3 Items to look for in a Stock

This is an excerpt from an article on Motley Fool regarding Google stock but the 3 items in the list below are valid and can be used when looking for very strong companies.  I have not worked out a stock screen yet to see if I can incorporate these 3 items into a screen but will be looking to do so.  I especially need to look at item 3 below to better understand what that means.

The Motley Fool | 2016-08-13T18:04:00Z

No book has had a more profound impact on my investing than Nassim Taleb's Anti fragile. It argues that the entire world can be broken into three categories:

• The Fragile: things that break as soon as stress is applied -- like a glass falling off of a table.
• The Robust: things that stay absolutely the same under stress -- a rubber ball falling from the same table.
• The Anti fragile:things that become more powerful when stressors are introduced -- think of how your bone heals back stronger than before after it's broken.

We want our portfolios to be as anti fragile as possible. But we often fail at this. That's largely because we are suckers for the narrative bias: We tell ourselves a story about a company: how its sales will grow and its products will revolutionize the world, and we invest accordingly.
I created a compelling narrative for the first stock I ever wrote about for The Fool six years ago. Since then, that stock has trailed the market by a whopping 172 percentage points!
By viewing the investing world through an "anti fragile" lens, I eliminate the narrative bias by focusing on three attributes:

1. Lots of cash and lots of customers: cash gives companies options during downturns -- outspending rivals, buying back stock, or acquisitions. Debt does the opposite. And by having lots of customers, a company doesn't run the risk of losing an outsized portion of business if a client walks away.
2. Management with skin in the game: When the people running the company have their own skin in the game -- via shares of the company's stock -- their long-term interests are aligned with ours. That benefit compounds when founders are running the company, as they often view it as a literal extension of themselves.
3. A barbell approach:This means having two sides to your strategy -- on one hand you have a business segment that has a wide moat. On the other hand, you take lots of low-probability, low-risk, high-reward bets -- a trait otherwise known as "optionality".

What is the Top Down Style of Investing?

The idea behind top down investing is that in the S&P 500 it is divided into sectors and within each sector is a number of industries.  As the economy moves through it’s different cycles between expansion and contraction, certain industries become more attractive than others and they tend to attract more investors (more money flowing) into them.  This tends to make that sector outperform the S&P benchmark while those sectors out of favor will underperform the benchmark. 

The screen shot above is from my think or swim platform that allows me to look at the sectors by performance compared to SPY (S&P benchmark) Notice the columns on the right.  This one is sorted by 10 day performance and shows currently (mid July 2016) that Biotech (an industry) is out performing the SPY by about 3% in the past 10 trading days while Utilities (sector) is underperforming SPY by around 2%.  I use 10 day performance for short term trend trades and 3 month for intermediate term trends

The concept I learned is the saying that “a rising tide floats all boats” which means that most stocks within an outperforming industry will outperform the S&P.  This is usually indicated on the charts by an uptrend.  The length of the uptrend to look at depends on the type of investing you are doing.  If you are a short term investor the uptrend does not have to be months long.  If you are an intermediate term investor you want the uptrend to at least show a small rise in the 30 day moving average and pointing up.  It’s not an exact science and this method is only intended to give an investor an “edge” in picking up trending stocks.

So, with that in mind, in order to find stocks that meet top down style we can run a screen.  FinViz at http://finviz.com has a pretty decent free screener.  See the screen shot below.

You do not need to register with them to run screens but do need to register to save them.  It is free to register and is well worth the time to do so.  To save a screen after you have set it up, just click the down arrow in “My Presets” (upper left corner) and give it a name.  You can adjust this screen to suit yourself but the ones I use are highlighted in yellow.  I like a stock to be over $1 in price with an analyst recommendation of buy or better.  I also like average volume over 200,000 to insure I can get in and out of a trade quickly.  In order for a growth stock to grow, earnings need to be improving so I look for those that grew earnings by at least 10% this year and projected earnings growth of 10% next year.  Additional test on earnings is improving earnings and sales quarter to quarter.  I like to add the current ratio of over 1.5 because I like to know that a company can cover it’s current liabilities with it’s current assets.   I save this screen setup with the name of “TopDownInvesting(addSector)”  

With this criteria mentioned above, today I am getting 172 results.  But, I’m looking for strong sectors or industries.  So I need to add a criteria in one or both of the items marked in red in the above screenshot.   Materials is one of the strong sectors over the past 10 days so by changing the sector to Basic Materials (screenshot below) I get 7 results.

