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.

Lorimer,MCX,Buffett and China

Of late, I have been caught up with certain things and posting frequency has dropped accordingly. However I started reading this book called “Letters from a Self Made Merchant to his Son” by one pig meat trader named George Horace Lorimer. Its comes widely recommended by Shane Parrish of Farnam Street blog and the partner of the most famous business of Farnam Street- Charlie Munger.

It is a a highly enjoyable book and I find it far better than all those books on aphorisms. It is almost a modern day “Letters from a Stoic” ( I highly recommend that one as well). And at times I felt that Lorimer is rebuking me for the countless mistakes I have done in my past just like his son Pierrepoint.

Sample this:

“You’ll find that education’s about the only thing lying around loose in this world, and that it’s about the only thing a fellow can have as much of as he’s willing to haul away. Everything else is screwed down tight and the screw-driver lost.”

Or the idea that the essence of capitalism is postponement of self-gratification.

It’s the man who keeps saving up and expenses down that buys an interest in the concern.

Or the most important mental model to success in the public markets:

If you find your crowd following him, keep away from it. There are times when it’s safest to be lonesome. Use a little common-sense, caution and conscience. You can stock a store with those three commodities, when you get enough of them. But you’ve got to begin getting them young. They ain’t catching after you toughen up a bit.

Please do buy and read it. It sits on my bookshelf between Letters from a Stoic by Seneca and the Autobiography of Benjamin Franklin.

They say that never push a good thing too far (and never get pushed by a bad thing in the tiniest). FTIL the erstwhile anchor entity of MCX, India’s largest commodity bourse and once of the world’s biggest had been taking the goodwill of authorities a tad too easily.
It adopted worlds oldest tactic for avoiding a decision.
Procrastination.
Delay.

While as early as September it lost the status of fit and proper entity it kept dragging its feet on the stake sale. [For those who are not very much familiar with it these links will get you upto speed-

1. Deepak Shenoy on Original Fallout of NSEL.

2. As early as July 30th market bloodhounds sniff problems in FT & MCX

A side note- whenever the CEO comes on record blaming bear cartels short the stock. Lehmann, Bears and Stern and even Satyam at one point of time blamed the infamous bear cartels.

3. And the whammy of CTT also strikes MCX killing the volumes off and attracting a Morgan Stanley downgrade

4. MCX hits an all time low of 212

5. FTIL gets “fit and proper” notice and Shah and Massey step down.

For valuations this will help, for my thesis this set of posts will help.

1. A tale of two kids- Part 1,  2, 3, 4 ]

So post two management changes , the new management has decided to take a very radical step. It has decided to keep the stake of 24% in an escrow account for MCX to sell it all by itself.

Now will the money go to MCX? No.
It will be just like the auctioning of a collateral by a lender. Over and above the amount liable i.e the sum of principal and interest, a lender returns the entire surplus to the original owner.
In this case FTIL doesn’t owe anything to MCX. Hence MCX will return the entire money to FTIL. Which is a good thing for MCX!

Why? Well simply because even the remotest association with a scrupulous man is costly. Hence that FTIL and MCX will go its own way is a very positive step.

For this to happen- MCX has to seek a shareholder nod for the change in its article of association. I am in favour of it and will vote my yes. However, is there a guarantee that this will not be used against anyone else?

I recommend to the directors to have a sunset clause associated with this proposal, where after a stated date without the shareholder’s nod the article association will revert to the present form.

On other ideas I am reading these days is 25iq.com where Tren Griffin echoes Buffett’s idea of mispriced optionality and his idea of portfolio of such bets-

“you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.”

This is at the core of probabilistic thinking. To weigh the final material gains and losses by their respective probabilities makes many decisions easier to make.

A higher application of such a mental model is a decision tree, where diverse alternatives are presented in an intuitive way. This kind of mental model is highly beneficial to assess special situation opportunities.

Which brings me to the special situation building up in the China seas. I am no Foreign Policy expert but the recent muscle flexing of China in the East and South China Sea is a cause of concern for India. It has huge conflicting claims with Japan, with South Korea (East China Sea – Diayou/Senkaku Islands and Goguryeo, Gojoseon problem).

Parallely it has problems with Vietnam and Phillipines in contradictory claims on Paracel Islands and Scarborough Shoal. If that was not enough, China went ahead and claimed one of Vietnam’s island (which is incidentally a very good fishing ground) as its own. In April this year, a Chinese fishing vessel uncermoniously crushed a Vietnamese counterpart. And it dragged a deep sea drilling platform into Vietnamese claimed waters.

In this light, what is India to do? Of note is in 2013 India unceremoniously dumped a joint sea exploration project with Vietnam, for fears of ruffling Chinese feathers. So what is India to do?

Or rather what is the cost of inaction?

The essence of value investing

The thoughts of others

                                   Were light and fleeting,

                        Of lovers meeting,

                   Or luck or fame.

Mine were of trouble,

And mine were steady,

So I was ready

                      When trouble came.

-A.E.Housman (1859-1936)
A Shropshire Lad