BDJ: Overweight Financial Exposure Makes This Fund Lag For Now

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Written by Nick Ackerman, co-produced by Stanford Chemist

BlackRock Enhanced Equity Dividend Trust (BDJ) is a well-run and respected fund offered by BlackRock. This is one of the names that I was buying during the latest COVID-19-induced market panicked selloff. In hindsight, I was buying much too early and I would have been better off waiting until later in March. I don’t regret my purchases though as I believe over the longer term that this well-run fund will deliver results. Even if that means it is difficult to see it at this point when everything was and still could continue to crash.

The fund is held at the CEF/ETF Income Laboratory in our Income Generator Portfolio. The fund is currently listed as a ‘Buy’ thanks to the wide discount of 8.90%. In my personal portfolio, it is quite a large position too, thanks again to picking up more shares at the end of February. This has been, and more than likely will continue to be, a position that I add to over time averaging down.

The fund’s investment objective is “provide current income and current gains, with a secondary investment objective of long-term capital appreciation.” They intend to meet this objective by “investing in common stocks that pay dividends and have the potential for capital appreciation and by utilizing an option writing strategy to enhance distributions paid to the Trust’s shareholders.” They state that “under normal market conditions, at least 80% of its total assets will be in dividend-paying equities.”

This is why I tend to gravitate towards an appreciation of this fund. They invest in most large-cap companies. Currently, the portfolio holds 96.66% in large-cap companies. These large companies can generally provide stability – that generally leads to growing dividends over time. Those growing dividends can be a reliable source for BDJ to keep paying out its own distribution too. Of course, the fund (and holdings) aren’t impervious to the current COVID-19 crisis. There will be dividend cuts from the underlying positions or even slower dividend growth due to slow to no earnings growth for the underlying positions. However, as you might have guessed, these large companies probably aren’t going anywhere for a long time. This will be evident when we take a look at the fund’s holdings.

BlackRock

Performance

The fund’s last closing price was $7.06, with a NAV per share of $7.75. This was good for the fund’s discount of 8.90%. That discount is exactly at the fund’s 5-year average. On a shorter-term basis of 1-year, the fund’s discount is at 6.33%. This leads to a 1-year z-score of -0.85. That is certainly attractive. However, several weeks ago, the fund dipped to a whopping 12%+ discount. Even at the current discount though, I am a buyer.

(Source – CEFConnect)

Since inception, the fund had quite a wild ride for the first few years. They launched this fund on 8/26/2005. Little did they know just a few short years later the 2008 GFC would happen. Then shortly after surviving that period, the fund appeared to jump to premium levels before diving in 2011 to remain at steep discounts for years.

Over the years, BDJ has merged with several other funds. In 2014, the fund merged with BlackRock Dividend Income Trust (BQY). In 2011, the fund actually was merged with two other funds too; the BlackRock Strategic Equity Dividend Trust (BDT) and BlackRock Equity Dividend Trust (BDV). That is a bit of how the fund got to be so large at $1,454 million in managed assets.

The fund also slightly changed in 2011 with a name change and slight investment policy change. Prior to 2011, the fund had a policy of “limiting its portfolio to approximately 60 to 90 issuers from the top 100 highest yielding common stocks in the Dividend Achievers Universe.” It looks like that move wasn’t received so well by investors as that is when its discount began to widen quite significantly. At this time, it is unclear if the fund will return to the narrowing discount that it was trending towards before this latest crash.

On a YTD basis, the fund is down quite significantly. Even more so than the broader market measured by the SPDR S&P 500 ETF (SPY). I believe this has a lot to do with the fund’s overweight exposure to financials in particular.

That isn’t all that surprising as SPY is loaded up with Microsoft (MSFT), Apple (AAPL) and Amazon.com (AMZN) making up its top holdings. MSFT is in the fund’s top holdings but as of their last full holdings report, there is no AAPL or AMZN. These three companies make up approximately 14.30% of SPY. Those are also the main stocks that are driving up SPY’s returns. In fact, there’s Facebook (FB) and Alphabet (GOOGL) (GOOG) in SPY’s top 10 as well.

