“November Income Security — 35.1% Yield!”

By Travis Johnson, Stock Gumshoe, November 18, 2007

I hope that everyone who reads the teaser email from StreetAuthority.com for Carla Pasternak’s High-Yield Investing takes their claims of a 35% forward dividend yield with a little bit of a grain of salt. Obviously, there’s no way to get a 35% annual dividend that’s sustainable and/or safe, so there must be something unusual going on here.

And there is, though it’s not necessarily a bad thing.

This “Income Security of the Month” teaser has made the rounds before, thanks to the fact that the security they’re teasing has been a very successful investment in the recent past and has spit out some nice “dividends.”

And I put “dividends” in quotes because this is nothing like the standard dividend you’ll get on a regular income-producing stock, or the coupon on a bond. It’s not to be compared with the 4% yield on Pfizer, or the 3% yield you get with GE stock.

According to the ad, “Although the fund’s upcoming $15.94 payment is a one-time payout, the bottom line is that this fund has a history of making strong annual distributions. For example, last year the fund paid out $7.12 per share, giving the fund a trailing 12-month yield of 15.7% as we go to press.”

Sounds pretty impressive, no?

And yes, this is a fund. They say it has average annual returns of 26.8%, which also sounds pretty nice. It owns a basket of 50 or so stocks, so it is somewhat diversified (though also quite focused, as we’ll see in a moment).

So what is it? Ready to find out? Well, you could go ahead and subscribe to Carla Pasternak’s High-Yield Investor to get the answer, and I’m sure she’ll also supply all kinds of special reports and analysis for you — I’ve never read her stuff, so I don’t know if it’s likely to be helpful or not.

But I do know that if you just want the name of this “income security of the month,” then the Gumshoe’s your man!

This high yield fund is …

Korea Fund (KF)

This is a well established closed end fund that invests solely in South Korean stocks (that’s the focused part). I actually owned shares of this one myself a number of years ago, but don’t currently.

They are planning what Pasternak is calling a “dividend” of $15.94 very soon — but it would be a mistake to think of this as an ongoing dividend. This is somewhat like the capital gains distributions that your regular mutual funds will spit out at the end of the year every year, to spread the taxable income around to shareholders. What it should tell you is that the Korea Fund has had a very good year.

How good?

Well, as you can see from the chart above, just about as good as the underlying index, as measured by the South Korea iShares ETF. The chart is for six months, but if you go back further the pattern looks more or less the same (it’s just that Yahoo didn’t account for their January payout this year, so that skews it a bit and I didn’t want to confuse the issue). Over a longer period, it looks like KF probably did outperform the index on average, though with the difficulty in accounting for distributions in comparing an ETF to a CEF it’s hard to tell (ETF’s generally don’t have distributions, their income is reflected pretty precisely in the net asset value and thus the share price).

Both the Korea Fund and the Korean market overall have had an excellent five years — no losing years going back to 2002. 2001 was pretty ugly for them, and they were both quite volatile before that, but essentially to know the future performance of KF you need to know how the Korean stock market is going to perform in the future. So far it’s been great, and luminaries such as Warren Buffett are investors in Korean companies (Posco in his case), and there is even some bloom on the shares due to the fact that the current threat of North Korea looks somewhat subdued … if war drums start beating on the peninsula again, all bets are off.

Korea itself is a very interesting investment environment, in my opinion — an extremely high tech economy, generally a developed country that’s still considered to be an “emerging market” by some, a huge amount of heavy industry and a very unionized and active workforce, but still quite low costs for most companies that operate there. Oh, and most of the companies have the kind of incestuous ties through various chaebol (conglomerates) that make Japan such a confusing place to invest — the Hyundai and Samsung names are attached to half the companies in the country, it seems, and they are all intertwined.

So … why would you want a fund with a management fee of just under 1% when you could have a cheaper ETF that has much of the same holdings?

Well, if you do want income to be distributed to you and you don’t want to have to sell shares to get it, a closed end fund is probably easier. It doesn’t make a difference in your wealth-building, particularly, since the closed end fund price will go down by exactly the amount of the dividend, and you’ll be taxed on the dividend income, but you do get distributed cash, which some people like.

If that’s your thing, buy before November 28 to get the distribution — but keep in mind that all you’re doing in most cases like this is getting a portion of your purchase money back AND paying taxes on the gains that you didn’t actually get. You buy a share for $49, get $15 back and your share is then worth $34, and you have to pay some kind of taxes on the $15. If you had bought the shares back when they were around $34 anyway, that’s a nice way of realizing your capital gains … but if you bought at $49, it’s just a way to give something back to the taxman unless you believe that the shares are going to be worth more in the future. I haven’t studied how the shares have reacted to disbursements like this in the past, but personally I’d probably buy after the distribution if I wanted shares.

I have nothing against the Korea Fund, though I did personally decide to move my Korean investments to the EWY ETF instead because I really wanted just to ride the Korean economy, not try to beat it or risk trailing it by taking on “manager risk.” I’ve since sold my EWY, too, because I bought Korea largely due to the fact that it was so incredibly cheap and I don’t think it’s cheap anymore. Reasonable maybe, depending on your perspective, but (arguably) no longer cheap.

