PHK: In Search of the Premium 18 comments
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According to Pimco High Income Fund’s (PHK) recent annual report, ninety-four percent (94%) of PHK’s portfolio, under FAS 157, is valued on a “mark-to-model” indirect pricing (“Level 2”) methodology. This means that PHK’s NAV is largely based on estimates generated by models developed by PHK’s advisor (PIMCO) and likely signed-off by PHK’s Valuation Committee.
As a result, PHK’s Valuation Committee materially determines its NAV based on PIMCO’s input. Ironically, investors are effectively betting against one of the best fixed income managers by bidding up the stock price 40% more than PIMCO’s current NAV estimates of $6.75 per share. Yet, on the other hand, investors will point to PIMCO’s skills as a reason for PHK’s higher stock price.
This conclusion is further supported by peer analysis and PHK’s historical multiple of net investment income. Based upon, PIMCO’s own NAV valuation ($6.75), a peer group discount valuation ($6.52) and a historical multiple of net investment income attributable to common equity ($8.34), the average valuation is $7.20 per share.
Rookie investors seem to be chasing PHK’s ephemeral annualized monthly distribution yield. Distribution yield is a lagging and not a leading indicator of the operational health of a closed end fund (CEF). It is not a particularly good valuation tool—particularly in isolation.
Summary: The following are two long-held CEF investment principals that go to the heart of PHK’s current valuation issues:
1. As a general rule of thumb, you buy shares of CEFs when they’re trading at significant discounts and sell them when they’re trading at significant premiums to their NAVs.
2. The powerful investment phenomenon known as “gravitation to the mean”, when applied to the CEF market sector, has a tendency to cause a significant discount or premium to gravitate towards its long-term average. (Prior to FY 2009, that premium was less than 1% for PHK.)
Let’s do the Numbers: Below is a detailed historical model of PHK’s operating results. (See model details summarized below.)
Over its operating history, the portfolio yield (row “A”) has averaged approximately 8.0% on its net investment income on total assets. Based on the model’s projections, PHK’s net investment income attributable to common equity (NIICE) will conservatively drop approximately 30% in FY 2010, YOY (intersect of “2U”). This is a primarily a function of approximately 50% fewer assets along with a 2.4% increase in number of shares outstanding than the average for FY’s ’05 to ’08.
From Here to There: In order for PHK to approximate the NIICE per share of previous FY years, its portfolio yield would have to be 50% higher than its historical average, or closer to 12% (row “A”).
Given the fact that PHK’s stated average portfolio coupon is currently 7.66%, this would imply that PHK has an imbedded portfolio discount of 36.2% which it has yet to disclose. On a “mark-to-market” basis, this valuation should be reflected in its current NAV.
Click to enlarge:
Where’s the Beef? Under FAS 157, any material changes in the portfolio’s valuation should be reported to the SEC through an 8-K filing in a timely fashion. Either the Valuation Committee is accurately valuing its NAV, or it’s in violation of timely and accurate reporting of fair value. I believe it’s the former.
Valuation Methodology: While valuing a CEF on its premium/discount is one valid valuation technique, there are others that should be used in combination to confirm that valuation.
My preferred valuation methodology is applying the appropriate multiple to net investment income available to common equity (NIICE). NIICE represents the core, recurring earnings of a CEF and the basis of a sustained steady distribution. Investors should pay little for capital gains distributions—given their relative unpredictability—and nothing for return of capital distributions.
NIICE Valuation: Based on the model’s projected NIICE estimate .86 per share and the HistrAvg multiple of 9.7, PHK’s current valuation would be $8.34 per share. (See point “4” & “5” in section below for HistrAvg analyses.) Excluding FY 2009 year-end ratios, the average of 2005-to-2008 multiple would generate a valuation slightly higher at $8.86 per share.
Neither the NIICE multiple or PHK’s own NAV supports the current stock price. Even on a peer comparison, PHK is currently trading at a 16% annualized monthly yield and a 40% premium to its NAV. This is in contrast to its peer group of HiYldBndFnds which are trading at an average distribution yield of 9.0% and a stock price to NAV discount of 3.4%. If PHK were trading based on its average peer group discount, the stock would be trading closer to $6.52 per shares.
Model Assumptions for Propeller Heads: While the model above may appear foreboding at first glance, a couple of quick instructions may be helpful in focusing on column “Proj2010” (column “2”) which is its purpose. This column contains the foundation for PHK’s FY 2010 projected net investment income available to common shareholders (“NIICE”) per share.
