Doing One Thing Well

To call General American Investors quaint is an understatement. Created in 1927, GAI was one of the original closed-end funds -- that is, a fund that trades on an exchange just like a stock. The firm that runs GAI does only that: It manages no other mutual funds (closed-end or traditional) or private accounts, and it does not offer investment advice. In its nearly 80 years of existence, GAI has had just five managers. The cozy midtown-Manhattan office of the current manager, Spencer Davidson, is the same size as those of GAI's analysts and other professionals. The typical GAI shareholder is something of a throwback, too. GAI investors tend to hold on to shares for generations, says Davidson.

But there's nothing quaint about the fund's record. Over the past ten years through 2005, a period that coincides almost precisely with Davidson's tenure, General American (symbol GAM) gained an annualized 15% on assets, six percentage points per year more than the return of Standard Poor's 500-stock index. (Because a closed-end's shares move independently of the value of the fund's holdings, performance is measured both on the basis of assets and on the moves in the share price; return on assets is a better barometer of a manager's skills.)

Davidson, 63, and his colleagues enjoy their privacy and rarely grant media interviews. But General American, which holds $1.3 billion in assets, has traded at a double-digit discount to its net asset value per share for three years, and its mid-January price of $36 represents a 12% discount to the value of its holdings. Sometimes a little publicity does wonders to stoke interest in undiscovered gems such as GAI. And that can narrow the discount.

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This unusual fund and Davidson's approach to stock picking were the subjects of our conversation on a winter day at General American's offices, around the corner from Grand Central Station.

KIPLINGER'S: You've compiled a terrific record at General American. What's your secret?

DAVIDSON: We look for exactly what everyone else does: growing companies with strong balance sheets, terrific management and stocks that we can buy and hold forever and never have to pay any taxes on. Our turnover averages 20% a year. What differentiates us is that we take full advantage of the fact that we're a closed-end fund. Our assets don't disappear, so we are not especially affected by market volatility. And our time horizon is much longer than that of most funds. So we can be opportunistic by buying when others are selling, without concern about near-term price action.

How would you characterize your style? We buy growing companies at reasonable prices. Compared with the SP 500, our holdings tend to exhibit stronger growth and have stronger balance sheets, but the price-earnings ratios of the stocks tend to be lower. Everything here is analyst-driven -- our six individual analysts really run the portfolio -- and we tend to focus on four categories: retail, health care, finance and hard assets.

Speaking of hard assets, one-fourth of the fund is in energy stocks. How did that happen? We started boosting our position in the group roughly 18 months ago. We observed that energy stocks were only 6% of the SP 500, but their contribution of earnings and cash flow to the SP was a multiple of that. And we remain overweighted in energy. Currently, energy stocks account for roughly 9% of the index and contribute almost two times that percentage in earnings and cash flow. Our long-term view is that other investors will see things our way and that the stocks will once again reflect their proper weighting in the index.

Do you make decisions on big-picture thinking, or do you assemble your portfolio on a stock-by-stock basis? It's a combination of the two. Within the top-down call on energy, we've been highly selective, emphasizing domestic natural-gas companies and oil-well-services companies.

How about an example of an energy stock you like? A good one is Weatherford International (WFT). We started paying attention to it about a year ago, when the company announced it would buy the energy-services and international-drilling businesses of Precision Drilling. We've owned Halliburton (HAL), a big energy-services player, for some time, so we know that many of the countries that own oil are starting to take on more projects on their own. In order to do that, they need more support from the service companies. The deal with Precision Drilling gives Weatherford the assets and technology to offer one-stop shopping internationally.

What's your favorite gas stock? It's hard to pick a favorite. We rank stocks on the basis of price to free cash flow [the cash that's left after making the capital expenditures needed to maintain a business], and we view $1 of free cash flow as the same, whether it's generated by Microsoft (MSFT), which we own, or Weatherford -- or Apache Corp. (APA) and Devon Energy (DVN) in exploration and production. Apache's got more oil and Devon's developing heavy oil, so we're not religious about owning natural gas only.

