2127: Nihon M&A Center

I was flipping through a book I bought a while ago while I was in Japan; it's a book about 41 CEO's of companies listed on the Tokyo Stock Exchange's "Mothers" market which is a sort of entrepreneurs' exchange.  The Mothers market was created to try to have a marketplace where young entrepreneurial companies can list shares, like the U.S. Nasdaq/OTC / pink sheets etc...

One criticism over the years in Japan was that there was a lack of entrepreneurs as there are in the U.S., and the over-regulated capital market system was partly blamed.  The Mothers market was an attempt to correct that.

I just looked but there are only 177 or so companies listed on the Mothers market (in accordance with my resolution to turn over tons of rocks, of course I will take at least a quick look at all of them soon), so I don't know if they actually succeeded.  The Mothers market and JASDAQ seem to be basically dead in Japan.

Anyway, flipping through that book, I did find something interesting, even though it may not be a great buy at the current price.  There are businesses in Japan that actually do have decent margins and ROE and seem to be growing.  This is one of them.  I will make posts about companies I find interesting even if I don't think it's a great buy at the moment.  If I only posted about great finds, then I might only have two or three posts a year. And if Buffett is right about five great ideas being enough in a lifetime, then this blog would be even deader than that.  Since I am going to be digging through a lot of stuff, I might as well jot down things I see along the way as it may interest others.  You never know; I often pass on things that other people love and vice-versa.

The company is called Nihon M&A Center, and it is exactly what you would think it is; it's an M&A advisory company.  Normally, I would skip past this right away as the M&A business is usually highly cyclical and prone to dramatic booms and busts.  But this one seemed a little different.

First of all, this company (Nihon M&A Center which I will call NMAC for convenience) was founded in 1991 as sort of a network of about 50 accounting firms across Japan.  I think the purpose was to share information regarding M&A of smaller firms. 

NMAC was listed on the Mothers exchange in October 2006 and moved to the First Section of the Tokyo Stock Exchange in December 2007.

NMAC focuses on mergers and acquisitions of small, family-owned businesses with anywhere from 10 to 100 employees (and some with fewer than 10 employees).  Their network with accountanting firms, regional banks and savings and loans around the country give them a big source of leads, and that is one of their competitive advantages.  Many businesses are family owned in Japan, and succession is often a difficult issue.  It is apparently more common these days for small businesses to have no successors, so a sale is the only real option.  Also, a difficult economic environment also plays into the increase in M&A as it is one strategy for businesses under pressure.

Since NMAC deals in very small firms, they play in an area where the large investment banks don't get involved (too small to make a dent).   Their total revenues was 5 billion yen in the most recent fiscal year, or just $65 million; not too economical for large banks to chase this business.

According to a comment by the CEO in the book, there are at least 120,000 small businesses that are potential M&A candidates so he sees plenty of room for growth for NMAC.

Here is the number of deals they closed in the past few years:

Year-ended           # of                   # of                 Sales per
March                   companies        transactions     transaction (per side)
2009                     122                    66                    32 mn yen
2010                     122                    66                    31 mn yen
2011                     156                    83                    31 mn yen

I couldn't find any good data on the number of M&A deals closed in Japan recently, but I did find a good chart that only goes to 2008:

So the number of domestic M&A deals (where a Japanese firm buys or merges with another Japanese firm) grew from 150-300 range in the late 1980s to the mid 90s to over 2,000 transactions in 2005.  I assume that this chart would continue to dip into 2009 and then rebound into 2010 and 2011.

In any case, with 120,000 candidates for M&A in the small and medium sized business sector and over 2,000 deals per year done and NMAC doing only 83 transactions per year or so, this would seem to suggest plenty of headroom for growth.

When they start advising a buyer or a seller, they typically sign an advisory agreement and a fee of 1-3 million yen for sellers and 1-5 million for buyers is paid.  If a deal is consummated, then a percentage based on the deal value is paid.  I looked around in the filings and couldn't find an average fee rate that is charged.  This is one thing I will have to track down.

So anyway, let's take a look at some numbers (figures in millions of yen except per share figures, ROE, P/E and number of employees):

                         (there was a 4:1 stock split in 2007)

These figures almost don't look like a Japanese company; ROE and net margin (below) consistently above 20% with some decent growth.

