Client Update – April 15, 2009

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.

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