CORNERSTONE TOTAL RETURN FD CRF S
May 13, 2015 - 11:32pm EST by
RoboCop
2015 2016
Price: 23.62 EPS 0 0
Shares Out. (in M): 5 P/E 0 0
Market Cap (in $M): 80 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 80 TEV/EBIT 0 0
Borrow Cost: Available 0-15% cost

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  • Closed-end Fund
  • Discount to NAV
 

Description

Cornerstone Total Return Fund is an overvalued closed end fund trading at a 33% premium. In a highly
valued stock market with the “bargain meter” showing 83% of members voting for few available bargains, CRF is a good boring
low risk short for someone looking for a general market hedge.
 
CRF looks like your typical equity-focused closed end fund holding a diversified portfolio of large
DOW/S&P 500 stocks. However, it is unique for two reasons: its outlier premium and its unbalanced
managed distribution policy. Closed end funds (CEF) are like mutual funds, but are exchange traded with
prices that can go below or above NAV. The reason for their existence is the idea that fund managers
can realize better returns if they have a permanent capital base and don’t have to worry about daily
redemptions. Closed end funds typically trade at a single digit discount to the underlying NAV of their
holdings, representing the cost of management fees. They typically pay dividends based on the income
of their portfolio investments, with low yields for equity funds and higher yields for bond/credit funds.
 
CRF is trading at a 33% premium to its NAV as the fund is propped up by a “dividend” that is really a
return of capital, not a return on capital. CRF currently pays a $.3319 month distribution (set at 21% of a
reference NAV), which is funded by Cornerstone selling its stock investments (essentially liquidating
itself) to pay out cash distributions. Retail investors seem happy for the moment receiving a 17% yield,
without paying too much attention to the underlying value of what they own. The premium should
eventually collapse, creating a market beating return for the short seller. CRF has traded at an average
of a 15% premium over the last year. Premiums can swing wildly inter year, with peaks of around 40%
premium and lows of around 5% premium. CRF traded at a discount as recently as October 2015. At
33%, I think CRF is trading near peak level premium. And if the premium goes higher, I think it will be
short lived (less than six months).
 
As far as “comps” go, CRF trades at among the highest premium of all CEFs and higher than its sister
cornerstone funds CLM and CFP which trade at 15% and 7% premiums
 
 

It may seem like a risky gamble to hope that the premium collapses in two years before your return gets
eaten up by the high distribution yield, but I don’t think that is the correct way to think about things as
the stock price will drop after each distribution.
 
Shorting a closed end fund at a premium is more compelling than your average overvalued or high
yielding short. First of all, the stock prices are somewhat grounded in reality by NAV. There isn’t some
new technology, hyped-up mineral reserve, or secular trend creating a “story” that can keep a stock
overvalued for years. Aside from dividend yield, story premiums in CEFs are typically short lived, arising
from in-vogue or recently high returning investment trends. Premiums usually reverse into discounts
within a year or so as the investment hype cools off or the high return sector starts producing negative
returns.
 
As an example, look at the premium of Herzfeld Caribbean Basin (ticker CUBA), which is also a good
short. When the Obama administration announced that U.S. trade restrictions would be eased in
December 2014, the stock quickly went from a 20% discount to a 70% premium as investors clamored
for a way to invest in the Cuba theme. The premium quickly spiked back down and is now at a 37%
premium, which I predict will decrease as Cuba investment hype fades away over time.
 
 
Secondly, the gravity of NAV somewhat prevents completely unfounded dividend yield overvaluations.
In a typical stock dividend overvaluation, investors may be able to dream about higher incremental
returns on capital, or growth from future projects that will allow the stock to grow its earnings to match
its current dividend yield. For a CEF like CRF, it’s a bit harder to believe that the underlying returns on its
portfolio of blue chip stocks is going to average 17% per year in order to match its distribution payouts.
So while illogical CEFs premiums can result from dividend overvaluations, investors are still prevented
from blindly putting a 10% yield on the distribution and telling themselves that the fund is fairly valued forever. 
 
This creates a compelling dynamic for short selling a liquidating CEF at a premium. The “gravity” of NAV
prevents premiums from increasing every year as the NAV declines from liquidating distributions.
Assuming a constant premium and underlying NAV price, a closed end fund trading at a premium will
decline in price after making a liquidating distribution (by an amount more than the distribution). In
CRF’s case, this dynamic creates over a 5% annual price decline at current distribution rates (what I will
call “decay”).
 