Growth rates for the six years since 2005 were:

Sales:                      +22.7%
Ordinary income:   +30.2%
Net income:            +26.4%

Here is the margin history:

Almost un-Japan-like.

So how are they doing so far this year?
In the six month period ended September 30, 2011,  this is how they did (in yen):

Sales:                          2,973 mn, +33.2% (year-over-year)
Operating income:      1,461 mn, +44.7%
Ordinary income:       1,476 mn, +48.9%
Net income:                   851 mn, +50.9%

EPS:                         12,772 yen/share, +50.8%
BPS:                         95,601 yen/share

The company's full year estimate for the year ended March 2012 is:
Sales:                            5,280 mn, +5.4%
Operating income:        2,200 mn, -3.6%
Ordinary income:          2,200 mn, +1.3%
Net income:                  1,250 mn, +4.1%
EPS:                            18,755/share

The stock price is trading currently at 405,000 yen/share, so that comes to a P/E ratio of 21.6x and a P/B ratio of 4.2x.   There is some cash and investments on the balance sheet that might take this valuation down a little bit, but not dramatically.  It's a 26 billion yen ($340 million) market cap company, so not exactly a tiny cap or nano cap stock. 

The dividend payout ratio has been around 35-38% in the recent past.  They expect to pay out a total of 7,000 yen/share in dividends for the year through March 2012 for a payout ratio of around 37%.  That's a dividend yield of around 1.7%.

This company does seem to be in an interesting niche with decent margins, ROE, growth and what seems like decent management. 

The valuation is not at a level that would interest me as I don't like to pay for growth and I really don't have a good feel for the future growth potential of the business.  Is the recent boom in M&A a sustainable trend, or is it a one-time wave that will end like the real estate restructuring boom that occured (and died quickly after the deals were done).  I don't have a strong view on that.

 I do think they are on to something very interesting, but it is a growth stock trading at a growth stock multiple.  There is nothing wrong with that and some people might be interested in this issue. 

I will keep this on my watch list and will follow it going forward, but I won't be buying into this at this point.

An interest side story is that in the same Mothers stock exchange book that I am skimming through there is another M&A advisory firm.  It's called MCA Savvian with the ticker symbol 2174.  This one doesn't have the track record of NMAC and it does look like a lot riskier business than NMAC.  MCA Savvian seems to be chasing the big deals; the deals that the major investment banks and money center banks would be chasing after. 

I don't want to post any details on MCA Savvian, but the biggest problem is that they are expanding worldwide with offices and presumably highly paid executives in a global branch network.  The problem here is obvious to me.  They want to go head-to-head with other more experienced M&A advisory firms (plenty of those in the U.S. and Europe), not to mention the  large global investment banks like Goldman Sachs and Morgan Stanley.

A quick reading of the history of the senior management doesn't indicate to me any 'edge'; I see no reason why the senior management in Tokyo would be able to do better than Nomura or other global investment banks in chasing after large M&A deals.   This is not to say that they can't succeed.  They may do just fine.

This is where NMAC differs and why it is at least an interesting idea; they stay focused on the Japanese domestic market and go for the small deals that large banks don't want to bother with.  It's definitely a niche area (even though I admit I don't have a grasp of the competitive dynamics in the sector; up and coming competition etc... Their large margins and returns on capital should attract competitors going forward).

However, MCA Savvian seems to be building out a global infrastructure even before establishing a strong profit base.  At least that's my impression from taking a quick look at it.  No niche area like NMAC, going head-to-head in larger deals with highly competitive global investment banks, expanding rapidly globally with no real 'experience' that I can see from the senior managers in Tokyo etc...   All of this, to me, spells trouble. 

Buffett Likes Japan

I was going through my stack of unread magazines, newspapers, newsletters, notes etc... and came across a Nikkei Weekly from November, when Buffett was in Japan.

He has said before that Japan is getting interesting because it is getting cheap.  After the earthquake/tsunami in March 2011, he also said it's a time to buy Japan, not sell. 

