Tuesday, March 8, 2011

Relative Value and Absolute Discounts in CEFs/Added 100 of the CEF GGN at 18.84/WMT and the Large Cap Valuation Strategy

I will frequently read interviews with fund managers. When I read the interview, I am invariably left with the impression that the manager has found the Holy Grail of investing. The manager will highlight one or two successful investments and present arguments why their investment approach is superior to all others. By the time I finish with the article, I am at least thinking about making an investment.    

A recent example was the interview of Richie Freeman and Evan Bauman, managers of the Legg Mason ClearBridge Aggressive Growth mutual fund, conducted in the usual non-adversary fashion by a young Morningstar employee.
I then noticed that the fund had a two star rating by Morningstar which must not be hard to achieve, a conclusion reached after looking at the fund's ten year record.  

Over the past ten years ending in December 2010, the average load adjusted return was .19% according to MSN Money. I would assume that performance was before taxes and certainly unadjusted for inflation. And, for that performance, the investor has to pay a 5.75% load plus an expense ratio of 1.29%. SHRAX What can you say other than "no thanks".

I was driving past the local gas station, blinked my eyes, and then noticed that the price of regular had increased ten cents a gallon.  

So I pulled into the station, topped off my tank, before it could rise another ten cents. The rise in gas prices has, of course, had no impact on driving habits that unnecessarily devour gas.  

Drivers still have the peddle to the meddle as they approach a stop sign or a red light, stomping on the brakes just in time to avoid a collision with the stationary vehicle in front of them. The Old Geezer just coasts into the red light, as drivers pass him barely avoiding a collision, shooting darks with their eyes at the OG while saying to themselves "get out of my way, your old fart".

The rise in oil prices has little to do with supply and demand. From my perspective, there does not appear to be any shortage of oil, anywhere, and the market is well supplied. Instead, there is a belief that the civil war in Libya should provide an opportunity for the Masters of Disaster to successfully speculate on higher oil prices.

Moody's downgraded Greek government debt by three notches on Monday, and noted that the rating may be cut further. Reuters The current rating is now below that of Egypt.

1. WAL-MART (Own 50 shares: Large Cap Valuation Strategy): Herb Greenberg views the recent 20.6% increase in Wal-Mart's dividend to be a sign of weakness. CNBC  In his analysis, he mentions that WMT's 12.25% return on capital and its 3.6% profit margins are just in line with peers. He then cites a report from a firm called Analytixinsight who noted that WMT's cash flow was relatively good compared to its peers.   

From those points, Greenberg draws the conclusion that the "big dividend increase may have been a sign of weakness". Wow! That is so profound that it just went way over my head.

There are some salient points omitted in Greenberg's analysis. The P/E for WMT's stock is under 12, using a $52 share price and the fiscal 2012 consensus estimate of $4.43. That fiscal year ends in January 2012. WMT Analyst Estimates  The P/E shrinks to 10.65 using the estimate of $4.88 for F/Y 2013. The forward 5 year P.E.G. ratio is 1.13 and the P/S ratio is .44, both according to YF.

The free cash flow yield is around 5.5%.

International sales are growing strongly, rising 8.9% in the last quarter.

Consolidated income for the entire F/Y 2011 was 25.5 billion dollars on revenues of 419 billion. Walmart WMT generated 10.9 billion in free cash flow in F/Y 2011 (see page 13:  SEC Filed Press Release) WMT's return on investment was 19.2% in the 2011 F/Y (see page 15).

According to Value Line date, the operating margin has been improving in recent years. VL currently rates WMT shares 1 on Timeliness and 1 on Safety.

A sensible investor would not view an acceleration of dividend growth, well supported by earnings, to be a sign of weakness. The payout ratio for 2010 was 30%, the same as 2009. The annual dividend was 30 in 2002 and will be  $1.46 per share for the upcoming year.  MSN

Admittedly, WMT is a contrarian play. Sales at the U.S. stores have been trending down, not unsurprisingly given the economic conditions and the characteristics of the average WMT customer. The rise in energy prices will place an additional strain on those customers. 

Yet, the OG is not one who will project current conditions into the indefinite future. Conditions change, and I suspect WMT sales in the U.S. will start to improve as the U.S. recovers more from its largely self-inflicted wounds. And, without question, the anticipated total return with the dividends reinvested to buy more shares will likely be modest.

I intend to round my position up to 100 shares, and I have changed the distribution option to reinvestment into additional shares. Bought 50 WMT at 53.52 (12/27/2010 Post).

