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.
- 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