Monday, February 23, 2015

Investing in Cuba - Tom Herzfeld Sizes Up the Prospects

Investing in Cuba: Tom Herzfeld Sizes Up the Prospects
Investment pro Tom Herzfeld started a fund focused on Cuba 21 years ago.
Now, it looks as if his foresight could be about to pay off.
February 21, 2015

"Look out there!" Tom Herzfeld exclaims, pointing to the sparkling
panorama of Miami and its port, visible from his condominium's rooftop
terrace. "There's where cruise ships come in; the cruise lines will
benefit from tourism to Cuba. There's a dredger; the Cubans need to have
some of their ports dredged. There are cargo containers; container ships
will be needed for U.S. trade with Cuba."

"I'd bet the [Cuban] embargo will be lifted during Obama's
administration, maybe even this year." —Tom Herzfeld Photo: Brian Smith
for Barron's
These are exciting days for the veteran money manager, as the U.S. and
Cuba take initial steps toward what eventually could be the resumption
of normal relations after a half-century U.S. trade embargo.

Cuba has been one of Herzfeld's passions for decades. In 1994, he
founded the Herzfeld Caribbean Basin closed-end fund, whose ultimate
purpose is to invest in companies that should benefit from a reopening
of the island nation to U.S. tourism and trade. The fund, whose ticker
symbol, naturally, is CUBA, was up 18.1% in 2014. This year, through
Thursday, it had fallen 1.9%. Over the years, reports and rumors about
Cuba have tossed it up and down, sometimes violently. This fund isn't
for the timorous, but the possible rapprochement between Washington and
Havana has boosted interest in it. And years of research have given
Thomas J. Herzfeld Advisors, the Miami Beach money-management boutique
that Herzfeld heads, perhaps the best database this side of the CIA on
Cuba's economy, resources, and needs—a big advantage if the embargo ends.

But there's more to Herzfeld than the Caribbean Basin fund, which
accounts for about $42 million of the approximately $300 million in
assets overseen by his three-decade-old firm. The unassuming money
manager, now 70, was a founder of a New York Stock Exchange firm when he
was just 25, was a pioneer in the use of individual accounts employing
closed-end funds as their investment vehicle, has written books and
articles on closed-ends, and has even created an average that tracks the
industry's performance and that appears in the Barron's print edition
each week (see page M40). And he and his son, Erik, run the portfolio of
Virtus Herzfeld (ticker: VHFAX), one of the few open-end mutual funds
that invests exclusively in closed-ends. (Herzfeld's daughter, Brigitta,
also is a member of the family firm.)

The individual accounts have varying goals, but most have done well,
especially over the longer term. Five of the six strategies they employ
finished in the top 5% of their Morningstar categories last year.
Morningstar gives five stars, its top rating, to two of them—Special
Situations and Foreign Equity & Fixed Income. The others get three or
four stars.

Herzfeld's success has come even though he says he's dyslexic, and
self-deprecatingly adds that he isn't facile enough in financial
analysis to be a Wall Street analyst. Indeed, his uncomplicated
investment approach might surprise some fundamental-oriented investors.
But first, his thoughts on Cuba:

Barron's: Tom, you were quite a bit ahead of your time when you brought
out the Caribbean Basin fund 21 years ago. What was its genesis?

Herzfeld: Well, we've been in Miami for about 40 years—I'm from New York
originally—and one can't live in Miami without being immersed in Cuban
society and culture. Not only did I know many Cuban-Americans socially,
but my children went to school with their children, and of course we did
business with Cubans. When you say I was ahead of my time, maybe I was
too far ahead. Even before all the latest excitement about Cuba, we'd
been getting calls at the office from people interested in the fund.
Some asked if I were still alive.

You seem to be.

Thanks. The calls really exploded on the day that President Barack Obama
made what I think is a very historic announcement. It reminded me of the
scene in Jaws when Roy Scheider sees the shark for the first time coming
out of the water and says, "You're gonna need a bigger boat."

It's quite a contrast to when we started the Caribbean Basin fund. None
of the big Wall Street firms would underwrite us. I used my life savings
to do the underwriting myself. At the time, our business included a
broker-dealer; it doesn't now. I guaranteed the first $5 million [of
share purchases]. Not everyone was happy about the fund. I later got
anonymous threats against my life from some people who had fled Cuba and
thought we were trying to circumvent the embargo, which we definitely
were not.

