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.
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.
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!
Long FFP.PA and RELLA.CO