Closed End Fund trading at a discount + offering 10.25% yield + upside from cyclical recovery

I think closed end funds are fascinating and I plan on writing a few posts about them. Unlike an open-ended mutual fund, closed end funds (CEFs) have a fixed number of shares and trade on exchanges much likes stocks. They can also use leverage to amplify their returns. Due to the fixed number of shares and actual IPO’ing of the fund, the asset base is “fixed” which can be attractive relative to open end funds which must sell assets when their shareholders sell the fund, which usually is at the precisely wrong period of time. This can also create opportunities for value investors since in times of volatility and shareholder selling, CEFs can trade at a discount to their net asset value.

For example, if a fund owned a 100 shares of Apple and the stock was at $200, the underlying net asset value would be $20,000. Let’s say there are 4,000 shares outstanding of this fund so the implied NAV per share is $5. But lets say one large shareholder of this fund needs to sell the closed end fund for liquidity and is willing to sell at $4.50 just to get out quickly. Well that creates opportunity for us to buy Apple at a 10% discount.

That’s essentially what happens with CEFs, though there are some caveats. Sometimes a fund can trade at a discount for good reasons. The managers’ performance could be abysmal, the fees could be too high, leverage could be too high or too risky so there’s an added risk premium involved, there could be large capital gains that will be distributed to shareholders eventually, and so on and so on.

I try to find opportunities in CEFs where there’s not only downside protection from the fund trading at a discount, there’s also a high current pay distribution, favorable tax treatment, and maybe some modest upside.

I think the ClearBridge Energy MLP Total Return Fund represents that example. It currently trades at a 5.4% discount to NAV, it offers a 10.25% yield (on cyclically depressed oil earnings), and has upside from the oil price recovery. Indeed, investors seem to be eschewing the MLP sector right now for poor reasons, which also attracts me to the sector.

The fundamental investment decision comes down to the MLPs having depressed stock performance when the factors that drive higher earnings (volume of oil gas produced) are moving in the right direction now that oil has recovered to the $70-$80 range today from the $20-$40 range in 2016. The Alerian MLP index was down nearly 12% in Q1’18.

Legg Mason has some stats I find interesting from their website. One, multiples in the MLP space are 2 turns below average and two, distribution rates are approaching levels when oil was crashing and everyone wanted out.

MLP Distributions above averageMLP EBITDA multiples

There are some reasons for concern. One, some MLPs, like Genesis Energy, unexpectedly cut their distribution. Enbridge, Williams and Plains All American also cut their distributions despite being viewed as “safe” midstream MLPs. However, this is a positive as MLPs often must consistently dilute shareholders by raising equity to fund capital projects. After the most recent oil rout, it appears MLPs are much more focused on self-funding, which is a positive for investors.

An announcement by the Federal Energy Regulatory Commission (“FERC”) in March also scared investors. It essentially stated that it would no longer allow MLP interstate natural gas and oil pipelines to recover an income tax in the cost of service rate. The Alerian index immediately traded down 10%, though has recovered somewhat, but 26 companies announced it would have no effect on them and the management team of CTR estimates it has a 1% impact to EBITDA, so not that meaningful. Only one fund that I know of cut its distribution on the news. This seemed like investors were shooting first and asking questions later.

The fund is somewhat concentrated with 43 holdings with Enterprise Products making up almost 10% of the fund and the top 3 holdings making up 22% of the fund, but I am comfortable with that risk. Enterprise is a great company, its distribution is covered 1.3x, and it has raised its distribution for 55 straight quarters. Pretty amazing.

I think a 30% total return on CTR is not unreasonable over the next 2 years driven by 1) the 10% dividend yield and 2) recovery in energy and recovery in MLP sentiment.

I should also take this time to say that the distribution is tax efficient. Most of the distribution is classified as a “return of capital”. This arises from depreciation claimed by the MLP which has reduced net income, though cash flow may be higher (since depreciation is non-cash expense). Therefore, if I had a $100 MLP and it paid me a $5 return of capital distribution, that would drive my cost basis to $95 and I would not owe taxes on it until I sold the units. This is highly advantageous for a 10% yield fund.

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.