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Closed End Fund Bargains Amid Stealth Bull Market!

David Dietze discusses closed end funds.

Defying the experts, Main Street, and the media, US stock markets have engineered an amazing comeback. Despite the worst economic downturn since the 1930s, the 2008 and 2009 bear market losses have been completely recovered. While the S&P remains 8% below its peak in October, 2007, when you factor in dividends an investor has been made more than whole.  

Remember talk about the lost decade in stocks? With the market’s summer rally, up nearly 13% since the beginning of June, there’s a new candidate for serving up investors with a lost decade, and that’s cash. For the ten years ending August 31, 2012, the average annual total return on the S&P 500 has been 6.51%, running circles around cash (90 day Treasury bills), checking in at just 1.67%.  

That’s right, you could have done well for the last 10 years, with each $100 compounding to $187, simply by becoming a Rip Van Winkle. Those gains would have been yours by failing to react to the Iraq invasion, the Katrina disaster, the housing and subprime meltdown, the AIG bailout, the Lehman collapse, the emergence of China as a superpower, the Euro sovereign debt crisis, and a 50% drop in the Dow between October, 2007 and March, 2009.

Outlook

There’s no question that the stock market is overbought: Following a 116% gain off the market bottom of March, 2009, and a 22.5% year over year gain to date, a correction is to be expected and should be considered healthy.   Further headwinds to the market are obvious.

The long-term solution to bloated budgets among the European economies has yet to be found. On this side of the pond, economists fret over the effects of the fiscal cliff: the tax hikes and spending cuts to occur in 2013 absent legislative relief. China, now the globe’s second largest economy, is reporting a significant reduction in exports. Corporate earnings growth is expected to tail off as the world economy slows and earnings comparisons versus last year are tougher.

Positives

Central banks around the world are determined to do what it takes, including injecting massive amounts of liquidity into the system, to fend off a debt crisis in the Eurozone and reduce unemployment here. The monetary stimulus is reflected in record low interest rates, making equities still look cheap. Indeed, rarely has the yield on the ten year Treasury, now at 1.86%, been less than the dividend yield on stocks, now at 2.15% on the S&P 500. That equity yield advantage bodes well for stocks; historically, dividends have grown 5% annually.   Investors have flocked to income alternatives, but it’s not clear that they will fare as well as equities, as these yield plays have now become quite expensive. Corporate bonds are trading with an average yield of just 2.88%, down from 3.6% a year ago. Junk bond yields are at record lows, below 7%. REITS, a favorite yield vehicle, have rarely been so expensive and yielded so little.

For example, Barron’s reports that Vanguard’s REIT fund ( Vanguard Real Estate Investment Trust (VNQ)) yields just 3% and trades at 18 times earnings.   While the fiscal cliff is cited as a major market hurdle, it actually may prove a long term salve. Europe proves, if it wasn’t known already, that deficits do matter; policy changes designed to reduce deficits and therefore the risk of skyrocketing inflation and interest rates down the road should be beneficial.   Although the unemployment rate remains way too high, housing is starting to stabilize. With the 30 year mortgage rate down to an historic low of 3.55%, home prices are remarkably affordable. This is likely to remain so for some time as the Federal Reserve has committed to buy $40 billion a month of mortgage backed bonds for an indeterminate time in an effort to reduce unemployment.   The all-important auto industry is showing signs of life, too, with recent sales at an annual rate of nearly 14.5 million/year, the best since 2009’s cash for clunkers surge.

Closed End Funds: Buying Great Portfolios at a Discount

No question, although the long term outlook is fine, with stock prices up so dramatically, the low hanging fruit is gone. Investors will have to work harder to find quality marked down.   One area where some great deals still exist are closed end funds (CEFs). CEFs are a hybrid between conventional mutual funds (CMFs) and exchange traded funds (ETFs). CEFs are like CMFs in that they are actively managed portfolios pursuing a stated objective. But, they are like ETFs in that there’s an initial public offering and then all trading takes place on the stock exchange between investors, without involvement of the CEF. However, unlike ETFs, CEFs make no effort to maintain parity between the net asset value (NAV) of their portfolios and the price of their shares.  