1. Vertically, rows “A” through “K” are key ratios that when arithmetically combined (as parenthesis indicate) would conclude in a NIICE return on common equity calculation (row “K”).
2. When the RetrnNIICommEq (row “K”) is multiplied by value of the CommonShrs (row “N”) and divided by ShrsOut (000) (row “R”) you arrive at the NIICE per share available to common shareholders (row “U”). (That number may be a few pennies different than the reported number (row “W”), but, nonetheless, valid for the purpose of this analysis.)
3. Columns “4” through “8” are the actual fiscal years’ investment ratios.
4. During FY 2009 (column “4”) there was a 61.0% drop in assets which significantly distorted the fund’s fiscal year-end operating ratios. Column “3” (“Avg2009”) is the FY 2009 ratios based on beginning and ending balance sheet averages which makes for a better representation of the historical performance ratios.
5. “HistrAvg”, column “1”, represents the average for fiscal years 2005 through 2008 and “Avg2009” (column “3”). The latter is a substitute for FY 2009, column “4” to help make the data relevant for comparative purposes.
Comments: When commenting, please provide facts when rebutting assumptions, methodology or conclusions, or don’t bother.
Disclosures: Short PHK
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If you believe we are going to have an aftershock in the near future from the 2008 global financial collapse, this make sense. What if the real-estate market stabilizes, defaults stop rising, and that market normalizes, too, or even if things simply stabilize and don't get any worse than now? Your projected declining assets looks wrong on the surface.
What does your table look like if Assets and Shares revert to the mean instead of shrink? As a corollary which has nothing to do with your analysis, but is a puzzle to me, if this fund is closed-end, how is it the outstanding shares have been dropping and then going back up?
Thanks for your in depth analysis.
There are some equity CEF's that are at insane premiums too where there is no doubt what the NAV value is. Still, small retail investors looking for yield in this difficult economic environment have pushed pushed many of the buy/write funds and dividend harvest funds to ridiculous premiums. I have a feeling this will not end well.
A CEF's growth in assets is a is function of their equity base and the leverage which it can employ.
As a result of the vast evaporation in equity value for PHK from 2008 to 2009 PHK’s portfolio growth is limited by its lower relative equity base.
I used the most recent NAV ($6.36) for the equity base and even increased the leverage versus its historical ratio while lowering its interest expense. In order for total assets to gravitate towards the mean you have to see a dramatic increase in the NAV.
I re-ran the model, at your suggestion, with a 50% increase in NAV. At that level, you begin to approximate the historical net investment income of 1.20 per share. The question becomes what’s the likelihood of that happening?
A CEF could have declining YOY share growth if there has been a tender offering or if the CEF is buying back shares for treasury stock. Additional shares can be a function of a dividend reinvestment program (DRIP).
Joe Eqcome
On Aug 12 08:51 AM Jade Bond wrote:
> I can't tell how net total assets (row 'O') fits into the formula
> and results. I can't tell how you concluded they would shrink from
> Avg2009. If the fund reverts to the mean, and the bond market doesn't
> collapse from here, why isn't NetTtlAssets shown to be up in 2010?
>
>
> If you believe we are going to have an aftershock in the near future
> from the 2008 global financial collapse, this make sense. What if
> the real-estate market stabilizes, defaults stop rising, and that
> market normalizes, too, or even if things simply stabilize and don't
> get any worse than now? Your projected declining assets looks wrong
> on the surface.
>
> What does your table look like if Assets and Shares revert to the
> mean instead of shrink? As a corollary which has nothing to do with
> your analysis, but is a puzzle to me, if this fund is closed-end,
> how is it the outstanding shares have been dropping and then going
> back up?
>
> Thanks for your in depth analysis.
There are a boatload of closed end funds that are under-covered, some of which could provide a relatively safe source of yield to many investors. You've made your points about PHK; time will tell. No one knows what will happen to the spreads on the investments in this portfolio. If they come in, you are wrong in your analysis. If they remain wide, you may be right.
Rather than beat this horse till it's dead, your credibility is better served looking at some other interesting CEF's good or bad.
Now if I add in my ability to borrow against those 1000 shares, and buy another security on margin, I'm employing leverage and can get additional growth potential.
