Making Performance Distinctions

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Smart investors can predict whether a company will gain or lose value due to the kind of stock in which it places its assets. The most obvious need for the investor is recognizing the distinction between common stock funds and balanced funds.

The latter maintain a substantial part (at least 35 percent) of their assets in bonds and preferred stocks of investment quality. In consequence, when common stock prices rise rapidly, balanced funds are not able to improve their net asset value in the same degree as common stock funds, other things being equal. Conversely, when common stock prices fall substantially, a balanced fund should be able to show a greater measure of stability.

A clear line of distinction must be drawn between investment companies with a one-class-of-stock capitalization and those employing bonds and preferred stocks in their capital structures. As the purpose of leverage is to accelerate the gains accruing to common stocks by the use of senior funds, common stocks of leverage-type investment companies may be expected to advance more rapidly in a rising stock market than stocks of investment companies with only common stock outstanding. In a falling stock market, the net asset value of common stock of a leverage-type investment company will decline more rapidly.

There are other distinctions of less fundamental importance. Companies that concentrate heavily are likely to show greater changes in asset value than those which distribute their resources more evenly over a wider range. This is the land of distinction that separates diversified from non-diversified companies. There are also the specialized types of investment companies—such as those investing in bonds alone or only in the common stocks of a single industry, such as air transport or farm machinery.

The following illustration emphasizes the importance of not shifting policy lightly. An investment company charter contained a provision that no more than 35 percent of the port–folio would go into the stocks of any one industry. Presumably, this provision was the outcome of careful consideration and was of some significance to investors.

The underlying principle was clear: if one industry constituted too large a part of the value of the portfolio, the investments would be more concentrated than might be desirable. In this instance, the investment company had a large position in oil stocks, bought at low prices in terms of later quotations. The prices of the oil stocks had risen under the impetus of improved earnings and fears of inflation, and also because of concern about possible shortages of petroleum products. When the market value of the oil stocks owned rose to substantially over 35 percent of the value of the investment company's assets, the company did not liquidate enough of this group to cut the total below the percentage stated in the charter. Instead, stockholders were asked to eliminate the restriction, and the change was approved. Some years later, oil stocks lost favor, and their prices declined materially.

This market change, however, is not the point at issue. Rather, when the provision limiting investment in any one area of the economy came to the point of genuine test, when—for the first time in 20 years—the provision had real meaning, it was abandoned.

The framers of the Investment Company Act regarded a change in general policy as a matter of great importance. Although a registered investment company's charter powers are sufficiently broad to permit radical changes in its policies without notice to, or consent of, its shareholders, the act requires that the consent of the majority of its outstanding voting securities be obtained before changing any of the fundamental policies of an investment company as given in its registration statement.

Investors must be careful to read the fine print and make sure they understand exactly how their money is being used. If they aren't careful, they could end up in a bad situation with a portfolio that is too heavily weighted in one industry.

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