Right Price Investing

Books: Economics & History

In the second part of the books series, I'll go over my favorite history and intermediate economics books.

To find the first part, which focused on beginner economics and investing books go here.

Intermediate Economics Books

An Austrian Perspective on the History of Economic Thought (2 Vol. Set)

Murray Rothbard was the dean of the Austrian School of Economics in the second half of the twentieth century. He wrote books on economics , early American history , libertarian political philosophy , the federal reserve , fractional reserve banking and the ethics of liberty .

He was the center of the libertarian movement in the 70's and 80's (He was a founding member of the Cato Institute, the Mises Institute, the LP and probably any other libertarian think tank or organization you can think of). He essentially created the anarcho-capitalist philosophy and was critical to its expansion in the Austrian School.

This book is Rothbard's history of Economic Thought. He starts with the Greeks and Lao Tsu and shows how economic history evolved from the Spanish Scholastics, to the first 'real economist' (Richard Cantillon), where it fell back a step with Adam Smith, then got better with the French-classical school (including JB Say), was perverted through Marx and finally where the laissez faire tradition started with Frederic Bastiat.

The book is a two volume set comprising over 1,000 pages total. In it Rothbard goes over the economists above and all others. He writes about their economic theories and their lives, showing how they were influenced.

I consider this book the best introduction to the many economists and their theories, unfortunately Rothbard died before he could get into the Marginalist Revolution and the huge onslaught of economics that followed.

The two volume set is $50 on Amazon (which isn't that much considering it's two 500 page books), but you can also find volume one here and volume two here for free online, and the lectures he gave on the subject here.

PJ O'Rourke On The Wealth of Nations    

I find the actual book by Adam Smith virtually unreadable (and for those who can read it, unnecessary as there are so many economists who have said it clearer and better), but this book by P.J. O'Rourke has the essence of the book and allows readers to understand the same theories while laughing and not creating migraines without compare.

Plus its only $4 on amazon apparently.

The Price of Everything

This was the first book I read on the Hayekian spontaneous order theory. Basically, in a free market prices are the feedback mechanism which create order, sort of spontaneously since there is no one in charge. For example, if there was a hurricane those who needed to build a new house would bid the materials away from someone who had a lesser need for the materials. Without a market there is no way to calculate who is most needing of the materials.

Roberts goes over this in much greater detail in a novel setting. In the story the local grocery store doubles prices after an earth quake, and an economics professor must convince a student activist that this is not the end of the world.

Atlas Shrugged

I read Atlas Shrugged and The Fountainhead in the summer after my senior year of high school. I had planned on only reading The Fountainhead, and it took me basically the whole summer to struggle through it.

Then with a couple days before school started I decided to read a chapter of Atlas Shrugged, and ended up not putting it down for the next two days and finishing the 1,200 page novel with a whole new perspective. Thankfully the arrogance and selfishness subsided, but the main economic theories remained.

In the book Rand follows two different parties - the good businessmen and the government leaders. She shows how government meddling has a bad affect on the economy. In fact one of the characters of the book is so tired of government meddling that he convinces every great business leader or likewise minded person to quit and move into the mountains of Colorado where a kind of paradise is made and everyone trades with gold.

The non-stop sexual references and "selfishness-is-the-only-way," are annoying, but the book is the best I've read at showing all the incentives in an economy and how people are affected by them.

The Failure of the New Economics

I took a macro-economics class last year at college. In the class we basically went over all the Keynesian models, and talked about the Monetarist models for a week and that was it. Thankfully I had this book to use to refute the stupidity I was learning in the class.

Keynes' General Theory came out in the mid-thirties, just in time for the government to use it to justify more and more government spending. Unfortunately the book is an unreadable blob which seemingly contradicts itself every other sentence.

Thankfully, Henry Hazlitt wrote this chapter-by-chapter (and sometimes line-by-line) refutation of the General Theory. Hazlitt destroys Keynes, and for those who like that kind of thing uses pretty funny writing to do it.

The Austrian Theory of the Trade Cycle and Other Essays

This book contains essays by Ludwig von Mises, Murray Rothbard and F.A. Hayek (probably the three foremost macroeconomist of all time) and has a forward and afterword by Roger Garrison, who is probably the foremost macroeconomist today. Note: none of these labels are accepted by the mainstream economists, who probably haven't heard of any Austrians except for Hayek.

