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Investing in Controlled Companies

July 29, 2014 | About:
John Emerson

John Emerson

145 followers

As I become older, I find myself more frequently investing in companies where the voting rights are controlled by an individual, a small group of investors or a respected investment fund. The group may consist of an individual, a family, a larger publicly-traded company or more commonly, a private investment company or hedge fund.

The advantages of investing in a controlled company are rather obvious: First off, the interests of the controlling entity are generally aligned with those of the minority shareholders. Secondly, since an individual or a small group of investors control the board, decisive action is reasonably easy to enact in most cases. And finally, minority shareholders can be reasonably certain that the actions of the controlling entity will be untaken in an attempt to create or unlock shareholder value.

Additionally, competent investment funds can reaffirm an private investor’s estimation of the intrinsic value of an equity without requiring the investor to pay for the research. Certainly, not all stock purchases made by investment funds are prudent and it is incumbent upon an individual to perform his/her due diligence before investing. That said, “coat-tailing” certain funds with histories of success, can provide an investor with an affirmation that the equity is likely underpriced.

Of course not all controlled companies are created equal and a potential shareholder must discern whether the entity which “calls the shots” is dedicated to value creation. In some cases, the individual or group who controls the company is more interested in maintaining their salary and position of power in the company. Many companies with small capitalizations would fit into this category.

In the past I have profiled the chronicles of the late Jeffrey Steiner and his utter disdain for the minority shareholders of Fairchild,(former ticker symbol FA). The following quote from my “Reflections” series sums up Steiner’s behavior perfectly:

Steiner had a reputation for several things: Most importantly, he could be described as a very successful wheeler/dealer that was known for buying businesses and later selling them for a tidy profit. Secondly, he was one of the most notoriously overcompensated CEOs on Wall Street and he controlled the board of directors at Fairchild.

When he made a successful deal he was handsomely rewarded in the form of a bonus as well as drawing an excessive base salary. Steiner’s legendary greed was profiled in newspaper articles, business magazines and was even the subject of an entire chapter from the book: "In Search of Excess: The Overcompensation of American Executives".

The problem with investing in similar companies to Fairchild is that little or nothing is ever returned to the minority shareholders. Rather the profits are returned to the controlling shareholders in the form of salaries, stock options, bonuses or some other form of excessive compensation. The goal being to perpetuate the compensation and the position of power for the controlling shareholders. Such stocks should be avoided without regard to their discount to “intrinsic value”.

Another common tactic used by overcompensated management is serial share buybacks which are conducted with the express intent of maintaining a stable share count to offset the excessive issuance of stock options or stock grants to the controlling entities. To a casual observer, the practice of issuing stock to management and buying it back seems rather innocuous since it is not dilutive the common shareholder. Furthermore, an investor might argue that the practice keeps the interests of the management aligned with those of the common shareholder. The problem lies in the reality that a significant portion of the beneficiaries of the stock grants or options routinely sell them and pocket the windfall without regard to the current price of the stock.

The real injustice to the common shareholder in the aforementioned scenario is that the cash spent on the options is not allocated with the greater good of the shareholder in mind. Instead of issuing dividends, reducing the overall share count by means of buybacks, or even making an acquisition which might increase earnings, the capital is redirected into the pockets of the controlling shareholders. Such practices are clearly not “shareholder friendly” since the controlling entity reaps the lion’s share of the benefits.

Examples of Stocks with Controlling Shareholders

One of the more recent additions to my portfolio is a niche insurer and business outsource processing company, Fortegra (FRF). Fortegra is an example of a broken IPO which was taken public by Summit Partners in late 2010 at a price of 11 dollars per share. Summit maintained about 62% of the company and is represented on the board of Fortegra by one of its managing directors, John R. Carroll.

Without going into the merits of FRF or building a case for investing in the company, it is sufficient to say that the minority shareholders appear to be well represented by Summit Partners. Mr. Carroll is the only uncompensated member of the board of FRF and Summit Partners interests in increasing the value of Fortegra are directly aligned with the minority owners.

It is not uncommon for private investment funds to provide financing or take equity interests in small private companies with the goal of taking them public. However, when the fund elects to maintain a controlling interest in the business which they have brought public, it reflects a belief that the company is undervalued.

When a broken IPO is still controlled by a private investment fund, it behooves the value investor to take a serious look into the merits of the business. In this type of scenario, an investor is virtually assured that the interests of the fund are similar to those of the small investor. In other words, they want the price of the stock to rise, hardly a revolutionary idea.

