CION - Special Opportunities Fund: Opportunistic Investing CEF With Multiple Levels Of Discounts

2023-05-23 08:30:26 ET

Summary

• SPE currently trades at an above average 17.3% discount to NAV. Way above its normal range.
• SPE has issued a 2.75% convertible preferred for leverage that also currently trades at a significant discount to par value.
• The fund recently modified its share repurchase plan to allow unlimited purchases of its common stock and convertible preferred whenever they trade at a discount to NAV or book value.
• The fund's underlying portfolio contains CEFs, BDCs and SPACs that also trade at significant discounts to NAV, book value or trust value.

In the current market environment, the general level of closed-end fund discounts is quite attractive. One CEF that I closely follow is the Special Opportunities Fund, Inc ( SPE ) which specializes in opportunistic investing in closed-end funds, BDCs and SPACs.

For more background on the history of SPE, you can read my article on SPE that was published back in 2017.

Special Opportunities Fund: A 'Hedge Fund' For The Little Guy (NYSE:SPE)

SPE Portfolio Holdings Breakdown By Strategy

In some ways, SPE is similar to a fund of funds that holds mainly closed-end funds. Other fund-of-funds that do this include FOF and PCEF. But SPE is quite different, because many of its closed-end fund selections are based on activism or at least the potential for activism.

They also try to extract the value of discounts with their BDC and SPAC strategies. With BDC's, they generally choose issues that trade significantly below book value. They usually look for well managed BDCs where they may personally know the management and are comfortable with them. But they also occasionally purchase a BDC with sub-par management if there is a strong possibility of activism.

The SPAC arbitrage strategy is also based on extracting discounts. They purchase SPACs that trade below the trust value before a business combination is formed. This is a very safe strategy and there are several ways of exiting these positions-

• Wait for a "pop" based on speculation which sends the SPAC price well above the trust value. SPAC warrants (obtained for free by splitting the SPAC units) can add to these profits in this scenario.
• The worst case is that there is never a "pop". But even here, there is some profit to be made, because the SPAC common can be cashed in for the trust value right before the vote on a business combination. SPAC trusts are generally invested in US Treasury bills, so the SPAC trust value is almost guaranteed to gradually increase in price over time.
• Note that the SPAC arbitrage strategy is one of the few that produced positive returns in 2022.
• The NAV of SPE was down around 13.8% in 2022, but this was better than its category peers which dropped 18.6%. The SPAC arbitrage strategy helped SPE produce better relative performance during this bear market year.

SPE has issued about $58 million in a 2.75% convertible preferred issue (SPE-C). Management uses most of the leverage offered by the convertible preferred issue to invest in the SPAC arbitrage strategy. Management believes that the SPAC arbitrage strategy has averaged good returns over time, so it is quite safe to use the 2.75% convertible preferred to leverage the portfolio.

Here is a quote from the Bulldog Investors web site regarding their SPAC arbitrage strategy:

"We think it is reasonable to expect an unleveraged gross annual return of 6-8 percent while maintaining a similar risk profile as U.S. Treasuries."

By using the leverage of the 2.75% convertible preferred, the overall return of the SPAC arbitrage strategy is boosted up to around 10% which is quite good for a very safe investment strategy.

SPE has lagged the performance of the S&P 500 during bull market years like 2021, largely because of its low exposure to technology stocks. But on a risk adjusted basis, SPE has managed to produce above average performance. Here is some data from Morningstar comparing SPE with some of its peers in the "Tactical Allocation" category

SPE Risk Adjusted Performance (as of April 30, 2023)

Five Year Discount History

The net asset value (or NAV) of SPE is published on their web site weekly. On May 19, the NAV was $13.01. So the discount to NAV based on the May 19 closing price of $10.76 is 17.3%.

On May 19, FOF traded at a premium of 0.09%. RIV trades at a 8.7% discount. As an ETF, PCEF trades at or close to NAV. So SPE appears to offer a much better value than its fund-of-fund peers.

