BlackRock Science and Technology Trust (BST): A Covered Call Tech Fund Under Scrutiny

BST: Covered-Call Tech Has Performed Well, Eyeing Risks (NYSE:BST)

BST offers exposure to current and emerging leaders in the technology sector, but uncertainties surrounding rates and market trends warrant a hold rating. The BlackRock Science and Technology Trust (NYSE:BST) has been among the better-performing closed-end equity funds over the past year. While many CEFs aim to take on leverage to garner a higher yield in income-focused stocks, BST takes a different approach. It primarily owns tech stocks, along with shares in companies adjacent to digital breakthroughs and communications, and writes call options on those securities. With most CEFs, much depends on the future of the interest rate environment. There are emerging dueling risks in that realm. The imminent macro event is what now seems like an inevitable September rate cut by the Federal Reserve, thus commencing a potentially quarters- or years-long easing cycle. On the flip side is the rising chance that former Donald Trump will become the 47th US president. The thinking is that another four years of Trump would bring about higher growth and higher inflation, putting upside pressure on rates. BST's effective leverage is just 0.46% today. Of course, BST's performance is highly dependent on what happens with the tech and growth trade. An investor preference shift from AI plays in favor of real-economy stocks, like cyclical and value equities, would likely cause BST to underperform. That's a lot to weigh. Hence, I have a hold rating on BST. I see the CEF as a decent choice for income-focused investors seeking a high yield with tech exposure but with unknowns regarding where rates go from here and emerging strength in areas like small caps, not to mention richly valued tech stocks, BST's best days may temporarily be behind the CEF. According to the issuer, BST offers investors access to current leaders and emerging winners in the technology sector with a flexible mandate for investing in technology companies across various market caps, regions, and industries. The fund sells (writes) call options on the underlying equity portfolio, potentially reducing the fund's volatility with the overall objective of providing income and total return through a combination of current income, current gains, and long-term capital appreciation. BST is a growing ETF, now with $1.4 billion in assets under management as of July 12, 2024, while its annual expense ratio is high at 0.88%, the fund performs the operations of selling calls for the investor. Also, the leverage component can contribute to a high expense ratio, but low leverage today makes that a modest consideration. BST's current trailing 12-month dividend yield is 7.78%. Prospective investors must understand the yield is not strictly from the cash flows and payouts from the shares of the companies it owns - that payout is largely made up of selling call options on the portfolio's holdings. A positive feature is BST's impressive share-price momentum. The fund suffered in late 2021 through 2022 amid rising interest rates and a severe selloff in tech stocks. But the downtrend has ceased, and a modest uptrend, which I will detail later, has been ongoing for more than 18 months. Looking closer at the portfolio, the 3-star fund by Morningstar plots along the top row of the style box, indicating its significant weight to large-cap growth. Just 6% of BST is considered mid-cap in size and there is scant small-cap access. There are also no value holdings, so a key risk is a more upbeat attitude among market participants toward strength in the underlying economy, so long as inflation continues to cool, resulting in blue-chip value stocks outperforming. BST also trades at more than 32 times earnings, though its long-term EPS growth rate is high at 19.9%. The high-momentum fund sells for a very lofty 7.8x sales, too. VST is somewhat risky in that nearly half of the allocation is comprised of the top 10 stocks. NVIDIA (NVDA) is an outsized position at 14%, but that was as of May 31, 2024. By the end of June, BlackRock marked the NVDA position at 14.8% with Microsoft (MSFT) being the next largest weight at 9.7%. While there is no seasonality data on BST, tech stocks in general tend to perform well through July but have historically encountered volatility over the back half of Q3 and into early Q4. I concede it's not as useful to apply chart analysis to high-yield CEFs and covered call ETFs, but we can still glean useful information when assessing broad trends and where momentum stands. With BST, notice in the chart below that shares have been on the upswing since notching a double-bottom low between $27 and $28 at the end of 2022. Since then, the long-term 200-day moving average inflecting positive in its slope, steadily rising from $32 to $35 today. Also, take a look at the RSI momentum oscillator at the top of the chart. It has been ranging in a bullish zone between 40 and 80, which I also like to see. The problem and primary risk right now is that the fund just recently tested the upper end of its long-term rising trend channel. I would not be surprised if BST retreated back down into the mid-$30s in the coming months based on the historical pattern. Overall, BST's trend is higher, but the near- to intermediate-term risk is a pullback toward the center of the rising trend channel. BST has outperformed some other equity income funds centered on tech stocks. But with a somewhat high expense ratio, seasonality about to turn suspect, high valuation, and a potential technical pullback, I have a hold rating on the product.

