Monthly Archives: April 2012

Capital Southwest (CSWC)

In the comments on my Urbana update a reader pointed me to an article of Geoff Gannon about Urbana and Capital Southwest. Just as Urbana Capital Southwest is in essence a closed-end fund that is trading at a significant discount to NAV. Capital Southwest reported $147 dollar in NAV/share at the end of 2011 while it is currently trading for $96: a discount of 35 percent (and that’s ignoring the fact that share prices are up nicely in 2012). The company describes itself as follows:

Capital Southwest is a Dallas-based investment company that provides patient equity capital to exceptional businesses. As a public company (Nasdaq: CSWC), Capital Southwest has the flexibility to hold investments indefinitely, which has provided its managers a stable ownership platform since its founding in 1961.

Since the company was founded more than 50 years ago they have managed to grow NAV/share from $1.25 to $147 (a 10% CAGR) while also paying out dividends. So at first sight this looks like a potential opportunity: the company has a good long-term track record and a sensible investment strategy, so there is no obvious reason why the company should trade at a large discount to NAV.

Portfolio holdings

Capital Southwest mostly invests in private companies, often as a minority shareholder, but sometimes they also acquire a controlling position. While the company has stakes in all kinds of things the majority of assets are concentrated in four companies that were bought decades ago. $371M of the total of $480M in investments are invested in the four top holdings. Two of those four companies are publicly traded, but the shares that Capital Southwest holds have restrictions on resale and are carried at a discount to the freely traded public securities:

While it makes sense to discount securities that have resale restrictions, those restrictions don’t reduce the economic value for long term holders. It’s a small detail: it should add around 25M in value on a total portfolio of 552M. While the public part of the portfolio is easily valued, the private companies are a different story. Capital Southwest provides some very limited information on the financials of the private companies:

The ReactorSeal Corporation:

During the year ended March 31, 2010, RectorSeal earned $9,571,000 on revenues of $102,075,000, compared with earnings of $10,170,000 on revenues of $112,762,000 in the previous year.  RectorSeal’s earnings do not reflect its 20% equity in The Whitmore Manufacturing Company. At March 31, 2010, Capital Southwest owned 100% of RectorSeal’s common stock having a cost of $52,600 and a value of $120,200,000.

The Whitmore Manufacturing Company

During the year ended March 31, 2010, Whitmore reported net income of $3,661,000 on net sales of $26,777,000, compared with net income of $3,209,000 on net sales of $28,163,000 in the previous year.  The company is owned 80% by Capital Southwest and 20% by Capital Southwest’s subsidiary, The RectorSeal Corporation (described on this page). At March 31, 2010, the direct investment in 80% of Whitmore by Capital Southwest was valued at $47,500,000 and had a cost of $1,600,000.

So those two companies are valued at a 12.5x P/E and a 13.0x P/E ratio. Impossible to judge how appropriate those ratios are without knowing anything about the companies, but given the fact that they have grown significantly since CSWC invested in them decades ago they are probably reasonable solid businesses and the valuations don’t look crazy at first sight.

Management costs

The biggest reason for a holding company and/or closed end investment funds to trade at a discount to net asset value is because management is adding an aditional layer of costs. The costs of running CSWC seem to be very reasonable. Operating expenses and management and directors’ fees were around 5M a year for the past 3 years, so that would translate to a bit less than a 1% TER. If you would assume that the management of CSWC would add no value this 1% would still warrant a decent discount to NAV. If you would assume that long term expected return of the portfolio would be between 5 and 10 percent a fair discount would be between 10 and 20 percent. Given the track record of CSWC this assumption is probably a bit unfair.

Taxes are another consideration that influence the discount. Capital Southwest has big unrealized gains, but since these gains are probably also not going to be realized in the next few decades the related taxes are not a big issue. The net present value of taxes that will only be paid at some point far in the future isn’t very big.


CSWC gives the investor an opportunity to buy at a significant discount a private equity fund that has a good track record. It can probably take a long time for the discount to get smaller, but I think that at the current discount you can be fairly certain that you are getting a good deal. You probably need a lot of patience, but that fits perfectly with the fund strategy and is exactly the reason why outperformance might be possible.

I don’t have a position, and I’m not planning to initiate one soon, because I have plenty of exposure to the USA already and don’t think it’s ridiculously cheap. I’m certainly going to keep CSWC on my watchlist.



