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Beware: SRF Is Likely To Cut Its 23.5% Distribution

Summary SRF has been punished by falling oil prices. The market price hasn’t fallen as much as the underlying asset value driving the CEF to trade at a 23.12% premium to NAV. SRF has an indicated distribution yield of 23.53%. This distribution is unsustainable if oil prices remain stay at current levels. Overview: Oil has fallen dramatically, pressuring the stocks of energy producers. Highly levered companies have been hit especially hard due to their risk of defaulting if energy prices don’t rebound. The Cushing Royalty & Income Fund (NYSE: SRF ) is a closed end fund that has been hit particularly hard by falling oil prices. SRF invests in energy related royalty trusts, exploration and production master limited partnerships (MLPs), and Canadian royalty trusts. Many of these investments have been hit hard by the falling oil price driving the fund’s net asset value down by 49.97% so far this year. SRF’s market price has held in a little better falling 37.21% likely supported by the fund’s large 23.53% distribution. The divergence in performance between the market price and the NAV has driven the fund to trade at a 23.12% premium. However, the large distribution and the 23% premium to NAV are likely unsustainable. Investors in the fund are likely to see a significant drop in value unless oil prices rebound dramatically. Key Investment Highlights: Premium to NAV: SRF is currently trading at a 23.12% premium to NAV. This is significantly higher than its 1 year average premium of 3.21%. Evidence of the wider than normal premium the Z-Statistic of 2.36 showing the current premium is more than 2 standard deviations wider than normal. Leveraged Exposure to Energy Prices: SRF invests in energy related royalty trusts and exploration and production MLPs. These investments are highly correlated with energy prices. Additionally, many of the holdings have taken on significant leverage to acquire drilling acreage. If energy prices remain depressed for long these investments will likely be forced to cut distributions and could face covenant violations or default. SRF itself has a leverage ratio of 20.76%. If the fund’s holdings have issues due to their high leverage ratios, SRF could also face issues with its regulatory leverage limits forcing the fund to sell assets. Unsustainable Distribution: SRF currently pays a 23.53% distribution. This distribution is unlikely to be sustained. Underlying holdings will likely have to cut their dividends due to lower energy prices which hurt their cash flow. SRF will likely need to follow suit so it wouldn’t be surprising to see a significant distribution cut from the fund. Key Investment Risks: Energy Prices: As mentioned above, SRF’s investment portfolio is highly correlated to energy prices. If energy prices rebound significantly, the underlying holdings should appreciate and the dividends may be sustainable. Company Acquisitions: It is in the downturn of market cycles that the strong players make their investments for long term growth. In this case, there is the risk that some of the oil majors my purchase smaller companies that have attractive assets. If holdings in SRF’s portfolio are purchased at premiums than it would support the share price and negate the downside case. Key Portfolio Metrics: Premium/Discount: 23.12% Z-Statistic 2.36 Market Distribution Rate: 23.53% Current Quarterly Distribution: $0.50 UNII Per Share: $0.1389 Effective Leverage: 20.76% Performance: Using ETFs with a similar investment objective can give a good comparison to evaluate management’s performance. I was unable to find ETFs that have a similar focus as SRF so I chose to look for ETFs that would give similar exposure to energy. I chose to use the iShares U.S. Oil & Gas Exploration & Productions ETF (NYSEARCA: IEO ), based on its similar focus on upstream energy production. The Energy Select Sector SPDR ETF (NYSEARCA: XLE ) is also included in the analysis to give a picture of the broader energy sector performance. SRF has significantly underperformed both ETFs during its relatively short life. The recent dramatic underperformance highlights the risk of SRF. Data as of 12/23/2014 Source: Morningstar Premium/Discount: (click to enlarge) Source: CEFConnect The fund closed 12/22/2014 at a 23.12% premium to the NAV, or underlying value of the portfolio. This is above the 52 week average premium of 3.34%. The dramatic fall in NAV over the past month may have contributed to the increase in premium as the market has not had a chance to respond to the lower value. Additionally the reported 23.53% distribution may have enticed some investors though the distribution doesn’t appear sustainable if oil prices remain low. The market price will likely adjust lower over time. A distribution cut could be a catalyst for the premium to erode. Expense Ratio: SRF pays 1.50% of weekly average managed assets to Cushing Asset Management for investment management. The annual expense ratio for AWF as of 11/30/2014 was 2.15%. This is a relatively high fee for investment management. The specialization and uniqueness of the portfolio are likely part of the high cost. However, investors have received a lot of risk without significant reward recently. Distribution: SRF pays a quarterly distribution of $0.50/share. Based on current market prices this equates to a 23.53% distribution. Nearly all of the distribution has been categorized as return of capital. Not entirely surprising due to the MLP structure of many of the