When calling a stock undervalued, we are, in effect, drawing a comparison. Traditional value investors use a company's economic fundamentals as the basis of a buy signal. For example, if XYZ is trading below book value or the multiples of similar stocks, they buy, assuming the shares will eventually reflect their perceived underlying worth.
More contemporary value investors are buying the Nasdaq, suggesting that tech stocks are undervalued now that they trade at a fraction of their previous highs.
As always, two sides make a market, and there are as many bullish reasons the Nasdaq is undervalued as there are bearish reasons it's overvalued. Like most investment decisions, it ultimately comes down to an arbitrary opinion. Only the tape will tell. And while the analysts scratch their heads on the next move for Cisco (CSCO),
Let's define our terms: A closed-end fund is a mutual fund that trades like a stock. Unlike the more ubiquitous open-ended funds, a closed-end fund's price goes up and down based on supply and demand, irrespective of the fund's net asset value, or NAV, per share. That means it's possible to find funds priced below NAV literally selling for pennies on the dollar.
It isn't unusual to find closed-end funds trading at a discount. Many other writers, including a few here at SmartMoney, have suggested the idea as a supposed sure thing. And yet despite the seemingly obvious reasons closed-end funds shouldn't trade with huge discounts to their NAVs, most usually have. As recently as last year, the average closed-end fund traded at a 13% discount to its actual underlying value.
But as the markets have continued to become more efficient and liquid, and more investors have begun looking for legitimate value, the trend of funds trading at large discounts to their NAVs seems to be ending. The Herzfeld Closed-End Average tracks the average discount, or premium, at which closed-end funds, in general, are trading. Over the past year, the spread between closed-end funds and their underlying NAVs has narrowed by over 13 percentage points, suggesting that , funds trading at large discounts are legitimately undervalued and worth a look.
And while there are closed-end funds that invest in everything from bonds to Brazil, I'm focusing my analysis on closed-end country funds, since their investment prospects are more predicated on international stocks as an asset class, rather than a particular fund manager's expertise.
So even though the stocks held in the Korea Equity fund (KEF)
More often then not, it isn't what you trade, but how you trade. Investment ideas are a dime a dozen, but if you agree with me that closed-end funds trading at a discount are legitimately undervalued, the next step is to determine the best way to trade them. Closed-end country funds are illiquid, volatile and carry a great deal of currency risk, so I'd recommend a more thoughtful strategy than simply "buy and hope."
Spread It Out
One technique might be borrowed from Michael Milken, the one felonious financier who have received a presidential pardon. It's a diversification play: When Milken began preaching the gospel of junk bonds in the late 1970s and early 1980s, many of them were also selling for a fraction of face value. Using research conducted in the 1950s, Milken correctly realized that even though junk bonds were risky (and indeed many corporations would default on them), buying a large portfolio of junk bonds and holding them over time would help mitigate the market risk and provide attractive returns.
A similar approach can be attempted with closed-end funds. So instead of simply buying one or two funds trading below their NAVs, you might consider pyramiding into a small basket of a half-dozen or more. Not every position will be a winner, but the rewards, especially those of the more volatile emerging markets, could outweigh the risk. Ideally, you'll risk no more then 5% of your overall portfolio. Remember that positions grow large, they don't start out that way.
Or Play the Spread
A slightly more sophisticated strategy would be to trade a spread. Often used by commodities traders as a method of hedging risk, a spread is established by the simultaneous purchase and sale of two different but related securities. The purpose of trading a spread isn't necessarily to buy low and sell high, but to profit from the change in the relationship between the two securities. For example, a popular (and lately profitable) spread has been to buy value stocks and short growth stocks, expecting that whatever way the market moves, the relative spread between the two assets will narrow.
Using closed-end funds, the spread would be established by purchasing a closed-end fund trading with a large discount to NAV while simultaneously selling short the exchange-traded fund, or ETF, that tracks the same underlying index. For example, the Taiwan Fund (TWN)