, on July 21 I lowered the Shock Absorber Growth model* from fully invested to only two-thirds exposed to the stock market. When the market experienced a sharp one day drop on July 31, having one-third in cash really helped us.
Dave Landry is a friend who writes a daily investment blog focused on identifying and capturing trends. One day after I lowered our stock market exposure on July 21, he expressed my feelings perfectly by writing: “Just like you can’t catch a tan when the sun isn’t shining, you can’t catch a trend when there is none.” July showed us sideways Index prices amid a deteriorating market – not a good trend.
Part of my analysis includes looking at the nature of the follow-through to significant market action as it is often very instructive. After the July 31 dip in the market, the follow-through on August 1 was negative – no bounce at all. I took that opportunity to trim back our stock portfolio even more and to add a hedge, a fund that will go up as the stock market declines which stabilizes the portfolio values without having to sell our remaining holdings.
In addition, our Flexible Income* model saw changes this past month as bond funds that are sensitive to the business cycle generated some small losses and were replaced with a hedge.
So, your Hepburn Capital portfolios are currently well situated to weather a market decline should one occur. Personally, I think we are overdue for one; but you never really know until it happens. If the market stabilizes and continues upward, I’ll merely drop the hedges and get back in step with the market.
Earn a Discount on Our Fees
Would you like to save hundreds of dollars every year? Simply refer family and friends to Hepburn Capital.
We give a “volume discount” based on the total amount of money we work with for a family or other groupings of clients, including friends. The higher the amount of assets being managed for the group, the lower the fee percentage becomes for everyone in that group.
Besides being one of the nicest things you can do for us (and them), mentioning Hepburn Capital to your friends can save you real money. The easiest way to introduce someone to our work is to forward our newsletter to them. Here is a link that will allow you to forward it with a just click. Click here to Forward this email to a friend.
Thank you for your help and support.
Scottsdale Office Date
If it is more convenient to meet with Will in Scottsdale, please call the office to schedule your appointment. 928 778-4000
College Classes Coming
Next month begins the fall schedule at Yavapai College (YC). I’ll be teaching Fundamentals of Investing for Retirement which is a class I’ve been teaching now for 25 years. Yikes!
In October I teach a new class on Managing an Inheritance: Planning It, Receiving It, and Keeping It.
For details, look in the YC catalogue that came in the mail last week; or call the college at 928.717.7755 for details.
Time For a Review?
It is not my style to call you and bug you about your investments, but I am always happy to go over your portfolio with you. In fact, it is very important that we do reviews periodically so that we can ensure that our investment objectives are still in sync with your life situation. If you have not had a portfolio review for a while and would like one, please call the office at 928.778.4000 to schedule an appointment, either by phone or in person.
If you don’t feel the need for a formal review, please remember that it is important for you to call me if you have a change in your financial situation, your goals or your sensitivity to risk.
Our Spotlight Strategy
With our Adaptive Growth Strategy we strive to provide high total return from a combination of investments from both the equity and income markets with the emphasis on equities.
Our proprietary Stock Market Exposure Indicator is used to determine a stock market exposure that adapts to the strength or weakness of the market, directing exposure in the HCM Shock Absorber Growth strategy to range from 20% to a maximum of 80% of account value. The balance, 20% to 80% is invested using the HCM Flexible Income strategy. The HCM Safety Net indicator is designed to warn of sudden potential declines in which case stock market exposure is quickly reduced.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Performance and activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** Indexes are unmanaged lists of stocks considered representative of a broad stock market segment. Investors cannot invest directly in an Index.
Shock Absorber Growth
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.
In all investing, past performance cannot assure future results, and as such, our efforts are not guaranteed. Losses can occur. All strategies offered by Hepburn Capital Management, LLC adapt to changes in the markets by changing the investments they hold, therefore, comparisons to broad stock market indexes such as the unmanaged indexes mentioned may not be appropriate. Sometimes client accounts are invested in stocks or markets not included in these indexes. Past performance does not guarantee future results. Investment return and principal value will vary so that when redeemed, an investor’s account values may be worth more or less than when purchased. Mutual fund shares and other investments used in our managed accounts are not insured by the FDIC or any other agency, are not obligations of or guaranteed by any financial institution and involve investment risk, including possible loss of principal. Advisory services offered through Hepburn Capital Management, LLC, an Arizona Registered Investment Advisor. Adviser will not transact business unless properly registered and licensed in the potential client’s state of residence.
Copyright (C) 2014 William T. Hepburn. All rights reserved.