So applying leverage on an existing portfolio, why wouldn't that sentence read "growth in assets is a is function of their equity base, the growth of the equity market value, and the leverage which it can employ."
On Aug 12 11:02 AM Joe Eqcome wrote:
> Jade Bond
>
> A CEF's growth in assets is a is function of their equity base and
> the leverage which it can employ.
I don’t think this is a question of your ignorance; it is more a question of whether you read the third paragraph of my comment. This is where I actually addressed the issue of expanding equity values as a basis for increased net investment income.
In this paragraph I assumed an increased of 50% of PHK’s equity base to calculate a new net investment income per share. So, your point regarding the growth in equity value was covered in this comment by specific example. The question still outstanding is a 50% increase in PHK’s equity value possible in FY 2010?
However, I do think the phrasing you’ve proposed is more inclusive.
Joe Eqcome
On Aug 13 11:00 AM Jade Bond wrote:
> Please excuse my ignorance, but that just seems wrong. If I own one
> security in my fund, 1000 shares of Google (my equity base?), my
> growth in assets as measured in dollars (holding all other things
> equal) is a function of the growth of Google's stock price.
>
> Now if I add in my ability to borrow against those 1000 shares, and
> buy another security on margin, I'm employing leverage and can get
> additional growth potential.
>
> So applying leverage on an existing portfolio, why wouldn't that
> sentence read "growth in assets is a is function of their equity
> base, the growth of the equity market value, and the leverage which
> it can employ."
>
> On Aug 12 11:02 AM Joe Eqcome wrote:
You’re correct on two points and mistaken on one.
Yes, this my second separate article regarding PHK being an overvalued security where I've provided data and analyses in support of that conclusion.
You’re also correct that the markets in the long run will be the final arbiter of value—it’s just that the market has spoken on this topic of excess premiums for CEFs on numerous occasions. I just don’t think this particular situation warrants a “new and wondrous” category.
My short position is not the issue; I can wait to the cows come home. My concern is for retail investors who I believe are going to lose their capital by chasing an ephemeral distribution. If I’m correct, it could be a double loss: first, on the dividend reduction; secondly, on an adverse stock reaction. I’ve seen this mistake made over-and-over again.
(In all fairness, investors do seem to understand the vulnerability of the dividend as the stock’s yielding an astronomical 16 %!)
I will be happy to stop writing about PHK’s misevaluation if someone, like you, can empirically demonstrate I’m wrong. Until that time, the thesis remains valid.
Just because someone legitimately yelled “fire!” in a theater and wasn’t heard the first time, doesn’t mean he/she shouldn’t repeat the warning.
Joe Eqcome
On Aug 13 06:21 AM iel76 wrote:
> If my recollection is right this is your second article in a month
> about the overvaluation of PHK. I guess your short position is becoming
> pretty uncomfortable, what with the dividend and all.
>
> There are a boatload of closed end funds that are under-covered,
> some of which could provide a relatively safe source of yield to
> many investors. You've made your points about PHK; time will tell.
> No one knows what will happen to the spreads on the investments in
> this portfolio. If they come in, you are wrong in your analysis.
> If they remain wide, you may be right.
>
> Rather than beat this horse till it's dead, your credibility is better
> served looking at some other interesting CEF's good or bad.
Thus far, the market has demonstrated empirically that you are wrong.
I wouldn't advise buying this fund at this point either. But I don't know that I would run out and dump an existing position either. You and I have been around this before....we don't know the spreads on these bonds, and we don't know the trading gains and losses in the fund until after the fact (thus we don't know the real dividend coverage level) . And by the way, I'm sure there are countless other CEF's out there where the current dividend levels are in jeopardy.
One last thought...before I buy a CEF for yield, I "haircut" the dividend 25%. If I like the underlying thesis and management of the fund, I buy (averaging in over time). If the dividend is indeed cut, I'm OK on a yield basis, if not, all the better.
On Aug 13 12:47 PM Joe Eqcome wrote:
> iel76
>
> You’re correct on two points and mistaken on one.
>
> Yes, this my second separate article regarding PHK being an overvalued
> security where I've provided data and analyses in support of that
> conclusion.
>
> You’re also correct that the markets in the long run will be the
> final arbiter of value—it’s just that the market has spoken on this
> topic of excess premiums for CEFs on numerous occasions. I just
> don’t think this particular situation warrants a “new and wondrous”
> category.
