Anyone familiar with economic history and particularly famous investors from past generations probably knows Benjamin Graham, the author of The Intelligent Investor, and David Dodd, author of Security Analysis.
These two books form the foundation of the philosophies of many successful modern-day investors, including Berkshire Hathaway (NYSE: BRKa ) founder Warren Buffett. Graham is commonly credited with creating the concept of value investing, in which one tries to identify companies whose stocks are trading at irrationally low levels in comparison to their fundamental prospects. By selecting stocks that are selling below the intrinsic value of the company, value investors hope to make future profits when stock prices rise to reflect the fair value of company shares.
Although Graham's theories are sound in principle, putting them into practice is often more of a challenge than one might think. Perhaps the most difficult obstacle for a value investor to overcome is to figure out what the intrinsic value of a particular company actually is. Even if you believe that financial markets have inefficiencies that astute investors can use to their advantage, it's generally the case that the more obvious a particular inefficiency is, the less likely the inefficiency is to persist, and the more difficult it is for you to react quickly enough to benefit from it. As a result, most successful value investors profit most from situations in which they have a rare level of understanding about a company's business. This information edge gives such investors a competitive advantage that takes longer for other investors to discover, making it easier for you to cash in on profitable situations.
Mutual funds and inefficiency
While pricing stocks can be tricky, pricing mutual funds is relatively straightforward. Most mutual funds calculate the net asset value per share on a daily basis. Because the vast majority of mutual funds invest in securities that are themselves traded on public financial markets, figuring out the net asset value is generally as easy as finding the closing price of each stock in the mutual fund's portfolio, multiplying by the number of shares of each stock, adding up all the values, and then dividing by the total number of shares outstanding. Traditional mutual funds usually only need to calculate these net asset values once daily, and since new investors are forced to accept the closing net asset value when conducting transactions, there's no opportunity to take advantage of inefficiencies in pricing without the assistance of fraudulent behavior.
Traditional mutual funds are generally able to issue new shares or redeem old shares at will according to demand in the marketplace. For instance, if a rush of new investors choose to invest money in a particular mutual fund, then that mutual fund can essentially create new shares and sell them to the new investors, thereby increasing the total number of shares outstanding. Similarly, if a rush of existing fund shareholders choose to liquidate their investments, then the mutual fund can buy back those shares and reduce the total number of outstanding shares. This ability for the mutual fund to adapt to changes in demand by immediately changing the supply of fund shares is one reason why mutual fund trading is orderly.
Although traditional mutual funds, also known as open-end mutual funds, make up the vast majority of all mutual funds available to investors, there's another type that acts much differently. This second type, known as a closed-end mutual fund, carries with it inefficiencies that astute investors can observe and use to their advantage.
Characteristics of closed-end funds
Closed-end mutual funds behave much differently from their open-end counterparts. At their formation, closed-end funds generally issue a specific number of shares to investors. Although this number is sometimes shifted upward or downward in response to demand, it's not as flexible as an open-end fund's immediate response to shifts in demand. During this initial stage of a closed-end fund's existence, the fund solicits subscriptions for shares, in many cases before the fund makes any investments. Once the fund finds enough buyers for its initial offering of shares, it ends the offering period and begins to make investments, operating like any other mutual fund.
The primary attribute that differentiates closed-end mutual funds is that once the initial offering period for fund shares ends, the fund itself no longer accepts any transactions to buy or sell fund shares. This often comes as a big shock to investors used to dealing with traditional mutual funds. They're used to being able to buy additional fund shares or sell existing ones back to the mutual fund itself. In contrast, with closed-end funds, if investors wish to buy or sell fund shares, they must find another investor to sell or buy those shares.
Because closed-end funds stop accepting new investments after their initial offering period, they tend to be relatively small. The largest closed-end fund, Tri-Continental (NYSE: TY ) , weighs in at just over $2.5 billion in assets, and many funds are far smaller than that.
Although the need to conduct transactions of closed-end fund shares with third parties complicates matter somewhat, it's not as big an obstacle as one might think. Most closed-end funds trade on a stock exchange, and as with shares of a publicly traded company, there are often market makers willing to provide fund investors with liquidity as necessary. As a result, investors generally don't have to worry that they wouldn't be able to sell their positions in a financial emergency. On the other hand, as the second part of this article discusses in greater detail, you may not be able to sell your shares for what you believe they're worth.
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Fool contributor Dan Caplinger likes buying dollars for dimes but rarely gets the chance. He invests in a number of closed-end funds but doesn't own shares of any that are mentioned in this article. He does own shares of Berkshire Hathaway. The Fool's disclosure policy is always open to you.