All of which are doing quite well on a YTD basis. With GOOG, GOOGL, AAPL and FB down marginally. Again, none of those but MSFT is in the fund’s holdings. Those large names are disproportionately pulling up SPY’s returns for the year. Which is actually fantastic for growth investors that are invested in those names. I also hold many CEFs that do invest in those names as well that can reap the rewards of capital gains to fuel distributions. I’m definitely not complaining there. It just might put a little more perspective for investors when they are looking at the SPY lately and what is going on with that fund.

Distribution

The fund currently pays out a distribution of $0.05 per month. This was raised in 2019. The prior rate of $0.0467 was paid monthly for several years. Before this, the fund paid a quarterly rate. Like many funds, they had to cut over the years after 2008. This seemed prudent to keep the fund from eroding too much of its assets away. In 2016 and 2015, the fund was paying out ROC that was at least slightly destructive. During that time, the oil crisis was happening that was impacting the overall market and presumably holdings within BDJ itself.

Thanks to the fund’s wide discount, investors can pick up shares with a distribution rate of 8.50%. This is attractive since the fund only has to earn, at the moment, a NAV rate of 7.56%.

(Source – Annual Report)

The fund does rely significantly on capital appreciation to continue to fund its distribution. NII coverage was 25.25% for 2019. In 2018, this coverage was quite a bit higher at 32.11%. NII was even higher in 2019, thanks partly to underlying positions growing their dividends. However, you can also clearly see that the fund paid out much more in 2019 too. This wasn’t all associated with the increase in its distribution. This also has to do with the fund paying out a healthy year-end payment of $0.1710.

(Source – CEFConnect)

For BDJ, they have 187,542,405 shares outstanding. That means the year-end distribution costs the fund a whopping $32,069,751 to pay out to shareholders. Meaning they would have paid out only $108,809,478 otherwise bringing BDJ’s NII coverage to 32.69%. That isn’t a terrible amount considering the fund is invested in all equities. It is also about in line with the fund’s NII that grew year-over-year, and that’s even factoring in the increased distribution.

Considering the fund’s drop, it might be a bit more difficult for the fund to reach the capital appreciation that is needed. The fund had been sitting at $465,674,437 in unrealized appreciation at the end of 2019. This leaves very little left in unrealized appreciation after the drop. The fund had $1.882 in assets, managed assets now sit at $1.454 – meaning the fund only has a roughly $38 million in unrealized appreciation. The shortfall for the prior year was $73.237 million. Meaning they have some work to do to earn the distribution for the year.

Holdings

Even with the fund’s apparent stretch that it has to maintain its distribution at the moment – I believe the fund’s top ten holdings aren’t going anywhere anytime soon. As alluded to above, these are large-cap names with some significant household name recognition. There are several that I hold directly too, that’s how much confidence I have in them.

It also invests quite heavily in the financial sector. I believe this overweight allocation has been what is dragging the fund down relative to other equity-based funds. The financial names make up 25.32% of the fund’s portfolio. This actually makes me a little bit more bullish on the fund going forward. I am looking to increase my financial exposure as the space has been hit quite significantly. For good reason too, with a weaker economy going forward these names will certainly suffer disproportionately compared to other sectors. This is attractive for a longer-term shareholder that is looking for values right now.

(Source – Fund Website)

In addition to the financial exposure, industrials and energy made up 8.14% and 7.97%, respectively. These two areas are also quite sensitive to economic changes going forward. The second and third sector allocation though is healthcare and tech. These have been relatively solid comparatively speaking. In this case, not enough to offset the downside though. We highlighted that above, in relation to the broader SPY performance on a YTD basis. In fact, SPY is 25.71% tech, with financials making up only 10.61%.

