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CEF Specialist

Central Securities Presents Rare Investment Opportunity

Realizing a huge capital gain has put the share price and discount in the spotlight.

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Central Securities (CET) is, perhaps, one of the quaintest closed-end funds, or CEFs, 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 in what was perhaps 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, somehow, 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  J.P. Morgan Chase (JPM),  General Electric (GE), 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%. There has really been little to note about this fund for years, as it steadily went about its business, 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% since then. 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 14.3% discount. General American Investors (GAM) is trading at a 14.0% discount. Tri-Continental (TY) has a 13.3% discount. In this light, CET's three-year average discount of 17.6% 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 discount persists.

For Central Securities, this risk has been accentuated because of a brilliant investment made 31 years ago.

Plymouth Rock
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 recent press release. 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 securities' excessive portfolio weighting, and managers' inability to sell shares, it's no wonder that the fund has averaged such a deep discount for so long.
But things are changing and perhaps significantly.

Realizing a Capital Gain
On July 12, Central Securities announced that on or before Aug. 30, it will sell 35,000 of its 69,660 shares in Plymouth Rock back to the company. That's huge news for the fund, for its investors, and for short-term traders. Not only will the portfolio weighting of the insurance firm be whittled down to about 14%, but much of the unrealized capital gain "overhang" that has kept the fund in a deep discount will also go away. Furthermore, it is possible that the company will--in future years--buy back the remaining shares or, at least, the sentiment should shift toward discounting that possibility.

The fund notes that the realized capital gains will be included in the normal distribution of such net gains at the end of the year. Central Securities typically makes such distributions in mid-November.

From the press release and the annual report, it is possible to determine that the cost basis of the Plymouth Rock stake is $31.36 per share. They are selling 35,000 shares for $2,650.00 each. This means that, from the sale of Plymouth Rock, the fund will realize capital gains of about $91,652,375, assuming that they are using average cost as the cost basis. To maintain its tax-exempt status as a closed-end management company, the fund will need to distribute 98% of that realized gain to shareholders. Therefore, each shareholder--based on the number of shares outstanding as of the annual report--will receive $3.87 per share in realized gains. This is, of course, before netting any realized losses and other realized gains in the portfolio. But, all else being equal--and the portfolio's historic low turnover rate suggests that the eventual distribution won't be too far from the mark--$3.87 will be distributed.

Opportunity
Once that distribution is made, it is highly likely that the discount on the fund's shares will decline and perhaps dramatically. If you've looked at CEFs for any length of time, you have probably realized that after a large distribution--even a one-time distribution--less-aware investors will flock into a fund, irrationally narrowing the discount excessively. Essentially, they see a posted distribution, do no homework, and simply buy shares in the errant belief that the distribution will continue to be high. This is sheer ignorance, especially when even a bit of scratching would reveal that the distribution was a one-time event. Still, it happens regularly.

 

Let's assume that the fund has the $3.87 distribution from the Plymouth Rock sale and $0.13 more to distribute for a total of $4.00 per share. Let's further assume that the net asset value remains relatively stable at $27.50 and the discount persists at 18% for a share price of $22.55 just before the fund's ex-dividend date. After the distribution, the net asset value will fall to $23.50 per share and, if the 18% discount persists, the share price will be $19.27. Investors who bought the shares at $22.55 would then have a return of 3.2% ($19.27 plus $4.00 of distribution, divided by $22.55).

However, let's say that for a brief day or two, the fund's discount narrowing overshoots itself and after the distribution the discount goes to 10%. Given the same parameters as in the previous paragraph, the net asset value would fall to $23.50 per share and the share price would be $21.15. Under this scenario, short-term opportunistic investors could reap a return of 11.53%.

Now, there are several assumptions here, not including the fact that the net asset value and share price will surely change between now and the ex-dividend date. Still, an opportunity does exist, though it is not without risk and may not present enough of a reward to entice many investors.

As to when the discount will narrow--if it indeed does--there are two arguments (and we've been discussing this around the desk for days). On the one hand, because Uncle Sam will want his bite of that $4.00 distribution, it is possible that this wide discount will persist until the distribution is made. On the other hand, some investors--including individual investors using tax-exempt and tax-deferred accounts--may not wait around for the realized gains to be distributed. They may start investing right away to ensure that they receive the distribution. In fact, Central Securities' discount has already narrowed from 21.1% on the day of the press release to about 18.2% on July 19, suggesting that in recent days the marginal investor is eager to buy shares now.

Risks
There are at least two risks to the opportunity. First, among the assumptions above, the net asset value could fall significantly between now and the ex-dividend date, which would make meaningless the amount of the discount. For instance, if the net asset value were to decline by 20% between now and the ex-dividend date, then even if the shares were trading with a 0% discount, the return would be negative. One could, at least in theory, buy puts on a broad equity market exchange-traded fund or simply short the market in order to short this risk, but that's not always practical--and can't be done in a nonmargin account.

Second, the discount may not narrow or may increase even if the NAV remains steady. However, keep this risk in perspective. If both the net asset value and share price were to lose $4.00 per share after the distribution, everything else remaining the same, the NAV would be $23.50, the share price would be $18.55, and the resulting discount would be 21.1%, which is about as wide as it was prior to this announcement. It would seem to me that the lowering of portfolio risk by selling down the Plymouth Rock stake would lower the discount, but still one never knows what other market factors could widen the discount for any CEF.

Conclusion
The selling of a long-term holding at a significant gain is always big news. Right now, Central Securities is offering long-term investors the potential to invest at a time when a very large unrealized capital gain in its portfolio is about to go away. There are, to be certain, other unrealized gains in the portfolio aside from the remaining stake in Plymouth Rock. The annual report listed $247.7 million in unrealized gains ($10.67 per share) as of Dec. 31, 2012. The realization of the capital gain and the reduction in the Plymouth Rock portfolio weighting are likely to narrow the fund's discount. Other long-time, equity-focused CEFs are trading at about a 14% discount, so it's not unreasonable to expect Central Securities' discount to settle down in that area, though a short-term tightening lower than 14% is possible, as mentioned above.

More opportunistic investors with shorter time horizons should also now be interested in this fund, as the excitement over events works to tighten the discount.

In 2014, Central Securities will likely go back to being a sleepy, quaint equity-focused CEF. For the next four months, though, its shares are in play.

Mike Taggart does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.