Published by Closed-End Fund Advisors, Inc.
July 2001, Volume I, Issue 3
George Cole Scott, Editor
An Interview with General American Investors
General American Investors (GAM-NYSE) was the top performing US listed, large-cap equity fund for the year 2000 with a 17.6% increase in net asset value per share (with reinvestment of all dividends) versus a decline of 9.1% in the Standard & Poor 500 Stock Index. Historically, General American's annualized total return is as follows:
Recent Performance Numbers
Data as of 6/30/02
GAM is the oldest surviving closed-end fund (1927); it invests primarily in medium and large-cap equities with above average growth potential. Less emphasis is placed on income. Historically, the fund has paid out large capital gains distributions. For the last three years, aggregate per share distributions were $4.40 (1998), $4.05 (1999) and $6.16 (2000) on the common stock.
In 1998, GAM raised $150 million in a 7.20% Tax-Advantaged Cumulative Preferred stock offering. Each share has a liquidation value of $25.00. At year-end 2000, the largest industry groups were in Finance & Insurance (23.6%), Retail Trade (14.6%), Health Care (11.3%), Consumer Products and Services (5.8%), Communications and Information Services (4.9%) and Semiconductors (4.3%). In December 2000, the fund held 22.9% of its assets in high grade money market instruments. The ten largest holdings: The Home Depot, Everest Re Group (property/casualty, reinsurance), IDEC Pharmaceuticals, Ford Motor, The TJX Companies (off-price retailer), Pfizer, Golden West Financial Corp., AMR Corporation, M&T Bank Corp. and Wal-Mart Stores comprising 33.2% of net assets. The total value at year-end was $1.3 billion. For the year 2000, GAM had an expense ratio of 1.05% and a portfolio turnover rate of 40.6%.
We interviewed Eugene DeStaebler, Vice-President, Administration on June 15, 2001.
Scott: Would you tell us something about your background?
DeStaebler: I am a CPA. I joined Arthur Andersen & Company in 1965, after serving three and a half years as a supply corps officer in the United States Navy. At Andersen, I worked on the audits of numerous financial services industry clients, including all forms of investment companies, partnerships and pooled investment products and was also a member of the investment industry competence team. I joined General American in 1975 as the administrative officer and for 25 years have been active in industry activities. I served as Chairman of the Investment Company Institute's closed-end fund committee from its inception in 1987 through 1992. I was one of the founders of the Closed-End Fund Association in 1997 and served as its President from 1997 to 1999.
Scott: That's an impressive record. Do you have any plans to retire or are you going to go on forever like me?
DeStaebler: I will be 65 in 2004. Life at General American has been challenging, satisfying and rewarding so I can't see myself not being associated with the Company. When I turn 65, I hope to slow down a bit especially since we now have two grandchildren. Perhaps I can work-out a reduced schedule helpful both to me and the Company. I don't have any plans to stop working at this time.
Scott: A good idea. This will keep you young at heart and in spirit. One thing I notice is that GAM holds shares in another closed-end fund, Central Securities. The SEC permits a fund to hold up to 10% of its assets in other funds, but I wonder why you chose this one. Only a few funds buy other funds. Bergstrom Capital once had a significant holding in Adams Express, which we spun off to shareholders. [George Cole Scott is on the Board of Directors of Bergstrom.] Boulder Total Return holds close to the limit in other closed-end funds, mostly bond funds. Do you plan to add to Central Securities or buy any other closed-end funds?
DeStaebler: You will note that our position in CET represents less than 1% of our net assets. We made this investment several years ago after meeting Wilmot Kidd and discovering his philosophy is very similar to ours. We will probably not add to this position, except through distributions taken in additional shares.
Scott: How many portfolio managers has GAM had since inception?
DeStaebler: We have had six portfolio managers in 74 years. Malcolm Smith served 28 years. The founder, Frank Altschul, served for the first 22 years. His son, Arthur, was Chairman from 1961 to 1995 and has just had his 81st birthday. That's significant continuity for General American, a fund whose philosophy hasn't changed over the years. We have remained long-term focused on growth stocks for our entire history.
Scott: Your president and portfolio manager, Spencer Davidson, has significantly increased your returns since assuming his responsibility in 1995. He has sold short in the down market. Could you tell us something about this?
DeStaebler: In 2000, we sold a limited number of securities short in order to protect some of our unrealized appreciation. While this program was moderately successful as a hedge against the downslide in the market, it generated a significant amount of short-term gains. We have since reduced our amount of short sales activity.
Scott: If more funds had been as careful as yours, their shareholders wouldn't be so turned off by having to pay capital gains when they had a loss on their shares. Is there one single issue that stands out in your mind regarding the closed-end fund industry?
