The recent discussion about a change in capital gains taxation is making hearts beat faster, especially among a small group of die-hard fans of closed-end funds.
The Trump administration is studying using its regulatory power (without going through Congress) to change the way unrealized gains are calculated. Specifically, it’s considering allowing investors to adjust the original purchase price of all assets—stocks, funds, homes—for inflation, which would reduce the gain.
That could be a boon for some of the ancient funds we wrote about early last year—funds that survived the 1929 stock market crash, then marched along, offering solid performance, high yields, cheap valuations, and strong share-buyback programs. The funds included Central Securities (ticker: CET), Adams Diversified Equity (ADX), General American Investors (GAM), and Tri-Continental (TY).
Closed-end funds trade on an exchange, unlike open-end funds, and have a fixed number of shares, unlike exchange-traded funds. The price of the shares bears a loose relation to the actual value of the securities owned in the fund’s portfolio. Typically they trade at discounts to net asset value. Ben Graham, Warren Buffett’s mentor and the father of value investing, was a fan. So is Edward Thorp, the mathematician and top-performing hedge fund manager.
One theory for the discount is that funds are sitting on hefty unrealized gains. The smaller the gain, the lower the eventual tax bill. Consider General American Investors, where unrealized gains account for more than 50% of NAV. When Graham wrote about General American in 1970 in his seminal book, The Intelligent Investor, the discount was 7.6%. Today, the discount is 16.5%. Says Jeff Priest, the fund’s manager: “Some of the discount is possibly due to a perceived tax bill.…It probably weighs on investors’ minds.”
Then there is Central Securities, where unrealized gains account for 54% of net assets, partly because closely held insurer Plymouth Rock, a longstanding investment, accounts for 19% of assets. The fund trades at a 17.3% discount to NAV. It has been run by Wilmot Kidd since 1973, and has put up a stellar track record: Over the past 25 years, it has returned 11.1% a year, versus 9.8% for the S&P 500.
To be sure, a change in capital gains would benefit a range of investments, including the house that you’ve owned for decades. “It’s an advantage to any person who’s owned an asset for a very long time,” says Mark Stoeckle, who has managed Adams Diversified since 2013. Unrealized gains at Adams Diversified are 32% of assets. Partly to close the discount, Adams some time ago began paying at least 6% dividends. Today, the fund trades at a 14% discount.
Discounts persist, and “the long-term stock holder shouldn’t be bothered” by them, Kidd says.
Another potential beneficiary, says Jim Branscome, a longtime fan of closed-ends and retired director of investment analysis at S&P, is Boulder Growth & Income (BIF). The fund has a third of its assets in Berkshire Hathaway, 11% in cash, and the rest in such blue chips as JPMorgan Chase, Caterpillar, and Walmart. Net unrealized gains account for 52% of assets. Much of the fund, Branscome notes, is owned by a an early investor in Berkshire, Stewart Horejsi, who reportedly began buying Berkshire after reading about it in John Train’s The Money Masters.
If nothing else, the prospects serve to highlight the charms of quirky, well-run funds trading at discounts whose managers continue to find opportunities in the market despite having vastly different views. Priest of General American follows a growth-at-a-reasonable price philosophy, looking to invest for three to seven years with corporate managers who are good capital allocators. He is a major shareholder of his fund.
General American recently added to existing positions in Anadarko (APC) and United Technologies (UTX), and eliminated Johnson Controls International (JCI) and Oracle (ORCL). Unless something goes “horribly awry” with the trade talks, says Priest, “there are still two more quarters at least of fairly significant earnings growth, and analysts estimates keep going up. As long as that’s the case, it will be tough to take the market apart.”
Meanwhile, Central Securities’ Kidd shares that he recently bought Capital One (COF) and Alphabet (GOOG), quipping, “Isn’t the argument that these are 21st century companies imprisoned in a 19th century accounting system?” Kidd himself believes that the market is risky today, but notes that “investments managers add most, if not all, of their value in bear markets.”
Ever since he took over Adams Diversified, Mark Stoeckle has read everything he can get his hands on about why discounts persist. He’s not holding his breath that a change in the tax structure will solve the problem. “As a rational person, that’s the most frustrating part. I’ve read everything there is to read. I won’t give this another thought until it gets closer.”
Write to Leslie P. Norton at firstname.lastname@example.org