Monthly Archives: October 2013

Some thoughts on holdco and CEF discounts

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My recent article on FFP received a lot of attention, but most comments were along the following lines: “sure there is a 50% discount, but what if the discounts stays at this level?”. I would say: that’s exactly what’s value investing is about! You buy cheap, and you have to have some faith that at some point in time the market will recognize how much its truly worth. This is what Benjamin Graham had to say about the subject in 1955 to a Senate commission (the full transcript is available online):

The Chairman: … One other question and I will desist. When you find a special situation and you decide, just for illustration, that you can buy for 10 and it is worth 30, and you take a position, and then you cannot realize it until a lot of other people decide it is worth 30, how is that process brought about – by advertising, or what happens?

Mr. Graham: That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it in one way or another.

I’m not saying that the discount will completely be eliminated in time, because there are valid reasons why a holding company or a closed-end fund should trade at a discount. These are overhead costs, tax inefficiencies and potential value destruction. In general overhead costs for holding companies are low, while closed-end funds incur higher costs because there is an ‘active investment manager’ that gets a fee based on AUM. Holding companies on the other hand are often less tax efficient. Dividends cannot always be passed through from the operating companies to the holding company in a tax free manner. In most jurisdictions this is not a major issue: It is usually possible to pass through dividends in a tax free manner if the holding company has a sufficiently big stake in the operating company.

The last important ingredient that should determine the discount is whether or not the manager is adding value, subtracting value, or is value neutral. I think the best assumption is usually the last one. Most CEF’s invest for example in large cap companies: they don’t underperform the market before trading costs in the long-term, but they also don’t deliver outperformance. If you already account for trading costs under the overhead the manager probably doesn’t add further negative performance. Holding companies are very often passive vehicles, and since they are passive there is neither value destruction nor creation. Rella is a nice example of a holding company that is actually creating value, simply by buying back undervalued shares.

Discount fluctuations

Both CEF discounts and holdco discounts usually vary over time. Sometimes they are small, and sometimes they are big. My thesis is that these fluctuations can be partly explained by the perceived attractiveness of the underlying assets, general investor sentiment and the fact that both holdco’s and CEF’s have a fixed supply of shares outstanding.

I wrote for example about mortgage closed-end funds two months ago. Rising interest rates resulted in declining prices for the underlying assets and at the same time the number of investors willing to invest in CEF with these type of assets also declined. As a result the discounts to NAV increased at the same time as NAV’s declined. If the market would be efficient this would be hard to explain since the lower underlying asset prices should already have reflected the bad news.

The reason that this doesn’t happen is that there is no (easy) arbitrage between share price and NAV. So when investors want to exit anyway only one thing can happen: the discount increases. Similar mechanics are at work behind the holdco discounts, except that there is even less of a possibility of arbitrage between share price and underlying value. When a closed-end fund starts trading at a huge discount activist investors can usually acquire a big enough stake to push for liquidation while holdco’s are often tightly controlled by their founders. They might want to take advantage of the discount by buying back shares at some point, but it’s also possible that you simply have to wait for sentiment to change.

Possible returns

I have no idea when investor sentiment is going to change for FFP, but I do think it will probably change at some point in time. Between 2007 and today the discount varied between 30 and 50%, and in the next five or ten years I would be surprised if it wouldn’t move back to the bottom of this range at some point in time. And you shouldn’t underestimate the amount of alpha you can create when this does happen.

If it would take 10 full years for the discount to shrink from 50% to 30% you still generate 2.9% alpha annualized (this is after accounting for 0.5% in overhead costs). If it takes ‘just’ 5 years you are looking at 6.4% annualized alpha. I don’t know about you, but that’s certainly attractive enough for me!

Disclosure

Long FFP.PA and RELLA.CO

Historical FFP discount to NAV

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A reader asked in what range the FFP discount to NAV has been historically, and that seemed like a good question to answer with a graph. I couldn’t easily find historical NAV data from before 2006, but what we do see is that the discount has been smaller in the past, and that the current discount of nearly 50% is at the top of the historical range. It would also not surprise me if the discount has been smaller than 30% if we would look further back.