A strong positive for SPE is company management. I respect Phil Goldstein and Andrew Dakos, who have a good reputation in the closed-end fund world as shareholder-friendly investment managers. They are well connected and highly experienced in closed-end fund activism.

Share Repurchase Plan

On April 24, 2023, SPE announced that the Fund may purchase shares of its common stock and convertible preferred, both without limitation , when they trade at a discount to NAV or book value.

SPE has done share repurchases in the past when the discount rises into double digits. The fund provides a table showing shares outstanding and share repurchases every month. You can see, that the fund repurchased $36,340 of the SPE convertible preferred in April, 2023 at an average price of $23.01. They started buying back the convertible preferred right after April 24 and most likely have repurchased even more this month.

NAV Calculation When a CEF Has Preferred Stock

There is an odd "quirk" in the way that closed-end funds compute NAV when they have preferred stock in the capital structure.

From an economic viewpoint, the preferred is similar to a short position in the preferred, so you would think the market value of the preferred would be subtracted from total assets to compute NAV. But that is not how it works. The rules require the par value of the preferred to be subtracted when computing the NAV.

For example this is how the NAV for SPE was computed in the annual report at the end of 2022:

Total Assets= $210,183,608

Total Liabilities= $ 2,700,723

Total Preferred Stock= $ 58,373,850

2,334,954 shares outstanding ============

Net Assets Applicable to Shareholders= $149,109,535

The $58,373,850 amount listed for the preferred was computed by multiplying the number of shares of preferred by the par value of $25.

But the closing price for SPE-C at year-end was actually $22.69. If the closing market price for the preferred was used for SPE-C (instead of the $25 par value), the negative NAV adjustment for the preferred would have been only $52,980,106. One could make the case that the NAV for SPE was effectively understated by over $5 million.

Because of this calculation "quirk", the SPE repurchases of the preferred when it trades below the $25 par value are immediately accretive to NAV.

Review of Some Large Portfolio Holdings

As an activist investor, Goldstein looks for undervalued companies where he can add value by fighting for shareholder's best interests. The portfolio tends to be opportunistic and the asset class mix can vary over time, although much of the portfolio is normally invested in undervalued closed-end funds.

Some of the larger holdings as of year-end were:

1) SRH Total Return fund ( STEW ): This is a closed-end fund with a large investment in Berkshire Hathaway stock that currently trades at a 19% discount. It is not an activism play, since Stewart Horejsi's family controls about 47% of the shares. But SPE's management feels the fund is a good investment because of the attractive discount and the 4% managed distribution payment.

2) General American Investors ( GAM ): GAM is one of four closed-end funds that provide broad-based exposure to US equities. GAM is one of the oldest CEFs and dates back to 1927. They must be doing something right. since the fund has reached its 96th birthday!

Here is a comment from Phil Goldstein in a SPE shareholder reports from last year which discussed ( GAM ), ( STEW ), ( ADX ) and ( CET ). :

"Each of these CEFs provides broad-based exposure to U.S. equities at double-digit discounts to their NAV. Although none of them is a promising candidate for shareholder activism, each offers good value at a double-digit discount to NAV."

Here is a link to an article I wrote about GAM back in 2016-

General American Investors Corp.- 89 Years Old And Still Going Strong (NYSE:GAM)

3) Texas Pacific Land ( TPL ): This is the largest holding in the "Other Common Stocks" category. Phil Goldstein discussed TPL in the last annual report:

" One of our largest operating company investments is shares of Texas Pacific Land ( TPL ), a company that owns approximately 880,000 acres of land in West Texas, primarily in the Permian Basin, and has traditionally generated revenue through rental and royalty payments by oil and gas producers. Despite generally strong stock performance over the past few years, a number of shareholders, including us, believe that its potential is not being fully realized and that senior management has deployed capital generated by its traditional high margin business to other businesses with lower margins to justify the executives’ extremely high compensation.

