The Japan Smaller Capitalization Fund (NYSE:JOF) is a closed-end-fund which is in the process of issuing rights to its shareholders. The record date for receiving the rights was June 23, 2011, and the ex-rights day was June 21.
The day that JOF started trading ex-rights, the stock fell $.40, and is currently trading $.50 below the cum rights price.
The way the rights offering works is as follows: For every share owned, the owner will receive one right, and for every three rights, the owner will be allowed to purchase one share of the fund at a price determined by a formula. The formula for calculating the price at which one can exercise the rights looks at the average of the price on July 22, 2011, and each of the four preceding trading days and multiplies that number by 0.9. If that number is greater than 75% of the NAV of the fund on July 22, then that is the exercise price for the rights. If that number is less than 75% of the NAV, rights holders can exercise their rights for 75% of the NAV.
For example, if the NAV of JOF on July 22 is $9.18 (which it happened to be Wednesday night) and the closing prices of JOF for the past five days were 8.21, 8.24, 8.31, 7.92 and 7.86, then rights holders would be able to exercise their rights for $7.30. If the closing price for the past five trading days was $4, and NAV was still 9.18, rights holders would be allowed to exercise their rights for $6.89 because the exercise price can not be below 75% of the NAV.
If that is clear, I have a trading strategy to possibly take advantage of the recent move in the shares.
First of all, I would like to say that I own JOF now for the exact reason I will describe, and I am in no way trying to manipulate an illiquid security by writing this article. JOF only trades between 50,000 and 200,000 shares a day, so a large order can move the shares a fair amount. With that being said, JOF has historically traded at about a 5% discount to NAV, and I have no reason to believe that after all of the dust settles from this rights offering, JOF will trade at a larger discount than 5%. This is the underlying premise for the trade, so if you disagree with this premise, you will probably disagree with the trade.
I am assuming that the NAV remains fairly constant until July 22 at 9.18, and I buy the shares today at 7.86. If the shares continue to trade at 7.86 until July 22, then the rights will be exercised at 7.08 raising the fund’s net assets from 195 million to 245 million and the share count from 21.2 million to 28.3 million. Thus, after all of the rights are exercised, each share’s NAV will be $8.65, and a 5% discount would imply a share price of 8.22. That would be a $.36 profit or 4.5%. The other possibility could be that NAV remains constant and the share price completely collapses causing the rights to be exercised at 75% of NAV, resulting in an exercise price of 6.89. In this scenario, net assets will rise from 195 million to 243.8 million and share count will once again rise from 21.2 million to 28.3 million. In this scenario, NAV will fall to 8.60/share, and a 5% discount would imply a price of 8.18. This would result in a $.32 profit or 4%.
Usually, one has to wait until after the rights expiration to close the trade because many traders are arbitraging the fund’s shares with the rights which can distort the price of both until after the expiration. Of course, if the discount to NAV never converges to the historical discount, the trade will not work, but I have no reason to believe that it will not converge (It won’t be the first time I am wrong).
Since the above strategy assumes NAV will remain constant over the next month, and I don’t like that assumption, I have chosen to short the EWJ to hedge some of the exposure of the long position in JOF. I also like this strategy because I am much more optimistic on Japanese small caps than large caps, so I am essentially long Japanese small caps and short large caps while I am exploiting the mis-pricing in JOF.
Disclosure: I am long JOF.
Additional disclosure: I am short EWJ.