We Study Billionaires - The Investor’s Podcast Network - TIP445: The Fall of Netflix and Overlooked Assets w/ David Stein

Starting point is 00:00:00 You're listening to TIP. On today's show, we have David Stein back to educate us on assets of the market that are likely overlooked or underappreciated. David is the host of the popular podcast Money for the Rest of Us, an author of the book by the same name. He's a previous allocator for endowments and brings a wealth of knowledge to our very wide-ranging discussion. For example, we discuss current risks posed by supply chain disruptions and food shortages, why the most contrarian bet today is to short commodities, The recent fall of Netflix and how other tech stocks might follow suit? Updates on Ever Grande, China, and Munger's recent bipolar trade on Alibaba, how David thinks through valuation and where the U.S. stands today compared to the global market,

Starting point is 00:00:44 why closed end funds are likely an overlooked asset trading on the New York Stock Exchange, what they are and why we should consider them, in addition to another asset called business development companies. That and a whole lot more. I learned so much from this discussion, and I hope you do as well. it's always a pleasure to have David back on the show. So without further ado, here's my conversation with David Stein. You are listening to The Investors Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared

Starting point is 00:01:19 for the unexpected. Welcome to the Investors Podcast. I'm your host, Trey Lockerbie, and today, I'm so excited to have back on the show, Mr. David Stein. Welcome back. And it's great to be here. Trey, thanks. This is the first time you and I are getting to speak personally, but I've been a fan of yours for a long time. I've always loved the conversations you've had on this show. And I wanted to kind of kick off this episode by exploring one of the topics that has been just top of mind as of late. And that is the disruption of supply chains and how that might create a very bullish picture, actually, for things like commodities.

Starting point is 00:02:04 We're seeing things like food and energy inflation, for example. One of the more alarming concerns today is that we might be seeing a global food shortage later this year. I'm wondering what you're seeing in the data and are we truly facing down a global famine scenario? There is likely or potentially a food shortage when you say global famine scenario here in the U.S. There's plenty of food. There will be plenty of food. There will be plenty of food for most places around the world when you get food shortages. and the reason why there's potential food shortages is just the spike in fertilizer prices. A lot of the inputs in the fertilizer comes from Russia with the sanctions that has shot up the price of fertilizer 12%.

Starting point is 00:02:49 So in a lot of the developing world, they're not planning as much because if you put more money into what's going into the ground, the risk is higher. And so farmers will often not plant as much as because they can't afford the fertilizer and they don't want to take the risk. So there's the potential for that. But, and I did an episode on this recently, the good news is there's, well, prices have shut up for corn, for wheat, for many other grains. Prices for rice have actually fallen 20%. There is a surplus of rice in the world. And that really came out of 2008 when there was a rice shortage.

Starting point is 00:03:22 And governments, farmers got together. And now there's plenty of rice. And so I don't spend a lot of time worrying about famine. When you think about commodities, I just saw a report by being a. B of A, where they interviewed well over 200 managers. This is a regular report that they do. So these managers collectively managed about $800 billion. What they found in that is the most crowded trade. The trade that people are most long is commodities. And I know we're going to talk a little bit about being contrarian, but when I think about commodities right now, that aspect,

Starting point is 00:03:56 a true contrarian is going short commodities right now. They're not expecting oil to double from here. they believe everybody's bullish on commodities because of inflation. The time to have bought commodities was two years ago, not today. I think that's a very interesting point. And similarly related, there's a lot of talk around stagflation. You mentioned inflation being high and we're facing potentially a recession. I mean, we saw the yield curve invert, which is sometimes a signal of that. Are you of the belief that we are going to face a stagflation scenario?

Starting point is 00:04:29 No, I think it's a risk. You talk about the other trade that people or the consensus, the consensus is a recession is coming. Now, if you look at the data, you go back to the last eight tightening cycles that the Fed did. Six out of eight led to a recession. But just because the Fed is tightening, those recessions weren't necessarily caused by interest rates. Think about 2020 recession. The Fed had been raising its Fed funds rate for 30. 36 months. The economy was slowing in the 2018, 2019. The Fed was on the cusp of a soft landing. They were going to land the plane. The economy was going fine. And then we get the pandemic. And we had the worst global recession, albeit short, since the Great Recession, had nothing to do with interest rates. It had everything to do with governments, businesses and households voluntarily shutting down to help prevent the spread of the virus. You know, last time you were on our show, you discussed the chaos surrounding Ever Grande with Stig was episode 384. And you were correct in pointing out that Ever Grande was different from Lehman in that, that was a narrative at the time, you know, in that it didn't have as much contagion risk for the global economy since it primarily dealt with Chinese real estate. Can you catch us up on what has happened with Ever Grande in the last six months?

Starting point is 00:05:52 And are they out of the woods now? No, if anything, they're deeper in the woods. Just last month, they announced that I might have actually been earlier this month, that they were delaying the release of their financial statements that Ever Grande's stock has stopped trading. China gave companies the opportunity to sue Evergrande in court to collect. This is a highly, highly indebted company. And so if you're a creditor of Evergrande, you're going through the workout, hoping to get some money back.

Starting point is 00:06:21 But in terms of contagion, we haven't seen it. China has way bigger problems than Ever Grande right now with the spread of the virus, with the just saw this report, yesterday reported in the Financial Times. The birth rate in China was down 30% from today compared to 2019. China has a huge demographic crisis where some experts are seeing potential population cut in half by the end of the century. China has always been this huge growth story. And it's sort of fascinating why China gets all this.

