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Recommendation: Long Special Opportunities Fund Inc 3% Convertible Preferred Shares (SPE PR)

Catalysts: share buyback; consistent outperformance of SPE

Thesis

Special Opportunities Fund (NYSE:SPE) is a special-situation closed-end fund managed by Bulldog Investors. Historically a consistent outperformer, Bulldog Investors continues to deliver outstanding absolute returns that are insensitive to markets at Special Opportunities Fund. Investing in SPE PR provides investors with additional dividend income and tax benefits without compromising the upside from the common shares.

Description of Preferred Shares

In July 2012, SPE issued 749,086 convertible preferred shares which were over-subscribed by 2 times at $50 face value. Each preferred share is entitled to receive 3% dividend annually. In addition, one (1) preferred share is convertible to three (3) common shares subject to adjustment in the case of distributions on common shares. Now the conversion ratio is 3.1918 common shares per preferred share. The fund can elect to redeem all the preferred shares at $50 when the NAV of common shares exceeds $18.9986 per share (adjusted from $20 per share when the preferred shares were issued). In addition, all preferred shares will be redeemed in 2017 at $50 per share. So far, there has been no request of conversion from preferred shares to common shares.

Special Opportunities Fund

A set of board members supported by Bulldog Investors gained control of Insured Municipal Income Fund in August 2009 after a proxy fight. The new board selected Bulldog Investors to manage the fund. After a tender offer at 99.5% NAV, Insured Municipal Income Fund changed its name to Special Opportunities Fund and altered the investment objective to providing total returns to shareholders. Special Opportunities Fund liquidated the holdings of Insured Municipal Income Fund and started building its own portfolio on Jan 25, 2010. The fund adviser, Bulldog Investors, merely charges a 1% management fee. The low management fee puts investors in a favorable position compared with high-net worth individuals who pay 2 and 20. Phillip Goldstein owns 33,075 shares of common shares and 3,693 shares of preferred shares which have a market value of $788,000. Based on the Form 4 that Phil filed over time, he has been gradually accumulating preferred shares since the shares were issued last year.

Portfolio Managers

Phillip Goldstein and Steve Samuels started Bulldog Investors back in 1992 and applied an activism approach in value investing. The flagship hedge fund is one of the most successful activists in the closed-end fund world. In his interview with Opalesque TV, Phillip Goldstein claimed that Bulldog won more than 30 proxy fights since 1996 which were full proxy fights rather than simply submitting a shareholder proposal. The flagship hedge fund has generated 12.8% of return annually until November 2009, according to SPE's 2009 annual report. The return is very impressive because the fund has weathered the market downturn following the Internet bubble and the great recession very well. In addition, the return outperforms S&P 500 by about 5% annually with much smaller volatility. According to the latest form ADV, Bulldog Investors have $533 million under management. The size is an advantage of Bulldog Investors, since Bulldog Investors is large enough to cause the managements of closed-end funds nervous and small enough to make meaningful bets on many small-cap closed-end funds that trade at a wide discount.

Strategy

Bulldog Investors utilizes multiple strategies to deliver solid risk-adjusted returns year over year.

1. Closed-end fund activism: The portfolio managers at Bulldog Investors are experts in closed-end fund activism. Basically, the fund accumulates shares of closed-end funds trading at large discounts to NAV and then demand the management of funds to enhance shareholders' value by providing a liquidity event, including share repurchases, tender offer, open-ending, and liquidation. Sometimes, Bulldog would join hands with larger institutional activists such as City of London Investment Management or Lazard Asset Management in attacking the target. Some of the successful examples include Greater China Fund (NYSE:GCH), Diamond Hill Financial Trends Fund (NASDAQ:DHFT), and Thai Capital Fund (NYSEMKT:TF). Bulldog benefits from a shrink in discounts and generates alpha relative to the index. Occasionally, Bulldog Investors could lose money in a closed-end fund even if the discount decreases because the value of the underlying portfolio dropped more than the gains from the discount shrinkage.

2. Special Purpose Acquisition Companies: Bulldog Investors invests heavily in Special Purpose Acquisition Companies, or SPACs. Once completed an IPO, a SPAC usually has two years to seek an acquisition candidate. After two years, a SPAC either makes an acquisition and survive or liquidates itself. The money raised in the IPO of a SPAC is held in a trust account and would be returned to a shareholder with interest if the shareholder votes "no" on the merger proposal or if the SPAC liquidates. SPACs are equivalent to cash but offer free options on attractive acquisitions. In recent years, a number of strong sponsors such as Tom Hicks and JW Childs started to enter the playground of SPACs, which substantially increases the chance that a decent deal is struck.

3. Special situation stocks: Special Opportunity Fund invests in special-situation stocks once in a while. In the past, the fund has made investments in Gyrodyne Company of America (NASDAQ:GYRO), which traded at $60 range before it received the compensation from New York State of $112 per share. The fund also invested in Myrexis (OTCPK:MYRX) below liquidation value and pressured for a liquidation of the company, which the company ended up doing.

4. Auction Rate Preferred Shares: Since 2010, Bulldog Investors has bought substantial amount of Auction Rate Preferred Shares (ARPS) at deep discounts to face value. ARPS are investment vehicles that offer money market-like returns. However, as liquidity dried up in the middle of the financial crisis, the equilibrium of low demand and high supply drove ARPS to deep discounts. After entering the positions, Bulldog Investors waited or persuaded the issuers to self-tender the shares near face value, thereby generating decent returns on these investments.