I can easily switch from one sector to the next to get the stronger stocks in any particular industry.  Adjusting any of the criteria up or down will of course change the number of results.  For example, if I changed Current Ratio to “Any”  I would get 13 results.  Any screener you use though is just that.  It’s a screener.  It does not say “buy me”.  You must look at and evaluate each stock before making a decision. 

Economic Cycle and Sector Rotation

The economic cycle is an important concept to understand when investing in stocks.  It is helpful to know where the overall economy is sitting in order to see what sectors of stocks might be under performing or over performing the S&P benchmark.  It also helps in forming an overall market posture and get prepared for a bear market and/or get back in at the beginning of a bull market.  The younger a person is doing long term investing the less this needs to be a focus.  However, once a person gets 10 to 15 years from retirement this knowledge can become critical in maintaining a nest egg that has been building.  Since an economic cycle can take 7 to 10 years to play out, as you get nearing retirement and can see that a late expansion situation exists, like the one I think we are currently in, then one should pay attention to how aggressive they have allocated their 401K or IRA and take steps to become less aggressive by transferring into safer funds etc.

 

 

Last 6 months sector performance as of June 21, 2016

Last 3 months sector performance as of June 21, 2016

These sectors will never follow a “textbook” looking scenario so one has to make judgements on what you see.  In the 6 month performance even though Utilities (late expansion) show strength, Energy, Materials and Consumer Staples are prominent indicating late expansion to early contraction.  Then in the 3 month performance Utilities has slipped but late expansion to early contraction continue to outperform SPY (S&P benchmark).  This is why I think we are currently in late expansion.  The market has been moving sideways for sometime now and as it moves sideways money has been leaving consumer discretionary and technology sectors and moving into safer consumer staples, energy and utilities.  With the market stalled right now, growth stocks are not getting the fuel they need to drive prices up.  While it might take another year to enter contraction, I think the threat is real because it is the normal flow of the economic cycle.  Below is an explanation of the economic cycle and business cycle and what to look at to help determine where we are.  Hint, the GDP report is very important.

What is the 'Economic Cycle'

The economic cycle is the natural fluctuation of the economy between periods of expansion (growth) and contraction (recession). Factors such as gross domestic product (GDP), interest rates, levels of employment and consumer spending can help to determine the current stage of the economic cycle.

BREAKING DOWN 'Economic Cycle'

An economy is deemed to be in the expansion stage of the economic cycle when gross domestic product (GDP) is rapidly increasing. During times of expansion, investors seek to purchase companies in technology, capital goods and basic energy. During times of contraction, investors will look to purchase companies such as utilities, financials and healthcare .

What is the 'Business Cycle'

The business cycle is the fluctuation in economic activity that an economy experiences over a period of time. A business cycle is basically defined in terms of periods of expansion or recession. During expansions, the economy is growing in real terms (i.e. excluding inflation), as evidenced by increases in indicators like employment, industrial production, sales and personal incomes. During recessions, the economy is contracting, as measured by decreases in the above indicators. Expansion is measured from the trough (or bottom) of the previous business cycle to the peak of the current cycle, while recession is measured from the peak to the trough. In the United States, the National Bureau of Economic Research (NBER) determines the official dates for business cycles.

BREAKING DOWN 'Business Cycle'

According to the NBER, there have been 11 business cycles from 1945 to 2009, with the average length of a cycle lasting about 69 months, or a little less than six years. The average expansion during this period has lasted 58.4 months, while the average contraction has lasted only 11.1 months.

The business cycle can be effectively used to position one’s investment portfolio. For instance, during the early expansion phase, cyclical stocks in sectors such as commodities and technology tend to outperform. In the recession period, the defensive groups like health care, consumer staples and utilities outperform because of their stable cash flows and dividend yields.

