The paradox of holding companies

Holding companies in the world of investing stand for a mirage. Many a novice have sharpened their horns by ramming against them. Looking from a strict Benjamin Graham style of play(where market capitalisation is compared against tangible assets) has resulted in many a tears and heartburns. They are numerously termed value traps, the final frontier where valuation fails and even a quicksand of the novice investor.

It is not that, they have not made money for investors but more often than not, the discount they were hoping to be closed never materializes. An extremely cheap stock of holding company just corrects 25% upwards instead of the expected 250% and penalises the investor with a decent opportunity cost. As a result this is an interesting puzzle in the equity markets- why doesn’t markets correct the severe undervaluation?

Numerous reasons have also been forwarded- holding company discount, conglomerate discount and so on which are often the different names for the same phenomena. However blaming conglomerate discount for 40-50% discount either implies that it not merely a discount but a wholesale writeoff. In facing such beasts , it is important to remember the customary honourable solution. Gently take a step back, ever so silently without disturbing the sleeping beast.

However instead of a strategic and brave retreat, just shuffle and observe it from a different perspective.

Look through Earnings

Throughout the 1980s Warren Buffett keeps etching, fleshing and time and again repeating the concept of look through earnings. In 1982 annual report he mentions( apparently, the then accounting rules don’t allow reporting of earnings where ownership is less than 20%)

“We prefer a concept of “Economic” earnings that includes all undistributed earnings regardless of ownership percentage. In our view the value to all owners of the retained earnings of a business enterprise is determined by the effectiveness with which those earnings are used”

Finally in 1993 Warren goes to define it:
“Look through earnings consist of : (1) the operating earnings reported in the previous section, plus; (2) the retained operating earnings of major investees that, under GAAP accounting are not reflected in our profits, less; (3) an allowance for the tax that would be paid by Berkshire if these retained earnings of investees had instead been distributed to us.”

In many ways, it reflects the difference between Berkshire Hathaway- a holding company and the other holding companies which never “come close to getting rightly valued.”

I believe Look Through Earnings is the correct lens to look through this problem. The entire ecosystem of Indian holding companies which I went through squarely looked costly to me rather than cheaply valued.

Economic Fortunes are enmeshed

The paradox gets resolved if we think in these terms: Whenever an investor buys a business from the market, he links his fortune inextricably with the economic fortune of the business adjusted suitably by his own buying price. Post that step, any and all fluctuations, gyrations and information thrown by the market ceases to matter materially to the owner-investor as far as the economic fortune is concerned. This implies that for the holding company the ultimate benefit comes from the economic earnings of the investee firm, implying free cash flow.

If in this lens, we try to analyse a few holding companies, they look inextricably costly. While a vast majority of the holding companies have their precious capital parked in businesses with questionable economics, the free cash flow (or rather the free cash sink) these businesses appear to throw, adjusted for the stake the holding company owns is materially reducing its book value.

In light of such facts, it is not a surprise that holding companies trade at a material discount to the book value. Consider for example a holding company which in its quoted investments owns the steel, power and other energy companies from the same stable. In essence it is investing in sister concerns. Though creates unwieldy holding patterns but not a crime definitely. However what makes it an economic sin is that the biggest holding- the sister steel company is the fact that, if it would have in its utmost graciousness returned the entire free cash generated by its operations- it would have wiped the book value of the holding company.

Capital Allocation

This problem can be described in only one way- capital allocation. Why allocate capital to a company which is a perennial cash guzzler rather than a cash thrower? But then the managers of these holding companies have precious little to do other than take a chunk of the stake away from the promoter’s names. Their decision making is zilch and capital allocation has nothing to do with it.

One holding company I came across, which also buys stocks of companies outside its parental stable is Bombay Burmah Trading Ltd. Not a pure holding company by itself, because it has its own operations of tea and coffee.However the proactive decisions (not necessarily the best) its management has taken has forced markets hand at valuing it at a premium to the book value. I consider the presence of an independent operation inside Bombay Burmah Trading Ltd to be an unintended advantage its owners , the Wadia group bestowed on it. Since a management which has some latitude in managing its operations will also be slightly more awake in picking and selecting the investee companies.

Before you go out and buy it, there are two factors worth knowing out here- one, it doesn’t imply that the aforementioned company doesn’t own its sister shares. At best its portfolio can be described a sister concern plus, implying sister concern stake and stake in other businesses(not necessarily the best ones), secondly the valuation of the same is too costly, perhaps only for my own taste.

There exists one holding company out there which breaks all these patterns and for breaking all of it, the market has rewarded it handsomely. That name is without doubt Berkshire Hathaway. But to be sure, that is not the only holding company out there which is charting a lone wolf story. There is Markel Inc and then there is Fairfax Holdings. All of them follow the best practice and praxis of capital allocation strictly.

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One thought on “The paradox of holding companies

  1. It all boils down to intent of the mgmt. Very few HCo are formed to create value for shareholders. Most of the time (especially) in Indian context they are a means to an end for mgmt ( giving them disproportionate control with min capital via Hco & cross holdings). You’ll be better off ignoring them and finding great operating businesses. It’ll give better ROIC/ROIT(time)/ROIS(stress). There aren’t too many WEB/Prem Watsa around.
    I have been ignoring HCos as a class all through my investing career and I do alright.

    Like

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