Late last year, we looked at a situation that very much resembled a leveraged buyout opportunity in which ordinary investors could partake. Today, we look at an opportunity in another area that retail investors are usually blocked from: venture capital. But in keeping with the value mantra, there is one special characteristic of this investment that makes it appropriate for this site: the company trades at a large discount to its investments.
Capital Southwest (CSWC) is a "venture capital investment company whose objective is to achieve capital appreciation through long-term investments in businesses believed to have favorable growth potential." But while the company trades for just $370 million, it has net assets of $514 million, giving investors the opportunity to participate in the equity of the underlying companies at a rather large discount.
Of course, as with any investment, there are specific risks of which investors should be aware. Valuing companies with steady cash flows is hard enough (as proof, consider the wild stock market fluctuations from year to year of even the most stable of corporations), but valuing young, development stage companies is even harder. There is no public market for most of Capital Southwest's investments, and therefore it's hard to know the margin of error surrounding that $514 million number quoted above; it's entirely possible that there is no margin of safety, or conversely, that the margin of safety is much larger than we think!
This company's investing policy also appears a bit mixed, as it doesn't really stick to its "venture" mantra. It also looks for companies with positive cash flow, which is rare in the venture capital space (hence the need for direct investment). As a result, Capital Southwest also owns a number of public companies, including Heely's, which has been discussed on this site as a potential value play.
It's also possible that the company will trade for a discount to its investments eternally, or at least for a very long period of time. But shareholders should still benefit from the discount as long as net assets grow (which, of course, is far from guaranteed); if net assets grow 10% for example, then an investor who buys at a 50% discount sees a return of 20%. It should also be noted that Capital Southwest was trading without any discount as recently as mid-2008, which may help reassure those who fear the dreaded "eternal" discount.
To protect ordinary investors from themselves, securities regulations make it very difficult for regular investors to invest in venture capital funds. But through public company Capital Southwest, ordinary investors can indeed participate in venture capital, and at a large discount to the approximated fair value of Capital Southwest's net assets.
Disclosure: None
Monday, March 7, 2011
Sunday, March 6, 2011
You Can Be A Stock Market Genius: Chapter 4
While spin-offs can lead to success (as discussed in the previous chapter), risk arbitrage is a loser's game, argues Greenblatt. Whereas investors used to be able to make money by buying stocks of companies with announced takeovers, that is no longer the case. Competition has reduced the spreads between current prices and the take-out prices, resulting in a lot more risk (as a result of financing falling through, buyers who change their minds, macro events etc.) than the rewards warrant. Greenblatt has had a few "sure-thing" lookalikes fall apart, and strongly advises against risk arbitrage.
However, that doesn't mean Greenblatt thinks one can't make money from mergers; it just has to be done in a different way. Greenblatt advises readers to scrutinize special merger securities. These are securities that are often thrown into merger deals as "sweeteners" to top a bid or convince shareholders to sell, without actually requiring further financing. For example, a buyer may offer cash plus stock plus some combination of warrants, preferred stock or convertible debt to shareholders of the target. It is the warrants and other non-cash, non-stock securities that Greenblatt says often get overlooked.
The idea behind this market inefficiency closely resembles that of the spin-off: shareholders receiving such merger securities often sell them, pushing their prices down in relation to their values. Like a spun-off company, merger securities are often not desired by receiving shareholders; for example, they often fall outside the mandates of the funds that receive them. As such, investors can purchase these (after having done the research on them, of course) after the merger has taken place, thereby avoiding the major risk: that the merger won't close.
Greenblatt takes the reader through a few examples where he has been able to purchase discarded warrants and preferred shares for a discount, as they were sold by shareholders who received them as part of a merger transaction.
Saturday, March 5, 2011
You Can Be A Stock Market Genius: Chapter 3
In this chapter, Greenblatt explores the world of spin-offs. The first point he makes is that spin-offs themselves generate above-average returns for investors. There are many logical explanations for this phenomenon, including the fact that owners of the parent company don't often want the spin-off as it may not be in the right industry or may not be of a size consistent with the investment mandate. This causes a sell-off of the spun-off company, resulting in an abnormally reduced price. As a result, investors tilt the odds in their favour just by venturing into this area.
