The Secret to Discovering the Hottest Stocks

Knowing what investments people are willing to pay premium prices for gives you a big edge over other investors. If you look in the right place, it's easy to find out which stocks investors can't get enough of -- and that can help guide your own investing accordingly.

Watching the trends
You can look to all sorts of indicators to get a sense of what stocks are hot. For instance, some technical analysts look at various measures of momentum to identify stocks that have seen strong price action and are likely to continue to do so.

But my favorite indicator of investor interest in various types of investments is the closed-end fund market. With closed ends, you can actually see what investors are paying above market value for, and conversely, which investments are being shunned by traders.

Understanding the closed-end universe
Closed-end funds aren't something that most investors are familiar with. Developed long before exchange-traded funds hit the investment scene, closed-end funds were the first mutual funds to trade like stocks. Unlike regular mutual funds, where buying shares is as easy as going to the fund company and making a purchase at the day's net asset value, closed-end funds are subject to market forces, and there's no guarantee that what you pay has any relation to what the assets within the fund are actually worth.

What makes closed ends so interesting is that each fund has a set number of shares available. If investors want to buy shares, they can't just go to the fund company; they have to find an existing shareholder willing to sell them shares. Similarly, those who are looking to sell have to find buyers for their shares. The resulting supply and demand push prices above or below the intrinsic value of the assets the closed ends hold.

So let's take a look at what closed-end buyers can't get enough of and what sellers can't seem to unload even at a discount.

The hot stocks
Perhaps the biggest theme in investing right now is income. With interest rates at historic lows, everyone wants ways to make their money produce bigger payouts.

The most popular closed ends take ordinary stocks but package them with so-called managed payout policies. So for instance, Cornerstone Total Return (FUND: CRF  ) has paid out dividends at a rate of more than 14% in the past 12 months, despite the fact that none of the stocks it owns pays a dividend anywhere near that. But while others hound Apple (Nasdaq: AAPL  ) and Google (Nasdaq: GOOG  ) to start paying dividends, the Cornerstone ETF finds its capital gains to be sufficient to justify the fund's payout -- and the fund's shares are fetching a premium of 57% over net asset value.

Similarly, the Pimco High Income Fund (FUND: PHK  ) uses high-yield bonds to produce payouts. The fund has done well with a big bet on AIG (NYSE: AIG  ) bonds, and its large positions in financial issues generally has produced strong returns and a 45% premium to its NAV.

By comparison, precious metals investments seem tame, but they've certainly maintained investor interest. Central Fund of Canada (NYSE: CEF  ) trades at a 10% premium to NAV, owning both gold and silver bullion.

Not so hot
At the other end of the spectrum, you'll find several real estate funds among those with the widest discounts. An example is RMR Real Estate Income (RIF). It pays a dividend of 5.6%, which you'd think would be adequate to gain investor interest. But with prospects for REITs Vornado Realty (NYSE: VNO  ) and Equity Residential (NYSE: EQR  ) in question because of the still-uncertain prospects for housing prices and the commercial real estate market, investors are apparently shying away from the sector.

Another problem area is in European stocks. The New Ireland Fund (NYSE: IRL  ) , for instance, trades at a 17% discount to NAV, near its widest levels of the year. Given the country's sovereign debt issues, it's not surprising to see investors hedge their bets. But such a wide discount invites speculative interest.

Keep your cool
With closed ends, it rarely makes sense to pay up for fund shares. After all, if you like the investments a fund owns, you can usually buy them yourself for their fair value.

But with discounts, a closed end can give you a unique opportunity. If you like buying unfavored assets on the cheap, closed ends give you a great indicator of where to look.

Don't settle for hot stocks -- find the ones that will actually perform the best. Click here to get The Motley Fool's free report, 5 Stocks the Motley Fool Owns ... and You Should, Too.

Fool contributor Dan Caplinger knows how to keep a secret. He owns shares of Apple. Google is a Motley Fool Inside Value recommendation and a Motley Fool Rule Breakers choice. Apple is a Motley Fool Stock Advisor recommendation. The Fool owns shares of Apple and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy keeps its secrets written in the palm of its hand.


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