Tuesday, December 20, 2011

BRK at a Discount?

Every once in a while, I hear this idea where you can buy Berkshire Hathaway stock at a discount.  There are apparently some closed-end funds (CEF) that own a lot of Berkshire Hathway (BRK) stock and they trade at large discounts to net asset value (NAV), so therefore you can buy BRK at a discount.

I usually respond the same way I respond to most CEF ideas; most of them deserve to trade at discounts, or even at deep discounts (see "Hedge Funds at a Discount? post).

The funds I'll look at here are the following:

BTF:  Boulder Total Return Fund
BIF:   Boulder Growth and Income Fund
DNY: Denali Fund

What all of these three have in common is that they are run by Boulder Investment Advisors and own a lot of Berkshire Hathaway stock.  Boulder Investment Advisors is run by a guy named Stewart Horejsi who is a Berkshire almost-billionaire.  He inherited the family welding business but instead of reinvesting the profits into the business, he used the profits to invest in BRK, starting in the early 1980s.

He sold the business in 1998 or so and has been a financial guy ever since.  One article said that he owns $400 million worth of BRK stock and another said he owns $600 million worth and is the tenth largest BRK shareholder.  Either way, that's a lot of BRK stock, and he has done well for himself. 

One of his things is to buy closed-end funds at a discount and then replace the investment advisor with his own company, buy a lot of BRK and other value stocks.

Buying CEF at a deep discount is certainly not a bad idea, but it really works great when you take over the investment advisor function because then you get to pay yourself advisory fees.   But more on that later.

First of all, let's take a look at how these funds have done.

Here are the long term return figures from the recent annual reports for these funds:

For years ended May 31 (annualized returns):

                                   3 year         5 year           10 year
BTF                           -0.2%          +3.0%           +4.6%
BIF                            +2.8%         +6.5%

S&P 500 index          +0.9%         +3.3%           +2.6%
BRK                           -4.1%         +5.2%           +5.6%

For BIF, since the new advisors took over in January 2002, they list the annualized return since then which was +6.5%/year versus +3.9% for the S&P 500 index and +5.2% for BRK for the same period.

Since DNY has a different year-end, I will list it separately below:

For the years ended April 30:
                                  3 year           5 year                                
DNY                         +2.3%           +1.4%
S&P 500 index         +1.7%           +3.0%
BRK                          -2.3%           +7.0%

So from the above, we see that these funds have outperformed the S&P 500 index in some time periods.  I was initially impressed that the BTF outpeformed the S&P 500 index over ten years; +4.6% versus +2.6%, but then realized that of course BTF is going to outperform the S&P 500 index if it owns a lot of BRK.  And if BTF is going to be a way of buying BRK at a discount, then the relevant comparison must be against BRK, which anyone can buy in the market without having to pay advisory fees. 

This is where this idea sort of starts to fall aparts.  BTF over ten years returned a decent looking 4.6%/year, better than the S&P 500 index, but did worse than BRK itself.  So the question is, why bother?

BIF has seemed to do better; +6.5%/year for five years versus +3.3% for the market and even better than BRK which returned 5.2% during the same five years.  Since Boulder took over management of this fund in January 2002, they also outperformed both the S&P 500 index and BRK (+6.5%/year versus +3.9% for the market and +5.2%/year for BRK).

BIF does look slightly better than BRK over this time period, but with such high fees, I would still go for BRK instead of BIF if you want exposure to BRK.  Cost will kill you in the end, and there is no telling what BIF will do in the future.   Over time, it looks like BTF did no better than BRK, and it is really not very clear why BIF would do better; I haven't really dug into what drove the difference in  returns between these funds.  I am more interested in looking at these as proxies for BRK at this point.

Also, DNY looks like it is underperforming both the S&P 500 index and BRK over the past five years.  Again, if there was some more consistency in outperformance by Boulder Investment Advisors, there may be a reason to own these funds.  But a quick look shows that if you want to own BRK, you should just own BRK.  Deep discount?  I will look at that later.

Here are some basic information about the funds:

                 Net                expense           BRK as %             Horejsi ownership
                 assets             ratio                of fund                  percentage
BTF          $247 mn        2.11%             37.1%                   42.15%
BIF           $202 mn        1.93%             25.3%                   33.88%
DNY           $81 mn        2.72%             18.5%                   18.50%

You will notice that these funds have large ownership positions by Horejsi and their affiliates.  This is how Boulder Investment Advisors became the advisor for these funds in the first place.  There is nothing wrong with that, but there is an issue of conflict of interest which I'll get to in a second.