As of January 2014, the last expansion was determined to have commenced in June 2009, the period when the Great Recession of 2007-09 reached its trough (technically, that recession began in December 2007).

Expansion is the default mode of the economy, with recessions being much shorter and less common. So why do recessions occur at all? While economists’ views differ on this subject, there is a clear pattern of excessive speculative activity evident in the latter stages of expansion in many business cycles. The 2001 recession was preceded by an absolute mania in dot-com and technology stocks, while the 2007-09 recession followed a period of unprecedented speculation in the U.S. housing market.

The average length of an expansion has increased significantly since the 1990s. The three business cycles from July 1990 to June 2009 had an average expansion phase of 95 months – or almost 8 years – compared with the average recession length of 11 months over this period. While some economists were hopeful that this development marked the end of the business cycle, the 2007-09 put paid to those hopes.

Recessions can extract a tremendous toll on stock markets. Most major equity indexes around the world endured declines of over 50% in the 18-month period of the Great Recession, which was the worst global contraction since the 1930s Depression. Global equities also underwent a significant correction in the 2001 recession, with the Nasdaq Composite among the worst-hit as it plunged almost 80% from its 2001 peak to 2002 low.

What does 'Expansion' mean

Expansion is the phase of the business cycle when the economy moves from a trough to a peak. It is a period when the level of business activity surges and gross domestic product (GDP) expands until it reaches a peak. A period of expansion is also known as an economic recovery.

BREAKING DOWN 'Expansion'

An expansion is one of two basic business cycle phases; the other is contraction. The transition from expansion to contraction is a peak, and the changeover from contraction to expansion is a trough. Expansions last on average about three to four years, but they have been known to last anywhere from 12 months to more than 10 years. Much of the 1960s was a time of expansion, which lasted almost nine years.

Economists and policy makers closely study business cycles. Learning about economic expansion and contraction patterns of the past can help forecast potential trends in the future. Whether cash is available or scarce, interest rates are low or high, and companies and consumers can borrow money to spend on goods and services affects how businesses and consumers react.

What is a 'Contraction'

A contraction is a phase of the business cycle in which the economy as a whole is in decline. More specifically, contraction occurs after the business cycle peaks, but before it becomes a trough. According to most economists, a contraction is said to occur when a country's real GDP has declined for two or more consecutive quarters.

BREAKING DOWN 'Contraction'

For most people, a contraction in the economy can be source of economic hardship; as the economy plunges into a contraction, people start losing their jobs. While no economic contraction lasts forever, it is very difficult to assess just how long a downtrend will continue before it reverses because history has shown that a contraction can last for many years (such as during the Great Depression).

Examples of Expansion and Contraction

Expansion, or a boom, occurs when the Federal Reserve lowers interest rates and buys back bonds in the open market to add money to the financial system. The bondholders put their cash in the bank, which lends out money to companies that purchase buildings and equipment and hire workers. The employees produce more products and services to meet consumer demand as the economy improves. Unemployment is low while productivity and consumer spending are high. Money flows freely through the economy.

When the economy contracts, or busts, productivity declines, business revenues go down and companies lay off workers to decrease expenses. Unemployment rises, and consumers spend less. When the GDP declines over two consecutive quarters, a recession occurs. When productivity and revenue slowly begin increasing, economic recovery begins. The unemployment rate decreases as consumers spend more and the economy begins expanding.

Since 1945, the U.S. economy has gone through 10 expansion and contraction phases. Expansion periods included 1975 to 1980 and 106 months in the 1960s. Durable manufactured goods were more affected than services, as were wholesale and industrial prices more than retail prices.

Leading indicators such as average weekly hours worked by manufacturing employees, unemployment claims, new orders for consumer goods and building permits all give clues as to whether an expansion or contraction is occurring in the near future. While not completely accurate, knowledge about a certain industry or company can help prepare for changes in the economy before they occur.

http://www.investopedia.com/terms/e/economic-cycle.asp

Putting CEF Research to Work

After reviewing the articles I’ve posted over the past few days on what makes up a good CEF and things to watch for, it’s time to put it to work.  A good free resource for closed end funds is at http://cefconnect.com which has a very good fund screener along with extensive research information on each fund.  So first I have to start with a screen.  For this particular screen I’m going to focus on equity CEF’s and not bonds.  My personal reasons for this is that I am most familiar with stocks and my knowledge of the bond market is not great so I choose not to learn about them at this time. 