>
> My short position is not the issue; I can wait to the cows come home.
> My concern is for retail investors who I believe are going to lose
> their capital by chasing an ephemeral distribution. If I’m correct,
> it could be a double loss: first, on the dividend reduction; secondly,
> on an adverse stock reaction. I’ve seen this mistake made over-and-over
> again.
>
> (In all fairness, investors do seem to understand the vulnerability
> of the dividend as the stock’s yielding an astronomical 16 %!)<br/>
>
> I will be happy to stop writing about PHK’s misevaluation if someone,
> like you, can empirically demonstrate I’m wrong. Until that time,
> the thesis remains valid.
>
> Just because someone legitimately yelled “fire!” in a theater and
> wasn’t heard the first time, doesn’t mean he/she shouldn’t repeat
> the warning.
>
> Joe Eqcome
I believe we’re in need of a point of technical clarification.
I am under the impression that these “spreads” and “trading gains” you continue to point out as hidden values are already priced into the NAV valuation based under the fair value standards which management is legally bound to disclose. This is no different than an unrealized gain in an equity position; the fact that you haven’t realized it doesn’t mean you don’t value it.
If my impression is correct, then investors are paying 40% more than the management is telling them it's worth. Would you buy a house for 40% more than the asking price?
As it relates to you claim that the PHK’s share price is evidence that the underlying valuation is correct misses the point of stock valuation. Stock prices are what investors are willing to pay for a stock not necessary its intrinsic value. This is the premise of the Graham & Dodd’s seminal 1934 book Security Analysis which was the birth of value investing which is still practiced today.
If you are correct in your assertion that stock prices accurately represent value, then we should have never experience stock price bubbles. I don’t know if that claim can be supported.
I would agree that there are numerous mispricing in the CEF industry that need attention.
Joe Eqcome
On Aug 14 06:15 AM iel76 wrote:
>
> Thus far, the market has demonstrated empirically that you are wrong.
>
>
> I wouldn't advise buying this fund at this point either. But I don't
> know that I would run out and dump an existing position either. You
> and I have been around this before....we don't know the spreads on
> these bonds, and we don't know the trading gains and losses in the
> fund until after the fact (thus we don't know the real dividend coverage
> level) . And by the way, I'm sure there are countless other CEF's
> out there where the current dividend levels are in jeopardy.
>
> One last thought...before I buy a CEF for yield, I "haircut" the
> dividend 25%. If I like the underlying thesis and management of the
> fund, I buy (averaging in over time). If the dividend is indeed cut,
> I'm OK on a yield basis, if not, all the better.
>
> On Aug 13 12:47 PM Joe Eqcome wrote:
Regarding spreads, perhaps here is where our arguments coalesce. If the market is pricing in more than what is a typical risk premium (again, I don't know this), then there is an opportunity for these bonds to gain in value (and for NAV to increase) when spreads return to a norm.
You say the market is mispricing PHK; perhaps you are right (although its been expensive to be right). If I am right, and the market is merely mispricing risk, then spreads will come in and the NAV will be more in line with the share price.
Bottom line: I totally agree that at some point this puppy has to trade in a realistic range around NAV; I simply admit that I don't know (and doubt that you do) if now is that time.
I'll let go of this now but my thanks for the debate...it is enlightening to be able to look at all sides of these CEF's openly, there is always more to learn.
Finally, take a look at a Blackstone fund BCF. Trades at a discount, has a handsome and thus far sustained yield and is a hard asset play on a recovering world economy....it would be great to get consensus on funds whose objectives (missions) are timely and whose yields seem relatively secure
On Aug 14 11:19 AM Joe Eqcome wrote:
> iel76
>
> I believe we’re in need of a point of technical clarification.<br/>
>
> I am under the impression that these “spreads” and “trading gains”
> you continue to point out as hidden values are already priced into
> the NAV valuation based under the fair value standards which management
> is legally bound to disclose. This is no different than an unrealized
> gain in an equity position; the fact that you haven’t realized it
> doesn’t mean you don’t value it.
>
> If my impression is correct, then investors are paying 40% more than
> the management is telling them it's worth. Would you buy a house
> for 40% more than the asking price?
>
> As it relates to you claim that the PHK’s share price is evidence
> that the underlying valuation is correct misses the point of stock
> valuation. Stock prices are what investors are willing to pay for
> a stock not necessary its intrinsic value. This is the premise of
> the Graham & Dodd’s seminal 1934 book Security Analysis which
> was the birth of value investing which is still practiced today.