Also, these funds do own a large position in BRK.  This is no surprise as Horejsi is a big fan of BRK and has done well with it over the years.  No problem owning what you like, of course.

Deep Discount
OK, so now we get to the gist of the story.  What makes this interesting to people is the discount that these funds trade at versus net asset value.  Mutual funds, of course, are bought or redeemed at net asset value; whatever the fund was worth on a per share basis on the close of the date you buy or redeem. 

However, closed-end funds typically can't be redemmed and can only be bought and sold on the stock exchange.  Therefore, what you get upon selling simply depends on what someone else is willing to pay for it.   Most of the time, this price will be much less than net asset value (ETF's are slightly different; there is a share creation/redemption feature that keeps prices closer to the NAV due to active arbitrage).

The discount to NAV of these funds as of now are (current price versus NAV as of Friday's close as NAV is published only once a week) :

                                                               current             3-year
                       NAV           price            discount           average discount
BTF                $18.54        $15.00           -19.1%           -18.06%
BIF                   $7.18          $5.61           -21.8%           -18.50%
DNY              $17.35         $14.40           -17.0%           -17.01%

These funds do trade at a discount to NAV.  Just off the top of my head, I tend to think CEF's typically trade at anywhere between 10-20% discount to NAV, so this doesn't look any different. 

Some will argue that the holdings in these funds are highly liquid and include high quality stocks like BRK, so it shouldn't trade at such a deep discount.  However, the last column shows that this is very typical of these funds; these funds (like most others) trade at a discount to NAV.

Will the Discount Close?
So here's the question:  How and when will this discount close?   First of all, going back to my contention that CEF's deserve to trade at a discount due to their high fees, that seems to be the case with these funds.  The expense ratios on these funds are, from one of the tables above, anywhere from 2% to close to 3%.  Those are very high and I would slap an automatic 20%-30% discount just to cover those fees.

Activists have in the past bought large stakes in closed-end funds to try to force a liquidation.  Of course,  these funds too started their new life from an activist action:  Horejsi himself buying up shares and then voting himself in as the investment advisor.

With Horejsi owning so much of each of these funds, it is highly unlikely that an activist will succeed in forcing a liquidation of these funds.  Phil Goldstein of Bulldog Advisors (who specializes in buying up cheap CEF and forcing liquidation or some sort of value enhancing transaction) has tried with one of these funds back in 2006 or so and didn't succeed.

Why would Horejsi not liquidate these funds, buy back shares at a deep discount or distribute the BRK shares to shareholders?  Because all of these actions would reduce net assets of the funds.  So what?  Because a reduction in the net assets of the fund will reduce the fees his advisory company receives!  

They will do what's best for themselves, which is a status quo.

Now we begin to see why CEFs often do rights offerings even when it makes no sense (prices are below NAV); they just want to increase assets under management and increase fees.  I don't think any of these funds have done that, but others have done so and this also explaines why there is almost always a big discount to NAV for CEFs; the managers/advisors' interests and fundholders' interest are not aligned.

This is not to say that Horejsi is dishonest or unethical.  There have been some controversy on this issue (you can google the name and you will see some debate). 

For me, it really doesn't matter.  It is totally plausible that Horejsi is doing what he really thinks is right and thinks his fundholders will benefit, even after paying such hefty expenses.

But we can't really argue that this isn't a really, really good deal for Horejsi and his family; they buy a bunch of a fund at a discount, vote themselves in as advisors and direct business to themselves etc...

What happens? 
  • They still own the assets they want to own (they just own it through a CEF), so they don't give anything up by owning the CEF
  • They don't mind the high expense of the CEF because they are just paying themselves and
  • For the assets in the fund that they *don't* own, they earn the fees as an added income stream on top of their investments in the fund.
Sure they have some expenses to deal with as managers/advisors of the fund, but the additional fee income should more than pay for that.

So in a sense, they are leveraging their own investments through these structures and are building an increasing (as they do more of these deals) stream of income.  It's a very good business for them.

As for the rest of us?  We're probably way better off just sticking to BRK.

1 comment:

  1. So this is one way of simplifying this and putting it in a manner that is very easy to comprehend. Nice job here.

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