Screen info:

I selected equity type funds and also included specific sector focus to help add to diversification.

Above is the criteria I am screening for.  I want to limit the exposure of leverage to those funds with 30% or less leverage.  My distribution rate is set to range from 5% to 9%.  I don’t want less then 5% to get the most return for the amount invested to be worth the risk.  But, over 9% is chasing yield and most anything that pays out 10% or higher is doing so because something is wrong and typically they can not sustain such high payouts.  They are not worth the risk.  I selected monthly on my Distribution Frequency as a matter of personal taste.  I already have several stocks in my dividend portion that pay quarterly and I’d like to have some monthly income flowing in.  I selected under 0 for Discount / Premium as I do not want to pay more than 1.00 per 1.00 of assets.  I was not able to get the Z-Score into the screen shot but I did select a 1 year Z-Score of all under 0 to confirm that fundamentally the relative discount is a value at the current levels.

At the bottom of the screener a tally of the number of stocks is kept and changes on each selection you make.  This one got down to 9 funds based on my criteria.  Clicking on “View Funds” button will bring up the results.

So above is the 9 funds that pass the criteria I set in the screen.  Am I don yet?  No, not even close.  Next I will research each of the 9 funds.  I will look at several years of NAV discount/premium history and confirm that NAV is at least the same or not significantly lower than around 5 years ago.  I’ll also look at 5 years of distribution history for consistency in payments and most importantly how the distributions are being paid, watching out for use of return on capital.  Then I’ll look at the charts to see how the technical’s look for entry. 

Once I narrow that down to the 2 or 3 postions I am thinking of taking on, I’ll have to position size based on my earlier post about that topic and then take the plunge.

One point I want to make here is that this list of 9 funds are not a buy list and no one should act on these without doing their own due diligence.

CEF Distributions

Except for a handful of exceptions, CEFs themselves do not pay taxes.

Instead, like open-end mutual funds and ETFs, CEFs pass the tax consequences of their investments onto their shareholders.

To maintain tax-free status, a CEF must pass onto shareholders, generally speaking, roughly:

• 90% or more of net investment income from dividends and interest payments
• 98% or more of net realized capital gains

Investors should be aware of the source of their distributions.

CEF distributions have four potential sources:

1. Interest payments on fixed-income portfolio holdings

2. Dividends from equity holdings

3. Realized capital gains

4. Return of capital:

• Pass-through (from master limited partnership investments, primarily)
• Constructive (from unrealized capital gains)
• Destructive (investors are literally receiving their own capital, minus expenses)

For accounting and tax purposes, distributions must be linked back to the initial source: usually dividends, income, and/or realized capital gains. These are actual cash inflows into the fund.

When the distribution exceeds the cash generated from these sources, the fund must ascribe the initial source as a return of capital.

Throughout the calendar year, funds estimate the breakdown of their distributions. Shareholders receive a Form 1099-DIV in January with the actual distribution breakdown for the prior year for tax purposes. Any previous information regarding the categorization of distributions are only estimates.

Prospective investors are at a disadvantage because they do not have access to the tax forms. They must wait until the fund files its annual statement to see the finalized distribution breakdowns in order to discern its use (if any) of return of capital.

Morningstar.com displays a fund's most recent distributions, along with their sources, as well as distributions for the four previous calendar years.

I chose ETV as an example screen shot from Morningstar as it shows all the types of distributions being used.  Return on Capital is a red flag for me as it can be very destructive to the fund if you do not know which type of ROC is being used (Pass thru, Constructive or Destructive)  I tend to make a worse case assumption when I see ROC is being used.  In this case I looked at the NAV history over 2 years and it appears ETV is not using the destructive exclusively but I think in some months it is being used.  The NAV in January 2014 was $14.53 and in July 2014 the NAV exceeded $15.  But in January 2016 NAV was $13.39.  I would not be interested in this CEF for a couple of reasons.  One is I don’t trust the ROC distributions and the other reason is that it is selling for $14.84 with a NAV of $14.02.  This is a 5% premium which in effect has you paying $1.05 for $1.00 of asset.