Starting point is 00:06:51 publicity on that aspect. But this is a, yeah, there's a lot of people live in China, but the population is not growing. And it makes up less than 3% of the global stock market, less than the UK. And so China gets a lot of press, but I'm not bullish on China just because it has some very big demographic headwinds. Right. But on that point, I mean, who doesn't, right? I think Japan's been declining in a similar fashion. And also the U.S. is even, I think, at 1.8, you know, I think you need 2.25 or 2.5 births just to maintain and grow a population. And we're well below that. So is this a global risk that all markets are facing, you know, maybe 20 years from now or even sooner?

Starting point is 00:07:37 Well, there are areas of the world where the prime population age, working age population, is growing. And that's the key. India, for example, has much more favorite. demographics than China. So I have a meaningful position in India, but you're right. The other thing to consider those is a valuation. So Japan, yes, has some demographic challenges, but their stock market earnings yield relative to the average is much cheaper compared to the U.S. or even compared to China. And so you always have to look at, well, what is baked in to the valuation of equities or other assets relative to the economic trends? And the other thing, and the other thing, is even in China. So I have a position in some of our models in smaller cap Japanese stocks, which have been able to sustain their growth rates. And so you can find your niche, but I agree with you that there are some demographic challenges throughout the world. So you mentioned that China's stock market makes up only about 3% of the global market.

Starting point is 00:08:38 And one interesting fact about China, you've mentioned on our show before, is that the stock market is much smaller than the country's contribution to the global GDP. What does that tell you about the future prospects of China and how does it compare to, say, the U.S. stock market compared to the global GDP ratio? Well, it makes me worried about the U.S., which makes up 61% of the global stock market, but only about 20% of global GDP. And their percentage, U.S.'s percentages, is shrinking. China, yeah, the stock market, the market capitalization will probably grow.

Starting point is 00:09:12 But in order to do that, it's not going to come necessarily from demographics, growing population is going to have to come from greater productivity, from Chinese companies becoming more efficient, from being more innovative. And that often comes from top down. Is there an environment for Chinese companies to do that? And we talked last time when I was on the show that China was sort of going in the opposite direction, making more difficult for Chinese companies to innovate. But China's backed off on that a little bit. And China's actually doing a great deal of investing in sort of the startup world, trying to fund startups all around the country with government funds in order to try to get more and more innovation within China itself,

Starting point is 00:09:54 as opposed to sort of technology transfers from other countries. So we'll see. I mean, China is a fascinating story, but it's, again, just one country, very small percentage of assets with some capital controls. As an allocator, there are many other areas of the markets that are more fascinating, at least to me. You know, you mentioned China kind of relinquishing a little bit on their control with some aspects to the capitalism there in that country. And one of the more curious trades over the last six months has been Alibaba and Charlie Munger, obviously, he's one of the billionaires we study most on this show. The stock had been declining, you know, since China was reminding markets of their ability to affect business decisions of the company, which, you know,

Starting point is 00:10:39 one way creates a lot of third-party risk. It dropped in Q4. after missing top line, bottom line expectations. But Charlie came in and doubled his position in 2021 and increased the position to 72 million, which left a lot of people, myself, included kind of scratching their heads. And China's regulators recently made concessions and said they would allow, say, Chinese auditors to share audit papers with public company accounting oversight board, which is basically this precondition to keep 80R shares of Chinese companies listed in the U.S. And Baba was bouncing around quite a bit, but it popped 40% and one day after some news about upping their share repurchases. And then at that point, you saw Charlie sell half

Starting point is 00:11:21 of his position. And so that left people scratching their heads once again. So with all of that, I'm just kind of curious if you have any general thoughts on why Munger would have made such a bipolar trade, it would seem. No idea. But I think it's a great example of how challenging investing can be. So Alibaba is now trading at a level it was in 2016. We're seeing Netflix today fall 40%. One of the challenges when investing in stocks, when you buy an individual stocks, is the underlying assumption is the market's wrong, that the stock is missed priced. So we don't own Netflix because we think it's a great growth company. The company has to grow faster than everybody already expects. And what you see time and time again with many of these well-publicized growth

Starting point is 00:12:08 companies at some point, they disappoint because the compounded growth that they need to continue to sustain very high PEs just isn't sustainable. Now, clearly there are exceptions, but most of the time, a company will disappoint and you'll see it fall 40%. And so now you have a growth stock, was a growth stock like Netflix. What's their growth strategy? The growth strategy, according to their press release, is to come after their users that are sharing passwords so that they can crack down on their customers. That doesn't sound like a growth company to me. And so anytime I don't spend a whole lot of time really any time investing in individual stocks because there's so many other opportunities in other asset classes. But one reason is I spent 17 years interviewing, meeting with hedge fund

Starting point is 00:12:55 managers, long only stock managers, our firm would meet well over 700 managers a year. And you meet with so many managers and you see how disappointing that is when they can't outperform a benchmark or one of their stocks blows up. And you realize, well, if they can't do it, if they can't get an informational edge and it's their full-time job, how am I going to do it on a part-time basis? I think that's a fair point. And you brought up Netflix. So I have to ask, you know, say we're not investing in individual stocks, but say an ETF like QQQ, it's down 14% or so from its high over the last 52 weeks. Do we think what's happened just now with Netflix? Do we think Netflix is sort of a canary in the coal mine for the other kind of basket of high flying tech stocks.

