GGZ CEF: too much leverage

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Thesis

The Gabelli Global Small and Mid-Cap Value Trust (NYSE: GGZ) is a diversified closed-end investment company focused on mid-cap equities. The primary objective of the fund is capital growth. According to the fund literature:

Under normal market conditions, the The Sub-Fund will invest at least 80% of its total assets in equity securities (such as common stocks and preferred stocks) of companies with small or medium market capitalization. The Fund currently defines “small-cap companies” as those with a market capitalization generally below $3 billion at the time of investment and “mid-cap companies” as those with a market capitalization between $3 billion of dollars and 12 billion dollars at the time of the investment. At least 40% of its total assets will be invested in equity securities of companies located outside the United States and in at least three countries.

The fund is quite small with approximately $100 million in assets under management and an expense ratio of 1.8%. The fund has a low Sharpe ratio of 0.2 over a 5-year range and has significantly underperformed both major mid-cap indices, the S&P Mid-Cap 400 Index (SP400) and the Russell Index, as evidenced by the ETF iShares Russell Mid-Cap (IWR). The fund has a total return over the past 5 years which is only 7% and its high leverage was responsible for a massive decline during the Covid crisis. We believe we are currently in the middle of a bearish rally and are not done with selling stocks, so there is further weakness ahead for GGZ. However, more importantly, over the long term, we do not see the necessary alpha generation capabilities that would cause us to go long in GGZ versus a regular ETF in the mid-cap space.

We believe this fund is running too high a leverage ratio and has a stock selection that failed to impress during the last market upswing. Leverage can be destructive when the underlying stocks aren’t outperforming the index, and that’s what we see in this case. It’s ultimately about total returns, and GGZ is lagging behind. The vehicle is trading at a -13.2% discount to NAV and has experienced discounts of up to -20%. There is nothing in this fund’s metrics or historical performance that would encourage us to go long in GGZ versus a plain vanilla index ETF in the space. We believe this is an example of a CEF using too much leverage that has not translated into returns.

Analytic

Assets under management: $0.1 billion.

Sharpe ratio: 0.2 (5 years).

Diversion St: 22 (5Y).

Yield: 5.78%.

Expense ratio: 1.8%.

Premium/Discount on NAV: -13.2%.

Z Stat: -0.9.

Leverage ratio: 38%.

* the fund uses leverage via a preferred stock offering rather than a traditional TRS line with an investment bank

* CEF has 4.00% Cumulative Preferred Shares Series B (GGZ.PRB) outstanding with an aggregate notional amount of $40 million

Assets

The fund counts Food & Beverage as its main sector:

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Top Sectors (Fund Fact Sheet)

The top holdings are as follows, but being in the mid-cap space, the companies aren’t big names:

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Top 10 Holdings (Fund Fact Sheet)

Herc Holdings (HRI), for example, is an equipment rental company with a history of over 60 years. The company has a market capitalization of 2.75 billion which has almost doubled in the past two years. The fund has an annual asset turnover of 23%, which means that holdings change quite frequently.

Performance

The fund is down almost -30% since the start of the year:

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Cumulative performance since the beginning of the year (in search of alpha)

The vehicle is down nearly -30% since the start of the year against -20% for the benchmark indices. The reason for this deeply negative performance is the fund’s high level of leverage, which stands at 38%. As a reminder, leverage amplifies both upside and downside returns. 2022 turned out to be the year when the decline is amplified.

More worryingly, the fund also failed to beat the indexes during the market rally:

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Performance over 5 years (in search of Alpha)

We don’t like to see this type of chart – a highly leveraged CEF with good stock selection should be able to beat the index when the market is static or rising. Otherwise, it is symptomatic of poor security selection and results in a CEF that should not be bought. We can see from the chart above that GGZ didn’t beat the index from 2017 to 2020, had a massive decline that hurt some of the holdings during Covid, and never outperformed afterwards. There’s not much to like here where a total return over a 5 year period is zero. Why hold an investment if it doesn’t produce a return while the benchmark index does?

Premium/Discount

The fund is currently trading at a -13.2% discount to net asset value. To put it in historical context:

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Premium/Discount (Morningstar)

The current discount to NAV tends towards the broad side, but the fund has always traded at a discount to NAV. We can see that in 2018, this discount reached a wide of -21.2%.

Conclusion

GGZ is a closed-end fund focused on US mid-cap equities. The fund has a fairly poor track record, underperforming unleveraged ETFs in the space. GGZ runs a very high leverage ratio of 38%, which is behind its deep negative performance of nearly -30% year-to-date. The vehicle also saw the destructive force of leverage during the Covid crisis when it suffered a very deep decline. With poor risk/reward analysis, we believe GGZ is a good example of a CEF executing very high leverage while not producing matching results. We see no reason to go long in GGZ versus a regular unleveraged ETF in the mid-cap space.

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