We think most of TPL’s profits should be used to repurchase its shares or be distributed to stockholders. The company has sued its largest shareholder for allegedly breaching a promise to vote its shares in accordance with the Board’s recommendation on a proposal that is arguably a prelude to an acquisition. We believe the shareholder will argue that the proposal in question is exempt from its voting agreement. While it is difficult to predict the outcome of this lawsuit, a ruling for the shareholder could be a catalyst for a higher stock price."

4) CION Investment Corp ( CION ): This is a well managed BDC that trades below book value. Here is a recent article I wrote on CION in January, 2023: CION: Good 2022 Performance, But Still Undervalued (NYSE:CION)

5) First Trust Dynamic Europe Equity Income ( FDEU ): FDEU was an activism play that has turned out pretty well. Here is an article I wrote on FDEU back in Sept. 2022:

FDEU CEF: 6.86% Yield, Contingent Conversion Vote In 2023

Phil Goldstein commented on FDEU in the last SPE shareholder report that was published a few months ago:

"A proxy contest and litigation appear likely for First Trust Dynamic Europe Equity Income Fund ( FDEU ). In 2023, FDEU is required to call a shareholder meeting to vote on whether to convert to an open-end fund. We reached out to the Board of Trustees to ask if it would recommend a vote for the conversion of FDEU to an open-end fund. The Board refused to make any commitment at all. Consequently, we expect to solicit proxies to elect Trustees who are not beholden to FDEU’s manager for their positions.

We think we are likely to prevail in a fair election. However, the Board has said that it will refuse to count our proxies if they are voted for our nominees and has not explained its stance other than to say that it has determined that our nominees are ineligible and that we should not question its good faith. That leaves us little choice but to litigate."

Top 10 SPE Holdings (as of 12/31/2022)

Closed-End Fund Activism- Many Successes

The next shareholder report for SPE should be coming out in late August of this year. The shareholder reports are usually quite informative, and I believe there are many investors who like to "coattail" the investments in the fund. Because of this, I often like to gradually add to my SPE holdings before new shareholder reports come out, especially when the discount is 14% or higher.

It is hard to find a unique publicly traded security that provides a true hedge fund-like investment strategy and trades at a discount to net asset value. But unlike hedge funds, SPE provides daily liquidity and lower fees. SPE is not the most liquid closed-end fund and usually trades around 30,000 shares a day. The bid-asked spread is usually around five cents a share, so smaller limit orders are definitely recommended. That said, you occasionally see a day when the spread narrows down to one or two cents when a big buyer or seller comes into the market.

The 2.75% SPE convertible preferred which matures in 2027, is a "safer" way to invest in SPE, but it is currently trading way below conversion value. It is highly illiquid and requires a lot of patience to accumulate a large size position at a decent price.

Special Opportunities Fund, Inc. ( SPE )

• Pays Managed Monthly Distributions
• Total Investment Exposure= $207.5 Million
• Total Common Assets= $149 Million
• Last Monthly Distribution= $0.0867
• Annualized Yearly Distribution= $1.0404
• Annual Distribution (Market) Rate= 9.67%
• Fund Expense Ratio= 1.89%
• (Does not include expense of underlying CEFs or BDCs)
• Discount to NAV= -17.3%
• Portfolio Turnover rate= 54%
• Average Daily Volume= 30,000
• Average Dollar Volume= $320,000
• Effective Leverage: 28%

Source: cefconnect

Given the strong possibility of a stock market correction later this year, SPE provides a good way to get equity exposure with a lower risk profile. It also provides good diversification for other more traditional investments. I believe SPE should provide good returns going forward.

I expect there to be significant share buybacks of both the common stock and the convertible preferred as long as the discounts remain at these levels which should help to support the price and be a good catalyst to help lower the discounts.

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