Starting point is 00:13:39 You've given rates are increasing and as you mentioned, the PEs need to be sustained and how unrealistic that might be. Do you think there's further to fall for the basket of stocks, say, within QQQQQ. I think there's more pressure on growth stocks like in QQQQQ just because interest rates are increasing. And given those earnings are the inherent or intrinsic value of a stock as it's future earnings as interest rates go up, you're discounting. There's earnings and they're more impacted than a value company that's paying dividends. And so, you know, I've been overweight value now just because it's more attractive. It's been the right move over the last year. And so, and the valuation has gotten so high for some of those growth companies. Now,

Starting point is 00:14:22 that doesn't mean growth doesn't work. I mean, momentum is an academically proven approach to investing that works very well. But it's very hard to do if you're just picking a couple momentum stocks. I'd rather own a basket of momentum stocks knowing some will blow up, but most will do just fine. I'd like to get your opinions on what it means to be a contrarian. So this is what makes investing so hard, right? Because you see Netflix drop like a rock today in today's market. We're recording this April 20th of 2022. And it's always that thing about is now the time to be greedy when others are fearful? Are we supposed to back up the truck? You know, so to speak, when you see a performing, you know, a company with, I think, fairly strong fundamentals and a good growth rate just get so crushed by the market in something like today.

Starting point is 00:15:08 Just added curiosity, is this an example of when it might be a good time to be a contrarian? Not for Netflix. The time to have been a contrarian for Netflix. And for me, a contrarian is somebody that's going against the consensus. There's usually a value component to it, but also some momentum. So the best time to be a contrarian is when you see an extreme, when there's, There's heavy pessimism, but then you start to see a reversal. So you get some momentum aspect to it. So I point out Netflix because it is one of those stocks that I should have bought, thought about buying five or six years ago, when it might even been longer ago, when Netflix got killed because the DVDs they were sending out, that was the business. They were transitioning to streaming. They missed earnings estimates. The stock got crushed. But it seemed logical that

Starting point is 00:15:57 streaming was coming on board. But again, in that case, I didn't do it because I didn't know what the consensus was what was already priced into that stock. But it would have been a better time to buy than today when the growth strategy is to crack down on your customers for sharing passwords and user IDs. And so from a contrarian standpoint, we always want to understand what the consensus is or what are people thinking about that. And if there's a heavy deal of pessimism, like we're seeing today where most people think a recession is coming, the pessimism, the pessimism, the pessimistic trade or the contrarian trade is take on more credit risk. Assume the economy is not going to enter into a recession in the next three months. You mentioned the inverted yield curve. Why is the

Starting point is 00:16:39 yield curve inverting? Well, yield curve's inverting because one reason is the Fed is raising their interest rate, their policy rate. So that gets reflected in the two year. At the same time, the 10 year hasn't shut up. Maybe it isn't because there's an expectation for a recession. Maybe it's because the market it believes the Fed will get inflation under control. And so there's less inflation assumptions embedded into the 10-year treasury bond. And so an inversion, just an inversion itself isn't enough for a recession call. You want to look at multiple time periods, multiple, you know, the one year or the three-month versus the 10-year, the two-year versus the 10-year. And understand what's driving it. It isn't a simple rule. It needs some context.

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Starting point is 00:21:30 Back to the show. You mentioned a great contrarian that would be shorting commodities, which is such an interesting point. Is there a way to do that? If one wanted to do that, I know there's, for example, an ETF that shorts the S&P 500. Is there something similar for a basket of commodities, or is there another way to kind of play that if you were interested in doing so. Oh, yeah.

Starting point is 00:21:52 There are ETS that will go short commodities. And in some ways, going short an asset class like that of futures, not to get into the midigritty of futures, but when you're long, let's say your long VIX or volatility or some of these other asset classes, again, with any type of futures contract, you're competing against all the other speculators. And if they think, for example, commodities are going to go up and price. And you saw this in oil. And then in order to make money in going long oil, it has to go up more than what's already priced into the futures contracts. And oftentimes what you'll see is because

Starting point is 00:22:29 there's an upward sloping future curves, every time you roll over that futures contract, it actually is costing money. And so you get what's called a negative roll yield with futures. And so in some ways, like shorting VIX is actually can be a beneficial strategy going back to volatility because of this, because then you get the positive role yield. So if everybody's on one side of the trade and is very excited about it, oftentimes it's embedded into a very steep futures curve. And so then commodities have to do better than what everybody thinks. And so I'm not shorting commodities because commodities is a zero sum game. Now, I own gold as a hedge, but I think there's better ways to invest in trying to speculate on commodities. Great point. You know, you mentioned the Fed is raising rates

Starting point is 00:23:16 because they're trying to quell inflation, and there's a lot of speculation around how much they can do so. And until we have to start doing something like potentially yield curve control, we're seeing that happen right now in Japan. They came out announcing that the Bank of Japan was willing to buy an unlimited, quote unquote, amount of 10-year bonds just to keep that fixed rate. Do you see that kind of playbook from our own Fed, you know, down the road? Is that the path we're on, in your opinion?

Starting point is 00:23:44 The Fed would only do yield curve. control if they felt the 10-year had just got completely out of whack. So when you think about interest rates, what makes up that 10-year treasury bond yield? You have the expectations based on what the Fed will do in terms of setting its policy rate going out one year, two or three years. So right now, basically, it's assuming by 2024 that Fed fund rate could be close to two and a half, three percent. So that's a big component. And that's one reason you've seen interest rates go up. But you also have the inflation expectations embedded into that yield. But there's a third component that's called the term premium. And a term premium represents just additional compensation that investors demand

Starting point is 00:24:26 for uncertainty regarding the Fed or uncertainty regarding inflation. And one of the interesting things, which is why we have 8.5% inflation, yet the 10-year treasury is less than 3%. What we don't have is a positive term premium. It's basically been flat to negative, whereas back in the 80s, you had a term premium of four or five percent. And so if investors lost faith in the Federal Reserve, in central banks in general and term premium shut up because they felt like they would not be able to get control of inflation, then you might see a yield curve control because then the Fed realized,

Starting point is 00:25:00 okay, this is all we got, is just our ability to create money out of thin air to buy bonds. And we'll see. So there's definitely been pressure in Japan, but the yields at zero. I mean, that's the bogey that they're impover. implementing yield curve control. They could allow it to go up a little bit just because of the inflationary pressure. But things seem like they've settled down. So the central bank can step in.

