ADX: Year-End "Bonus" Coming Up

Summary

• ADX runs a rather plain portfolio, which is precisely what some investors might find appealing.
• The fund's discount is quite appealing at this time, although there aren't any catalysts to close it at this time.
• This year's year-end special distribution could be significantly higher than last year's based on the earnings over the previous nine months.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

Galeanu Mihai/iStock via Getty Images

Written by Nick Ackerman, co-produced by Stanford Chemist

Adams Diversified Equity Fund (NYSE:ADX) is amongst the oldest closed-end funds in existence today. In fact, it wasn't originally a CEF, but converted over to one in 1929. Originally, it was called Adams Express Company. Being around for this long means they've survived a market cycle or two before.

Though it might not be the most exciting fund, it has a relatively straightforward plain equity style portfolio. Besides the longevity and deep discount that this fund has going for itself, it also has a different approach to its distribution. They pay a minimum 6% annual distribution to shareholders based on the share price. However, this comes via small quarterly payments and is topped off by a sizeable year-end special.

As we head into the end of the year, shareholders are undoubtedly going to be looking forward to this payout. While the minimum annual target is 6%, they often pay over this amount. Last year came to a 6.8% distribution, though, in prior years, it has been materially more significant. They also tout the fact that they have paid 80+ years of distributions.

(Source - Fact Sheet)

Since CEFs can payout however much they want, there is no way to know precisely what they will pay. With ADX's approach, we at least know what the minimum could be anyway. Essentially, ADX could be viewed as a way to get an investor's year-end bonus that some might be familiar with in the employment world.

(Source - Adams Funds)

The Basics

• 1-Year Z-score: 039
• Discount: 13.75%
• Distribution Yield: 0.94% (based on the regular quarterly)
• Expense Ratio: 0.59%
• Leverage: N/A

Their investment objective is simply; "long-term capital appreciation." The investment policy is quite straightforward as well. They intend to meet this objective by "investing primarily in large U.S. companies." This makes it quite comparable to the S&P 500 ETF (SPY). Their returns are identical as well on some time frames. Below is comparing the two over the last five years.

Data by YCharts

...on the other hand, performance can slip over greater periods. Below is for the last 20 years.

Data by YCharts

Helping keep the performance relatively similar over some time frames is the fact that ADX has a very low expense ratio for a CEF. It comes in at just 0.59% versus the "simple average of all equity mutual funds" for the year ended 2020 of 1.16%.

The fund is quite massive, with over $2.721 billion in total managed assets. That generally provides plenty of daily average trading volume, which comes in at almost 133k shares traded daily. That's not terrible, considering the rather basic nature of this fund.

Performance - Strong Returns

The returns over the last decade certainly haven't disappointed as one would expect for being invested in large-cap U.S. names. Large-caps and U.S. investments have been the market leader over the previous decade-plus now. In fact, the tech-heavy portfolio that ADX carries has been the driving force behind most of the gains over the last several years.

Tech has been the sector leader for three of the last five years. For 2021, energy has been the dominant player, but that's because it did so poorly the last few, which is precisely the occasion that made it one of the best performers in 2016 - after a tremendously weak 2014 and 2015.

(Source - Novel Investor)

The YTD performance for ADX as of September 30th, 2021, was hampered by September being a downer month for most investments.

(Source - Fund Website)

With the markets rebounding throughout October, ADX's returns have also risen quite rapidly.

Data by YCharts

I guess the real question is, why invest in ADX rather than SPY? As we can see, the fund has been lagging SPY over more extended periods. Well, I think there are a couple of reasons for this.

The first is that the fund carries a deep discount. This might be less compelling as it has carried a deep discount for at least a couple of decades now. So there really isn't anything too compelling about that argument, at least not in the short term. It seems they are content with running the fund as is. That means no breaking the cycle of a deep discount, at least from the management team.

The chart below shows the fund's average discount going back to 1999.

Data by YCharts

One idea would be that if an activist ever attempted to make a move at this fund to help spur some interest, due to the size and the more volatile nature of equity positions, that generally keeps activists away. It can take several years for them to persuade the Board to see things their way.

The other argument about the discount would be the fact that it is right near its long-term average. At this time, most CEFs are well above their averages. We are seeing funds that have never traded at premiums do just that -- trade at premiums. This could mean that at least investors will be relatively sheltered from greater losses through discount expansion during the next downturn.

However, I think another reason that ADX is worth investing in is for the year-end special. It is a way to force investors to take profits. This is generally the case with all equity CEFs. They fund their high distributions through capital gains. That means they are taking profits over time and paying those profits out to investors.