The essays go over the Austrian Theory of the Business Cycle (wherein a surplus of fake money unnaturally reduces the interest rate and discoordinates investment with consumption, causing malinvetsment and an eventual, but necessary, recession or depression to realign investment with consumption).

Meltdown

Thomas Woods is a historian, and a great one at that, but late last year he took up the task of being the first one to explain the current crisis, and do it from the Austrian point of view.

In this amazing book (the first ever that focused on the ABCT and ended up on the New York Times best seller list), Woods goes over how Greenspan reduced the interest rate to a negative rate and then legislation pushed all the easy money into the housing industry. He also goes over why bailouts won't work and a recession is the necessary cleaning of malinvestment.

Plus, he backs it up with a history of the priors panics, depressions and recession in the US.

Antitrust: The Case for Repeal

This book is a more focused one.

In it the author, Dominick Armentano, shows how the history of anti-trust is that of lesser competitors trying to find a way to compete without being more efficient or better satisfying their consumers than their better competitors.

Armentano also uses monopoly theory to show why Anti-trust is not needed.

Great Austrian Economists

Most of the good advances in Economics have come from Austrian Economists. This book goes over the 15 most prominent, from a Spanish Scholastics in the 1500's to Murray Rothbard, and shows their additions to economic theory.

The Case Against the Fed

In this booklet Rothbard not only goes over the history of the Fed and shows how it was created frivolously, but also why it is unnecessary and a negative for free societies.

Economic Science and the Austrian Method

In this book Hans Herman Hoppe (the current foremost Austrian) destroys positivism and shows why economics must absolutely be deduced from the action axiom, or praxeology.

-

History

The Politically Incorrect Guide to the Great Depression and the New Deal

The current crisis is very comparable to the Great Depression, realizing this Bob Murphy (of the PIG to Capitalism) wrote a great guide to it and destroyed all the myths surrounding it.

Unfortunately, his book centers more on destroying myths then the ABCT. But, it is full of great stats and facts and arguments to use to destroy the myths (apparently that's what it does seeing as I've said it three times in two sentences).

The book also has a chapter on the current crisis and what the government should do.

America's Great Depression

Rothbard's book was the first great one on the Great Depression.

Rothbard goes over the ABCT, kills the arguments against it, then shows how the money supply and easy credit rose in the late 20's.

He also goes over how interventionist Hoover was and how Hoover turned a 2-3 year correction into the Great Depression.

Mobs, Messiahs, and Markets

I just finished this book last night. In it Bill Bonner (of the Daily Reckoning)and Lila Rajiva take readers on a gallop through history to show how mobs are usually wrong and why one should take this into consideration when investing.

Books on my list to read in the future

ESSAYS IN THE HISTORY OF LIBERTY (Selected Writings of Lord Acton)

Democracy In America

A History of the American People

Conceived in Liberty (4 Volume Set)

Men of Wealth

Jefferson

Reassessing the Presidency

A History of Money and Banking in the United States

Final Thoughts

Most of the books here are more specialized than in the prior list, I believe this allows readers to pick and choose which subjects are most interesting to them at the time and read about that.

Again you do not need to read all of these books right away, though it would do one well to read them all eventually.

You can find all the books mentioned here on the Right Price Book Store

Entrepreneurs: Ken Iverson

After I thoroughly enjoyed Iacocca's book I decided to continue reading entrepreneur's books - I don't really see a negative, if I don't learn something from them, I still like reading them.

So the next book on my list is by Ken Iverson, called Plain Talk.

Iverson was the President of Nucor for about thirty years. I'd heard of how successful Nucor was in competing with the big steel companies (I think from a Peter Lynch Book actually) and my interest in his management style was renewed when I read an article in a magazine I've saved for the past couple years on the top 50 entrepreneurs of all time.

Here are the three parts of Iverson's management style, in my opinion.

Decentralization

This was Iverson's first innovation in the management. At Nucor there were only four layers of management: supervisors,department managers, general managers, and the CEO. So an hourly worker needs only four promotions to be the CEO.

I really like this theory as it eliminates a lot of the bureaucracy inherent in most big companies.

In the company each general manager is in charge of his mill, he is the CEO of that business. He gets funding from the central company, but he sets his own standards and makes his own rules for his mill.

