Given the recent market strength, many of the best large-cap stocks are rallying hard.
But what if I told you that you could buy a lot of the best blue-chip stocks right now at a 10% to 15% discount?
Sounds too good to be true, I know. But let me show you how to get big names like Exxon Mobil (XOM), Philip Morris International (PM), AT&T (T), Procter & Gamble (PG), Qualcomm (QCOM), McDonald's (MCD), Costco Wholesale (COST), JPMorgan Chase (JPM) and Wells Fargo (WFC) today, at large discounts.
You can do this by turning to a hybrid type of fund that often gets overlooked by investors, even though it has a storied history going back a century or more: the closed-end fund. Stock-oriented funds in this class own a lot of shares of companies like those above, and the funds are selling for less than the value of their portfolios.
In short: Buy them, and you buy your favorite stocks at a discount. I'll have a list of some particularly attractive options at the end of the column, but first we'll look at how these funds work.
A closed-end primer
Unlike mutual funds, which get the capital they invest directly from investors, closed-end funds raise investment capital in an initial public offering.
As with mutual funds, you get access to their portfolio holdings by purchasing fund shares, but those shares trade throughout the day like stocks. And unlike mutual funds, when you buy, your money goes to an investor who is selling, rather than to the fund for use in expanding its holdings.
This is also why closed-end funds can provide access to stocks at a discount. Because their shares trade like stocks, closed-end funds get pushed around by market supply and demand. Thus, a fund's shares can move independently of where the shares "should" be trading based on the market value of the fund's stock (or bond) holdings.
So, a closed-end fund might trade at a market cap of $90 million, even though the value of all its stocks adds up to $100 million. Such a fund would be said to be trading at a 10% discount to its "net asset value," or NAV. NAV just means the market value of all its investments.
When you buy this closed-end fund at a 10% discount, you're getting a piece of all the stocks it owns for 10% less than what they are worth in the market. These bargains show up more often than you might think.
But why?
One big reason: The fund may specialize in a sector or asset class that's out of favor. In essence, you're betting that the sector will come back into favor, close the discount and give you a profit.
Here's why that matters right now.
For the past few years, investors have decidedly favored bonds and the "safety" of income over stocks. So income-producing closed-end funds trade close to NAV or even at a premium. Meanwhile, many stock-oriented closed-end funds are now selling at a discount, and current prices could prove to be bargains if stocks come back into favor.
"We think 2013 is the year that will change," says Cecilia Gondor, an analyst with Thomas J. Herzfeld Advisors, which specializes in closed-end funds.
Indeed, there's evidence that investors are turning back toward stocks. If this keeps up, stock-oriented closed-end funds trading at discounts should pay off as those discounts shrink.
A new fund of closed-end funds
Problem is, it would take you hours to get up to speed on closed-end funds and then monitor them daily to spot the discounts. One way around this is to purchase shares of a new mutual fund that specializes in buying discounted closed-end funds.
It's called Virtus Herzfeld Fund (VHFCX) and it is run by Tom Herzfeld and his team at Thomas J. Herzfeld Advisors. Tom Herzfeld has followed closed-end funds for decades, and he's considered one of the top experts in this space. An offering with a similar strategy, his firm's Flagship Balanced Portfolio for private clients, has produced 7% annualized returns over the past 10 years. The Virtus Herzfeld Fund, which just launched, pays a 6% yield. The fund charges 2.35% in expenses and has a load of 1%, so the fees are a little high. But the 7% return for the private fund was against an expense ratio of around 3%, which is a combination of Herzfeld's fees plus the fees charged by the underlying closed-end funds he invests in.
Herzfeld typically watches for unusual discounts in closed-end funds and then pounces on them, which makes this a kind of value approach to investing. He likes funds that not only trade at a discount, but also at a markdown that's bigger than their historical discount.
For example, his mutual fund owns shares of Alpine Total Dynamic Dividend Fund (AOD), a closed-end stock fund that trades at a 13% discount to its NAV, compared with an average discount of about 1% over the past three years. Alpine recently hit the slopes because it cut its "distribution rate," a kind of payout to investors. But the current discount is likely to narrow and return closer to those historical levels of around 1%, meaning the shares should rise from here.
Another example: Herzfeld's mutual fund owns shares of Delaware Enhanced Global Dividend and Income Fund (DEX), a foreign-stock closed-end fund that trades at a 4.5% discount compared with about a 1% discount over the past three years. Another holding is AllianzGI International & Premium Strategy Fund (NAI), a closed-end foreign-stock fund going for a 4.2% discount compared with an average discount of 1.4%.
The average discount on closed-end funds in the Virtus Herzfeld Fund has been running just below 10%. Often such gaps close independently of what is going on in the stock market, meaning Herzfeld's funds can go up even in a sideways market. So theoretically, at least, the Herzfeld mutual fund can add diversification to your portfolio, points out Peter Batchelar, of Virtus Investment Partners (VRTS).
Large-cap stocks at large discounts
If you want to buy the closed-end funds themselves to get at some discounted blue-chip stocks, here's a quick guide to help you.
I put this guide together by asking Herzfeld and his team for the closed-end funds trading at the biggest discounts. Then I looked at their holdings to produce a short list of closed-end funds offering you exposure to blue-chip, large-cap stocks. All of these are Herzfeld holdings.