Annual Loss Assuming Flat NAV  
Starting NAV 17.74
Premium 33%
Starting Price 23.62
Distribution Payout 3.98
Ending NAV   13.76
Premium 33%
Ending Price 18.32
Price + Distributions 22.30
Loss % -5.6%
 
 
The decay is the result of losing the premium valuation on the NAV of the liquidating distribution. If 
CRF immediately traded at NAV or liquidated itself entirely, the gain would be $5.88, or 25% on the
$23.62 stock price. Losing the 25% overvaluation x the 21% liquidating distribution each year will create
a -5.25% annual decay headwind.
 
 
To prevent the per share price from trading to exceptionally low levels after liquidating distributions,
Cornerstone funds routinely go through reverse stock splits (CRF did a 4-1 split in December 2014), or
merging funds together (like CFP merging 1:1 on NAV into CLM).
 
At a 7% premium, CFP represent an excellent hedge to CRF (same manager, similar assets, similar distribution policy, so premiums should be similar) or a
standalone arbitrage opportunity. CLM and CFP are similar equity CEFs and will be merging with CLM as
the surviving entity by the end of Q2 2015. As CLM trades at a 15% premium, by buying CFP and
shorting CLM, one can make 7% assuming shareholders approve the merger (which they should,
between arbs voting yes and the incentive of a lower expense ratio), creating a high ~30% IRR arbitrage
opportunity.
 
There is also an investment headwind created by the management fee paid to the investment advisor
selecting stocks for CRF. The management fee is 1.0% of NAV. Adding in other expenses, total expenses
are 1.4% of NAV, which is much higher than the 0.05% expense ratio of the Vanguard S&P 500 ETF
(ticker VOO). With an underlying dividend yield of its holdings of around 2%, CRF yields only a small
amount (0.6% of NAV) of sustainable dividend yield (the fund does not use any leverage). The liquidating
nature of the distributions present a risk to the fund manager who will see the decreasing management
fees paid out each year as NAV declines. The manager incentive, therefore, is to issue more shares to
stabilize or grow NAV, which is a risk to the short seller if capital is raised above NAV. 
 
Selling shares at a premium to NAV will increase the NAV per share and replenish the manager fees.
Cornerstone management has raised equity above NAV through rights offerings before, with CRF raising
$37M at the end of 2013. Cornerstone rights offerings are typically done on a one-for-three offer at 90% of the
market price. One successful rights offering per year would roughly offset the natural decay from
liquidating distributions.
 
  Pre Raise Post Raise
NAV Per Share 17.74 18.62
Shares 4.5 6.0
Total NAV 80 111
Premium 33% 33%
Price 23.62 24.79
Price Increase %   5.0%
 
With Cornerstone management busy with the CLF:CLM merger, and the incentive to first try a raise at the
merged CLM fund (which will have 5x the NAV as CRF), I think the premium will collapse before another CRF
raise is completed. If a raise is completed however, it should not be a disaster to the short as raise
announcements do not typically cause significant price increases, and can sometimes result in price
declines like the October 25 2013 raise.
 
The manager fee incentive to keep/increase overall AUM/NAV also creates a catalyst for the short seller.
The fund managment fees would evaparate in a half dozen years if the dividend was kept at a constant payout per share. So
annually, the fund manager resets the distribution for the following year to be based on a percentage of the latest NAV. So
baring a year of exceptional market returns, each year the dividend will get cut. The distribution is
usually set for 21% of the NAV at the end of October. As with most other dividend yield overvaluations,
the stock price typically declines as the distribution is cut. If the distribution was reset today, it would
result in a 7% distribution cut. See the below chart showing how the stock price and premium are
typically reduced around the 4Q dividend cut.
 
 
 
 
CRF should underperform the market due to the impact of the expense ratio, liquidation decay, and an eventual
reduction in premium. My 1yr target underperformance of over 21% before borrow fees is built up as follows:
 
Fund Holdings
 
Target Underperformance
Excess Expense Ratio             1.3%
Decay                                    2.5%
Premium Reduced to 10%     17.4%
1yr Underperformance           21.2%
 

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

Dividend cut in Q4

Natural wax and wane of premium

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    Description

    Cornerstone Total Return Fund is an overvalued closed end fund trading at a 33% premium. In a highly
    valued stock market with the “bargain meter” showing 83% of members voting for few available bargains, CRF is a good boring
    low risk short for someone looking for a general market hedge.
     
    CRF looks like your typical equity-focused closed end fund holding a diversified portfolio of large
    DOW/S&P 500 stocks. However, it is unique for two reasons: its outlier premium and its unbalanced
    managed distribution policy. Closed end funds (CEF) are like mutual funds, but are exchange traded with
    prices that can go below or above NAV. The reason for their existence is the idea that fund managers
    can realize better returns if they have a permanent capital base and don’t have to worry about daily
    redemptions. Closed end funds typically trade at a single digit discount to the underlying NAV of their
    holdings, representing the cost of management fees. They typically pay dividends based on the income
    of their portfolio investments, with low yields for equity funds and higher yields for bond/credit funds.
     