As noted previously, WMT shares have been trading largely in a narrow channel between $50 to $60 since 1999. Wal-Mart Stores From that fact, the Masters of the Universe and assorted analysts believe that the stock is a dog.  

I look at the issue differently. The problem is not WMT but its valuation in the late 1990s placed on the stock by irrational investors. The last big move in the stock from around $19 in 1997 to $70 during the Crazy Period was simply not rational. Actually the stock has done well in the years after 2000 just to trade in that channel, as earnings catch up with valuation. WMT was not appropriately valued at 50 times earnings in 2000, nor is properly value at an 11 P/E now with accelerating growth in its dividend.

{See Item #  3. Multiple Compression for Many Large Cap Stocks/Long Term-Large Cap Valuation Strategy at  Large Cap Valuation Strategy-A New Long Term Strategy.  I discussed the multiple compression issue as it relates to WMT in a post from July 2010, when I decided to pass on buying WMT shares:  Item # 1  Consumer Debt Levels-Still Way too High; see also  Large Cap Valuations}

The sentiment is just so negative on WMT that I have elected to postpone adding 50 shares hoping to buy them closer to $50. 

2. Relative and Absolute Discounts in Closed End Funds: This article in Morningstar focuses on the differences between absolute and relative discounts in CEFs. Relative discount simply refers to the relationship of a CEF's current discount to its historical average.  A CEF that have has an average discount over the past 3 years of 20%, which is now selling at a 10% discount, is expensive under this theory.  The support for this approach is found in academic studies that show that a CEF's relative discount or premium remains relatively constant over time.  This is explained in more detail in this 2010 Morningstar article involving Relative Discounts.

The Old Geezer has been investing in CEFs for far longer than the author of these articles has been alive.

LB  could not help itself, adding "with age does not necessarily come wisdom". 

RB defended the Old Goat, saying that the OG is wise for a scaredy-cat.

Based on my experience, relative discounts can be material as one component of an investor's decisions regarding buying and selling CEFs. A blind reliance on this process could easily lead the investor, by way of example, to buy a CEF selling at a 10% premium to its net asset value, down from a 3 year average of a 20% premium, which could easily be characterized as a mistake. Individual investors may be buying that CEF primarily due to a relatively high dividend yield, compared to other similar funds in the sector, but that dividend may be supported by a "destructive return" of investor's capital.

A real world example of the foregoing is the CEF Gabelli Utility Trust (GUT), selling at an absurd premium of 16.91% to its net asset value as of the close yesterday.  WSJ.com   I last discussed this CEF, which I have never owned, in a post from March 2010: Item # 7  Insane Pricing of the CEF GUT  I noted in that post that GUT had closed at $7.62 on Friday March 5, 2010, an astounding 49.1% premium to its net asset value of $5.1.  While this CEF was paying a good dividend, almost 90% of the dividend had been classified as a return of capital over the prior year.  WSJ.com This is a link to the tax information provided by the fund for 2010, which shows that $.64212 out of 72 cents was classified as a return of capital. gabelli.com/2010_GUT.pdf The monthly dividend rate was then 6 cents per share.

Under the relative discount theory, the price of GUT would be "inexpensive" at a mere 17% premium, simply due to it selling at a much smaller premium than its average, a totally preposterous conclusion for this CEF.  {The market price was $6.5 at yesterday's close, representing a decline of almost 15% from the close on 3/5/2010, and the dividend has been reduced to 5 cents per share (the net asset value as of yesterday's close was $5.56). Based on the funds historical earnings, the lower dividend would still represent mostly a return of investor capital.   An investor could have bought a dumb ETF that invests in Utility stocks, XLU,  at $30.39 on 3/5/2010, XLU Historical Prices, and sold it yesterday after collecting several quarterly dividends for 32.13 or a 5.7% gain on the shares.}

For CEFs selling at a premium to their net asset values, it is frequently easy to find a mutual fund, selling at its net asset value, that has similar or even better returns in the sector than the CEF selling at a significant premium. The investor needs to ask themselves "why am I paying a premium to net asset value when I have alternatives available at net asset value"?

The relative discount needs to be taken in context.  For example, during the Near Depression, the discounts of leveraged CEFs in the real estate sector rose tremendously over their averages.   

