Value Investors Club / CENTRAL FUND CANADA -CL A (CEF.A)

Description

Last November I recommended going long Central Gold Trust (GTU), a

closed end fund holding just physical gold, then selling at a record high

11% discount to its NAV, or as an alternative, going long GTU and

hedging by shorting an equivalent amount of GLD, an ETF that always

trades right around its NAV.

I was thinking then of also writing up Central Fund of Canada (CEF),

similar to GTU and run by the same management, but older and larger,

with a roughly 62/38 mix of gold and silver bullion as its assets. It also was

selling at a relatively high discount to NAV then, but I had a couple other

ideas for possible VIC write-ups that weren’t so similar.

Time has moved on, my VIC anniversary date draws near, and even

though the discount from NAV is lower than before (~6%), I now like CEF

better, hedged or unhedged, than the other ideas. One reason is that a

Canadian activist investor, Polar Securities, has begun a campaign for CEF’s

two stablemates, GTU and Silver Bullion Trust (SBT-U CN), to allow

redemptions at NAV like an ETF. If that succeeds, CEF is clearly the next

target.

So this idea is either a hedge of long CEF short 61.5% GLD and 38.5%

iShares Silver Trust (SLV), the latter two being ETFs that always trade

close to NAV, with the idea of CEF’s discount diminishing over time. Or, I

can make a case that the bear market in gold and silver have either ended

or is getting close to that point, and being just long CEF is a good gamble

here too.

Description: CEF owns 1,694,644 ounces of gold and 76,964,103 ounces

of silver, almost entirely in physical bullion form as opposed to certificates

from counterparties. I believe that when CEF was formed in the 1960s, and

with subsequent capital raises (which it did quite a few times when it was

selling at a 10% or so premium over NAV) the money is spent in a way

that brings the value of gold and silver components of the portfolio closer

to 50/50. In recent years silver has underperformed gold, so as of Friday’s

close gold makes up 61.5% of the asset value.

Although it is a useful vehicle for anyone who wants to play an expected

price move in silver and gold, the fund was designed for those who would

love to store large amounts of gold and silver in their basement, but who

do not want to deal with the risk of theft, the expense of assays and

insurance, and the necessity of alarms and guns to protect their stash.

CEF lists these safeguards:

“Central Fund’s bullion is stored on an allocated and fully segregated basis

in underground vaults located in Canada which are controlled by its

Custodian, the Canadian Imperial Bank of Commerce (the “Bank”), one of

the major Canadian banks.

The Bank may only release any portion of Central Fund’s physical bullion

holdings upon receipt of an authorizing resolution of Central Fund's Board

of Directors.

Bullion holdings and Bank vault security are inspected twice annually by

Directors and/or Officers of Central Fund. On every occasion, inspections

are required to be performed in the presence of both Central Fund's

external auditors and Bank personnel.”

There are reasons why closed end funds usually sell at discounts, but most

don’t apply here. Liquidity of the underlying assets are not an issue; while

$2.1B worth of gold and $1.2B worth of silver are large amounts, the

markets are usually deep enough that they could all be sold in a few days

without too much impact on the prices of gold and silver. We know what

the underlying assets are and always will be, so one doesn’t have to worry

that the manager will sell good investments and use the money to buy bad

ones, which is sometimes a worry in other closed end funds. Expenses are

very low at 0.32% annually of assets as of the most recent quarter, well

below most closed end funds.

History: CEF was formed in 1961. I don’t know when it went public, but

Bloomberg price history goes back to 1986. Up until 2002 CEF bounced

back and forth between selling for a premium and a discount to NAV. The

premiums got highest near market tops of gold and silver, and the

discounts got deepest at market bottoms.

From 2002 to the end of 2012, i.e., from about a year and a half after the

start of the great bull market in precious metals that ended in the spring of

2011, to a year an a half after its end, CEF always sold at a premium.

Why would a closed end fund ever sell at a 10% premium, when one can

buy ETFs or open end funds holding the very same assets at very close to

NAV? Closed end funds have a tax advantage over commodity ETFs. For

reasons that I lack the legal training or interest to pursue, a closed end

fund is considered by the IRS to be similar to that of any stock, such that if

one sells it for a profit after holding it for more than a year, taxes are at

capital gains rates, currently at 20% federal. ETFs like GLD are considered

an investment in “collectibles” in which long term gains are taxed federally

at 28%. (The one proviso is that you have to fill out something called an

IRS form 8621 to take advantage of that; please do not listen to me on this

- check with your tax advisor.)

So at market tops people are optimistic, they expect capital gains, so they

are willing to pay more than NAV when there are cheaper alternatives,

because they want to save on taxes when they take their gains. At market

bottoms people are pessimistic and have no hope of long term gains, so

that premium disappears, and then some.

One to three times a year from 2006 to 2011, when its premium got in the

10% range, CEF had additional stock offerings, “bought deals” as they call

them in Canada, at a discount from the then current stock price but still a

premium to NAV. That had the effect of increasing NAV and expanding

assets, the latter increasing the total fees to the trust advisor but, since it

is paid on a sliding scale, reducing the fees as a percentage of NAV.