In interviews and comments to the Japanese press while in Japan in November, he said that he is interested in large Japanese corporations and have them on his radar.  He also said he would love to get a call from them because he would only be interested in buying a large stake if invited to (I don't know why he wouldn't want to accumulate shares over time like he did IBM), and that if a major corporation called Berkshire, he would fly back to Japan on a moment's notice to get a deal done.

Of course, this is exciting to people who like Buffett and Japanese stocks.

So it did occur to me that it would be an interesting idea to try to figure out which Japanese corporations Buffett would be interested in.  We know he likes sustainable competitive advantages (moats), high returns on capital, reasonable price and all that.  It's not too hard to come up with a mechanical screen to see what would hit Buffett's radar.

But anyway, this is where my thinking on this stops;  Over the past few years, how many Buffett fans would have guessed what Buffett's next big stock purchase is going to be?

Just to name a few big 'surprises' in the recent past:  Burlington Northern, IBM, Lubrizol.  Who'da guessed Buffett would buy IBM?  Or Burlington Northern after spending years explaining to people that he doesn't like capital intensive businesses?  Nobody that I know of and I try to follow Buffett fan sites so am aware of quite a few attempts.

So back to Buffett and Japanese stocks.  The above made me realize that I'm not going to be able to guess what stock it's going to be.  And you know what?  Even if I did guess it, what Buffett is looking for and what I am looking for is not going to be the same thing; he needs to move size, and he needs to buy something he is not going to have to worry about for the next 20 or 30 years.   Of course, I would like an investment like that too, but I am a bit more flexible than that.

In any case, off the top of my head, I can't really imagine what company he would be interested in Japan.  The financials are all pretty much disasters.  I don't think there is a Wells Fargo or American Express over there.  Insurance companies too might be interesting to him, but I don't know that Japanese insurance companies are that well managed or great businesses.  Life insurers are disasters, I think.

Most of the major blue chips that I've looked at over the years are low margin and/or low return on capital more interested in corporate socialism than shareholder return.

Anyway, it is an interesting question so I will keep it in mind when looking at stuff in Japan, but it won't be something I focus on too much.

Happy New Year! (and resolutions)

So, here is my new year's resolution:  turn over more rocks this year.  A LOT more.

The process of investing is pretty much just looking for interesting things to do.  The more situations you look at, the more chance you have of running into an interesting idea.  I have to admit that in the past year or so, I have not been digging a whole lot in obscure areas.  Buffett has said that you can still make 50%/year returns (he said this back in 2006-2007 when everything seemed expensive), but that you have to really dig and turn over a lot of rocks in places where others aren't looking.  He often mentioned how he went through the Moody's manual looking at each company one at a time.   When someone asked him with so many companies out there where should they start, he said start with the "A"s.

I've had my share of doing that; going through one-by-one all the stocks in the S&P small cap index, in some of the micro-cap/nano cap indices and going through everything in the Walker's Manual (whatever happened to that organization?).   I also went through the Japanese "Shikihou" (Japan listed company handbook which is like the S&P or Moody's handbook with all listed companies and relevant statistics) a few times over the years.

It's actually a lot of fun to look into those tiny companies, and it often doesn't take a lot of time to look at, say, compared to digging into the 10K of AIG or Citigroup.

But I haven't done a lot of digging into obscurity over the past couple of years, mainly because so many of the big large caps seemed so cheap and interesting to me.  I still think there are a lot of decent buys in the large cap area and I still do like many of the financials.  But we can't put all of our stock into financials, nor should we sit around and wait for the big blue chips to go up.

I do think it's a great time to be digging around again so I will specifically allocate a lot of time to go through tiny cap stocks, one by one.  I hope to look at thousands of stocks over the next few months.

One thing I've found over the years that I should put more into practice is that the best ideas are the ones you find yourself.  I've been reading all sorts of blogs and websites on stock ideas for years and I have to say that it is very rare that I get anything useful out of them.  I still look at them for informational purposes (to know and understand what people are looking at and thinking), but I don't remember the last time I got any good investment ideas from them.  

