Finding that Elusive 90-Cent Dollar

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If I offered to pay you a crisp $1 bill for the 90 cents you have jingling in your pocket… well, you’d probably think I was either crazy or a scamster. Or maybe both.

But if, after inspecting the dollar bill, you determined the deal to be legit, you’d jump on it in a heartbeat. In fact, you might even run to the bank and take out your entire life savings in dimes in the hopes that I’d give you a dollar for every 90 cents you could throw together. Why wouldn’t you? It’s free money.

I’m not going to give you dollar for 90 cents… so, sorry if I got your hopes up there. But I will point out several pockets of the market today where these kinds of deals (or better) are on offer.

But first, we need a little background. “Book value” or “net asset value (NAV)” is the value of a company’s assets once all debts are settled. Think of it as the liquidation value of the company.

Now, for most companies, book value is a pretty meaningless number. If you’re a service or information company like a Microsoft or Google, the value of your business is in intellectual capital and in the collective brainpower of your workforce. And that’s something that is a little hard to put on a balance sheet.

Likewise, the accounting book values of old industrial companies with a lot of property, plant and equipment – think General Motors or Ford – are also pretty useless as the numbers on the books reflect historical costs rather than current market or replacement value. And this is further distorted by accounting depreciation.

But while NAV is more or less worthless for most mainstream companies, it’s extremely useful in a few pockets of the market, such as mortgage REITs and closed-end funds. In each of these cases, the book value of the companies is based on the real market value of the securities they own, minus any debt used to finance them. What you see really is what you get.

And this is where it gets fun. At current prices, many mortgage REITs are worth more dead than alive.

Mortgage REITs have an interesting business model: They borrow a ton of money at cheap, short-term rates and invest it in mortgage securities offering a higher yield. When the spread between short-term rates and long-term rates is wide, mortgage REITs leverage up aggressively and make a ton of money. When the spread narrows, they tend to reduce leverage and bide their time.

Many mortgage REITs often trade at healthy premiums to book value, which makes sense. The whole is worth more than the sum of the parts, and you’re paying for management expertise, instant diversification and the REITs access to cheap and abundant credit – three things you’re going to have a hard time getting on your own.

Well, today, it’s not uncommon to see these trading for just 80%-90% of book value, implying that you could hypothetically buy up the entire company, sell it off for spare parts, and walk away with 10%-20% in capital gains… all while collecting dividends.

Closed-end bond funds are another quirky corner of the market where it’s easy to find some nice bargains these days. Closed-end funds are very different from what you’d think of as a “normal” mutual fund. In a regular, open-ended mutual fund, the size of the fund changes as new investors buy shares and old investors leave. Shares are priced every afternoon based on the closing prices of the stocks or bonds in the portfolio. So, you can never have a situation where the price of the fund deviates from its net asset value.

Closed-end funds are a different animal. They have IPOs like stocks and have a fixed number of shares that trade on the New York Stock Exchange. And these shares are priced throughout the day, just like any stock. So, you can get quirky situations where a dollar’s worth of quality bonds are selling for $1.05, $0.90 or whatever price the fickle Mr. Market wants to assign that day. And right now, we’re seeing discounts as high as 10%-20% in some funds.

Today, as an asset class, closed-end bond funds are trading at the deepest discounts since the pits of the 2008 crisis and aftermath. In an otherwise expensive market, we have the opportunity to profit three ways:

  1. Earning a very solid current yield of anywhere from 6% to 9%.
  2. Enjoying capital gains as the values of the bonds in the portfolio appreciate.
  3. Enjoying additional capital gains as the current deep discounts to NAV start to shrink to something more reasonable.

Given how expensive the broad market is right now, these closed-end funds really present us with a nice alternative.

Photo credit: photosteve101

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