Tuesday, November 1, 2011

The Wages of Fear: Buying Closed-End Funds, Part 1

In the Clouzot's great French existentialist film The Wages of Fear, four down-on-their-luck workers agree to transport a truck of nitroglycerin across the Amazon to an oil well, a harrowing ordeal that only one man, Mario, survives. Because Mario is forced the whole journey to the oil well to drive slowly and with painstaking caution, so that the nitroglycerin would not explode, on the return journey he drives his empty truck with such gleeful abandon that he sails the truck right off a cliff. Thursday's more than 300-point rally in the DOW reminded me of that last scene (up to the falling-off-the-cliff part) of the film; equity traders for the last few months have been so stymied by fears of a double-dip recession here in the U.S. and concerns of a banking collapse in Europe, that they have been, since August, driving their trucks cautiously across what they considered perilous terrain.

Last week's announcement of a 50 percent haircut for Greek bondholders and more solidarity from the French and German leadership than the world is accustomed to caused a short-covering rally that surprised many of us. Equity traders gleefully jumped on board the rally and, like Clouzot's Mario, pressed the accelerator because they finally felt free to do so. My guess is that as soon as the Europeans utter some cautious remarks or look at each other funny, the Wall Street traders will run for cover again, and shares will erase much, if not all, of the roughly 1000-point Dow advance thus far accumulated in October. I'm afraid that the market is more than a little overbought here, and a pullback would be healthy and wouldn't be very deep, inasmuch as traders will remember the vehemence of the market's ascent last week. If the market goes much higher without a pause or pullback, we may live the last scene of The Wages of Fear: you know, the falling-off-the-cliff part.

As I watched most stocks last week rise almost indiscriminately, I felt a pang for all those stocks I could have bought at a lower price, like MGM International (MGM), a casino stock, which just weeks ago I traded when its price was toggling between $9.50 and $10.50 and which, Friday traded above $12.00. If you missed the big move last week in the market, you'll probably, if you did not chase the momentum money Friday, get a chance to buy, in the coming weeks, all those stocks whose dramatic move sent a tremor of jealously through your gut. This week's early market retreat seems to suggest that your chance to pick up your favorite shares at a more reasonable price may be even sooner than I am suggesting (yikes! I'd better type faster). This is the time to make a shopping list for stocks that you would like to have for the next short-covering rally.

Over the past few years, I have become increasingly interested in closed-end funds (CEFs), which are collections of shares that track an underlying collection of assets, like bonds or global dividend-paying stocks, and which rise and fall in price based largely on the value of the underlying assets, called the net asset value (NAV), and, specifically, whether or not the shares are trading at a discount or premium to NAV. That's really the greatest attribute of CEFs: their shares sometimes trade at a discount to NAV, so immediately, you can better ensure that you are not overpaying for shares, as opposed to shares of a company, whose true value is so difficult to quantify. Often a CEF's net asset value is updated daily, so you can track easily how its shares are trading relative to NAV.

Let's get specific. Currently, I own two CEFs, PIMCO Corporate Opportunity Fund (PTY) and Wells Fargo Advantage Global Dividend Fund (EOD), two very different funds that, owing to their differences, offer an excellent introduction to CEFs. Let's start with EOD, which I would consider by far the riskier CEF. The Wells Fargo closed-end fund, as of Halloween, traded at around $8.35 per share, but its NAV, according to Morningstar.com was around $9.00, which amounts to about a 7% discount.  EOD shares have traded during the past year between $7.45 and $10.73, and the fund's NAV has ranged between a -10.52% (a discount) and 5.26% (a premium) differential from its share price, according to the useful site cefconnect.com; therefore, while a 7% discount is nice, if we wait for a steeper discount, namely closer to its 52-week high discount of about 10%, then we might do better. The best part about EOD is its roughly 13 percent annual dividend, which amounts to a $0.28 quarterly payout. While that high dividend may be signaling that the EOD may have to reduce its payout soon, I find it difficult to believe that the reduction will be so significant that the share price will be affected that much; after all, if the NAV is correct for EOD, any future dividend cuts should be factored in already to the value of the underlying assets. EOD typically trades at a discount, so we shouldn't necessarily hide under the typical Wall-Street-must-know-something-that-I don't blanket and pass up a potentially rewarding opportunity. Perhaps Wall Street is wrong, and EOD won't cut its payout after all.

Next time I'll talk about how the Normal Model and z-scores can help us time the buying of CEFs, and I'll outline the very different closed-end fund PTY.

At the time of this writing (Tuesday morning), the market is indeed falling off Clouzot's cliff.

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