DeStaebler: The economics of organizing, underwriting and operating a closed-end fund and the changes over the years in the business are significant issues. You should consider devoting a chapter on this issue in your new book. Closed-end funds are fairly stable pools of assets because they, as a general rule, distribute taxable income and realized gains to their shareholders. It is hard to increase the size of a closed-end fund: we have been able to retain some of these assets by offering shares for the distributions in lieu of cash — about 65% of our distributions are taken in shares. In addition, the economics have changed over the years. If you go through a period of high inflation as the late 1970s and early 1980s, your expense ratio will rise. This can cause havoc for many funds. If a fund cannot retain a large portion of their distributions, it can become uneconomic to operate. These are big issues for smaller funds which are not a part of a larger complex where the advisor has other means to cover expenses. When expenses rise faster than assets or if the net assets decline, it may become uneconomical to continue to operate. That is what happened with Niagara Share, Madison Fund, U.S. and Foreign and dozens of others that no longer exist as they were no longer viable. Economics, therefore, appears to be a significant issue facing our industry.
Scott: I agree and hope some of the smaller closed-end funds take note. What do you think of funds which pay out a fixed amount of cash quarterly, such as 10% of assets?
DeStaebler: I think there is a major downside there. During the period of 1973-74, which may re-occur, funds with a guaranteed pay out would have been required to make a return of capital distribution. In addition, shareholders could get to the end of the year and find that they had lost 10 or 15% or sometimes 50% in the market price. They find that, despite the decline in value as a result of dividend payments, they have to report a lot of income or capital gains and have to pay the taxes. You then could have disgruntled shareholders, so this is a public relations issue.
Scott: This is indeed an important issue which I would like to explore further at a later date. Another significant issue is that many investors think they cannot make any money on closed-end funds except through a narrowing of the discount. Few people seem to understand this. What are your views?
DeStaebler: I think one of the unfortunate aspects of closed-end funds is that they are often compared to other publicly listed companies rather than to mutual funds. With Cisco Systems or Intel, you see the market value rising over a long period of time. Then you look at General American or Adams Express which pay-out large distributions, there is little market price increase because of the dividend distribution policy. When an investor looks at charts and other measurement tools used by brokerage firms, investment advisors, financial planners, as well as by individuals, hopefully, they will become more cognizant of the elements in evaluating performance. One must look at the investment results including dividends reinvested over time or total return. This is the way to properly evaluate the record of a closed-end fund.
Scott: General American was able to increase its performance in the year 2000 by narrowing its discount, partly through share repurchases. Would you describe the details of this program?
DeStaebler: In 2000, we repurchased 1,017,200 shares of common stock at an average discount of 8.6%. This provided a benefit of 14 cents a share to our net asset value and improved our net asset value by 0.3%. I now believe most closed-end funds are aware of the beneficial aspects of share repurchases and many now are doing this. A repurchase program may have a limited and temporary impact on price, but I don't believe any mechanism like this can provide a significant or lasting impact. Repurchasing shares essentially improves the performance of the remaining shares by raising the net asset value and is, therefore, an anti-dilutive transaction. However, as our discount has narrowed this year, the impact on NAV is less. In the year 2001, we have only repurchased 19,000 shares. I think you have to look at closed-end funds the same way mutual fund investors do where they buy shares over time using dollar cost averaging. The most important aspect of the process is to determine how well the fund implements its investment policy and to evaluate if the portfolio manager has a good track record. Then investors should assess their own investment needs. If they want long-term capital appreciation through investment in growth stocks, General American should be considered.
Scott: We are gratified that many funds now realize the value of share repurchases to narrow discounts and to raise the net asset value at the same time. Many resist this as it reduces the size of the fund as well as it means there is less liquidity as fewer shares are available to trade in the market. I hope more funds will follow your lead. What is the Board's responsibility to narrow the discount?
DeStaebler: The Directors are responsible for being aware of factors that contribute to shareholder value including the narrowing of discounts. However, I don't think that they are responsible for narrowing a discount. It has been my observation that very good performance has resulted in lower discounts. Therefore, Directors should focus on factors that contribute to good performance and sound operational practices.
Scott: That's true, but it seems to me that too many funds, particularly the newer ones, spend too much time worrying about the discount rather than paying attention to other issues. I am sure you agree that good performance will usually narrow the discount over time while poor performance will widen it no matter what you do to prevent this.What are your thoughts on the new full disclosure requirement (Regulation FD)?
DeStaebler: Most closed-end funds have no problem with this as they maintain a quarterly disclosure practice. General American publishes complete financial statements every calendar quarter. We do not divulge any information to anyone other than what is in our reports. Periodically, our Board will make a determination to continue our share-repurchase program or to declare a dividend. We then issue a press release, which conforms to the new requirement.
Scott: It looks like the closed-end fund industry is ahead of the pack on full disclosure. There are some funds, which only publish reports twice a year because that is all that is required, and they say this is to save money. What do you think of that practice?
DeStaebler: It is unfortunate some funds only publish reports every six months. Such funds are doing their shareholders a disservice. It is a different matter for the mutual fund industry which focuses very intently on holding down costs. We think communicating with shareholders is more important than trying to save a small amount of money with fewer reports.