The takeaway from this is that when looking at CEF’s it is important to look at the distribution  and understand how it is being paid.  It is one of the several things that need to be evaluated in a different light then regular stocks are looked at.

CEF’s Relative Premiums & Discounts

In truth, all discounts and premiums are relative to another number. Absolute discounts/premiums are relative to the net asset value (NAV). Relative discounts/premiums are relative to the average discount of the particular CEF being considered.

Because absolute discounts and absolute premiums tend to persist, relative discounts and relative premiums matter.

Academic studies have shown that current discounts/premiums converge to their average discounts/premiums much more regularly than they converge to their NAVs.

Measuring Relative Discounts/Premiums

• To measure relative discounts, we use a z-score:
  z = (current discount – average discount) / standard deviation of the discount
• A negative z-score indicates that the current discount is lower than its average.
• A positive z-score indicates that the current premium is higher than average.

In our opinion, a z-score of less than -2 signals that a fund is relatively inexpensive, and a z-score greater than +2 signals that a fund is relatively expensive.

Example 1

• Current discount = -8%
• Average 1-year discount = -15%
• 1-year standard deviation of discount/premium = 2
• z-score = (-8 - -15) ÷2 = (-8 + 15) ÷ 2 = 7 ÷2 = 3.5

With a z-score of 3.5, this fund would be considered relatively expensive. But this doesn't necessarily mean that the CEF is overvalued.

Example 2

• Current discount = -15%
• Average 1-year discount = -10%
• 1-year standard deviation of discount/premium = 2
• z-score = (-15 - -10) ÷2 = (-15 + 10) ÷ 2 = -5 ÷2 = -2.5

With a z-score of –2.5, this fund would be considered relatively inexpensive. But this doesn't necessarily mean that the CEF is undervalued.

Why Are Relative Discounts Helpful?

For one, they can help you avoid value traps.

Let's look at the mythical CEF trading at a 15% discount. According to the oft-cited "CEF wisdom," this would be a good trade because the market is offering investors $1.00 of assets at the bargain price of $0.85. (Forget the fact that the $1.00 worth of assets may fall in value to $0.85!)

Consider this:

• 3-year average absolute discount = -25%.
• Current absolute discount = -15%
• Standard deviation over the certain time period = 2
• z-score = (-15 - -25) ÷ 2 = (-15 + 25) ÷ 2 = 10 ÷ 2 = +5.

A z-score of +5 indicates that, far from being relatively inexpensive--as CEF wisdom would have it--this CEF is relatively expensive. It could represent a classic value trap.

Z-score can also help investors uncover potentially truly undervalued and overvalued CEFs. If the z-score is greater than +2 or less than -2, more research would be warranted.

Using relative discounts/premiums is a bit of an art. The time period analyzed is a large factor in the z-score.

The same CEF may look relatively expensive on a 6-week basis and relatively cheap on a 3-year basis.

Even though the CEF may look relatively expensive or relatively cheap, it may not be truly overvalued or undervalued.

Consider a CEF that is going to liquidate in one month. Liquidation is a method of making a CEF's share price converge with its NAV. All assets are sold and the remaining capital is distributed to shareholders. At the point of liquidation, the discount will be 0.

• Current discount = -2% (in anticipation of the pending liquidation)
• 1-year average discount = -12%
• 1-year standard deviation = 1.5
• z-score = (-2 - -12) ÷ 1.5 = (-2 + 12) ÷ 1.5 = 10 ÷ 1.5 = +6.7
• This CEF is relatively expensive, but with very good reason: A corporate action has narrowed the discount. If an investor attempted a short sale of this CEF in the market, the likely outcome would be a capital loss.

There could be a fundamental reason behind a high or low z-score. Do not buy or sell a CEF simply because of its z-score. Further analysis as to why the current discount has deviated so far from its historic average is warranted.

