In our previous article, "Sourcing PIMCO High Income Fund's Distributions" (4/19/12), the question was posed: Is the marginal CEF investor just focused on distribution yields to the exclusion of other important CEF metrics, such a premium/discount ("prem/disc")?
Based on anecdotal evidence we concluded the answer was "yes". This prompted a comment from one of our readers asking to provide some empirical evidence to support this supposition. This was a fair request.
Distribution Yield vs. Prem/Disc: The following chart is a scatter diagram of over 600 CEFs in our GrowthIncome CEF universe comparing each CEF's total annualized distribution yields to their respective prem/disc's. We then plotted a linear regression line through the data to illustrate that relationship.
(click to enlarge)
A Positive Match: If the line were flat, it would indicate there is no relationship between higher CEF yields and their respective higher prem/disc's. However, the line traversing through the data shows a positive slope. This indicates that there is a tendency for CEFs with higher yields to have "premium" valuations, i.e., lower discount or high premiums on a graduated scale.
Counterintuitive: This flies in the face of investment logic. An investor would want to buy a CEF at a discount. The thinking goes an investor is buying the stock for pennies on the NAV dollar-its underlying intrinsic value. Furthermore, this logic suggests that a CEF stock price that is selling at a discount would gravitate towards its NAV per share over time and investors would benefit from the closing of that price/NAV gap.
Reasons for this Positive Slope: Below we have listed a number or reasons why a CEF could enjoy a premium valuation.
1. The Marginal CEF Investor is a Putz: With current investment yields so low, retail investors are desperate to find attractive yields. As a result, many will buy the highest yielding stocks without doing any additional analysis. Because CEFs can distribute to its shareholders' a return-of-capital distribution, i.e., returning to you your own money after a management fee has been collected, distribution yields are "jacked-up" on a nominal reporting basis. (Most financial quotation services don't make the distinction between quoted yields that come from income and those that come from return-of-capital. Having said that, there are some legitimate return-of-capital distributions for some of the natural resource and real estate CEFs.)
2. Premium Valuations May Indicate Sector Momentum: Since stock prices anticipate economic events, a CEF stock could be anticipating the rise in the NAV and trade at a premium for a limited amount of time until the underlying value catches up.
3. Relative Discount More Important than Absolute: We find that premiums and discounts will gravitate towards what has been the historical relationship for that particular CEF. An absolute huge discount is not a necessarily a good indicator of its intrinsic value. Investors may have decided in the case of some CEFs, Adams Express Company (ADX) for example, that the stock is not worth its NAV. Conversely, we have seen CEFs trade at premiums for years. As a result, investors may become comfortable with a premium valuation-as long as the distribution level remains constant. A big important "if".
4. Quality of NAV Reporting: Both the valuation methodology and timing of a CEF's NAV can play a role in the determination of its premium or discount as some assets are difficult to value and some CEFs advisors don't provide timely NAVs.
5. Investors Focus on Historical Total Returns: Some investors will look at the immediately preceding total return and buy a CEF that has recently performed well based upon a belief that history will repeat itself. (This is the underlying foundation for the whole fund IPO business.)
6. Franchise Value of the Sponsor/Advisor. Many investors become comfortable with a particular sponsor and will "pay up" for the association.
Reason "1" is the only direct supportable explanation for the positive slope between high distribution yields and premium valuations. The other reasons for premium valuation are that they are driven by other non-distribution factors.
To paraphrase one of my favorite 20th century philosophers, Yogi Berra, as it relates to CEFs: the high yield/high premium phenomenon is 75% a function of uninformed, marginal CEF investors, the other half is something else. Our investment model for CEF valuations utilizes a multi-variable screen to weed out such noise.
Alternative for Marginal CEF Investors: CEF analysis is more complex than it may appear. It is not all about "yield". So, if you are not good enough to play a "winners' game", by being superior analysts and investors, play the "losers' game": just keep the "ball in play" and let your opponent make the mistake that will cause him to lose and for you to win.
Recommendation: So, for marginal CEF investors seeking attractive yields that do not have access to a knowledgeable advisor in this market segment, PowerShares CEF Income Composite Fund (PCEF) may be a reasonable alternative to "win" at the "loser game" for the following reasons:
1. It is an ETF that trades at its NAV, so you'll never be paying a premium relative to its holdings;
2. It offers diversification through its multiple CEF holdings of a CEF index that mitigate large CEF premiums allowing the average prem/disc of the index to gravitate to the sector mean which is currently at par;
3. It currently yields an attractive annualized monthly distribution of 8.2%.
There is an old saw in the investment business, "If you're sitting around a poker table and can't identify the "sucker", it's probably you".
Disclosure: I am long PCEF.