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And finally, just to give you some idea of what you’re getting with this Fund, here are their top ten holdings, in order:

Samsung Electronic
Hyundai Heavy
Samsung Fire and Mar.
Daeweeo Shipbuilding and Marine
GS Engineering
Kookmin Bank
Shinhua Financial
Samsung Heavy

And here are the top ten holdings of the Korea ETF (the top ten largest companies in the Korean exchange, more or less):

Samsung Electronics
Kookmin Bank
Shinhan Financial
Hyundai Heavy
Korea Electric Power
Hyundai Motor
Samsung Corp.
Samsung Heavy

You can’t tell from that, but KF is actually somewhat less concentrated on the biggest names — it owns a bit less of Samsung Electronics, which is 14 or 15% of the entire Korean market, and of Posco, and it seems to be generally slightly more weighted on the heavy construction and marine business (Korea is a world center of shipbuilding these days). But overall, one would expect that the heavy focus of both of these funds on the few largest companies in Korea means they’re probably going to continue to move more or less in line with each other over time. KF might be helped by their smaller helping of Samsung Electronics at the moment, since the chipmaker (among other things) has been a bit mired in the mud in recent years.

The other benefit, if you want to call it that, of a closed end fund is that they usually trade at a discount — so the Korea Fund trades at about a 7% discount to the underlying net asset value of the shares they own. There isn’t a way to harvest that discount unless the fund gets popular and suddenly trades at a surplus in the future, but many people like the perceived “cushion” that a discount might provide. My personal theory is that the discount or premium just amplifies what the returns would have already been, so when the fund is falling people sell in panic and the discount gets larger, meaning that your shares fall faster than the index. When the fund is climbing, people want to buy and the discount shrinks, meaning your return might outpace the index. I haven’t proven this theory, it’s just my personal view.

So … certainly it has been a high income security, though not necessarily the best one to buy for immediate income, depending on your circumstances. And if you believe that Korea is on the cusp of great things this is one way to get a piece of that in a tradeable security (you can also buy several of the individual companies, including Kookmin, Posco, and a few others, as ADRs on the NYSE).

Oh, and I just checked the details — the default for this distribution is additional shares of KF. So unless you’re a shareholder of record by the 19th (Monday — which means you had to buy it last week) and specifically tell them that you want cash, your dividend will be in the form of additional shares. And the dividend is almost entirely a taxable long term capital gain in this case. You get the dividend as long as you buy shares by November 28, and it will be distributed on the 29th, on which day the share price of the fund will also drop by roughly the amount of the dividend.

Happy Investing, everyone.



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November 18, 2007 10:17 pm

I just discovered your blog a couple of days ago and I have to say I love it. I’m a broker and I subscribe to a lot of the free investment newsletters that send you these types of teasers to get you to sign up to their premium service. The information you’re putting out there is top notch and impressive. Keep up the good work.

November 19, 2007 5:40 am

Two thoughts: (1) The date by which you had to be an owner of record of KF to get this dividend has already passed. This is one of those situations with large dividends where the ex-div date is moved beyond the dividend payment date to keep the stock price more stable. See Investopedia.com for details.
(2) The assertion that a mutual fund’s price will drop after a dividend is paid by exactly the amount of the dividend is IMO a bit of conventional wisdom that doesn’t apply to a closed-end fund like KF. KF trades like a stock, so you will be able to buy shares at continually varying asking prices throughout the day after the dividend is paid out. It is not like an open-end fund where you buy at the NAV in effect at the close of the day.

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One Guy
One Guy
November 19, 2007 1:18 pm

Thanks for the comments, nomdeplume.

1) Because the ex div date is after the distribution date, everyone who buys shares before November 28 will get the dividend — though the record date has passed, anyone selling shares now is also selling the right to get the dividend. The record date is largely meaningless in this case.
2) It’s true that the shares don’t have to drop exactly $15.94 on the ex div day (November 29), but they will almost certainly open at almost exactly that drop. Since they trade freely, it’s true that people are free to buy and sell at any price, but the open will be probably be precisely $15.94 less than they closed at on November 28 unless something crazy happens to Korea or to Samsung overnight.

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November 19, 2007 5:54 pm

One Guy: Back when planning to buy KF before the record date, I checked with my broker who gave the same answer that you did. Nonetheless, I did not delay.

I realize that Wikipedia is not necessarily the most authoritative source. But the following wiki excerpt at least shows where the difference arises in our respective interpretations of when one would have to buy KF to get the dividend.

I’m not wedded to my position, but this is why I hold it:

— Begin quote —

Special or Significant Dividend Payments.

The amount of the Dividend is declared Special or Significant in relation to the stock price. For this reason the ex-dividend date is set one stock trading day after the payment date. The stock will trade on an ex-distribution basis, adjusted for the amount of the dividend paid