Key Takeaways

• Buy-and-hold investors can use z-scores to determine whether the absolute discount/premium is truly signaling that the CEF is under- or overvalued or whether the absolute discount/premium could be a value trap.
• Trading-oriented investors can z-scores to find candidates for buying or selling short. (In practice, this is the most common use of relative discounts/premiums.)

• Regardless of how they are used, they are no guarantee of future investment gains. All that matters once a CEF is purchased is the subsequent total return. Just as absolute discounts/premiums can converge to NAV with no gain for the shareholder, so too can relative discounts/premiums.
• It is important to understand why a CEF is trading at a current discount/premium that is widely divergent from its historic average. There could be a very good reason, aside from market sentiment.

CEF Discounts and Premiums

(information from Morningstar.com’s CEF section)

CEFs have an underlying portfolio of securities. From this portfolio, a net asset value (NAV) can be derived.

NAV = (assets – liabilities) / shares outstanding

the investment portfolio primarily, if not solely, comprises the assets. For leveraged CEFs, the leverage itself is the bulk of the liabilities.

CEFs trade on an exchange. This means that they have a share price, which is set by the market. These two prices, the NAV and the share price, are rarely the same, and when they are, it's only by coincidence.

The differences between the share price and the NAV create discounts and premiums. Shares are said to trade at a "discount" when the share price is lower than the NAV.  The discount is commonly denoted with a minus ("-") sign. Shares are said to trade at a "premium" when the share price is higher than the NAV. The premium is commonly denoted with a plus ("+") sign. The calculation is (Share price ÷ NAV) – 1. Examples:

Share price = $19.00

NAV = $20.00

Discount = ($19.00 ÷ $20.00) – 1 = 0.95 – 1 = -0.05 = -5.0%

Share price = $12.00

NAV = $10.00

Premium = ($12.00 ÷ $10.00) – 1 = 1.20 – 1 = +0.20 = +20.0%

What gives rise to discounts and premiums? Why is the market seemingly inefficient?

Efficient market hypothesists have tried to explain discounts and premiums for years with myriad explanations. Most commonly, the reason a CEF trades at any given discount or premium is related to the fund's distribution rate, regardless of the source of the distribution. (Some fund families seemingly abuse the knowledge that this occurs to justify--in their minds, not ours--the use of destructive return of capital.)

Other typical reasons for premiums and discounts include:

• Overall market volatility
• Recent NAV and share price performance
• Brand recognition of fund family
• Name recognition (or lack thereof) of the fund manager
• Recent changes in distribution policy
• An asset class or investment strategy falling out of market favor
• An asset class or investment strategy rising in the market's esteem

Whatever the reason for a CEF's discount or premium pricing, it is crucial that CEF investors realize that discounts and premiums exist.

At Morningstar, when comparing a share price with a NAV, we often refer to discounts and premiums as "Absolute Discounts" and "Absolute Premiums."

We do this because, as discussed in another Solution Center presentation, there are other ways to look at discounts and premiums. For instance, if we compare a CEF's discount to its average historic discount, this is what we refer to as a "Relative Discount."

Most long-term investors just look at Absolute Discounts and Absolute Premiums. But when considering valuation, it's important to look at Relative Discounts and Relative Premiums.

There are three things to consider regarding discounts and premiums:

1. Regardless of the discount or premium, what matters to an investor is the share price at the time of purchase and the subsequent total return of the CEF.
2. A CEF's discount or premium tends to persist. If the CEF typically trades at a large discount, it will tend to stay at a large discount, barring any corporate actions from the board of directors. The same can be said of premiums. Even in periods of extreme market volatility, CEFs that typically trade far below or far above the universe's average discount will more than likely continue to trade that way, even if during the downturn the premium turns to a discount.
3. Over a complete market cycle, most CEF share prices will trade below, at, and above their corresponding NAVs.

Absolute Discounts

The standard thinking for CEFs is to focus on funds trading at discounts and to avoid funds trading at premiums. We think this maxim is simplistic and could lead to unrealistic expectations for investors.

All that matters for a CEF investor is the share price at which the CEF was purchased and the subsequent total return. Discounts and premiums wax and wane over time. For instance, if a CEF is trading at a 15% discount, people often tout this as an opportunity to buy $1.00 of assets for $0.85. The unstated premise is that eventually the price will reach $1.00.