With a little more work, investors can enhance even the already high returns that accrue to spin-offs by picking their spots, Greenblatt argues. He takes the reader through several examples of spin-off opportunities where prices appreciated strongly in subsequent periods due to market inefficiencies.
There were several recurring themes in the examples. Greenblatt looks for spin-offs where insiders own a lot of the stock of the new companies. He argues that managers will set themselves up for big returns, and so potential shareholders should look to align themselves with managers when possible.
Greenblatt also advises readers to look at the parent company of a spin-off as well. During partial spin-offs, for example, parent companies can trade at very low values relative to their ownership in the spun-off company.
Friday, March 4, 2011
Insider Trades vs Swaps
Where management has a significant portion of its net worth invested along with shareholders, agency costs are likely to be at a minimum. Shareholders can easily determine how invested management is in a company by looking in the same place that a company's executive compensation can be found. Unfortunately, the use of equity swaps, becoming more common in the financial world, can render the information on management's stake in the company essentially useless.
Equity swaps are a financial innovation that allows one party to swap the returns of one asset for the returns of another asset. Consider an example of how this might be useful:
Andre Preneur started a company from scratch, and recently took it public. His net worth is now several hundred million dollars, but all of his wealth is invested in just this one company, a risky portfolio no matter how strong the company. Andre has family commitments and wants to lock in some of these gains, however, as this undiversified portfolio could result in a significant loss of capital should something go wrong. Selling 20% of his holdings in order to diversify would drag down the stock price, hurting all investors in the process. But a swap in which he trades the returns on a portion of his holdings to a dealer that pays him the return on the S&P 500 (minus a fee) allows him to achieve some diversification without high transaction costs.
Clearly, this type of swap serves a useful purpose. Unfortunately, regulators must constantly play catch-up to avoid unforeseen problematic consequences. For one thing, Mr. Preneur would owe a substantial sum of taxes if he actually sold his shares, so when this product first came out, it would have saved him a tidy sum. (Regulators have since closed this loophole.) Furthermore, an insider could effectively sell his shares in a company - without having to report any insider sales, which shareholders often count on as a clue towards management's outlook! (This loophole has been closed as well.)
Unfortunately, one loop hole that has not (yet?) been closed has to do with the fact that management may show ownership of a number of shares, but may have swapped the returns away. Shareholders wouldn't know unless they pieced together disclosures of insider sales, insider buys, restricted stock issuances, stock option issuances, and stock option exercises - and even then, these particular disclosures are not likely to form a complete picture of exactly how much a manager owns. In an extreme case, this could lead to a problematic situation where a manager has voting control, but suffers no consequences as a result of his actions (for he has swapped the returns away), while shareholders believe that the manager has a full stake in the company!
Innovation in the banking and financial industry has benefited us all. Of course, if unchecked, things can go awry in a hurry, as evidenced by the bank-induced recession that took the world by storm two years ago. This doesn't mean innovation should be stifled; but it does mean investors and regulators must stay abreast of what's going on, and take corrective action when publicly disclosed information is unintentionally suppressed as a collateral result.
Equity swaps are a financial innovation that allows one party to swap the returns of one asset for the returns of another asset. Consider an example of how this might be useful:
Andre Preneur started a company from scratch, and recently took it public. His net worth is now several hundred million dollars, but all of his wealth is invested in just this one company, a risky portfolio no matter how strong the company. Andre has family commitments and wants to lock in some of these gains, however, as this undiversified portfolio could result in a significant loss of capital should something go wrong. Selling 20% of his holdings in order to diversify would drag down the stock price, hurting all investors in the process. But a swap in which he trades the returns on a portion of his holdings to a dealer that pays him the return on the S&P 500 (minus a fee) allows him to achieve some diversification without high transaction costs.
