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More of those “Social Security Insurance” Ideas

Part two of our look at the latest teaser pitch from High-Yield Investing

By Travis Johnson, Stock Gumshoe, September 15, 2016

Yesterday I spent some time looking at Nathan Slaughter’s “Social Security Insurance” pitch, which ended up being a roundabout way of saying “you should buy high-yielding stocks, and I’ve got some favorites to share if you’ll subscribe to my newsletter.”

And I ended up naming three of those stocks for you, and taking a quick look at them… but I didn’t get to all five, so that’s the task for today: What are the other two “Social Security Insurance” ideas pitched by Slaugher for High-Yield Investing, and are they worth a closer look?

Let’s jump right in with number four, these are the clues from the ad:

“Cash Out Your CDs and Get Paid 13X More Instead

“With interest rates near zero, keeping your money in a bank is a terrible way to generate income.

“What you might not know is that there are a few dozen “private banks” that are very similar to traditional banks… only they pay out up to 13%.

“That’s 13 times more than the average one-year CD.

“These outfits operate in a restricted area of Wall Street that is off-limits to normal investors. But I’ve found an end-around into this high-paying safe haven that anyone can use.

“It’s a private bank that lends money to dozens of small companies at an average interest rate of 12.5%. By also taking equity stakes in its clients, it bumps up its cash flow and yields 12.8% to shareholders.

“I see no reason to keep your cash in a CD when you can get paid so much more here.

“It has made 86 straight dividend payments and thanks to its growing cash flow, the dividend will almost certainly jump higher in the next 12 months. That makes it a cinch for our Social Security Insurance Program.”

Comparing any equity investment to a CD is obviously disingenuous — equity investments are inherently variable in value and always have some risk. You don’t buy CDs because you want to maximize your income, you buy CDs because you can’t afford to lost that cash and want the best income you can get without risk.

But which one is this? The structure being teased here is the business development company (BDC) — BDCs are essentially banks that gather capital in the form of both equity (the stock you buy) and debt, and use that capital to lend to smaller companies. They are pass-through investments (sort of like a REIT), so the earnings they make are not taxed at the corporate level but are passed through to investors, who also get that tax obligation. And very much like real estate investment trusts (REITs), BDC dividends are treated like regular income on your personal taxes (no special lower dividend tax rate, etc.).

Most BDCs are not trading at quite that high a yield these days — the yield on the BDC ETN (BDCS) is about 8%, and the yield on the newer BDC ETF (BIZD) is about 8.5%, so that’s more of an average for the sector… but there are a few outliers with much higher yields, and the best match here for Slaughter’s tease is Prospect Capital (PSEC).

Prospect Capital is a lightning rod of a BDC stock, and I’m certainly not in a position to say anything definitive about them — they’ve been pilloried for poor performance and for SEC investigations, but have also done very well on a total return basis for their investors in the past year or so… though you may want to consider the risks of reinvesting dividends in a stock like this, where the stock price has moved relentlessly lower over time.

PSEC has generated a total shareholder return of 95% since going public at about $15 in 2004, and some of that is because of reinvested dividends and the ability of those dividends to generate more dividend income… but the share price has now fallen roughly in half from that IPO level too, so those reinvested dividends have a big hurdle to jump to add value.

It isn’t just PSEC that has this problem, of course, these are interest rate-sensitive investments so they move around based on their cost of capital (their cost to borrow, plus the cost in terms of dividends for them to raise more capital to grow their portfolio) and based on the valuation of competing income investments like REITs, MLPs or bonds. And they’re also investors, so they see their performance fall when their investing goes badly — when they either have their equity investments fall in value, or have borrowers who fail to pay them back.

