2023-09-11 01:26:06 ET
Summary
- Cornerstone Strategic Value Fund is a closed-end fund that aims for long-term capital appreciation through equity securities.
- CLM's top holdings closely resemble those of the S&P 500, but it underperforms the market and has a higher expense ratio.
- CLM's poor performance can be attributed to its distribution policy, which relies on selling assets to fund dividends and leads to NAV erosion.
- Investors, who consider investing in CLM to capture ~17% dividend, should factor in a gradual decline of the future distributions.
Cornerstone Strategic Value Fund ( CLM ) is a closed-end fund with a very long history dating back to 1987. The investment objective of CLM is secure a long-term capital appreciation by allocating most of its capital into equity securities. In term of the asset allocation policy, CLM sticks to a plain vanilla approach by going long without any help of external leverage or option strategies. There is also almost no exposure to fixed income or preferred stock positions.
In essence, it is a combination of value and growth strategy in its simplest form. By looking at the Top 10 holdings of CLM we can clearly see how basic the strategy is, where majority of the largest holdings are also notable constituencies in the S&P 500.
Cornerstone Strategic Value Fund, Inc.
In terms of the sector exposures, there is not that much of difference from the S&P 500. Namely, the Top 3 sectors (i.e., IT, health care and financials) of the S&P 500 account for ~53% of the total AuM, while for CLM the corresponding exposure constitutes ~47% of the total value.
Cornerstone Strategic Value Fund, Inc.
Granted, if we peel back the onion a bit, we will see that among the remaining securities within CLM there are some deviations from the S&P 500. However, considering that the largest factors are somewhat similar and that even among the remaining investments there are some clear similarities, there is a sufficient basis to a assume CLM embodies strongly correlated risk and return factors to those of the S&P 500.
With that being said, there are three obvious differences between CLM and the market.
First, CLM is structurally underperforming the market.
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Second, CLM's current dividend yield is ~17%, which implies a ~15% of a premium relative to the market yield.
Third, the expense ratio of CLM is by 100 basis points higher relative to the SPDR S&P 500 ETF Trust (NYSEARCA: SPY ).
Thesis
Let's figure it out why CLM is doing so poorly.
One reasons is that CLM is more expensive, which imposes a drag on the total returns. We cannot argue against this, but at the same time it is clear that 100 basis points of spread in expense ratio does not explain the 120% underperformance over the past 10 year period.
Another reasons which is also rather obvious is the CLM's sector and security-level allocations, which have differed from the pure-play market cap weighted approach that comes along with investing in SPY. Historically, the top largest holdings of SPY have been the key drivers of the total returns, where even a slightest deviation from the exposure towards these mega-cap names would have resulted in a negative alpha. Looking into the current and historical holdings of CLM, we can see this to be the case.
While the two aforementioned aspects have indeed contributed to a subpar relative performance of CLM, these are not that CLM specific, meaning that most of the CEFs, which deploy their capital in a different manner than SPY have suffered from the same problem (i.e., negative alpha relative to SPY). Although one could argue here that in CLM's case investors should punish more the Fund given that there is no clearly stated edge from the market as it can be seen from the prevailing investment structure.
Now, the key explanation of CLM's poor results lie in the fact how CLM distributes its capital to shareholder. CLM's strategy is to maintain abnormal distribution levels to attract yield-seeking investors.
Cornerstone Strategic Value Fund, Inc.
By looking at the table above, we can see that the annual net investment income accounts for less than 1% of the total NAV. The net investment income is determined by subtracting CEF's fees from the received dividends stemming from the investment in the equity securities. The actual investment income is somewhere between 0.5 to 1.5% (depending on the year), but the CLM's fee structure consumes almost half of the received dividend proceeds.
To accommodate a massive dividend yield, CLM has to tap into the capital gains portion that is associated with the equity investments. Namely, it has to give away a notable share of its NAV to cover dividend.
Without additional unit issuances or investor choices to substitute the received dividend with an increased exposure to CLM (i.e., more units), CLM's NAV would eventually approach zero. The pace of it would depend on how solid the equity performance is, but assuming that markets cannot deliver double digit returns every year, the assumption about CLM's limited life would still hold.
So, the only reason why CLM has not lost most of its value over so long time period is the fact that there is demand for its units. And the demand is there because CLM typically trades at a premium to NAV, where the existing unitholders by choosing additional units (priced at NAV) over dividends can actually make some profit. In other words, they can buy at CLM at a discount and assuming a constant dividend increase the next received amount of dividends accordingly.
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Well, the dividend history of CLM indicates that such strategy over the long-run have not been too profitable. Almost each year CLM has gradually reduced its dividend. This is because there is still some investors who opt to receive dividend in cash and not reinvest in CLM. This way, CLM's asset base shrinks and in the periods of poor equity market performance, CLM has to sponsor the distributions by divesting some of it existing asset base.
The bottom line
In my humble opinion, there is no clear advantage of CLM considering the fact that the equity exposures do not differ that much from the S&P 500. CLM is also more expansive and the historical equity-selection approach has led to an even more pronounced underperformance relative to the S&P 500.
While CLM's dividend distribution policy might seem attractive, given that a heavy portion of the distributions are funded by selling part of the existing asset base, it becomes a constant battle with NAV erosion. This is what we can see by looking at the historical performance and the structural decline in the dividends.
For further details see:
CLM Is A Structural Value Trap