Starting point is 00:25:24 They can change their wording. They can buy more. And oftentimes trust gets restored and things settle down. And markets tend to be very narrative-driven. And they go from one narrative to the other and they sort of lose interest in one story to worry about. And then the things settle down. And we see that a lot. They can definitely change the narrative and they can definitely change the numbers, it would seem. For example, the 1980s way to define inflation apparently would calculate it closer to 20%, but here we are seeing it at 8.5%. When people talk about yield curve control, sometimes I wonder what would happen first. Would they just manipulate the CPI number down just to say they're quelling inflation before they have to implement something like that?

Starting point is 00:26:05 No, I don't think so. Calculating CPI and inflation is inherently difficult. You have this reference basket of items, hundreds and hundreds of different items, and it's based on consumer preferences. Well, one thing you see with inflation, as certain things go up in price, other things fall in price, those preferences change. We can substitute. At the same time, you have innovation and technology. These different analysts that look at inflation and say, well, the basket should never change. we should still have landline phones in that basket comparing what AT&T charge for landline today versus back in the 19-4s. That's not what inflation measures.

Starting point is 00:26:45 Inflation measures cost of living. How we live changes over time. And so we have to change what we measure. We can't keep the basket the same. At the same time, you do have to take into account quality improvements. Computers are better today than they were. Automobiles are better today than we were. and that should be reflected in the inflation number.

Starting point is 00:27:06 And we just have to recognize that there's some judgment, there's subjectivity in the inflation number. But inflation is high. If they were hiding it, you know, that would be the time. And they're not. It's just the process of estimating inflation that costs living is incredibly subjective. In our last discussion,

Starting point is 00:27:24 you touched on how often you're using earnings yield to compare investment opportunities. And with the inflation over 8%, I'm wondering how that compares to the S&P. today, its earnings yield is 4.15%, which is not as high as inflation, but also much higher than bonds. So what are the latest numbers telling you and how our market is priced? Our market, if the U.S. market is still expensive. So the latest year, month end, March, earnings yield for the U.S., looking at the previous yields earnings. And earnings yield is just

Starting point is 00:27:56 the inverse of the price to earnings ratio. I like to use earnings yield because it compare at the bonds. So the earnings yield is 4.3% in the U.S. The average earnings yield going back to 1969 is 6.8%. And so the market is still pricey despite interest rates going up. And so that's why I'm underweight U.S. and I'm not completely out of the U.S., but I wouldn't put 61% in my equity portfolio in the U.S. because there are many other areas of the world that are much cheaper. If we look at Japan, its earning yield is actually is 6.9%. Europe's at 6.5%. U.K. is at 7%. U.K. is at 7%. And so when you look at the all-country world index, it's at 5.2% basically at its long-term average going back to 1995. But if we exclude the U.S. and look at the world XU.S., we're at 6.4%. So most of the world is cheaper than the U.S. And let's go back to Japan. Japan has significantly trailed the U.S. stock market over the past decade going back to 2012. Most of that underperformance, even if we adjust for different sector rates, is due to the U.S. getting more expensive than Japan.

Starting point is 00:29:09 So it wasn't earnings. It wasn't dividend. It's just people are paying more for the U.S. versus the rest of the world. And if you buy an asset that's higher priced, you should expect a lower return than if you buy something similar that's at a cheaper price. You also reference standard deviations to find relative strength between indices. With the contraction that we've had in the U.S. as of late, even though it's not that big, I'm kind of curious how it compares to its average, you know, now that it's come down a little bit. It's come down a little bit. So the latest Schiller PE or sickly adjusted price to earnings ratio, so in this case,

Starting point is 00:29:47 we're taking the price divided by the average earnings over the past decade. It's at 33.8. The average, going back to 1980, is 21.3. So we're still one and a half standard deviations above average. And the standard deviation really is, it's measuring the range of a particular point relative to that average over time. And so one of the ways that I look at the financial markets is and we look at it in our membership community, we look at all the different asset classes and we want to know what is their standard deviation. Like, is this an extreme valuation? And the U.S. West remains the most expensive stock market in the world. And maybe it'll continue to outperform in order to do so. It'll either have to buy back a boatload more stock, significantly increase

Starting point is 00:30:33 earnings growth, or it's going to get more expensive to where we're looking at decade from now in the Schiller PE is over 40. That's not an investment that I would have a lot of confidence in. And as a contrarian, I'd rather be overweight other areas of the market. Well, keeping 30 to 40% in U.S. in terms of my overall equity allocation just because you never know. So buying back a ton of shares is interesting because there's a lot of narrative out there around how one of the reasons we might be running into trouble is that CEOs of companies have bought back a ton of shares instead of, for example, investing in future prospects of the business or investing in, you know, Cappex needed to increase production. And obviously the

Starting point is 00:31:18 market's valuation comes from increasing earnings over time, increasing revenues over time. Is buyback shares to a degree, does it go against sort of the longer term advantage of the market? Well, as a CEO, it's the easiest thing to do because CEOs are measured not on total earnings. They're measured on earnings per share. And so if they can goose the earnings per share by buying back stock, then they do it. It's a sure thing versus trying to invest in some project 10 years down the the road and given the turnover in CEOs, they tend to be short-term focused. And so they're going to continue to buy back shares. It's an interesting thing because if you look at what drives the

Starting point is 00:31:58 stock market over time, it's the dividend. It's the earnings growth. And it's what investors are paying for those cash flows. And historically, across the country, the overall earnings has been basically most of the time only keeps up with the per capita GDP. So three, four, four, And so when we saw what's happened in the past decade where you've seen earnings compound at 7, 8%, that has helped. But it isn't overall earnings. It's the earnings per share because there's less shares outstanding. That is what has driven the stock market.

