|Shares Out. (in M):||0||P/E|
|Market Cap (in $M):||98||P/FCF|
|Net Debt (in $M):||0||EBIT||0||0|
CRF is a closed end fund offering a special situation that I think is overlooked by many of the people merely short for the 90+% premium to NAV that it trades at (as an aside, I think being outright short is a very good trade, but perhaps not the optimal trade). In fact, I think there are three more attractive structures that utilize CRF than being outright short.
CRF’s optically high yield reflects a self-cannibalizing return of capital that, with each payment, improves the likelihood of premium collapse. It “yields” a bit over 20% of NAV or 11% on market value. Because of its limited size, this is an investment best situated for individuals rather than fund managers. This write-up should also serve as a reference for those already short CRF or CLM.
Please see Pepper512’s excellent write-up from October of 2005 for additional detail.
CRF and its sister-fund, CLM, are closed end funds managed by Cornerstone Funds. Everything said here applies to CLM as well, though it trades at a mere 50% premium (vs. CLF’s 94% premium). Cornerstone’s Ralph Bradshaw is the primary fund manager, though one could argue he does not manage the funds so much as merely collect fees from the funds. The funds pay 1.5% of NAV for performance that has averaged 3% below the S&P 500 since it became and all equity fund four years ago. Not only has it trailed the S&P 500 each year for the last four years, it has trailed each quarter for the last four years. He is kind of like Bizarre-o Bill Miller.
CRF’s board has provided those of us that are short CRF with a gift (addressed below). For those that do not want to risk the potential irrationality of Mr. Market and who assume that a premium that goes from 50% to 94% can go from 94% to 200%, there is a riskless arb associated with CRF that I discuss below as well.
As a closed end fund, CRF pays a regular distribution. Until recently, CRF followed the questionable practice of paying out a fixed amount, regardless of performance. In November, Cornerstone announced that it is changing to a non-fixed distribution amount reset annually. The release seemed to indicate that the distribution would be more tied to performance but simultaneous stated that for 2007, it was increasing the monthly distribution and set it at $0.178 per month or $2.14 per year or 21% of the NAV. For all but the most legendary investors, 21% is a high hurdle. Should performance come in below 21%, obviously CRF will have distributed capital, not income. Given Mr. Bradshaw’s past track record, I expect a significant amount of the distribution to represent capital. Sending back capital is an inherently unsustainable proposition and ultimately forces a cut in the dividend policy. The worse performance is relative to 21%, the more unsustainable the distribution.
For those that do not want to make a bet on how crazy Mr. Market can be, there is an interesting opportunity being provided by CRF’s Board. The Board allows CRF owners to reinvest their monthly distribution proceeds into the fund at the lower of market or NAV. In essence, this benefits investors when the fund trades at a premium to NAV. Investors who utilize the plan can receive an instant doubling of the distribution by reinvesting at NAV and selling at market (okay, 94%, not quite a double). This can be made riskless by going long and short identical amounts of CRF without closing out the position (i.e., boxing the position). This will isolate the ability to take advantage of the premium at reinvestment. Basically, with no capital at risk and no basis risk, the holder of the boxed position will receive:
Profit = Distribution * Premium
That means with today’s 11% yield, the owner of a boxed position will receive:
11% * 94% = 10.3%.
To the extent you are stuck with a cost of borrow, it would reduce this riskless return, but if you set up a securities lending account and get paid to lend your long CRF position, you can recoup a fair amount of this.
I view this as an extremely attractive arb made more attractive by monthly (as opposed to quarterly or annual) distributions. The only risk to this trade is if the premium crashed all the way to a discount between the time you reinvest a distribution and the time you sell the new shares. a) This is highly unlikely; and b) because distributions are monthly, you will never have significant capital at risk.
Shorting for low/no cost:
Derivations on the risk free arb trade clearly can be employed as you can use the right to reinvestment from the long as a way to put on the short in a low/zero cost fashion. For example, at today’s 94% premium, you could short 1.94 shares for every 1.00 share you are long and by reinvesting the long distribution at NAV and selling at market, you perfectly cover the cost of being short. This requires more attention (monthly rebalancing) than other structures because the hedge ratio changes with the premium. To me, this is the ideal way to short this position because it allows you to put on just as much of a position but it takes the biggest problem out of the short, which is paying the distributions created by the borrow.
Another way to de-risk the trade is to take the above hedge ratio and add on an S&P 500 short. This isolates the premium and the manager’s skill (or lack thereof) and takes out a lot of market risk. This would be structured as 1.94 CRF shares short, 1.00 CRF share long, and enough S&P 500 long to match 0.94 shares of CRF. In essence, this creates a 1.94 long/1.94 short set-up where the cost of the distribution owed by the short is offset by the long and the risk of a strong bull market is minimized by boxing the position with a combination of CRF itself and S&P 500. We have basically isolated the manager’s skill (or lack thereof) and the premium. To the extent that CRF’s NAV continues to underperform the S&P 500 or if the premium declines, it is accretive to our position.
A final choice would be to go long CLM and short CRF on the basis that performance will be similar but that CLM is valued at half the premium of CRF. I think the other structures are superior to this.
I have chosen to go the low cost short (1.94 short CRF: 1.00 long CRF) route since I not only want to capture the premium but I like having some hedge against a bear market.