Guys like Buffett did their own work looking for their own ideas, and Michael Burry (the hero in the book "The Big Short") does the same thing; he looks for his own ideas.  Many of the best investors all seem to say the same thing.  I can't prove it, but I would guess that the guys that act on other people's ideas probably don't do as well over time as the ones that find their own.

This is not to say that we should ignore the great investors and not listen to good ideas.  We should all keep our eyes and ears open to any interesting ideas wherever they come from.  But one shouldn't expect to generate decent, above average returns from just jumping on second-hand ideas.


Anyway, just as a salesman has more chance of generating a sale the more calls he makes, we value investors have more of a chance of finding something interesting the more things we look at.  This will be a big theme for me this year.

Let's see how this goes.  I hope to post some interesting things I find on this "journey".

YHOO Deal?

There is talk out there that Softbank and Alibaba is going to bid $17 billion for Yahoo's Asian holdings in some sort of tax free deal.  I don't know what the real term sheet looks like, it was just on CNBC.  But let's take a quick look to jot down some of th facts.

Here's the basic information:
(grabbed from the CNBC screen)

• 40% of Alibaba ($12 billion)
• 35% of Yahoo Japan ($5 billion)
• Yahoo keeps 15% stake in Alibaba
• Tax-free, cash-rich split
• Yahoo "core" valued at $6/share?

I don't know what the last item valuing Yahoo's core business at $6.00 means. The stub value after deducting the $17 billion on the deal is $2/Yahoo share.

Actually, dividing $17 billion by the 1.24 billion shares I think is outstanding gives $13.70/share, and Yahoo is trading around $16/share so that gives the Yahoo operation a value of $2.30/share.

But actually, the 3Q figures show that Yahoo has cash, cash equivalents and bonds worth $2.87 billion on the balance sheet.  That's $2.31/share, so the market is actually giving the Yahoo "core" business a value of zero.

So here's my math:

Yahoo's Asian holdings:  $13.70/share
Cash, cash eq and bonds on balance sheet at September-end 2011: $2.31/share
Total:  $16.01

Stock price: $16.00

Implied value of core business: $0.00

What is this business actually worth?  Here's some info for the last four quarters of Yahoo's core business:

For the last four quarters through September 2011, Yahoo had total revenues (excluding traffic acquisition costs) of $4.4 billion and operating income of $778 million.  Using a 35% tax rate, that is a net income of $506 million or so and with 1.24 billion shares outstanding that's around $0.41/share in EPS.  This is also very close to free cash flow per share.

At a 10x p/e ratio, that would value Yahoo's core business at $4.10/share giving a total value of $20.00/share or so for the whole of Yahoo (including the Asian holdings).  I think I heard an analyst mention the value of Yahoo at $20/share, so this calculation is not far off.

If you assume a 10% free cash flow yield for Yahoo's core business, we can get a similiar figure. With free cash flow in the past four quarters of $560 million, that's $4.51/share, so not too far off from using a 10x p/e multiple (which gives a $4.10/share value).

As of the end of the third quarter, Yahoo's guidance for the 4Q 2011 was:

Revnues: $1,125 - $1,235 million

Operating income:  $200 - 260 million

Using the midpoint of this guidance, you get 4Q 2011 revenues of $1,180 million and an operating earnings figure of $230 million.

So doing the above exercise using a 2011 fully year projection would result in a figure that is pretty close to the last four quarters.

The problem with the above analysis is that revenues at Yahoo has been declining 4-6% year-over-year in the past four quarters.  If this trend continues, it's possible that Yahoo may not be worth the above.  It may well be worth much less.

JEF Up 20%

So it's nice to see Jefferies Group (JEF) stock up 20% today to just over $14.00 after dipping below $10.00 at one point in November.

Despite the panic and near-run on JEF due to a faulty report be Egan-Jones, JEF managed to make money in the quarter.  The market is relieved and the stock price is showing it.

I won't get into details on the quarter or yearly earnings announced today, but there was an interesting comment on the conference call:  JEF said that this 'issue' of misinformation and misunderstanding in the quarter really disrupted their business and that if this didn't happen, they might have had yearly earnings of $400 million and revenues of $3 billion or so.

