Co-authored with “Hidden Opportunities.”
Warren Buffett made some of his largest banking deals during the industry’s darkest times. A review of past transactions and success stories shows that he doesn’t worry about buying at the absolute bottom price and making the last nickel. The Oracle of Omaha seeks big long-term dollars as the business changes and grows.
“The best thing that happens to us is when a great company gets into temporary trouble…We want to buy them when they’re on the operating table.” – Warren Buffett
On August 7, Moody’s announced its rating actions on 27 U.S. banks. These included the downgrades of 10 banks, modified outlooks for 11 other banks from stable to negative, and six banks placed on review for possible downgrades. In coming to these decisions, the credit rating agency considered several factors, including the banks’ second-quarter earnings releases, interest rate risks, and more.
The credit agency has pointed out known issues, and there isn’t anything that was a surprise. Much like when Fitch downgraded the U.S. sovereign credit rating, Wall Street likely used Moody’s downgrades as an excuse to sell financial sector names.
Yes, there are issues created by the rapid rate hiking cycle, and it has provided little time for banks to adjust their balance sheets; this industry is on the operating table. As interest rates stabilize, higher rates favor banks whose primary business is lending and collecting interest payments.
Eventually, the market will begin looking past it. Investors will miss buying opportunities if they insist on waiting for the “all clear” signal of moderating interest rates and dissipating recessionary fears.
“The future is never clear; you pay a very high price in the stock market for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values.” – Warren Buffett
Buffett likes picking the long-term winners in industries that will be around for centuries, and few industries are more durable than banking. What is more durable than banking, capital markets, and insurance companies? These are time-tested industries that we will be controlling more of the global transactions around us. Let us now discuss two high-yield picks to benefit from this sell-off.
Pick #1: BTO – Yield 9.8%
BTO is actively managed, and investors can expect to see allocation changes from time to time as the fund managers identify better opportunities. BTO’s top positions include two leading alternative asset managers at this time when private equity consolidation is hitting new records. The CEF holds 164 positions and operates with a 20% leverage to boost total returns from its active management strategy.
Thanks to credit agencies downgrading key players in the banking sector, in recent trading days, BTO saw a steep drop in its share price without a similar correlation to NAV (Net Asset Value). Notably, BTO holds four out of the top 10 downgraded banks.
Income seekers can now buy BTO at a modest 2% premium to NAV, the cheapest valuation this year for this high-quality CEF that has beaten the broader market in the past three tumultuous years while growing its NAV by 21%.
BTO has been around for about 30 years and has an excellent track record of solid performance and NAV preservation. BTO pays a quarterly distribution of $0.65/share. This calculates to a healthy 9.8% annual yield. In the two quarters for FY 2023, BTO’s distributions have been 17% NII (Net Investment Income), 37% ROC (Return of Capital), and 46% long-term capital gains, making it quite efficient from a taxation standpoint.
We can expect BTO to continue pursuing safer bets in this beaten-up sector and extract value for shareholders. This is a bargain CEF to buy during the uncertainty and sit back and collect those big tax-friendly distributions.
Pick #2: RILY Preferreds & Baby Bonds – Up To 7.9% Yield
B. Riley Financial, Inc. (RILY) is a diversified financial services firm that is omnipresent in everyday Wall Street affairs. From asset management to distressed lending, and from consulting and appraisals to liquidation and bankruptcy restructuring, the company has its involvement in businesses of varying health and well-being. Source.
During Q2, RILY reported to have closed more investment banking transactions YoY, and the company added several new and current engagements to its pipeline. RILY also reported that retail liquidation has picked up both in the U.S. and in Europe, and demand for its financial advisory and appraisal services continues to be strong. Source.
The company has been active with acquisitions through market uncertainties. Recently, RILY announced the acquisition of Crawford & Winiarski, a boutique forensic accounting and litigation consulting firm based in Detroit, Michigan. Earlier this year, the company acquired Farber Group, a Toronto-based restructuring and business advisory firm. In recent weeks, RILY raised $115 million through a common stock offering, creating uncertainty and doubt about the company’s debt, dividend safety, and overall liquidity.
RILY reported $234.7 million in adjusted total EBITDA for 1H 2023. This provides adequate coverage for the $94.8 million in interest expenses, $4 million in preferred dividends, and $80 million in common stock dividends for the same period. For Q3 2023, the company has guided an operating adjusted EBITDA of at least $105 million, which provides adequate coverage for the quarterly debt obligations and preferred dividends and leaves a healthy amount for common dividends and other corporate activities.
At the end of Q2 2023, RILY reported $1.9 billion in cash and investments, and the total debt net of cash and investments is $406 million. RILY has an impressive 50% insider ownership, indicating a solid alignment of management decision-making with the interests of the shareholders. Insiders, including CEO Mr. Bryant Riley, have continued to load up on the common stock in recent quarters. Source.
As such, the equity offering does not create any red flags about the company’s financial health at this time. RILY preferreds and baby bonds continue to present safe income investments at deeply discounted prices.
5.0% Senior Notes Due 12/31/2026 (RILYG)
5.5% Senior Notes Due 3/31/2026 (RILYK)
6.375% Senior Notes Due 2/28/2025 (RILYM)
6.5% Senior Notes Due 9/30/26 (RILYN)
5.25% Senior Notes Due 8/31/2028 (RILYZ)
Among the bonds, RILYT and RILYZ offer Yield-To-Maturity at 11.8% and 13%, providing steady +7% interest payments until 2028. RILYT offers a higher current income at 7.5%, whereas RILYZ offers 7.3% with a moderately higher capital upside to par value.
6.875% Series A Cumulative Perpetual Preferred (RILYP)
7.375% Series B Cumulative Perpetual Preferred (RILYL)
Thanks to its deep discount to par and its call date that is just 13 months out, preferred stock RILYP offers an impressive 21% Yield-To-Call. However, it is to be noted that both preferreds are perpetual, and the company can let them trade past their call dates indefinitely. Among the preferreds, RILYP offers an impressive 7.9% current yield and ~14% upside to par. Both preferreds pay qualified dividends.
Considering RILY’s high insider ownership, counter-cyclical business model, and widespread prevalence in Wall Street’s happenings, the preferreds and baby bonds present attractive income opportunities for the foreseeable future.
Our investing group is a buyer of discounted dividends, and we aim to make our portfolio a paycheck producer that we can count on through good and bad economic conditions. It is usual for a few companies to suffer setbacks and experience headwinds during unfavorable markets. But through prudent diversification across +45 instruments, we can withstand (and even thrive) the adverse dividend decisions of a few companies.
“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.” – Warren Buffett
The financial services sector is experiencing a sell-off, making quality companies a strong buy. Banks are not going away. In fact, more significant and prominent players will be more dominant in the future. The giants will absorb smaller, struggling players, and the financial system will thrive again. We look forward to enjoying the show while strategically capitalizing on substantial yields from well-established securities proven to navigate challenging market conditions and risks adeptly. Up to 9.8% to greedily bolster your retirement income amidst widespread market fears.