Investment Thesis
This article will take a look at the Cornerstone Strategic Value Fund (NYSE:CLM). The likely distribution increase is a product of NAV increasing from the COVID low and the low average NAV in 2020. It does not mean that the distribution coverage has improved. CLM isn't a good income investment because it overpays the distribution. Its stock picks are pretty good. And given its very high distribution policy, I am quite impressed at how close it comes to covering it. But in the end, it is just paying out too much.
I want to own CEFs that pay me a stable flow of income. I have developed a method of determining whether a specific CEF could provide a reliable stream of income. I developed my method after reading this article. My thinking is that rather than the share price, how the portfolio of the fund behaves and the income it generates is the determining factor in the reliability of the distribution. I look at a specific CEF and apply that method to determine if the fund has been supporting the distribution. Then based on current holdings and past performance, I try to determine whether or not the fund will be able to support the distribution in the future. You can read an explanation of my method and get links to the other articles in the series here.
Cornerstone Strategic Value Fund
Most funds and companies have had a very good year since the end of the initial lockdowns from COVID. I start my analysis of distribution coverage by looking at how a fund's portfolio did over the last 12 months. So, how did CLM's portfolio do?
Returns of 24.7% are very good. But as I regularly point out, even great returns can be squandered by too generous of a distribution. Is the 21% of NAV distribution policy of CLM too generous? Let's look at how NAV did to get a better understanding of that question.
Over the last year, CLM had its NAV grow 3.4%. That is a good sign that the performance of its portfolio provided enough cash to cover the distribution. Let's next take a look at the distributions paid out.
Source: CEFData
There was a significant amount of ROC in the distributions over the last 12 months. But with NAV increasing, that was likely not destructive. Let's run the rest of the number to be sure.
For the last 12 months, distributions totaled $1.9977. This included one distribution cut (distributions are set for the next calendar year at 21% of NAV on October 31). Using the average NAV of $9.977, I calculate that the yield on NAV was 20.02%. Based on the peak NAV of $10.34, I get a yield on NAV of 19.32%. With those two yield estimates above the total NAV return of 24.68% and the increase in NAV, I judge the distribution well covered over the last 12 months.
Long-Term Trends
A single year can be atypical. Timing and luck can have a big impact on a single year's performance. As the last year or so since the COVID pandemic has not been a typical year. I like to look at long time frames as the impact of timing and luck, both good and bad, tend to average out over longer periods.
So first, I look to see if the fund's portfolio produced enough returns to cover the distribution over the last 3 years. How did CLM's portfolio do?
A return of nearly 53%, or 15.2% CAGR seems pretty good for a 3 year period. But then we must remember that CLM distributions 21% of its NAV each year. So how did NAV do over the last 3 years?
Well, not so good. Yes, the fund has done well in the last year, but that doesn't put it back to where it started in 2020. And even in 2020, it was down from where it started in September of 2018. In fact, NAV decreased an average of just over 7% each year over the last 3 years. That doesn't bode well for distribution coverage.
Over the last 3 years, with 2 distribution cuts, CLM paid out $6.602 in distributions. With an average NAV of $10.42, that produces a total yield on NAV (not an annualized number) of 63.36%, or 21.12% average per year. And those numbers exceed the total return on NAV, both the total and the CAGR amounts. Coupled with the decline in NAV, which has despite significant growth this last year not yet returned to the average level of the last 3 years, I judge the distribution not covered. This accounts for why the distribution was cut twice over the last 3 years.
Let's look at NAV over a 10 year period and see what has been happening.
At a nearly 60% decline, that is a fairly substantial erosion of the fund's capital base. How did the distribution do?
This downward stair-step pattern is one of the worst for dividend investors. Investors should keep this in mind when CLM announces the distribution for next year. Unlike most of the last 10 years, this will likely be an increase.
Impact of Rights Offerings
This year CLM did a rights offering. The fund offered current shareholders the opportunity to buy more shares, proportional to the number of shares they currently owned. It was a very big success for the fund, which raised quite a lot of money.
In the chart above, we can see that CLM regularly does rights offerings. Those are the big jumps in assets under management. The one this year increased the size of the fund by nearly 50%. And since the price of the new shares offered was set at 107% of NAV, these rights offerings also are accretive to NAV.
We can also see that back in 2015, CLM did a reverse split. Numerous rights offerings and reverse splits are how CLM hides the huge NAV erosion it has experienced since its inception. The current NAV is less than 10% of the NAV at the fund's inception. The fund has on average lost 6.9% of NAV each year since it was started. This is because it is over-paying its distribution.
Future Distribution Coverage
So, while I think it is critical to understand that CLM hasn't been covering its distribution in nearly every year since the fund started, investing is about the future.
Over the last 10 years, CLM's portfolio has produced 14.5% returns on average each year. That isn't enough to support the distribution policy of 21% of NAV. So while it has done a very good job of supporting the distribution this year, can it continue to do so much better than it has in the past?
Source: CEFData
The fund is heavily into FAANG stocks and does hold Berkshire (BRK.A) (BRK.B) as well, which is good. Tesla (TSLA) is always one to expect share price appreciation. And they all have done quite well over the last year. And I think they will do well going forward. But I just don't see them growing anywhere as fast in the next 3 years as they did over the last year. And that will be a problem for CLM covering its distribution.
CLM uses no leverage and pays out 21% of its NAV. Yes, in a few years it has managed to produce that from its portfolio, and in even more years come pretty close. In fact, I am impressed by how close management has come to covering such a generous distribution. But using no leverage, it just isn't possible to generate 21%+ returns year in and year out with the types of investments CLM makes. And that overpayment has consequences.
Let's take a look at USA which invests in similar companies but has a more modest (but still pretty solid) distribution policy of paying out 10% of NAV (done by paying out 2.5% of NAV each quarter).
Conclusion
I want to point out that there are several tactics that one can do to wring more money out of a position in CLM. CornerStone offers a distribution reinvestment plan that allows shareholders to reinvest the distributions by buying shares at NAV (if it is lower). Since CLM nearly always trades at a significant premium to NAV, this is an easy way to make more money. You can keep all the shares and grow income even faster, you can sell all the shares purchased from the drip and realize an immediate profit, or you can cash out enough new shares to equal the cash distribution and still grow the number of shares you own. This is a big enough benefit that if one decides to own CLM, you should be sure your broker participates in this program. The rights offering also offers another way to get shares at a price better than what is offered on the open market.
One thing all these trading tactics depend on is that CLM shares trade at a fairly significant premium to NAV. That may not always be the case (in fact it hasn't) even if it is fairly common now.
I want a fund that pays me a dependable stream of income. CLM does not really do that. And no, just because they announce a distribution cut in November of each year, doesn't mean the income is dependable. While it is not an investment for me, that doesn't mean it can't produce a lot of cash for those who understand how the fund works. But it also means that if you want to own it and try to make money off of it, you must understand how it works.
For those who are in it, and are making money by selling off the shares they purchased through the drip plan, I think early November will be an important time. I expect the share price of CLM to go up when they announce the distribution for next year. Management has already committed to keeping the 21% of NAV policy, so this will be very likely to produce a sizable bump in the distribution. For those who are looking to sell some shares, after that announcement will offer a very good price at which to sell.
After that point, I see CLM returning to its more typical pattern. I remain bearish on its general prospects.
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