General Survey | Discount and Premium | Leverage

GENERAL SURVEY

Closed end funds differ from open-end funds (mutual funds) in three important respects:

1. Closed end funds do not constantly sell shares in order to raise additional money. As a rule, the capitalization of closed end funds changes infrequently, if at all.



2. Prices of closed end-company shares are determined (like the quotations of all shares other than those of open-end com­panies) by supply and demand. Closed end shares, therefore, may sell at, above, or below net asset value. The stocks of most important closed end funds are listed on a national secu­rities exchange.



3. Closed end funds do not agree to redeem their out­standing shares at the request of shareholders.

For many years, the aggregate capital of closed end com­panies far exceeded the funds of open-end companies. Open-end companies appeared on the scene later. In terms of net assets, closed end funds in 1940 were still substantially larger. At the end of 1940, the net assets of closed end com­panies totaled approximately $614 million, whereas their younger brethren (mutual funds) had net assets of only $448 million. By 1949, open-end companies took the lead. Table 5 illustrates what has occurred in recent years.

closed end funds have consolidated or merged with other companies, thus reducing their number. Between 1940 and 1950, they also reduced their capital through repurchases of their outstanding shares. Since the amount of new capital raised by closed end funds during this decade was small, capital was reduced by some $227 million. Few new companies were organized. Not until 1958 did closed end funds obtain a substantial amount of new money. This relative decline may be attributed to competition from mutual funds, which had been rising in popularity.

TABLE 5 Total Net Assets of Investment Companies igsi-ig6i (Dollars in millions)
closed end funds			Open End Companies
Calendar Year End	Number of Companies	Assets	Number of Companies	Assets	Total Assets All Member Companies
1961	25	$2,132	170	$22,789	$24,921
1960	25	1,775	161	17,026	18,800
1959	24	1,697	155	15,818	17,515
1958	24	1,633	151	13,242	14,875
1957	24	1,210	143	8,714	9,924
1956	25	1,264	135	9,046	10,311
1955	26	1,199	125	7,838	9,037
1954	30	1,188	115	6,109	7,298
1953	32	928	110	4,146	5,075
1952	34	978	110	3,931	4,910

Source: Investment Companies: A Statistical Summary, 1940-1960, Na­tional Association of Investment Companies, New York.

Before discussing the special characteristics of closed end funds, one should note certain similarities between them and the open-end companies. Both are subject to the regula­tions of the Investment Company Act. In regard to manage­ment, the typical closed end fund functions in almost the same way as the typical open end fund. In a number of instances, the same management is responsible for the invest­ment policies of companies of both types.

DISCOUNT AND PREMIUM

As pointed out earlier, "discount" is the term for the differ­ence between the market price of a closed end-company stock and the stock's net asset value at a given time. If the price as of December 31 is $8 per share and the net asset value of the com­pany on that day is $10 per share, the discount is 20 per cent. "Premium" is the term for the converse position. If the price per share were $12 and the asset value $10, the premium would be 20 per cent.

Discount is a problem that concerns only closed end funds because almost all open end funds re­purchase their shares at net asset value (redemption); at the very least, a number of companies agree to repurchase their shares at 99 per cent of net asset value; so the discount is only 1 per cent. Discounts which have prevailed in recent years are set forth in the table below:

Dec 31	Adams Express	Lehman	Madison Fund	Tri-con- tionantal	United Statesand and foreign Securities
1961	3%	+5%	+23%	13%*	16%
1960	14	1	2	23	22
1959	8	+2	14	21	18
1958	4	+10	14	14	13
1957	11	+12	23	24	9
1950	29	+12	+4	43	34

+ = Premium.
* 5% if warrants were converted.

As a rule, the heaviest discounts have prevailed during pe­riods when markets were falling or were depressed, as in 1939-1940 and 1946. Greater familiarity with stocks on the part of investors and rising stock prices in recent years have tended to bring market price and net asset value closer to each other. A few closed end fund shares have consistently commanded a premium. The largest premium prevailed when the value of the shares was small, partly because the shares represented a long-term option at low cost.

