The Zweig Fund, Inc. (ZF), Adams Express Company (ADX), Tri-Continental Corporation (TY): How To Buy A Dollar For 85 Cents

It is not often that we get the chance to buy a dollar for eighty five cents. But markets aren’t always rational, and that’s how we get our opportunity. I believe that every investor should implement a strategy of buying closed-end funds when they trade at a proper discount.

What’s a closed-end-fund (CEF)?

Almost all the funds you probably know are “open-end” funds. This means the fund will issue as many shares as investors are willing to buy. When investors put more money into the fund, the fund issues more shares and buys more shares of the underlying stocks. Because of this, the price you pay for a share of an open-end fund will always be the total value of the stocks in the fund divided by the current number of shares outstanding. This value is known as the “net asset value,” or NAV. Open-end funds always trade at their NAV.

Closed-end funds work differently. These funds issue a limited number of shares. If you want to buy these shares, you must go into the stock market where they trade like a normal stock. In other words, to buy a closed-end fund, by definition someone else must sell you their shares.

The opportunity

Since CEFs trade like normal stocks, the value of a closed-end fund can fluctuate significantly and does not necessarily reflect its NAV. Any difference between the share price and NAV of a closed-end fund is known as the premium or discount, depending on if the share price is higher or lower than the NAV. In theory, this situation makes no sense. Closed-end funds should never trade at a discount, and they certainly shouldn’t trade at a premium. After all, it would be foolish to sell a fund for less than it’s actually worth. And it definitely makes no sense to buy a fund for more than it’s worth.

But in the real world, it does happen. Whether it’s because someone has to sell for reasons unrelated to the fund, such as a margin call, or folks irrationally selling out of fear, like we saw in 2008 and 2009. Whatever the case may be, closed-end funds will sometimes sell at a significant discount to NAV. This can be a huge opportunity for savvy investors. It’s because under most circumstances, the fund’s share price will return to NAV. One of two things is going to happen–either the market will realize the fund is under-priced and drive the share price up, or the fund managers will get shareholder approval to buy back shares and remove the discount. It’s a win- win situation for the investor.

Real life examples

Right now, there are three CEFs that are worth your close attention. All three are relatively safe funds because they invest solely in large cap U.S stocks that have sufficient liquidity. This means that the fund shouldn’t have any problem to liquidate its position in the market and pay back the difference (the discount) to its shareholders.

1. The Zweig Fund, Inc. (NYSE:ZF) is a $355 million closed-end-fund that invests mostly in U.S equities. Its major holdings include large, highly liquid names such as Apple, Qualcomm, JPMorgan Chase and MasterCard. Shareholders enjoy a distribution rate of 7%. In addition, the fund currently trades at a discount of 12.26% to its NAV. This means that if the fund, as a whole, sells all of its assets tomorrow, it’s left with 14% more cash that what it trades for today. Pretty amazing, isn’t it?
2. Adams Express Company (NYSE:ADX) invests in the same segment as The Zweig Fund, Inc. (NYSE:ZF). The huge $1.3 billion fund is currently invested in names like IBM, Honeywell International and Merck. Investors in this fund enjoy an annual distribution rate of 5.6%. In addition, they are likely to enjoy some capital gains too. The fund is currently trading at a 12.9% discount to its NAV.
3. Tri-Continental Corporation (NYSE:TY) is a $1.3 billion fund. Over 10% of its capital in invested in Cisco, Microsoft, Pfizer, Chevron and Apple. Tri-Continental Corporation (NYSE:TY) has a relatively modest distribution rate of 3.8%. It’s now trading at a respectable discount of 12.85%.

The Fool looks ahead

There’s never a free lunch in the markets–but from time to time you can have a free snack. Investing in high quality, highly liquid closed-end-funds is a winning strategy. Invest accordingly.

The article How To Buy A Dollar For 85 Cents originally appeared on Fool.com and is written by Shmulik Karpf.

Shmulik Karpf has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Shmulik is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.

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