Fundamental analysis appears to be a sub-optimal valuation technique for investing in publicly-traded shares of closed-end funds ("CEF"). Key concepts of fundamental analysis such as "intrinsic value" and "earnings yield" plays a much smaller role for professional investors participating in this stock market segment. In fact, we believe that CEF share price valuation has more in common with underlying concepts of technical analysis.
Based on fundamental analysis, The Adams Express Company (ADX) should be a "buy" and Gabelli Utility Trust (GUT) should be a "sell", but "Mr. CEF Market" appears not to currently support that conclusion. (See analysis below)
Failure of Fundamental Analyses: We believe fundamental analysis fails to ascribe accurate share price value expectations for CEFs on two key fundamental concepts.
- Intrinsic Value: This concept attempts to value a stock based upon alternate methods of enterprise valuation (managed assets in the case of investment companies), i.e., discounted cash flow, private market's values, enterprise cost replication, comparable assets valuation, etc. If intrinsic value were the only criterion, then CEFs would trade much closer to their net asset value ("NAV"), which in most cases is calculated and posted on a daily basis. For those CEFs that hold highly-liquid securities, intrinsic value is highly-tangible.
- Earnings Yield: CEFs are investment companies. By definition CEFs must payout their earnings (net investment income and capital gains) in the form of distributions to their shareholders annually in order to maintain their conduit status, i.e., pay no entity level taxes on the earning they distribute.
The Envelope Please: In the case of the former (intrinsic value), CEFs trade at premiums and discounts that range from a premium high of 74% to a discount low of 26%, and everything in between. While an argument can be made that premiums and discounts reflect other aspects of a CEF's profile, CEFs are some of the most transparent securities available to investors with respect to their underlying value. Such wide ranges of market valuations negate the concept of intrinsic value for CEFs. Even in the staid investment grade bonds CEF fund type (InvGrdBndFnds), the premium/discount ranges from a premium of 14% to a discount of 11%.
Shell Game: Because of a CEF's conduit status, CEFs appeal to investors seeking steady income. Yet, distributions being paid to investors may not be true earnings. In many cases, distributions from earnings are augmented with distributions that represent a return of the shareholders' capital. Such combined, nominal yields are routinely posted on financial news services thereby misleading investors regarding the true return on their invested capital.
Here again, fundamental analysis fails to rationalized the share prices of CEFs with large components of return-of-capital ("ROC") distributions. In fact, we have reported that many of the highest yielding CEFs paying a large return-of-capital component are also those with the highest premiums. This represents, in our opinion, a financial oxymoron. (We refer you to our article entitled, "PCEF: How Marginal CEF Investors Can Avoid Being 'Gamed'", April 24, 2012)
"Fundamental" Distortion of Value: One of the many examples of the failure of fundamental analysis is a comparison of the Adams Express Company with Gabelli Utility Trust (GUT). Both are CEFs with long track records and pay attractive distributions. Yet their valuations are at odds with fundamental analyses.
For past 5 years The Adams Express Company has traded at a considerable discount of 14.7%. This is despite the fact that its management has done a workmanlike job of investing its assets. Yet, a CEF like Gabelli Utility Trust has traded at a consistent premium of 36.3% for the same time period.
As the chart demonstrates, over the past 5 years, ADX has cumulatively distributed $3.48 per share of earned income and capital gains versus only $0.97 per share for GUT. Based upon the share price at the beginning of the period, that yield is only 9.7% for GUT versus 21.9% for ADX. More importantly, based on NAV the total earnings yield for GUT is 11.2% versus 19.1% for ADX. This latter metric is a better indicator of management's investment prowess.
With Mirrors: GUT has been able to maintain a higher nominal yield through distribution of return-of-capital to shareholders which represented 72% of its total distribution for the period. (Unlike real estate securities, utility stocks typically don't generate non-cash earnings.) This accounts for GUT's NAV declining 35.8% during this 5 year period versus a lesser decline of 25.3% for ADX. However, this translates into a much lesser decline in GUT's share price of 19.8% during the period versus ADX greater decline of 26.0%.
Is There Better CEF Valuation Methodology? We have found valuation of CEFs share prices has more in common with technical analysis than with fundamental analysis. In technical analysis, participants agree on a certain set of historical facts and their likely impact on stock valuation, i.e., a "head and shoulders", "double bottom", "blow-off top", etc.-in absence of any fundamental input. Some technical traders trade stocks not knowing their underlying business. It is the fact investors agree on "cause and effect" that creates a fulfillment of expectations.
To a certain degree, like technical analysis, CEF prices seemed to be based on historical valuations upon which investors in this tight institutional community agree. GUT seems to trade at a premium because it historically has and investors expect it to in the future; ADX, on the other hand, seems to trade a discount for the same reason with different results. Yet, an average 5 year premium/discount spread between the two of over 50% seems indefensible based on fundamentals.
A Conspiracy Theory: Everyone loves a good conspiracy theory because it provides a simple explanation (a "conspiracy") for an unsatisfying account of the cause of a particular event(s). In our case, an alternative share price valuation mechanism for CEFs is based on what we perceive is a failure of fundamental analyses to accurately set share price valuations. When we review CEFs like the Cornerstone advised funds, Cornerstone Total Return Fund (CRF), Cornerstone Progressive Return Fund (CFP) and Cornerstone Strategic Value Fund (CLM), we're convinced that fundamentals play a "back seat" to investors' expectation that the past is prologue-particularly for a CEF's relative historical premium/discount.
Been There, Done That: We have researched and traded other small market segments where a small group of institutional investors have effectively set securities prices-particularly on IPO's and follow-on offerings. Their shadow on these stock prices is not so much through collusion but through careful observance of pricing algorithms. Effectively, a few institutional investors can create the technical basis for trading securities with in certain bands. These pricing algorithms are then perpetuated and expectations become a reality for the broader CEF trading community.
No "Byes": In my tour of Wall Street, the best analysts and investors were skeptics. Even in the face of high-pitch criticism, they took nothing for granted and explored alternative logic trying to make the facts "talk". Nothing and no one gets a "bye" in this business! For a reminder of this fundamental principle, I provide exhibit "1" and "2" exemplified recently with the "Banking King" and the "greatest IPO ever" disappointing investors.
Remember, as both Joseph Heller wrote in his novel, "Catch-22", and later Kurt Cobain incorporated into his lyrics, "Just because you're paranoid doesn't mean they aren't after you".