August 29, 2014
Dear Fellow Shareholders:
Despite the stock market’s phenomenal run since March 2008, investors have shown little fear of heights, at least through the date of this letter. On June 30, 2014, the Fund’s market price closed at $16.70 per share, down 4.33% from its closing price of $17.45 per share on December 31, 2013. (Conversion of almost all the convertible shares during the period resulted in dilution of $1.44 per share.) For the same period, the S&P 500 Index gained 7.14%.
The Fund’s recent underperformance is due in large part to the widening of the discount to net asset value after the retirement of our convertible preferred stock was announced in January. By early 2014, the price of the preferred stock had increased in value so much that it had become a proxy for the common shares and some preferred shareholders had converted their shares to common shares. Rather than having to deal with unplanned conversion requests on a one-by-one basis, the board determined to retire all the convertible preferred stock. Although we feel the Fund had properly accounted for the dilutive effect of the convertible preferred shares in reports to shareholders, the stock price of the common shares fell about 6% on the day of the announcement.
As a reminder, the goal of Special Opportunities Fund is to outperform the market over the long-term with less short-term risk than a broad-based index fund. We have been incurring, and probably always will attempt to incur, less risk than the S&P 500 Index. Currently, we have a fair amount of investments that have little or no correlation to the stock market such as SPACs and special situation stocks like Gyrodyne and Imperial Holdings.
For shareholders that have become accustomed to extensive discussions about our current investments, this letter may be a disappointment. We always want to afford shareholders as much insight as possible into our investment philosophy and our thinking. On the other hand, we have become increasingly concerned about disclosing details about our current investments that could have a harmful effect on the Fund. A respected value investor once put it this way: “Truly good investment ideas are simply rare commodities, particularly so when price discipline is so infused into our decision making process.” Bulldog Investors, LLC, the Fund’s investment advisor, gets paid to try to make good investments for the Fund’s benefit and, when necessary, to take measures to enhance their value. As a prominent legal scholar told me privately, “[The problem] is that disclosure is [available] to friend and foe alike….The foes, e.g. competitors, can use that information to construct their own portfolios.”
In particular, as an activist fund, we have become acutely aware of the free rider problem. With that in mind, we have determined that, from now on, we will only elaborate on our current investments if we believe there is a low probability that it will negatively impact the Fund’s performance. The investments discussed below fall into that category.
To compensate for the lack of specifics herein, we invite all shareholders to attend the annual meeting in person at a date and location in the New York City area to be announced. I promise to be as open as possible until the Fund’s counsel kicks me under the table.
Gyrodyne Corporation of America (GYRO, Financial)
Just before the end of 2013, Gyrodyne paid a special dividend of $66.56 per share consisting of $45.86 in cash and the balance in units of an untraded LLC. In addition, Gyrodyne distributed nontransferable “dividend notes” with a face value of $10.89 per share. A plan of merger was to be put to a shareholder vote at a special meeting which, if approved, would have resulted in the LLC units and dividend notes being converted into publicly traded equity interests (at pre-established ratios) in a newly formed company with a goal of maximizing the value of that company. However, the unusual distributions apparently led to a shift in the shareholder base from value investors to day traders. The result was that a quorum was not reached and the special meeting has been postponed. We continue to believe there is value in Gyrodyne’s stock and in the other Gyrodyne securities. Given our experience as activists and our long history as investors in Gyrodyne, we may seek to play a role in unlocking Gyrodyne’s intrinsic value.
Imperial Holdings (IFT, Financial)
To recap, following an FBI raid on Imperial’s office in September 2011, we commenced buying stock at about $1.60 per share. We later gained representation on the board with an immediate goal of reducing the cash burn that was being driven by inordinate legal expenses. We have made substantial progress since then. On June 30, 2014, Imperial’s shares closed at $6.82 per share vs. a stated book value of $9.83 (not including dilution from the exercise of Imperial’s convertible notes). A portfolio of life insurance policies with an aggregate face value of approximately $3 billion, which is valued by assuming an average discount rate of about 19% per annum, represents substantially all of Imperial’s book value.
Imperial’s board and management team are focused on maximizing shareholder value by reducing expenses, especially legal expenses, defending Imperial’s life insurance policies from challenges to their validity by carriers, and capitalizing on opportunities to enhance shareholder value as a result of its improved financial position. There are still risks but, absent any calamities, we think the stock price could rise significantly over the next five years. Those that want to do their own research might wish to check out an archived presentation that was given at Imperial’s June 5, 2014 annual shareholder meeting at http://ir.imperial.com/events.cfm.