All the managers meet a few times each year, where they set goals, review the financials, share techniques which work and decide where the funding will go.

This does put a lot of responsibility on each level (where I work the supervisors have 6, and at most 8-9 employees working for them at any one time, at Nucor each supervisor will work with 45-50 guys at a time), but Nucor's methods (which are discussed below) create great, hard-working and innovating employees who can handle it.

Innovation

One of the talking points on the back of the book is that Nucor pays the most per worker in the industry, yet has the lowest total labor cost.

This is done through a Charles Schawb like bonus structure. At Nucor the base rate that each employee makes is lower than just about every other company in the industry. But, then Nucor sets a number on each area of the mill for production. After that number is passed every percent over that number that is produced is an extra percent bonus the employee gets in his pay check that week.

This spawns a lot of innovation, Iverson tells the story of a machine that had a rated capacity of 10 tons per hour.The employee's base number was 8 tons per hour, and within a year they had made enough adjustment to the machine and added enough things on that they were making 20 easily.

Iverson tells a similar story from when he was still an engineer. The company needed a $200,000 machine to make a certain product, but at the time they didn't have enough funds to build it.

So Iverson and his men built a similar machine that did everything they needed form only $5,000 in raw materials they found in the plant.

It is obvious that Iverson knew there was a type of person (he was one of them) who loves to innovate and make constant improvements - he is not content in just sitting around watching the same-old same-old. Iverson created the right environment and culture and gave the right incentives to employees to take advantage of the trait.

Egalitarianism

Iverson says Nucor's relations with employees follow these four principles:

1. Management is obligated to manage the company in such a way that employees will have the opportunity to earn according to their productivity;
2. Employees should feel confident that if they do their jobs properly, they will have a job tomorrow;
3. Employees have the right to be treated fairly and must believe that they will be;
4. Employees must have an avenue of appeal when they believe they are being treated unfairly

This sounds like it's coming straight from a union handbook - which probably explains why Nucor never had any (and in fact the hourly workers once ran union guys off, when they tried to get Nucor workers to join their union).

If you think about each of these, they all make sense:

1. At Nucor allowing employees to earn according to their productivity is what fosters their endless innovation.
2. How would it make sense to fire someone who is doing his job properly?
3. A big part of Nucor's operation is to be as decentralized and small as possible. They also try to eliminate any barriers between levels of management and hourly workers - when supervisors are working there is no way to tell who is the supervisor most times. This could not work if employees were not being treated fairly
4. Part of number three upper management needs to know if lower management isn't doing his job correctly.

One of the things Iverson did to show this egalitarianism was to make all the hardhats the same color, that way there would be no differentiation (except with maintenance) in the look of employees and management.

When the company puts a huge amount of differentiation between management and employees, the employees tend to get restless and see themselves as doing the 'real work,' and the managers as not doing important things.

I've seen this at KFC, they make a big deal of just being a shift supervisor. I had a different color shirt and a different name tag than everyone else. And the manager and co-manager had still different shirts, with their names sewn in. So when the managers or supervisor had to do work in the office, the new people or people who didn't want to move up would get upset that they were out dealing with customers while the manager was, "just sitting in the office."

In my experience I've been able to counter this by simply not being a jerk and always working hard.

If the other people always see me working hard to get things done and I explain to them how what I'm asking them to do will help us get done faster, in stead of just yelling at them to do it, they will see what needs to get done and do it. Also, when I don't have to go into the office as much as other managers because I don't waste time, people don't complain that I'm, "just sitting in the office."

The same thing happened at Nucor, manager who treated employees poorly would fired, and there were no barriers between management and the workers - the workers never had a reason to think management was just sitting in the office.

Conclusion

I enjoyed this book a lot more than Iacocca's, it was not burdened by economics non-sense, but it was also written better and read more like a group of stories, with principles attached.

I would recommend it to anyone who likes business.

Buy the Book

Or visit the new Right Price Book Store

Entrepreneurs: Lee Iacocca

I'm interning at my Grandpa's company this summer. The company makes corrugated sheets and part of my job is to take notes at meetings and then analyze whether the proposals are put through.

In one of the meetings my Grandpa mentioned how Lee Iacocca changed his name from Lido to Lee, when he moved to work in the South for Ford.