FFP historical discountWhile this is of course encouraging to see I don’t think it’s extremely important. A 50% discount is a 50% discount, regardless of the past, and I have looked at enough holding companies to know that this kind of discount is big.

Disclosure

Author is long FFP.PA

FFP: investing in France at a 50% discount

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Societe Fonciere, Financiere et de Participations or simply FFP is a diversified French holding company that is trading at a discount of roughly 50% to it’s NAV. The biggest shareholder in the company is the Peugeot family with a 79.2% stake. So while FFP has a €1.08B market cap the free float is just €225 million. Given the fact that the FFP is majority owned by the Peugeot family it shouldn’t come as a surprise that the largest position is also in the company Peugeot, accounting for almost 30% percent of gross asset value. The other assets consist mostly of publicly traded French companies, private equity investments and real estate. Given the large amount (>83%) of publicly traded assets inside FFP it’s easy to calculate an updated net asset value, confirming the big discount:

FFP NAV spreadsheet

The spreadsheet you see here is publicly accessible on Google Drive using this link and updates automatically all share prices and the current discount. Not all assets in FFP are publicly traded, and since the CAC 40 index is up ~15% since the end of June the real discount to NAV is most likely hitting 50% at this moment. This is basically the whole investment thesis! I could write thousands of words about the valuation of the individual companies inside FFP, but the truth is that I don’t really care. The companies that FFP owns have market caps in the billions of euro’s, and I do trust the market to some degree.

What’s positive to see is that FFP appears to have a good track record with their investments outside Peugeot. As you might know the family business isn’t doing very well these days, and if you would have invested in Peugeot 5 years ago you would have lost half your money. If you would have invested in FFP on the other hand you would have made more than 20%, a remarkable achievement given the huge historical stake in Peugeot.

FFP performance relative vs Peugeot

An investment without a catalyst

What I do want to discuss is why I like an investment at a big discount in a holding company, even though I don’t expect that this discount will disappear anytime soon. The Peugeot family owns almost 80% of the holding company so there is no way an outside investor can pressure the family to do something to eliminate the discount, and the family is presumably not extremely interested in the market price of FFP since they are holding this for the very long term. FFP is the vehicle that allows them to control Peugeot SA: their legacy.

I don’t think this really matters though. Even if the discount would never get smaller you buy a company that can support a dividend steam that is twice as high as the underlying assets. And that is what ultimately determines intrinsic value: the dividend stream back to shareholders. You don’t need to sell a stock at a higher price to realize value: if you buy cheap and just hold you will simply enjoy an above average yield.

While there is nothing wrong with holding a stock till infinity I actually don’t think that you have to do this. At some point in time the market will probably realize that a 50% discount isn’t warranted. Last year FFP didn’t pay a dividend because of the poor results at Peugeot and the re-initiation of a dividend could possibly act as a catalyst.

I also assume that the Peugeot family doesn’t hate money. The undervalued shares represent an easy opportunity to make money if they start a repurchase program. You also have to figure that there is probably going to be some point in time when the Peugeot family wants liquidity. They would be stupid to sell their FFP shares at a 50% discount when they could for example divest some assets and realize NAV. Since I think they will care about the NAV discount at some undetermined point in the future you can expect that it will eventually be eliminated. It’s going to take a lot of patience, but I don’t mind that if I’m owning an asset that has intrinsically a yield twice as high as the market average.

Conclusion

The investment thesis in FFP is extremely simple. The holding company trades at a 50% discount to NAV, and I don’t think such a large discount is warranted. Luckily I believe that the simpler the investment thesis, the better, and it doesn’t get any simpler than this!

Rating: on a scale from one to five I’m going to give this idea two stars. The thesis in FFP shares many similarities with Burelle: both are French, family controlled holding companies at a ~50% discount with a focus on the automotive industry. An identical rating is logical.

Disclosure

Author is long FFP.PA

Incentives matter

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I suspect that a lot of my readers also visit the Whopper Investments blog, so you might have noticed that I gave this post an identical title as his last one: Incentives matter. Whopper summarizes my thinking about the subject in the following sentence: “I believe that people are always going to do what’s in their best interest”.

