Please note, this article was first published on Morningstar.com, a sister site of Morningstar.co.uk, and analyses data from to US-listed CEFs.
Last week's article looked at the ongoing events in the Middle East and North Africa to see if any closed-end funds that invest in the region were offering opportunistic discounts. We found that, while the discounts were widening overall, they weren't widening out to levels that suggested investor panic.
That article got us wondering whether other recent periods of unrest and uncertainty had caused discounts of related CEFs to widen out to levels that represented good bargains. So, this week, we looked back on the Thai crisis of last spring and the European debt crisis, which was at fever pitch in late May and early June of 2010.
Using Relative Discounts
Many CEF investors like the investment vehicle because it offers a chance to buy assets at discounts to net asset value. They see discounts as a chance to purchase something on sale. While this is certainly true, there is no guarantee that the discount is going to narrow to net asset value or that any capital gain will be realised. What good is purchasing a CEF at a 15% discount if that 15% discount persists--or gets wider--and the net asset value falls? We consider using relative discounts to be a better method of spotting undervalued share prices than using discounts to net asset value (what we call absolute discounts). For more on relative discounts and premiums, see our Solutions Centre on the topic here.
With relative discounts, one key consideration is the time period used. For this brief survey, we used a six-month period. Investors who use relative discounts to spot bargains often have their own favourite periods to look at, and one can add on subsequent screens as well.
Again, opportunistic investing is just one way investors put capital to work in CEFs. Using relative discounts to patiently wait for a good fund to become "cheap" enough to purchase is a good way to avoid value traps and to spot when a good fund may be trading at irrational levels. It's not much different than finding a wide-moat company's stock that you're interested in investing in and then waiting for the "fat pitch" valuation to come along. But are relative discounts the end-all and be-all of CEF valuation? The short answer is no.
The Thai Demonstrations
In early March, 2010 anti-government protestors took to the streets of Bangkok, setting off more than two months of intermittent demonstrations that were met with violent government crackdowns. Even though the government in June met some of the protestors' demands, violence continued to be reported throughout the summer. After the dust settled, almost 100 citizens had been killed and more than 1,800 injured. US investors were most exposed to news of these demonstrations in April and May, before the media's attention turned to Greece's debt crisis. It's important to distinguish between local events and US investors' exposure to the news of those events, as this forms the basis of the difference between net asset values (determined largely in the local market) and the share price (determined largely by US investors and solely on US stock exchanges).
Thai Capital (TF) is one of two Thailand-focused CEFs. On May 4, using closing share prices and net asset values, the fund's z-statistic was below negative 2 for the first time. Although investors differ on when a relative discount represents a truly meaningful discount, we believe a z-statistic of negative 2 or more is indicative of relative value. The share price on that day closed at $10.81, the net asset value was $13.38, and the resultant absolute discount was 19.2%. Over the course of the next two months, the z-statistic was below negative 2 six more times, reaching a low of negative 4.8 on May 20, which coincided with the market low share price (closed at $9.80). In other words, using the z-statistic, market fears reached a crescendo for Thai Capital on May 20.
Investors who purchased shares at the close on May 4 would have experienced a paper loss of 9.0% by May 20. However, for those who had purchased shares on May 4 and still hold those shares today, the gains are impressive. In mid-December, the fund paid an annual distribution of $3.11 per share. The closing share price as of March 3 was $12.05, and the NAV was $13.61. Note that the fund still trades at an absolute discount of 11.5%. The total return since May 4 for the share price is 40.2%, versus a NAV total return of 25%.
The other Thailand-focused CEF is Thai Fund (TTF). Results are similar to those of Thai Capital. Again, on May 4, the fund's z-statistic suggested a good time to buy. Over the next two months, the z-statistic was below negative 2 a dozen more times, reaching a low of negative 6.1% on May 20, again signifying that market fears had reached a top on that date. The share price, again, reached its low during the crisis, closing at $8.40.
Had investors purchased at the closing price on May 4, their maximum paper loss (using only closing share prices) would have been 11.9%. That's a pretty steep drop over the course of less than three weeks. However, had they held until today, the returns once more are impressive. The fund paid an annual distribution of $0.5502 per share in December. The closing price on March 3 was $12.43, and the net asset value on that date was $14.38, reflecting a discount of 13.6%. The total return since May 4 for the share price is 36.2%, versus a 29.2% total return on NAV.
In both cases, the z-statistic did not signal a good buying opportunity until nearly two months after the street demonstrations began. It seems patience paid off. However, had investors decided to make a contrarian investment at the first sign of unrest, their returns would not have been significantly different. In fact, on most days, the March closing prices were lower than the share price on May 4. In other words, using the relative discount to uncover true value would have led to healthy returns, but it is difficult to argue that it flagged a unique, opportunistic moment to purchase shares.
