Seeking Alpha

Rights Offering, 2011 Version: Time to Sell Cornerstone Management

Includes: CLM, CRF
by: Aristides Capital
Aristides Capital
Long/short equity, Deep Value, special situations, contrarian

We are short both Cornerstone Total Return Fund (NYSEMKT:CRF) and Cornerstone Strategic Value (NYSEMKT:CLM).

Cornerstone Total Return Fund (CRF) and Cornerstone Strategic Value (CLM) are two closed-ends funds that pay a large "dividend" stream to investors which typically consists mainly of the investors' own capital. Because many investors are hungry for yield, these funds have often traded at a large premium to their underlying net asset value (NAV).

Currently, investors in these funds are paying more than $1.40 for each underlying dollar of assets held by the funds. Only two closed-end funds trade at comparable premiums, PIMCO High Income (NYSE:PHK) and PIMCO Global StocksPlus and Income (NYSE:PGP). The PIMCO funds have an annualized trailing 5-year net return (by NAV) of 9.77% and 10.61%, respectively. In contrast, CRF and CLM sport an annualized trailing 5-year return (by NAV) of 1.10% and 1.78%.

I suspect that most investors in the Cornerstone funds simply don't realize that they are, in essence, paying $140 (or more) for $100 worth of stocks, managed by a mediocre fund manager, who invests their capital in fairly average equity investments, racks up annual expense ratios of 1.74% (CLM) to 2.36% (CRF), and then returns $21 to the investor each year (about $1.75 each month), which is largely generated by selling some of that $100 worth of stocks.

The end-game for such a fund is obvious. Unless the fund manager chooses investments very well and generates extremely high returns (which is clearly not the case with Cornerstone), the fund's asset base will shrink year after year until (1) the fund slashes its monthly payout to slow the shrinkage, or else (2) the fund shrinks so much that it decides to close. Unless, of course, the fund can find new suckers--oops, I mean investors--to buy new shares directly from the fund company at a price above their net asset value.

Cornerstone has mastered the art of selling new shares of CLM and CRF. What knowledgeable investor in their right mind would they sell these shares to? Why none, of course. So they don't sell to knowledgeable investors--they sell to the current owners of CLM and CRF, using a rights offering.

In 2010, Cornerstone announced a rights offering for CLM and CRF shares, which ultimately gave holders the right to add to their position at a 10% discount to the market price, which was still a significant premium to NAV. From June 28, 2010, when the preliminary SEC filing was made, to December 10, 2010, when the rights offerings were completed, the market price of CLM fell from 10.61 to 9.15 (an 8.1% drop when adjusted for dividends) and the price of CRF fell from 10.37 to 8.03 (a 17.9% drop adjusted for dividends). Meanwhile, the S&P 500, which is reasonably similar to the fund's holdings, gained 16.4% over the same time period.

Those who owned CRF and CLM shares when the rights offerings were filed, and did not recognize the bright red flashing "SELL" sign, saw their holdings underperform the market by 24 percentage points or 34 percentage points, respectively, in the next four and a half months. Ouch.

The academic literature offers ample evidence of high premium closed-end funds severely underperforming during a rights offering, so this underperformance should not have come as a surprise to anyone paying attention.

Last year's rights offering was poorly subscribed (surprise, surprise, surprise), and now it's another year, and Cornerstone's management has to figure out how to get their funds' dwindling asset base back up. So, after the close of June 28 (CRF) and during the trading day on June 29 (CLM), Cornerstone has filed with the SEC for two new rights offerings which will be nearly identical in form to the 2010 version.

What do you think is going to happen to the shares in the next four months?

So, we are short CLM and CRF. I wouldn't recommend that anyone try to follow our trade. The shares are hard to borrow, and the cost of borrowing them is high. Because of the danger involved, it is a very small position for us.

If, on the other hand, I were long CLM and CRF today, it would be a very easy decision to sell them any day the market is open. If you must own CLM and CRF (WHY?), then why not keep 100 shares, participate in the rights offering, and oversubscribe for as many shares as you'd like? If this rights offering goes anything like the last one, you'll be able to get as many shares as you want at much less objectionable prices.

Disclosure: I am short CLM, CRF.