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Buying Funds Below NAV

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Geoff Gannon
Apr 10, 2012
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Someone who reads my articles asked me a question about closed end funds. He mentioned that Warren Buffett and Charlie Munger invested in these funds – a long, long time ago.

And in "The Snowball" we learn that Warren Buffett read a book about closed end investment funds and put a lot of his money into these stocks:
Wisenberger published “Investment Companies”, an annual “bible” on closed-end investment funds. These were like publicly traded mutual funds, except that they did not accept new investors. They nearly always sold at a discount to the value of their assets, which made Wisenberger a proponent of buying them. In short, they were like mutual-fund cigar butts. The summer before graduate school, Warren had sat in a chair at Buffett-Falk’s office, reading Wisenberger’s bible while Howard worked. “Before I went to Columbia” he says, “I used to spend hours and hours reading that book from cover to cover, religiously.” He bought two of Wisenberger’s cigar butts, United States Internal Securities and Selected Industries, which in 1950 had made up more than two-thirds of his assets. While at Graham-Newman, he also managed to meet Wisenberger and had impressed him, “even though I wasn’t very impressive in those days.” In 1957, Wisenberger called Dr. Davis out of the blue and explained that, although it was not necessarily in his own interest to do so, he was recommending a young man to him. “I tried to hire him myself,” said Wisenberger, “but he was forming a partnership and so I couldn’t.” He urged Davis to consider investing with Buffett.
So we know that Warren Buffett put over half of his own money into two closed end funds in 1950. That he read Wisenberger’s closed end fund “bible.” And that closed end funds were something Buffett was very interested in back in the 1950s.

Are closed end funds something you should be interested in today?


Most are not very interesting. Because a lot of closed end funds – like their open ended kin – have poor long-term return records. As a result, buying into a mutual fund – even at a deep discount – is a lot like buying into a sub par business at a discount to its book value.

However, just like with small stocks selling below book value – not every closed end fund sells at a deep discount to its liquidation value because it’s actually a bad business.

There are good businesses and bad businesses that sell below book value. There are also good funds and bad funds selling below their net asset value.

Let’s look at two examples.


One is a Canadian company called Urbana (URB, Financial). It has a very concentrated portfolio:

· NYSE (NYX): 37%

· CBOE (CBOE): 31%

· Bombay Stock Exchange: 13%

So 80% of Urbana’s net asset value per share is invested in just three exchanges: NYSE, CBOE and BSE.

There have been several good blog posts written about Urbana. Like this article from Whopper Investments. Or one of the three blog posts he cites:

· Kerrisdale Capital: Urbana

· Barel Karsan: Urbana

· Petty Cash: Urbana

The company has also been written about at Pretoria Investment. And a post about Urbana over at Hardcore Value correctly stresses the importance of the company buying back shares when it trades at a deep discount to NAV. This is an important part of the Urbana story.

The company gives updates as to its net asset value. For example, you can find the net asset value calculation for April 5 here.

The CEO – and controlling shareholder – Thomas Caldwell writes an annual letter and sounds rational enough.

For example, he does not sugar coat the situation with one of the company’s holdings:

Our holding in the Bombay Stock Exchange (“BSE”) has continued to be challenging.

The Jalan Report, noted in last year’s Annual Report, remains somewhat of a cloud. The good news is that our efforts and those of others has diffused some of its more offending recommendations (control of pricing, profits, salaries and a prohibition on exchange IPOs).

Finally, Urbana is able to buy back up to 10% of its shares at a discount to its net asset value each year under its current buyback program.

Two other blog posts to read about the company are this one about Urbana at Free NPV and this much longer one over at Intrepid Value Investors.

Obviously, all these posts were written on different dates. Keep that in mind when reading them.

Now, should you buy Urbana?

Basically, I think this comes down to what you think about those three investments I mentioned:

· NYSE: 37%

· CBOE: 31%

· Bombay Stock Exchange: 13%

Right there, that’s four-fifths of Urbana’s value. And the whole idea of buying into Urbana at a discount is that the market price of those investments in some way reflects economic reality.

