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Closed-End Fund Craziness

By Alan Gula, CFA Last week, Barack Obama became the first U.S. president to visit Cuba in nearly nine decades. As you may recall, President Obama announced that the United States would re-establish diplomatic relations with Cuba in December of 2014. Of course, investors immediately began searching for ways to profit from the re-opening of trade and travel with Cuba. Some investors thought they had uncovered a gem called The Herzfeld Caribbean Basin Fund (NASDAQ: CUBA ), a closed-end fund (CEF). After all, the ticker seemingly told you all you had to know. From December 16, 2014 to December 23, 2014, CUBA rose 107%. The fund went from a discount of over 10% of its underlying net asset value (NAV) to a massive 70% premium . Except there was one big problem: CUBA had little direct exposure to Cuba. Close, but no cigar. By mid-January 2016, the fund had lost over 60% of its value and was once again trading at a discount to its NAV. CEFs, like CUBA, have a set number of shares outstanding. Therefore, supply and demand forces determine whether the shares trade at a premium or discount to NAV. CEFs tend to be relatively small and illiquid, so their holders are predominantly individual investors. As a result, CEF share prices are heavily influenced by the herding of retail investors – perfectly illustrated by the CUBA episode. However, CUBA is an especially small CEF. Such pricing anomalies would never occur with the larger funds run by prominent financial institutions, right? High-Yield CEFs In June of 2014, near the height of the “reach for yield” mania, I recommended selling two high-yielding PIMCO closed-end funds . At the time, the PIMCO High Income Fund (NYSE: PHK ) and the PIMCO Global StocksPLUS & Income Fund (NYSE: PGP ) were trading at absurd 57% and 66% premiums to their NAVs, respectively. Over the next 15 months, PHK and PGP both lost roughly 40% of their values (distributions included but not reinvested). The premium for PHK evaporated and the premium for PGP hit a more reasonable but still elevated 18%. But wait… The herd is back for more! The premiums have since re-inflated for both funds. In fact, the premium on PGP recently reached an unprecedented 103%. It seems as though many folks are using the snapback rally in the credit market as an excuse to bid up several closed-end funds with impunity. The following table is a list of several CEFs trading at high premiums: The premiums on Eagle Point Credit Company Inc. (NYSE: ECC ) and the DoubleLine Opportunistic Credit Fund (NYSE: DBL ) have recently surged to their highest levels ever. The Babson Capital Corporate Investors (NYSE: MCI ) is rated five stars by Morningstar and has a great track record, but no fund is worth a 20%-plus premium. The PIMCO Municipal Income Fund (NYSE: PMF ), PIMCO California Municipal Income Fund II (NYSE: PCK ), PIMCO New York Municipal Income Fund II (NYSE: PNI ), and PIMCO California Municipal Income Fund III (NYSE: PZC ) are all trading at very high premiums. No matter how bullish you are on muni-bonds, there’s no reason to pay up this much for exposure. The financial markets may not make sense all of the time, but, as you can tell, craziness is the norm in CEF land. When a CEF you own trades at a small premium to its NAV, you should at least consider selling it. When that premium exceeds 15%… hit the bid and get out as if you’re fleeing a communist dictatorship.

Country ETF Update

By Joseph Y. Calhoun The theme for Single Country ETFs over the last month is either countries that produce a lot of natural resources (commodities) or countries in which sane people don’t invest. Okay, maybe sanity isn’t the proper metric but surely investors who can’t afford to take a loss shouldn’t be investing in Russia, Peru or Turkey, all three of which make the top 10 for performance over the last 3- and 1-month periods. For the one-month period, just for kicks, Greece makes the top 10, another place the typical retiree probably ought not be chasing yield or returns. To be serious though, the performance of these Country ETFs proves one thing for sure – risk is not a static thing. Any market can become sufficiently cheap that investing in it can be a low risk endeavor. And some of these countries’ stock markets were very cheap before these rallies and even more importantly, some of them still are. Here’s the return rankings: Click to enlarge Click to enlarge This is part of the weak dollar/strong commodity/higher inflation expectations theme I’ve been writing about the last couple of months. As the dollar has softened, commodity prices have risen and stock markets in countries that are heavy commodity producers have risen dramatically, an indication that the sentiment had moved way too far in the other direction. Almost no one was expecting a commodity rally with the global economy – especially China – so weak. But a weak dollar is powerful stuff even if it isn’t fully realized. I think this rally has actually moved a little too far, too fast. Commodities and stock markets in countries where they are produced are due for a rest and the hawkish jawboning of the Fed last week started to take the froth off a bit. Based on the frequency and timing of the Fed’s passive/aggressive hawk/dove act, one could be excused for thinking maybe the object of their obsession is the stock market rather than real economy factors. But I digress and so does James Bullard. It may seem as if the central banks have control, that the dollar is trading in a range that is acceptable to all… something that happens only very rarely and surely won’t last. But in the simplified world of Keynesian economics, the strong dollar was the source of the recent market troubles, a harbinger or reflection of economic woes and therefore had to be nipped in the bud. If a strong dollar caused the problems, a weak one will cure them and the world is on board with that – to a point. Right now, all of these short-term moves don’t mean a thing though from a momentum standpoint, mere dead cat bounces from very oversold conditions. Not one of the Country ETFs in the 3-month or 1-month best return top 10 lists has a buy signal from our long-term momentum indicators. I do think that the dollar’s rise is over for now, though, and some of these will eventually turn out to have been great investments. But not yet. Patience is probably an investor’s best friend right now. As for valuation, using Market Cap/GDP, several of these stick out as cheap. Singapore, Spain, Russia, Brazil, India and Indonesia all look cheap relative to where they’ve traded historically. Watch the dollar carefully for clues about your stock investments. Generally, a weaker dollar will favor foreign equities over domestic. That’s a generalization so it doesn’t apply all of the time with all markets but it is a major factor for monetary as well as economic reasons. For investors, there are ways to cope with a weak dollar and higher inflation. For the Fed, I will just say what I’ve said before about their hope for higher inflation – be careful what your wish for, you just might get it good and hard.

