People are funny. Suppose an airline company made a big point of advertising that it had been flying the same airplanes since 1929, or that an elevator installer boasted about having used the same motors and cables for the last eighty years. Not such great selling points, you would think. But when it comes to investments, the age of a vehicle is supposed to make up for its mediocre performance by wrapping it in the glow of tradition.
At least that's the pitch from the board and management at Adams Express Company (ADX) as they urge shareholders to vote against proposal #3 on the proxy for this year's annual meeting. The proposal, sponsored by the Gramercy hedge fund group, asks the board to authorize a self-tender offer for 50% of the shares at or near net asset value, and to consider liquidation - merger or open-ending - if more than half the shares are tendered.
Gramercy's argument is a straightforward appeal to investor self-interest: ADX has persistently traded 13% or more below the net value of its portfolio of large, liquid equities, and $100 cash in hand beats $87 worth of ADX shares. To repeat, at least for any investor with a touch of rationality, $100 cash in hand beats $87 worth of stock in ADX, just about any time, anywhere.
The folks in charge at ADX naturally see proposal #3 as a threat to their comfortable status quo. Their first response was to engage the Venable law firm - the proponents of the Roach Motel approach to investing - and try to persuade the SEC staff that shareholders shouldn't be allowed to vote on Gramercy's proposal. Venable's attorneys proceeded to shovel forth ten pages of single-spaced argument (billed, no doubt, to ADX and paid from shareholder assets), but the SEC staff sensibly ruled (.pdf) that the proposal could remain on the proxy ballot with only minor changes.
So now the board and managers at ADX must attempt to persuade the shareholders to vote against their own manifest self interest. The proxy "Statement of Opposition" drones the usual litany: Buzz ... "long-term investors" ... buzz ... "activist hedge fund" ... "opportunist" ... buzz ... "destroying the company" ... buzz ... "coercion"... " foisted"... "not prudent"... buzz, etc. Using upside down logic, it claims that discounts are good for shareholders because they can buy assets for pennies on the dollar. [The fallacy here is that anyone, not just current shareholders, can buy at a discount, but the value lost for those who sell at a discount weighs entirely on those already owning shares.]
Two aspects of this proxy fight deserve attention: performance claims and psychological appeals. Gramercy called ADX's portfolio performance "mediocre" compared to the S&P 500 benchmark. The board responded by attacking Gramercy's calculations as "flawed", and proffering other figures indicating that ADX had generated "competitive" returns. At issue is the way a closed-end fund like ADX should handle reinvested dividends when calculating the performance of the portfolio - the return on asset value, rather than on the market price.
ADX, like many CEFs, exploits an accounting loophole that juices up reported returns: it uses discounted market prices when calculating the buying power of reinvested dividends but switches to the higher net asset value when calculating what the acquired shares would be worth at year end. Gramercy's "flaw", it turns out, was in consistently using net asset value for both parts of the calculation, while ADX prefers to switch apples for oranges.
Example: A CEF starts with net assets of $1,000. It has 100 shares outstanding (NAV $10 each) and consistently trades at a 20% discount. Each year it has an income of $100, which it distributes at year end, so each share gets $1 and NAV is again $10.
Question: What is the CEF's "total return based on NAV"?
Gramercy: "If the $100 had been reinvested at NAV, the CEF would have had 110 shares and $1,100 in assets. Going from $1,000 to $1,100 is a 10% return."
ADX's answer: "No, no, no. Flawed. The stock price was $8/sh at year-end, so that $100 distribution could have bought 12.5 shares at the market price. And because NAV at year-end is $10 per share, the asset value of those shares would be $125. Compared to the $1,000 at the start of the year, that's a 12.5% 'total return based on NAV'."
ADX's approach is legal, although not all funds do it this way, and the SEC staff has bigger things to deal with than fixing the glitches that result from applying mutual fund accounting rules in the closed-end context. Note one side effect of using the ADX method: the bigger the discount, the better the apparent performance. Had the CEF traded at a 50% discount, that $100 distribution could have bought 20 shares at market, and allowed the portfolio manager to brag about a 20% "total return based on NAV". In the case of ADX itself, which has typically distributed at 6% per year while trading at a 15% discount, its chosen method has added about 1% per year to reported returns. Compounded. It adds up.
So what do the numbers look like? ADX has filed on EDGAR since 1996, and its early N-30Ds include 15 year retrospectives, so we can track yearly "total return at market" and the claimed "total return at NAV" from 1982 to the start of 2011. How does ADX compare to the S&P 500? How about the S&P 500 minus the 20 basis points that a reasonably efficient ETF might charge? What about some simple measure of risk, such as the standard deviation of annual returns?
Looks like ADX is pretty close to being a proxy for the S&P 500. It's done a tiny bit worse, on the average, and is a teeny bit riskier. Those little bits do add up over time: for example, $100 invested in ADX at market in 1991 would be valued at $502 at the start of this year, while a S&P ETF would have grown to about $553. But if you ask, does ADX offer anything unique, anything that makes $87 worth of ADX stock better than $100 in cash or in index ETF shares, it's pretty clear that the answer is "no". Like an airplane or an elevator, an investment company is a vehicle, a means to get where you want to go, and ADX is just plain obsolete.
When logic fails, try appealing to emotion, and for ADX, that means nostalgic tradition. "The company has a long-term investment focus and has been structured as a closed-end fund since 1929. Stockholders have benefited from this structure for over 80 years." Why else would the cover of the 2010 Annual Report picture baby hands, a playful child, a happy family and elder ladies enjoying their Golden Pond years?
Years ago, such a sentimental appeal to the seniors would have been a sure winner. The Venable firm's letter (.pdf) to the SEC says:
In a 1999 survey, Adams Express found that approximately two-thirds of its stockholders have held their shares for ten or more years and over 77% of the stockholders are 65 or older.
But the times they are a-changing. The latest round of 13F reports showed institutions holding 16.7% of ADX's 89 million shares, led by Gramercy (2.57 mm shares worth about $30 million), along with other names familiar to CEF activists, such as Lazard (2.2 mm shares), Karpus (2 mm shares), 1607 Capital (560K shares), Doliver (450K shares), and the like. Appeals to sentiment have less effect on these shareholders. And if the original founder of Adams Express, a flint-faced New England Yankee named Alvin Adams, were to return to our world, he might well join in asking, "what good is a tradition of consistent mediocrity masquerading as prudence?
Disclosure: I am long ADX.