BST: A Strong Cocktail Of Small Caps, AI, And Dividends (NYSE:BST)

Moreover, the BST CEF should benefit from the appreciation in small-cap stocks as the Federal Reserve loosens monetary policy. Normally, the big players in the artificial intelligence ("AI") game like Nvidia (NASDAQ:NVDA), Apple (NASDAQ:AAPL), and Microsoft (NASDAQ:MSFT) do not provide the dividend yields that income investors vie for. Yet, remaining insensible to the capital gains these big tech can provide isn't easy. As such, this thesis aims to show that the close-ended fund ("CEF") BlackRock Science and Technology Trust (NYSE:BST) can provide both capital appreciation together with monthly income. In this respect, while it has gained 19% since the advent of OpenAI's ChatGPT in November 2022, BST's share price of $38 remains far below its 2021 high of $56 as charted below. This is partly due to one-fifth of its portfolio made up of small-cap holdings. Now, with the possibility of the Federal Reserve getting more dovish later this year, this small-cap exposure should prove beneficial. I start by differentiating the BlackRock (BLK) fund from others that pay relatively high yields by making use of covered call strategies on tech stocks. In this connection, one of the main differences between BST, the Global X Nasdaq 100 Covered Call ETF (QYLD), and the JPMorgan Nasdaq Equity Premium Income ETF (JEPQ) is the securities held. The QYLD tracks the Cboe Nasdaq 100 BuyWrite Index, while JEPQ also selects its holdings from the Nasdaq 100. By contrast, BST has a much wider mandate. In addition to public equities, it also invests in private ventures, namely Project Debussy, which constituted 2.26% of its holdings on June 28. This is similar to venture capital funds providing exposure to startups with high potential. For this purpose, its asset filtering mechanism benefits from BlackRock's experience managing assets valued at over $10 trillion throughout the world. Moreover, by not being tied to the Nasdaq 100 as its peers, it includes companies from the Euro Zone, the UK, Japan, and Taiwan which make for around 8.5% of its portfolio. The rest are made up of the U.S., as illustrated below. On the other hand, since it includes a wider universe within the tech theme, it charges fees of 1.09%, which is much more than QYLD's 0.61% or JEPQ's 0.35%. Looking at the size of the holdings, the Nasdaq-100 index (NDX) is made up of securities issued by 100 of the largest non-financial companies, while BST is composed of 20.2% small caps as shown above. These suffered relatively more than larger companies in 2022 as the Fed tightened monetary policy aggressively to combat high inflation, resulting in BST underperforming QYLD during the past three years, as shown in the chart below. Investors will note that I have excluded JEPQ from the comparison, as it was incepted only in May 2022. Tellingly, the opposite seems to be happening recently, with BST outperforming QYLD by more than 8% during the past three months due to softer CPI figures. It was 3% for June, its lowest level in more than three years, which indicates that the Fed's policy action against inflation is bearing fruits. As a result, more market participants, or 90% compared to 70% previously, expect a rate cut in September. Now, the loosening of money policy augurs well for small caps, which are normally the ones to suffer more from higher borrowing costs because they normally make use of a relatively higher percentage of floating-rate debt than larger companies. To obtain an idea of BST's small caps-led upside potential, consider that the Russel 2000 index (RTY) has gained 6.7% YTD, with 5.2% of this upside achieved in the last five days alone. However, it remains more than 250 points below its November 2021 high of 2,442, or by around 10%. Therefore, incrementing BST's current share price of $38, I have a target of $41.8. It is noteworthy that this is also about half the amount by which BST has been underperforming QYLD as per the above chart. This means that the BlackRock fund could potentially deliver a higher upside of 19.61%, but $41.8 remains a fair target because of the risks. One of these is the U.S. Central Bank not reducing rates as expected by market participants and the upside seen in small caps reversing course, which would result in high volatility. Secondly, the economy could slow down further during the rest of the year after decelerating to 1.4% on an annualized basis in the first quarter and consumer spending, the biggest economic driver, not being sustained. In this case, smaller businesses are more prone to economic cyclicality risks, especially during tightened credit supply conditions, and are more likely to be impacted by weaker consumer demand. Therefore, a 10% upside