That is win-win for both the trust unit holders and the advisors, but when

the big premium turns to discounts, as they have recently, it isn’t surprising

that a large shareholder who wants to unload would rather get NAV than a

big discount to NAV, and would like the trust to make changes to allow

that.

Choices: The safest way to make money is to go long CEF and short

61.5% GLD and 38.5% SLV. You will earn 6%, the current discount, over

whatever time period it takes for the discount to be removed, at close to

no risk. The discount has been greater than that, as recently as last

November during tax selling season when gold and silver were at lower

prices than today. With the rise of an activist investor at the other two

closed end funds run by this advisor, getting verbal support so far from the

largest shareholder of one of them, the bulls eye on CEF’s back is coming

into focus.

So I don’t know that one will have a chance to buy the stock at much more

of a discount than is the case today any time soon. From about 1994 the

discounts have rarely spiked to 10% and only then at decent bottoms, as

was the case in 2000 very near the absolute bottom of a bull market that

moved CEF up close to ten times by 2011.

For the longest history of CEF’s price relative to NAV, use the NAV function

on Bloomberg and change the start date to 4/3/86, where the data start.

At some point the discount will disappear, and you will be able to close out

both sides of the hedge at a net profit. 6% isn’t exciting, but if it happens

in a year, either because of activist investor success or because of the

psychology of the precious metals market turning more favorable, that that

isn’t a bad risk free return. If the stock returns to a premium over NAV, as

it was for many years on end until two years ago, then so much the better.

CEF’s premium/discount is reported in the late afternoon every market day

at http://www.centralfund.com/Nav%20Form.htm

The other approach is to consider CEF as a long only. It is easy to find

extensive commentary both bullish and bearish on the prospects for gold

over different time periods. I won’t waste much space here on those

arguments. I’ll just point out that the premium or discount compared to

NAV that CEF sells for, since it is a good measure of the bullish or bearish

sentiment in the gold market, has proven to be a reasonably good

predictor of which way gold is going next.

Anything can happen. Maybe gold will go down for many years and bottom

out much lower than current prices. Nothing can be ruled out. But if gold

and silver are close to a bottom here, and about to embark on a bull market

taking it back to its previous highs or beyond, one could look back a few

years from now at the discount that CEF had, both in terms of the size of

the discount and the extended length of time that it traded at discounts, and

conclude that the bottom in late 2014 should have been obvious at the

time.

A newish factor that never existed until recently is the increasingly

widespread imposition of negative interest rates by the (clueless, IMO)

central banks. That could make holding gold and silver an attractive

alternative to losing money in cash; all that it would take for that viewpoint

to spread is for their prices to start heading higher, since price action

counts more for most people than any monetary theory.

Silver Prices: I think people are well exposed to the arguments pro and

con about gold prices, but silver is a little more complicated, involving

different factors. Since it makes up a significant part of CEF’s assets, I

should discuss what affects its pricing.

There are two ways to look at silver prices. One is to assume that silver is

the poor man's gold, and will go up and down with gold, only with more

volatility. Over the decades and centuries the ratio of silver and gold prices

can make big swings, from gold selling for roughly 15 times silver in ancient

times through the early 20th century, to the 73 times silver that gold now

sells for today. For any given year, however, the correlation between their

price movements is high.

The second way is to actually analyze supply and demand. Unlike gold,

where industrial and jewelry demand is trivial compared to the stock of gold

in existence, and the output of all mines is equally inconsequential, silver

has many applications in a range of products, and the output of mines does

make a difference in overall supply and demand. Gold is always worth

retrieving and reusing, so other than perhaps wedding rings that slip down

drains and disappear in the sewer system, most of the gold ever mined has

been recovered from its original use and is reused or sitting in a gold bar or

coin somewhere. Silver, not as valuable, is often not worth trying to

recycle, especially when used in microscopic quantities as it often is.

You'll find many complications and surprises with silver, such as the fact

that even though, unlike gold, most of the demand for it is for industrial

applications, a slowing economy can actually be bullish for silver prices,

because most of the supply of silver isn't from pure silver mines, but comes

as a byproduct of mining other industrial metals, especially

copper. Anything that affects copper production, such as economic

strength or weakness, affects silver supply.

Life is short, I prefer the first approach: If gold goes up, silver will

too. Investment (or speculative if you prefer) demand and supply for silver

are what have the biggest impact on prices, because by comparison

industrial demand and supply are relatively stable. If you do want to delve

into the details of supply and demand, this outfit has

it: https://www.silverinstitute.org/site/

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise do not hold a material investment in the issuer's securities.

Catalyst

Reduction or elimination of discount to NAV due to activist investor action; possible bull market in gold and silver

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			2015	2016
Price:	12.36	EPS	0	0
Shares Out. (in M):	254	P/E	0	0
Market Cap (in $M):	3,144	P/FCF	0	0
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	3,144	TEV/EBIT	0	0