Value Investors Club / CORNERSTONE TOTAL RETURN FD (CRF)

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

show sort by

			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 (in $M):	80	TEV/EBIT	0	0
Borrow Cost:	Available 0-15% cost