Clearly, this type of swap serves a useful purpose. Unfortunately, regulators must constantly play catch-up to avoid unforeseen problematic consequences. For one thing, Mr. Preneur would owe a substantial sum of taxes if he actually sold his shares, so when this product first came out, it would have saved him a tidy sum. (Regulators have since closed this loophole.) Furthermore, an insider could effectively sell his shares in a company - without having to report any insider sales, which shareholders often count on as a clue towards management's outlook! (This loophole has been closed as well.)
Unfortunately, one loop hole that has not (yet?) been closed has to do with the fact that management may show ownership of a number of shares, but may have swapped the returns away. Shareholders wouldn't know unless they pieced together disclosures of insider sales, insider buys, restricted stock issuances, stock option issuances, and stock option exercises - and even then, these particular disclosures are not likely to form a complete picture of exactly how much a manager owns. In an extreme case, this could lead to a problematic situation where a manager has voting control, but suffers no consequences as a result of his actions (for he has swapped the returns away), while shareholders believe that the manager has a full stake in the company!
Innovation in the banking and financial industry has benefited us all. Of course, if unchecked, things can go awry in a hurry, as evidenced by the bank-induced recession that took the world by storm two years ago. This doesn't mean innovation should be stifled; but it does mean investors and regulators must stay abreast of what's going on, and take corrective action when publicly disclosed information is unintentionally suppressed as a collateral result.
Thursday, March 3, 2011
Belzberg: An Uncertain Payout
Value investors usually cringe when a company trading at a large discount to its assets announces an acquisition, as it usually means capital that would otherwise be distributed to shareholders is ending up elsewhere. True to form, last week Belzberg (BLZ) fell 19% in the trading day following an announcement that it was going to purchase Frontline Technologies for cash and stock. But looking deeper into the transaction suggests a strategy that actually unlocks for shareholders the little value that is left in Belzberg.
This is because the purchase transaction is rather small compared to how Belzberg plans to proceed with the rest of its assets. In the year following the transaction, Belzberg will issue a special dividend and distribute to current shareholders all of its working capital less:
1) $2.75 million
2) The costs associated with shutting down its US operations (offset by referral fees Belzberg will receive for sending clients to a new firm)
3) The $1 million purchase price for Frontline
With Belzberg's latest working capital balance sitting at $12 million, the payout as things currently stand (assuming #2 nets out to zero) would be 56 cents/share, versus the 40 cents/share at which shares closed in the day following the announcement. This would seem to suggest a value opportunity; however, there are two quirks to the situation that add significant uncertainty to the size of the dividend.
First, Belzberg has a proven track record of consistently losing money throughout the last few years. While the $12 million in working capital referenced above is as of the company's latest snapshot, five months have elapsed since this company's last financials. Furthermore, the dividend may not be paid out for another year. This means shareholders should allow for about 1.5 years (adding up the past and the future) of further losses, which could be anywhere from a few cents to tens of cents per share, based on the company's recent performance.
Another hidden factor with the potential to materially affect the size of the distribution is the fact that Belzberg will have acquired the working capital of Frontline at the time the distribution calculation takes place. But Frontline is a private company, and so Belzberg shareholders don't have details as to what amount is included there. It is possible that Frontline's working capital is approximately $2.75 million, which is why #1 is part of the equation above; but without any disclosure on the matter from Belzberg, shareholders are kind of in the dark. We do know that Frontline has revenue of $4 million, so the company probably requires a decent working capital amount, which could swing the distribution tens of cents per share once again.
The fact that there's a distribution of Belzberg's assets is good news for shareholders. Unfortunately, based on the information provided, the range of possible payouts is quite wide. Shareholders who buy in at the current price could end up with excellent returns; but on the other hand, there is also the possibility that they will lose. Shareholders who prioritize safety of capital may wish to take this opportunity to exit this value opportunity and deploy the cash towards an opportunity with a better risk/reward ratio.
Disclosure: None
This is because the purchase transaction is rather small compared to how Belzberg plans to proceed with the rest of its assets. In the year following the transaction, Belzberg will issue a special dividend and distribute to current shareholders all of its working capital less:
1) $2.75 million
2) The costs associated with shutting down its US operations (offset by referral fees Belzberg will receive for sending clients to a new firm)
3) The $1 million purchase price for Frontline
With Belzberg's latest working capital balance sitting at $12 million, the payout as things currently stand (assuming #2 nets out to zero) would be 56 cents/share, versus the 40 cents/share at which shares closed in the day following the announcement. This would seem to suggest a value opportunity; however, there are two quirks to the situation that add significant uncertainty to the size of the dividend.
