The Closest Thing to 'Free Money' in the Stock Market
I remember the moment I became an investor.
I was idling in line at the drive-through window of my local bank, sitting in my '63 Buick Electra. I was listening to the radio while I waited to deposit my paycheck from the steakhouse, where I had climbed up to baked-potato chef.
As I inched toward the vacuum tube, the AM radio talk-show host promised to reveal the simplest trick to making money in finance.
He explained that it was a way to buy a dollar of assets for $0.80. It seemed too easy and too obvious. If I bought at $0.80 and the price traded up to the full $1 value of the assets, I would enjoy a "natural" 25% gain on my money. I didn't have to do anything except wait.
I drove off from the bank convinced. And within days, I opened up my first brokerage account. I bought a few hundred dollars' worth of that fund... I don't remember the name. But I do remember how I felt that day.
It was the first time I took advantage of an opportunity to create money seemingly out of thin air and pull one over on Wall Street.
Since then, I've spent years doing the same thing over and over again...
If you haven't guessed it yet, I'm talking about closed-end funds (or "CEFs"). Here's how they work...
First, a fund company and a portfolio manager decide to create an investment vehicle for a category of investments (like municipal bonds). To get the money to invest, the managers go to the stock market and hold an initial offering. They'll sell 10 million shares at $10 each. Investors now hold shares of the fund, and the managers have $100 million to invest. The managers take that money and buy $100 million worth of municipal bonds according to their strategy.
Now, here's where things get interesting... At this point, the value of the CEF's shares and the price of the shares can (and do) diverge. That's because the shares trade openly on an exchange, so they are priced independently from the underlying value of the securities the fund holds.
Remember, the value of the shares comes from the market value of each individual security it holds (in this example, each municipal bond). This is what we call the net asset value (or "NAV").
If the bonds rise in value to $110 million, then the NAV of each share becomes $11. But the CEF's share price in the market doesn't have to go to $11 right away. The price is determined by whatever people are willing to pay for shares in the market. Shares could still trade for $10 or $10.50. They could even trade for more than the actual value, say $12... meaning people are paying extra to invest in the bond portfolio.
Think about it... if the value goes up to $11, but the shares still trade at $10, you can buy $1.10 worth of assets for $1.
It's not hard to see why this is the easiest way to become a value investor. You don't have to project future earnings, sales, or price-to-earnings ratios on an individual stock. When you spot a CEF selling for cheaper than its value, you get to buy it at that price... at a discount to its true value.
Every day, you can find hundreds of funds trading at a discount to NAV. At any time, the average fund sells at a discount to its NAV.
You can find which funds are trading at a discount on CEFconnect.com. Just enter a fund's symbol and you can see whether it's trading at a premium or discount to its NAV.
We've used this strategy in my Retirement Millionaire advisory to buy shares of the Nuveen AMT-Free Municipal Income Fund (NEA) in October 2008. At the time, investors were fearful of municipal bonds for reasons that we thought were nonsense. Because of those fears, the fund traded at a 24% discount to the actual bonds in its portfolio.
Since then, municipal bonds have performed well. Nine years later, we were up nearly 130% on one of the safest investment classes in the market.
You don't have to be the next Warren Buffett to see why investing in CEFs trading at a discount to the value of their assets is such a winning strategy.
Here's to our health, wealth, and a great retirement,
Dr. David Eifrig