From Seeking Alpha

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The CUBA fund is a Caribbean Basin fund with holdings that are mostly US, Mexican and Panamanian companies with operations throughout the Caribbean islands.The fund has no direct relationship to the country of Cuba nor the economic performance that could materialize if relations are normalized between them and the US.
Irrational exuberance given the ‘dumb money’ within the investing space has bid up the share price to a 60% premium over the net asset value of the fund.
Insiders took full advantage of the situation selling 12% of the shares at the astronomical spread to NAV indicating the nature of the opportunity.
Pair trading with a basket of the current holdings will eliminate the underlying NAV risk while isolating the mispriced spread and exploiting the mean reversion trade.
For those experienced within the closed-end fund world, the below chart is eye-popping.

The above chart is the discount/premium of the Herzfeld Caribbean Basin (NASDAQ:CUBA) closed-end fund. The shares of the fund have largely done nothing in the last fifteen years until recently when the Obama Administration announced a relaxing of relations between the US and Cuba. The restoration of full diplomatic relations opens the door for greater economic trade between the two nations.

On the news, the Herzfeld Fund jumped from $6.81 on December 16th, 2014, and a 12.6% discount to NAV to $8.78 and a 9.2% premium over one trading day. As of June 2nd, the share price had risen to $11.80 and an amazing 60.3% premium to net asset value.

Not A Traditional Country-Specific Closed-End Fund

Country closed-end funds have a long history dating back to the 1800s when the English created them to invest in the Argentine Republic. They are formed with the objective of having the capability of investing into a single security but gaining access to a large chunk of the underlying country’s market. The closed-end fund wrapper is extremely efficient as it creates a fixed-pool of assets eliminating redemption and issuance risks given the underlying securities tend to be fairly illiquid.

These pools of assets were important in allowing for investment into nascent market-based economies, especially during the 1970s through the 1990s. These funds would invest directly into the debt and equity securities of companies within these countries. For instance, the Mexico Fund (NYSE:MXF) states clearly within their annual reports:

The Mexico Fund, Inc. (“the Fund”) is a non-diversified closed-end management investment company with the investment objective of long-term capital appreciation through investments in securities, primarily equity, listed on the Mexican Stock Exchange. The Fund provides a vehicle to investors who wish to invest in Mexican companies through a managed non-diversified portfolio as part of their overall investment program.

The Fund’s investment objective is long-term capital appreciation through investment in securities, primarily equity, listed on the Bolsa Mexicana de Valores, S.A. de C.V. (the “Mexican Stock Exchange”). The Fund may invest in Mexican fixed-income securities and bank time deposits of Mexican banks, all of which are peso-denominated and may be dollar-linked (i.e., paid in pesos but with repayment linked to a dollar exchange rate), in order to provide appropriate liquidity to take advantage of market opportunities and meet cash requirements. The Fund may also invest in dollar-denominated deposits and floating rate notes of Mexican banks. As market or other conditions require, the proportion of the Fund’s assets held in fixed-income securities or bank time deposits may vary. The Fund will not realize capital gains for the sole purpose of making distributions to shareholders.

The difference between the typical country closed-end fund, one of which we detailed above, which typically invests in equities of the country, and the objective of the Herzfeld Caribbean Basin Fund is important. The strategy is centered on investing in issuers that are “likely, in the Advisor’s view, to benefit from economic, political, structural and technological developments in the countries in the Caribbean Basin, which consist of Cuba, Jamaica, Trinidad and Tobago, the Bahamas, the Dominican Republic, Barbados, Aruba, Haiti, the Netherlands Antilles, the Commonwealth of Puerto Rico, Mexico, Honduras, Guatemala, Belize, Costa Rica, Panama, Colombia and Venezuela. The fund invests at least 80% of its total assets in a broad range of securities of issuers including U.S.-based companies that engage in substantial trade with, and derive substantial revenue from, operations in the Caribbean Basin Countries.”

In no part of the objective of the fund does it even mention the country of Cuba – other than the ticker symbol itself. The fund invests mostly in US equities which constitute 48% of the fund’s holdings with 14% from both Mexico and Panama. They do note on the geographic allocation that they have zero ownership of net assets in Cuba – which is not currently possible.