First, Belzberg has a proven track record of consistently losing money throughout the last few years. While the $12 million in working capital referenced above is as of the company's latest snapshot, five months have elapsed since this company's last financials. Furthermore, the dividend may not be paid out for another year. This means shareholders should allow for about 1.5 years (adding up the past and the future) of further losses, which could be anywhere from a few cents to tens of cents per share, based on the company's recent performance.
Another hidden factor with the potential to materially affect the size of the distribution is the fact that Belzberg will have acquired the working capital of Frontline at the time the distribution calculation takes place. But Frontline is a private company, and so Belzberg shareholders don't have details as to what amount is included there. It is possible that Frontline's working capital is approximately $2.75 million, which is why #1 is part of the equation above; but without any disclosure on the matter from Belzberg, shareholders are kind of in the dark. We do know that Frontline has revenue of $4 million, so the company probably requires a decent working capital amount, which could swing the distribution tens of cents per share once again.
The fact that there's a distribution of Belzberg's assets is good news for shareholders. Unfortunately, based on the information provided, the range of possible payouts is quite wide. Shareholders who buy in at the current price could end up with excellent returns; but on the other hand, there is also the possibility that they will lose. Shareholders who prioritize safety of capital may wish to take this opportunity to exit this value opportunity and deploy the cash towards an opportunity with a better risk/reward ratio.
Disclosure: None
Wednesday, March 2, 2011
Comtech Telecom: Past Or Future
Comtech Telecom (CMTL) provides telecommunication systems and services. The company trades for $785 million despite a net cash position of $400 million and operating income over the last four quarters of $130 million. This type of balance sheet strength and earnings power (relative to market value) is very inviting for value investors, but they should investigate further in order to be fully aware of what they're getting into.
As value investors, we're conditioned to place a heavier emphasis on past, as opposed to forward, P/E ratios. Indeed, market research does suggest that future estimates can be way off base. Furthermore, it has been empirically demonstrated numerous times that a portfolio of low P/E stocks tends to outperform the market as a whole. Nevertheless, this is no excuse to wear blinders when it comes to estimating a company's future earnings.
In the case of Comtech, it relies on the US government for more than 2/3's of its revenue. And a good chunk of this revenue is at risk, as a couple of important contracts have recently expired. As noted by Comtech's CEO on the company's first quarter press release:
"...[S]ales to the U.S. Army are expected to decline in future quarters..."
This example also underscores the risk of investing in companies with heavy customer concentration; at the end of 2008, the company traded at $45/share while today it trades at just $28.
Buying a company that's about to experience revenue losses isn't always a bad thing, however. A shrinking business can free up assets for shareholders, as seen with Nu Horizons. But for shareholders to profit, they are much better off buying at a large discount to book value. Doing so would allow shareholders to benefit from these freed up assets even if they are sold at a loss. In Comtech's case, however, the company trades at a premium to book value, so the company will actually have to generate half-decent returns on its assets in order for shareholders to make money over the long term.
A portfolio of low P/E stocks will outperform the market. However, investors can do even better than a passive portfolio of this nature by weeding out the companies with the most risk. This requires additional effort and due diligence, but positions the investor for the kind of returns that a simple, passive portfolio based even on low P/E stocks can't provide.
Disclosure: None
As value investors, we're conditioned to place a heavier emphasis on past, as opposed to forward, P/E ratios. Indeed, market research does suggest that future estimates can be way off base. Furthermore, it has been empirically demonstrated numerous times that a portfolio of low P/E stocks tends to outperform the market as a whole. Nevertheless, this is no excuse to wear blinders when it comes to estimating a company's future earnings.