This is problematic. Nothing mandates that a share price, even discounted at 15% to NAV, must converge to its NAV over time. Furthermore, the NAV could decline to $0.85 (or lower).

We recommend not purchasing CEFs at absolute discounts in the hope that the share price will converge to a higher NAV. The primary benefit of purchasing a CEF at an absolute discount is for income-seeking investors to enhance their yield.

"Yield Enhancement" and Absolute Discounts

Putting aside sources of distribution, let's assume that a fund's underlying portfolio at NAV yields 10%.

Distribution = $1.00 per share

Net Asset Value = $10.00 per share

Distribution Rate at Net Asset Value = $1.00 / $10.00 = 10%.

Let's further assume that the shares trade at a 10% absolute discount.

Net Asset Value = $10.00 per share

Share Price = $9.00 per share

Absolute Discount = (share price – NAV)/NAV = ($9 - $10) / $10 = -10%

Because they are buying at a discount, investors purchasing these shares will get a higher yield:

Distribution = $1.00 per share

Share Price = $9.00 per share

Distribution Rate at Share Price = $1.00 / $9.00 = 11.1%

So, "Yield Enhancement" = Dist Rate (Share Price) / Dist Rate (NAV) = 11.1% / 10% = 1.1%

Buying $1.00 of assets for $0.85 isn't necessarily a bargain.

The table below sets forth the nine scenarios that can play out when purchasing shares at an absolute discount.

How the Absolute Discount Can Narrow

1. NAV falls faster than the share price: This is the worst possible scenario. The underlying portfolio is losing value and your shares are worth less.
2. NAV falls and share price remains steady: This is the second-worst scenario, in that the underlying portfolio is losing value. At least your shares haven't declined in value.
3. NAV falls and share price rises: The investment portfolio is heading south but at least you are making some money. Be careful, though, because ultimately the discount or premium will rely, at least in part, on the portfolio's performance.
4. NAV is steady and share price rises: This is the scenario implied by investors who say they buy $1.00 for $0.85.
5. NAV rises and share price rises even faster: This is the best of all possible scenarios. Of the nine scenarios, this occurs in only half of one (because the NAV could rise faster than an increasing share price, meaning the discount would widen).

Also note the several scenarios where the share price declines or the absolute discount widens. Using absolute discounts as the sole method of finding undervalued CEFs is akin to investing in a value trap.

On the flip side, there is no reason to avoid all CEFs trading at an absolute premium.

If you are purchasing shares at an absolute premium, you are taking on risk. Your capital could decline, even if the underlying portfolio performs well.

This isn't to say you should never invest at a premium. Most CEF investors have no qualms investing at slight premiums to NAV. But absolute premiums above 10% should really give you pause.

The table below shows the nine scenarios that can play out when purchasing shares at an absolute premium.

If you find yourself in a situation where the share price is rising and the NAV is declining, you are likely in what Warren Buffett might call a "greater fool" scenario. You may want to consider taking your profits and finding a more suitable investment.

Note that only one half of one scenario leads to a rising share price and a narrowing premium.

Unwittingly purchasing shares at an absolute premium, only to see the share price decline as the premium narrows, is the number one reason people have a poor experience with CEF investing.

Key Takeaways

• Every CEF has a discount or a premium. It is rare, and short-lived, for a share price to equal the net asset value.
• Absolute discounts are an inappropriate method of finding undervalued CEFs. When searching for undervalued CEFs, use relative discounts
• Absolute discounts can and should be sought for "yield enhancement." Make sure to see our Solution Center presentation on distributions.
• Absolute premiums should not preclude investment, but they do represent additional investment risk. Extreme premiums above 10% should really give investors pause. Unless the NAV rises to meet your purchase price, even in the long run you will likely lose money on your investment.
• While there is nothing that mandates a CEF share price equal its net asset value, history shows that funds normally trade at both an absolute discount and an absolute premium over the course of a full market cycle. In other words, the share price does tend to revert toward, and then through, the NAV.
• Again, when investing in CEFs, discounts and premiums don't ultimately matter. What matters is your cost basis and the subsequent total return.