He later told me this was one of the first and best business books he read, so I searched it out, found his copy and read it on a trip to Florida and back.

The book is a fairly easy read and I recommend it, though there are some bad parts.

The Story

Iacocca was born to Italian immigrants Nicola and Antonietta Iacocca on October 15, 1924 in Allentown, Pennsylvania. Nicola Iacocca ran a successful restaurant and taught Iacocca how to run a business.

He went to college at Lehigh University, and after graduating got a scholarship to Princeton where he took electives in plastics.

After he graduated he got a job at Ford as an engineer, at the time Ford's policy with new engineers was to have them work in every area of the company. Iacocca soured of this and moved into the sales side of the company.

Here he worked his way up to the product development team and became the 'Father of the Mustang,' then was eventually promoted to be President of the Ford Motor Company.

There, despite record profits year after year he was fired by a paranoid Henry Ford II.

After taking time off to recoup he went to work for Chrysler, which he quickly realized could not rise out of its hole without help.

He hired many great people away form Ford, changed the whole communication and cost structure and eventually got loan guarantees form the government to allow Chrysler to continue operating.

Within a few years Chrysler had turned around, paid off the government loans and was the only profitable car company.

Communication

Communication seems to me to be Iacocca's biggest management principle, here are a few examples:

In his 'Key to Management,' chapter Iacocca talks about a Quarterly Review System. He believes that when managers meet with their people each quarter, review the last quarter, and set goals for the next, it keeps both parties up to date with the progress in the company and allows for good communication between the two parties. Iacocca told stories of how using this method employees would usually admits when they hadn't met their goals and discussed why, in stead of acting ignorant of their previous promises.

When Iacocca first came to Chrysler he could not believe the disorder and lack of communication between the departments. The Cars would be designed that could not be produced. When they finally could be, they would be produced without any thought of how many would be sold. Iacocca eliminated a bunch of levels of management and all the barriers between departments - forcing people to work together.

One of Iacocca's most unique techniques is how he deals with the unions. He talks about not looking down upon workers, and talking them them at the same level - he even appointed the head of the union to the board of directors. 

Consumer Sovereignty

I believe the story is a great example of consumer sovereignty. Over and over in the book Iacocca was able to improve his business and take market share away from his competitors, only by pleasing consumers.

Better yet, Iacocca realizes this and talks about it at numerous points in the book.

The Loan Guarantees

The Chrysler loan guarantees form the government are supposed to be a hard argument. Iacocca shows, and I agree with him, that much of the problems in the car industry came from excess government regulation and extremely high gas prices (which I would argue were also a result of the government's intervention) - two things out of Chrysler's control.

These two things are true, however it does not mean the government needs to intervene. If a car was totaled and damaged to the point where it was almost beyond repair, you wouldn't pay someone unheard of sums of money to try to repair, you'd start over with a whole new company.

Likewise, had Chrysler simply gone out of business or found private market financing it probably would have merged stronger and more efficient.

Also, Iacocca uses a precedent argument, saying the government had bailed companies out before Chrysler, and this supposedly makes it OK. This argument is inane - during World War II the government imprisoned all Japanese-Americans without any form of a trial, that doesn't mean it would be OK to do it again.

Mercantilism

Other than the Loan guarantees section the book is mostly good - until the last part. The last part, which Iacocca calls Straight Talk, is about how to make 'America great again,' most by initiating a trade war with Japan.

Iacocca talks about the strengths of Japan, as if they were weaknesses of America, this mercantilist argument was destroyed 500 years ago.

According to the Law of Association, even if one person is better at all things then the next person it makes sense for him to delegate some things to the next person.

For example, Lebron James may be the best lawn mower in the world, but it makes no sense for him to mow his own lawn when he could better use the time to work in basketball.

In the same way it makes sense for countries to use free trade to get goods where they can be more efficiently made.

Also, in this section Iacocca talks about how unions cause inflation because they tie their wages to the CPI, and their wage raises cause rises in the CPI down the road.

This is incorrect, the only thing that can cause inflation is an increase in the money supply. If union members start making more the money has to come from somewhere, so either owners are making less (that would be stockholders, many of which are not millionaires) or consumers are paying more.

Conclusion

I really enjoyed the book, despite the economic shortcomings, and would recommend it to any who either want an intro to great management or likes the drama of business.

