Tuesday, October 14, 2008

Buying Stocks For Less Than What They Trade For

At Barel Karsan, we are all about the concept of buying stocks for less than their intrinsic values.

For example, a few months ago, we considered the discounts to net asset value that a few closed-end mutual funds were trading at. This basically means that these funds could be purchased for less than the value of what they owned. Due to the recent decline in the general stock market, the prices of many closed-end funds have taken a large beating. Below is a graph showing the percentage of net asset value that the median closed-end fund trades at (thanks to Kevin Gates for putting this together using Bloomberg):

At first glance, it appears that closed-end funds are trading at tremendous discounts by historical standards. While the chart indicates that the median fund trades at more than a 25% discount to its net assets, investors must pay careful attention!

If you're considering the purchase of a closed-end fund due to its discount, you must consider several factors. First of all, how up to date is the net asset value calculation? If the NAV listed is from 10 days ago, and the market has dropped since then, the price of the fund might be low but the NAV is lower than is shown.

Second, many funds own assets that are not part of the stock market. In these cases, management has some discretion over the methodology used in the determination of the fair value of such securities. As was raised in an SEC speech here, fund ownership of illiquid securities can lead to NAV valuation inaccuracies that can mislead investors. We met this valuation challenge when we looked at Equus, a fund concentrating in the alternative energy space.

Don't buy a closed-end fund blindly due to its discount! Understand what the fund owns, when its assets were valued, and how much you can trust that valuation (i.e. are its assets traded on a liquid public market, or is some other valuation metric used).

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