There’s a pretty interesting look at the data on these guys from a Seeking Alpha article here, he compares some of the PSEC fundamentals to other BDCs, so that might be helpful for folks who are trying to understand where PSEC fits in the BDC universe. It’s a high yielder, and it’s a hotly debated stock, so you’ll see plenty of opinions and analysis on PSEC if you browse the interwebs. Personally, I’ve had a hard time getting excited about BDCs in this environment, since I think the risk of rising interest rates would hit them harder than REITs, but if I were to invest in the space I’d probably use an ETF unless a particular company stood out for me as being a much better operator than others — I haven’t done much analytical work on the universe of BDCs of late, but at a quick glance PSEC doesn’t stand out to me as particularly appealing. Your opinion may differ — if so, I’d love to hear it, and hear why PSEC is worth a deeper look, just use our friendly little comment box below.

And moving on… what’s the last high-yielder pitched by Slaughter?

Clues for number five:

“Collect a Paycheck from Your Own Retirement Business

“You don’t find an opportunity like this every day…

“Authorized by a special act of Congress in 1986, this outfit is totally exempt from taxes… which leaves a lot more money to be distributed to YOU.

“As an added bonus, your personal taxes on this income are so low that 90% of the money you get is tax-free until you sell. Which I’m betting will be never.

“Unlike a regular stock, which gives you zero say in how much of the profits you get to keep… this company pays out all its profits directly to you. It has to, by law.

“It’s like owning a business, but one where you don’t have to manage anyone, keep any books or worry about countless regulations.

“But you do get the profits. And they’re considerable. Since it opened its doors in 1993, this outfit has showered its owners with a total return of +1,107%.

“Even better, it operates in an industry where payments are guaranteed for years in advance. So it is as reliable as they come. It has relentlessly hiked its distribution for 23 years and has never once reduced it.

“Now yielding almost 9%, this is the perfect low-risk cash-cow play for anyone who wants a never-ending stream of retirement income.”

This one, sez the Mighty, Mighty THinkolator, is OneOK Partners (OKS), a midstream master limited partnership (MLP) that owns primarily natural gas and natural gas liquids (NGLs) pipelines and processing and storage facilities in the US, with a big concentration of assets in Oklahoma, Texas and Kansas.

And yes, many contracts in gas and oil pipeline transport are long-term in nature, and they have never cut the distribution — though they don’t raise the distribution every single year, either (they last raised the quarterly payout in 2014). Like most MLPs, it has suffered some as oil and gas prices have collapsed over the past couple years — so the shares are well off their highs of near-$60 from 2014, but they have recovered a bit in recent months.

OKS did go public in 1993, and it’s the only major MLP that did so — and MLPs were indeed created by tax reform in 1986, largely to encourage investment in energy infrastructure… so those are some specific matches for those of you who are keeping track of the clues. And the yield is still pretty close to 9% (it’s about 8.5% right now), and the stock has had long-term total returns of more than 1,000% — it would have been 1,107% a few months ago, it’s now more like 1,400%.

MLPs are indeed required to pay out 90% of their earnings to unitholders, and they’re partnerships so your income will be reported on a K-1 that complicates tax filing a little bit (not a huge deal, in my opinion)… but I don’t think there are any MLPs that distribute as little as 90% of their earnings — they almost all distribute vastly more than earnings, because they essentially take those big non-cash depreciation charges that large capital projects (like pipelines) generate and turn much of that depreciation into “distributable cash.”

Because they distribute far more than they earn in profits, much of the distribution is typically “return of capital” to unitholders, not actual taxable earnings, so that “return of capital” part (often 70-90% of the distribution) doesn’t generate a tax bill like a dividend does but it does lower your cost basis in the shares/units… so that tax is effectively deferred until you sell (and last I knew, MLP holdings can still be passed along to heirs with a reset cost basis as of the date of death, so in some cases they can get deferred for a generation — though once the cost basis drops below zero, the distributions may become taxable income). There are lots of complications in MLP ownership, particularly when it comes to state taxes (some MLPs create a tax obligation in states where you don’t live) and retirement accounts (large MLP positions in retirement accounts might generate taxable income through what’s called UBTI), so it’s probably wise to do some research and pay a little attention to those concerns before you buy an MLP. Whether those complications are minor irritants or huge hassles for you probably depends mostly on the size of your account and your relationship with your tax preparer.

