By Robert Barker
Now in his 33rd year specializing in closed-end mutual funds, no one knows these eccentric little investments quite like Tom Herzfeld. With $100 million under management, Herzfeld operates as a closed-end broker, an adviser on private accounts, and as manager of his own closed-end fund, Herzfeld Caribbean Basin (CUBA ). Then, of course, there's his monthly newsletter, The Investor's Guide to Closed-End Funds, the market segment's bible.
Unlike their more common open-end cousins, closed-end funds trade like stocks. That makes them more difficult to understand, but recently they've been gaining favor in the market. In this week's Special Report on closed-end funds (see BW, 2/12/01, "Closed-End Funds: Upstaging a Down Market"), BusinessWeek reports that the average closed-end equity fund last year gained more than 11.2%, while its average open-end counterpart lost 3.5%.
To clue into the world of closed-end funds, along with what stocks he has been buying for Herzfeld Caribbean Basin, I reached Herzfeld this week by phone at his office near Miami. Here are edited excerpts of our conversation:
Q: What makes a good closed-end fund investment?
A:What has always attracted me most to the closed-end funds is the ability to buy assets at a discount.... To answer your question, a fund trading at a very wide discount to net-asset value is the best type of closed-end fund investment.
Q: Is there an absolute amount that makes a wide discount, or does it vary depending upon the fund and the current market?
A:It depends upon about 20 variables. Sometimes a fund that's at a 20% discount may be more attractive than a fund at a 25% or 30% discount because the latter may have some problem that's a genuine reason for it to be trading at such an extraordinarily wide discount. The trick is to find the one that is at a discount that's out of whack -- that doesn't have any fundamental problems.
Q: Are those many or few among the more than 500 closed ends?
A:There are few, but when you find them it's very rewarding.
Q: Can you give me an example of one you've found recently?
A:MeVC Draper Fisher Jurvetson Fund (MVC ) really fits the type of fund that meets all of our tests for having a most favorable risk-reward relationship.
Q: Tell me about it.
A:The fund was launched last year at $20 a share, with an initial net-asset value of about $19. It was created, for lack of a better word, as an incubator-type venture-capital company to invest in the Internet industry. When the Internet group fell severely out of favor along with other technology companies last year, the shares of MVC began to decline right from the moment it commenced trading.
Q: Great timing, eh?
A:That's not unusual. Very often -- just to digress -- the closed-end fund industry along with the investment bankers will launch closed-end funds which are easy to sell to the public but which may not necessarily be great investments at the time.
Q: Yet another reason to be skeptical of the Street.
A:I remember when the Duff & Phelps Utilities Income Fund (DNP ) came to market in January, 1987, the day the [Dow Jones] utility average reached an all-time high. So when a group is at its high, there's great clamor and interest, and it's an easy sale for the brokerage firm.
Q: Nice of them.
A:It took years for that fund to turn around. Anyway, returning to MVC, from June, when trading commenced, to mid-December, the share price of the fund fell 51%, from $20 to $9.75, while the net-asset value remained quite stable, close to $19 a share.
Q: When did you start buying?
A:On the way down, but we kept our powder dry and took our largest position in November and especially in December, acquiring holdings at a 45% discount to net-asset value. What often happens with closed-end funds is that last year's worst performers are usually the current year's best.
Q: The last shall be first, and the first shall be last?
A:Exactly. So why do we like the fund now? There has been a January rally, which always happens with closed-end funds, and the shares rebound. But even at today's levels, MVC is still changing hands at a 31% discount to its net-asset value. The Internet group, having been among the worst performers last year, will probably be in the leaders in 2001. As that rotation of leadership occurs, usually the discount in a fund will narrow.
Q: Is it ever a good idea to buy a closed-end fund at a premium?
A:[MVC] reminds me of one called the Nautilus Fund [which is no longer trading]. That goes back 20, 25 years. The Nautilus Fund, just like MVC, had been trading at a very large discount to net-asset value, perhaps a 30% discount. And all of a sudden, that inverted and it went to a premium. And the reason it went to a premium is that they had a private investment in a company, which a few people had heard about, Apple Computer.
A:And the only way you could buy Apple Computer prior to the IPO was to buy the Nautilus Fund. And Nautilus went from a large discount to about a 40% premium to net-asset value. I think MVC is the type of company where you'll see...they have these private placements in these Internet companies that eventually are going to start going public. And when they do, the discount on MVC will narrow.
