General American Investors: A Superior Closed-End Fund

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 |  Includes: BRK, BRK.A, EPHC, GAM, SPY
by: Dan Plettner

One simple and effective strategy for closed-end fund investors is to choose index equivalent or outperforming funds at net asset value NAV discounts that narrow. The results can be dramatic.

Let’s assume the NAV of a certain closed-end fund doubles in an identical 8-year period to the S&P 500 index fund (NYSEARCA:SPY). Assume the closed-end fund investor bought at a 15% discount and can sell at the end of the period at only a 5% discount. This hypothetical closed-end fund investor would achieve a cumulative return 23.5% greater than the SPY investor.

The challenge to such a simple effective strategy is the identification of NAV discounts likely to narrow. Quoting the candid Phil Goldstein of Bulldog Investors in tempering the avoidance of some large discounts: “There is a price for everything.” The challenge of research is to assess the appropriate price.

General American Investors Company (NYSE:GAM) is currently a superior long-term alternative to investing in the S&P 500 (SPX) or core equity mutual funds. GAM closed Thursday at a 15.7% discount to its NAV. During the last 10 years, General American averaged only a single-digit discount to its NAV. Even more noteworthy, those 10 years were the “lost decade,” with equities generally out of favor. Today’s investors may be rewarded by a favorable future valuation.

Attractive Observations

General American’s portfolio generally avoids big banks. Such may be attractive to market observers that contend big banks are the target of both windfall taxation and additional detrimental political forces. GAM’s financial diversification is primarily in select insurers, which chief executive officer and portfolio manager Spencer Davidson likes for “strong liquid balance sheets at discounts to book (value)”.

The "invest in what you know" mantra may contribute to historical NAV performance. One of General American's holdings is an investment management company, Epoch (NASDAQ:EPHC). Davidson’s own company used to manage funds for institutions (pension plans) - Epoch’s business. Beyond understanding the business, conviction for owning Epoch is bolstered with an appreciation for the underlying talent of its CEO and senior portfolio manager, Bill Priest. I have no personal opinion on Epoch, but in determining whether to grant Davidson the benefit of the doubt in assessing asset managers, it is worth noting that Priest invests in Warren Buffett's Berkshire Hathaway (NYSE:BRK.A)

Through the 50-year period ending with tumultuous 2008, GAM outperformed the S&P 500 with its own double-digit returns both on NAV and market return basis. General American also publishes clear graphs depicting superior NAV and market returns in comparison to the S&P 500 over 5-year and 20-year periods.

GAM’s expense ratio is 0.87%. When considering the relevance of any closed-end fund’s expense ratio, it is very important to realize that in addition to obvious benefits, lower expenses should translate to fewer conflicts of interest.

General American buys back stock for the NAV-accreting benefit of all shareholders. On Wednesday, GAM announced the extension of its repurchase program for an additional 800,000 shares. During the past 14+ years, General American has bought back $412 million of its stock, at an average discount of 11.7% per each $1 million of stock purchased. NAV accretion is an important benefit which separates buybacks from insider purchases. In the scope of closed-end funds, the event of a buyback supplements NAV as it takes place, while insider purchases have no similar effect and (in theory) can accumulate voting power for entrenched management.

Catalysts

Shareholders assigning value or voluntary governance actions are preferred routes in narrowing a discount to historically normal levels. GAM existed when the Investment Company Act of 1940 was drafted with input from such companies. General American had the opportunity to organizationally internalize an appreciation of the Act’s long-term benefits to investors and managements alike. Good governance should now be ingrained in General American’s culture. By law, the primary goal of a closed-end fund is to serve its shareholders, and good governance sometimes requires reducing assets under management to do so. GAM’s announcements imply its willingness to do so.

Among Spencer Davidson’s titles, he is chairman of the board. During my interview with Davidson, he conveyed through discussion of specific topics and scenarios an ideal of exceptional corporate governance. If the current discount persists, it will be interesting to see whether General American actually demonstrates such ideals in practice. I will say this much: Spencer Davidson made a strong impression on me.

Disclaimer

Because the timing and likely catalysts are less clear, I have less conviction about the discount of General American one year from now. In my own portfolio, I use GAM for a less aggressive equity investing utility with broader diversification. All readers should remember that I am not their financial advisor. To the extent any article interests individuals, they should evaluate the article by discussing its merits with their advisor because free insights are often worth less than those you pay for. This article does not encompass everything I've learned about General American, which may have influenced my personal investment interest. While I have already done a significant amount of research into the subject of this article, I continue to aspire to learn more. I encourage commentary, and I certainly intend to remain objective into the future when evaluating any aspect of this subject material.


Disclosure: Long GAM, no other positions in securities mentioned