Does it?

The problem here is the kind of companies we are talking about. If you look at the economics of something like the CBOE it looks a lot like a dominant local newspaper once did. The problem is that these exchanges are losing market share.

CBOE trades at astronomical price-to-book and price-to-sales ratios. These ratios are perfectly justified if the company has something like a 35% operating margin. Right now, it has an operating margin over 40%.

But how sustainable is that?

Very few companies that have anything short of total dominance within their little niche can achieve operating margins of 30% or higher. Obviously, it is possible to have operating margins far above that.

For example, FICO’s operating margins are over 60% in its scoring business. Facebook has operating margins around 50%. Facebook can sustain that. Can CBOE?

CBOE has a 26% share of the overall options exchange business in the U.S. It was over 33% just five years ago. Usually, when looking at a company with a price-to-sales ratio around 5 – that’s not the direction the market share is moving. It should either be totally dominant or growing share. CBOE is doing neither.

Yes, sales may grow a lot. Because volume can grow. But does volume growth without market share growth actually lead to sustained operating margins of 40% or more?

Competition can completely destroy the stock prices of some of these exchanges. Because there is a huge distance between where shares of a stock like CBOE trades today and where it would trade if the price-to-sales ratio reflected a highly competitive industry.

It’s not a business I think I can understand. Analyzing CBOE is a lot harder than analyzing Facebook or FICO. There are a lot of factors in any trading business that encourage a great deal of customer attention on price. Never a good thing. Of course there are also wonderful economies of scale. But you are betting very heavily on very fat margins in these businesses for a long time to come at today’s prices.

Based on the very little I know about the exchanges, I would not buy them. It’s not that I think they are overpriced. It’s just that – at the kind of prices they trade at – I think they are far outside my circle of competence.

Certain things like CBOE’s ability to exclusively trade S&P 500 index options probably account for a large amount of the company’s future value. If you look out 10 years, do you still see them having exclusivity? There are a lot of questions like that. And I’m not good at answering those kinds of questions.

These stocks are not for me.

Now, it might sound like I am making way too big a deal out of whether or not I would actually buy the stocks in Urbana’s portfolio. After all, every investment company that trades below its net asset value is going to have stocks in its portfolio that I don’t like and would never buy.


And that’s usually fine. If the stocks in an investment company’s portfolio closely mirror the overall market – I can make a pretty good guess what they are worth as a group.

With diversified portfolios, you’re going to often end up owning something that looks a lot like the overall market. I can give a pretty good guess as to what that’s worth.

It’s hard for me to guess what Urbana’s top holdings are worth. So it’s hard for me to guess what Urbana is worth.

If you like any of Urbana’s top holdings, you should definitely buy Urbana instead of buying NYSE or CBOE directly.

Right now, Urbana is trading at about 60% of its net asset value as reported on April 5. You can update the NAV number yourself using the last trade prices on NYSE and CBOE.

But unlike a lot of investment companies selling at a discount to their net asset value – Urbana’s value depends on just a couple investments. And those investments face the exact same risks. So, you have an extreme concentration of risk in Urbana’s portfolio. There’s nothing wrong with that if you understand the companies in Urbana’s portfolio and are willing to take on those risks.

But you should view an investment in Urbana as a “look through” investment in NYSE and CBOE. You should buy Urbana not because it is trading at a 40% discount to its liquidation value. You should buy Urbana because when you apply a 40% discount to the last trade prices of NYSE and CBOE – you think those are very low prices for those stocks relative to their intrinsic value.

In other words, you should buy Urbana because you want to own NYSE and CBOE. You just don’t want to pay today’s prices for those stocks. You want to pay a lot less.

You can pay a lot less. And you can do it by buying Urbana.

Capital Southwest

The other investment company we’re looking at also concentrates on just a few holdings. Like Urbana, Capital Southwest (CSWC, Financial) trades at a deep discount to its net asset value. Today, the stock trades around 65% of its NAV.