How long do you see this energy cycle lasting? My view is that we're not running out of oil and that there's plenty of it. But energy companies have underinvested for quite some time, and it's probably going to take three to five years before supply catches up with demand.

How will you know when it's time to sell your energy stocks? I think the signal will probably come from excessive developments in the stock market rather than from the fundamentals of the companies. In other words, we'll sell when the stocks get overpriced.

You also have a big stake in financial stocks. It's our largest sector, and it's mostly in specialized insurance companies, such as Everest Re (RE) and PartnerRe (PRE), Bermuda-based reinsurance companies. These are companies with established long-term records and excellent credit ratings, and we felt that they were undervalued. Interestingly enough, the reason we got involved with Halliburton had nothing to do with oil prices or rigs. Its stock had fallen because of concerns over asbestos exposure. Our insurance analyst put us into Halliburton after concluding that the company's liabilities were so overly discounted that you could essentially buy Halliburton's entire energy business for free.

To switch gears, you own a fair amount of Pfizer, which has been a miserable performer. We've owned Pfizer (PFE)for years. Our continuing to hold it represents our value shoes. The stock yields a lot. It's one of only eight industrial companies in the SP 500 with triple-A bond ratings. We like management, and everyone knows what the bad news is, particularly all the patents that are expiring. What we don't know is what $7 billion a year in RD will generate in the future. But at these levels, we're willing to bet that it's more likely than not that all that spending will generate some good things.

And talk about a blast from the past. What's the case for Xerox, one of your most recent purchases? For starters, Xerox (XRX) has solved some operational problems and we expect its bond rating to be upgraded from non-investment grade to investment grade. That will lower Xerox's borrowing costs. On the product side, we expect a big increase in sales of color copying machines. By 2007, the growth in color machines is likely to offset declines in black-and-white copier sales. Profit margins on color products will be higher than on black-and-white products and, because this is a classic razor/razor-blade business, the gross profit margins on the ink and the paper and on servicing will be much higher than the margins on the machines themselves. So Xerox has an improving financial structure and a new product cycle. We've got an attractive entry price for buying the stock, and again, because of our closed-end structure, we don't have to worry that we're a quarter or two early.

Let's turn to General American's structure. You're allowed to leverage your assets? Yes, we have issued $200 million worth of preferred stock with a 5.95% coupon. It trades on the New York Stock Exchange and is rated AAA.

So in essence you've borrowed that money and invested it. Yes, we are effectively 115% invested.

Was your ability to sell stocks short a major reason General American held up as well as it did in the first two years of the bear market, gaining 20% on assets in 2000 and losing just 2% in 2001? Yes. There was a sense that things were getting out of hand with tech stocks, and we just said, "Enough is enough."

Do you currently have any short positions? No.

Your third-quarter shareholder report indicates that you sold call options on the shares of Devon Energy in your portfolio. This was an effort to get a better price for an energy stock that had grown to 6% of our portfolio. We ended up buying back the calls and realizing a short-term loss, then using that loss to offset short-term gains that arose when another energy-stock holding, Unocal, was taken over.

You also hold shares in something called Silicon Genesis, which doesn't seem to be publicly traded. We are permitted to invest in nonpublic companies. When the bubble broke, we still had two tech analysts. They didn't have a lot to do, and I foolishly thought that there might be some opportunities in the private market. So we put a total of $6 million into two private placements, neither of which has panned out and neither of which is reflected as an asset in our net asset value.

Have you ever thought of expanding your empire by, say, launching a series of open-end funds? No, although it would not be a difficult thing to do: Spin off a management company, promote our record, give the executives -- that is, me -- a lot of stock in it, and then go raise a couple of billion dollars. We will continue to approach our jobs the old-fashioned way. We make plenty of dough. Our assets are large enough to support a very serious, very rigorous research effort, and the proof is in the pudding.

TOP TEN: General American

These are General American Investors' ten biggest holdings as of September 30, 2005.