That would have been $1.81/share giving JEF a valuation of less than 8x p/e even at the current price of around $14/share, and an ROE of 11.7% and a return on tangible book value of 13% which is not bad at all in this environment.

Of course, there is no guarantee that that is what JEF would have earned.  I think they just looked at the run rate revenues and earnings up until the panic set in when they had to take measures to shrink the balance sheet and deal with a market where customers fled and counterparties hesitated etc...

Anyway, I don't own JEF but I am still bit shocked at the incompetence and carelessness of Egan-Jones in publishing such a sloppy report and his refusal on live TV to admit the error.  An admission of error would be a blow to the credibility, of  course, to Egan-Jones but his refusal to admit a simple mistake to me is much more enlightening and scarier.

Again, this sort of really explains some of what happened during the upside of the credit bubble, and now these same organizations threaten to cause panics and runs at totally viable institutions.

I am more in favor of restructuring this industry than ever before having been supportive of them over the years (even though I would never depend on their research or opinion of anything).

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.

Performance
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.

FOFI: Hedge Funds at a Discount?

I am not a big fan of closed end funds, but if something is trading at a steep discount, we have to take a look.  In general, a lot of funds have expense ratios in the 1%-2% range, sometimes higher.  So in my mind, they deserve to trade at a discount to net asset value (NAV).

I use a simple 10% for my discount rate for most things, and this 'expense' to me is worth 10%-20% of NAV (2% expense ratio / 1% = 20%).

Of course, if the fund is going to outperform the market or whatever index by at least 1 or 2%, then that's a different story; it may be worth it.  But most of us who have been in the business for a long time know that most closed end fund managers are not going to outpeform anything.

Anyway, this one is interesting because 50% of the assets are invested in hedge funds.  Now, when people say "hedge funds", people do tend to get excited imagining 20% or 30% performance uncorrelated with the stock market.  But we also know that *most* hedge funds won't do too well.  Only a handful of the top funds are going to do well over the long haul, and that lists tends not to grow as quickly as the ones that try and fail.

But let's take a look at this thing anyway.

First Opportunties Fund (ticker: FOFI)
This fund is interesting.  Until last year, some time in the spring of 2010, this was a normal financial sector equity fund run by Nicolas Adams of Wellington Management.   And then at some point early last year they decided that they will reorganize the fund to be able to invest 50% of the assets into hedge funds (run by the same Wellington Management; I think one of the hedge funds is now run by Nicolas Adams).

And then the SEC apparently didn't like that a NYSE, publicly listed equity fund is going to turn into a sort of conduit for individual investors to be able to invest in hedge funds (you have to be an accredited investor to invest in unregistered private investment partnerships).  Apparently under pressure from the SEC, the NYSE delisted FOFI and now FOFI is a pink sheet stock.

Since at least one of the hedge funds is run by Nicolas Adams, let's see how he has done over the years.  I assume the return figures through March 2010 is the 'old' fund (before reorganizing), because the shareholder vote took place after that.

I cut and pasted a table from an annual report and it doesn't fit the width of this blog, so I had to just cut and paste the figures; the labels won't fit so I will place that on top of the table (don't know how to line them up side-by-side, sorry)

The bottom line seems to be that over time, this fund has done well, gaining 12.2%/year over a 10 year period compared to the S&P 500 index being down -0.7%/year.  This is not bad given the huge financial crisis which occurred during this period. 

However, the fund does seem to have lagged the S&P 500 index in all other periods.  But again, that is not suprising given the financial crisis that just happened.  In fact, the fund has outperformed the financial sector indices in all periods periods from 1 year, 3 year, 5 year and 10 years. 

To get more color on this fund going back, I pulled some performance figures going back as far as I can from SEC filings.  Nicolas Adams seems to have been the manager since the mid 1990s, at least.

So going back all the way to 1996, the fund has returned an average +7.74%/year versus an 8.22%/year return for the S&P 500 index.  It looks very volatile having had great years in 1996-1998 and then tanking hard, almost 70% in 1999-2000 and then coming back strongly in the early 2000s until getting hammered in the financial crisis.

I actually don't really know what to think about this performance as it is a sector fund; Adams does seem to have outperformed the sector indices in the above cut and paste from the 2010 annual report.