Alpine Total Dynamic Dividend Fund, which shows a 14% discount, counts Apple (AAPL), the global spirits vendor Diageo (DEO), Wynn Resorts (WYNN), Royal Dutch Shell (RDS.A) and JPMorgan Chase among its top holdings. (To check the holdings of Alpine, for example, go to CEF Connect and click on portfolio characteristics. You can do this for other closed-end funds as well.)
General American Investors (GAM), which has a 14% discount, owns big positions in Qualcomm, Costco Wholesale and Diageo.
Adams Express (ADX), which carries a 13.6% discount, has large positions in Apple, JPMorgan Chase, McDonald's, Wells Fargo, Microsoft (MSFT), AT&T, Pfizer (PFE) and Procter & Gamble. (Microsoft is the publisher of MSN Money.)
Tri-Continental (TY), which trades at a 13.5% discount, gives you exposure to Apple, Pfizer, Chevron (CVX), Verizon Communications (VZ), Microsoft, JPMorgan Chase, Philip Morris International, the investment company BlackRock (BLK), and Amgen (AMGN).
Petroleum and Resources (PEO), which has a 12% discount and specializes in energy stocks, has large holdings in Exxon Mobil, Chevron, Schlumberger (SLB), Occidental Petroleum (OXY), Anadarko Petroleum (APC), National Oilwell Varco (NOV) and Freeport-McMoRan Copper & Gold (FCX).
Liberty All-Star Equity (USA), which goes for a 10.9% discount, has big positions in Apple, JPMorgan Chase, Qualcomm, Google (GOOG), Schlumberger, SunTrust Banks (STI), Wells Fargo and Citigroup (C).
The risks
Getting stocks so easily at a 10% discount isn't too good to be true, but there are some possible pitfalls. Here are the big ones:
• The never-ending discount. You don't want your discounted closed-end fund to stay on sale forever. This is why Herzfeld likes to see activists and dissident shareholders snapping up shares of a cheap closed-end fund. Some of the most notable activists to watch for are: Bulldog Investors, Karpus Investment Management, Western Investment and City of London Investment Group. These activists hunt for discounts, then build positions and put pressure on funds to take steps to close the discounts.
Bulldog has recently been buying the Eaton Vance Risk-Managed Diversified Equity Income Fund (ETJ). Bulldog hasn't announced what it will do to get the fund to take steps to close the gap. "But we want to own them before that announcement, because once that happens, the discount narrows a few points," says Herzfeld.
One common tactic of activists is to lean on closed-end funds to make an offer to buy some discounted shares back at prices close to NAV. This creates windfall profits for shareholders who sell. Late last year, for example, City of London Investment Group persuaded Morgan Stanley Asia-Pacific Fund (APF) to buy back some shares at close to NAV, even though the shares were priced in the market at a 13% discount.
In one extreme endgame, activists get funds to liquidate at NAV and give cash to shareholders, says Gondor. That might be the fate of the Greater China Fund (GCH), currently being hounded by activists to close its discount.
And sometimes funds take steps on their own to close discounts to stave off activists, says Gondor. They might buy back shares, announce a more generous payout policy or convert to an investment style that's more popular to attract investors. Sometimes discounts narrow as the sector or asset class that they invest in comes back in style.
• The capital gains dump. Like mutual funds, closed-end funds have to distribute capital gains to investors, cautions Mike Taggart, a closed-end fund expert with Morningstar, which rates 125 of the 600 closed-end funds traded in the U.S. If you buy a fund that has a lot of unrealized capital gains, it might then reap the gains and distribute them to you. This would leave you with a big tax bill. You can reduce the impact by holding a closed-end fund with big unrealized gains in a tax-protected brokerage account such as an individual retirement account. Funds have to report the value of unrealized capital gains in the "net assets" section of their balance sheets in their annual and semiannual reports.
• The margin punch bowl. It's common for closed-end funds to juice returns by using borrowed money to invest, or buying on margin. About 80% of closed-end funds are leveraged to some degree, says Gondor. Bond funds typically own about 24% of their portfolios with borrowed money, while stock funds are typically around 16% leveraged, she says.
You need to be aware that investing with borrowed money can make the good times better and the bad times worse. In other words, shares of a leveraged closed-end fund may fall more than the market in a downturn, cautions Taggart. Likewise, they may outperform in a bull market.
• The deceptively high yield. If a "distribution rate," the closed-end fund equivalent of a stock yield, looks too high, be skeptical. Part of the high return may be a return of capital to shareholders, as opposed to income from investments. This means the high payout won't persist. Closed-end funds will tell you if they are returning capital in the press releases announcing distributions, says Taggart.
• The premium trap. By now, you get the point that it's usually better to buy closed-end funds at a discount. Nevertheless, many people make the mistake of paying too big a premium to NAV, cautions Taggart, meaning premiums of around 10% or more. If you do, you probably won't start making money until the fund manager invests wisely enough to produce returns that overtake the premium. That's tough to do when premiums are in the double digits, says Taggart.
Yet many investors regularly fall into the premium trap. "We see this time and again when people get overenthusiastic about a fund," says Taggart. "You have to be patient. This is what the Herzfelds of the world do very well. They are patient."
At the time of publication, Michael Brush owned shares of the following companies or funds mentioned in this column: Philip Morris International.
Michael Brush is the editor of Brush Up on Stocks, an investment newsletter. Click here to find Brush's most recent articles and blog posts.