Buy the book

Or visit the newly redesigned Right Price Book Store for more great Business, Investing Economics or History Books.

Special Situations

I've always liked speical situations, they remind of a special investigator and how he makes money somewhere where noone else is looking.

I hope to focus a lot focus a lot on special situations this time around, and will be changing my scottrade account to allow for options trading soon.

So here are the four articles I wrote before on Special Situations, as I begin to trade options I will write about the strategies I use.

---

Arbitrage is totally risk-free. An example of arbitrage could be buying shares of a company on the NYSE, then selling them immediately on another exchange -- like a foreign one -- for more money. There is no risk in this -- unless your phone breaks and you can't call your broker -- there also so isn't much reward, because of this I'll be writing about a different kind of arbitrage, with more potential returns.

Risk arbitrage, is arbitrage, with the risk of losing money attached. Joel Greenblatt wrote the primer on risk arbitrage, he is also the creator of The Value Investor Club Website. I recommend his book for a further look at Risk Arbitrage, or as it is more commonly know Special Situation investing.

There are a number of ways to invest in special situations:

• Spin-offs
• Bankruptcies
• Restructuring
• Rights Offerings
• Re-Caps
• Merger Securities
• Companies Going Private

Spin-offs

Spin-offs are my favorite types of investing in special situations. Sometimes a company will decide it will do better, or a section will do better, if part of it is spun-off. Basically a division is separated from the parent company.

A study conducted by Penn St. found spin-offs out-perform the S&P by 10% per year, during the first three years of independence.

 

Peter Lynch talked about spin-offs in his first book.

 

Institutions have a lot of limitations, detailing the amount of companies they can own, the sizes of companies they can own, the percent of a company they can own, etc. Usually when a division is spun-off the institutions have to sell their shares immediately, resulting in the spin-off being undervalued, if you can understand the new company and find a spin-off undervalued you will likely beat the market over time.

 

Simply reading The Wall St. Journal will point you towards spin-offs.

Merger Securities

By looking at Investhelp you may find a few companies that are trading below what they will be acquired for. I would strongly advise against investing in any mergers, the risk is to great to make up for small potential returns. If you need to invest in a merger to get your adrenaline pumping before working-out I would say only invest when both companies are 80% owned by insiders who are dead set on the merger going through.

Merger Securities on the other hand are different. Usually companies pay the shareholders of the company being acquired with cash, sometimes shares, when they pay with bonds, preferred stock, warrants, or rights, etc. Companies usually only use merger securities to pay for a portion of the payment - they use them because they probably exhausted their ability to raise cash.

Like spin-offs - and Rodney Dangerfield - merger securities don't get any respect, institutions sell them almost immediately, producing a great buying opportunity.

This means, don't try to invest in pending mergers because they're too risky, but follow the merger and if any merger securities are being used to pay for the company wait a while after the deal goes through - if it goes through - and try to put a value on the securities, they're probably undervalued.

Bankruptcies

Just reading that makes you think about Airplane companies, doesn't it? You'd think that investing in bankrupt companies would be a way to become one of them, but it turns out it could make you rich, if you do it at the right time...

Don't buy shares of a company that is currently going through chapter 11, that won't be profitable until a cow jumps over the moon, and if you have that money to burn you can just subscribe to an expensive newsletter and you won't need to invest for yourself.

You could buy bonds, bank debt or trade claims from bankrupt companies, but that wouldn't be smart unless you specialized in bankrupt companies.

There is a profitable way to invest in a company that went bankrupt... After the company comes out of bankruptcy it has to pay off it creditors, usually doesn't pay them with cash, it pays them with its brand new common stock, and of course do the creditors want this common stock? NO!! Seems like this is happening a lot, institutions own a company and it spin-offs shares or pays them with merger securities and it sells the shares almost immediately, creditors are paid with common stock from a company that went bankrupt and they sell the shares, because they don't have any reason to hold them.

Investigating this is pretty easy, go to the SEC website, http://www.sec.gov/ and you'll find a filing for bankrupt companies that tells you when the bankruptcy issues will probably be resolved, read this and pick your spots only invest in these companies when you are totally sure of the outcome, and have learned more than what you've read here.

Going Private Transactions

Cheap Stocks provides a good tutorial here. And Old Niu here The SEC here.