No one expects the price of an industrial company's stock to bear any relation to asset or book value. The relation is also tenuous for other equities. Investors recognize that book values of assets, particularly plant and equipment or natural resources, do not purport to represent the current sales value. Table 6 speaks for itself as to the absence of any relation between book and market quotations.

TABLE 6
Book and Market Value of Fifteen Industrial Stocks, December 31, 1960
	CLOSING PRICE	BOOK VALUE PER SHARE
Allied Chemical	54⅜	$22.35
Aluminum Company of America	68¾	35.53
American Can	35⅜	30.74
American Telephone & Telegraph	107⅛	55.37
American Tobacco	65¼	35.53
Anaconda	43½	85.85
Bethlehem Steel	39⅝	34.72
Chrysler	38⅜	79.33
E. I. Du Pont de Nemours	187¼	54.38
Eastman Kodak	111¾	18.23
General Electric	74½	16.84
General Foods	70⅞	13.87
General Motors	40⅝	18.77
Goodyear Tire & Rubber	34¾	17.63
International Harvester	42⅝	67.39

The assets of investment companies, however, are made up almost entirely of marketable securities; so the proceeds, which would be received in the event of sale, can be closely estimated. Why then are closed end-company shares frequently available at discounts of 20 to 25 percent?

First, we must assume the company does not intend to liqui­date or go out of business; so the investor cannot expect to receive the equivalent of his pro-rata share of the assets.
Secondly, the investor cannot turn in his stock certificate and ask that the company pay him the current net asset or liquidat­ing value, as is usual with an open-end fund. Accordingly, to this degree, the net asset value is merely "theoretical."

In the absence of imminent liquidation, a number of reasons may be cited to account for some difference between the net asset value per share and the prevailing market quotations. The cost of management averages around 15 per cent of investment income and is a continuing expense. It follows that, if common stocks generally yield 3.5 per cent a year, an investment com­pany will earn no more than about 3.0 per cent net for distribu­tion as dividends from ordinary income. For many years, this return was substantially less than the income, which one could get from a representative group of sound common stocks.

The Investment Company Act forbids closed end funds to purchase securities of which they are the issuer except (1) on national securities exchanges or other open markets desig­nated by the SEC under specified circumstances, (2) pursuant to tenders, or (3) under such other circumstances as the Com­mission may permit. Among the most important rules adopted by the Commission under the Investment Company Act are those requiring the seller not to be an affiliated person (to the knowledge of the issuer). The price paid, furthermore, must not be above market or asset value, whichever is lower. The issuer must disclose to the seller or his broker the approximate asset coverage of the subject securities. The purchase must be made without undue preference. If the security is a stock, notice of intention to buy must have been given to the stockholders at large. The purpose of these rules is to eliminate unfair discrimi­nation and to prevent overreaching conduct.

Before the stock market's collapse in 1929, repurchases were generally effected to "support, peg, fix, or stabilize" prices. After 1929, repurchases of bond issues were often made to prevent defaults arising out of so-called touch-off provisions contained in many bond indentures. These clauses provided that the de­cline of the market value of the assets of an investment com­pany below a prescribed percentage of the principal amount of the company's outstanding funded debt constituted a default. By purchasing bonds at a discount, the debt was reduced pro­portionally more than the company's assets. This lifted the asset coverage of the remaining bonds outstanding above the mini­mum level provided in the touch-off clause. There were numerous instances of repurchases from insiders, enabling them to convert into cash security holdings too large to liquidate in the open market. In other instances, repurchases were made to create the appearance of a strong market.

Other practices also needed correction. During the years 1927-1935, closed end funds and investment holding com­panies repurchased (net) about $472 million of their own out­standing securities, which represented about 12 per cent of the value of the total sales of their security issues. The securities repurchased included approximately $320 million of preferred stocks, some $99 million of bonds, and $114 million of common stocks. The repurchases represented 29 per cent of the bonds sold, 25 per cent of the preferred stocks, and only 5 per cent of the common stocks. Repurchases were heaviest in 1930, when they amounted to $154 million, and in 1931, when they amounted to $88 million.