is more reasonable, and, to further justify my bullish stance, the fund could also benefit from AI transitioning from the initiation phase in 2022-2023 to gaining widespread adoption in 2024-2025. For this purpose, the currently available IT infrastructures in data centers cannot support super smart applications, meaning that there is a need to build more powerful and compute-intensive systems. This is where the AI builders come into play, with their respective roles in the Gen AI ecosystem also detailed in the table below. The relevant names have been shaded in pink to differentiate them from Apple and Meta Platforms (META) which are more of consumer and social media AI plays respectively, as I elaborate further below. Focusing on the AI builders, according to Gartner, spending for data center systems is poised to jump by 10% this year compared to only 4% in 2023. This is driven mainly by the planning requirements of Gen AI, with most of the actual deployments to be done in 2025. This means that the process of building AI infrastructure is only just getting started, in turn implying sustained demand for the products and services of companies like Nvidia, Microsoft, Broadcom (AVGO), Micron (MU), Microsoft, and Amazon (AMZN). Thinking aloud, high demand normally translates into better profits and to this end, the average of the YoY growth consensus estimates for the current and next fiscal year shows double and triple digits as illustrated above. Tellingly, with its high bandwidth memory chips being complementary to Nvidia's parallel processing GPUs, Micron's EPS should grow at an average of 353%. As for the laggard iPhone maker, its EPS growth averages to 9% in two years. However, it has been upgraded by analysts at Morgan Stanley (MS) based on Apple Intelligence driving product upgrades to the tune of 235 million devices for fiscal 2025 and more in 2026. Talking social media, Meta should continue its growth and profitability trajectory in a rapidly evolving digital landscape and competitive advertising industry, helped by its scale and investments in AI, combined with its leadership position and new product catalysts. Thus, despite their P/E trading on the high side, these stocks can still expand their earnings at a rapid pace, in turn justifying their higher multiples as demand for AI is sustained, somewhat like the digital transformation secular trend. The next step is to explore how it can generate those juicy yields of 7.9% (as of July 15). This may seem surprising, as it does not hold stocks known for paying high distributions. Well, this has to do with its income strategy, consisting of selling call options to earn premiums from option buyers. Furthermore, in contrast to its peers, the fund managers only write covered calls on 33.5% of the portfolio, which is not the case for other tech income funds which do not seem to have such a limit. However, BlackRock's fund managers also mention that this could change over time, meaning that such a move may impact capital appreciation. Looking at the dividend history, 2021 was an excellent year and a special dividend of $1.5584 was paid in addition to the twelve regular monthly payments, resulting in a total income of $4.26 as illustrated below. Subsequently, for 2022 and 2023, $3.00 was paid for each of those years. For the seven months of 2024, $1.75 has already been paid at the rate of $0.25 monthly. In the eventuality that $0.25 is paid for each month, meaning a total of $1.25, the fund remains on target to pay $3.00 for 2024 while at the same time delivering capital gains estimated at 10% for the rest of the year. In conclusion, this thesis has made the case for an investment in BST based on the income rationale, the capital appreciation potential of its small caps, and a sustained upside for its star AI plays. This said, in addition to performance and rate-related risks, the fund also uses leverage which can amplify returns when things work well, but, on the other hand, losses can also be accentuated when investments perform badly. Furthermore, after having delivered an upside of nearly 12% for this year alone, a temporary retrenchment cannot be excluded. Its P/E of 32.7x remains above its category average, and there could be a drastic policy change voiced out by any of the two candidates competing for the post of President. Finally, as seen in BST's price action has been marked by volatility, but it should trend higher as the science and technology theme got a boost acceleration from Gen AI. In this respect, the fact that 46% of the fund includes the big AI players helps it in a lower-rate environment where there will be more competition from alternative investments like utilities or real estate, which make large distributions to shareholders.