Starting point is 00:32:32 And they do it because it's the easiest thing to do. But it does sort of go against, if you really want to be innovative, then you're going to invest in long-term projects. But CEOs aren't measured on that. They're measured on, did they beat the earnings estimate in the market? most recent quarter. All right. So I'd like to shift gears a little bit, talk about kind of the meat of the discussion for today, which is around different assets that retail investors may or may not be familiar with. So for example, a lot of people might assume that the New York Stock Exchange

Starting point is 00:33:03 exchanges stocks, right, in companies, which they do, and that's mostly right. But there's also a lot of different assets that trade on the New York Stock Exchange. I'm curious, what are some of the overlooked assets that investors should consider? Sure. So my favorite investment vehicle that trades on the New York Stock Exchange are closed-end funds. And closed-in funds are the oldest mutual fund out there. They were there before open-end mutual funds.

Starting point is 00:33:31 So an open-end mutual fund is sort of what's in your 401 plan, for example, where at the end of the day, the fund sponsor strikes a net asset value. It looks at that value of all the assets it owns, divides it by the number of shares, and comes up with the price per share. And that's what you buy that mutual fund for, that opened-down mutual fund. Closed-in funds are more like exchange trade of funds, as they trade throughout the day. And because of that, you can see the price of the fund.

Starting point is 00:34:02 It can differ from the net asset value. In theory, it can for ETS also. We've talked about in the past flash crashes for ETS. So that's where there can be a disconnect between the price of the ETF and its net asset value, but there are what are known as authorized participants that are always trading the underlying holdings of the ETFs, called the reference basket, the shares of the ETFs. And so there's all this trading activity around that to make sure the price of the ETF equals the net asset value. Closed-end funds by design have never been able to do that because there isn't an outside entity

Starting point is 00:34:36 that can get enough to sort of close that discount. So if you go to a website like CEF Connect that list out the 500 or so closed-end funds in the U.S. It's about $300 billion of assets. You can rank them by discount to net asset value and see these vehicles that are selling for 10, 15%, 20% discount to the value of what it owns. And to me, that's a great deal. If I can buy an asset at a 15% discount, a 10% discount, and it's an attractive. asset in an area that I'm interested in. For example, right now, a recent closed-end fund I bought is the Black Rock Debt Strategies Fund, the tickers DSU. This fund invest in bank loans. So syndicated

Starting point is 00:35:22 non-investment grade bank loans. It fell to greater than a 10% discount. These bank loans are variable rates. So you're protected against rising interest rates. And you're seeing these yields go up for these bank loans as the Fed raises its policy rate, the yields on bank loans goes up. What these have is credit risk. So we talk about being contrarian. Instead of buying commodities, maybe you take more credit risk currently thinking that the recession might not be out. It might be two or three years away or might not come at all. And so what a closed-end fund does is basically, in any time I invest, I always want to ask who's on the other side of the trade. Who am I competing with? When I buy commodity futures, I'm competing.

Starting point is 00:36:05 against bots, institutions, algorithms, hedge funds, that's who's selling it to me. When I buy a closed-end fund, I'm competing against retail investors. And that tend to panic when markets fall and they start dumping their closed-end funds, which aren't terribly liquid. And then you see discounts widen. Anytime there's a sell-off, you see discounts widen. And that's where it becomes more of an opportunity to get an asset class that typically they use leverage. So these sponsors, most closed-end funds are more income-oriented. The sponsor uses leverage that they can get very cheaply. So this debt strategies fund, DSU, is able to borrow at LIBOR plus 80 basis points. And then it's investing in loans that are having interest rates of four and a half to five percent. So it's able to

Starting point is 00:36:53 keep that spread. The expense ratios tend to be higher, but ultimately this is a way to compound at a much higher, much better than just owning, let's something like the Vanguard Total Bond Index fund B&D because this has leverage. The distribution rates tend to be higher. So DSU, for example, has a distribution rate of 7%. And you're getting it out of a discount to its net asset value. Now, are all closed-in funds a basket of credit products? No, so there's equity closed-in funds. There are closing funds to do more option strategies. Some do mass limited partnerships, utilities. But because most of the investors tend to be retail oriented investors. It's just an area that has tended to gravitate more toward leveraged fixed

Starting point is 00:37:41 income type income products. So there's equity REITs, there's convertible bonds, there's all different types. But I typically don't, for example, buy straight equity type closed-end funds. I prefer something a little more predictable on the bond or some other type of income strategy side. I like the credit investment aspect of it. It's not something I've really experimented with at all, But it's sort of like betting on a horse to just finish the race, whereas equity investments are like betting on the horse to win or at least place in the show. Is that how you see it? I mean, when you're investing in credit products, the company just has to essentially survive long enough to pay back the principal and interest. And is there a way to kind of audit the basket of the CEF and monitor the companies and get a feel for if you think that horse is going to finish the race?

