Stocks/International

Lyn Alden Schwartzer

Filtering Through the Noise to Find Value

The CEF Contrarian Indicator

Value investors generally like to avoid the crowded parties and start looking into opportunities that seem unloved, underappreciated, left behind, and most importantly, cheap.

In addition to my primary focus on measuring value in various asset classes, regions, and stocks, an additional and unusual place I like to look for signs of exuberance is in the world of Closed End Funds, or “CEFs”. 

Unlike ETFs which can change their number of existing shares as needed to meet demand, CEFs have a fixed number of shares. Each share represents a portion of an investment corporation that owns a portfolio of assets. This closed structure allows the fund to use leverage or to invest in less-liquid assets that would be unsuitable for ETFs.

However, this closed structure and fixed number of shares also means that share prices can fluctuate dramatically compared to the net asset value (NAV) of the fund.

For example, suppose a CEF consists of 1 million shares and owns $100 million in assets (equal to $100 per share in assets held, or net asset value). If each share of the CEF is valued at $100 on the open market, then the difference between the share price and the net asset value is zero. However, if investors turn bearish and sell shares of the CEF while the CEF’s assets remain unchanged, and the share price goes down to $90 while the NAV is still $100, then this particular CEF would have a 10% discount to NAV.

In contrast, if a CEF gets very popular and everyone wants to own it, its shares might trade at a premium to NAV. If $130 million in capital wants to own shares of the $100 million asset CEF from the previous example, and they bid the 1 million shares up to a price of $130, it means the shares are now trading at a 30% premium to NAV. Investors are paying 30% more per share than the underlying assets of the share are actually worth, which is usually a bad idea.

CEFs are mostly focused on paying high yields, which makes them popular and mostly-used by retail investors rather than institutional “smart money”. Weird things happen in this market, in other words.

I want to give three quick case studies for investors to be aware of. As a reference, most CEFs by default trade at a 5%+ discount to NAV as something close to the average.

“BRIC” Euphoria

Back in 2006/2007, the “BRICs” consisting of Brazil, Russia, India, and China were super-popular. Popular enough to have their own acronym, like FAANG. Everyone was talking about how BRICs, due to their fast growth rate, were going to be the future. You could invest at any valuation. They peaked in 2007, with China and India reaching valuations higher than the 2000 US dotcom bubble, and went on to have terrible returns for 12 years as fundamentals caught up to valuations.

Here is the Aberdeen India Fund (IFN) historical price-to-NAV ratio:

A pasted image

Chart Source: CEF Connect

The India Fund is a well-performing fund without leverage, and is often a good investment.

This fund traded at a massive 20-35% discount during the late 90’s, in the aftermath of the Asian Financial Crisis. This was an awesome buying opportunity for emerging markets in general. The U.S. dollar went on to weaken for a while, which helped emerging markets really take off into the early/mid 2000’s, resulting in emerging market BRIC euphoria. Investors were now willing to pay up to a 30% premium to NAV in 2006, because they were thought to be going to the moon in terms of growth, right near what we later look back on as the peak. Terrible timing.

Currently it offers a pretty good discount again. Emerging markets are out of favor, but I am bullish on several of them in particular over a 5-year timeframe from current price levels.

“FAANG” Euphoria

After experiencing an economic slowdown in 2016, the US economy resumed strong growth in 2017, and tech stocks in particular took off to nosebleed heights.

The BlackRock Science and Technology Trust (BST) is a well-managed unleveraged CEF that invests in technology stocks. Due to strong performance, investors started piling into it in late 2017/2018:

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Chart Source: CEF Connect

As you can see on the price-to-NAV chart, BST was trading at a deep 10%+ discount during the flat market of 2015/2016. When tech stocks took off in 2017 and investors piled into it in 2018, the drove up the premium to 5-10%. Now the euphoria is starting to wear off, but it’s still trading at a mild premium, unlike most CEFs.

“High Yield” Euphoria

At the current time, investors are euphoric for high dividend yields and high bond yields, with seemingly little comprehension of the risk involved.

I know from first-hand experience that dividend-focused keywords do very well for search traffic. In addition, Seeking Alpha’s service marketplace has a disproportionate number of high-dividend services, including the most popular one there. In a world of negative-yielding or low-yielding bonds, people are willing to take on substantial risk in search of yield. We have yield euphoria, folks.

One of the weirdest examples is the Delaware Investments Interest and Dividend Fund (DDF). This fund invests in a variety of high-yield stocks and high-yield junk bonds. It uses about 30% leverage to further boost returns and yield, in exchange for higher risk.

Over the past year and a half, it suddenly started trading at a 20-30% premium:

A pasted image

This one is so spooky that it’s worth repeating. It invests in high-yield slow-growth stocks and high-yield junk bonds during a period where corporate debt as a percentage of GDP is at a historical record and high yield spreads are historically low. It then leverages those risky assets with another layer of debt. Retail investors then currently pay a price 20-30% higher than the fund’s underlying market value per share to own a piece of this, in addition to paying a 1%+ expense ratio, because it yields 7-8% per year. Please, for your health, don’t do this.

There could be a time and place for an aggressive investor to buy into a fund like this at a big discount as a contrarian purchase. Ten years into an economic expansion with record debt levels and a 25% premium that investors are crowding into? Please no.

Final Thoughts

These types of euphoria spikes are self-reinforcing. When investors pile in and start pushing the price-to-NAV ratio high, it increases the share price. Investors that don’t understand the price/NAV relationship think the fund is doing very well because the share price is going up, so they buy too, which further exacerbates the problem.

It’s useful to keep an eye on the weird CEF market to see what retail investors are piling into, because it’s a useful contrarian indicator. 

Lyn Alden Schwartzer covers North American stocks and international equity ETFs with a focus on fundamental valuation. Her background is a blend of engineering and finance, and she uses a dispassionate long-term quantitative and qualitative approach to filter through the noise and find value in stocks and markets around the world.
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