Chapter 10

Two Short Cuts To Growth Profits

Short cut no. 1:Sbic—The Investment Fund With Built-In Growth

What if you can afford neither the time necessary for developing your own portfolio nor the expenses involved in professional management? A new investment vehicle called SBIC (Small Business Investment Company) might be your answer.

An SBIC is a finance company organized under the Small Business Investment Act of 1958. This was specifically designed to stimulate the growth of the nation's economy by supplying small businesses with private equity capital and long-term loans. In addition, SBIC's offer unique tax advantages plus a degree of leverage on invested capital not found in any other form of investment.

Growth-Insurance in SBIC

SBIC's have two unique built-in growth features: (1) a high leverage factor; (2) tax shelter. "The high leverage factor," in the words of Hanns E. Kuehner of Laird, Bissell & Meeds, "rests in the Act's provisions for an SBIC's capitalization. Private interests need a minimum equity of $150,000 of their own in order to obtain a like amount by selling 5 per cent debentures to the SBA (Small Business Administration). Having thus a minimum paid-in capital of $300,000, an additional $ 150,000 may be borrowed at 5 per cent from the SBA and four times the amount of paid-in capital or $ 1.2 million in private, nongovernment funds. An original investment of $150,000, therefore, creates a borrowing as well as lending capacity of $1.5 million or ten times as much."

In addition to this high leverage factor SBIC's enjoy the following unique tax advantages as summarized by Filor, Bullard & Smyth analysts:

(1) Should a stockholder of a privately or publicly owned SBIC sell his shares at a loss, he may offset this loss against his ordinary income to the full extent of the loss, rather than as an offset against a compareable capital gain. This particular tax feature is of relatively greater significance to the individuals in the higher income tax brackets.

(2) Realized gains on the sale of SBIC shares are taxable at the usual capital gains rates, i.e., long or short term.

(3) Should an SBIC incur a loss on one of its investments, it may offset this loss against ordinary income instead of against capital gain.

(4) Any   SBIC may elect to be taxed as a regulated investment company under the Investment Company Act of 1940. If such an election is made there is no corporate income tax on the amounts distributed to shareholders as ordinary dividends provided that at least 90 per cent of the SBIC's gross income is derived from interest, dividends and capital gains, and is distributed to shareholders (certain other provisions not discussed).

(5) Dividends received by an SBIC upon stock of a domestic small business concern is nontaxable (except in a year in which the SBIC elects and qualifies to be taxed as a regulated investment company).

No wonder the number of SBIC's licensed by the SBA reached 260 by June, 1961, as compared with 175 at the 1960 year-end or only 61 at the 1959 year-end.

The Newest Banking System

This dramatic growth of SBIC's is basically due to the unprecedented demand for long-term equity financing by business concerns to keep pace with the rapid expansion in the nation's economy. Before the appearance of the SBIC's, small companies had a difficult time in obtaining adequate financing. Realizing the vital importance of small business to the nation's economy, Congress passed the Small Business Investment Act of 1958, authorizing the establishment of a new type of small business banking institution—the SBIC.

To qualify, an SBIC should (1) be privately held and not dominant in its respective industry; (2) have total assets not in excess of $5 million; (3) have a net worth not in excess of $2½ million; and (4) not have had annual earnings after taxes averaging over $250,000 for the preceding two years. Of the estimated 4.7 million business establishments in the U.S., over 95 per cent of them qualify as SBIC's, indicating the tremendous growth potential in this investment medium.

Initially, an SBIC was allowed to finance small companies only through the purchase of convertible debentures or by making long-term loans. Now, they may invest through various other means: common stock, debentures with or without conversion features, some form of debt with common stock warrants. Formerly not allowed, investments can now be made in companies whose securities are traded on stock exchanges or over-the-counter.

Growth with a Shelter

Generally speaking, the convertible debenture is still the most popular form of investment medium. Typical is the way Electronics Capital Corporation (the first licensed SBIC) made its first commitment by buying $750,000 in 8 per cent convertible debentures of Potter Instrument Co., which were convertible into 333 per cent of total common stock. Because of this conversion feature, Electronic Capital Corporation is assured of a direct participation in the growth of its invested firm.

