A High-Yield Investment for You to Consider

There is no doubt about it: We have experienced one of the great bull runs in history — already 5¼-years old. On March 6, 2009, the S&P 500 was 676.53; on May 31, 2014, it was 1,923.57. Total price appreciation: 284 percent. Compounded annual price appreciation: 22 percent!

These are astonishing numbers for any era, for any market, but especially for a big, developed market like the United States.

Never in the past few hundred years — and we can start with the founding of the Bank of England in 1694 — has any equity market rally been accompanied by as massive and long-lived a monetary stimulus as this one. Said another way, never in the past few hundred years has an economic recovery and stock market boom been as clearly attributable to the stimulative actions of monetary authorities, starting with our own Federal Reserve.

When trying to size up this bull market in the context of previous bull markets, we find ourselves in uncharted territory. There has simply never been a bull so pumped up with adrenalin injected by monetary authorities.

There has never been a bull so pumped up with adrenalin injected by monetary authorities as this one.

Indeed, thanks to the Federal Reserve’s experimental monetary policies, it’s been a great five years to be in the stock market.

However, there is a major transition occurring on Wall Street as the factors that have propelled stock prices higher and higher over this period are running out of steam. As an example, let’s take a look at how 2013’s amazing 32 percent return on U.S. stocks was achieved …

Recall that there are only three components of stock returns: Dividends, earnings growth and the change in the price-to-earnings ratio.

Drilling deeper into 2013’s eye-popping returns, we can see that 2 percent was from dividends; about 5 percent was earnings growth; and 25 percent was from a change in the price-to-earnings ratio. This means that in 2013, investors were willing to pay a lot more for stocks at the end of the year than they were at the beginning of the year.

Yes, that’s right: Most of 2013’s return was attributable to the willingness of investors to simply pay more — a significant amount more — for stocks at the end of 2013 than they were at the beginning of the year. So it was a change in pricing that was the primary reason stocks soared in 2013, not a dramatic improvement in the underlying fundamentals of their businesses.

What’s more, a careful look back to the bottom of the financial crisis reveals that earnings growth over this period has relied heavily on profit margin expansion — meaning making the assets work harder — rather than on sales growth, which has been at best lackluster. As a result, corporate profit margins remain at record levels, and their cash piles have burgeoned as they have been reluctant to make significant purchases of property, plant and equipment.

Thus, stock market returns over the past five years have been turbo-charged by price-to-earnings multiple expansion and extraordinarily high corporate profit margins, both of which are now reaching the upper limits of historical ranges.

What’s next?

For stocks to go higher, it’s time for the world’s leading companies to show some real, honest-to-goodness earnings growth led by top-line sales increases. But in a debt-laden world where the consumer is struggling, growth is hard to find.

That’s why stock prices have advanced only about 5 percent this year. There has been no sign of any sustainable earnings growth.

Take a look at the chart below. It measures GDP growth since the technical start of each economic recovery period. And the current one began in 2009. As you can see, the most recent numbers show this to be the slowest recovery in post-World War II history.

Click for larger version

If we are indeed in a slow growth world, what investments should you consider adding to your portfolio beyond traditional global franchise companies and emerging market stocks that I have suggested in previous Money and Market columns?

If it’s cash-on-cash yield that you are seeking — and who isn’t in this low-yield environment — I suggest you think about adding business development companies (BDCs) to your investment portfolio. That’s because the average BDC currently yields about 9.6 percent.

BDCs are publicly traded private equities, made possible by Congress in a 1980 amendment to the Investment Company Act of 1940. BDCs invest primarily in the debt of private companies. Different BDCs specialize in different kinds of debt. But their mainstay has been mezzanine debt (debt that the holders may convert into equity if not repaid) and collateralized loan obligations (pools of leveraged loans). This debt is often issued in connection with private equity buyouts and can be risky.

If you don’t understand BDCs at first glance, you’re not alone. Typical BDC investors are sophisticated and have done their homework.

That’s why the Financial Regulatory Authority placed business development companies on its list of potentially unsuitable investments for 2013. That said, all investing is a matter of weighing risk and return, and in my view BDCs provide a superior risk-return profile to many other specialty investments.

What’s more, BDCs have had an impressive track record through the financial crisis. Oppenheimer & Co. recently reported that BDCs have generated a 59 percent positive return since 2007 compared with other financial intermediaries, which as a group still have a cumulative negative return of about 25 percent depending on which financial services index you use as a benchmark.

However, BDCs take significant credit risks to generate their high yields. Leveraging a portfolio to invest in illiquid-debt securities issued by private companies is bound to be risky. But no BDC went bankrupt during the 2009 financial crisis, although many were forced into workouts with their lenders. And it’s likely that they would come under similar liquidity pressure in the event of another recession.

In a slow-growth environment, BDC’s — because of their high yields — are well-positioned to generate strong relative returns for the remainder of 2014. If your risk profile permits, you should consider adding them to your portfolio.

Have you had success investing in the BDCs? I welcome your comments — click here to participate in the discussion.

Check back next week and I’ll tell you which BDCs I am currently recommending.

Best wishes,

Bill

P.S. The wealthy investors I work with take the road less travelled. Plus there are a few other secrets that set the wealthy apart from average investors. Here is how you can use them to grow your wealth in record time.

Bill Hall is the editor of the Safe Money Report. He is a Certified Public Accountant (CPA), Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP). Besides his editorial duties with Weiss Research, Bill is the managing director of Plimsoll Mark Capital, a firm that provides financial, tax and investment advice to wealthy families all over the world.