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Before Mr. Merrill Met Mr. Lynch

George C. Fisher

Long before Mr. Morgan met Mr. Stanley, Mr. Dean met Mr. Witter, and even before Mr. Merrill met Mr. Lynch, individual investors were buying securities which had advantages similar to Exchange Traded Funds (ETFs). Who says ETFs are a completely new idea? They were called something different in their early days - closed-end funds listed on the major stock exchanges. According to Adams Express, "closed-end funds were essentially the only attractive vehicle for individual investors to participate in the equity market and several hundred were created in the late 1920s. Of those, forty-six survived the Depression and six remain in operation today."

Closed-end funds sell a predetermined amount of shares and the finite pool of equity is invested in stocks or bonds. The value of the equity is also known as the net asset value (NAV). The shares are then traded like stocks. ETFs and standard vanilla brand "open-end" mutual funds, on the other hand, can issue more shares as additional investors are lured in, and the extra cash is invested in securities. When investors want out of a mutual fund, assets can be sold to generate the necessary cash for redemption. ETF and mutual fund investors can buy and redeem new shares from the fund, while closed-end fund investors are buying from and selling to other investors. Closed-end fund assets can be managed, unlike most ETFs where a specific basket of stocks are usually bought and held. Closed-end funds do not have the same pressures to churn investments generating cash for fleeing investors. Since the closed end fund is not trying to attract new equity (as the fund is "closed"), there is no need for advertising and expenses are usually less. Another major difference is ETFs and open end mutual funds usually trade at their NAV. Closed-end funds can traded at a discount or premium to the underlying value of the assets based on investors' belief of future prospects of the specific investments.

One of the six remaining funds from the 1920s is Petroleum & Resources Corporation (PEO $28), which is traded on the NYSE. PEO is a corporation managing a $688 million portfolio of equities, mainly in the energy sector. Founded in 1929, PEO has a rich history of conservative investments and a focus on large to mid-cap stocks. Their investment goals are preservation of capital, income and long-term growth with low risk. The current manager has been at the helm since 1985. For the year ending 12/31/00, PEO generated a 33.8% after tax return (36.1% before capital gains tax liabilities), exceeding even the stellar return of 24.2% by the Dow Jones Energy Index. According to Morningstar's calculations (based on a 39.6% tax rate for income and a 20% rate for capital gains), PEO realized a 3-year after tax average return of 9.6%, and a 5-year after tax average return of 12.2%. PEO outpaced the S&P 500 by a whopping 43.8% in 2000.

PEO is 78% invested in energy, 10% in utilities, 10% in industrials, and 2% in other. PEO is currently 96% invested long term, with 4% of assets in short term investments and has historically held 3% to 5% in cash. According to Morningstar, 38% of its market capitalization is in medium cap, 30% in giant cap, and 21% in large cap companies. As of Dec 31, 2000, PEO held stocks in 63 companies, and the top ten assets comprised 43% of the NAV. PEO's top ten common stock equity investments, along with the percentage of net assets are:

ExxonMobil 7.7%
Royal Dutch Petroleum 7.6%
General Electric 4.0%
BP Amoco 3.3%
Anadarko Petroleum 3.1%
Schumberger 2.7%
Coastal 2.6%
BJ Services 2.0%
Chevron 1.8%
EOG Resources 1.8%

Other stocks with market values of over $7 million (equal to 1.0% of assets) held by PEO include: Shell Transport, Kerr-McGee, Equitable Resources, Nabors Industries, Transocean Sedco, Texaco, Total Fina Elf, Amerada Hess, Apache, Devon Energy, Ocean Energy, El Paso Energy, Energen, New Jersey Resources, Questar, Williams Co, Weatherford International, Duke Energy and Dynergy.