Reorganization
So wht the reorg?  I don't want to get into the specifics of exactly what happened (advisors/subadvisors changing etc...), but I think the change occured lead by Stewart Horejsi, whose entities own (and have owned) 36.4% of FOFI.   Securities filings show that his entities have owned 30-40% of FOFI at least back into the 90s, so this is not something he picked up during the recent financial crisis.

I may research and write more about Horejsi later, but for now let's just say he is a value investor that likes to buy closed end funds at steep discounts and take over the management of the assets.

This reorganization too was presumably lead by him.  This may be due to the volatility of the fund itself; having gone down 70% once in the late 90s and by more than 50% again in the recent crisis.

There is obviously a little boom in non-correlation, and moving assets out of long only stocks into 'hedged' or non-correlated assets like hedge funds sort of fits that trend.

As I said above, one of the hedge funds is managed by Nicolas Adams, who has run this fund before the reorganization.  The difference is that he will be running it as a hedge fund, meaning that he will be buying and shorting financial stocks.

This can be a good or a bad thing.  Back in the old days, I've heard of many people go from mutual fund, long only strategies to long/short only to not do too well.  Short selling stocks is a very tough and tricky game and it does take a different kind of temperament to deal with it.

My impression over the years has been that I tend to think that this conversion from long only investing to long/short strategies don't usually go well.  As evidence, look at all those long/short funds that mutual fund companies offered over the years; I don't think too many of them have good performance track records even though the mutual fund companies have a lot of great research infrastructure to support that kind of business.  I think it's just a whole different mindset and it's hard to switch over.

I could be wrong about that.  I haven't done any research to prove this, so it's just a guess.  I wouldn't necessarily be wildly excited about someone who has managed long only for many years suddenly going long/short.

Of course, I have no idea how this Nicolas Adams is, so it might be that he has in fact been running a long/short portfolio for Wellington all along and may be very good at it.  But if that is the case, we don't have information to support that either.

The 2010 proxy does say that the board has been studying Wellington (and presumably it's hedge fund business) for eight years, so the performance must be pretty good. The proxy does state that the process to invest in Wellington's funds started in 2008 or so as they were looking for a way for FOFI to get more investment flexibility including being able to short. So the 2010 switch occured after a couple of years of work after figuring out how legally to get it done.

So How Has it Gone?
The new advisors took over in June 2010 and the realloaction process began then. Since then and through September 2011, this is their performance:

FOFI:         +1.8%
S&P 500:   +5.0%

This is the annualized return since June 2010 through the end of September 2011. Of course, this is way too short a time period to evaluate anything.

Valuation
As of 12/9/2011 (closed-end fund companies only annouce NAV once a week) the net asset value per share of FOFI was $8.58/share and it is trading now at around $6.14/share for a discount of 28.4%.

Half of the net assets are invested in a group of hedge funds; I won't list them here as I don't have any information on them so it wouldn't mean anything (all holdings are listed in the FOFI reports to shareholders).

Going forward, this fund will no longer be a financial sector focused fund; the new advisor (entity run by Horejsi) is having Wellington Management liquidate the legacy portfolio (banks, thrifts and savings and loans) while Horejsi buys large positions in stocks like Johnson and Johnson.

If only I can figure out the return potential of the hedge funds, this can be an interesting idea, particularly at a close to 30% discount. It's important to remember, however, that closed end funds do typically trade at a discount of anywhere from 10-20%.

If exposure to hedge funds is the objective, I would prefer Greenlight Reinsurance (GLRE) now at a reasonable valuation as David Einhorn does have a very public, good track record.  Also, hedge fund operators often do better than the fund themselves due to the operating leverage of running a money management business.  As assets under management (AUM) grows and costs remain stable, additional fees can all fall to the bottom line.  I will look at some more asset managers in the future.

In further posts, I may look more into Stewart Horejsi and his other entities that people sometimes recommend as a way to play Berkshire Hathaway at a discount (Horejsi is an early Berkshire Hathaway shareholder; he made is wealth with it and has since become a full time value investor working with these entities. The entities, by the way, are ticker symbols BIF, BTF and DNY (and maybe some others).