Background Adams Express Company (NYSE:ADX) is a medium large ($1.5bb) closed-end fund that invests in large-cap US equities. It was founded in 1854 as an express delivery business, and has been a CEF since 1929. (For the back-story on ADX's attempt to portray its obsolete business model as a vintage heirloom, see "Old and In The Way.")
ADX has long traded at a large discount to asset value (currently 14.5%) because it performs like a mediocre large-cap index fund 1, and because the folks in charge seem to think that big discounts are good for the current owners2. In 2011, a shareholder proxy proposal for a 50% self-tender received support from a respectable 14.2% of all shares: 40.3% voted "No," and 45.5% abstained, weren't instructed, or just didn't show up.
Unlike most CEFs, ADX is managed "internally" by its own hired officers and employees rather than by an outside investment advisory firm. Its holdings include 8.2% of Petroleum & Resources (NYSE:PEO) an $800mm energy sector CEF that also trades at a steep discount. The two funds share Directors, top officers and some overhead expenses. (ADX's stake in PEO predates the Investment Company Act of 1940, which added rules that discourage CE's from acquiring significant positions in each other.)
The Proposal: The 1940 Act also says that funds may not grant stock options, issue stock for services, sell shares below net asset value (except to existing holders), or let "affiliated persons" participate in stock purchase plans, unless the SEC grants an exemption as "appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the Act's policy and provisions." Both funds currently operate Executive Incentive Compensation plans under exemptions dating from 2005 that will expire next year. So on April 22, 2014 counsel filed a 124-page application seeking new exemptions for an expanded menu of manager incentives. (This article focuses on the ADX plan; the PEO plan is its twin.)3
Under this plan, about 4 million new shares (94 million are now outstanding) would be available during the next 5 years for the Board's Compensation Committee to award to the five officers (who are also PEO officers) and some of the 13 other employees (10 also work at PEO). The seven outside Directors (who are also the Board at PEO) would have 25% of their base fees paid in restricted stock with one-year vesting. Newly issued shares would earn dividends and receive capital gain distributions like those already outstanding, even if the new shares are later forfeited.
The proposal is vague on key structural details, leaving them for future Committee decision. The equity incentives, for instance, could take several forms, including
- At-the-money options, exercisable at times to be determined
- Stock appreciation rights, on terms to be determined
- Restricted stock with 3-year vesting
- Restricted Stock Units with 3-year vesting
- Deferred Stock Units
- A mixture of cash awards and stock, and
- Vested Bonus Stock
In order to avoid tax tangles with the "excessive employee remuneration" rules under Tax Code Section 162(m)4, some stock awards must be linked to "performance" targets. The time frame for measuring "performance" might be as short as one year or as long as ten: the plan leaves it to the Committee to decide. And when they forge the measuring rod for "performance," the Committee may pick, choose and permute from a long list of "business criteria":
"(1) return on net assets, return on assets, return on investment, return on capital, return on equity; (2) economic value added; (3) operating margin; (4) net income, pretax earnings, pretax earnings before interest, depreciation, amortization and/or incentive compensation, pretax operating earnings, operating earnings; (5) total stockholder return; (6) performance of managed funds; (7) increase in market share or assets under management; (8) reduction in costs; (9) expense ratios; (10) amount of net assets under management; (11) net asset value; (12) increase in the Fair Market Value of Common Stock; and (13) any of the above goals as compared to the performance of the Standard & Poor's 500 Stock Index or any other published index deemed applicable by the Committee." (Application, plan attachment Section 8.B.2)
With so many details missing, the best way to gauge the proposal is to look at how the current ADX plan works in practice.
The Current Plan: Lots of Incentives… It's not easy to spot the performance targets or discern how they are linked to the equity rewards. They are barely visible, wrapped in opaque wording with a Flesch readability score close to zero, in the middle of footnote 10 on page 14 of the most recent proxy5. The money quote:
"…. The target shares (the target number is shown in the Grants of Plan-Based Awards table below) will vest after three years if, on January 1 of the year in which they vest, the Company's three year total net asset value ("NAV") return meets or exceeds the three year total return of a hypothetical portfolio comprised of a 50/50 blend of the S&P 500 Index and the Lipper Large-Cap Core Mutual Funds Average ("Hypothetical Portfolio"), with a lesser percentage or no shares being earned if the Company's total NAV return trails that of the Hypothetical Portfolio, depending on the level of under-performance on that date. In addition, if, on that date, the Company's three year total NAV return exceeds that of the Hypothetical Portfolio, an additional number of shares ("additional shares") (the maximum number of additional shares is included in the Maximum column in the Grants of Plan-Based Awards table below) will be earned and vest, depending on the level of outperformance."