Another fund I like to follow is FIMI; the company manages over a billion dollars in investments and is Israel’s largest private equity firm. Around a year ago the company acquired a controlling interest in TAT Technologies (TATT),--one of my larger holdings--for a price of 7.30 dollars per share after bidding on a large share of the company through a court appointed receivership. Interestingly, FIMI had formerly held a large position in TATT and sold it at a large profit a few years prior.

During FIMI’s history, they have purchased interests in about 60 companies, subsequently selling around half of them. FIMI also holds a large interest in Priortech which is the controlling interest in Camtek (CAMT), another one of my holdings.

Premature Selling Involving Controlled Companies

One of my most egregious blunders in selling a stock too early involved another controlled company, PGT Inc (PGTI). Incidentally, I bought that stock at about the same time I bought another controlled stock, a solar energy company named SunPower (SPWR). SPWR was majority-owned by energy titan Total (TOT). I paid about 5.50 a share for SPWR and sold it in the same calender for about enough profit to pay for my round trip commissions which were 9.99 per trade. Unfortunately, I have to relive that experience routinely as the stock scrolls across the bottom of CNBC at close to 40 dollars a share! One might say I was a wee bit early in taking my profits in SPWR.

Back to PGTI, the little Florida company sold hurricane resistant windows, mainly within their home state, and they were absolutely demolished by the credit crisis and its effect upon the construction market in “The Sunshine State”. As it turns out the company would have likely gone under had it not been for large equity raising which was enacted by JLL Partners who held approximately 60% of company. The stock offering was enhanced by some lucrative warrants to purchase shares in the range of 4 dollars as I recall. Anyway, the minority shareholders did not like the deal and the stock price dropped to a dollar a share.

As an aside, JLL is the private investment fund that brought JP Wentworth public earlier in the year. I guess JLL could not resist the urge to “Call 877-CASHNOW” and sell a minority position in the company. My apologizes to JLL for lampooning them; I truly love the commercials and respect the fund for their investing prowess.

I became interested in the PGTI as a housing rebound play. Further, Florida had ramped up the codes on impact-resistant windows, playing right into PGT’s wheelhouse. Any replacement windows or any new construction windows installed in hurricane zones would have to meet the new standards and in that regard, this little niche company had limited competition. Additionally, they had closed a plant and consolidated their manufacturing cutting their costs while insisting that they could handle a massive influx of increased window orders.

My shares which I had purchase for a dollar, quickly jumped to $1.90 a share; I existed the stock with a 90% gain in just a few months, foolishly electing to lock in a rapid short term gain. In retrospect, I would never have held the company into the double digits but I had handicapped the growth scenario perfectly and I should have at least held the stock to the point where the sizable warrants would have been exercisable. At that point I could have built a case for selling based upon the dilution but I still would have been premature in liquidating the stock, in light of the duration of the increasing future profits. A more sensible approach to take would have been to hold on to the shares until JLL had started selling theirs.

One of the most difficult tasks that an investor must perform is deciding when to sell an equity. In my experience, patience is just as important in holding a stock when it is rising as it is when it is descending. The courage of the value investor is much ballyhooed when he shows the courage to hold a stock as it plummets; however no such courage is attributed to the investor if he holds the same resolve as the stock ascends. Rather, the investor is frequently labeled as greedy. Like most value investors, I sometimes fall into the category of mouse as opposed to man when one of my holdings ascends quickly.

Summary

Investing in controlled companies can result in lucrative profits for an investors so long as they make sure that the controlling shareholders are interested in increasing or unlocking the value of a business.

Investors of controlled companies should be cognizant of whether the controlling entities are using their position to maintain exorbitant compensation. Investors should monitor stock buybacks to see if their sole intent is to offset excessive options issued to the controlling shareholders.

“Coat Tailing” successful investment funds or individuals can provide a validation of the intrinsic value of a stock. However, it remains incumbent upon the investor to conduct his/her own value assessment.

Investors who show conviction in holding on to descending equities; frequently lack the same fortitude when one of their stock ascends rapidly. Taking profits prematurely is an emotionally-based phenomena which does not carry the same negative stigma as panic selling; yet it can be equally damaging.

Disclosure: Long FRF, CAMT, TATT

About the author:

John Emerson
I have been of student of value investing since the mid 1990s. I have continued to read and study value theory on an ongoing basis. My investment philosophy most closely resembles Walter Schloss although I employ considerably less diversification. I also pattern my style after Buffett's early investment career when he was able to purchase shares of tiny companies.

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