For years the Board of Directors of the Cornerstone Strategic Value Fund (NYSEMKT:CLM) and Cornerstone Total Return Fund (NYSEMKT:CRF) has vowed publicly to maintain or increase the rate of fixed distributions, regardless of investment results. On November 29, 2006, however, they changed their tune. From now on, the fixed distribution rate is totally dependent on investment results.
The new policy sets the annual distribution rate at 21 percent of the prior year’s net asset value [NAV] per share as of the end of the month each October. This massively aggressive distribution rate will virtually guarantee that dividends will be cut annually, most likely starting in 2008. Put another way, unless the Cornerstone Funds’ NAV return is 21 percent in any given year the dividend will be cut.
As it stands now, the Cornerstone Total Return Fund - despite four straight years of underperforming its benchmark index, negative news articles and a reported Securities and Exchange Commission investigation into fixed distribution policies - defies gravity by trading at a whopping premium to NAV [as of October 13, 2006] of 92.57%. [Investors are paying $1.90 for each $1.00 of actual value.]That currently is the largest premium to NAV of any closed-end fund.
CRF trades at $19.70 yet its NAV is only $10.23 [as of December 8, 2006]. NAV is a closed end fund’s intrinsic value – basically. I say basically because some funds, those that have a history of out-performing their benchmark, might deserve to trade at a slight premium to NAV. Yet others, those that have historically underperformed their benchmarks, might deserve to trade at a discount to NAV. Cornerstone’s case is fundamentally clear – given its consistent poor NAV returns, it should trade at a discount to NAV.
Why then does CRF trade at a 93% premium to NAV? There is only one explanation for this amazing feat. Unsuspecting investors who are attracted by the high dividend yield do not realize the large monthly distributions are not earnings but a return of their own money.
Cornerstone’s story has been in the news before. On October 26, 2005 The Wall Street Journal printed an article titled “The High Cost of High Dividends.” Additionally, MarketWatch’s Herb Greenberg has written two articles - “Is Cornerstone Just Giving Back Money?” and “The Return of Cornerstone" - which have had, at best, a temporary impact on investors’ awareness and today’s premium is near an all time high. Historically, once investors realize what they own they dump the security. However, like moths to a flame, new investors are continually attracted to CRF’s misleading dividend yield. A glance at the chart below should make Cornerstone’s situation clear.
click to enlarge
The articles mention Cornerstone’s NAV return has underperformed its benchmark, the S&P 500 Index. What is amazing is that Cornerstone Total Return Fund’s NAV return has under-performed its benchmark every quarter for four years. The table below shows quarterly NAV returns of Cornerstone Total Return Fund vs. iShares’ S&P 500 Index Fund.
Year-to-date through September 30, 2006, Cornerstone’s NAV return has underperformed its benchmark by 3.11 percent. During the past four years the average annualized underperformance has been nearly 3 percent - 80 percent of all funds in its category have performed better since 2003 [the first complete year Cornerstone was purely an equity fund].
Cornerstone’s Board of Directors has stated:
“The main goal of the Fund’s investment manager…has been to…outperform our benchmark.”
[From SEC FORM N-30D for December 31, 2002]
Poor history aside, future out-performance will be difficult considering significant portions of Cornerstone’s operating costs for managing the Fund are fixed. As a result, Cornerstone’s decreasing asset base has increased its annual expense ratio to 1.58% for the six months ending June 30, 2006 from 1.50%, 1.43% and 1.23% for the years ending December 31, 2005, 2004 and 2003, respectively [from SEC FORM N-CRS for June 30, 2006]. This trend will likely continue to adversely impact future NAV returns.
Edwin Meese III, formerly the US Attorney General under President Ronald Regan, and his fellow Board of Directors at the Cornerstone Funds, CRF and CLM, have claimed that their “innovative” and “aggressive” fixed distribution policy is in the best interest of shareholders [from SEC FORM N-CRS for December 31, 2003]. That may be true for investors that purchased shares at a discount to NAV and sold them at a premium. [The largest beneficiary has been Ronald Olin and his investment advisory firm Doliver Capital Advisors, Inc., formerly known as Deep Discount Advisors. Olin’s brother-in-law, Ralph Bradshaw, is the current portfolio manager, President and a Director for both Cornerstone Funds.] Unsuspecting shareholders that pay premium prices may not fair as well.