In addition to providing participation in the possible growth of the associated company through the conversion feature, the convertible debentures supply a steady source of income to pay an SBIC's operating expenses. Moreover, the major SBIC's have

A LIST OF REPRESENTATIVE SBIC'S*

                                                            Approx.  Premium  Assets     % of
                                          Issue          current     or            in             capital
                                          price           price        discount   millions    invested
Boston Capital Corp.          15.00         l83/4       125%      21.3        32%
Business Funds, Inc.           11.00         l0½         95%        19.6        3%
Capital for
Technical Ind., Inc.             10.00         l33/8       134%      7.7          33%
Electronics Capital Corp.    27.00         285/8      106%      33.3        41%
Electro-Science
Investors, Inc.                     11.00         273/4      252%      14.9        47.8%
First Small Bus. Inv. Corp
of N.J.                                12.50         13s          109%      3.7          33%
Florida Capital Corp.            8.00         8½          106%      10.5        61%
Franklin Corporation          10.00         l62          165%      9.6          42%
Greater Washington
Ind. Inv. Inc.                       10.00         20           200%      5.0          64%
Growth Capital, Inc.           20.00         32½        163%      10.6        76%
Gulf Southwest Corp.         12.00         93/8        78%        16.7        81%
Marine Capital Corp.          15.00         l3¼         88%        10.1        16%
Mid-States Business
Capital Corp.                     11.00         l3½         123%      2.7          42.4%
Midland Capital Corp.        12.50         158         121%      16.6        34%
Narragansett Capital
Corp.                                 11.00         12¾        116%      5.5          52%
St. Louis Capital Corp.       10.00         75/8        76%        7.2          8.5%
Science Capital Corp.           8.00         63/4        84%        3.9          0%
Southeastern Capital
Corp.                                 12.50         9             72%        6.1          2.5%
Techno Fund, Inc.              12.50         9½          76%        5.2          l34%
Texas Capital Corp.             7.75         9½          123%      9.8          40%
Water Industries
Capital Corp.                     11.00         97/8        90%        5.0          0%

*A list of representative SBIC's compiled in November, 1961, by Troster, Singer & Co.

† Qualified for a SBA loan after 100% Investment of original Capitalization. been very selective in their investments and so far only made use of a comparatively small portion of their lending capacity. While in the process of ferreting out attractive situations, their funds are largely invested in government securities, with yields generally sufficient to defray operating expenses.

The Diversified Portfolio

Since most SBIC's are venture capital minded, they are basically speculative in nature. Their portfolios are made up of younger companies with their greatest growth potential ahead. This gives investors a safe way to participate in the glamour issues of the day. At the same time, it reduces risk through diversification and professional management.

While the majority of SBIC's will place their capital in any attractive area without regard to industry, some seek to concentrate in specific industries such as real estate, electronics, or other new technological areas. Generally speaking, SBIC's should give investors a diversified portfolio of possible rapidly growing situations.

Short Cut No. 2: Management Companies-New Master Key To Growth Profits

Similar in certain aspects to SBIC's are mutual fund management companies. These should not be confused with mutual funds. They are managers of the funds, with their chief sources of income coming from the management services they provide.

Few investors seem to be aware of the existence of some sixteen publicly held mutual fund management companies, most of which have come to the market in the last two years. During this short period of their existence, they have experienced an outstanding growth record, comparable to any of the growth industries. That's why management company shares were priced at high earnings multiples 30 to 40 times 1959 earnings.

A number of factors have brought about their subsequent decline in market evaluation, with most shares, as of March 1961 available at about 15 to 20 times estimated 1961 earnings. Among them are adverse effects from a falling stock market, low level of new mutual fund share sales, and growing criticism of their contractual relationship with mutual funds. However, the current  market  evaluation  has  overlooked   the  excellent  growth  potentials of the industry in favor of the troubles which may beset the group at some future time.

The basic growth prospects of management companies is, of course, based on the continuously excellent growth potentials of the mutual fund industry which is expected to keep outgrowing its competitors for savings because of its basic advantages of diversification and professional management. With its net assets estimated by Oppenheimer analysts to expand at 15 per cent compounded for the next five years, the industry should still be one of the fastest growing areas of the United States economy.

