Disclosure: This idea to short CRF is only suitable for VIC's smaller investors. It is a short idea and the borrow is difficult to get, although not impossible. Furthermore, the risk of is getting called in on your borrow not the idea itself. I don't want to minimize this point as it is my major concern. I am hopefully that posting the idea here will not increase the risk of a buy in, however, I also realize that just the opposite may be true. Either way, its a remarkable story and getting the story out there may be enough to create its own catalyst.
I wrote this up over the weekend. The stock is down significantly today, from $16.60 to $15.25 (8%) but I have chosen not to adjust my write-up for the price drop.
Here we go........
Question: How can a closed end fund that is in liquidation and has underperformed its benchmark by nearly 3% per year since its inception trade at a 51.3% premium to NAV?
Answer: Pay large fixed monthly distributions, regardless of the underlying performance of the fund.
The practice of paying fixed distributions is currently being scrutinized by the SEC. Last year the commission suspended granting authority for funds to initiate new fixed distribution policies. Cornerstone Total Return Fund and Cornerstone Strategic Value Fund exemplify the potential problems being examined. Each has aggressive payout policies and they both trade at larger premiums to net asset value than any other closed-end mutual funds out there. The contention is that naive investors might not understand the distinction between return of capital and return on capital. What else could explain the market price of Cornerstone Total Return Fund and Cornerstone Strategic Value Fund being, respectively, 51.3 percent and 39.2 percent higher than NAV?
Gabelli Funds, LLC has published information on their website highlighting this problem. “A managed distribution policy may create confusion regarding the true “yield” of a closed-end fund. All too often, investors, financial publications, newspapers and websites simply use a fund’s distribution payment and current market price to calculate the “current yield”. Investors should be wary of these incorrect “yield” calculations, particularly when applied to closed-end equity funds. A “current yield” calculation for a closed-end equity fund with a managed distribution policy is irrelevant because the fund's current market price is not a factor in determining a fund’s distribution….a fund’s distribution may contain a return of capital, which should not be counted as “yield”.
Disclosure requirements for closed-end funds are minimal. Wachovia Securities Closed-End Fund Manual states “Unlike open-end funds, closed-end funds do not offer shares continuously. A closed-end fund issues a prospectus only at its initial public offering. After that, the fund is required to publish semi-annual and annual reports….Unfortunately, key information that would describe a closed-end fund often is not provided in an annual or semi-annual report.” For example, Cornerstone Funds have no reference about current or historical NAV returns on a stand alone basis or compared to its benchmark. The funds do not have websites either.
Furthermore, investor’s heavy reliance on third party sources may be misleading. As Lipper disclosed last Friday, sometimes these sources provide inaccurate information. Lipper’s data, which is published in the Wall Street Journal and many other places, overstated Cornerstone’s NAV returns for the past year through September 30, 2005 as 16.4% when it was actually 9.2 percent. The S&P500’s return was 12.3 percent for the same time period.
Morningstar’s rating system is seriously flawed for closed-end funds because it does not factor in premiums or discounts.
To understand the SEC’s concerns consider the record of Cornerstone Total Return Fund. On January 1, 2002 the Fund initiated such a policy when its NAV per share was $18.30. Since then Cornerstone has paid a fixed distribution every month, initially $0.165 later raised to $0.176 in December of 2003. Through September 30, 2005 the Fund disbursed a total of $7.13 per share of which 95 percent, or $6.75, has been return of capital while only 5 percent, or $0.38, has been investment income (return on investment).
The implication is that unknowing investors might assume the distribution yield of 12.7 percent ($2.11/$16.60) is all profit when in actuality the return on investment has been only 0.6 percent ($0.1055/$16.60), assuming 95 percent of the distribution is a return of capital.
As of October 7, 2005 the Fund’s NAV, which is only $10.97, is a shadow of its former self. With the Fund distributing $2.11 per share to investors each year NAV is likely to continue to fall at an exponential rate. When the policy was initiated the payout rate was 10.8 percent of NAV. Comparatively, the distributions now are nearly 20 percent of NAV.
If history is any guide the future doesn’t look good. The Fund’s advisor has stated that “it is the goal of the Fund to have its long term investment returns match or exceed these [fixed] distributions.” Is that goal achievable given that the distribution rate is almost 20 percent of NAV? Since Ralph Bradshaw took over the helm as portfolio manager, the Fund has realized annual returns of only 2.6 percent.
Shareholder communications have also stated that “the main goal of the Fund’s investment manager…has been to…outperform our benchmark,” yet for the past three years annualized results have underperformed its benchmark, the S&P500, by 2.8% per year. In fact the Fund has underperformed its benchmark every quarter for the last three years.
At the current rate the Fund will be completely liquidated in five years, if not sooner. Given that the board of directors has vowed publicly to maintain or increase the rate of fixed distributions, regardless of investment results. As silly as this policy may seem, the board is committed. Consider that the even though the Fund’s NAV declined from $18.30 to $13.42 from January 2002 through December 2003 when the rate of fixed distributions was $1.98 per year, the board increased the distribution rate to $2.11 per year in December 2003.
Short of a change in the distribution policy, liquidation is inevitable. Long before NAV goes to zero the Fund is bound to hit a breaking point whereby its asset base becomes so small that it is no longer feasible to operate. This event might be further accelerated by a stretch of negative returns.
The Fund’s investment advisor has proudly claimed that their “innovative” and “aggressive” fixed distribution policy is in the best interest of shareholders. That is true for shareholders that purchased their shares at a discount to NAV and sold them at a premium, like Bradshaw’s brother-in-law, Ron Olin, who personally and through Deep Discount Advisors purchased in excess of 50 percent of the Fund when it was trading at a large discount and completely cashed in at premium prices.
Unsuspecting shareholders that paid premium prices will not fair as well. In spite of the Fund’s management setting noble goals the reality is clear: performance does matter. Ultimately the dividend will be cut or the fund will liquidate and the 51.3 percent premium will to collapse to zero. That is a $5.64 decline on a $16.60 stock. Ouch!