They are a rarity on the market today.
Most of the headlines over the summer have been about how the stock market is nearing all-time highs… making it difficult for investors to find a good entry point for many stocks.
But that could be changing. In August, the S&P 500 fell about 4.5%, while the Dow Jones Industrial Average fell 5.4%.
Could the bull market we’ve experienced over the past few years be coming to an end? It’s entirely possible. As I reported last week, it all has to do with the looming Bernanke bond bubble burst or what I’m calling the “October surprise.”
But a slow down, or a complete turnaround in the stock market, should not be looked at as a bad thing. It should be viewed as an opportunity.
What if there was a way to invest just 90 cents and get a full dollar’s worth of interest-earning power? In other words, what if we could easily buy stocks discounted by 10% or more and boost the dividend yield we collect from them at the same time?
There is a way we can do that. But first, let me explain how we got to this point…
For the past few years, interest rates have been tilted in the borrower’s favor, which has allowed companies to borrow cash cheaply and use it to quickly expand. But short-term interest rate hikes could throw a wrench into the works.
This isn’t just a distant threat. Rates have already shot higher in recent weeks as traders prepare for a new reality without quantitative intervention from the Federal Reserve.
With historically low interest rates, the playing field is still tilted in the borrower’s favor, but it’s much tougher for companies to grow than it was just a few months ago. And asset prices have fallen accordingly.
But as stocks fall, there are some that go too low — to the point of becoming bargains. And one of the easiest ways to find stocks that are trading as bargains is to look at closed-end funds.
Closed-end funds are simply mutual funds that hold stocks. Unlike open-end mutual funds, which most people hold in their 401(k) and offer as many shares as investors are willing to buy, closed-end funds carry a fixed amount of shares that investors can purchase on the market.
I could go through every detail, but basically because closed-end funds can’t increase their share count, their market value can fluctuate and be much different than their “net asset value” (NAV), which represents how much the holdings are worth.
And if closed-end funds should sell off along with the rest of the market, it could mean we have an opportunity to buy a basket of quality stocks at discounts of 5%, 10% or more compared with what they’re really worth.
Let me give you a real-life example to explain.
Consider The Zweig Fund, Inc. (NYSE:ZF). It’s a closed-end fund that has $340 million in net assets, which are invested in a diverse basket of blue-chip stocks such as PepsiCo, Apple, JPMorgan, Comcast, U.S. Bancorp and Qualcomm.
With 22.8 million shares outstanding, each share of the fund is worth $14.93 (according to the NAV). But here’s the good part: You don’t have to pay full price. The Zweig Fund, Inc. (NYSE:ZF) shares have dipped deep below NAV, so you can get $14.93 worth of dividend-paying stocks for just $13.00.
That means we can essentially buy shares in each of those quality companies at a 13% discount. If you bought this fund today, you’d pay just $424 for each share of Apple it holds — which last traded around $487 per share on the market. You get the same 13% discount for all the other stocks held in the fund, too.
Not to mention you get to collect the dividend income from those stocks. But because you paid less for your shares, you’re effectively getting higher yields. So instead of collecting a 2.5% yield from Apple, you’re getting 2.87% ($12.20 per share dividend on $424 shares = 2.87% yield).
Now, that doesn’t automatically make The Zweig Fund, Inc. (NYSE:ZF) a buy. If for no other reason, overall total returns have been lackluster over the long haul.
With that in mind, I conducted a screen for funds with lofty 5%-plus yields, no leverage (and no exposure to rising rates) and double-digit discounts to NAV. I also looked for funds with superior performance whose trailing three-year returns outrun their respective benchmarks.
Here’s what I found:
The advantages of buying an income-paying fund at a double-digit discount are obvious, particularly when the stocks or bonds inside that portfolio are themselves undervalued.
If a quality fund that typically trades at a slight 1% to 2% discount suddenly slides to a 10% discount in a broad market pullback, there’s an opportunity. There’s usually a reversion to the mean. But don’t automatically assume that a discounted fund will close the NAV gap — some stay underwater for years, always showing somewhat of a discount. That’s why it’s more instructive to compare a fund’s current discount with its historical average.
But this list is a good starting point to conduct more research on whether one of these funds would make a good investment. And if Bernanke & Co. do indeed decide to taper the Fed’s bond purchasing program and the market takes a hit, which is very likely, these funds will be some of the first investments I’ll look at to buy on a pullback.
P.S. — As I mentioned earlier, I’m predicting an “October Surprise” in the market this year, and it’s all Ben Bernanke’s fault. Thanks to the Fed’s reckless monetary policy, this collapse could affect millions of investors — and anyone not prepared for it could lose a fortune. But I have a plan. To learn how I’m preparing for this collapse, read this special report.
– Nathan Slaughter
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