Distribution - Year-End Incoming

As we've mentioned, this fund runs with a distribution plan that generates small quarterly payments. Then they make one large year-end special. They announce this special sometime in the first half of November, so we should get an announcement within the next couple of weeks.

(Source - CEFConnect)

The 6% minimum is factored in by the average month-end market price of the fund. This is a bit unusual as a lot of managed plans with specific targets are based on NAV. Either way, this allows us some insights into what the minimum distribution could be. As mentioned above, we won't know exactly what it is because they can payout however high they really want.

The average month-end share price for ADX for the trailing twelve months comes to $17.19. Since they will already have paid out $0.20 with their regular, that could mean a year-end of $0.8314. However, they would likely round it up or down. Again, that is just the minimum that the fund might announce. It could be as high as they would like it to be.

As of Q3, 2021, the fund has realized a significant amount of gains over its fiscal year. That could suggest that it might be quite a bit larger if they don't take losses to offset these gains.

(Source - Q3 Report, highlights from author)

According to their Semi-Annual Report, based on the prior full year, they paid out just shy of $112 million to shareholders. They almost constantly have the number of shares going up since they issue new shares for dividend reinvestment. Additionally, they have done share buybacks in the past. Finally, that figure includes the $0.88 special they paid out as well. All those factors make it hard to come up with an idea of what they will be paying exactly as we go forward.

That could suggest that based on the earnings we see in the fund so far, this year's special could be more than double what it was last year. At least, if earnings for the last nine months this year versus prior year are any gauge. They've realized more than 2.5x gains than they did in the prior year.

Therefore, if I were to make my best guess, I would believe that the year-end will be between $0.83 and $2.64. The high number would be significantly above anything they've paid out in the last three decades. So I'd temper expectations to the lower half of this estimate.

For taxes, we will primarily see ordinary income and long-term capital gains. This is from their previous Annual Report.

For tax purposes, distributions paid by the Fund during the years ended December 31, 2020 and December 31, 2019 were classified as ordinary income of $20,660,825 and $23,238,400, respectively, and long-term capital gain of $91,333,875 and $126,415,026, respectively.

Holdings - Mega-Tech FAAMG ----> MAMAA

With Facebook (FB) changing its name through its rebranding, we might not be using this acronym for much longer. However, we kept Alphabet's (GOOG) "G" from the Google days. Replacing it is several different things, but my vote is MAMAA to update for GOOG's change. I think it is fair to drop Netflix (NFLX) because it isn't held in many CEFs anyway. So at least for my purposes, it has appeal.

That then leaves us with Meta (MVRS) (Facebook's rebranding,) Apple (AAPL), Microsoft (MSFT), Amazon (AMZN) and Alphabet. All of which just so happens to line up with ADX's top five holdings being each of these companies. Notably, the top ten positions now account for a higher allocation than previously, 34.6%, compared to 31.8% prior.

(Source - Fund Website)

Unsurprisingly, this pushes ADX's portfolio overweight into the tech sector.

(Source - Fact Sheet)

This allocation to tech has also grown since we last touched on the fund earlier this year.

Of the MAMAA names, only AMZN's position has shrunk in terms of its percentage of net assets in ADX. It was by only one basis point, so we aren't looking at a drastically different portfolio. On the other hand, MSFT's lead has only widened over that period as well.

Data by YCharts

As I mentioned, the portfolio is relatively straightforward and plain. Sometimes a simple portfolio is exactly what an investor needs.

However, I'd also note that they aren't necessarily sitting around doing nothing. They reported 78.6% portfolio turnover in the prior six months ended June 30th, 2021. That suggests that, at least under the surface, they are making quite a few changes.

Conclusion

ADX is heading into the end of the year. That would mean that investors should find out before too long what bonus they will be getting at the end of the year. If the numbers mean anything from this year versus the prior year, this could be one of the largest yet. On the other hand, a CEF can really pay out whatever they'd like. That means we really won't know until they officially announce it.

At this time, the fund's discount is quite attractive. I don't see any catalyst over the short term to narrow that discount. However, it has been right at its average over the last couple of decades. That should indicate that there could be less downside through discount expansion during the next downturn, as we could see with other funds.

ADX isn't a portfolio for everyone, and I'm sure there will be a lot of discussion on why one shouldn't own it. Still, I see the merits in owning this fund - even just a bonus to add one of the oldest closed-end funds that are still around.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of ADX, MSFT either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

This article was originally published to members of the CEF/ETF Income Laboratory on October 31st, 2021.