Realizing a huge capital gain has put this closed-end fund's share price and discount in the spotlight.
A version of this article originally ran as a CEF Specialist on July 30, 2013.
Central Securities CET is one of the quaintest closed-end funds that you'll ever come across. This wasn't always the case. On Oct. 1, 1929, the firm began operating as a closed-end investment company with maybe the most inauspicious launch of a fund in history: Black Thursday, Black Monday, and Black Tuesday all occurred within a month. Somehow the firm persevered, and perhaps the experiences of its early days still influence the culture.
It is, after all, a rather sleepy equity CEF in this day and age. There is nothing that most investors would consider to be excessively risky or controversial about the fund. There are no covered-call overlay strategies. There is no leverage. There is no inflated, return-of-capital-fueled distribution rate. Instead, there is a portfolio stocked with blue-chip equities, such as Intel INTC, Bank of New York MellonBK, and Walgreen WAG. The portfolio managers are value-oriented investors who tend to hold securities for years, if not decades. In the past five years, the portfolio turnover rate exceeded 10% only once--in 2008 when it jumped to 11.04%. As it steadily went about its business, there has really been little to note about this fund for years, except for its discount. And that's where things could get very interesting very soon.
The Reason for the Persistent Double-Digit Discount
At Morningstar, we have a massive database on CEF information. For Central Securities, our historical data on discounts goes back to 1980. A lot has changed since then, especially for closed-end funds. But even if we go back to the summer of 2003, which gives us 10 years' worth of data, Central Securities has never traded with a discount narrower than 4.7%. In fact, during that 10-year stretch, it has traded with a discount between 4.7% and 26.5%, averaging 15.7%. That's pretty remarkable, even for an old-school equity CEF. Most CEFs will trade with both a premium and a discount over a market cycle. So why have investors shunned the shares?
Most equity-oriented CEFs that do not have an income component trade at discounts. Adams Express ADX is currently trading at a 14.6% discount. General American Investors GAM is trading at a 14.4% discount. Tri-Continental TY has a 14.5% discount. In this light, Central Securities' three-year average discount of 17.5% looks fairly ordinary. Such funds tend to trade at these discounts because they have unrealized capital gains that, when realized, will be passed along to investors. New investors are facing tax risk on those as-yet unrealized gains and, therefore, are unwilling to pay full freight to buy the funds. Hence, the deep discounts persist.
For Central Securities, this risk has been accentuated because of a brilliant investment made 31 years ago.
Back in 1982, Central Securities invested in a newly founded, privately held insurance company called Plymouth Rock. That firm underwrites and services auto and home premiums in New England. At a cost basis of $2.2 million, the holding is now valued at nearly $185.0 million, based on the fund's annual report and a press release in July. However, this is an illiquid holding. While that makes it perfect for an investment in a CEF, it also makes it extremely difficult to sell. Essentially, the fund has been stuck with this holding. Between the unrealized capital gains on Plymouth Rock, the security's excessive portfolio weighting, and managers' inability to sell the shares, it's no wonder that the fund has averaged such a deep discount for so long.
But things are changing and perhaps significantly.