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SOR is struggling so far in 2015. But it’s been an up and down year when comparing the first and second quarters. And the narrower than average discount suggests now isn’t the time to jump aboard. Source Capital (NYSE: SOR ) is an old hand in the closed-end fund, or CEF, space, having been in business since 1968 . It’s long used a focused portfolio to opportunistically invest in small- and mid-cap companies with high returns on equity. That’s great, but a narrower discount than normal of late suggests new investors would be better off waiting here. Here’s what’s been going on. What a difference a quarter makes According to SOR , its net asset value return was 3.1% in the first quarter. That was below its Russell 2500 benchmark, which was up over 5%, but well ahead of the S&P 500, which was up less than 1% in the first quarter. So it’s no surprise that investors would be generally pleased with the closed-end fund, or CEF. Indeed, during the first quarter, the market price of the shares went up along with the NAV. However, something changed in the second quarter. SOR’s NAV fell 2%, worse than the 0.3% or so loss for the Russell 2500 and the around 0.3% gain in the S&P. But while the NAV has been falling, investors haven’t reacted by selling the shares. In fact, they’ve pretty much been holding the line. With that backdrop, SOR’s discount, which has recently been averaging around 9% but has a three-year average of about 10%, has narrowed. The discount is recently hovering around 7% or so-roughly in line with its 10-year average according to the Closed-End Fund Association . Long-term investors should probably tread carefully here since the shares are clearly not on sale. Those looking to play discounts and premiums, meanwhile, should also be on the sidelines. What’s been going wrong? Obviously losing positions outweighed winners in the second quarter . More specifically, retailers Signet Jewelers (NYSE: SIG ) and CarMax (NYSE: KMX ) have been sagging and that’s a big problem. These two are the second and third largest holdings in the fund, making up about 15% of assets. CarMax is down nearly 6% this year and Signet over 8%. With a concentrated portfolio, big bets are the norm. And that’s something that investors in SOR need to fully understand. For example O’Reilly Automotive (NASDAQ: ORLY ), a winner for the fund so far this year, makes up nearly 15% of assets. Taking that a step further, the top three holdings make up about 30% of the fund. For reference, the top 10 holdings account for around 60% of the fund. So you can see the impact O’Reilly, Signet, and CarMax will have on performance. With two of the three struggling, it’s no surprise that SOR’s NAV is only slightly ahead of where it started the year. Adding to the negatives, at the start of the second quarter two other struggling companies were in the top 10, Knight Transportation (NYSE: KNX ) and Heartland Express (NASDAQ: HTLD ). Only Knight remained a top 10 holding at the end of the second quarter at roughly 4% of assets. Knight is down around 18% so far this year and Heartland, the tenth largest holding at the end of the first quarter, is down about 20%-no wonder it fell out of the top 10 by the end of the second quarter. Once again, however, you can see that the focused approach comes with risks. And with the fund’s discount narrower than its recent history, now isn’t the time to jump aboard. That said, over time, SOR has rewarded investors for taking on added risks, so don’t write the fund off entirely. For example, over the trailing 15-year period through June, the fund’s annualized total return, which includes reinvested distributions, is nearly 11%. That’s ahead of its benchmark Russell 2500 by about two percentage points a year. And it’s over twice the annualized return of the S&P over the same span. So being selective and betting heavily on management’s best ideas has paid off over time. Just not in the second quarter… Keep it on your watch list If you are looking for a small and mid cap closed-end fund, SOR is one that should be on your watch list. Its expense ratio is around 0.8%, which is very reasonable for a CEF. Yes, that’s notably higher than straight index ETFs, but ETFs in the same space don’t usually have the same distribution history. For example, SOR’s yield is currently around 4.5%. The WisdomTree U.S. SmallCap Dividend Growth ETF (NASDAQ: DGRS ), meanwhile , has an expense ratio of around 0.4%, but yields about half as much even though it’s focused on dividend paying stocks. That said, capital gains account for almost the entire disbursement at SOR, so distributions will fluctuate over time and probably fall in difficult markets. Thus, this is more of a total return play than an income play. That doesn’t mean distribution focused investors should avoid SOR, just that this is an important fact to keep in mind when buying it. In the end, it was a tough second quarter and middling first six months for SOR. That doesn’t make it a bad fund, but it does highlight the risks inherent in the fund’s focused approach. Long-term investors should keep the fund in mind, but don’t bother jumping aboard now because the discount is slimmer than it has been in recent years. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Scalper1 News
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