There’s obviously some risk in the “distribute lots of your depreciation cash” model, since you’re making a judgement call about how much depreciation really needs to be reinvested into refreshing the capital base (upgrading pipelines, repairing or replacing equipment and assets, etc.) and how much is “excess” depreciation that you can just give to your partners — I don’t have a good handle on how much of a risk that is, but it’s worth thinking about… particularly because most MLPs, instead of reinvesting some of that depreciation, use equity offerings and debt to fuel their growth.

That works until it doesn’t work, and it really stopped working well when oil fell and investors stopped being excited about energy investments. It’s true that pipeline companies don’t necessarily worry about what the precise price of oil or gas is at any given time because they charge a “toll” for transport that’s not based on energy prices… but if prices fall to the extent that production growth doesn’t match the pipeline provider’s forecasts, or entire production areas are shut down, there’s less oil or gas to move so there’s less income. And if prices fall dramatically, there’s pressure from oil and gas companies to cut costs wherever they can… including on pipelines and other transportation.

I don’t think MLPs are necessarily bad, and I’ve owned some over the years — but it’s worth remembering that there’s quite a bit of leverage and risk built into the MLP model these days, particularly after they were so successful for 15 years and attracted so many new MLP IPOs in the years following the financial crisis. If you want to read some criticism of the model itself, particularly of the financial engineering that goes into those distributions, Brian Nelson over at Valuentum often rails against MLPs and has a good short piece from last year presenting his position here.

And about OKS itself, I know very little other than that it’s a natural gas infrastructure company, not oil. It has been one of the more popular MLPs among investing pundits for a long time, and we’ve seen it teased quite a few times over the years, but I don’t know what their current financial situation is in any detail… and I don’t own any MLPs at the moment.

So there we are, five “Social Security Insurance” ideas wrapped up with a nice little bow for you — interested in these kinds of stocks, or have favorites or foes on those lists? Let us know with a comment below.

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David B.
David B.
6 years ago

Here are the stats from late 2015 directly from the SSA, rather scary, but most of us here should be in much better positions than this.

Social Security is the major source of income for most of the elderly.
•Nine out of ten individuals age 65 and older receive Social Security benefits.
•Social Security benefits represent about 39% of the income of the elderly.
•Among elderly Social Security beneficiaries, 53% of married couples and 74% of unmarried persons receive 50% or more of their income from Social Security.
• Among elderly Social Security beneficiaries, 22% of married couples and
about 47% of unmarried persons rely on Social Security for 90% or more of their income.

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👍 855
6 years ago

PSEC is probably fully valued here with a high risk. The great numbers it posted last quarter were effectively from a non-recurring one time gain. There are many BDCs which are really quality companies Like GSBD, TPVG, and HTGC.

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👍 4
6 years ago

Hi Travis – normally I agree with you but PSEC represents the second time I haven’t (the other was WATT which, as I wrote to you at the time, was worth buying provided it was sold immediately before the Apple 7 announcement; I made an easy profit of 38.86% in 22 days because I assumed that most investors are “sheep who follow the leader” and too many were pushing it based on wishful thinking). As to PSEC: bought on 10/14/15 @ $7.64; now $7.92 as I write this (+3.76%) but with this month’s dividend I will have received approximately $1.00 per share in one year which is an additional 13% return (as capital gains) – the combined total is not great, but not bad either. Of course, stocks like this need to be watched carefully and one may need to jump out when the Fed changes rates (but as an old Washington hand I think it is foolish to think they will six weeks before a national election since rate changes cause market and general economic fluctuations and the Board members are politically astute). SO – it gives a great capital gain return to its holders but may be a short term holding if bought now (By the way, I expect the Fed to act in December so will sell before they meet unless the economy tanks after the election).

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