Opportunity arises when the shares trade at a meaningful discount to NAV. That provides you with the chance to profit two ways. First, skillful management of the fund (or investor sentiment) can permit the NAV to head north. Second, the discount can narrow, further boosting the value of your shares. It’s analogous to a stock whose price to earnings multiple rises even as its earnings grow.   Why would the discount narrow? The CEF can come back into favor. Sometimes, the CEF will take steps to close the discount by buying in shares.  

CEFs can prove superior to CMFs as the managers don’t need to deal with cash coming in from new investors or face demands to raise liquidity for departing holders. While CEFs’   management fees are typically higher than ETFs, those fees do pay for active management. Further, when coupled with, say, a double digit percentage discount from NAV, the higher fee becomes acceptable, and would typically have to be incurred for many years to offset the discount.   CEFs are frequently leveraged to improve returns. The current low interest rate environment makes such borrowing attractive.

Closed End Fund Picks

We like CEFs whose asset class and sector have lagged or even declined relative to the overall market. A discount from NAV is a must, ideally at least a double digit percentage or more. And we insist on reasonable expense ratios, less than 2%. Necessary, too, is strong fund management, an understandable investment process, and a solid portfolio. Here’s what we like currently:

Royce Focus Trust (FUND)

FUND is a member of the Royce family of funds, which operates under the auspices of legendary value investor Chuck Royce. FUND targets attractively priced blue chips, including the likes of Berkshire Hathaway "B" (BRKB) shares, Microsoft (MSFT), and Exxon (XOM). Employing just a bit of leverage, 15%, it trades at an attractive 15% discount to NAV. Over the last 15 years its portfolio has outpaced the S&P 500 by nearly 4% a year.

ASA Gold and Precious Metals (ASA)

This is a low cost (0.6% annual expense ratio), non-leveraged, portfolio of the major gold and precious metal producers from around the world. It’s returned over 10% annually for the last decade, despite being down 16% in the last year. This is an attractive entry point for a well-diversified basket of gold stocks. This portfolio may be just the ticket to hedge the risk that central banks inject too much liquidity into the system, engendering a lack of confidence and inflation.

Petroleum and Resources (PEO)

This CEF provides excellent exposure to the energy sector. It sports a big discount of over 13% and a small expense ratio of just 0.56%. While no one likes to pay any expense ratio, the discount covers over 24 years of it. This fund is committed to paying out 6% of the value of its shares annually, so it may be a good choice for those requiring income. However, if the actual income generated from the portfolio is insufficient it will sell holdings to make the payout. Exxon (XOM) and Chevron (CVX) account for about 30% of the portfolio.

Japan Smaller Cap Fund (JOF)

JOF provides an opportunity to diversify over an asset class not easily invested in, at a healthy 12% discount and with a reasonable 1.34% annual expense ratio. There’s a real possibility to profit from not just a closing of the discount but the share price climbing to a significant premium to NAV: Over the last three years the fund has traded as richly as with a 9.4% premium. The holdings are extremely cheap, averaging less than 10 times earnings, below book value, and at less than 40% of annual sales.

Swiss Helvetia (SWZ)

SWZ is an excellent vehicle to get exposure to some of the highest quality companies on the planet – at a meaningful discount. Nestle (NSRGY), Novartis (NVS), and Roche (RHHBY) are the top three holdings, together constituting over 40% of the fund, and SWZ shares trade at a 14%+ discount to the value of its holdings. While over the last three years that discount has been as much as 17% it’s also been as small as 6%, suggesting the downside risk small relative to the upside potential. SWZ has outperformed the S&P 500’s total return by 2% annually over the last 15 years. The defensive nature of its top holdings may be especially appealing during volatile market periods.
 

Closed End Fund Symbol Discount 52 Week Market Return 9.14.12 Price Royce Focus Trust FUND -14.50% 5.40% $6.89 ASA Gold ASA -10.90% -16.30% $25.08 Petroleum and Res PEO -13.80% 11.80% $26.81 Japan Smaller Cap JOF -12.00% -2.40% $7.33 Swiss Helvetica SWZ -14.20% 5.20% $10.91

   

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