Some Much-Needed Relief From a Volatile Market

 | Jun 21, 2013 | 9:30 AM EDT  | Comments
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When we encounter trading sessions like what we saw Thursday, they can drive an investor to say, "I want my money back."

That's actually quite possible via income securities.

First, when an investor buys a security that's trading below face value, it means that investor will be made whole when the bond is redeemed, either at maturity or -- in the case of redemption -- by the issuing company. That's natural call protection, and the degree of discount is driven by the pricing of benchmark securities (like the 10-year U.S. Treasury) and the market's perception of the creditworthiness of the security. The deeper the discount, the higher the perceived risk of default -- and betting against mispriced risk is a big part of what we do at my firm Portfolio Guru.

But it's not all we do, and in times of market turmoil, there is an option with more visible returns. I'm talking about high-quality preferred shares trading at reasonable premiums with a high likelihood of early redemption. A perfect example: the 8.5% Series A preferreds of Evolution Petroleum (EPM). These shares are currently trading at $26 against a face value of $25, and the first redemption date for the preferreds -- which carry no stated maturity -- is July 1, 2014.

Evolution Petroleum has assets in the Delhi Field in Louisiana, where it is using CO2 flood technology to exploit the field, and it is also developing assets in the Mississippian Lime play in Oklahoma. The company, like several others in its space, is also looking to offload non-core assets in South Texas, and Evolution additionally sells its patented GARP artificial-lift technology to other operators.

So valuing this company is a complicated proposition, but its balance sheet presents the ultimate in simplicity: zero debt. In addition, the firm had $22 million in cash at the end of the first quarter. It generated about $9.4 million in earnings before interest, taxes, depreciation and amortization in the last reported nine-month period, and preferred dividends for that period totaled just over $500,000.

Evolution Petroleum, then, is covering its preferred dividend payment with operating cash flow by a whopping 18x, and the cash sitting on the balance sheet would cover the dividend payment for about 35 years. It's the safest payer in the Portfolio Guru model portfolio, and is as close to bulletproof as an investor will see.

So if you are feeling shaken by the markets -- a common feeling this week -- then just buy Evolution's preferred shares, and sit back and collect the interest payments. At a price of $26, they are currently yielding 8.1%. The worst (i.e. first) redemption date would knock off 4% from your return, as the preferred would be called at par vs. the premium you paid.

So, after commissions, that's a net of 4% with a one-year time horizon. Evolution management has indicated that the preferreds are likely to be redeemed -- but every month past July 2014 that they don't would add to the total return on the investment.

Is a guaranteed worst-case return of 4%, with likely return of principal in 12 months, "enough?" It all depends on one's outlook on the financial markets. But, with the 52-week U.S. Treasury bill yielding 0.13% today, and with money market accounts yielding basically zero, the opportunity cost is completely market-related.

The S&P 500 is yielding 2.02% after Thursday's plummet, so the question to be asked is: Do I expect at least a 2% capital gain on top of that 2% yield for the next 12 months? After the last two trading days it's easy to believe the stock market's return will be negative over the next 12 months. In that scenario, the capital return afforded by Evolution Petroleum preferreds would be even more attractive.  

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