>
>
> If you are correct in your assertion that stock prices accurately
> represent value, then we should have never experience stock price
> bubbles. I don’t know if that claim can be supported.
>
> I would agree that there are numerous mispricing in the CEF industry
> that need attention.
>
> Joe Eqcome
>
Thank you for your comments.
I'm always open to incremental input and civil discussion.
Joe Eqcome
On Aug 14 12:09 PM iel76 wrote:
> First, PHK may be priced right or wrong, I don't know and my argument
> is neither do you. Unrealized gains are clearly included in the NAV
> valuation as are the results of trading gains. Trading gains, if
> they exist, increase distributable income and could support a higher
> dividend level. My point is we won't know cash flow dividend coverage
> until results are disclosed.
>
> Regarding spreads, perhaps here is where our arguments coalesce.
> If the market is pricing in more than what is a typical risk premium
> (again, I don't know this), then there is an opportunity for these
> bonds to gain in value (and for NAV to increase) when spreads return
> to a norm.
>
> You say the market is mispricing PHK; perhaps you are right (although
> its been expensive to be right). If I am right, and the market is
> merely mispricing risk, then spreads will come in and the NAV will
> be more in line with the share price.
>
> Bottom line: I totally agree that at some point this puppy has to
> trade in a realistic range around NAV; I simply admit that I don't
> know (and doubt that you do) if now is that time.
>
> I'll let go of this now but my thanks for the debate...it is enlightening
> to be able to look at all sides of these CEF's openly, there is always
> more to learn.
>
> Finally, take a look at a Blackstone fund BCF. Trades at a discount,
> has a handsome and thus far sustained yield and is a hard asset play
> on a recovering world economy....it would be great to get consensus
> on funds whose objectives (missions) are timely and whose yields
> seem relatively secure
But if I had real-estate develpment skills, the money, and opportunity to buy a controling interest in half the city of Detroit (you know, all those $100 houses sitting idle) after the Unitest States federal government had passed a bill to spend $1.3 trillion revitalizing the economy around Detroit, I might do just that, but of course I wouldn't be too eager to raise the value of the individual houses until the revitalization effort had taken a firm hold.
On Aug 14 11:19 AM Joe Eqcome wrote:
> iel76
>
> Would you buy a house for 40% more than the asking price?
In that light, I've published an article titled "When Premiums Make Sense" (source: stocks-bonds-currencie...)
On Aug 19 01:14 PM Jade Bond wrote:
> I found out yesterday, in the car industry there are also rare events
> where certain cars sell at a premiums to MSRP when the product is
> rare and not likely to ever be available again.
>
> In that light, I've published an article titled "When Premiums Make
> Sense" (source: stocks-bonds-currencie...)
Let us consider:
1. In March 10, 2009 the PHK NAV was $2.98. The price on that date was $4.08 and the premium to NAV was 36.9%.
2. The September 17, 2009 NAV was $8.09, the price was $9.79 and the premium to NAV was 21.07%.
3. PHK has had to dispose of some leverage (and, thereby, assets at distressed prices), moving from about 61% of assets leveraged to about 1/3 that amount today. Preferred shares (leverage in 7 day debt) have decreased from about 36,000 $25,000 shares to about 12,000 such shares today.
4. The cost of that interest in November '08 was 1.20% vs about 0.22% today.
5. The underlying investments are paying very little on the leveraged amounts which increases the return on the common shares.
So? As the probability of debt instruments being paid increases and the gains inure almost entirely to the common share holders, the price is likely to increase until A) short term interest rates increased dramatically, thereby reducing the return on common, and B) long term rates increase dramatically, thereby reducing the 'mark to market' values of the bonds.
Although the rate of return is attractive, that tends to make it appear more risky than it is. I like Joe Eqcome's analysis and article, but not his conclusions because they assume usual circumstances and we're still in unusual times.
Having said that, I'm long PHK having ridden that horse from March 2009 and thinking that the risk of sharp reversal is a concern. Right now, I think our positive run is likely to run for a short time longer. I just wish I knew where I could get some shorts to sell against the box.
The premium (price over NAV) on September 17, 2009 was 39.94% not 21.07% as written there. (I don't know why I typed the lower #)
My argument is not changed, since I had the higher number in mind.