This is of course very important when you scrutinize what insiders are doing at a company, but it is equally true when you read an article online. What are the incentives of the author? I recently wrote a post for Seeking Alpha about Deswell Industries. For regular readers of my blog not a new name since I own it since the beginning of 2012. At the time I spend little time about looking at the underlying business, my main concern was whether or not the company was potentially a fraud since it’s doing business in China.

So my incentives for writing this post, and publishing it on SA:

  1. Reviewing and updating my investment thesis
  2. Gain some exposure on SA, maybe attract some new readers to my blog
  3. Last but not least: make a few bucks

SA pays authors a minimum of $150 dollar for a good article on a under-followed micro/small cap while there is minimum payment of $500 dollar for an article that is selected as an “Alpha Rich” idea. So what is your incentive as a writer: to write a piece that convinces the SA editors that the stock offers an asymmetrical risk/reward ratio! It’s no longer about publishing the most balanced research. Of course you should mention some negatives because you sound smarter if you do, but it’s easy to downplay a specific issue. I wish it wouldn’t be true, but after writing the article I realized how you are tempted to do it. Even without the money the incentive would be there: it’s also an ego thing.

In the case of Deswell Industries I don’t think it would have been too hard to write an article that sounded a lot better. You have the downside part of the story covered with the large amount of cash on the balance sheet, and it’s easy to write for example a nice story on how the business has decent long-term prospects (not impossible) or how the leasehold land of the company could potentially be a very valuable asset (for the record: I don’t think this is very likely, but you see on SA a reader that is trying to make this case). It doesn’t even matter if you fool the SA editors or not, the end result is the same.

So what does this mean for me?

My number one motivation of starting this blog is to improve my investment process and skills. I often think about my write-ups as a sort of public visible checklist (without the checks). By writing an ‘exclusive’ article for SA I’m giving myself a competing incentive, and that is a dangerous thing because it’s already easy enough to be biased towards your own idea’s. So you don’t have to expect a lot of other SA articles from me in the future, although I might occasionally review an existing position (or maybe write about something I don’t own).

A slightly related topic is my decision to keep the blog free from advertisements. That would also introduce a competing incentive: away from the quality of posts and towards the quantity of posts. I don’t think advertising revenue would be material anyway, so no reason to do something that subtracts from the main goal of the blog.

What should it mean for you?

Nothing! You should be doing your own thinking and research anyway. But when you read something it still pays to think about the incentives of the writer, because it can tell you where you could start looking to find the weak points in the thesis. Unfortunately this means on SA that authors have an incentive to make the story sound as positive and convincing as possible. I understand why they are doing this, because it’s at the same time also an incentive for people to write true “Alpha Rich” articles, and I think they are succeeding with that part of the equation. I do see more interesting articles appearing than in the past.

Why I invest in illiquid micro-caps in one graph

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Someone on twitter linked to a presentation of Montanaro Asset Management. The company invests in small caps in Europe and seems to have a pretty solid track record. I find it always interesting to read what other investors are doing, but sometimes what they are not doing is equally interesting. What Montanaro isn’t doing is investing in (small) micro-caps:

Montanaro presentationThis is of course not anything new, but just a nice illustration of how the smallest stocks attract little interest from professional investors. If they think small caps are already under-researched it’s clear that nano/micro-caps are even less efficiently priced. That’s exactly the corner of the market were I’m trying to find my idea’s, and I think that should make sense for most serious individual investors. The market doesn’t pay you based on how smart the guy at the other side of the trade is, so no point in making investing harder than it needs to be.

Individual investors usually don’t have a huge amount of money that needs to be put to work so if the average trading volume per day is a couple of thousand dollars worth of shares it should be possible to build a position without any problems. With some patience you can buy even less liquid stocks. Something that is truly uninvestable is pretty rare.

What’s of course important when you buy illiquid stocks is that you know that you won’t be forced to exit your position at an inopportune time. The professional portfolio manager often has to worry about clients that want to withdraw at exactly the wrong time, making investments in illiquid stocks less desirable. I don’t think you should be invested in the stock market if you don’t have a long time horizon, so when you invest in something you might just as well capture a liquidity discount. No reason to pay for something you don’t need!

Disclosure

Long a lot of small and illiquid stocks