fund’s investments. The distribution appears unsustainable and may need to be cut if energy prices don’t rebound significantly. Even with higher oil prices, SRF’s income received only covered 70% of its distribution after accounting for the advisory fee and operating expenses. The slide in oil prices will put additional pressure on this ratio. Leverage: SRF employs leverage gained through a margin account at Bank of America Merrill Lynch. The interest rate charged on margin borrowings is LIBOR plus 0.65%. The use of a margin account is a concern as margin could be pulled or the rate increased due to the fall in the margin collateral. Also, if interest rates were to increase, the cost of borrowing would increase putting upward pressure on an already high expense ratio. Liquidity: SRF is a small CEF with $116 million in net assets. Trading volume is thin with 73,000 shares traded on the average day. This represents $625 thousand in daily volume at current prices. This is thin liquidity for a CEF and large orders could cause wide swings in the market price. It is always wise to use limit orders to purchase or sell shares of closed-end funds, as the bid/ask spread can be wide. Management: SRF is managed by Cushing asset management, a subsidiary of Swank Capital. The management team is seasoned with managers averaging over 24 years of industry and investment experience. The management team is located in Dallas Texas close to the major players in the energy sector. Portfolio: Portfolio Allocation (click to enlarge) Source: Cushing Asset Management as of 9/30/2014 The fund is invested in upstream energy MLPs and trusts. The majority of the fund is invested in the United States with some exposure to Canadian royalty trusts. The focus on these high assets that have high distributions has increased they distribution the fund is able to pay but also comes with a significant amount of risk. The underlying value of the fund will be significantly influenced by energy prices. Top 10 Holdings Source: Cushing Asset Management as of 8/31/2014 SRF has a focused portfolio with 40 positions. The top ten holdings represent 76.2% of the total portfolio. The turnover rate has been relatively high, with 94.34% turnover in FY 2013. This concentration can be attractive when times are good, however, it increases the portfolio risk. A closer look at some of the top holdings reinforces the concern about the portfolio distribution. For example, Linn Energy, LLC (NASDAQ: LINE ) represents 9.4% of the total portfolio. LINE has an implied yield of 24.43%. However, LINE has $11 billion in long term debt vs. $4.9 billion in shareholder’s equity. If energy prices don’t rebound LINE will likely have to cut the dividend and use the cash to pay interest and repay debt. This would reduce the amount of cash available for SRF’s distribution. This is one of the starker examples in the portfolio, but many other holdings face similar issues. Strategy: SRF’s primary investment objective is to seek high total return with an emphasis on current income. Under normal conditions the fund will invest at least 80% of net assets in securities of energy related U.S. royalty trusts, Canadian royalty trusts, and exploration and production MLPs. Conclusion: The drop in energy prices has pressured SRF’s net asset value and share price. The net asset value has fallen faster than the share price driving SRF to trade at a large premium to the portfolio value. Additionally, SRF shows a 23.53% implied distribution. This distribution is likely to be cut if oil prices don’t rebound significantly. A lower distribution and a reduction in the premium price has the potential to drive the share price over 20% lower. Further, if energy prices don’t stabilize there is significant risk of additional downside. Investors should make sure they understand the risks before allocating capital to this fund.

Country CAPE Ratios: Wizard In 2013, Dunce In 2014?

Summary The CAPE ratio was a fantastic predictor of country returns in 2013. In March 2014, Mebane Faber and Cambria Investments launched GVAL, which uses CAPE-like methodologies to buy the cheapest global markets. How did CAPE and GVAL do in 2014? Introduction As followers of my Buy-the-Dip High-Yield portfolio would know, I am a value investor at heart. The fact that value stocks outperform growth stocks has been proven by ample academic research, and is also attested to by the legendary value investor Warren Buffett’s remarkable track record over the years. One commonly used measure to determine market valuation is the cyclically-adjusted price-earnings [CAPE] ratio, also known as the Shiller P/E ratio. This metric was developed by U.S. economist and Nobel laureate Robert Shiller, and is defined as price over 10-year average earnings adjusted for inflation. By using 10-year average earnings rather than one-year trailing (or forward) earnings, fluctuations in net income caused by variations in profit margins over a typical business cycle can be reduced. The use of CAPE as a valuation indicator does have its limitations. While high CAPE values have been associated with lower future long-term returns, and lower CAPE values with higher future long-term returns, the CAPE ratio does not reliably predict near-term tops and bottoms. In a chart from a December 2013 article by Hussman Funds entitled ” Does the CAPE still work? “, the projected 10-year returns predicted by CAPE was found to correlate nicely (> 90%) with actual 10-year returns, except when markets became very overvalued or very undervalued . (click to enlarge) (Image