This was not initially a buying opportunity for them due to the dynamics at work. Many of the funds eventually sank to the low single digits in market price, some even to a buck, as the funds were forced to sell assets that had declined drastically in price in order to reduce the amount of their leverage. Several of those funds are still selling in the low single digits. So, in context of what is happening in the real world, the relative discount may be expanding for a very good reason.

I have considered relative discounts in making some purchases. An example would be adding to my position in RVT and RMT after those funds ending their managed distribution policies in early 2009. The quality of the managers did not change, nor did their long term track record in the small and micro cap sector. 

And there was a reason for the distribution change given the pounding that small cap stocks took during the Dark Period.  Yet, the discounts to their respective net asset values expanded as a result, most likely due to individuals selling due to the elimination of the dividends, which turned out to be temporary (and that selling was at a low point in the market cycle) 

As noted in a February post, those funds have re-commenced a managed distribution policy. RVT and RMT And both have just gone ex dividend for those new managed distributions on 3/3. Royce Value Trust, Inc. (NYSE - RVT) Royce Micro-Cap Trust, Inc. (NYSE-RMT) Please note that I have bought the double short ETF for small caps as a hedge. RMT and RVT are long term positions.

Another important context is the current status of a market's cycle. Take a bond fund for example.  The relative discount for bond funds that invest in long term bonds may be expanding due to a shift in interest rate cycles.  It is no secret that bonds have been in a long term secular bull market since 1982.  

A fund that invests in long term bonds may have an average discount of 3% for several years near the end of that super cycle, and now has a 12% discount. This would not be a buying opportunity, if investors are correctly predicting a shift from a long term bull market in bonds to a long term secular bear market. It would be an opportunity only if the long term bull market in bonds reasserted itself, with prices rising again and yields resuming their decline.

Assuming no change in the market context impacting the relative discount, I will take the relative discount into account when deciding to add or to pare a CEF position.  

An example would be Adams Express, a stock CEF that has had a persistently high discount for as long as I can remember. I may add to that fund when the discount expands to greater than 15%. Added To CEF ADX at $9.98 Bought MSPRA RJZ & ADX at $8.34 {The performance since those purchases has to take into account the distributions made by the fund, which can be found at page 22 of the last annual report: adams-express.annual_report_2010.pdf If I notice that the fund is normally selling at a 14% to 15% discount and it is currently selling at a 12% discount, I will not add to the position. On the other hand, if the discount expands to say 20%, with the average around 15%, I would consider adding to the position.

The recent buying and selling of both IMF and WIW is in part tied to the expansion and contraction of relative discounts. Sold 200 IMF at $17.15  Bought 200 of the Bond CEF IMF at 11.65  Bought 300 CEF IMF at 16.51 Sold: 300 IMF @ 17.23  Sold 300 WIW at $12.61(2/1/2011 Post)-- Item # 5 Bought Back 300 of the CEF WIW at $12.17 (1/20/2011 Post)/Bought 300 of the CEF WIW at $11.94 (March 3/2010 Post)--- SOLD 200 of 300 WIW at $12.5 (5/13/2010 Post)/ Bought 200 WIW at 12.29 (6/30/2010)-- Sold 300 WIW at $12.53 (9/2/2010 Post)/ Bought 300 of the Bond CEF WIW at $12.14 (12/10/2010 Post)--Sold 300 WIW at 12.43 (12/23/2010 Post) 

Lastly, I would disagree with the author of those Morningstar articles on the following point. He asserts that discounts remain constant for a reason, suggesting that those with high discounts are somehow worse than those selling at a premium. This assumes that investors are making rationale decisions, the so called efficient market theory applied to CEFs. Efficient Market Hypothesis as Hokum Discounts and premiums, relative and absolute, are frequently the result of irrational, inconsistent and unjustified judgments being made by fallible human beings, whose decision making processes are frequently infested with concerns that have nothing to do with reality, performance, or relative value.

Morningstar releases each week a summary of its relative value analysis by CEF sector.

3. Bought 100 GGN at 18.84 in the ROTH IRA on Monday (see Disclaimer): Since my retirement accounts contain mostly bonds (fixed and floating rate), and some preferred stock floaters, I thought that adding GGN would provide a small measure of equity exposure in a sector that can frequently run counter to bonds.