The greater the discount from asset value at which the se­curities are repurchased, the greater the advantage to the re­maining holders. Assume the capitalization of an investment company is as follows:

Preferred stock, 6 per cent cumulative
	($100 par value) $2,000,000
	Common stock ($100 par value) 4,000,000
	Liquidating value of preferred stock is $100 per share

Now let us assume that the following is true:

	Net assets of investment company	$3,000,000
	Book value per share of preferred stock	150
	Book value per share of common stock	25

If the company could buy $500,000 par value of preferred stock at $80 per share, the book value of the remaining preferred stock would be raised to $173.33 per share. The book value of the common stock would increase to $27.50 per share, even though the company's net assets had been reduced.

In a one-class capitalization, the result is also favorable to the remaining common stockholders. Assume an investment company has outstanding 100,000 shares, with a book value of $10 per share, and it can repurchase 20,000 shares at $6 per share. It will in effect give up assets of $120,000 to buy back stock with an asset value of $200,000. The $80,000 "profit" is equivalent to $1 per share on the remaining 80,000 shares out­standing after the transaction has been consummated. True, in weak markets, the stockholder who desires to sell may find that he would be better off if the issuer were willing to make a bid, even at a discount. Judging from past experience, the likelihood of overreaching conduct is so great, however, that it is wise for the investor to be placed on notice and for other investors to be offered a similar opportunity.

Before passage of the Investment Company Act, repurchases were frequently used to improve the balance sheet. As the SEC stated in its report, this was done "in the same manner as if the increased asset average or asset value of the remaining securi­ties had resulted from appreciation in the value of the portfolio securities, or from an increase in income, or from other results of expert investment management." (Report of the Securities and Exchange Commission on Investment Trusts and Investment Companies, Washington, D.C., 1939, Part 2, p. 239.)

So far, we have assumed that the securities of investment companies, especially their common stocks, always sell at a discount in the market. This is not true. At one time, some of these stocks sold at premiums of 40 per cent and more. High valuation placed on expert management accounted for this situation. The investor put his bet on the ability of management to secure him a high rate of earnings on his invested capital and capital appreciation as well.

There is one exception to the general rule that most closed end investment company stocks sell at a discount. The ex­ceptions, peculiarly enough, are common stocks of leverage companies with a small net asset value for the common stock, or even none whatever. Investors are willing to pay more than the net asset or liquidating value on the ground that, if the stock market advances substantially, the common stock will acquire a value through the operation of the leverage principle. As an illustration, consider the common stock of Tri-Continental Corporation. This stock had an asset value of 7 cents per share at the end of 1941; yet during the year the price of the stock was never less than 62.5 cents and it sold as high as $2 per share. On the other hand, at the end of 1950, the asset value amounted to $17.08 per share, but at that time the stock sold for $10,875 per share.

A general peculiarity is that, in the past, the discount at which closed end-company shares sold has generally been larger at low levels of the stock market. The discount tended to shrink as stock prices rose and greater optimism prevailed. This seems inconsistent. But the market often is inconsistent. Actu­ally, other things being equal, the risk in the stock of an invest­ment company with a diversified portfolio would be less when stock prices were depressed than after a substantial advance had occurred.

In several years past, a few closed end investment company stocks (other than those with little or no asset value) have been selling at a premium or close to net asset value. Among these are stocks of investment companies, which have had a con­spicuously favorable record. The discount generally has tended to narrow in the last decade.

The tendency of closed end investment company shares to sell at some discount may be interpreted in a number of ways. Since security prices reflect investor choices, a substantial dis­count (more than 10 per cent) as much as says that the investor prefers other securities. The importance of the redemption fea­ture is indicated by the fact that investors buy large amounts of open-end-company shares at a fairly substantial premium. Careful investors know, too, that attractive though a 15 to 20 per cent discount may be, they have no assurance that the discount may not be even larger within six months or a year, and this although the underlying net asset value has not changed. Finally, after the original offering has been made, less effort is put into selling closed end shares than into selling open-end shares.