The Award table shows a grant of 3,062 restricted shares to a continuing officer. Two-thirds, i.e. 2,041 shares will vest (that is, be owned free and clear) if the fund's total NAV return through 1/1/2016 matches the return of the S&P 500 index averaged with the Lipper Largecap Core index. NAV returns above this average would vest more shares, in some undisclosed proportion, up to a maximum of 1,021. Lagging the market will reduce the number that vest, but things would have to be really bad for all to be lost. For example, even though the 44.6% return of ADX for 2011 to 2013 was well behind the 56% of the S&P 500, 63.8% of the targeted shares still vested.
In Other Words, "Pay for performance" at ADX means Match the Market. How hard is it to match (or almost match) the market?
In the words of Professor Malkiel ("Mr. Random Walk") "a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts." Others agree. See "Can Monkeys Pick Stocks Better than Experts?," "The Long-Term Value of Analysts' Advice in the Wall Street Journal's Investment Dartboard Contest," and "Excess returns of large-cap US portfolio managers are random in the aggregate."
|Warning: Don't Try This at Home!|
|Since monkeys are known for slinging poo as well as darts, most investors would be better off paying 5 basis points a year to cover operations at an index ETF such as Vanguard's S&P 500 (NYVOO). The savings on dry cleaning bills alone could easily justify the cost.|
The Current Plan: … But Not Much Performance ADX says it needs to dilute current investors in order to compete for investment talent. But its officers win 2/3rds of the maximum equity grant if the fund performs as well as a chimpanzee with a dartboard, and they still get rewarded when the fund lags behind.
The fund's recent midyear report sounds a positive note: for the most recent 12 months ADX returned 24.9% vs. 24.6% for the S&P 500. Shareholders should hope that this is the result of skill, rather than luck, but it could be the normal statistical dispersion of returns. (Historically, ADX leads the S&P 500 about one-third of the time, but still lags overall, like the high rollers who never quite beat the casino.)
And there's something odd about those "return on net asset value" figures. The numbers ADX reports are higher - typically by 100 to 200 basis points a year - than those shown on independent third-party sites. Morningstar pegs ADX's total NAV return for the last 12 months at 23.81%, not 24.9%. For all of 2013 CEF-connect shows 28.5%, though ADX claims 29.7%, and for 2012 CEF-connect says 13.6%, while ADX has 14.7%.
ADX, it seems, calculates "performance" in a way that combines its portfolio returns with the asset value that gets shifted among investors when some reinvest distributions and get new shares issued at discounted market prices, while others take cash and have per share asset value diluted by the new issue. Closed-end discounts can produce shareholder returns that exceed those enjoyed by the fund itself, and mixing one with the other moves the targets a little closer. (Here's more explanation of the way this legerdemain can add to reported returns.)
Myths and Legends The pending application to the SEC doesn't offer empirical facts about compensation or mention efficient markets. It tries instead to justify diluting the equity of ADX investors by rhetorical assertions that amount to: "We're doing it to protect you, in the public interest, in lots and lots of ways." Such as:
A) Since the new plan would only water existing shares by 3.85%, "The Applicants believe that the potential dilutive impact would not be significant." (Application, p. 44) What a silly belief! Try asking your broker or banker for an "insignificant" portion of their net worth, "say, 4% or so," and watch their reaction. Us primates ain't that stupid.
B) The plan might "attract talented professionals who enhance management of the Applicants' assets, thus increasing the value of the Applicants' assets and enhancing stockholders' interests." (id.) And it might not. ADX assumes that it can do something that portfolio theory, as well as its own history, says is very hard to do: identify in advance the managers who are most likely to beat the market in order to hire them. It's another version of the "You get what you pay for" myth. To be sure, markets are not perfectly efficient. But if ADX is not able to distinguish the results of talent from luck, or if it can't pick out tomorrow's winners from the pool of applicants, then high-powered manager compensation is simply a waste of the shareholders' money.
And what about the competition? Even if it's possible to predict who the superstars will be, won't the banks, brokers and management companies that are less constrained by the 1940 Act simply outbid ADX? In a business where asset gathering is the key to fees and where there are economies of scale in overhead costs, a closed end fund is inherently at a disadvantage in bidding for "talent," because its asset base is relatively fixed. That may be why, according to a recent academic study, CEF managers with the worst performance records tend to stay on the longest:
"Long manager tenure weakens the impact of poor NAV performance on the probabilities of manager departure and fee decreases, and is associated with poor NAV performance and more persistent fund discounts. These findings suggest that CEF shareholders have little capacity to extract rents from skilled managers, and have difficulty in disciplining unskilled managers."6
High pay itself, it seems, can also undermine performance. Another recent study found:
"… [E]vidence that CEO pay is negatively related to future stock returns for periods up to three years after sorting on pay…. Our results appear to be driven by high-pay induced CEO overconfidence that leads to shareholder wealth losses from activities such as overinvestment and value-destroying mergers and acquisitions."7
C) "But," sputters counsel, "We have safeguards." (Application, p. 45) "There's the Compensation Committee" (chuckle… ) "and 4% dilution is less than we or anyone else got away with in the past" (… giggle, giggle…) "and we'll send the stockholders a concise "Plain English" description of the plan and ask them to approve it." (… uproarious laughter, as copies of footnote 10 on page 14 of that recent proxy rain down like cheap confetti.)