GGN concentrates its holdings in natural resource and gold stocks, and long term spikes in commodity prices can be associated with inflationary pressures that erode the value of fixed coupon bonds. This was the case in the 1970s, when commodity stocks were in a bull market while bond investors were suffering in a big way.  Item # 3 Hyman Minsky & the Economic Profession/ Correlation of Asset Classes (December 2009)  In short, commodity stocks can be negatively correlated with bonds.  I say "can" because there are no absolutes in correlations between asset classes. Instability & Volatility in Asset Correlations (May 2009)

Since March 2009, commodities have enjoyed a big bull move but so have junk bonds and investment grade corporate bonds. Long term treasuries have failed to participate materially since that time in the bull move of commodities, stocks, several foreign currencies, and bond classes other than longer dated treasuries. So, for most bonds, there has been a positive correlation since March 2009, but this can change into a negative correlation and the conditions may be ripe for such a change. No one can predict the future of course.

In the retirement accounts, I do not reinvest the dividends. For most of the securities, I would not have that option anyway. I do constantly reinvest the cash flow generated by the income securities to buy whatever appears to be my best option at the time, which is subject to errors needless to say. GGN does have the advantage of contributing to that cash flow with its 14 cent per share dividend, which is paid monthly.  

With the onset of the Near Depression and its aftermath, some of the dividends paid by this fund have been classified as returns of capital, and I never view that as a positive. To avoid a return of capital, the fund will have to realize capital gains, since dividends paid by its holdings will barely pay for the fund's expenses. The substantial rally in natural resources stocks has provided the fund with the opportunity, if it so chooses, to harvest enough capital gains by selling shares to support the dividend.

As I have mentioned in the prior post discussing a 100 share purchase in a taxable account, another knock is that this fund has been selling at a small premium to its net asset value. ITEM # 4 Bought Back 100 GGN at $18.65 (2/25/2011 POST). I have nothing further to add to that recent post about this fund.

I have bought and sold this CEF: Sold 100 GGN at 19.36 (1/4/2011 Post) BOUGHT: 100 GGN @ 17.85 (11/20/2010 Post) Sold: 100 GGN @18.13 (11/17/2010 POST)  Bought 100 GGN at 17.41 (10/4/2010)

GGN closed at $18.99 in trading yesterday, unchanged for the day, after trading in a range between $18.77 and $19.22. Marketwatch shows the yield at 8.85% at the $18.99 price. The net asset value as of 3/7 was $18.27, creating a premium of 3.94% to net asset value. The net asset value at last Friday's close was higher at $18.41 per share.

Notwithstanding the rise in the oil price yesterday, many energy companies declined in price.   XLE, a low cost ETF containing the energy stocks in the S & P 500, declined by .7% yesterday to close at $77.79.

I will discuss the remaining trades from Monday in the next post. 


  1. Can you suggest a rationale for the fact that "notwithstanding the rise in the oil price yesterday, many energy companies declined in price."?

  2. Cathie: On a daily basis, there is no absolute correlation between the price of oil and the price movement of energy stocks.

    There may be several reasons why the positive correlation may breakdown. Large cap energy companies have already risen in price before pulling back today and yesterday. As a stock, they can be more subject to supply and demand factors that impact the daily movement of any stock, rather than the fluctuations in the price of oil. This would include profit taking. And as a stock, they are vulnerable to the up and down mood swings of the stock market. A higher oil price might also adversely impact other operation of the large integrated companies that have large refining operations.

    Another factor is that the market may be reconsidering the recent run up in oil prices. Unless the uprisings spread beyond LIBYA, oil may start to trend back down. I also made the comment in the post that the world seemed to be well supplied with oil for the time being and the price run up was more due to a belief by the Masters of Disaster that a profit could be made by throwing a ton of money at purchases of oil futures.

    Over the long term, I do believe that prices will rise to $200 per barrel, based on peak production occurring at a time of rising demand. So I am unmoved by the day to day movements in the stocks or the current oil price. I am a long term holder of Canadian oil producers, particularly those heavily involved in the long lived oil sands.

    I would not be surprised to see in 20-30 years, assuming I am still around, severe restrictions on the use of gasoline powered private vehicles, mostly due to price and availability of the product. The supplies may be rationed to military use and for use in distribution of products and public transportation. The price of oil could easily be $300 per barrel then.

    Production will simply not be able to keep up demand. Auto purchases in China, for example, are just surging. New sales rose 14% in January 2011.

  3. Thanks for your informative and interesting response. I'll continue to hold my natural resources fund for the reasons you outline, which neatly summarize most of my reasons for buying it in the first place. Sometimes the volatility in commodities is unsettling, but I should be used to it by now.