In spite of the Fund’s management setting noble goals the reality is clear: performance matters. Ultimately the dividend will be cut or the fund will be liquidated and, if either happens, Cornerstone’s premium will collapse.
If history can be any guide, consider what happened to closed-end fund MFS Special Value Trust (NYSE:MFV) shareholders on December 13, 2001, when the Trust issued a press release stating that the fund would review its options regarding their fixed distribution policy in order to avoid liquidation. Shares slid sharply on the news, falling $5.49, or 35.8%, to close at $9.86. Shortly thereafter shares traded lower, ultimately to a low of $7.18 per share, which was a discount to NAV.
At the time of the MFS Special Value Trust debacle, the closed-end Trust’s NAV was approximately $8.93 per share and the fund was distributing $1.65 per year – its distribution rate was 18.5 % of NAV per year. On the day prior to the press release the market price was $15.35 per share, a 72% premium to NAV. CRF's current vital statistics are more precarious.
Cornerstone’s Board of Directors have also stated:
“It is the goal of the Fund to have its long term investment returns match or exceed these [fixed] distributions.”
[From Business Wire Press Release, August 9, 2006]
Is this second goal even remotely achievable given its underperformance and a distribution rate that is adjusted annually to 21 percent of NAV? Let’s take a closer look…
When Ralph Bradshaw took over the helm as portfolio manager on January 1, 2002, the Fund initiated an aggressive fixed distribution policy. With NAV at $18.30 per share, it began to distribute at a rate of $1.98 per share annually. It raised the annual distribution to $2.11 in 2003. By June 30, 2006 the Fund had disbursed a total of $9.25 per share.
However, given its poor returns relative to its payout rate, 95 percent of distributions have in fact been a return of capital - only $0.49 of the $9.25 has been actual investment income [ from SEC FORM N-CRS for June 30, 2006]. The Funds current NAV of $10.23 [as of December 8, 2006] is accordingly a shadow of its former self.
The effect of Cornerstone’s liquidating distributions becomes clear with one look at the NAV trend line in the following chart.
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If the Fund continued to distribute $2.11 per share each year, NAV would fall at an accelerating rate and Cornerstone would likely be completely liquidated in five to seven years, if not sooner. The following table projects how long it would take for Cornerstone to completely liquidate given various assumed NAV investment returns at the current distribution rate. Read this keeping in mind that Bradshaw has achieved annual returns of only 3 percent since taking over the fund.
In order to slow down CRF’s rapidly accelerating rate of liquidation, the board of directors needed to modify the distribution policy, hence the new policy. Logically, by cutting future dividends, the fund’s life will be prolonged.
Additionally, in order to slow the outflow of capital resulting from CRF’s aggressive distribution policy, Ralph Bradshaw has tried hard to convince shareholders to reinvest dividends. The heavy promotion of the reinvestment plan has doubled participation in the reinvestment plan.
His sales pitch makes no sense, however, for any shareholder that thinks through the circular logic of his argument. In order for reinvestment to make sense an investor would have to be confident that CRF’s market price premium to NAV will continue to increase, essentially forever [which is only possible through the greater fool theory of investing]. If the premium to NAV stays constant, investment returns will exactly equal the underlying NAV returns. If the premium to NAV collapses to zero, investors will recover no more than NAV, which will prove to be a very bad investment.
The major benefactor of the new distribution policy and reinvestment plan is Cornerstone Advisors [Bradshaw’s management company] as it has slowed the decline in total assets under management, upon which a management fee is collected.
In the future, it is likely that Cornerstone shareholders will have to deal with the harsh reality that their fund does not deserve to trade at a premium to NAV. Had Cornerstone’s new distribution policy been in place since Ralph Bradshaw took the helm in January of 2002, the dividend would have been cut each and every year. I suspect that future dividend cuts will result in CRF trading at a price much closer to NAV than it does now. It is very possible that the fund will even at a discount.
Since 2002 Ralph Bradshaw, Edwin Meese and their fellow Board members have been determined to increase CRF’s market price premium to NAV. As a result of many years of the Board of Directors’ unwavering commitment to an aggressive fixed distribution policy regardless of investment returns the board has achieved its objective. The problem is that this is not in the best interest of long term shareholders. Ultimately, innocent shareholders who purchased shares at inflated prices will be left holding the bag. If the premium to NAV collapsed today, investors would recovery just $10.23 per share. That is only 52 percent of the current market price of $19.70.
Disclosure: Author is short CRF.