Cashing In on Closed-Ends: The first three months of this year saw the seventh consecutive quarterly loss for the major stock market averages. From 2009’s peak to trough (January 6 to March 9), the stock market dropped nearly 30%. However, amidst the continued carnage, there exist some very interesting securities. These securities are very misunderstood and this allows a patient and careful investor to take advantage of the current environment. What makes them a real value is that their higher volatility is due to other peoples’ fear and panic and not reality. When you understand how they work you will be more comfortable with the volatility and realize how profitable these securities can be, when purchased as others panic.
They are unusual, so stick with me and I believe I can explain them. First, on Monday, March 9, 2008, the stock market was down nearly 4%. One of these misunderstood securities, Eaton Vance Limited Duration Income (symbol EVV), was also down 3% in price. However the actual value of this security increased by 0.2%. Further, from February 1 to March 9, EVV’s price fell 20%, but its value fell only 4%. So, while the stock market may move its price around, its true value is much more stable. How can this be?
A little history is in order! At this point my kid’s eyes usually glaze over, but please stick with me. This type of security is called a closed-end company and there are many hundreds of them. They’ve been around since 1822 when King William I of the Netherlands first authorized and used the concept. They are the predecessor to today’s mutual fund, which were created in 1924 in response to a “flaw” these securities have; a “flaw” that can be exploited. Where mutual funds only price at the end of the day and everybody gets in and out at the same price, closed-end companies are traded all day long at varying prices. So they are basically mutual funds that trade on the stock market, or to think of it in other terms, a stock/company whose sole business is managing a portfolio for its shareholders. There is an important difference (as noted above): Closed-end company stock prices can move differently than the true value of the portfolio they manage for you. This perceived “flaw” led to the creation and popularity of mutual funds and their pricing fairness. However, the “flaw” can be used to your advantage when there is sufficient fear in the market.
Both mutual funds and closed-end companies have a Net Asset Value (NAV) which is their true value and a market price they trade at. The NAV is the value of the stocks or bonds that the fund holds. Where a mutual fund’s NAV (value) and price are always the same, only a closed-end company has a price that can be different from its NAV (value). Thus, while EVV’s portfolio of notes and bonds fell only 4% (from $11.77 to $11.30 due to panic and mass selling around the world in early March), your fellow investors were in full panic mode and selling everything they could, driving its price down 20% in a few short weeks.
So, while most investors were reacting to its 20% price drop, we were comfortable with EVV’s 4% value drop and felt certain it would correct quickly. By March 31, EVV’s value was up 5% (from $11.30 to $11.87), recouping all its drop incurred during the 30% market sell off, and its price was up 17%, almost recouping all its 20% drop. But, we care more about its value for gauging safety and real progress. For the first quarter of 2009, EVV’s value was up 7% while the stock market was down about 15%. Did I mention that it pays 1% per month in dividends? So, EVV’s year to date return was actually 10%, based on value. Based on price, the return was about 9%, but with more volatility, which I’m suggesting you ignore as long as the value is holding up.
I have attached a chart that shows its movements since December 31, 2008. Please use the left scale in dollars for Value and Price and the right scale in percent for the Discount. You can see the green Value line has remained quite steady. If EVV were a mutual fund, its NAV (the green Value line) would have made it a steady performer in the recent 30% sell-off. In contrast, the blue Price line has moved quite a lot. The yellow Discount line tracks the difference between the Value and Price. For example, at March 9, EVV’s value was $11.30 per share, but you could buy it for $8.89 per share, a 21% discount. That’s nothing but fear!
On top of that, I should explain how we can find a bond portfolio yielding over 12% per year. Well, it was a bond portfolio yielding about 8% last August that has fallen 25% in value from roughly $16.00 to $11.87 and its price dropped even further to $10.51, causing its yield to go from 8% to 12%. Thus, EVV’s income producing securities are trading at a 25% discount to their maturity value, and you are able to buy the fund itself at a discount. A discount on a discount and 12% per year in dividends while waiting for it to go back up could be a good thing. We just need to tolerate the price volatility (while we closely monitor the value) to be sure this gem continues making real progress.
EVV is just one example and over the coming months we plan to continue researching and acquiring other deeply discounted closed-end securities as opportunities arise. Thank you for your patience and I hope this helps you understand more about the unusual opportunities available in this confusing market environment.