When the stock of an investment company is permitted to sell at a discount of 25 per cent and more and the common stock is the sole capitalization (complex problems arise if there are senior securities), there is good reason for repurchasing stock in the open market or asking for tenders. This practice would lead to the elimination of the discount or would reduce it to nominal proportions. It is hard to envision a more desirable or advantageous use of a company's assets.

The use of resources to reduce the outstanding shares by re­purchase and thus attempt to lessen the discount is advocated strongly by some commentators. As recently as 1960, one in­vestment company declared that in buying its own stock at a substantial discount "this action was considered a definite ad­vantage to its shareholders." This step received warm praise in a leading financial periodical, whose editor stated: "This policy has been long-neglected by practically all of the closed end funds in the face of the demands therefore by a number of their shareholders and disinterested observers who have contended that the management's negative attitude has not coincided with the best interests of the shareholders . . .. Such constructive action has been abstained from apparently owing to the con­trolling desire by managements to increase rather than 'un­wind' total assets handled." 2

In a few instances in recent years, in order to raise new funds, closed end investment companies have offered addi­tional stock to the public at a time when their shares have been selling in the open market at less than the net asset value. This practice seems open to the valid criticism that the offering, if the stockholders have pre-emptive rights, will result in diluting the value of their equity, unless they are in a position to exercise their rights. If the offering is made to the general public without first being made to the present shareholders, the in­equity is even clearer.

Finally, it may be asked why funds can be attracted to open-end companies at a premium and, at the same time, manage­ment and investors must be exhorted to take special measures to "buy dollars at a discount"? No doubt the major factor is that closed end shares are not redeemable at the holder's op­tion. Another important factor, if the investor has no cause to think he will seek liquidation in the foreseeable future, lies in the character of the brokerage business. The commission on a regular agency transaction is small; the ordinary compensation in the sale of an open-end stock is several times as large. Hence, as mentioned earlier, more energy is given to directing inves­tors' attention to the merits of open-end stocks than to closed end issues.

LEVERAGE

Investment companies, which have outstanding securities sen­ior to the common stock, i.e., securities with prior claims to, and fixed maximum participation in, the companies' assets and earnings are said to have "leverage." Bonds or debentures and preferred stocks are the instruments, which provide leverage. As described by the SEC, "the existence of leverage amplifies the effect of a given amount of force—the effect of fluctuations in the value of total assets upon changes in the value of the common stock equity."

The underlying assumption is that the funds borrowed from bondholders or received from the senior partners invited to buy preferred stock will earn more than the interest or dividends to be paid to them. The common stock therefore will benefit. This may be described as "income leverage." Secondly, the as­sets acquired with the proceeds of the sale of senior securities will give the common stock control of additional assets over what would have been acquired otherwise, increasing the pos­sibilities of capital appreciation of the common stock.
2 A. Wilfred May, Commercial and Financial Chronicle (New York), Feb­ruary 2, 1961, p. 1. The position taken in the article cited is a reiteration of views previously expressed.

The converse also must be true. If the earnings of an invest­ment company do not cover the interest or preferred dividend requirements or if the prices of the portfolio securities decline, the impact will be heaviest on the common stock.

So strong was the feeling against leverage that the issuance of senior securities by open-end investment companies was for­bidden in the Investment Company Act, although bank loans might be contracted. The issuance of senior securities by closed end funds is rigorously circumscribed by the act.

To illustrate the significance of leverage, let us assume that an investment company has net assets of $2 million.

Capitalization of the company is as follows:

4 per cent debentures	$1,000,000
Common stock ($10 par)	800,000
Annual net earnings	108,000
Debenture interest	40,000
Balance for common stock	68,000

Although earnings on the total invested capital of $1.8 mil­lion were equivalent to only a 6 per cent annual rate, because only 4 per cent was paid on the borrowed funds, earnings on the common stock would be equivalent to 8.5 per cent.

