In the comments on my Urbana update a reader pointed me to an article of Geoff Gannon about Urbana and Capital Southwest. Just as Urbana Capital Southwest is in essence a closed-end fund that is trading at a significant discount to NAV. Capital Southwest reported $147 dollar in NAV/share at the end of 2011 while it is currently trading for $96: a discount of 35 percent (and that’s ignoring the fact that share prices are up nicely in 2012). The company describes itself as follows:
Capital Southwest is a Dallas-based investment company that provides patient equity capital to exceptional businesses. As a public company (NASDAQ:CSWC), Capital Southwest has the flexibility to hold investments indefinitely, which has provided its managers a stable ownership platform since its founding in 1961.Since the company was founded more than 50 years ago they have managed to grow NAV/share from $1.25 to $147 (a 10% CAGR) while also paying out dividends. So at first sight this looks like a potential opportunity: the company has a good long-term track record and a sensible investment strategy, so there is no obvious reason why the company should trade at a large discount to NAV.
Portfolio holdingsCapital Southwest mostly invests in private companies, often as a minority shareholder, but sometimes they also acquire a controlling position. While the company has stakes in all kinds of things the majority of assets are concentrated in four companies that were bought decades ago. $371M of the total of $480M in investments are invested in the four top holdings. Two of those four companies are publicly traded, but the shares that Capital Southwest holds have restrictions on resale and are carried at a discount to the freely traded public securities:
While it makes sense to discount securities that have resale restrictions, those restrictions don’t reduce the economic value for long term holders. It’s a small detail: it should add around 25M in value on a total portfolio of 552M. While the public part of the portfolio is easily valued, the private companies are a different story. Capital Southwest provides some very limited information on the financials of the private companies:
The ReactorSeal Corporation:
During the year ended March 31, 2010, RectorSeal earned $9,571,000 on revenues of $102,075,000, compared with earnings of $10,170,000 on revenues of $112,762,000 in the previous year. RectorSeal’s earnings do not reflect its 20% equity in The Whitmore Manufacturing Company. At March 31, 2010, Capital Southwest owned 100% of RectorSeal’s common stock having a cost of $52,600 and a value of $120,200,000.The Whitmore Manufacturing Company
During the year ended March 31, 2010, Whitmore reported net income of $3,661,000 on net sales of $26,777,000, compared with net income of $3,209,000 on net sales of $28,163,000 in the previous year. The company is owned 80% by Capital Southwest and 20% by Capital Southwest’s subsidiary, The RectorSeal Corporation (described on this page). At March 31, 2010, the direct investment in 80% of Whitmore by Capital Southwest was valued at $47,500,000 and had a cost of $1,600,000.So those two companies are valued at a 12.5x P/E and a 13.0x P/E ratio. Impossible to judge how appropriate those ratios are without knowing anything about the companies, but given the fact that they have grown significantly since CSWC invested in them decades ago they are probably reasonable solid businesses and the valuations don’t look crazy at first sight.
Management costsThe biggest reason for a holding company and/or closed end investment funds to trade at a discount to net asset value is because management is adding an aditional layer of costs. The costs of running CSWC seem to be very reasonable. Operating expenses and management and directors’ fees were around 5M a year for the past 3 years, so that would translate to a bit less than a 1% TER. If you would assume that the management of CSWC would add no value this 1% would still warrant a decent discount to NAV. If you would assume that long term expected return of the portfolio would be between 5 and 10 percent a fair discount would be between 10 and 20 percent. Given the track record of CSWC this assumption is probably a bit unfair.
Taxes are another consideration that influence the discount. Capital Southwest has big unrealized gains, but since these gains are probably also not going to be realized in the next few decades the related taxes are not a big issue. The net present value of taxes that will only be paid at some point far in the future isn’t very big.
ConclusionCSWC gives the investor an opportunity to buy at a significant discount a private equity fund that has a good track record. It can probably take a long time for the discount to get smaller, but I think that at the current discount you can be fairly certain that you are getting a good deal. You probably need a lot of patience, but that fits perfectly with the fund strategy and is exactly the reason why outperformance might be possible.
I don’t have a position, and I’m not planning to initiate one soon, because I have plenty of exposure to the USA already and don’t think it’s ridiculously cheap. I’m certainly going to keep CSWC on my watchlist.