Building a winning investment portfolio: Part 3

In part 1 of this mini series, we looked at how to build the two portfolios every household needs:  an emergency fund and a retirement fund.

In part 2 we looked at how to build a portfolio geared towards short-term goals such as buying a house in a few years.

Today we will quickly look at closed-end funds as a potentially interesting investment opportunity, and we will look at some stock picking tips for those interested in bypassing the ETF route and build their own stock portfolio.

Closed end funds

Closed end funds (CEFs) are a type of investment with characteristics of both a mutual fund and a stock.  CEFs operate in a similar manner to a mutual fund:  Both are usually actively managed by a fund manager and both will invest in stocks, bonds, real estate, etc.  But unlike mutual funds, CEFs trade on stock exchanges like stocks.  Like stocks, and also unlike mutual funds, there are a set number of shares for each CEF.  When additional money pours into an existing mutual funds, the managers simply create more units.  This doesn’t happen with stocks or CEFs.

Because of this, CEFs will often trade at a premium or a discount to their net asset value (NAV).  This is where things can occasionally get interesting.  To illustrate this idea, consider a CEF that holds $100 in investments and has issued 50 shares.  Each share has a claim on $2 worth of investments, so the NAV of each share is $2.  But that doesn’t mean they will necessarily trade at $2 a share.

Most CEFs trade on very thin volume.  Many trade less than 5000 shares a day.  Contrast this with a big company like Royal Bank which will see several million shares change hands on a typical day.  Because of the thin volume of CEFs, they are considered a semi-liquid investment.  There is no guarantee that when you need to sell you will be able to find a willing buyer at near the last trading price.  To compensate for the lack of liquidity, CEFs often trade at a discount to NAV.  It varies for each fund, but a 10% discount is not uncommon.

Where CEFs become VERY interesting is during times of market panic.  Because they are very illiquid, it is possible to buy them from desperate sellers at extremely cheap valuations.

As an example, during the depths of the market crash I started researching a few CEFs and found one that was trading for less than the cash value held by the fund.  It was trading at a 80% discount to NAV.  I’m not kidding.  The market crash saw some ridiculous valuations in some CEFs.  This particular fund had a NAV of about $5 if my memory serves me, but that five dollar NAV represented $3 worth of stocks and $2 worth of cash per share.  But the shares were trading for less than $2!!!!  It made absolutely no sense at all, but in the absence of willing buyers, sellers were dumping their shares on the cheap.  I loaded up and promptly tripled my investment when the markets stabilized a few months later.

I will say that in general I’m not a huge fan of CEFs.  They often have ridiculous management expenses.  But as this example illustrates, when the market sours, desperate sellers are often willing to give them away on the cheap.

A few tips for buying CEFs:

  • Make sure you have a good idea of what the typical discount to NAV is.  Some CEFs have traded at a 50% discount for the several years I’ve been watching them.
  • NEVER buy a CEF at the initial offering price.  Always buy in the after market.
  • Place a ‘stink bid’ for a CEF you like, and then wait patiently.  Because they are illiquid, the bid-ask spreads are often extreme.  You’ll be surprised how often you can pick up a CEF for a very cheap price.
  • Use Globe Fund’s Closed End Fund filter for research.
  • Only buy at extreme discounts to NAV.  Sell when it normalizes.  CEFs are not great long-term investments but can periodically offer great bargains.
  • Avoid split shares.  Without getting into the dubious structure of a split share, it suffices to say that they are not investments I would touch.  They often have the word ‘split’ in the name of the fund.

Stock picking tips

You know by now that I am a fan of using ETFs to build the core of any portfolio.  They eliminate the risk associated with an individual security as they represent the entire market.  They are extremely useful for international and emerging market exposure in particular.

But I will admit that I do hold a number of individual Canadian and US stocks as well.  I know the research overwhelmingly indicates that our ability to pick winning stock portfolios that can outpace the market is questionable at best.  However, occasionally I see an individual security that looks just too undervalued to pass by.

I always start by looking at the macro picture.  I see the world awash in debt originated not from savings, but from rampant credit creation via our fractional reserve banking system.   My personal belief is that once a society reaches peak credit, the lee side of that credit mountain looks dramatically different from the summit.  I believe we are near that peak in Canada, while the US passed theirs in 2008.  You’ll recall that I do see a period of strong deflation caused by collapsing velocity of money and deleveraging at consumer level before any significant inflationary forces will be felt.

This shapes my stock picking rules.  They have served me well, and I believe that as the next credit crunch arrives at some point in the next couple years, companies with the following characteristics will be the ones to prosper.  Here are a few simple rules I follow.  I look for companies that meet ALL of these requirements:

  • Look for companies that have debt/equity ratios well below 0.5.  I prefer 0.2 or less.
  • Look for companies with earnings that are at least 1/3 of their total debt.
  • Look for companies with strong cash positions.  A current ratio of at least 2 is a must.
  • Look for companies trading at less than their book value.
  • Look for companies trading at a Price/Earnings multiple in the single digits.

I will not even consider a company that does not meet these criteria.  Granted the debt levels are different by industry, but I want stocks with strong balance sheets.  In addition, I like it when a company also has the following characteristics, though they are not always a must.

  • Look for companies with good liquidity.  An average daily volume of at least 10,000 is a must.
  • Look for stable earnings.  How did the company fare in 2008 and 2009?  If they were still profitable during those years lean years, it’s a good sign.
  • A nice dividend yield greater than the 5 year BoC bond rate is a real sweetener, but not a must.
  • I am less concerned about specific industry a company is in as I am about the balance sheet and cash flow, though most financials weird me out.
  • I like companies with a cash stockpile greater than their current total debt, though it is not a must.
  • If a company is trading near its 52 week low, it’s a bonus.

Most brokerages will let you customize a search filter that takes these rules into account.  Though I don’t trade with TD Waterhouse, I do have an account with them just to access their fantastic research tools.

Once I find a stock that meets the criteria mentioned above, I consider the following questions:

  • What is the business model?  Do I know exactly how this company makes money?  Can I explain it?  In this sense, the most boring companies are usually the best investments.
  • What is the big picture for the industry they are in?  If it is not a good picture, are they at least the dominant player in that industry with pricing power?  Having little debt and lots of assets often makes the difference in a declining industry as it allows a company to maintain their margins when others come under pressure.  Two of my favourite stocks right now are in industries that have questionable big picture outlooks:  Shipping and newspapers.  But the valuations are so ridiculous that they will likely be an excellent investment even if these industries continue to tank.  Buy the company for what they are currently worth, not what they may or may not be worth in a year or two.

There you have it.  I hope this mini series has been helpful.  As always, I am happy to help with any question you may have.  Feel free to email me.  Also as always, the content on this site is meant as general information and NOT an recommendation to buy or sell any specific security.  Do your own research!  If you’re not comfortable with that or if you are overwhelmed, get the professional financial advice you need.

I’m hoping to post some economic predictions for 2011 this afternoon if I can find the time.  If not, they’ll be posted tomorrow.

Cheers,

Ben

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5 Responses to Building a winning investment portfolio: Part 3

  1. Earl says:

    Happiest of new years Ben and thanks for the amazing work you do on this blog.

  2. Pingback: More on demographics and the Canadian housing bubble; Rosenberg’s new love affair with Canada | Financial Insights

  3. Pingback: Food inflation in China skyrockets; Retailer margin squeeze coming; More thoughts on stock picking | Financial Insights

  4. Pingback: Should everyone rent? When does it make sense to buy? A closer look at the price/rent ratio… | Financial Insights

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