Q: So, does it ever pay to buy a fund at a premium?
A:Yes, if it has something unique, or if by purchasing it, it makes available to you something that you otherwise couldn't buy directly in the marketplace.
Q: What about fixed-income funds?
A:Bond funds, in the right interest-rate environment, could be purchased at premiums. But for us, there are usually enough bond funds around at discounts that we don't need to pay a premium.
Q: Should closed-end funds be bought and put away, or are they something to trade?
A:Most people buy and hold them -- a strategy which leaves a lot on the table. There are much better gains at hand for those willing to do the extra homework and analysis that puts them in a position to trade them, which of course [is] our investment philosophy. We trade them as actively as we can.
Q: Explain, please.
A:In addition to dividend income and capital-gains distributions, the short-term profits we make trading them make the total return very attractive. In addition, we believe it reduces our risk because we always wind up holding an investment portfolio of closed-end funds whose average discount to net asset value is wider than average. And therein is a cushion that we have. If we're wrong on the market and the NAVs start to deteriorate, that excessive discount tends to offset the losses.
Q: That's your margin of safety. Now, you also run your own fund, Herzfeld Caribbean Basin. It had a rocky time in 2000, down 29%. What's the outlook for that fund this year?
A:It's off to a very good start, up about 20%.
Q: So you feel the prospects are good for the fund?
A:I never like to talk about what the prospects are. Let me talk about the investment philosophy and what we're invested in. I like to leave it to others to judge what the prospects are.
Q: O.K., shoot.
A:The fund was formed to invest throughout the Caribbean Basin, and eventually, we intend to concentrate on Cuba, once we're permitted to. Many of the holdings -- most -- in the portfolio are bought with the following view: The company should be able to do well on its own merits, and yet if the [Cuban trade] embargo is lifted, would get an increase in business as a result of resumption of trade with Cuba. And that's how we've structured the investments.
Q: I see.
A:I suppose a large question mark with investment in the fund is, what is the outlook for Cuba and the Castro regime? That's very unpredictable. If the embargo were to be lifted, there's no doubt in my mind that there will be a boom in Cuba, which most likely would proliferate throughout the Caribbean basin. And we feel the companies that we have invested in will benefit from that.
Q: What's the latest addition to the portfolio?
A:AT&T Latin America (ATTL ). We took on a 60,000-share position at the worst moment for the telecom stocks, which was the last few days of 2000. Our average cost for the position is $2.55. And it's trading at $5.25 today.
Q: What's your thinking?
A:One, they're in the right [location], of course. What especially interested me is that they're in Colombia, one of the countries that we invest in. But it's hard for us to find investments in Colombia. We [also] think there's going to be a good rebound in telephone companies.
Q: What else have you done lately with the portfolio?
A:We've been adding to our Mexican position. We bought some Coca-Cola Femsa (KOF ), which is the Coca-Cola bottler there. We bought some at $20 and some at $21.69. It's at $22 today. We like Mexico right now, and our second-largest position in the fund is actually the Mexico Fund (MXF ), which gives us a way to participate in the Mexican equity market at an 18% discount.
Q: What's the case for Mexico?
A:Of course, Mexico is a major trading partner with Cuba, and if the embargo were lifted, we think Mexican companies would reap the benefits. That aside, President Bush is meeting with President Fox next month, and that should attract significant attention. We think it will bring buyers into the Mexican market. When that occurs, the discount on the Mexico Fund should narrow.
Q: I see. What else?
A:The fund's largest position is Florida East Coast Industries (FLA ), which is in real estate, and also they have a technology company now.
Q: This is the old railroad company, yes?
A:Yes, that's probably the main business. They run the main railroad line between Jacksonville and Miami. The reason we own the company is for the railroad. We've always considered it undervalued, especially when you consider the real estate. It's most interesting as a Cuba play because, one, a lot of freight will be shipped up and down the east coast of Florida, going to and from Cuba. Secondly, they announced several years ago a plan to run a rail barge to and from Cuba.
Barker covers personal finance in his Barker Portfolio column for BusinessWeek. His barker.online column appears every Friday, only on BW Online.
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Edited by Patricia O'Connell