According to Pimco High Income Fund’s (NYSE: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.
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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