By Donald L. Cassidy

My focus is on two areas of value in the market that are virtually ignored by brokerage firms’ research departments and rarely traded by institutional investors: Closed-end funds, which account for roughly one-eighth of common stocks listed on the New York Stock Exchange; and recently issued preferred stocks.

Knowing where to find the hot action areas of the market is always simple: Watch the headlines. The media focus on the day’s, quarter’s, or year’s, biggest winners, whether they are individual stocks, industries, styles, or mutual funds.

Unfortunately, this focus comes after they’ve already jumped. More conservative, value-oriented, and contrarian investors look away from the glamorous and seek the solid but neglected areas of the market. There, we find intriguing possibilities precisely because the spotlight of media attention is focused far away.

This, of course, is one of the underlying premises on which the AAII’s Shadow Stocks screening and selection process is based [see the February 2000 AAII Journal articles on stock screening]. In this article, I’ll explore some other places where value is being ignored by a large majority of investors.

My focus is on two areas many investors have never explored very thoroughly. The first area is where approximately one-eighth of common stocks listed on the New York Stock Exchange cluster, yet it is virtually uninhabited by institutional investors and ignored by brokerage firms’ research departments—closed-end funds. These investment companies present value that can be captured with a little study, analysis, and patience in the following ways:

Dividend-capture plays are available late each year although primarily for tax-free accounts; A December/January cycle exists, in which best and worst performers reverse roles; Municipal bond closed-end funds offer unusually strong opportunities, including inefficient market yields; World equity funds are generally depressed, trading at just above all-time deep discounts, and many of their underlying markets are presently out of favor; The advent of dozens of exchange-traded funds, many duplicating the investment objectives of closed-end funds, implies heightened pressure on the latter to open-end or liquidate.

The second neglected area is recently issued preferred stocks. These issues have virtually no brokerage or institutional support in the aftermarket, providing periodic value opportunities for the patient, contrarian investor.

Closed-End Opportunities

A closed-end fund is an investment company registered under the Investment Company Act of 1940; unlike a mutual fund, it does not stand ready to redeem its shares from owners on days the market is open for business. About 90% of closed-end funds are traded on stock exchanges; the remainder are untraded but do offer occasional exit opportunities via tender offers, typically quarterly.

Market-traded closed-end funds are priced according to current supply and demand, like any other stock. They therefore can trade either above their reported net asset value, which is referred to as trading at a premium, or they can trade below net asset value, at a discount. Barron’s and the Sunday New York Times, as well as the Monday Wall Street Journal, carry weekly tables of premiums and discounts compiled and supplied by Lipper Inc.

Dividend-Capture Plays

Like mutual funds, closed-end funds are required by Internal Revenue Service and Securities and Exchange Commission regulations to distribute their net realized long-term capital gains annually. Just as many savvy investors refuse to buy highly successful mutual funds late each year (so as to avoid “buying the distribution” and its attendant tax consequences), closed-end fund investors display similar behavior. Because of this pattern, an opportunity arises in closed-end funds for those watching the details closely, due to the fact that tax-averse behavior creates changes in premiums and discounts.

As with any other stock, market prices will fall on the ex-dividend date by roughly the amount of the dividend entitlement per share. In closed-end funds, however, tax-averse buyers delay purchasing for the few weeks prior to the “ex” date, and then buy the fund on or right after that day. As a result, the discount predictably widens before the event and suddenly narrows thereafter. It is not uncommon to see a closed-end fund paying a $5/share year-end capital gains distribution trade down only $3 or so on the ex-dividend date.

Capturing this differential offers an immediate profit opportunity if accomplished in a tax-free account such as a Roth IRA, or in a potentially zero-bracket account in a child’s name. In such accounts, one buys the stock that others are avoiding just before the ex-dividend date. Thus, one is entitled to the long-term gains distribution. When the stock trades down by considerably less than the dividend amount, two choices arise: selling captures the gain over a very short period, while holding effectively gives the longer-term investor a net cost that has already built in a moderate paper-profit cushion.


© AAII Journal November 2000, Volume XXII, No. 10