from Hussman Funds) The current CAPE ratio of the U.S. market (27.33) is significantly higher than both its historical average (16.58) and median (15.95), suggesting moderate overvaluation of the market, and thus, low future returns. However, the above commentary from Hussman Funds states that actual returns can exceed CAPE forecasts when stocks become overvalued (“Actual 10-yr. returns overshoot in 1990 and 2003 because market overvalued in 2000 and 2013”). My own interpretation of this is that if the U.S. market were to remain overvalued for the next couple of years, then the subsequent returns could be greater than what is currently predicted by CAPE. However, Hussman Funds is seemingly confident that would not be the case: The CAPE Ratio is doing exactly what it has always done, which is to help investors anticipate the investment returns they should expect over the next decade. Those returns will very likely be in the low, single digits. Country CAPE Does value investing work for countries? According to Mebane Faber, co-founder and Chief Investment Officer at Cambria Investments, the answer is a resounding “yes”. In a January 2, 2014 posting on his “Meb Faber Research” website, Faber points out that the countries with the cheapest CAPE ratios massively outperformed those with the highest CAPE ratios in 2013. The bottom-5 and bottom-10 CAPE countries averaged 20.74% and 21.11% returns, respectively, in 2013, while the top-5 and top-10 CAPE countries averaged -17.81% and -5.39%, respectively. This represents a differential of 38.59% for the top-5 versus bottom-5, and 26.5% for the top-10 versus bottom-10, a remarkable outperformance. (Image from Meb Faber Research ) I compiled the total return performances into a bar chart. Blue bars represent the cheapest countries, red bars represent expensive countries. Countries are sorted from left to right, in order of increasing CAPE values. I have also compiled the data into a scatterplot, to show the relationship between CAPE on the December 31, 2012 and 2013 returns. On the face of it, the divergence between the most expensive and the cheapest stocks in 2013 was pretty dramatic. Even with the outliers (Russia and USA) present, a statistical test conducted on this data revealed that the negative correlation was highly significant (p-value = 0.00018). In other words, countries with high CAPE values showed lower 2013 returns, while countries with low CAPE values showed higher 2013 returns. These results, therefore, suggested that CAPE was an excellent metric for identifying cheap markets to obtain outsized returns. Three months later, Cambria debuted the Cambria Global Value ETF (NYSEARCA: GVAL ), an ETF fund (with a relatively high 0.69% expense ratio for a passive fund) that uses CAPE-like methodologies to invest in the cheapest markets globally. Coincidence? Maybe. How good was CAPE as a valuation measure in 2014? Last year, Faber had actually pre-empted his new year’s article with a December 5, 2013 posting that showed the impressive performance of the CAPE indicator through the first 11 months of 2013. Unfortunately, he had chosen not to do so again this year. Therefore, I took it upon myself to obtain data for CAPE ratios for countries from the start of the year and compare those with their YTD performances. 2014 Country CAPE Evaluation Meb Faber updated his CAPE ratios at the start of the year. As reported by Seeking Alpha : Mebane Faber updates countries’ cyclically-adjusted price-earnings ratios for the start of the year, and Greece, Russia, Ireland, Argentina, Hungary, Jordan, Austria, and Lebanon make the list of the cheapest – all under 10. How did the CAPE do in 2013? If you bought the 5 highest-priced countries – Peru, Colombia, Indonesia, Mexico, and Chile – you would have lost 17.8%. If you bought the 5 cheapest – Greece, Ireland, Argentina, Russia, and Italy – you would have gained 20.7%. Unfortunately, I do not have a subscription to The Idea Farm, Faber’s subscription service, and so could not access Faber’s updated list of CAPE ratios. Therefore, bits and pieces of data were instead obtained from StreetAuthority and from StarCapital . In the table below, CAPE ratios for countries marked with (^) are from StreetAuthority, and are from 12/11/2013. CAPE ratios for the remaining countries are from StarCapital, and are from 1/31/2014. Although the two sets of CAPE data originate from time points nearly two months apart, I reasoned that it should not have a large effect on the analysis, because CAPE is a long-term measure of valuation. 2014 YTD return data are from Morningstar . Country ETF CAPE 2014 YTD % Greece (NYSEARCA: GREK ) 4.03 -36.35 Argentina^ (NYSEARCA: ARGT ) 6.91 -3.12 Ireland^ (NYSEARCA: EIRL ) 6.94 0.67 Russia^ (NYSEARCA: RSX ) 7.11 -42.54 Jordan^ 8.64 Italy (NYSEARCA: EWI ) 8.8 -7.98 Austria^ (NYSEARCA: EWO ) 9.16 -19.47 Hungary^ 9.46 Croatia^ 9.81 Lebanon^ 9.97 Israel^ (NYSEARCA: EIS ) 9.98 -1.39 Spain (NYSEARCA: EWP ) 10.3 -2.22 Belgium (NYSEARCA: EWK ) 12.2 4.81 Norway (NYSEARCA: NORW ) 12.3 -21.68 United Kingdom (NYSEARCA: EWU ) 12.6 -5.77 Singapore (NYSEARCA: EWS ) 12.9 2.6 France (NYSEARCA: EWQ ) 13.8 -7.97 Netherlands (NYSEARCA: EWN ) 14.5 -3.53 Australia (NYSEARCA: EWA ) 16.2 -4.73 Germany (NYSEARCA: EWG ) 17.3 -9.51 Hong Kong (NYSEARCA: EWH ) 18.2 3.15 Canada (NYSEARCA: EWC ) 18.6 1.57 Switzerland (NYSEARCA: EWL ) 21.6 0.28 Japan (NYSEARCA: EWJ ) 23.9 -4.22 USA (NYSEARCA: SPY ) 24.6 14.68 The 2014 YTD total return performances have also been compiled into a bar chart. Blue bars represent the cheapest countries (CAPE