Why Large Cap CEFs Are Significantly Undervalued: ADX, GDV, TY, And ZF

Includes: ADX, GDV, TY, ZF
by: Joe Eqcome

GenEqFnds CEFs classified as large cap appear to be significantly undervalued relative to their implied return benchmark, the S&P 500. According to our analysis, the four CEFs classified as large cap CEFs - The Adams Express (NYSE:ADX), Gabelli Dividend & Income Trust (NYSE:GDV), Tri-Continental (NYSE:TY) and Zweig (NYSE:ZF) - should be trading on average at a share price 8.3%-to-11.2% higher than their current stock valuations.

Investment Return Prem/Discounts: The following chart ("Chrt1") is an indexed comparison of the average price of the four CEFs classified as large-cap within the CEF GenEqFnds fund type versus the S&P 500 since 2003 (SPDR S&P 500 ETF SPY used as the proxy).

As the chart demonstrates the average adjusted-returns (including distributions) for the "Large-Cap CEF Index" ("red") track closely with the SPDR S&P 500 ETF ("blue") since 2003-with the notable divergence since late 2011.

Investment Return Discount: The "green" line represents the "Investment Return Discount" of the adjusted-returns (including distributions) of the "Large Cap CEF Index" compared to similar returns of SPY over that period. Since the SPY trades at par to its NAV, the returns for the SPY are similar both on a market and NAV basis. This makes comparisons with the large-cap CEFs adjusted market returns more transparent.

Historic Investment Return Discount: Since 2003, the discount of adjusted returns in the "Large Cap CEF Index" expanded during periods of decline in the adjusted returns of SPY. This is confirmed in "Chrt1" during the stock market swoon of 2008 following the U.S. financial crisis with the expansion of the "Investment Return Discount".

Current Divergence of Historical Return Discounts: What we find interesting is the current divergence in valuation between the rise in large cap stocks since late 2011, as represented by SPY since late 2011, and the "Large Cap CEF Index".

This is most visible by tracking the "Investment Return Discount" ("green") as it begins to widen (drop) in the face of higher adjusted returns posted by SPY since late 2011.

Closing the Gap? The average discount between the "Large Cap CEF Index" since 2003 averaged 3.7%. We believe this is the "true" discount-not price to NAV that is traditionally used to value CEFs either on an absolute or relative basis (more on this concept later). Currently, the "Investment Return Discount" has expanded to 6.2%. If it gravitates back to its mean those large-cap CEFs should on average receive a 10% boost on top of its traditional correlation with the S&P 500.

A Potential Attractive Entry Point: At their current share prices, we believe a package of these four large cap CEFs (listed above) may represent an attractive entry point for investors looking to realize incremental investment returns (alpha) over the next 12 to 18 months. This is premised on the current "Investment Return Discount" of large cap CEFs gravitating back to its longer-term average.

Secondly, given the defensive nature appropriate for this turbulent investment environment, large-cap stocks paying an attractive distribution may be a comfortable place to "run-in-place" while investors sorts out risk-premiums in other sectors of the capital markets.

Thirdly, we can find no justification for large-cap CEFs trading on average at a 13.4% discount when the Eqcome CEF Equity Index Prem/Disc was trading at 8.2% discount at the end of June and the aggregate CEF market segment is trading at 2.1% discount.

We would certainly entertain any cogent defense of why the large-cap CEFs are trading at such a significant discount on a traditional premium/discount basis when investor focus should be on relative adjusted returns.

Disclosure: I am long ADX, TY. I will likely be buying GDV and ZF over the next couple of months to complete the portfolio.