Basically micro-cap companies usually have very small revenues, sometimes under $1,000,000, the ~$100,000 they have to pay to the SEC could be 20% of their potential profit, the company will probably want to get rid of these fees.

 

This is where we come in, if the company can reduce the number of shareholders it has to under 300 it can file at will, and is no longer required to do so quarterly. To do this they have a reverse split, ex. 1-100 for every 100 shares you have they give you one.

 

If you have less than 100 shares, then the company pays you for the remaining fractional shares. In their SC 13E3 (usually announces the intention to go private, kind of like a proxy statement) they will declare a tender price, which is the price they'll pay for fractional shares.

 

When you find a company that is trading well below the tender share price, then, after investigating risk, you would usually buy one less than the split amount to make all your shares fractional.

The bad part is: usually these company's share prices are so low $100-$1000 is the most you'd be able to invest to make a good profit, sometimes companies will want to go private for reasons other than not wanting to file, they may be big enough that more money could be invested in the situation.

Finding these situations is extremely easy, check this page on the SEC website to find companies that filed the SC 13E3 filing. The Cigar Butt Hunters Group on Yahoo! follows these situations intently. George on Fat Pitch Financial follows all of these transactions, and for $15 a month or $125 a year he tracks the difference between tender and current prices for most arbitrage situations.

 

Investing here does not go without risk. There is also the problem with the amount of time it takes for the cash to appear in you account.

Restructuring

Corporate Restructurings are similar to spin-offs; in restructuring a business sells a badly performing division of the company -- a really big division. Except in restructuring we're looking to buy the company after the restructuring...

 

The reason to buy restructuring is hidden value may be obtained from the selling of the bad division, and the company being more profitable. Say a company is trading for $20 per share and it's earning $1 per share, it has a P/E of 20x and a 5% earnings yield, but one really bad division is losing $1 per share. Joel Greenblatt looks for companies that restructure and sell the bad division, which was depressing earnings. After selling the division the company is making $2 per share, and has a 10% earnings yield (probably above bond yields) the company is now relatively undervalued.

 

Look for situations that are well managed, have a great business to be restructured around and limited downside. Lastly, make sure the restructuring is significant in comparison to the total value of the company.

Recaps & Stub Stocks

In a Recapitalization a company usually buys a large portion of shares back from shareholders.

An example of this is a company trading at $18 that decides to distribute $15 dollars of bonds to investors, at $18 per share we’ll assume it earns $1.50 per shares, or a P/E of 12x, taking out the 40% tax rate it is making $2.50. After the recap it should be trading at $3 per share ($18 minus the $15 in bonds), it still earns $2.50 per share, assuming the bonds paid ten percent we first subtract $1.50 from earnings for interest expense, which is tax deductible, to get $1 per share, then multiply it by the 40% tax rate to get $.60 EPS.

 

If the company is trading at $3 this is a P/E of 5, probably too low. Of course the highly leveraged stub stock (stock after recap) probably doesn’t deserve the same P/E as it did before, but if we assume an 8.33 P/E is justifiable – it’s has the same business model, the only thing that has changed is the amount of debt - it should trade at $5, giving us a recap package of $20 ($5 stock, plus $15 bonds), this is a gain of 11% from the original $18.

 

Recaps aren’t as popular as they were in the mid ‘80’s, but when you find one Joel Greenblatt says, “There is almost no other area of the stock market where research and careful analysis can be rewarded as quickly and generously.”

Rights Offerings

Profiting from rights offerings is a little bit more complicated then the other situations described here, so I encourage you to buy You Can Be a Stock Market Genius and explore it, to find how to profit from this and other special situations

 

The third part of the series is about special situations used by hedge funds today, mainly from the books, Super Cash and How to Trade Like Warren Buffett by James Altucher and Value Investing Made Easy by Janet Lowe. I recommend these three books for any one looking to master special situations investments and to be up in down markets as well as rising markets.

The special situations written about here will be:

• Closed-End Fund Arbitrage
• Activist 'piggy backing'
• Deep, Deep Value
• LEAPS

Closed-End Fund Arbitrage

Closed-end funds are mutual funds that have a limited amount of shares and trade on a public exchange (NYSE, NASDAQ) like stocks. Because of the nature of the funds trading on an open exchange they frequently trade above, at a premium, or below, at a discount, to their NAV - Net Asset Value or the value of the mutual fund at the time. Thus a smart arbitrager can find a closed-end fund trading at a discount and buy it until the gap closes, or do vice versa and short a closed-end fund trading at a premium.