Western Asset Inflation Management Fund (IMF, Financial)
We began to purchase shares of IMF, a closed-end fund that invests in inflation protected government securities, at a double-digit discount in the third quarter of 2013. A key factor in our decision was that a standstill agreement entered into several years ago by a very large shareholder had recently expired. On November 22, 2013, we filed a Schedule 13D indicating that our group owned over 8% of the outstanding shares of IMF and stating that we “intend to communicate with management about measures to address the disparity between the Fund’s stock price and its net asset value.” Purely by coincidence, the other large shareholder filed its own Schedule 13D on the very next business day disclosing that it would nominate candidates for election to the board of directors. We saw that filing as leaving management with no choice but to provide a liquidity event. IMF’s discount narrowed after the filing but we continued to buy aggressively because we thought it would inevitably go to zero. Sure enough, on January 21, 2014, IMF announced a proposal to dissolve the Fund and it liquidated on June 2, 2014.
SPACs
Our portfolio continues to have a significant weighting in SPACs or blank check companies. A SPAC raises funds from investors in an IPO that are placed in a trust account while the sponsor pursues the acquisition of an unspecified company. Each SPAC is unique, but most are issued as units consisting of a share of common stock plus a “free” warrant. The common stock provides us with a modest return and we hope to make money on the warrants if a successful transaction is completed (because, with the elimination of a possible liquidation, the warrant price often increases, sometimes substantially). Otherwise, we just make a modest profit or break even, give or take a few cents per share.
Foreign Closed-End Funds
As we have mentioned, we are planning a spin-off of a new closed-end fund with a primary focus on investments in foreign closed-end funds and similar vehicles. The plan has been delayed due to certain concerns expressed by the SEC’s Division of Investment Management. However, we expect those concerns to be resolved very soon and hope to be able to consummate the spin-off by the end of the year. We continue to see value in offshore closed-end funds that trade at a relatively wide discount or have discount control measures such as periodic self-tender offers or a commitment to permit shareholders to vote on the fund’s continuation at some time in the future.
Why We Invest in Closed-End Funds
The Fund is almost always heavily invested in closed-ends funds. A diversified portfolio of well-selected discounted closed-end funds should generate outperformance over the long term and limit short term risk. In this and future letters, we will explain why we like closed-end funds.
Every thinking investor buys an asset that he thinks is cheap and sells those assets that he thinks are fairly valued or overvalued, or at least less undervalued than some other asset in which the proceeds can be re-deployed. In that sense, every thinking investor is a “value investor.” The problem is determining the fair value of an asset. For example, investors that bought Amazon early this year at more than $400 per share must have thought it was cheap. Otherwise, why buy it? It is now below $350 per share. Is it cheap now? The truth is that no one knows the answer with any degree of certainty because the factors that affect Amazon’s prospects at any point in time are perceived, weighted, and processed differently by different people.
Another example of the inherent difficulty of valuing a company’s stock is the well-publicized (and entertaining) feud between two high profile very vocal activists, Bill Ackman (Trades, Portfolio) and Carl Icahn (Trades, Portfolio), over Herbalife. Ackman claims Herbalife is an illegal pyramid scheme and is short the stock. He has been attempting to induce federal regulators to investigate Herbalife with the goal of shutting it down. Icahn, meanwhile, has taken a large stake in Herbalife, says it is undervalued, and that Ackman is “completely wrong” and his crusade is “almost bordering on the insane.” Thus, despite the fact that they are looking at the same facts, two very intelligent and very successful investment managers are poles apart on Herbalife’s valuation. We have no dog in this race1 but that should give pause to anyone who thinks valuing an operating company is cut and dried.
Contrast that with a closed-end fund trading at a double-digit discount to its net asset value, e.g., Swiss Helvetia Fund. We think both Ackman and Icahn would agree that SWZ is cheap.2 While there are other factors to consider before investing in a closed-end fund, the most important factor is almost always the discount. Thus, errors in valuation are much less likely, and hence short term risk is significantly lower, with a discounted closed-end fund than with an operating company.
To be continued….
Sincerely yours,
Phillip Goldstein
Chairman
1. However, even if Ackman is right, we are dubious about his chances of getting regulators to act. Harry Markopolos tried for years, without success, to get the SEC to shut down Bernie Madoff’s Ponzi scheme. And, as documented in his book, “Fooling Some of the People All of the Time,” David Einhorn (Trades, Portfolio) not only failed to get the SEC, the Justice Department or the SBA to act against Allied Capital’s accounting fraud, but he himself became the target of an investigation.
2. There are likely other reasons that Ackman and Icahn might not invest in a closed-end fund, including legal constraints, the inability to put huge amounts of money to work in a reasonable time, and the fact that they are looking for assets with greater, albeit more uncertain, undervaluations (and hence higher returns) than closed-end funds.
Source: Special Opportunities Fund, Inc. - Semi-Annual Report for the six months ended
June 30, 2014