The portfolio is also overwritten by 53.09% at the end of March 2020. The fund utilizes writing options on single stock names. During times of volatility, the fund can actually collect higher premiums on the written contracts. Of course, the downside here is that single stocks can be called away if the option isn’t closed and the stock is trading above the strike price. They do provide the range of options overwritten should stay between 30 to 40%. They state that it “may vary over time with market conditions.” As they have ramped up over this range, I believe they are viewing the current market as a time to get defensive. An option writing strategy is slightly defensive as one can collect some premium even if the price of the security heads lower. Ultimately, it isn’t defensive enough to be able to prop the fund up beyond its underlying portfolio dragging performance lower.

(Source – Fund Website)

As previously mentioned, the fund is composed of primarily large-cap names – coming in at 96.66% of the portfolio. The other portion is mid-cap at 3.61% and cash and derivatives account for exposure of -0.27%.

The geography is overwhelmingly the U.S. as well, accounting for 77.86% of the portfolio. The U.K. is 6.10%, the Netherlands is 4.92%, Germany 3.15% and France, Switzerland and South Korea all make up most of the remainder.

For U.S. investors, there is probably only one name that shows up that you may not be the most familiar with; I believe that is Koninklijke Philips N.V. (PHG). It’s more for its company name that might throw off some confusion. Though they offer several different household items such as, “male grooming and beauty products, kitchen appliances, home care, garment care and coffee products.” So, even though the name might not jump out at you, it is the Philips-branded items that we have around our houses. This also is a portion of the portfolio that makes up the Netherlands’ exposure.

The rest of the top ten are probably pretty well known. As we can see where the bulk of the financial exposure comes from names like Bank of America (BAC), Citigroup Inc. (C), Wells Fargo (WFC) and JPMorgan Chase (JPM). Those four names make up almost 12% of the portfolio and are good for almost half of the fund’s financial exposure.

Last time we covered the fund, Verizon (VZ) was the fund’s top holding then as well. This hasn’t changed but the weighting has actually increased in VZ since then. This could be a function of the company holding up relatively well since we last covered the fund. This is also quite the solid dividend stock as a telecom like VZ can pull in steady amounts of cash. Much like a utility company that has predictable cash flows coming in. Now more than ever too, people are relying on their VZ products and services to power business and everyday life.

(Source – Seeking Alpha)

Conclusion

BDJ remains one of my larger positions and one that I will continue to add to. I see the merits of the fund as a long-term-type position. What I’m looking for most with this fund is the fact that I can get access to large-cap dividend companies. Access to these companies without having to really do the daily work as the fund managers should be. These tend to be a bit more stable than their smaller counterparts too. Though the fund won’t generally return much in the way of capital appreciation as they pay out a significant portion through distributions. This is typical of most CEFs, of course. The current rate of 8.50% is attractive if they are able to maintain it. Additionally, the 7.56% NAV rate isn’t too egregious in most environments to maintain. With that being said, the volatility recently can certainly change things in a quite hurry.

Additionally, the fund’s options strategy can prove to reap some gains in volatile years. In years that are up significantly, the option strategy can drag the performance of the fund though. That played a role in why the fund might only show total NAV return in 2019 at 24.23% – at a time when many other funds had a banner year. Speaking of dragging performance, I believe that the financial sector is disproportionately dragging the fund down so far in 2020. The environment is certainly not conducive to large banks. That is another reason why I believe it is worth a look though for any value type investor – looking for a beaten-down sector. Overall, the fund is diversified for the most part, just merely that it is overweight in the financial sector at the moment.

A topic that has come up quite a bit lately too is the concern for leverage in a fund. For those that might not be wanting those additional risks, BDJ could be for those investors. While a down market and dividend cuts will still play a role in the fund’s earnings – having to deleverage the fund isn’t a concern for an earnings hit in this case.. Since there is no leverage, the expense ratio for this fund also drops quite drastically. The expense ratio last reported was only 0.87%, which is quite low relatively speaking to other CEFs.

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Disclosure: I am/we are long BDJ, MSFT, VZ, JPM. 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 was first published to members of the CEF/ETF Income Laboratory on May 4th, 2020.

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