5. Bankruptcy claims: Since many institutions are not allowed to invest in the bankruptcy claims, the fund has the opportunity to invest in sweet deals from time to time.

Asset Allocation

According to their latest filing, as of March 31, 2013, the asset allocation of SPE is as follows:

  • Closed-end Funds-78.09%
  • SPACs-13.50%
  • Business Development Company-7.45%
  • Money Market Fund-6.67%
  • Commons Stocks ex. SPACs-6.62%
  • Preferred Stocks-5.30%
  • Auction Rate Preferred shares-3.89%
  • Corporate Bonds-3.28%
  • Closed-end fund preferred shares-2.78%
  • Warrants-0.74%
  • Promissory Notes-0.35%
  • Convertible Notes-0.08%

As we can see, the fund invests heavily in closed-end funds and SPACs (91.5% in total). SPACs are higher-yield riskless vehicles that will return the cash within a specific time frame. Closed-end funds in which SPE invests are mostly trading a wide discount to NAV, which provides downside cushion. Moreover, Money Market Funds, ARPS and Closed-end fund preferred shares are very safe investments. In short, a portfolio that mainly consists of these investments should be able to weather the storm if a bear market comes.

Performances

Since inception, SPE has appreciated by 33.23% while its NAV has risen 34.25%, with standard deviation of only 8.84% in the past three years. The performance lags the S&P 500 index, which has risen by 55.88% during the same period. However, simply comparing the returns does not let us see the big picture. According to Morningstar, SPE has a beta of 0.55 relative to the MSCI World Index and an alpha of 6.92%. Thus, its management fee of 1.0% is really an outstanding deal compared with the level of alpha it has generated. SPE's three-year Sharpe Ratio of 1.59 is actually higher than SPY's Sharpe Ratio of 1.28. The fund captured 71% of the upside in the market but only captured 37% of the downside in the market, which shows a very favorable risk-return profile. As Phillip Goldstein wrote in the 2010 annual report, SPE tends to outperform in the bear market and underperform in the bull market.

Why Buy Preferred Shares Rather than Common Shares

There are a few reasons that make the preferred shares a better investment than the common shares.

1. Zero conversion premium: Each one of the preferred shares is convertible to 3.1918 shares of the common shares. At the current prices, this implies a 0.75% conversion discount. Since the conversion premium is close to 0%, holding preferred shares will allow investors to capture all the upsides of the common shares.

2. Addition yield and tax benefit: Since the conversion ratio adjusts after the distributions on common shares are paid, the preferred shares effectively "earn" the distributions paid on common shares too. In fact, while common shareholders are taxed on the distributions, preferred shareholders see the conversion price decreased by the full amount of the distribution. Thus, preferred shareholders actually get paid more on distribution of common shares. Because the preferred shares offer an additional 3% dividend, preferred shareholders earn a total yield close to 5% per year. Since Bulldog Investors generates 5%-6% alpha for common shares, investors of preferred shares receive roughly 8%-9% of alpha over the market in the long run.

3. Long-term absolute return: Although the preferred shares are callable at $50 per share if the NAV of the common shares exceeds $18.9986 per share, it is unlikely that the fund chooses to call the preferred shares any time soon because the interest paid to the preferred are so low compared with other alternatives of getting leverage. As a result, we can take the advantage of the benefits of holding preferred shares for a long time.

Additional Considerations

1. A Pipeline of activism investments: Unlike Carl Icahn, Bulldog's activism in a specific closed-end fund usually benefits all the shareholders in that specific fund. While we could be a free-rider and enjoy the benefits of Bulldog's activism, the discount to NAV already shrinks a lot by the time you know Bulldog is running a proxy fight. Moreover, SPE offers us the chance to invest in a pipeline of activism investment opportunities. If we invest individually, we might get stuck on a specific investment while waiting for the Bulldog to reach a deal with the management teams of the closed-end fund, which limits the flexibility in our asset allocation.

2. Access to inefficient markets: As an institutional investor, Bulldog Investors can get access to many investments that retail investors are unable to participate. For example, Bulldog Investors' investments in bankruptcy claims, ARPS, SPAC (at IPO) are not available for retail investors. By investing in SPE, retail investors can get exposure to these investments where the markets are likely to be inefficient.

3. Unlimited share repurchases: The management team has endorsed an unlimited repurchase of SPE shares. The repurchase should help the fund manage its discounts to NAV.

4. Clear investment strategies: Bulldog Investors writes great letters to investors. They describe in detail why they entered a position, the latest development of the situation, and when they expect to exit the position. I have learned a lot about SPACs, auction-rate preferred shares, litigation-related special situations and other investment ideas from the letters that Phillip Goldstein wrote. From these letters, we can easily determine that the managers are sticking to the stated objectives of the fund all the time.

Risks and Concerns

1. Limited liquidity of the preferred shares (~1200 shares per day): Preferred shares have very limited liquidity on the stock exchange. Hence, there is large bid-ask spread on the market. If I want to sell the shares, I will have to wait for a long time before my orders are executed, unless I order to sell at market. However, if I plan to invest in the preferred shares for long term, the liquidity is not an issue.

2. Broad market risks: Since SPE does not hedge the market risk when it invests in closed-end funds, a substantial drop in broad market could harm the value of holdings in closed-end funds. I can always hedge the broad market risks manually and inexpensively, so the market risk is not a big issue if I am not comfortable with the net long exposure.

Source: Special Opportunities Fund Preferred Shares: 5% Alpha Plus Another 3% Yield

Additional disclosure: I am long SPE PR.