And what about risk? Doesn't targeting returns leave out half of the "risk/reward" equation? The application tells us not to worry about managers trying to "game" the performance standards and maximize their awards through speculative investments because "We have a conservative philosophy … and speculative portfolio trading is inconsistent with this strategy."
This sounds nice - but philosophy can be more solace than safeguard. For example, consider the portfolio back at the start of 2001. Scattered among the blue chips were firms on the verge of fraudulent implosion, such as Enron ($41,562,500), Worldcom ($7,700,000) and Global Crossing ($15,082,250), accompanied by soon-to-be troubled Qwest ($39,782,500), Calpine ($36,627,814), DiamondCluster International ($9,150,000), Nortel Networks ($47,773,125) and Corning ($61,790,625). All apparently consistent with the philosophy of preserving capital, reasonable income and opportunities for gain.
Conclusion: A thought-provoking article recently suggested that the asset management industry is ripe for disruption, because:
"[T]the asset management industry collectively plays a near-zero-sum game. Each new investor tends to raise valuations and lower returns for all the other competitive investors. It is mathematically impossible for the median investor to beat a low-cost index, after expenses."
Yet at present: "Asset managers can earn far more money at less risk than in any other industry."
ADX is a good example. If no one asks the SEC for a hearing, the application will be rubber-stamped as "unopposed." But facts, rather than myths, should be the guide in deciding whether the new incentive plan is or is not "in the public interest and consistent with the protection of investors."
'Gwailo (long ADX since 2006)
1 ADX says it invests for "preservation of capital, the attainment of reasonable income from investments, and an opportunity for capital appreciation" - which is about as meaningful as saying "Buy stocks that go up. If they don't go up, don't buy them."
Morningstar shows ADX highly correlated with the S&P 500 (R^2 of 98.83 over 3 years and 97.27 over 10 years), but with generally lower returns (Alpha -3.81 over 3 years and -1.01 over 10), volatility the same or higher, and with a lagging Sharpe reward/risk ratio. While these numbers appear based on market prices, a rough analysis using NAVs is similar -- NAV is very highly correlated with the index, lags by a bit over 1% per year on average, and is about equally volatile. See also CEFAnalyzer.com (99.15% one-year total return correlation with Largecap Blend benchmark)
2 See Def14A 2/18/2011 at p. 24 and DefA14A 3/17/11 "We strongly disagree with your statement that the Board has an implicit duty to narrow the discount. There is no such duty imposed under Federal or Maryland law."
Seeking Alpha commentator Adam Alosi also concluded:
"This management, like many other closed-end fund managers, seems keen on collecting its fee and not keen on taking demonstrable steps to narrow the discount. Thus, I think the market, given the fairly uninspired nature of Adams Express, has it about right with the currently applied discount."
3 The text of the application is almost identical with a year 2012 filing by a different CEF, Central Securities (NCET), which also sought permission to offer restricted stock etc. to managers. Through dozens of paragraphs the only difference is the reference to "Applicants" instead of "Applicant." Since "copyright inheres in the work," it would appear that CET's counsel (Kevin C. Smith. Esq. of Chadbourne & Parke LLP) might well have potential copyright infringement claims against ADX's counsel (Kevin C. Smith, Esq. of Chadbourne & Parke LLP). The reputed tenacity of the attorneys at Chadbourne, a white-shoe firm founded in 1902, should make for some dazzling legal maneuvers if the matter is litigated.
4 For those who don't already know why companies prefer to avoid "excessive employee remuneration," consider the following dialog from the movie Ghostbusters (1984)
Dr. Egon Spengler: There's something very important I forgot to tell you.
Dr. Peter Venkman: What?
Dr. Egon Spengler: Don't cross the streams.
Dr. Peter Venkman: Why?
Dr. Egon Spengler: It would be bad.
Dr. Peter Venkman: I'm fuzzy on the whole good/bad thing. What do you mean, "bad"?
Dr. Egon Spengler: Try to imagine all life as you know it stopping instantaneously and every molecule in your body exploding at the speed of light.
Dr. Ray Stantz: Total protonic reversal.
Dr. Peter Venkman: Right. That's bad. Okay. All right. Important safety tip. Thanks, Egon
6 "Managerial Rents vs. Shareholder Value in Delegated Portfolio Management: The Case of Closed-End Funds" by Wu, Wurmers & Zechner.
7 "Performance for pay? The relation between CEO incentive compensation and future stock price performance" by Cooper, Gulen & Rau.
Disclosure: The author is long ADX, PEO, CET. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it. The author has no business relationship with any company whose stock is mentioned in this article.