Fibrek tender offer arbitrage

Today Fibrek’s share price dropped 11% to CA$0.96 after a court decision related to the battle over the control of the company. This is interesting because Resolute has made a tender offer for CA$1.00/share and Mercer is trying to buy the company for CA$1.40/share. Resolute has already bought 46.8% of the outstanding shares, and has extended the tender deadline to April 23 for remaining shareholders. So this seems to be an opportunity to make an easy 4.1% in a short time period with minimal risk.

I’m going to keep the write-up fast and quick because the idea is time sensitive, but there is quite a soap story behind the tender offer. The offer was made in November 2011 and besides the buying party and some other big shareholders that entered lock-up agreements with Resolute there has been little enthusiasm from minority shareholders for the CA$1.00 deal because they think (probably rightly so) that it’s a lowball offer, and that the parties agreeing to the deal have misaligned incentives because they also have a stake in the company buying Fibrek.

A second party – Mercer – emerged after the initial bid was made, and has made the offer to buy the company at CA$1.40 per share, but because of the lock-up agreements that Resolute has with other big shareholders this bid is probably not going to be accepted (so minority shareholders here have every right to be unhappy!) and the court decision referenced above was also a negative for the higher bid. The company issued warrants in a private placement with Mercer to break the voting power of the Resolute group, but this move was not allowed by the court.

Buying some shares at CA$0.96 and tendering them at CA$1.00 seems to be the easiest and least risky way to make some money, but there are also some other moves possible. I’m not really familiar with how the process exactly works in Canada, so take everything (as usual) with a grain of salt, but to take the company private they need to acquire 90% of the shares to be able to take compulsory action against remaining shareholders. Since Resolute has so far only acquired 46.8%, shareholders that do not accept the current bid could get a higher bid in the future. But it is certainly also riskier: maybe Resolute will be happy with just a 50%+ controlling position.

I’m going to take the easy to understand, low-risk option, and hope that it’s not going to take too long before I get the cash after tendering the shares.


Author is long FBK.TO

Urbana Corporation update

Urbana Corporation, in essence a closed-end fund focused on stock exchanges, released it’s annual report for the year 2011 previous month. Initially I didn’t intend to write an update because the report didn’t really contain any news. The company is publishing an overview of it’s NAV and portfolio holdings every week, so there are no surprises with regards to the portfolio performance or the number of shares bought back. Urbana is steadily buying back shares, reducing the share count from a peak of 87.5M in the beginning of 2010 to 72.5M now. Since the company is trading at a significant discount to NAV those share buybacks add to the value per share for remaining share holders in a meaningful way (the discount was around 45% when I initiated my position in November, and is currently still around 40%).

The reason for this post is that my original write-up didn’t include an estimate what a fair discount for Urbana is. It’s easy to understand that the current discount is too high: the company is buying back 10% of shares per year, and with a 40% discount that would result in a growth of NAV/share of 4.44%:

(InitialNAV - CostOfBuyBack) / NewShares = NewNAV
(1 - 0.06) / 0.90 = 1.0444

At the same time the company has ~3% in overhead costs per year, so thanks to the buybacks Urbana should currently have a portfolio that is capable of outperforming the market with 1.44%/year. And a fund that’s capable of outperformance should trade at a premium! But this of course can’t be true for Urbana since the outperformance can only be realized while trading at a discount and it certainly should trade at some discount because of the high fees. What we want is to find an equilibrium where the fees of the Urbana corporate structure are exactly cancelled by the share buybacks.

Before we can do that we need to take a look at another variable: the expected return of the portfolio. If you would for example expect that the equities in the Urbana portfolio have a return of 6%/year in the long run it would imply that a discount of 50% would be fair if the company would not be buying back shares. With a 6% return and a 3% expense ratio you would basically have a situation where 50% of the earnings are siphoned off. With a higher return assumption a fair discount would be smaller since you would need a smaller part of the asset base to cover the fixed 3% costs.

Major assumptions:

  • The expected return of the URB portfolio is equal to ‘the market’ minus 3%
  • A fair discount for URB is when it returns ‘the market’ after fees
  • The company continues the share buybacks indefinitely
  • The company does nothing else to close the gap to NAV (liquidate, self tender)

With some crude Excel work to include the effect of share buybacks I get a fair discount of 14% when we assume that the expected future market return is 10%, and a fair discount of 20% when the market return is 4%. So I think it’s safe to say that a discount around 17% would be appropriate for Urbana Corporation.

