Co-produced with "The Value Portfolio"
Adjusting one's portfolio post COVID-19 is key for future performance. We recently highlighted in a report right here on Seeking Alpha which sectors are set to outperform. While some sectors will emerge as very challenged ones, others are set to strongly outperform based on new facts of life including social distancing and an increased trend of working from home. Today, investors are offered the opportunity to start looking beyond COVID-19 and allocate their portfolio opportunistically.
As witnessed since the emergence of the virus and related lockdowns, usage of smart devices, and demand for additional Internet bandwidth and cloud storage, has surged. We believe that this is a trend that will continue in the future. Business owners and managers will reassess the need for employees to commute to the office. This is true today given that the business community was given a chance to test the efficient of work from home. Some functions will need presence in the workplace, but for others, working from home can result in cost savings (reduced office space) and possibly increased productivity. I'm sure many employees value this freedom. Furthermore, small businesses may decide that a separate office to operate is not a bad idea after all.
These are just a few examples of many technologies that have gained advantage today, and this is incredibly important because many of these companies have better services than their peers.
A great way to add a diversified exposure to these great companies is through Nuveen Nasdaq 100 Dynamic Overwrite Fund (QQQX) which is a closed-end-fund with a focus on the largest tech companies.
QQQX is one of the most interesting funds on the market at the current time. The fund attempts to replicate the Nasdaq 100 index while using Covered CALL options to generate significant income for shareholders. Since the start of the year, the fund is down more than 20% vs. 11% for the Nasdaq 100. That disconnect, combined with the potential of tech, and the fund's income generating abilities make the closed-end-fund a powerful investment opportunity.
Credit: Technology Trends - Forbes
One of the most substantial aspects of QQQX is the index fund it attempts to replicate, the Nasdaq 100. The Nasdaq 100 drove a substantial part of this recent bull market gains due to the power of companies like Apple (AAPL), MSFT, AMZN, and GOOG. The strength of these companies is unrivaled, with an unmatched ability to generate cash.
More importantly to their long-term sustainability, the companies each have unmatched moats around their businesses. Amazon's AWS, Google, the iPhone, Microsoft Windows, etc., are all products that would take a well-capitalized company decades to potentially usurp. More importantly, not only would potential R&D competitors be competing against some of the worlds best capitalized companies, theyll be competing against some of the heaviest R&D spenders.
Source: R&D Spending by Company Idea to Value
The above image shows the worlds top 25 companies by R&D spending in 2018. Many of the names on here are the leading names on the Nasdaq 100 such as AMZN, GOOG, MSFT, Intel (INTC), AAPL, Facebook (FB), and so on. This heavy R&D spending and strong financial portfolio mean that these companies have an effectively insurmountable market position that will lead to continued dominance and shareholder returns.
As stated above, because of COVID-19, many of these companies are benefiting. The data released since the start of COVID-19 shows massive growth in the demand for many of these companys products.
At the end of the day, many of these companies benefit in an unprecedented way from the shutdown, and will continue to benefit. People spending more time at home, working remotely, but also using the Internet, will help all the companies.
Fundamentally, when Internet traffic has grown by double-digit percentages, no one would expect the top internet companies not to benefit.
When investing in a closed-end fund, its important to understand the companies that make up its top holdings. For QQQX, we want to highlight that at the current time the companys share price is at ~6.7% discount from its NAV.
Source: QQQX Top 10 Issuers Nuveen
The above image shows Nuveens top 10 issuers. Together, they make up a substantial 64% of the companys portfolio. The classic big tech companies make up an astounding 49.6% of the companys portfolio. Thats important because, as we discussed in the above section, all these companies stand to benefit significantly from the current COVID-19 crisis.
More importantly, these are some of the largest and financially strongest companies in the United States. Outside of AMZN, every company in the top five has tens of billions worth of cash and the financial ability to comfortably handle a recession. That means the chance of any significant percentage of QQQX going bankrupt is nearly zero. The only way that would happen is if a significant percentage of U.S. companies go bankrupt.
Some investors must be wondering, how does QQQX provide investors with almost an 8% yield while owning technology stocks only yielding several percent?
Source: QQQX Option Portfolio Nuveen
The company achieve these returns by utilizing short-term options. The company sells covered CALLs on the stock it holds. That means that if the stock price goes up, investors get their shares called away from them. However, if the stock stays constant or goes down, investors get to keep the additional income. At the same time, in a volatile market, with high option prices, the income can be much higher.
For example, FB stock is currently $158 / share. Right now, CALL options with a $160 strike price for FB stock and an April 17, 2020, expiration date are trading at ~$5.6 / share. Thats an annualized yield on options of 85%. Clearly, investors are pricing in significant volatility into the companys share price. In our current environment, the company will generate significant cash flow due to volatility, while continuing to hold onto quality stock.