Starting point is 00:38:29 Well, you buy, for example, DSU has 1,200 different credits in it. And Black Rock has been in the bond business for decades, and they have huge quantitative strengths. They're very, very good at analyzing bonds, much better than any of us would ever be. So I'd rather have a professional management team selecting which of these bank loans to purchase. We talk about, you know, equity is winning the race. Well, what is the race? When you're buying a stock, the race is, I think the price is wrong.

Starting point is 00:39:02 And so it has to surprise to the upside. That's actually more challenging than just getting your money back from a bond. And then you have the structural leverage built into the closed-end funds. And you're buying it at a discount to the net asset value, which means you're getting $100 worth of assets for $90. And so that's what makes it attractive to me. And recognizing, you know, these can be used as trading. vehicles. Once, for example, DSU, once that discount narrows, I'll potentially exit, depending on where we are with the economy at that point. So there's just a lot of different tools you can

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Starting point is 00:43:12 like building a fund of funds, right, where you've got the blackstone, as you mentioned. But Oak Tree has another promising CEF as well. And obviously, people know of Howard Marks and how well he's done in the credit markets over time and could consider Oak Tree a great manager for that fund or for that product. Is that how you kind of look at it where you're building sort of a basket of these baskets of funds? Yeah, I mean, you can do that. In fact, there's an ETF, they amplify high income fund. The ticker is Y, Y, Y, Y. It is tracking the ISC high income index, which is an index comprised of 30 closed-in funds that are ranked based on their yield, based on their discount to the net asset value based on liquidity. But yeah, as an investor, I'm an allocator. That's what I did

Starting point is 00:43:56 in managing assets for endowments and foundations. If my portfolio, which I share with my members and money for the rest of us, it's an allocation portfolio with over a dozen different asset classes, mainly because that's how I'm most comfortable investing. And it's because it's how I have invested. Now, it's not the only way to invest. To me, it's an asset garden approach where We just want a diversified mix of different assets, just like you have a garden, you've got a diversified mix of vegetables and flowers, different return drivers. And so as retail investors, we have some advantages. And one of those advantages is hedge funds can't buy closed-end funds. They're not liquid enough. The market's too small. So there's some niche assets that we can participate in where we're not competing against hedge funds who are on the other side of the trade. So that discount to NAV opportunity, so to speak, is really interesting. My only experience with something like that is investing in the grayscale Bitcoin Trust.

Starting point is 00:44:59 And that has had a negative discount to NAV for, I mean, a year now. And it's around 21% today, which can be very frustrating, right, to see that discount not catch up to the NAV. Is that not as common in these CEFs, for example? Do you ever see a situation where that gap is not closing? Oh, it usually doesn't close. So that's the other thing with closed-end funds is if you go to a site like CEF-connected, it calculates a Z-score, which is a statistical measure looking at the current discount relative to the average discount, and then it factors in the volatility of that discount over time. And so generally I tell people, look for a Z-score of greater than negative three, which means the discount is wider than it typically is. And you can see price chart C, well, where is that discount? relative to historically. But yeah, oftentimes the discount never narrows. Other times it becomes a premium and the premium never narrows. And that's how you know, this is an inefficient asset class when you can see a closed-end fund consistently selling for a 20% premium. And that never closes.

Starting point is 00:46:06 In a case like the gray scale Bitcoin Trust, that was at a premium a year or so ago. Now it's at a discount, mainly because it has more competition with lower expense ratios. And so I'm not sure the gray scale of Bitcoin Trust if you'll see the discount narrow as long as other products keep coming out with lower fees in order to get access to Bitcoin. Part of that discount could be also because of how thinly traded they are. How thinly traded are we talking with these CEFs? You mentioned there are only $300 billion market. How does that compare to the rest of the assets on the New York Stock Exchange and give us an idea of the volume differential? Well, for an individual CEF, I mean, You can, as a retail investor, you can get in that it's not like the gap between the bid ask spread is super huge.

Starting point is 00:46:53 I mean, it's similar to like an ETF. And so they're market makers. You can get in. The thing about CEFs, in some ways, they shouldn't even exist because what happens is a sponsor comes along and says it wants to do a new fund. And it goes to the broker community. And there's a 5% load invested in that. And the IPO price is at the net asset value. And then immediately you'll see the thing sell off to become a 10% discount.

Starting point is 00:47:20 Anybody that buys a closed-end fund at the IPO has gotten ripped off because you know it's going to fall in price. And so we always want to buy these things in the secondary market. Is that what you would say is the biggest risk of owning a CEF? The biggest risk is because it is a market that is primarily retail oriented, And the biggest risk is a major sell down. So with the pandemic selloff, you saw some closed-end funds sell off 40, 50%. And you have to be able to stomach that volatility. But because they're leveraged, at some point, you saw this in the master limited partnership

Starting point is 00:48:01 space. So these are energy infrastructure assets. They're invested in oil pipelines, natural gas pipelines. A number of those closed-end funds were 30 to 40 percent levered. And then you saw MLP sell off 60 percent. So then the closed-end fund is getting margin calls on its debt. And so they're having to sell assets. And so that's a risk.

Starting point is 00:48:22 Any leveraged asset is risky when the asset itself that it owns that's been levered up falls. And so that's a risk with closed-in funds. So with any investment, you have to understand, you just don't go buy them blindly. Say, oh, it's at a 20% discount. You have to say, well, what is the asset that it's invested in? What is the leverage? What is the fees? and really understand what it is and what is sort of your investment thesis.