If the company raised $500,000 through the sale of 5 per cent preferred stock, the situation would be as follows on a $2.3 mil­lion capital investment:

Net earnings (at 6 per cent)	$138,000
Debenture interest	40,000
Preferred stock dividends	25,500
Balance for common stock	73,000
Rate of earnings on common stock	9.125 per cent

The hypothetical example assumes a higher rate of earnings than is likely, but during the twenties, little distinction was made between earnings from ordinary investment income and capital gains. Actually, companies were then issuing 5 per cent obligations and 6 per cent preferred stocks and buying common stocks to yield 4 per cent and less. Inevitably, this spelled trou­ble when stock prices started to move downward.

The attraction of leverage on changes in net asset value for the common stock is illustrated in the following example:

Capitalization of Investment Company X

Debentures	$1,000,000
Preferred stock ($100 par)	500,000
Common stock ($10 par)	800,000

Assume that having invested $2.2 million of the $2.3 million available in common stocks during the course of the year, the value of the common stocks has risen by 20 per cent.

The assets of Company X now are as follows:

Cash	$ 100,000
Value of common stock owned	2,640,000
Total	2,740,000

The claims of the senior securities (debentures and preferred stock) have remained unchanged. Deducting $1.5 million, $1.24 million now remains for the common stock. With a rise of $440,000, or less than 20 per cent, in the value of the total as­sets, the increase in the value of the common stock is fully 55 per cent. Small wonder leverage was so popular during the twenties.

The collapse of prices showed that the principle could have disastrous results if it were ill timed or combined with question­able management. An investment company with more than one class of securities has a number of the characteristics of a mar­gin account. Most of the older closed end investment companies were financed through issues of either debentures or preferred stock, or both, in addition to common stock. When the SEC made its report, it found that 109, or 67 per cent, of the closed end investment companies had multiple-security structures in 1929. They had $1.9 billion in assets, or 67 per cent of the as­sets, which the 162 open-end companies could count. At the end of 1929, owing to large sales of additional common stock, funded debt amounted to less than 9 per cent of total liabilities and capital. Preferred stocks were especially popular; they con­stituted 33 per cent of total liabilities and capital and amounted to $581 million in 1929.

Leverage was carried to extremes in the attempt to capture all its advantages. American investment companies and their sponsors resorted to comparisons with British experience, where multiple-security investment companies were almost universal. British practice, however, varied from our own in one vital characteristic: British companies patterned their investment policy after their capital structures. Whereas American com­panies, whatever the amount of senior securities outstanding, had only a small fraction of their investments in high-grade bonds and preferred stocks, British companies generally kept 50 per cent or more of their assets in senior securities. This policy reduces the effects of a leverage capital structure.

Under the Investment Company Act, closed end funds may issue securities representing indebtedness or preferred stocks, if (1) such securities have an asset coverage of at least 300 per cent and 200 per cent, respectively; (2) provision is made to prohibit the reduction of such required asset coverage by dividend payments or distributions; (3) voting rights are provided for preferred stockholders and in certain contingencies for senior securities other than loans; (4) in the case of pre­ferred stocks, such stock has priority over any other class as to dividends and distribution of assets.

closed end funds may not issue more than three classes of securities: one class representing indebtedness, one class of preferred stock, and one class of common stock. Open-end com­panies are prohibited from issuing senior securities. They may borrow from banks, however, provided that at all times they maintain an asset coverage of 300 per cent for such borrowings.

A moderate degree of leverage may be justified. Trading on the equity, as it is sometimes called, is used by almost all pub­lic utility companies, and the number of large industrial com­panies without long-term obligations or preferred stock is relatively small. Always the underlying principle is that the company will earn more on its investment than the cost in interest or preferred dividends on the funds raised through the sale of senior securities. The prevalence of multiple-security capital structures tends to show that management does not nec­essarily have to neglect or sacrifice the interests of creditors or preferred stockholders for the advantage of common shareowners.