Students of value investing may be aware of the Buffett Partnership coup which unlocked the underlying value of Sanborn Map is the late 1950s. Sanborn Map traded around $45 per share but had an investment portfolio which amounted to about $65 per share.
The problem Buffett encountered was dealing with the Sanborn board which consisted of various members of the insurance industry who used the company's products but had little interest in separating the investment portfolio from the business. The management and board viewed the excessive liquidity as a rainy day fund without regard to best interests of shareholders. Further, the board owned very few shares of the company and held little in the way of motivation to unlock the underlying value.
Buffett had spent many months buying up the shares for himself and his family as well as successfully encouraging others in his investing sphere to do likewise. His fellow investors included the likes of Walter Schloss, Fred Stanback and Henry Brandt, all of whom continued to buy up the stock. The idea was to purchase sufficient shares to effectively take control of the company and force a tax-friendly separation of the investment portfolio from the operating business. Once the two entities were separated through a tax efficient method which involved swapping the investment for stock, shareholders would be free to sell their shares and recognize a substantial gain.
Finally in early 1960 Buffett's extended efforts became successful and Sanborn Map exchanged a portion of the investment portfolio for company shares. As part of the deal, the Buffett partnership tendered all their shares.
What Is a Workout?
A workout is a special situation where an investor does not rely upon the market to record a gain on his investment. The workout may be a direct result of shareholder activism which is intent upon unlocking the value, as in the case of Sanborn Map, or it may be a simple arbitrage play where a favorable spread exists between the buyout price of a company versus its current offer price. Other examples would be spinoffs, special dividends or various hedging techniques. For instance, Benjamin Graham was known to utilize a simple hedge of going long the preferred and shorting the equivalent common stock to grind out profits during certain market periods.
Workouts can take many forms but they do not come without risk. An investor had better be quite sure that a merger is certain to take place if he is willing to purchase common shares at a price that is just slightly lower than the take-over price. If the merger fails for any reason, the price of the stock is almost certain to drop to well below the price that the arbitrage investor paid for his shares.
Further, sometimes a buyout offer is not taken seriously by the market and the arbitrage premium is little more than a mirage. Case in point, in the spring of 2005, George Schultze made an unsolicited bid for Imperial Sugar (formerly IPSU) merely because he was perturbed at the low price of the stock. While the offer temporarily spiked the price of the stock, Wall Street quickly recognized that the offer was not serious. Unsavvy arbitrage investors who took the $17 buyout offer at face value were burned when the stock soon dropped below the price at which it was trading prior to the "attempted takeover."
TATT as a Workout Strategy
Last month financially troubled KMN Industries who is the controlling shareholder of TAT Technologies (TATT), was served with a petition which granted a lending institution the right to enforce a lien against KMN. The purpose of the lien was to usurp the shares of TATT which KMN held as collateral for an outstanding loan. On Oct. 23, the lending institution filed a petition requesting the appointment of a temporary holder for the enforcement of that lien.
No formal announcement has been made; however, it appears that over 50% of TATT stock is now controlled by a lending institution. When a bank seizes majority control of a company, the most likely result is that the company will be sold in the near future. In other words, the current TATT situation is not so different from Buffett's position with Sanborn Map in the late 1950s, although the goal of the lending institution will likely involve selling all the assets of TATT rather than merely dispersing its excess cash and investment. Similar to the lending institution, Buffett had no real interest in owning the map business; instead he wanted to liquidate the investment portfolio which was not reflected in the value of the stock.
As of last quarter, TATT had around $7 per share of net current assets and a tangible book value of about $9 a share. Included in those current assets were approximately $2.70 per share in cash and short-term bank deposits. It is highly probable that the lending institution could sell the assets of the business at a price of somewhere between its net current asset value and its tangible book value.
Successful investing in workouts or special situations is a matter of risk versus reward and it remains imperative that the investor demand a sufficient margin of safety without regard to the nature of the catalyst. In the case of Sanborn Map, Buffett's activism and his seat on the board provided the key catalyst necessary to unlock the value of the company. Still, had Buffett's activism failed to separate the investment portfolio from the business, it is unlikely that his investment would show much of a loss. The price to book value was low enough and the company's profits were sound enough that the stock would have likely languished near the price that Buffett was paying for his shares.
Value investors frequently hold on to stocks that sometimes appear to be terminally undervalued. Net-nets frequently languish for long periods absent of a catalyst. Such has been my experience with TATT. I have held the stock patiently for over four year and I have averaged down along the way. It been my expectation that its earnings would eventually increase as various cycles in the aircraft industry reemerged.
It now appears that a sale of the company rather than increased profitability will provide the needed catalyst to drive the price per share higher. Even if the sale of the company does not materialize as I anticipate, the stock still holds a substantial margin of safety in the form of a 33% discount to its net current assets.
Disclosure: Long TATT
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