Starting point is 00:48:47 When will you exit? It's a vehicle is what a closed-in fund is, just like a mutual fund, an open-day mutual fund is a vehicle. We want to understand what's under the hood that's driving the performance of that particular investment vehicle. And what's under the hood? I'm curious, it doesn't seem to turn over very much. So, for example, if you look at, say, the price performance of a CEF, let's say, MCI,

Starting point is 00:49:10 for example, and you compare it to the... the S&P 500. I mean, it looks like it's just getting crushed. The S&P, say, over the last five years is up 105 percent. MCI's negative 1.18 percent. But that's just the price differential. So that could be a mistake that some investors make when they look at how did these things compare. So how should we look at how they compare to the S&P 500? And is it true that the underlying assets don't turn over very often? Well, what you don't see is because these are income-oriented asset classes using leverage and they're trying to maximize their dividend. So basically pay out all the returns in the dividend. And as a result, you don't see the net asset value of the CEF's increase. And so if you look

Starting point is 00:49:53 at a chart like that, basically you're looking at the price return. We want to look at the closed and fund on a total return basis where the dividend is being received and reinvested. So that's really key. But when you analyze closed in fund, that's important. So typically, so MCI, for example, it's the Barron's corporate investors fund or it's a debt fund. They're doing private debt lending in this case. It's a closed-in fund that I own also. And its total return on a net asset value basis it's been 10% annualized over very much every time period going over a decade because they're basically what's known as mezzanine debt. So they're lending to private companies, middle market companies. Oftentimes they'll get an equity participation. So they'll participate in the upside. It

Starting point is 00:50:39 providing some counseling and things of that sort. So because they're providing that, they can get a higher yield on their debt, on this private debt. And that's been that strategy. The key is that they don't default. But when you look at, when I looked at buying MCI, you pull up the annual report and you look at, all right, here's the net investment income that was created. Is that enough to cover the dividend? Or how are they paying for the dividend? Because some of these closed-in funds, they have what's known as a managed distribution. strategy where they try to keep the dividend the same, but in reality, one way they do that is that their dividend is too high. So they're always basically returning capital. And then you see

Starting point is 00:51:18 the net asset value drop over time. So you don't want to see the NAV consistently falling on a consistent basis because it means the managers basically taking assets selling them and they're just giving it back to the shareholders. And the shareholders think, oh, this is a really attractive dividend, but they're just getting the money back. And so in some ways, closed in front, I mean, it's like analyzing an individual stock if you're digging into the 10K. So you need to understand how is that distribution being funded. Is this a strategy that might supplement for, say, someone who was looking for high dividend yielding equities in their portfolio, say if they're getting older and they're looking

Starting point is 00:51:57 for just more of a dividend income for the return? Is this somewhat of a supplemental option for someone like that? Yeah, it certainly is an option. There's a guy who goes, Steve Bavaria is his name. a book called The Income Factory. And it's all about closed-end funds. And his strategy, it's all buying whole. I'm going to buy the highest yielding closed-end funds, and I'm going to hold them through thick and thin and as long-term hold. I tend to be a little more trader. I have some holdings that I'll hold for a long time. But once that discount narrows to where it's narrower

Starting point is 00:52:27 than average or even goes to a premium, I'll often sell. And then I'll invest opportunistically when I see discounts widen. But it is a way to generate income. It's a good portion of my bond allocation because the yields are 6, 7%, as opposed to 2.5% in the bond market. And so, it can be used to generate income for retirement. Digging into closing funds a little bit more, there's one type in particular that's pretty interesting called business development companies. Walk us through why we might want to take some interests in business development companies and what they are. Right. So business development companies are a little different. They fall under the regulatory structure for closed-end funds. But in this case, it's not like a traditional

Starting point is 00:53:14 closed-end funds. So if you go to CEF Connect, you won't find business development companies. There's only about 40 or 50 outstanding in the U.S., about $53 billion in capital. And this was created from the Small Business Investment Incentive Act back in the 80s. And really, as a way for middle market companies to get debt, so these are private companies. So a BDC has money, they've raised money, they're basically lending to private companies and they're providing some additional counseling. Again, it's sort of like a mezzanine strategy. And as a result, they'll often get some equity participation. They can charge higher interest rates. And so it's very much a niche strategy. It can be very concentrated, but a way to invest in BDCs is the Vanac BDCs, is the BNACBDC income

Starting point is 00:54:01 ETF. So the ticker is B, B, I, ZD. It's been around, it's about 650 million. in assets, it's got just about a 10-year track record and it's done decent. It's returned 6 to 7% annualized, just investing in 25 or 30 of these BDCs. Now, similar to the CEFs trading at a discount to NAV, do you see a similar thing happening with these BDCs? In many regards, you see them selling at a premium to the net asset value. And what's interesting is there isn't like a website where you can see and screen based on the discount, at least that I'm a little. of maybe somebody should create one if there isn't. But I think that the niche is so small. But I, for example, had one of my members who the day asked about a couple of BDCs that he owned

Starting point is 00:54:47 in our member forum. And once I looked at it and he didn't realize it that this BDC is like, well, the performance is done well. It's doing well. And then I looked at it selling at a 60% premium to the net asset. And I don't give investment advice. And I didn't. Like it had to been mine, I would have sold it right then because it just I just am viscerally opposed to owning something at a premium if there's a chance it could fall. And so I much prefer a discount because you have that margin of safety. But you can, I mean, in a down market because the risk of BDCs is like Clostin funds, they can sell off 50 to 60 percent in a down market. And at that point, potentially you are seeing them at a discount to the net asset value, but you have to go to the website of the particular BDC,