However it is not that simple - if it was these situations would not exist. Some closed-end funds trade at a steep discount to their NAV - EQS is the steepest current at a 23.4% discount to NAV, reversion to the mean would present a 31% return - but the discount is probably deserved, closed-end funds that underperform or have always traded for a discount should not be bought without a foreseeable catalyst - like activists - that will propel the fund back to it's NAV.

Currently my favorite in this category is the Gabelli Dividend & Income Trust (GDV). The fund "invests at least 80% of its assets in dividend paying or other income producing securities. In addition, under normal market conditions, at least 50% of the Fund's assets will consist of dividend paying equity securities." according to its website. Currently it trades for about a 15.5% discount to its NAV. Returns have been satisfactory and the dividend yield is 6.6%, so while you wait for reversion to mean, which is about 18%, you own a fund with satisfactory performance and a good yield.

Activism

A method rising in popularity among hedge fund managers is activism. In this method the manager buys >5% of a company he believes is not returning value to shareholders and becomes active in the business until value is returned to shareholders. When selecting companies to buy the manager usually looks for undervalued companies based low cash flow multiples, or companies with a lot of fcf and cash, he then buys 5 or more percent of the company which requires him to file with the SEC, when he files he not only discloses his holdings in the company but he also writes a letter to the board of directors about why he has bought the shares, what he thinks is wrong with the company and how he believes value can be released. This filing is available for everyone to see on the SEC website. Sometimes the company will immediately comply with the manager, but other times the fight can get pretty scary between a manager and a company.

Obviously regular investors cannot become activists, but 'piggybacking' activists is easily possible. When trying to find good activist investments one can use the sec website to follow each filing daily from activists, follow all 13Ds filed, when one is found it must be scrutinized to be reassured that the company will comply with the activist and value will be returned to shareholders, but when an opportunity is found great returns will most likely follow.

My friend Kevin Kelly, of Market Money, has, by far, the best information on potential activist situations. Read the following articles on different situations Kevin has analyzed:

• IASG
• JRCC
• PBY

Deep, Deep Value

Deep value has been discussed on this site before, I interviewed deep value focused investor Henry Lu and I purchased Lazare Kaplan which is trading below its Net Net Current Assets. Deep value is basically buying companies trading deeply below assets, at a very low price to earnings multiple or a very high cash flow yield. Companies trading at a fraction of their book or for 1x earnings is what Benjamin Graham originally championed buying.

This type of investing is usually called "cigar-butt" investing, you buy the stock, or pick up the cigar butt, for one last puff then quickly sell it. When investing in deep value the quality of the company is ignored and the investor is focused just on finding companiess so ignored by Wall St. they can be bought for as low as $.25 on the dollar. Because business quality is ignored value traps may be purchased, value traps are companies which appeared to be undervalued but are discounted for a reason, and they will stay discounted, or fall and become more discounted.

To avoid value traps one must look for companies not only deeply undervalued but also with quality, or at least profitable and have an expectation of earnings which will not fall. Also you must make sure management wants to return value to shareholders, if a company is trading below its cash, you must determine how management is going to use the cash, if they will just let it sit then a discount must be applied to cash to adjust for ignorant management.

One deep value opportunity I like right now is ExpressJet Holdings (XJT), XJT trades at about 3.5x earnings with $80 million of net cash and a contract with Continental which guarentees a 10% operating margin, XJT also trades at 1/5 of sales.

LEAPS

I won't go over the basics of options here, go here for that. LEAPS are options with a longer period of time attached to them, usually about two years.

As an example lets say I have resarched DirecTV and have decided they are a good business which is discounted when compared to its peers, has good financials and good management, but the only thing holding them back is the fact that GM holds a large portion of the common stock and investor fear this. I also believe in the near future GM will sell all of these shares, whether it be because they are forced into bankruptcy or if DTV buys back these shares, as they have already started doing.