Scott: We strongly agree. Right now The Scott Letter urges shareholders of funds which only publish every six months to contact their funds right away about this. We will address this issue as well as many others in our book. You are still an internally managed fund. How do you think this structure works to the investor's advantage? Also, at one time you were considering externalizing into a management company. What happened to that proposal?
DeStaebler: With respect to the internal management structure, our compensation program rewards our analysts and portfolio manager for good performance through the use of bonuses, which allies their work with the interests of shareholders. This is one of the benefits of an internally managed fund: there is no advisory fee based solely on the total net assets of the fund. When we considered changing to a management company, we managed assets for institutional accounts, which became a very significant business. We thought of putting all of our assets including General American into a wholly-owned subsidiary. Unfortunately, the market turned against us, and we lost some clients. Externalization became uneconomical, so we abandoned the idea. Since Spencer Davidson took over as portfolio manager in 1995, we have focused all of our efforts on the operations of the Company including managing the portfolio and doing everything we can to enhance shareholder value.
Scott: You certainly have succeeded with this. How has leveraging GAM with preferred stock worked out for your shareholders?
DeStaebler: Number one, the closed-end fund structure permits a greater use of leverage than mutual funds can use. It seems to us a good idea to take advantage of this opportunity. The historical return on common stocks has been in the 11% range over the last 70 years. If you can borrow money at less than 11% and can achieve a market rate of return, you have enhanced performance for the common shareholder. In our case, we issued preferred stock in 1998 and have never invested it into equities. Today, our cash is about 26% as we are still very cautious on the market. We did not suffer during the decline that has occurred starting in early 2000. As a result of the preferred offering, we did not have to sell securities in the down market to put ourselves into a more liquid position. Leverage isn't for everybody but is part of the equation to look at when considering risk and reward. It adds risk and volatility, but we felt we could manage the additional risk. There are pluses and minuses which you must consider before deciding on leverage. The Closed-End Fund Association web site has a discussion of the issues relating to the use of leverage by closed-end equity funds under the research articles section.
Scott: We get a lot of calls from mutual fund investors who have difficulty understanding closed-end funds. We try to explain CEFs to them, but many investors don't really see the advantages. What do you think are the principle advantages closed-end funds have over mutual funds?
DeStaebler: The Closed-End Fund Association has published a booklet which describes these issues called "Understanding The Advantages of Closed-End Funds". It is also available on their web site, www.closed-endfunds.com.
Scott: GAM is tax-efficient and has a low turnover. Do you think this is an important consideration for investors considering purchasing a closed-end fund?
DeStaebler: I don't think the issue of tax efficiency is the way to consider an investment in a closed-end fund. Recent regulations require mutual funds to calculate and report their after-tax returns. This does not apply to closed-end funds, probably because they are listed like stocks and their differential between NAV and market price. From an accounting standpoint, there are certain steps you can take to reduce the tax impact of securities transactions such as the use of specific identification of tax lots. When we sell shares, we take the highest cost and longest term tax lot in relation to the proceeds of what we are selling in order to report the lowest amount of realized gain we are taking on that transaction. Your investment consideration should be portfolio-manager driven rather than tax-efficiency driven. Whether a fund is tax efficient should, therefore, be way down on the list of why you should invest in a particular closed-end fund. The structure of a closed-end fund is more suitable for focusing on portfolio management which will hopefully produce better results. The manager has fewer distractions such as having to worry about cash flows into or out of the fund. There are no marketing distractions. Investing at a discount can boost performance if the discount narrows. Also, the return is higher as you have more assets working for the you than the amount invested. In spite of this, a well-run family of mutual funds is appealing because of the simplicity and ability of the shareholder to shift into funds with different objectives. This is a feature closed-end funds don't have. However, from a portfolio manager's perspective, a closed-end fund should be easier to manage and should perform better over time.
Scott: We call this buying 85-cent dollars when you can buy shares in a fund at a 15% discount. Many thanks for this highly informative discussion of some of the important issues facing our industry. You are certainly highly qualified to help us to inform and educate our readers about closed-end funds. General American Investors' net asset value at the end of the first half of 2001 was $37.94 with a market price of $37.71 and a discount of -0.61%. For the last 12 months, the discount averaged -4.46%. NAV performance for the first half was 0.57% and market return was 10.90%, according to Weisenberger Closed-End Weekly Review (1-800-631-9737) According to the 2001 proxy statement, insiders at GAM held over 2.4 million shares or 8.4% of the total. Closed-End Fund Advisors has held a significant number of shares in GAM for many years. George Cole Scott and his family also hold shares.
Note: None of the information contained herein should be construed as an offer to buy or sell securities or as recommendations. Performance results shown should under no circumstances be construed as an indication of future performance. Data, while obtained from sources we believe is reliable, cannot be guaranteed.
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