    CRF is trading at a 33% premium to its NAV as the fund is propped up by a “dividend” that is really a
    return of capital, not a return on capital. CRF currently pays a $.3319 month distribution (set at 21% of a
    reference NAV), which is funded by Cornerstone selling its stock investments (essentially liquidating
    itself) to pay out cash distributions. Retail investors seem happy for the moment receiving a 17% yield,
    without paying too much attention to the underlying value of what they own. The premium should
    eventually collapse, creating a market beating return for the short seller. CRF has traded at an average
    of a 15% premium over the last year. Premiums can swing wildly inter year, with peaks of around 40%
    premium and lows of around 5% premium. CRF traded at a discount as recently as October 2015. At
    33%, I think CRF is trading near peak level premium. And if the premium goes higher, I think it will be
    short lived (less than six months).
     
    As far as “comps” go, CRF trades at among the highest premium of all CEFs and higher than its sister
    cornerstone funds CLM and CFP which trade at 15% and 7% premiums
     
     

    It may seem like a risky gamble to hope that the premium collapses in two years before your return gets
    eaten up by the high distribution yield, but I don’t think that is the correct way to think about things as
    the stock price will drop after each distribution.
     
    Shorting a closed end fund at a premium is more compelling than your average overvalued or high
    yielding short. First of all, the stock prices are somewhat grounded in reality by NAV. There isn’t some
    new technology, hyped-up mineral reserve, or secular trend creating a “story” that can keep a stock
    overvalued for years. Aside from dividend yield, story premiums in CEFs are typically short lived, arising
    from in-vogue or recently high returning investment trends. Premiums usually reverse into discounts
    within a year or so as the investment hype cools off or the high return sector starts producing negative
    returns.
     
    As an example, look at the premium of Herzfeld Caribbean Basin (ticker CUBA), which is also a good
    short. When the Obama administration announced that U.S. trade restrictions would be eased in
    December 2014, the stock quickly went from a 20% discount to a 70% premium as investors clamored
    for a way to invest in the Cuba theme. The premium quickly spiked back down and is now at a 37%
    premium, which I predict will decrease as Cuba investment hype fades away over time.
     
     
    Secondly, the gravity of NAV somewhat prevents completely unfounded dividend yield overvaluations.
    In a typical stock dividend overvaluation, investors may be able to dream about higher incremental
    returns on capital, or growth from future projects that will allow the stock to grow its earnings to match
    its current dividend yield. For a CEF like CRF, it’s a bit harder to believe that the underlying returns on its
    portfolio of blue chip stocks is going to average 17% per year in order to match its distribution payouts.
    So while illogical CEFs premiums can result from dividend overvaluations, investors are still prevented
    from blindly putting a 10% yield on the distribution and telling themselves that the fund is fairly valued forever. 
     
    This creates a compelling dynamic for short selling a liquidating CEF at a premium. The “gravity” of NAV
    prevents premiums from increasing every year as the NAV declines from liquidating distributions.
    Assuming a constant premium and underlying NAV price, a closed end fund trading at a premium will
    decline in price after making a liquidating distribution (by an amount more than the distribution). In
    CRF’s case, this dynamic creates over a 5% annual price decline at current distribution rates (what I will
    call “decay”).
     
    Annual Loss Assuming Flat NAV  
    Starting NAV 17.74
    Premium 33%
    Starting Price 23.62
    Distribution Payout 3.98
    Ending NAV   13.76
    Premium 33%
    Ending Price 18.32
    Price + Distributions 22.30
    Loss % -5.6%
     
     
    The decay is the result of losing the premium valuation on the NAV of the liquidating distribution. If 
    CRF immediately traded at NAV or liquidated itself entirely, the gain would be $5.88, or 25% on the
    $23.62 stock price. Losing the 25% overvaluation x the 21% liquidating distribution each year will create
    a -5.25% annual decay headwind.
     
     
    To prevent the per share price from trading to exceptionally low levels after liquidating distributions,
    Cornerstone funds routinely go through reverse stock splits (CRF did a 4-1 split in December 2014), or
    merging funds together (like CFP merging 1:1 on NAV into CLM).
     
    At a 7% premium, CFP represent an excellent hedge to CRF (same manager, similar assets, similar distribution policy, so premiums should be similar) or a
    standalone arbitrage opportunity. CLM and CFP are similar equity CEFs and will be merging with CLM as
    the surviving entity by the end of Q2 2015. As CLM trades at a 15% premium, by buying CFP and
    shorting CLM, one can make 7% assuming shareholders approve the merger (which they should,
    between arbs voting yes and the incentive of a lower expense ratio), creating a high ~30% IRR arbitrage
    opportunity.
     