Overall, dividend yields in the 1990s were below historic levels. Dividend increases did not kept pace with the gains in stock prices, so yields declined. To goose up its own dividend payout, PEO has 10% of its assets in higher yielding securities, mainly Enron Convertible Preferred stock (7.6% of assets) and Calpine Preferred stock (2.0% of assets). Distributions from income were $0.39 in 2000, down from a 5-year average of $0.49. Portfolio turnover was low at 7% in 2000, which translates to lower phantom capital gains taxes due from investors. Capital gains distribution in 2000 was $1.35 per share. With the longevity of PEO and its historically low portfolio turnover, about $17 of its current $32 NAV is unrealized capital gains. Total fund fees in 2000 were 0.59% of assets, up from 0.43% in 1999 and higher than the 5-year average of 0.49%. Distributions from income and capital gains totaled $1.74 in 2000, up slightly from a 5-year average of $1.54.

Enough of the numbers. Although I usually abhor mutual funds, selected ETFs and closed-end funds can serve a very worthwhile purpose, at a small price. PEO is such an option. PEO's portfolio of assets is conservatively managed, includes mostly top quality companies and has a better tax efficiency than other funds. In addition, the fees are low. Most importantly, investing in PEO gives DRIP and direct investors easy access to a diversified portfolio of energy investments.

Unlike most funds, PEO has developed an interesting approach to share management over the past few years. Almost unheard of within the mutual fund industry, PEO split its stock 3 for 2 in year 2000. In Oct 2000, PEO was trading at around $42 a share. As mainly a retail investment, management believed the stock would be more attractive to retail investors at a lower price. Just like any corporation, PEO split its stock and the per share price was reduced according to a more affordable $28.

PEO is also in the midst of an unusual share plan for a fund - it is buying back shares on the open market. Since closed-end funds can trade at a premium or discount to the NAV, PEO established a share repurchase plan when the market price is greater than an 8% discount to the NAV. In 1999, PEO repurchased 43,000 shares at an average discount of 17% and in 2000 repurchased 848,000 shares at an average discount of 16%. According to the 2000 Annual Report, "the repurchase program initiated in 1999 appears to have served the intended purpose by increasing liquidity- and there was a narrowing of the discount during the year which may indirectly be attributed to the share repurchase." Like any reduction in shares outstanding, the value of the underlying assets per share increases, which in turn should increase the price of the stock. PEO allows for shareholders to accept additional newly issued shares in lieu of distributions, causing the number of shares to increase over the years. In 2000, PEO issued 760,000 shares into investors' DRIP accounts, and shares outstanding have increased from 19.5 million in 1996 to 21.4 million currently.

As of Feb 15, 2001, PEO traded at $28.55, representing an 11.8% discount from its NAV of $32.11. PEO's NAV discount has shrunk from year-end discounts of 18.3% in 1999 and 14.6% in 2000. The average NAV discount as the end of each year for the past 5 years is 12.3%.

Over the past 3 years, an investment in PEO has outperformed many of its oil industry competitors. I like to use the "what if I had invested…" tool found on ShareBuilder. This tool allows comparison of historic performance of a dollar cost averaging investment in competing investments. I prefer to look at minimum 3 years history, with an initial net investment of $500 and a net OCP of $100 a month, for a total investment of $4,200 (reinvestment of dividends are not calculated). A recap follows:

Company Value as of 2/15/01 Total 3-year return
Apache Corp (APA) $7,270 + 73%
Petroleum & Resources (PEO) $5,140 + 22%
Texaco (TX) $4,750 + 13%
Royal Dutch Petroleum (RD) $4,570 + 9%
S&P 500 Index (SPY) $4,570 + 9%
Chevron (CHV) $4,290 + 2%

PEO offers both a direct investing and a DRIP program administered by Bank of New York. There is a $500 minimum direct investment, which carries a $7.50 set-up fee and a $0.05 per share commission. OCP fees are $2.50, with a nickel per share commission. Reinvestments of year-end distributions are fee-free if made in newly issued shares. Fees have not been raised for 27 years (a longer time than most funds have been around).

DRIP investors looking for an easy way to diversify their portfolio with a single energy investment, and are will to accept a small amount of fees and capital gains tax, would be hard pressed to find a better conservative investment than PEO.

George Fisher, author of The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002) and All About DRIPs and DSPs (McGraw Hill, 2001), Sagamore Beach, MA

Copyright North Shore Associates 2001