Why today may have been significant to our economic future! We would like to share with you an article written by Steve Forbes, Editor and Chief of Forbes magazine. Mr. Forbes writes about the unnecessary regulations and new accounting rules that have brought on many of the problems surrounding our financial crisis: In particular he discusses the so called “mark-to-market” accounting rules that make companies and banks recognize prices for assets that are not realistic but have a profound impact on our financial system. This rule has forced many whose operations are profitable to appear as if they are losing money or insolvent. To the credit of this administration, this rule was greatly changed yesterday, and the stock markets around the world have reacted by going up significantly.
Although many good financial lessons were learned during the Great Depression, unfortunately many of the laws passed at the time to stabilize our financial system have been undone in the past few years: mark-to-market accounting, short sale uptick rule, naked shorting, and the Glass-Stegall Act to name just a few. This article was written about a month ago and he clearly lays out the problems being caused by mark-to-market accounting. Our hope is that it will help you understand the benefits of changing the rules back to where they had been. We don’t need more regulation, we just need to go back to what has worked fairly well for the last 70 years. Here’s the article:
By STEVE FORBES
What is most astounding about President Barack Obama's radical economic recovery program isn't its breadth, but its continuation of the most destructive policies of the Bush administration. These Bush policies were in themselves repudiations of Franklin Delano Roosevelt, Mr. Obama's hero.
The most disastrous Bush policy that Mr. Obama is perpetuating is mark-to-market or "fair value" accounting for banks, insurance companies and other financial institutions. The idea seems harmless: Financial institutions should adjust their balance sheets and their capital accounts when the market value of the financial assets they hold goes up or down.
That works when you have very liquid securities, such as Treasury bonds, or the common stock of IBM or GE. But when the credit crisis hit in 2007, there was no market for subprime securities and other suspect assets. Yet regulators and auditors kept pressing banks and other financial firms to knock down the book value of this paper, even in cases where these obligations were being fully serviced in the payment of principal and interest. Thus, under mark-to-market, even non-suspect assets are being artificially knocked down in value for regulatory capital (the amount of capital required by regulators for industries like banks and life insurance).
Banks and life insurance companies that have positive cash flows now find themselves in a death spiral. Of the more than $700 billion that financial institutions have written off, almost all of it has been book write-downs, not actual cash losses. When banks or insurers write down the value of their assets they have to get new capital. And the need for new capital is a signal to ratings agencies that these outfits might deserve a credit-rating reduction.
So although banks have twice the amount of cash on hand that they did a year ago, they lend only under duress, or apply onerous conditions that would warm Tony Soprano's heart. This is because they know that every time they make a loan or an investment there is a risk of a book write-down, even if the loan is unimpaired.
If this rigid mark-to-market accounting had been in effect during the banking trouble in the early 1990s, almost every major commercial bank in the U.S. would have collapsed because of shaky Latin American and commercial real estate loans. We would have had a second Great Depression.
But put aside for a moment the absurdity of trying to price assets in a disrupted or non-existent market, of not distinguishing between distress prices and "normal" prices. Regulatory capital by its definition should take the long view when it comes to valuation; day-to-day fluctuations shouldn't matter. Assets should be kept on the books at the price they were obtained, as long as the assets haven't actually been impaired.
Mark-to-market accounting does just the opposite. When times are good, it artificially boosts banks' capital, thereby encouraging more investing and lending. In a downturn it sets off a devastating deflation.
Mark-to-market accounting is the principal reason why our financial system is in a meltdown. The destructiveness of mark-to-market -- which was in force before the Great Depression -- is why FDR suspended it in 1938. It was unnecessarily destroying banks.
But bad ideas never die. Mark-to-market was resurrected by the Financial Accounting Standards Board and became effective in the fall of 2007 (FASB rule 157) to the approval of the Bush administration, its Treasury Department, and the Securities and Exchange Commission. Even as FASB 157 began to take its toll on financial institutions last year, Mr. Bush refused to kill or suspend it. When Congress voiced displeasure last fall, the administration and regulatory authorities made some cosmetic changes, but the poisonous essence remained.
If the president really takes Roosevelt's legacy seriously, he should suspend mark-to-market accounting rules, restore the uptick rule, and enforce the prohibition against naked short selling. If he doesn't, historians will look back in utter amazement at Mr. Obama's preservation of Mr. Bush's worst economic policies.
Cashing In on Closed-Ends: The first three months of this year saw the seventh consecutive quarterly loss for the major stock market averages. From 2009’s peak to trough (January 6 to March 9), the stock market dropped nearly 30%. However, amidst the continued carnage, there exist some very interesting securities. These securities are very misunderstood and this allows a patient and careful investor to take advantage of the current environment. What makes them a real value is that their higher volatility is due to other peoples’ fear and panic and not reality. When you understand how they work you will be more comfortable with the volatility and realize how profitable these securities can be, when purchased as others panic.