Well, we're glad nothing came of that. At its recent price of $8.72, the
Caribbean Basin fund was trading at a 11.8% premium to its net asset
value. But that's nothing compared with what happened right after the
Obama announcement, when it went to a crazy premium—about 100%—meaning
the shares were selling at double the value of the investments they

Yes, it hit $15 a share, and the net asset value was about $7 or $8.
That's in keeping with its history. Whenever there is good news on Cuba,
it reacts like that. It could be the Pope going to Cuba or a rumor of
Castro's death. On the other hand, when there is adverse news—say a
plane is shot down trying to rescue people fleeing the island in a leaky
boat—our stock is shot down, too.

When do you think full normalization will occur? Fidel Castro can't live
forever, although he's doing a great impression of a guy who thinks he can.

Well, there have been eight believable rumors of his death since our
fund started. But Castro's health is just one issue. The whole movement
toward a normal relationship is on a much faster track than many people
imagine. As we speak, there is a U.S. delegation in Cuba to discuss
various issues, including the opening of a U.S. embassy. There is
tremendous pressure from American companies to restore trade with Cuba.
The resistance is primarily from the Cuban-American community in South
Florida. The older generation saw everything they had taken away by
Castro, and they are still very bitter about it. The younger generations
share their families' views, but not as strongly. The polls are about
50/50 here in South Florida at the moment; 20 years ago, it would have
been 90% against lifting the embargo. Technically, only Congress can do
that. But Obama's executive action can do a great deal; people can
travel to Cuba much more easily now. I'd bet that the embargo will be
lifted during Obama's administration, maybe even this year, rather than
next year.

How do you select investments for the Caribbean Basin fund?

Our first aim is to find companies that would do well, even if there
were no political or economic change in Cuba. At the same time, we focus
on companies throughout the region that could get a significant amount
of business once they could operate in the country. As we sit here now
and look out at the port of Miami, I see many of the companies we're
invested in. One of the first—you can see one of its vessels on the
other side of the cranes out there—is Seaboard (SEB). We started buying
it around the time we started the fund, at about $200 a share; it's now
well above $3,800. Seaboard is a shipper, and it's also a pork and
poultry seller, among other things.

It has never split its shares?

Not that I know of. Also, from here, you can see where cruise ships dock
in Miami. I used to count the number of passengers that got on, or off,
each one, to get an idea of how they were doing. Then, I was told that,
to judge how full they are, it's better to watch how low they are in the
water. We own Royal Caribbean Cruises (RCL), Carnival (CCL) and, more
recently Norwegian Cruise Line Holdings (NCLH), which went public two
years ago. And then throughout the Caribbean Basin, Central America,
South America, we've found companies that we think will do very well.
Copa Holdings (CPA), the parent of Copa Airlines, is a good example.
It's based in Panama City [Panama] and serves Colombia, Venezuela, and
other countries. We've done well over the years with companies like
these, but now we're changing our strategy.


We are going to start redeploying our assets as we take profits in some
of those companies. We plan to start a private-equity fund in March. In
our existing businesses, we already have 300 individual accounts, and 50
to 200 of the investors in those accounts want to make direct
investments in Cuba. We have someone who might want to build a hotel. We
have someone who might want to start a U.S.-Cuba ferry. This fits in
perfectly with our expertise. For 20 years, we have been analyzing
potential investments in Cuba and the surrounding countries. Mostly,
we've looked at projects that could be done under the current laws. We
think there are 20 or 30 projects that we and our clients can invest in
this year alone.

Are you talking about companies based in the U.S. or elsewhere that
could work with the Cubans, or about Cuban companies?

All of the above. Just think of all the things that Cuba will want once
the embargo ends. Let's take construction. They'll need
aggregate—basically little pebbles—for the material to produce highways.
A couple of American companies that are in this business are Martin
Marietta Materials (MLM) and Vulcan Materials (VMC). And they'll need
cement itself, made by a company like Cemex (CX). They're all in the fund.

The pure Cuba domicile companies will pose the highest risks. I mean,
running a ferry to Cuba is one thing, but building a ferry terminal in
Cuba is another, but both are the types of things we might consider for
individual investments. We have on our team two Cuban-American Ph.D.s,
Teo Babun and Jose Oro. Teo is a philanthropist and has been a
businessman and an electrical engineer. And Jose was an assistant
minister in Cuba. He got his Ph.D. in mining geology in Russia, where he
had access to studies showing where all the minerals are in Cuba. Over
20 years, we've looked at every industry in the country and hundreds and
hundreds of potential investments.