In addition, many of the top holdings already have a presence on the island that is likely to see only marginal benefit if economic relations fully normalize. Their top holding, Copa Holdings (NYSE:CPA), is a regional airline based in Panama. It already has service to Havana from Panama City. And an American can already fly to Havana indirectly through Panama or Mexico. While the number of travelers is likely to increase significantly from the ~300K to roughly 3+ million per year (where it was prior to the embargo), Copa is likely to see substantial competition from the American airlines who will then be able to fly directly to the island. If that’s the case, Copa is likely to a possible reduction in American passengers on its routes.

We can expand this to many of the top ten holdings of the fund as well:

Seaboard Corp. (NYSEMKT:SEB), a top holding for the fund for a long-time, is in the pork and agribusiness industries. But in 2000, the Clinton Administration passed the Trade Sanctions Reform and Export Enhancement Act, which allowed for the export of food and agricultural products on a cash basis. Over the last fifteen years, the US has exported $15 billion worth of agri-products to the island, which is a large sum for people that on average earn $20 a month.

Cuban Irrational Exuberance

The fund’s annual report highlighted the change in the relations situation. As they note, the US-Cuba embargo remains in place and the new policies include easing travel restrictions, allowing US financial institutions to open accounts with Cuban banks, credit card cross-border transactions, and the export of more goods and commodities to the island. The notion that the island is going to see an influx of capital and an economic boom starting almost immediately is a fallacy.

The talks are ongoing and could fail at any point in time. The Cubans got their most important issue, having the President take the country off the state sponsors of terrorism list (allowing it more freedom for banks to operate there) and assistance in finding a US bank that was willing to handle Cuban money. Meanwhile, the US still has not received what it wants from the talks, namely unrestricted travel by US diplomats throughout the island and, most problematic, which was thrown in by President Castro just two weeks ago, was the shutdown of some of the pro-democracy programs run out of the interests section (the de facto embassy for the US to Cuba which resides in the US).

Clearly, the entrenched Cuban government is skeptical, with a bit of paranoia thrown in, believing that this move by the US is some submissive plot to create dissent and overthrow the Castro regime. The decision on establishing an embassy on Cuban soil is creating a significant amount of hesitation with the move into the country by American companies likely a long way away. While some industries that would be highly beneficial to their infrastructure build-out may be permitted – namely telecom – along with the sale of food and agricultural products already allowed, other business in the country is likely to be extremely difficult. At the end of the day, the Castro regime still controls everything that occurs on the island, has a complete disdain for capitalism, and believes in the micromanaging of everything including limited restaurant seating to just 50 seats.

Foreign investors are likely to remain very cautious when and if they are able to start investing more heavily in the country. For one, Cuba insists that it retain a majority stake in nearly all ventures on the island. Secondly, they have an intricate bureaucracy with complicated work arrangements, which can require long lead times to hire employees. Legal contracts and property rights are non-existent and while the workforce is educated, they have no concept of work incentives, and basic business concepts like ledger accounting.

Other complicating issues are the estimated $1.8 billion in US-certified foreign claims on a wide variety of assets including homes, sugar mills, and hotels brought on by their confiscation following the 1959 revolution. President Obama noted on his December 19th address that the full relaxation of relations between the two countries may take years, even though he has offered that the policies are not meant as an attempt to remove the Castro regime from power.

It should also be realized that the US embargo only affects the US, as other countries have been doing business in Cuba for decades. The country’s largest trading partners are Canada and the Netherlands with Canadian and European tourists having been regular tourists to the island since the 1990s. Cuba has been cultivating this relationship for a significant amount of time allowing the use of Euros in the tourist areas of Havana and waiving surcharges against the conversion of British pounds and Canadian dollars.

China, Venezuela and Brazil have operated in the country for two decades after support from the Soviet Union collapsed in 1992. These countries have attempted to exploit the country’s mining and energy wealth. In the last ten years, Cuba’s oil production has increased 400%. Most results outside of energy have been decidedly mixed mostly due to the regime itself and the massive regulatory state in control of every aspect of the enterprises. Thus, it is highly likely that even if all embargo and trade restrictions imposed by the US were lifted tomorrow, US businesses would see a bounty of economic opportunity.

The Trade Opportunity

We believe the trade exists because the closed-end fund community tends to have little institutional money behind it and it’s mostly reliant on retail investors and small advisors. Many tend to call the retail investors in the space “dumb money” with price volatility in the funds tending to reflect herd mentality. Investors tend to react towards macro events by bidding up or selling off assets on minor events. For instance, during the “taper tantrum” of May and June 2013, spreads on closed-end funds blew out, even among floating rate issues, even though these would benefit from rising rates.