And while I’m waiting for the gap between the current ~40% discount to close to less than 20% I’m owning an asset that should outperform the market with ~1.4%/year. So unlike a lot of other asset based plays I don’t really care how fast value is realized. Either the discount remains big and I can make money because the company can grow intrinsic value at above average rates by buying back shares, or the discount simply gets smaller. I would prefer the last option, but it’s not a situation where you will end up with terrible returns if it’s going to take ages before this happens.


Author is long URB-A.TO, and short a little bit CBOE and NYX as a partial hedge

China Mass Media (CMMCY.PK)

A reader pointed me in the direction of China Mass Media (CMMCY.PK), another Chinese company that’s trading for less than the cash on the balance sheet. The company paid a special dividend of $22.98/share at the end of December last year (an amount almost equal to the share price the previous day) and was delisted from the NYSE two weeks ago because the market cap of the company was insufficient (below $15 million over a 30 day period). Even though the company paid a total of $57.9 million in the special dividend there is still plenty of cash on the balance sheet:

Last price: 1.80
Shares outstanding (ADS): 2,505,659
Market cap: 4.5M
Cash and Equivalents (mrq): 17.7M
P/E (ttm): 1.9x
P/B (mrq): 0.19

Is it real?

As is the unfortunate case for Chinese companies listed in the US the biggest question that needs to be answered first is “is it real?”. As discussed in my post on DSWL the only way to be sure that a company is not a fraud is to see that’s returning more money to share holders than that it has raised in the equity or debt markets. So the big dividend is a clue that the company might be real, but we do need to take a closer look at the past.

The company became public using an IPO of ADS shares (sold 7.2M shares at $6.8, raising $42 million after fees). The IPO was used to raise cash to invest in the business, and diluted the ownership of the CEO from ~100% to 70%, and that percentage has remained roughly constant to this date (it’s up a bit due to option grants and some share buybacks). So this also looks good, but it’s important to realize that the company did not pay out more in dividends than it raised in cash in the IPO. Since the CEO owns around 75% of the shares today just 14.5M was returning to outside investors in the dividend.

With the market cap of the company currently at 4.5M, and the CEO receiving ~43M in dividends it’s easy to imagine a positive scenario where the company is taken private at a nice premium to the current share price.

So I think the bull case is clear, but at the same time while just scrolling through the IPO prospectus and the annual reports there are all kinds of weird things I’m not comfortable with. Some examples:

  • The company originally tried to IPO at a significantly higher price, but after failing to do so it had no problems accepting a lower price (raise money at any cost?).
  • The ADS structure seems to be weird to me since the underlying shares aren’t traded anywhere
  • The company used an IPO to raise cash for the business, but why do this while paying dividends?
  • The company stated in the IPO prospectus that it intended to (continue) to pay regular dividends, but failed to do so after the IPO.

Or something like this:

Subsequent to the issuance of the shares, on June 24, 2008, the existing shareholders controlled by Mr. Shengcheng Wang entered into investment agreements with a group of third parties and sold the Preferred Shares at USD 60 million.


On July 23, 2008, the existing shareholders controlled by Mr. Shengcheng Wang entered into an agreement to repurchase all the Preferred Shares for USD 60 million plus one month of interest at an annual rate of 8.0%. None of the repurchase cost was borne by the Company.

How does this make sense?


China Mass Media does have some interesting things going for it, but to quote Buffet:

In this game, the market has to keep pitching, but you don’t have to swing. You can stand there with the bat on your shoulder for six months until you get a fat pitch.

No reason to swing the proverbial bat when just at first glance there are things going on I don’t like, especially not when we are talking about a company in China.



SGF tender offer results

I closed my position in SGF today for a loss of 1.74 percent. While the main part of the thesis proved to be correct, the acceptance rate was 51.3% instead of the 25% worst case scenario, the discount to NAV of the fund increased from ~5% to ~10% after the completion of the tender offer (it was ~6% before the offer was announced). I think this was a bit of negative variance, although other explanations are also possible such as the market already anticipating the tender offer or front running by insiders.

From a big picture perspective I actually think it’s not unreasonable to assume that the discount to NAV should be smaller on average after a tender offer, since it is reducing the available supply of the fund while it should not reduce demand (I would actually see it as positive for existing or potential new holders). At the same time there are shorter term dynamics caused by people such as me that buy before the tender, and sell after.