Description

Source Capital (SOR) is a closed-end mutual fund trading at a 33.9% premium to NAV. The FPA Perennial Fund (FPPFX) is an open-end mutual fund managed by the same portfolio manager with a portfolio is almost identical to the SOR portfolio. I believe that by shorting SOR while simultaneously purchasing the FPPFX attractive investment returns can be achieved with little to no risk.

The Short:

There is no justification for SOR to trade at a significant premium to NAV. The current premium to NAV for SOR is at or near an all time high and four times as great as when the following was written by Eric Ende, SOR’s portfolio manager, in the 2000 annual report:

MARKET PRICES AND SHAREHOLDER RETURNS

“In the long run, the future returns for Source Capital Common shareholders will depend primarily on how well we manage the firm's investment portfolio. The longer the period of time involved, the more important portfolio investment returns will be in determining shareholder returns. However, in the short run, changes in the market price of Source Capital Common shares, which deviate from the underlying changes in net asset value can cause shareholder returns to be either enhanced or diminished.

The Year 2000 represents the most dramatic case in many years of shareholder returns far exceeding those of the underlying portfolio. Source ended 2000 selling at a 8.4% premium to net asset value, a gratifying turnaround from its 4.8% discount at the end of 1999. This positive change in the market's view of Source's value had the effect of more than doubling the return realized by Source shareholders in 2000--from the 9.6% actual return on the underlying portfolio, to the 22.5% return of the stock.

Although we were very pleased with the stock market's increased enthusiasm for Source, we feel compelled to point out that not only is this unlikely to repeat itself in 2001, but could easily be reversed, resulting in a year of shareholder returns well below the actual performance of the portfolio. For example, if the market price of Source were to decline to a 5% discount by the end of 2001, it would require a 14% return on the underlying portfolio just to keep shareholders at breakeven for the year.”

The Hedge:

The following table is a statistical look at the quarterly returns for SOR’s NAV and the FPA Perennial Fund:

COMPARISON IN QUARTERLY RETURNS
SOURCE CAPITAL's NAV VS. FPA PERENIAL FUND

AVERAGE QUARTERLY DIFFERENCE IN RETURNS (DELTA): -0.12
STANDARD DEVIATION 1.59
CORRELATION BETWEEN SOR & FPPFX 0.99

SOR's NAV FPPFX DELTA
2002 Q3 -15.67 -12.11 -3.56
Q2 -11.72 -8.28 -3.44
Q1 7.01 5.92 1.09
2001 Q4 24.98 22.45 2.53
Q3 -14.6 -13.4 -1.2
Q2 22.25 21.52 0.73
Q1 -4.43 -4.76 0.33
2000 Q4 9.95 8.52 1.43
Q3 3.39 2.97 0.42
Q2 -8.33 -7.9 -0.43
Q1 5.18 7.04 -1.86
1999 Q4 11.82 12.8 -0.98
Q3 -4.98 -4.46 -0.52
Q2 27.06 29.16 -2.1
Q1 -8.85 -9.98 1.13
1998 Q4 22.11 21.27 0.84
Q3 -19.81 -20.28 0.47
Q2 -1.11 -0.84 -0.27
Q1 9.21 9.32 -0.11
1997 Q4 1.13 0.63 0.5
Q3 9.95 9.96 -0.01
Q2 13.94 16.49 -2.55
Q1 -0.91 -3.56 2.65
1996 Q4 9.51 8.98 0.53
Q3 2.57 1.12 1.45
Q2 3.48 4.53 -1.05
Q1 5.33 4.52 0.81

These two funds are highly correlated, as they should be. Aside from some structural differences, the SOR and FPPFX portfolios are almost identical. One difference worth pointing out is that FPPFX currently has about 12.5 percent in cash versus about 2 percent for SOR. Historically cash levels have been more comparable between the funds. This difference largely explains the larger DELTAs for the past four quarters. FPPFX’s cash position has dampened its relative return in up quarters while enhancing its relative return in the down quarters.

The Dividend:

Using faulty logic, some investors may believe SOR’s dividend yield is 8 percent. However, not only is a portion of the current dividend a return of capital, SOR will cut the dividend if the NAV is not increased to $46.00. Currently SOR’s NAV is $43.02. In order to hit the $46.00 bogey within one year the portfolio return will have to be 17.6 percent (10.7 percent ($4.60/$43.02) plus 6.9 percent ($2.98/$43.02)).

Any cut in the dividend will be an immediate catalyst to close the gap between the market price and NAV. Unless the performance of SOR’s underlying portfolio is stellar, a dividend cut seems like a distinct possibility. Alternatively, strong portfolio returns will likely boost NAV at a faster rate than the market price. Either way, I believe the premium will contract.

In SOR’s September 30, 2002 Third Quarter Report to Shareholders the following statement was written regarding dividends:

DISTRIBUTIONS TO COMMON SHAREHOLDERS

“A regular quarterly distribution at the rate of $1.15 per share was paid on September 15, 2002 to shareholders of record on August 23, 2002. Source's 10% Distribution Policy, adopted in 1976, calls for payments to Common shareholders approximating 10% of the Common Stock's ongoing net asset value. Shareholders are reminded that these payments substantially exceed the Company's net investment income and thus represent a continuing payment of a portion of the Company's capital. As we repeatedly point out, maintenance of the current $4.60 Common distribution rate is dependent upon achieving investment results, which will sustain a net asset value of approximately $46.00.”

Working the Trading Range:

One way to profit from this trade is to wait until the gap narrows to a smaller premium. This could happen very quickly, particularly if there is a dividend cut. However, if it appears as though it may take a while a more creative approach can be used to boost returns. Additional profits can be realized by increasing the commitment to the trade whenever the premium is above some threshold, for example 23 to 25 percent, and unwinding (or partially unwinding) the trade whenever the premium falls below another level, say 15 to 13 percent. Given the history of how the premium fluctuates (Morningstar’s website has a good premium/discount chart) this appears to provide opportunities to profit without ever needing the gap to fully close. As long as there is enough volatility the trade will likely produce satisfactory returns regardless of how long it may take to settle at a more reasonable premium, par, or a discount.

The Mechanics of the Trade:

Currently, the best hedge ratios would be to short 1.34 (1 + the premium percentage) or 1.20 (1 + the premium percentage)*(1/(1- the excess cash in FPPFX vs. SOR)) dollars of SOR to each dollar of FPPFX. The second ratio adjusts for the excess cash currently in FPPFX vs. SOR.

FPPFX is a load fund. The load charge is tiered so that it declines as the amount of money invested is increased. For a $1 million investment there is no load. Additionally, by committing up front to invest a certain amount of money in the fund over the course of one year the appropriate load charge can be locked in. For example, by committing to invest $1million within one-year there will be no load charge and the position can be built throughout the year. More information on the load charges can be found in the FPPFX prospectus.

Executing the short side of this trade is perhaps the most challenging aspect of this opportunity. According to the Yahoo profile there were 127,000 shares of SOR sold short as of November 8, 2002. This number has increased consistently throughout the year. So far, however, this has proved a difficult trade for me to execute. The borrow has been available on a few occasions, even in reasonable sized blocks of 10,000 to 20,000 shares. However, SOR is thinly traded, approximately 6,000 shares per day, and the blocks were only available to me for one day then they were gone.

I believe anyone who executes this trade will be rewarded with annual returns in the range of 15 to 30 percent while incurring little to no risk.

Catalyst

A dividend cut, volatility, reversion to a more sensible premium, par or a discount to par.