Evaluating Management Companies

In examining mutual fund management companies, expert analysts utilize five "salient yardsticks" which they consider essential to the evaluation of an equity investment: (1) quantitative earnings growth; (2) qualitative earnings growth; (3) management; (4) sociology of stock ownership; and (5) timing and value.

Of special importance is, of course, the earnings growth pattern. Accounting for the major portion of management company income were the management fees which it considers are more desirable than earnings from distribution activities, the latter being the other main source of revenues.

Management company earnings are made more attractive by the fact that there may never be a need for new equity money, or even retained earnings. This is a service industry with virtually no plant or equipment required for operation.

Specialized Funds—Which One Looks Best?

The types of mutual funds most investors deal with is, of course, the load-type. There is another type which is no-load in nature. It is marked by absence of the load charge, or sales commission charged by most open-end investment companies. Ranging from 6 to 9 per cent, this charge is included in the offering price of mutual fund shares.

About 10 per cent of mutual funds are the no-load type, with Energy Fund Inc. attracting the most recent attention.

While most no-load funds are of the balanced type, Energy Fund specializes in industries operating in the energy fields. It was founded by a group of private investors headed by Mr. Ralph E. Samuel, senior partner of the firm of Ralph E. Samuel & Co., who believe that energy is an integral part of all economic and technical progress.

Energy Fund has stressed from the very beginning the use of scientific consultants to ferret out significant developments in the various fields of applied science. The management relies heavily on outside experts to keep it up-to-date on broad industry trends. Its brain trust includes such people as Dr. Albert M. Stone of the Applied Physics Laboratory at Johns Hopkins, Dr. Mirek Stevenson of Samson Associates, a consultant in physics to IBM, etc. It calls on Arthur D. Little, Inc., for the evaluation of new products and processes, while all investment ideas are cleared through the research staff of Goodbody k Co.

"With capital gains its prime target," said Financial World, "the fund's portfolio is weighted heavily with growth stocks in the various fields relating to energy. Some balance is provided, however, by large holdings of utility, oil and gas issues, which have defensive characteristics as well as growth possibilities. The star performers in the Energy Fund have been stocks from fast-expanding areas of high technology—electronic data processing, microwave, infrared, cryogenics, fuel cells, semiconductors and similar glamour industries."

A Significant Trend

Another recently organized investment company is the Oppen-heimer Fund. It is designed to operate as freely as any sophisticated individual investor. It can sell short, borrow money for leverage, or place 25 per cent of its assets in one security.

The emergence of such special-type funds as Oppenheimer illustrates an interesting trend among newcomers to the industry. The traditional emphasis on well-rounded portfolios for small and medium-seized investors, with primary emphasis on safety, is shifting to a more aggressive search for capital gains.

This trend away from the conventional funds not only reflects the effort to attract customers in the higher brackets, but also points up the mounting competition in the industry. For example, Revere Fund slants itself toward the securities of smaller growth companies not tied too closely with the over-all economy, placing heavy emphasis on companies producing consumer specialties. Samson Convertible Securities and Capital Fund invest chiefly in convertible debentures. Eurofund, Inc., specializes in European securities.

Stock-Swap Funds

Deserving special mention are the so-called stock-swap funds which offer their shares in a tax-free exchange for individual holdings. The swap fund idea was conceived in 1960 to help investors who are locked into large capital gains. Individuals who participate are allowed to exchange securities that have shown considerable appreciation for shares in this type of mutual fund without paying any immediate capital gains. In this way, the investor may quickly diversify his assets while postponing his tax liability or spreading it over a period of years.

The swap funds are made possible by Section 351 of the Internal Revenue Code, which permits tax-free contributions of assets when a new corporation is formed. So, once the organization period is over it no longer issues new shares in exchange for stock, as different from most mutual funds which make continuous offerings of new shares.

The swap plan works like this: in trading, the fund accepts what it rates as choice issues. It then puts them in escrow while assembling a complete portfolio. The investor can look over the lineup before making his decision. If he doesn't like the stocks chosen or the diversification he is free to refuse them. Acceptable stocks are listed in a prospectus, and the choice is usually very wide.

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