Co-authored with “Hidden Opportunities.”

In middle school physics, we learned about simple machines, those basic mechanical devices for applying force and getting work done. Think about the wheel and axle, one of the most important inventions in the history of humankind. As simple as it is, we wouldn’t survive without it – automobiles, trains, and nearly all factory equipment wouldn’t exist. We would be moving loads by carrying them or by using sleds or the backs of animals.

Pulleys, wedges, and inclined planes are all examples of simple machines instrumental in our daily lives, simplifying tasks that would otherwise be hard to complete. The engineer in me can’t stop appreciating and talking about simple tools and technologies that make our lives more comfortable. Let us get back on track to discuss simple techniques to brighten your retirement.

Dividends are the simple machines in the financial world, simplifying an otherwise complicated retirement by supplying a regular cash infusion into our accounts. No matter what the market does daily, I know a certain set of dividends will be credited into my account – this feeling is priceless.

They say the first million is the hardest. This is because once a certain level of wealth is attained, the power of compound interest plays a significant role. As investments pay dividends, and when those dividends are reinvested, we accelerate wealth accumulation, making subsequent millions easier (and more automated) to attain.

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” – Albert Einstein.

Like simple machines powering complex machinery, simple dividends coupled with the power of compounding is the secret to my healthy retirement. So, that is enough physics for today; let’s look at two picks to make some money.

Cash Flow Machine: RVT – Yield 7.5%

The financial markets ended FY 2023 with value stocks being historically cheaper than any other class of securities. The small-cap value category carried an average price / fair value ratio of 0.84%, implying a 16% discounted pricing, while large gap growth stocks traded at a whopping 15% premium. The divergent recovery from the 2022 bear market is clearly seen in the chart below, with investors overpaying for growth names at a time when our economy is grinding into a recession. Source.

According to a study by Goldman Sachs, in 80% of the election years since 1984, the Russell 2000 has outperformed the S&P 500. Source.

In addition to being an election year, in 2024, we expect to see a significant change in the Fed’s interest rate policy, and normalizing rates will trigger a valuation reset, fueling small-cap recovery in 2024.

Royce Value Trust (RVT) is a small-cap closed-end fund, or CEF, managed since its inception in 1986 by the same portfolio manager – Chuck Royce. Although Mr. Royce has taken a step back from lead portfolio manager duties since 2022, the Royce funds continue to benefit from his oversight and experience.

RVT is massively diversified across 486 holdings, a much-needed requirement as small caps tend to be a riskier investment class. The CEF is actively managed, with a 2022 portfolio turnover rate of 60%. This means a holding stays in the portfolio for about 20 months. As such, it doesn’t come as a surprise that a significant portion of RVT’s distributions over the past ten years have been from long-term capital gains.

Industrials and manufacturing companies stand to benefit significantly from government incentives and initiatives to enhance domestic manufacturing capabilities. This segment is the largest holding for RVT, representing ~24% of the CEF’s assets. The next largest sector is financials (~19%), which continues to be deeply discounted following multiple bank failures from 2024 and stands to demonstrate strong recovery with interest rate normalization.

RVT does not utilize leverage in its investment strategy and maintains a variable distribution that is adjusted quarterly based on NAV at the end of the trailing four quarters. This means that the distribution rises and falls with RVT’s NAV, but since the calculation uses an average of the past four quarters, the payment changes are gradual.

RVT’s management fee structure reveals a rare feature among CEFs, indicating a significant incentive for management alignment with shareholder interests:

• Advisor fees can increase or decrease based on the fund’s performance relative to the S&P 600 SmallCap Index benchmark.

• The fund managers will forfeit fees for any month when the fund’s performance over a trailing 36-month period is negative.

At a ~11% discount to NAV, RVT presents an excellent bargain to ride the recovery of the small-cap sector. Small caps are well-positioned for a strong recovery in 2024, and RVT is one of the best income-oriented funds to ride this recovery. Driven by a time-tested active management strategy and a management team that eats its own cooking, this CEF pays 7.5% to wait for the big valuation reset.

Hidden Gem: BTO – Yield 9.1%

It has been ten and a half months since the FDIC shut down Silicon Valley Bank, making it the third-largest bank failure in the United States. Mr. Market feared banking names, and regional banks got the worst of his emotional spree.

Banks almost became the pariah of the stock market, with analysts of varying reputations and backgrounds attempting to predict the next “shoe that will drop.” But the reality is that the Feds

Banks have been on a roller-coaster ride in recent times. As we’ve witnessed, when the horizon seemed bleakest, the banking sector showed resilience, recovering steadily. Even as banks clawed back from their lowest ebb in 2023, they still stand grossly undervalued.

The imminent terminal interest rate holds significant promise for the banking sector. Historical data indicates that banks tend to excel when interest rates hit their zenith and commence a downward trajectory. As interest rates dip, the valuations of the bond market soar, easing the burden on banks and enabling them to ramp up their earnings and regulatory capital ratios.

Analysts from RBC emphasize the impact of past rate peaks on banking sector upswings. In the 1994-95 rate cycle, a 55% surge ensued after the Federal Reserve concluded its rate raises. Similarly, during the 2004-06 rate cycle, stocks rallied before crashing due to the Global Financial Crisis, culminating from credit issues.

It is evident that credit quality played a pivotal role in the market’s contrasting outcomes in 1994 and 2006. Credit standards were not a concern in 1994 but spiraled into a crisis for the financial sector in 2006, leading to vastly differing market performances.

Credit quality is currently on a solid footing, with banks adopting a cautious approach in the face of Quantitative Tightening. Their capacity to absorb losses remains robust historically, indicating preparedness to navigate an uncertain macroeconomic and regulatory landscape.

With most banks bolstering their reserves and regulatory capital, the sector is on a recovery trajectory post the March 2023 upheaval. An ideal play on this resurgence is the John Hancock Financial Opportunities Fund (BTO), with about 95% of its allocations in banks, capital markets, and other financial services entities.

The fund’s distributions in 2023 comprised predominantly of long-term gains, and with the expectation of sustained capital gains as bank valuations improve, it presents an attractive investment opportunity for 2024.

BTO operates with approximately 18% leverage at a modest interest expense, positioning the fund for amplified returns amid the banking sector’s resurgence.

Investors eyeing substantial yields would be enticed by BTO’s distribution of $0.65 per share every quarter, reflecting an annualized yield of 9.1%. Given the fund’s historical performance and demonstrated shareholder returns, it currently trades at an attractive price point.

Contrary to prevailing market pessimism, BTO’s 9.1% yield is a compelling avenue to capitalize on the banking sector’s resurgence. As the saying goes, “time in the market is money,” and BTO’s healthy distributions offer a lucrative channel to hitch a ride on the banking sector’s recovery.

Generating multiple income streams is akin to the proverbial ocean – vast and awe-inspiring. Achieving a diverse portfolio income of over 9%, comprising +45 securities with no single source accounting for more than a single-digit percentage, is emblematic of shrewd financial management. After all, dividends form the bedrock of financial success and progress, paving the way for long-term wealth accumulation.

The John Hancock Financial Opportunities Fund (BTO) and RVT are steadfast CEFs that have navigated numerous bear markets and recessions with aplomb. Their focus on undervalued sectors and discounted valuations makes them compelling picks to fortify a portfolio’s income. The timeless philosophies of beginning early, investing regularly, reinvesting consistently, and making informed, rationed decisions are the keys to propelling income portfolios to greater heights.