    There is also an investment headwind created by the management fee paid to the investment advisor
    selecting stocks for CRF. The management fee is 1.0% of NAV. Adding in other expenses, total expenses
    are 1.4% of NAV, which is much higher than the 0.05% expense ratio of the Vanguard S&P 500 ETF
    (ticker VOO). With an underlying dividend yield of its holdings of around 2%, CRF yields only a small
    amount (0.6% of NAV) of sustainable dividend yield (the fund does not use any leverage). The liquidating
    nature of the distributions present a risk to the fund manager who will see the decreasing management
    fees paid out each year as NAV declines. The manager incentive, therefore, is to issue more shares to
    stabilize or grow NAV, which is a risk to the short seller if capital is raised above NAV. 
     
    Selling shares at a premium to NAV will increase the NAV per share and replenish the manager fees.
    Cornerstone management has raised equity above NAV through rights offerings before, with CRF raising
    $37M at the end of 2013. Cornerstone rights offerings are typically done on a one-for-three offer at 90% of the
    market price. One successful rights offering per year would roughly offset the natural decay from
    liquidating distributions.
     
      Pre Raise Post Raise
    NAV Per Share 17.74 18.62
    Shares 4.5 6.0
    Total NAV 80 111
    Premium 33% 33%
    Price 23.62 24.79
    Price Increase %   5.0%
     
    With Cornerstone management busy with the CLF:CLM merger, and the incentive to first try a raise at the
    merged CLM fund (which will have 5x the NAV as CRF), I think the premium will collapse before another CRF
    raise is completed. If a raise is completed however, it should not be a disaster to the short as raise
    announcements do not typically cause significant price increases, and can sometimes result in price
    declines like the October 25 2013 raise.
     
    The manager fee incentive to keep/increase overall AUM/NAV also creates a catalyst for the short seller.
    The fund managment fees would evaparate in a half dozen years if the dividend was kept at a constant payout per share. So
    annually, the fund manager resets the distribution for the following year to be based on a percentage of the latest NAV. So
    baring a year of exceptional market returns, each year the dividend will get cut. The distribution is
    usually set for 21% of the NAV at the end of October. As with most other dividend yield overvaluations,
    the stock price typically declines as the distribution is cut. If the distribution was reset today, it would
    result in a 7% distribution cut. See the below chart showing how the stock price and premium are
    typically reduced around the 4Q dividend cut.
     
     
     
     
    CRF should underperform the market due to the impact of the expense ratio, liquidation decay, and an eventual
    reduction in premium. My 1yr target underperformance of over 21% before borrow fees is built up as follows:
     
    Fund Holdings
     
    Target Underperformance
    Excess Expense Ratio             1.3%
    Decay                                    2.5%
    Premium Reduced to 10%     17.4%
    1yr Underperformance           21.2%
     

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Dividend cut in Q4

    Natural wax and wane of premium

    Messages


    SubjectAgree . . . . but
    Entry05/15/2015 05:55 PM
    MemberElmSt14

    RoboCpp - thanks for the good write-up.  I have some history with these closed end funds and while I agree with your rationale completely, I'm resigned to the fact that there is no catalyst for the premium to shrink unless the market collapses.  In the meantime, you have to eat the borrow cost (which has been somewhat high at times) and the bullsht dividend.  If they were not able to do the rights offerings to replenish the asset base, I would agree this is a great short, but until that stops, this Ponzi scheme will keep going. 

    I also think the people involved are much more sinister than you discussed.  I wrote a long letter to the SEC because this is (by definition) a publicly traded Ponzi scheme taking advantage of unsophisticated people, but the SEC didn't care.  Even after I had a 2 hour conference call with them, they didn't do anything because technically CRF is not breaking any laws since they disclose everything in the fine print of a prospectus that no one reads.  Here is the letter I sent to the SEC in case you care:

    https://www.dropbox.com/s/owd03al01ghl6db/Updated%20Cornerstone%20Letter%20v3%20Redacted.pdf?dl=0

    Good luck on the idea, I hope it works and these crooks get screwed . . . but I've grown too cynical.


    SubjectRe: Agree . . . . but
    Entry05/17/2015 07:44 PM
    MemberRoboCop

    Thanks ElmSt you raise good points and I agree with what you wrote in your letter. Thanks for providing that link.  The weakness of this idea is certainly the lack of catalyst. While the premium would definitely collapse in a market downturn, I think it may be good to keep this idea on your radar and short in September or so. If they don't complete a rights offering before then the distribution will get cut materially and that should send the fund and  the premium lower. 

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