Because I believe in the company, and think investors will realize this once GM sells the shares and DirecTV is no longer connected to them, I can buy LEAPS for JAN 08 with a strike price of $17, the current price is $17.50 and the options are priced at $2.75. If I buy one contract my investment is $275 (one contract is 100 shares), as opposed to $1,750 if I had bought 100 shares of the common stock.

Lets say in the next year and a half the stock appreciates to $26 per share because GM sells their shares and investors realize it's a good company, my investment in the LEAPS has appreciated about 330% (I bought them for $2.75 the price of the options is now $9, $26-$17) and my investment in the common stock is up only 49%.

Also if DirecTV were to fall because GM refused to sell it shares or something else happened to force DTV's shares down you would only lose you initial investment of $275 with the LEAPS, but you could possibly lose a much higher amount.

Conclusion

I believe that even great investors can only find 6-8 really good investment per year, to insure good investment returns when markets are volatile and good investments are hard to find special situations are needed to propel returns to an exceptional level. Afterall special situations are just 'value with a catalyst'.

Fund manager Matthew Richey wrote for The Motley Fool for a number of years before leaving to start a hedge fund with fellow writer Zeke Ashton. About one year ago Zeke and Matthew started managing the Tilson Dividend Fund, focused on picking growing, undervalued, companies which pay out a good dividend as well.

A few days ago Matt and I talked about using covered calls to generate a 'synthetic' yield.

Right Price Investing: How do you use covered calls in your general strategy?

Matthew Richey: Our ideal is to sell calls at strike prices that we otherwise would be happy to sell the stock at anyway. For instance, if I think Netflix is worth $40, then I might be happy to sell the $37.50 call and collect a premium of $2.50. That gives me an effective sell price of $40, assuming the stock gets called away, and otherwise I get the $2.50 as a "synthetic dividend" of sorts. Occasionally we're willing to sell calls at a strike price below our estimate of fair value, but only if the call premium is exceptionally high, allowing us to lock in a very high synthetic dividend yield.

RPI: When you find it appropriate, how much of your position do you usually sell calls on?

MR: There are many factors, but ultimately the decision boils down to how much upside in the stock we're willing to give up in exchange for the call premium. On mature businesses where we typically know fair value with reasonable precision -- take Costco, for instance -- we're frequently willing to sell calls on our entire position, so long as the strike price gives us our fair value estimate. But on growing businesses where fair value is less precise -- take Netflix, for instance -- we're less willing to cap our upside with calls, and so might only write calls on one-third or one-half of the position.

RPI: How often do you have to sell stock when you don't want to because you sold the calls?

MR: Rarely. It's happened to us only two times over the past three years, and each time involved a stock that paid a very high dividend, which incentivized the call owner to exercise his call and receive the dividend. For non-dividend paying stocks, I think the chance of being called prematurely is remote. Either way, it's actually to our advantage to have the stock called away early because that means we earn our entire premium without having to wait until the option's expiration, which results in a higher IRR on our invested capital.

RPI: What yield on the total portfolio do you expect each year to come from covered calls?

Honestly, we don't have any specific expectations from one year to the next. It all depends on what types of opportunities Mr. Market pitches our way. To the degree we're finding very deeply undervalued stocks, we'll tend to use less covered calls and rely more on capital appreciation; and vice versa. In the current market, where we're finding many moderately undervalued securities but few deeply undervalued ones, we're using covered calls on a regular basis. So in a year like this one, we expect covered call income may account for perhaps one-quarter of the portfolio's return.

RPI: Would you recommend individual investors use this strategy?

MR: Yes and no. Yes, in that it's a low-risk strategy and an intelligent value investor should be able to make informed judgments about choosing appropriate strike prices that offer adequate premium. But no, in that many individuals will have trouble distinguishing when a covered call offers the best risk/reward versus straight common. The greatest danger with covered calls is that you have to be willing to cap your upside (to the strike price + call premium), so you have to be very careful to only write calls where you're getting a good premium at an acceptable strike price. It takes discernment to recognize which situations are well-suited to covered calls, and which aren't. A 7% covered call yield may look tempting, but it'd be a foolish choice on a stock that has 30% upside in capital appreciation.

The above interview corresponds to a strategy employed by the Tilson Dividend Fund. At the time of the original printing the fund owned shares in Netflix and Costco, but this could change at any time. Mike Price does not own shares of either company, but family members of his own shares of the Tilson Dividend Fund.