Markets Will Always Present Opportunities For The Patient Investor

There is a theory that markets perfectly process external information such that they always serve up fair valuations for a stock. I beg to differ. I have had serious reservations about the validity of the efficient market hypothesis for a long time. I believe that markets overreact to negative news that is not stock specific. I’ll provide a couple of examples where I think this is the case. Alibaba I have had my eye on Alibaba’s (NYSE: BABA ) stock for a considerable period of time. Ever since the IPO in fact, I had been looking for opportunities to own the stock. However, time and again, the company just proved itself too be too far out of my strike zone, and traded above a valuation at which I would be interested to make a purchase. I didn’t let that disturb me too greatly as I felt the next scare about China related growth or fears of a worldwide recession would bring the company back to a price that I was more comfortable buying. It’s not hard to see why I was so keen on the Alibaba business. The company benefits from strong network effects, courtesy of being the dominant e-commerce play in China. At latest count, BABA had roughly 367M buyers across its marketplaces. Taobao in particular enjoys strong brand loyalty among a younger generation of Chinese consumers. A platform with the greatest number of buyers attracts the greatest number of sellers and provides strong monetization for Alibaba. Having such a dominant platform makes it hard for competitive platforms to find a place. Others either need a clear value proposition to supersede BABA, such as better pricing, or offer services in a small niche that Alibaba doesn’t cater to. What’s interesting to note is that the Alibaba business has been on a constant upswing in recent times. Revenues have grown at a strong pace over the last five years, averaging just under 30% annually. Operating income and EPS have shown similar levels of growth over the last five years. Most recent quarterly growth has been outstanding as well, with revenue and operating income increasing 30% year on year. BABA’s growth potential remains immense. China’s e-commerce sales still only represent about 10% of total retail sales, implying that there is still a long way for digital commerce to go. Yet looking at the movements in the Alibaba stock price suggests a market that is confused by the prospects for this business. Alibaba’s stock was down 20% in 2015. In the year to date, the stock is down another 7%. However, it was a lot worse just several weeks ago when the stock was down almost 26% year to date. Alibaba’s prospects haven’t changed at all in the intervening few months. There have been no new competitive threats, no profit warnings and no stock specific bad news. Yet the stock plunged almost 25% in the year thus far on concerns over poor Chinese data, even though the underlying business is in glowing health. Even if poor economic data from China did indicate a slowing down of the economy, does that justify marking down a high quality business growing at 30% annually by almost 25%? Baidu Another victim of market irrationality was Baidu (NASDAQ: BIDU ). Baidu is the “Google of China” and controls close to 80% of the overall share of internet search in the country. This provides a natural monopoly for the business. Users are likely to continue to leverage the dominant search engine if it continues to provide them with the most relevant search results. Having the most users in turn tends to attract the largest share of advertisers willing to pay the most to advertise. The company has a great track record of long-term growth. Average annual revenue growth over the last 10 years has come in at close to 82%. Revenue growth over the last couple of years has still averaged over 40%. Yet, the stock has been hammered. It was down 17% in 2015, and down almost another 26% at various points during 2016. While the stock has significantly bounced back in the last few weeks, Baidu was another name that sold off in the absence of specific information impacting the underlying business. With the Chinese online advertising market set for steady growth over the coming decade, market hand wringing over Baidu’s prospects arguably set up an attractive share valuation for patient, long-term oriented investors. I have given examples of 2 companies that I think have compelling growth stories that should be well placed for the long term, which the market chose to mark down on no real company specific news. I’ll offer one further example of a company that I believe has been overly marked down on a company specific event. Chipotle Chipotle (NYSE: CMG ) is a relatively rare success story in the retail space, as it is one of the few businesses that has managed consistent revenue growth at close to 20% annually over the last decade. This also isn’t a case of a business with growth that has started strong and been progressively declining. The business has seen 3-year average revenue growth top 20% for each of the last few years. Chipotle’s gross margins and operating margins have been responsible for juicing earnings growth. It’s amazing that gross margins have increased from 18.5% to almost 27% in the last decade. Even more impressive is that operating margins have grown from 4% to 18.5% in that same time. However, a spate of E. coli and noro virus scares have decimated the company and the company’s stock. Chipotle’s stock plunged from close to $750 in 2015 to a low point of $400 which was reached early in 2016. That’s a fall which is just shy of 50%. This is another example of a business that I have really liked, which was trading at a valuation that I wasn’t comfortable with. However, that large share price drop was tough to ignore. Now these sorts of E. coli scares and virus epidemics are actually relatively common place in the fast food industry. A lack of hygiene amongst employees and problems in the supply chain make these incidents unavoidable. In fact, Jack In The Box (NASDAQ: JACK ) had a particularly nasty virus outbreak a number of years ago that caused the deaths of close to 10 people. Comparatively speaking, Chipotle’s problems are thankfully relatively less severe, but nonetheless, its stores are currently sparsely populated and the company’s earnings have suffered. Thankfully, consumers have relatively short memories, and they typically return back to these stores after a period of time. Lost consumer traffic takes about a year to recover, but consumers eventually return. The market seems to be pricing Chipotle on the basis that it will see severe and sustained consumer losses that will hurt long-term growth. I think a 50% reduction in business value is an overly pessimistic assessment of the business’s prospects and overstates how long a consumer’s memory is. Markets always offer up opportunities for the patient investor. The key is to be willing to wait for them.