QQQX shareholders get broad exposure to technology in a market where they stand to grow significantly in the long run. However, there's one significant downside to this strategy, one that well discuss further in our shareholder return scenarios below. That means, in a market where the Nasdaq 100 is growing rapidly, QQQX could consistently see its stock called away limiting upside.
For those who invest now, lets discuss QQQXs potential shareholder return scenarios.
Source: QQQX Hypothetical Growth Nuveen
The above image shows the growth of a $10,000 investment in Nuveen since 2007. For those who had simply invested in the Nasdaq 100 that $10,000 would be worth ~$42,000 or roughly $10,000 more. However, theres significantly more to the story thats important to pay attention to here especially for income-based investors.
So, investors might be wondering, why invest in QQQX, a fund that has underperformed the Nasdaq 100 index since its inception.
The reason to invest in QQQX is because the past several years represented QQQXs largest weakness. That is, due to the funds covered CALL option strategy, the fund underperforms in a market that's rising rapidly. However, its worth noting that until the 2016-2019 tech bull market, QQQX performed in line with the Nasdaq 100. From January 2007 to February 2016, investors in QQQX saw roughly the same return as the Nasdaq 100.
Since we do not expect the equity markets to gain rapidly over the coming months, as it did in the 2016-2019 tech bull run, we see the chance of QQQX repeating this underperformance compared to the Nasdaq index (QQQ) as low. In fact, QQQXs option strategy outshines in a volatile market where the premiums on options are high. Thats great because we do expect volatility to remain in the markets over the coming months.
Whats important to pay attention to here is the 8.7% dividend that QQQX has paid out across this time period. In 2008, during one of the worst market crashes, it took investors only a year to recover their original investment. However, throughout that time, they continued to earn 8.7% cash flow from options.
Going forward, in down markets, which tend to be more volatile, investors will see returns go up as option pricing increases.
Going forward, there are three scenarios for investors to pay attention to:
Scenario 1 Market declines or stays constant
In this scenario, QQQX will continue to drop along with its NAV while continuing to earn income. As we discussed above, income from options should increase significantly, as investors price in more volatility for options. Those who invest today should earn a steady dividend yield of almost 8%, not affected by dividend cuts by the companies, and will see less volatility than the Nasdaq 100.
Scenario 2 Market goes up
In this case, the rate of an increase really matters. In the event of rapid increases, the technology company shares held by QQQX will regularly get sold through options. That sell price will likely be lower than the current price, meaning that QQQX shareholders will, on average, earn less on a percentage of the portfolio. However, since we view the chance of the market going straight up over the next year as unlikely, this is a less realistic scenario.
Scenario 3 Market goes sideways
In such a scenario, QQQX will also greatly outperform since it's generating income from its call strategy.
One of the reasons why QQQX is such an interesting investment is because it outshines the broader market from a risk perspective in every scenario except the scenario where the market is going up rapidly. In a massively volatile market, like the current one, it can be expected to outperform. The only other risk not discussed here is bankruptcy, but by being composed of the 100 largest companies in the Nasdaq, the company has no significant bankruptcy risk it can basically be expected to track close to the S&P 500.
In a scenario where markets are steady, investors are getting a 7.5% yield from selling these covered tech options.
In a scenario where markets are dropping, investors see the same drop, but gain significant cash from the selling of covered options. That means investors see a lower drop than the broader market.
In a scenario where markets are recovering, QQQX sees its stock holdings called away at lower prices, meaning the recovery isnt as strong as the broader market.
However, investors who invest today in QQQX not only have strong income perspective, but they dont need a specifically-timed market recovery to outperform. That means you get paid to wait. As the markets recover, investors realize strong capital gains from some of the strongest companies in the United States.
Our daily lives and the way of work will look much different after COVID-19. Some aspects will change permanently. We have identified in the article above a few of the tech giants that set to greatly benefit from this future trend. Investing in QQQX is one way to do it.
QQQX has seen its share price drop, along with all other companies, as a result of the bear market, making this CEF trade at significant relative discount to its historic NAV. Furthermore, QQQX has several things going for it that make it an exciting investment. Among these is the fact that it's a technology-driven investment and technology stands to outperform in the current market environment.
QQQX has a unique ability to generate high income on top of its capital appreciation potential. Today, it offers a 7.5% yield thats secure and not dependent on the dividends or financial performance of the companies it holds. In fact, during periods of volatile markets, the amount of income that this CEF generates gets a huge boost.
By investing in QQQX, you are repositioning your portfolio to beat the markets as we beat COVID-19.
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Disclosure: I am/we are long QQQX, AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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