What's the minimum you will accept in your individual accounts?

It changes from time to time, depending on where the premium and
discounts are at closed-end funds. It's currently $1 million. If
discounts are narrowing, we raise the minimum above that to discourage
new investment. When discounts are wide and closed-end funds are out of
favor, we lower the minimum. When discounts are wide and the funds are
out of favor, no one wants to buy in, but that, of course, is precisely
when you should.

This is a good time to recount how closed-end mutual funds work. Unlike
open-end funds, they issue a certain number of shares at inception and
don't issue more later. Their shares also trade like stocks, meaning
they can be bought or sold at anytime during the trading day, rather
than just once a day like open-ends. And their share price can trade at
a premium or a discount to the value of their underlying
investments—sometimes a very large premium or discount.


In addition to the Caribbean Basin fund and individual accounts, you
also manage Virtus Herzfeld, an open-end mutual fund that invests in
closed-end funds.

Yes, it's aimed at small investors. Over one year, it's up about 10%,
which puts it in the top 2% in Morningstar's conservative allocation
category. We're very proud of that.

What are some closed-ends you like now for your individual accounts and
the Virtus fund? Readers should know, by the way, that this fund charges
an initial sales fee, ranging up to 5.75%, depending on the share class.

First, let me describe my approach. I was never trained as a Wall Street
analyst. I was drawn to closed-ends because they're the easiest form of
investment to analyze. Usually, the best are those trading at big
discounts to their underlying assets. If the value of the assets is $10,
and the share price is $8, that's obviously a 20% discount. Very often,
these discounts exist because the industry that a fund focuses on is out
of favor. But when that industry eventually rotates back into favor, the
discounts narrow and you make money.

That's been my way of investing in closed-ends for 45 years, and it
usually works. I've always concentrated on what is out of favor and
offers the deepest discount. I've had to emphasize that to the younger
generation now at our company, who, unlike me, are trained in analysis
and have M.B.A.s and Ph.D.s. They can make judgments on what industries
are going to outperform, what companies will earn, and what sectors of
the economy will do well or poorly. I don't. But my approach has worked
well throughout my career.

OK, let's hear some names.

Some of the outperformance we had in 2014 was because we sold some
energy closed-end funds in which we had been overconcentrated. Now that
energy is out of favor, we've gotten back into that sector. One fund we
like there is Kayne Anderson Midstream Energy (KMF). It recently was
selling at a 15% discount to its assets, but the discount has narrowed
to 7.2%. Another is First Opportunity fund (FOFI), which has been at a
21.4% discount. We also like Nuveen Credit Strategies Income (JQC),
which has been at a discount of 11.8%. This is a pure income play; it
invests in loans, preferreds, and other things and currently generates a
yield well above 5%.

How has the advent of exchange-traded funds affected you? Like
closed-ends, you can buy or sell them throughout the day, and they're
very low cost to invest in.

When ETFs started gaining popularity, everyone said, "This is the end of
closed-ends." But, on the contrary, we've actually seen more
institutional interest in closed-end funds. People realized that they
could buy a closed-end fund at a wide discount and short an ETF with a
similar portfolio. It's a great arbitrage. The advent of ETFs also has
encouraged activism. If an activist wants to buy control or a large
stake, for instance, to try to eliminate a discount and raise the stock
price by forcing the fund into an open-end, there's a risk that he won't
succeed and will be stuck with shares still selling at a big discount.
But now with ETFs, activists usually can hedge the market.

How important is the quality of management of closed-end funds?

Well, you might think that the funds to bet on are those that are the
best managed. But the best-managed fund isn't necessarily where the most
money is made. Let's eliminate the very best and worst managers from
this discussion. If you look at the middle 75%, the difference in
performance isn't much more than a couple of percentage points.

Which could matter a lot over the long term.

Sure. But if you can buy a poorly managed fund at a discount of 20% or
25% and capture a 10 percentage-point profit when the discount narrows,
you'll make twice as much as you would by buying a fund that's priced at
a premium or only a narrow discount because it has a good manager. Also,
the consistently poor performers are candidates for activists to come in
and force them to open-end or liquidate, another way you can make money.

Talk about lovable losers! Well, that's certainly a different approach
than a lot of investors are used to. Thanks, Tom.


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