The primary limitation is that the size of these is capped by the small market caps of CRF and CLM and the spotty ability to get borrow (though it is out there; I found some more this a.m.). In the two situations outside of the “Riskless Arb”, there is a risk that the premium continues to increase. For the Riskless Arb, an increase in the premium actually benefits you (the longer and more it persists, the better).
The catalysts are for premium collapsing:
- continued payment of equity capital rather than income as distributions;
- continued poor relative performance;
- poor absolute performance/sharp market correction;
- SEC crackdown on these sorts of distribution policies.
|Subject||How to setup reinvestment|
|Entry||01/17/2007 01:46 PM|
|Thanks for the nice idea. I'm a private investor investing mainly through Ameritrade. How do I specify that I want my distributions reinvested at NAV?|
|Entry||01/22/2007 12:51 PM|
I am a little perplexed by the logic of your hedge. Unless you believe that the premium is going to expand there is no rational to hedge. The dividend reinvestment plan, although heavily promoted by Bradshaw, is pure BS. Bradshaw's arguments make no sense and relies on circular logic. Or, perhaps I should say, the logic that the premium to NAV will increase - or at least stay the same.
Correct me if I am wrong, however, from my perspective the premium collapses on every distribution. In other words, if the market price premium to NAV stays constant you make money on every distribution. Alternatively, if you are long the stock and the market premium to NAV stays constant you tread water by reinvesting - there is no money being made. If you don't reinvest you lose market value because the premium collapses on the distribution. Bradshaw makes it sound like reinvestment is a winner but his statements are misleading.
If you do the math using various hypothetical cases for different changes in premium to NAV, your hedge bet only makes sense if you think the premium to NAV will increase. If that is what you think will happen why would you desire to short any CRF?
Please let me know your thoughts.
|Subject||Circular Logic of the Dividend|
|Entry||01/24/2007 05:12 PM|
I've been waiting for a reply from Chuck but given his silence I am glad you have chimed in. As far as I see it the arb makes no sense. I would appreciate your feedback after reading this post.
This situation is easiest to understand by working through three different scenarios: 1) Premium to NAV stays constant; 2) Premium to NAV declines; and 3) premium to NAV increases. For this analysis, lets assume that NAV is $10.00 per share and the premium is 100% (market price is $20.00). Here is what would happen given a dividend of $1.00...
1) Premium Stays Constant:
Beginning market value of one share is $20.00. Post dividend NAV goes to $9.00 and market price to $18.00. Someone long one share would have lost $1.00 of value if they did not reinvest their dividend (their one share has a mkt value of $18.00 plus they got the $1.00 dividend. This is what I meant by the premium collapses with every dividend paid). Someone long one share that reinvests their dividend at NAV would end up with $10.00 of NAV and $20.00 of mkt value, which is exactly where they started. Someone who is short one share would make $1.00 (a mark to market gain of $2.00 less the $1.00 dividend charge). So, if the premium stays constant, Chuck's arb of being long one share and reinvesting the dividends and short one share would produce $1.00 of profit – which is exactly what the profit would be if you were just short one share.
2) Premium Decreases by 50%:
Beginning market value of one share is $20.00. Post dividend NAV goes to $9.00 and market price to $13.50. Someone long one share that reinvests their dividend at NAV would end up with $10.00 of NAV and $15.00 of mkt price, which is a loss of $5.00 per share of mkt value. Someone who is short one share would make $5.50 (a mark to market gain of $6.50 less the $1.00 dividend charge). So, if the premium gets cut in half, Chuck's arb of being long one share and reinvesting the dividends and short one share would produce $0.50 of profit – which is $5.00 per share less than the profit that would be achieved if you were just short one share.
3) Premium Increases by 50%:
Beginning market value of one share is $20.00. Post dividend NAV goes to $9.00 and market price to $22.50. Someone long one share that reinvests their dividend at NAV would end up with $10.00 of NAV and $25.00 of mkt price, which is a gain of $5.00 per share of mkt value. Someone who is short one share would lose $3.50 (a mark to market loss of $2.50 plus the $1.00 dividend charge). If the premium increases by 50%, Chuck's arb of being long one share and reinvesting the dividends and short one share would produce $1.50 of profit. This is obviously a better outcome than being short one share.
So…where does that leave us? My first question to Chuck was whether he thought the premium to NAV would remain the same, collapse or increase. If you believe that the premium is unsustainable, as I do, then you think the premium will collapse. If that is your belief there appears no rational for Chuck’s hedge. There is in fact no increase in profits, or free lunch. If you think the premium to NAV will increase, then just go long the stock. However, no rational investor would expect the premium to increase – at least over the long term.
I believe the proper hedge is to go long an S&P 500 index fund in the amount of the underlying NAV per share. The S&P 500 has outperformed CRF’s NAV by approximately 3% per year.
The one risk to this trade is being squeezed on the CRF short position, which I view as not insignificant.
I look forward to your response.
|Entry||01/30/2007 04:54 PM|
|Entry||02/01/2007 01:59 PM|
|As noted in my write up, I think an S&P hedge is a great idea as CRF's manager is a proven value destroyer and the likelihood of the premium permanently increasing seems minimal.|