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Valyooo (34.27)

Thoughts for beginners Part 1: Book value of CEF's



March 12, 2013 – Comments (2)

I am more of a macro investor than individual stocks...not the best with those.  I remember there were a bunch of questions that I had that confused me when I was brand new.  A handful of CAPS players got me to where I am today, so I am offering my opinion on a few misconceptions.  There will probably be about 10 of these blogs over the course of a few weeks.  


So, many people look at a company, especially CEF (close-end funds, similiar to ETFS) trading at under its tangible book value as a bargain, and companies trading over their book value as too expensive.  I do not think these things alone determine the worth of a closed-end fund.  I will use an analogy to illustrate my point.

Lets say you have two investors and you can't decide who you want investing your money.  

Jim is a very successful investor who has been returning 20% a year for 10 years. 

Bob has been averaging -1% a year for 10 years.


Jim is charging a one time front load fee of 10%.  If his performance keeps up, You are giving him 100k, which automatically gets deducted to 90k.  10 years from now, compounded, if he keeps doing 20% a year, your investment will be worth $557,256.


Bob is actually paying you 10% upfront for your money.  So you give him 100k, it is immediately worth 101k.  In 10 years, if his track record keeps it up, your investment is worth $99,482.


Compare Jim to a very well managed fund that is trading for 1.1x book value, and Bob as a very poorly managed fund trading at 0.9x book.


Which one would you choose?  Of course you choose Jim.  He commands a premium for a reason; he is very talented.  Bob, not so much.


Now, if there is an insane discount, like a fund trading at half of book value, and the portfolio consists of  very liquid assets, there is a case that a big shot investor can come in and liquidate the fund and distribute the money to shareholders creating tremendous value.  It is unlikely that an investor will do so if there is only a 10% discount to book though.  And if you don't have the ability to raid the company yourself, the "discount" you are paying, 10 years from now, won't look so great.


However there is no reason to short a fund that is trading at say 1.3x book value, if it is paying a dividend of 10% a year.  If they are sending you cash payments of 10% a year why do you care about the value of the assets they hold?  Nobody views mcdonalds or coca cola this way, so I dont know why a fund would be any different.  If a lemonade stand was generating 20% a year and distributed it all as a dividend, and their only assets were a table and a lemonade pitcher, would you not buy shares in their business just because their assets dont have value?  


If you want to buy undervalued assets to resell, then you can be a broker-dealer at an antique show.  If you want to earn good returns on your money, you should be concerned with the income stream, not the asset values.

So I used to believe that funds should trade at book value because their assets were liquid.  You're not buying the assets though, you're buying the management.  If you were buying the assets, you would construct your own portfolio, not be buying a fund.


I hope this clears things up for some beginners, as it took me a while to really understand! 

2 Comments – Post Your Own

#1) On March 14, 2013 at 2:50 PM, TheDumbMoney (67.34) wrote:

More broadly, valuation alone (high P/E, high P/B) is never really a good reason to short anything or any stock.  That is the most common error made by neophytes who want to short something.  A well-identified technical trend is a good reason to short a stock (with a stop if it goes up).  And a well-researched thesis about why the company's business model sucks or why it is a fraud is a good reason to short a stock, again while doing something to manage one's risk if it keeps going up.

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#2) On March 14, 2013 at 5:24 PM, Valyooo (34.27) wrote:

Yes, could not agree more.  If a company had no problem getting a p/e tag of 180 why would it have a problem getting a p/e tag of 200?  

With those type of highfliers youre actually better shorting when p/e is lower.  p/e of 200 for nflx and i wont short...but when it falls 20% and p/e is 160 I would probably be more likely to short because technically it is breaking down 

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