In the case of Comtech, it relies on the US government for more than 2/3's of its revenue. And a good chunk of this revenue is at risk, as a couple of important contracts have recently expired. As noted by Comtech's CEO on the company's first quarter press release:
"...[S]ales to the U.S. Army are expected to decline in future quarters..."
This example also underscores the risk of investing in companies with heavy customer concentration; at the end of 2008, the company traded at $45/share while today it trades at just $28.
Buying a company that's about to experience revenue losses isn't always a bad thing, however. A shrinking business can free up assets for shareholders, as seen with Nu Horizons. But for shareholders to profit, they are much better off buying at a large discount to book value. Doing so would allow shareholders to benefit from these freed up assets even if they are sold at a loss. In Comtech's case, however, the company trades at a premium to book value, so the company will actually have to generate half-decent returns on its assets in order for shareholders to make money over the long term.
A portfolio of low P/E stocks will outperform the market. However, investors can do even better than a passive portfolio of this nature by weeding out the companies with the most risk. This requires additional effort and due diligence, but positions the investor for the kind of returns that a simple, passive portfolio based even on low P/E stocks can't provide.
Disclosure: None
Tuesday, March 1, 2011
Pensions Become Unrecognized Assets
What a difference a couple of years makes! In 2009, as the market set low after low, investors were cautioned to be aware of companies with defined benefit pension plans. Since shareholders are on the hook for the pension obligations, any drop in pension plan assets (as a result of the market declines) should result in a drop to a company's valuation.
Over the last little while, however, the opposite effect has taken place. As companies with fiscal years ending on December 31st will release their annual reports in the coming weeks, companies with defined benefit plans will likely see improved financial positions! Since pension asset values are only reported once a year, investors using 3rd quarter reports are likely underestimating the value of their companies under study. In other words, companies with defined benefit plans are likely worth more than investors are giving them credit for!
As an example, consider Twin Disc (TWIN), a company that has been previously discussed as a potential value investment. In 2009, the value of the company's pension assets fell by $24 million, pushing the company to cease accruing pension benefits for employees. For a company with a market cap (at the time) of just $100 million, this change in the value of its pension assets is clearly material to the value of the stock.
Since the broad market has gained significantly since that period, Twin's pension assets likely experienced a material gain as well. Unfortunately, until the 10-K comes out (and for TWIN, that is not for several months, as their fiscal year-end is not the same as the calendar year-end), all the investor can do is estimate the gains. (The pension assets gained $7 million in the last 10-K.)
Unfortunately, estimating gains is not easy. While companies do disclose their planned asset allocations, determining the rise in values of private equity or real-estate investments is not an easy task. Furthermore, in the interests of conservatism, investors are cautioned from being overly optimistic when estimating returns. However, in cases where pension assets are material, recognition of this issue can help the investor improve the accuracy of his valuation.
Disclosure: None
Over the last little while, however, the opposite effect has taken place. As companies with fiscal years ending on December 31st will release their annual reports in the coming weeks, companies with defined benefit plans will likely see improved financial positions! Since pension asset values are only reported once a year, investors using 3rd quarter reports are likely underestimating the value of their companies under study. In other words, companies with defined benefit plans are likely worth more than investors are giving them credit for!
As an example, consider Twin Disc (TWIN), a company that has been previously discussed as a potential value investment. In 2009, the value of the company's pension assets fell by $24 million, pushing the company to cease accruing pension benefits for employees. For a company with a market cap (at the time) of just $100 million, this change in the value of its pension assets is clearly material to the value of the stock.
Since the broad market has gained significantly since that period, Twin's pension assets likely experienced a material gain as well. Unfortunately, until the 10-K comes out (and for TWIN, that is not for several months, as their fiscal year-end is not the same as the calendar year-end), all the investor can do is estimate the gains. (The pension assets gained $7 million in the last 10-K.)
Unfortunately, estimating gains is not easy. While companies do disclose their planned asset allocations, determining the rise in values of private equity or real-estate investments is not an easy task. Furthermore, in the interests of conservatism, investors are cautioned from being overly optimistic when estimating returns. However, in cases where pension assets are material, recognition of this issue can help the investor improve the accuracy of his valuation.
Disclosure: None
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