Starting point is 00:55:29 you go through and they're sharing their net asset value. Often though, because this is private debt, they're not sharing it on a daily basis. It could be a quarterly release of the NAV, so you have to kind of estimate it, but it is an important component to look at. Should retail investors look at BDCs as an opportunity that, for example, may have used to be something you'd find it through private equity, but is now available as a product to retail investors and that's an advantage that they should consider? It is, right. It's a way to basically invest in what in the private equity space is known as mezzanine debt. So somebody,

Starting point is 00:56:10 a typical private equity investor, you know, it's mostly an equity investment, but there are mezzanine funds that are lending directly to the company and get some type of warrant option to participate in the upside, whereas a traditional venture capital or biot manager, it's an equity investment. So there are some of these vehicles, BDCs, even closed-end funds, that are sort of because their advantage is there's only a certain number of shares outstanding. So it can be a steady pool of capital that isn't turnover. If it's an open-end fund, you can't have illiquid investments in an open-end mutual fund or to some extent in an exchange trade of fund because there's always a risk the shareholders want to exit. But with a closed-end fund and even with BDCs, there's a certain

Starting point is 00:56:55 number of shares unless they do some type of follow-up offering. And so the manager can hold private investments in that fund structure. And this is a way for retail investors to participate in that. You know, one peculiar thing about BDCs and CEFs is that they both seem to have these expense ratios that are pretty crazy high. You kind of touched on it earlier. They do have this expected higher yield, but the cost seem relatively high. I'm curious, what is causing such a high cost for these types of funds? With the BDCs, since technically under the regulation, it's a fund of funds. So you have the BDC and then it's lending to individual companies. And so the SEC says because of that, when you publish your expense ratio, you have to basically include all the fees, some of the

Starting point is 00:57:43 operating fees for running the companies. There's the incentive fees that are baked in there. There's the interest expense. And so the way to look at a BDC or to look at a closed-in fund is look at the, what is the management fee? So what is vehicle charging to actually choose the underlying investment? So that's sort of the base level. So a closed-end fund, you can see, I'm in closed-on funds where the expense ratio, just the management fee is 75 basis points. And so, but there are definitely closed-in funds where it's one and a half percent. And so recognize that the overall, the expense ratios are higher than you're going to see in ETFs and in an open-end mutual fund, which is another reason to buy them at a discount, the net asset value. And that, that's sort of

Starting point is 00:58:24 have offset some of the pain of the higher fee, but always don't just look at the expense ratio and say, oh, it's really high. Understand, well, what are the components of that expense ratio? What's included in that? Because it needs to be an apples to apples comparison. If you're looking at it relative to an ETF, the comparison is the actual management fee itself. So if you were a retail investor that was considering BDC CEFs as part of the overall portfolio, what level of allocation, I mean, given there's differences in sophistication and expertise, I know it's hard to say, but roughly, you know, you mentioned gold, for example, is this a similar allocation where it's just sort of a smaller part of a overall portfolio?

Starting point is 00:59:06 And if so, how should retail investors think about allocating to things like CEFs or BDCs as part of an overall portfolio? BDCs, they're definitely a very niche strategy. So I mentioned that the ETF, the VNAC, BDC income ETF, it only has 25 or 30 BDCs. And the drawdown for these can be 50 or 60%. And so that should be single digit percentage allocation. Closed in fund is different. It just depends on what the overall allocation is for the particular investor. The thing with closed end fund, so because you have different layers, yes, it's a bond fund,

Starting point is 00:59:45 let's say, but it's leverage and it trades on a stock exchange. So you can see volatility in your bond fund that looks like in your bond closed-in fund that looks like stocks. So you have to be comfortable with just the volatility of this particular vehicle. And that I think tends to keep investors for not making it a huge allocation. But again, you have to understand that the CEF is just the vehicle. What's the underlying strategy and how diversified in it? If I'm comfortable with my entire bank loan allocation or most of it being in one Closedon Fund because Black Rock owns 1,200 underlying bank loans and they're doing credit research. And so in that case, I'm more comfortable having a higher allocation, recognizing it will be volatile. And there's a risk that the discount

Starting point is 01:00:29 could widen further. Wow. Well, David, this was so interesting. I definitely learned a few things that were new. CEFs, BDCs are all assets that we've never explored on this show. And I'm really thankful that you were able to bring them up and educate us on. on it. And I also love that we were able to just have a very wide-ranging discussion touching lots of different things. And you brought such a wealth of knowledge to all of it. And it's always a pleasure to have you on the show. I really enjoyed it. Before I let you go, I definitely want to give you the opportunity to hand off to our audience where they can learn more about you and your books, your podcast, any other resources you want to share. Sure. So the website is Money for the

Starting point is 01:01:07 rest of us.com. There are a lot of free investment guides on there, one that covers closed-end fund so you can check that out. The podcast is also money for the rest of us and you can learn more about there as well as some of the other courses and resources that we offer. So it's all right there at Money for the rest of us.com. Fantastic. Well, again, thank you, David, and I hope we can do it again soon. Yeah, it was great. Thanks, Trey. All right, everybody, that's all we had for you this week. If you're loving the show, don't forget to follow us on your favorite podcast app. And if you're looking to diversify into other markets around the world, definitely go to the investorspodcast.com. investing resources for you there, we actually have a list of the best indices from every country,

Starting point is 01:01:48 and it's a great place to start. And with that, we will see you again next time. Thank you for listening to TIP. Make sure to subscribe to Millennial Investing by the Investors Podcast Network and learn how to achieve financial independence. To access our show notes, transcripts, or courses, go to TheInvesterspodcast.com. This show is for entertainment purposes only, before making any Decision Consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.

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