I'll Trade You 83 Cents for a Dollar

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There's a neat video on YouTube, showing viewers how to make an easy $10 from a friend. You basically take out a $20 bill and ask them for another $20 bill. You then put both bills in a box and ask them if they want to buy the box for $30.

The friend will likely agree, unaware that he or she is actually paying $50 for a $40 payout.

You know it's an effective trick because half of the viewer comments are from poor saps who can't figure out who is walking away with the extra $10 in the exchange.

This brings me to closed-end funds. Many of them continue to trade at steep discounts to their actual holdings, despite six months of rallying markets. One of the many intriguing offerings at the moment is Royce Value Trust (NYSE: RVT  ) , a proven market-beater that is currently trading for just $0.83 on the dollar.

The polite way to rob mutual funds
Closed-end funds differ from their more popular open-ended mutual fund cousins in that they trade throughout the day on the stock exchanges. There are a set number of shares outstanding, and that actually gives the portfolio manager the flexibility to freely invest without worrying about redemption orders or where to allocate income purchases.

Exchange-traded funds -- or ETFs -- are similar, but closed-end funds go beyond index tracking. Closed-end funds are typically actively managed and have been around for decades before ETFs became the flavor of the week.

Royce Value Trust is no slouch. A $10,000 investment made at the time of the fund's launch in November 1986 would have been worth $74,317 as of June 30. One can compare that to the $51,852 you would have had if you'd invested the same amount in the broad Russell 2000 index.

Royce Value Trust's investments may be familiar to some of our newsletter subscribers. Here are some of the portfolio's 10 largest holdings as of the end of July:

  • Ritchie Bros. Auctioneers (NYSE: RBA  )
  • Seacor (NYSE: CKH  )
  • Idexx Labs (Nasdaq: IDXX  )
  • AllianceBernstein (NYSE: AB  )
  • Allegheny Corporation (NYSE: Y  )
  • Rofin-Sinar (Nasdaq: RSTI  )

AllianceBernstein was a Motley Fool Income Investor pick until earlier this year. Ritchie Bros. Auctioneers and Rofin-Sinar Technologies are active Motley Fool Hidden Gems recommendations. 

If that's not enough to warm you up to the fund's potential, consider that several of Royce's traditional mutual funds have put in similarly strong performances. 

The attraction to Royce Value Trust is that while the stock closed at $9.44 last Friday, its net asset value (NAV) is a whopping $11.41 a share. Investors can buy $11.41 worth of vetted value stocks at a 17.3% discount.

Deep value meets deeper value
It gets better.

Charles Royce is one of the more prolific value investors in the fund industry, and he serves as Royce Value Trust's lead portfolio manager. He's a stiff advocate of underpriced securities, and dabbles in microcap and small-cap equities where the greater pricing discrepancies can occur.

The weighted average P/E ratio of the profitable stocks in his funds is a modest 14.4. The weighted average price-to-book ratio is an attractive 1.5. And if you like those metrics, remember that they're based on the NAV. Investors are buying in at a 17% discount, so it's as if they are checking in at weighted average P/E and P/B multiples of just 12 and 1.25, respectively.

Now, an important caveat here is that Royce Value Trust has typically traded at a similar discount to its NAV. You may be paying $0.83 for a dollar's worth of small value stocks, but it's not as if you can cash out at a buck. Investing isn't that easy.

However, you will find plenty of neglected closed-end funds out there, trading at ridiculous markdowns to what they would be worth in liquidation. If you're going to buy a value fund, why not buy it a discount?

Getting more bang out of your buck is what investing is all about. At the very least, I just taught you how to make an easy $10 from a friend, or preferably a former friend.

Other ways to get down with the bargains:

Ritchie Bros. Auctioneers and Rofin-Sinar Technologies are Motley Fool Hidden Gems recommendations. Try any of our Foolish newsletter services, free for 30 days.

Longtime Fool contributor Rick Munarriz feels that not every bargain is a bargain, but he's willing to give it a shot. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. He does not own shares in any of the companies in this story. The Fool has a disclosure policy.

Read/Post Comments (2) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 09, 2009, at 7:29 PM, lwbaum wrote:

    I'm surprised that some of the huge hedge funds haven't specialized in arbitrage on discounted close-end funds: buying them up gradually at a discount until they own much of the shares, then issuing an offer for the remainder at a higher price, and finally liquidating the fund to profit from the discount to NAV at which they bought most of the shares. Maybe it wouldn't work because once they started buying shares, the price would rise too much, wiping out their discount too early to make the whole effort worthwhile. Or maybe the discount is too small to earn much profit. Or maybe close-end funds have poison pill defenses to prevent such buyouts. I don't know.

  • Report this Comment On October 13, 2009, at 1:08 PM, clayglenn wrote:

    In the example at the beginning of the article, it sounds to me like my "friend" buys the "$40 box" for $30: the $10 price plus the $20 bill that he put inside. It looks like I lost my $20 bill and got $10 in return. What's so great about that?

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