Given the lack of institutional players in the space, we think the closed-end market is the ultimate area of the market for identifying mispricings and irrational exuberance or irrational apathy. This appears to be occurring in the Caribbean Basin fund on the vision that the fund’s underlying holdings will benefit substantially from the better relations between the two countries. Given the ‘surprise’ nature of the announcement by the President, we think the enthusiasm has exaggerated the potential.

An investor could simply just short the fund, opening themselves up to price risk if the “dumb money’ continues to bid up the premium to even loftier levels. Given the size of the fund at just $27 million, institutional players are unlikely to enter in and ‘correct’ the current situation. It may even be too small for most hedge funds to get into as the borrow may be difficult in the size they would need. At a 60% premium, the short seller is likely to realize a return potential of at least 60% since the fund should be trading at a discount. Given the lack of anything special within the fund, in addition to an exorbitant expense ratio of 2.46%, the fund should be at a discount to NAV in perpetuity.

Another way to play it would be to hedge out the NAV risk and isolate the premium for a mean-reversion trade. Within Bloomberg, we created an equity basket to mimic the movement of the NAV of the fund in order to isolate the premium. We created a five-position portfolio consisting on the top holdings of the fund, which also hit on several end-market industries (tourism, airlines, agribusiness, infrastructure build-out, and beverages). The basket consists of Copa Holdings, Seaboard Corp., MasTec (NYSE:MTZ), and Royal Caribbean Cruise Lines (NYSE:RCL).

This basket of their top holdings over the last five years actually did much better than the NAV of the portfolio as a whole with some of that due to expense ratio drag. Still, the portfolio is a good representative of the Herzfeld Fund with an adjusted beta of 0.983 over the last five years and a tight correlation of nearly 0.60. The alpha intercept of 0.069 shows the superior performance of the basket as compared to the NAV of the fund. It should be noted that this is backward looking and the portfolio of the fund was not static over the time period.

Using the terminal’s correlation function shows a similar level of significance at 0.61, which the software notes is “most significant.” We do not think this needs to be a perfect hedge by any means as the goal is to separate the spread to NAV and not benefit or detract significantly from the main objective of the trade. If the number of holdings in your accounts doesn’t have capacity, then one can simply add more of the top 25 holdings and get the correlation to be much tighter.

The return potential is now over 60% with little to no downside for the patient investor. The only risk in our view is that the retail investors continue to push up the premium to even higher astronomical levels. But in time, we think the chances of the fund reverting at least 30% towards NAV over the next two years close to 100%. Mean reversion within closed end funds has been studied and demonstrated to be factual, most recently in a paper by Patro, Piccotti, and Wu in Exploiting Closed-End Fund Discounts: The Market May Be Much MOre Inefficient Than You Thought and over ten-years earlier in the paper by Gasbarro, Johnson and Zumwalt, Evidence on the Mean-Reverting Tendencies of Closed-End Fund Discounts.

We think the market will start to realize that the closed-end fund holds no assets within the country of Cuba itself, nor anything that remotely relates to it, in the near future. This could be driven by the annual report coming out as of the end of the month, which will likely highlight some of the premium and discount issues. Another strong catalyst has to be the insider selling that followed the announcement and subsequent bid in the share price. You can see that Thomas Herzfeld and his family sold over 282K shares ($3.35 million) or 12% of the fund in less than a week taking advantage of the mispricing.

Conclusion

We think there is a strong pair trade opportunity within CUBA with the market likely realizing the folly of their actions over the next month as the annual report comes out (and is shipped to their homes). If they read it, they will know that their fund holds no Cuban assets and has little relation to the “benefit” likely to befall the island should the embargo actually be lifted. Instead, we think we’ve made the case that even if the embargo is lifted, economic ‘progress’ is unlikely to be swift in materializing nor will profits come quick to the major players.

The Castro regime still believes that the US is their enemy and is likely harboring some paranoia around this all being some master plot to overthrow their government. Even if they do go the full way to allow foreign investment, it will be tightly controlled with the island’s government controlling majority stakes and encumbered by the massive and inefficient bureaucracy. The Castro regime still has a complete disdain for capitalism and that is unlikely to change with the new relationship between the country and the US. We think the shares represent one of the most skewed risk-reward opportunities that can be imagined with 60%+ potential returns.

For more on this story go to: http://seekingalpha.com/article/3236076-pair-trade-opportunity-exploiting-irrational-exuberance-over-the-herzfeld-caribbean-basin-fund

IMAGE: www.herzfeld.com