Also like Urbana, Capital Southwest once traded at much lower discounts to its NAV. In fact, Capital Southwest once traded at a premium to its NAV.

Urbana – I should mention – traded at a 60% premium to NAV in 2007. So, the premium/discount to NAV isn’t really about liquidity or management control or something like that. It’s not about most of the rational justifications we can offer for why investors neglect these stocks.

It’s really much simpler than that.

An investment company’s discount to NAV is just a gauge of how much investors like or hate that company. Whether it fits their taste or not. In fact, if you look at the long-term record of either Urbana or Capital Southwest – you’d have a hard time understanding why they should trade at large discounts to NAV.

Many people argue you should only buy an investment company selling below its NAV if the discount to NAV is much larger than normal. I’m not sure I agree with that. In fact, for long-term investors I don’t think that is the most important issue. I would start by looking at:

· Management expenses

· Portfolio turnover

· Taxes

· Very long-term performance

If a closed end fund scores very well on those four points, it could be worth buying – in fact it should be preferred to an open end fund – for long-term investors who can get shares at any discount to NAV.

If a closed end fund scores badly on those four points – you may not want to buy it even when it trades at an unusually large discount. Don’t outsource the job of judging an investment company. Look at the reasons why a fund should sell at a discount. And decide for yourself whether the fund you are looking at is too expensive, too active, too tax inefficient, and too terrible an investor. If it is, you shouldn’t buy the fund for the same reasons you shouldn’t buy a truly awful net-net. It may be cheap. But it isn’t good. You want good and cheap. You can afford to get stuck in a good, cheap business. You have to flip a bad, cheap business very fast.

The same rule applies to funds. Just because a fund is selling at an unusually large discount to its NAV doesn’t mean you will make money if the usual return of the fund on its own NAV is very bad. If you can combine a situation where you get a decent enough return on NAV from inside the fund and a decent enough discount to NAV from outside the fund – that may be your best bet, even if it’s not the stock that deviates furthest from its past average discount to NAV.

Capital Southwest does fine on these points. Even if it sold everything it owns today and paid a 35% capital gains tax – it’d still be selling at a discount to NAV after paying that huge tax bill. Of course, Capital Southwest will never actually pay a tax bill like that. If you look at how long it has normally held companies, you’d expect Capital Southwest to only realize about 5% of its gains in any one year. Spreading a tax bill out over 20 years is a lot different than paying it in one year.

Capital Southwest is an ultra long-term investor. So, it’s hard to see how fears of taxes could change your view of the stock intrinsic value by more than a couple percent one way or another. Certainly, not anything like 35%. So taxes alone don’t explain the discount.

What kind of discount to NAV does Capital Southwest normally trade at?

Here’s Capital Southwest’s market price divided by its net asset value per share for the last 26 years.

1985 0.76
1986 1.00
1987 0.76
1988 0.78
1989 0.82
1990 0.77
1991 0.82
1992 1.11
1993 1.06
1994 0.96
1995 1.20
1996 1.17
1997 1.20
1998 1.09
1999 0.88
2000 1.09
2001 1.05
2002 0.89
2003 1.00
2004 1.01
2005 0.93
2006 1.16
2007 0.82
2008 0.69
2009 0.70
2010 0.64

The median discount is 5%. In other words, since 1985, Capital Southwest has tended to trade at about 95% of its net asset value per share. Right now, it’s actually 1.8 standard deviations from its 26-year mean (of 94% of NAV).

Should you buy Capital Southwest?

Yes. It’s a better choice than buying the S&P 500. And a much better choice than buying an open end mutual fund.

Portfolio turnover is low, management expenses are miniscule (they are often covered just by interest), and Capital Southwest’s 10, 25, and 50 year total return records are better than the S&P 500.

For a long-term investor, there is little reason to prefer the S&P 500 over Capital Southwest even when Capital Southwest is trading pretty close to its NAV (like 90%). When it’s trading at 65% of its NAV, I think it’s clear you should prefer Capital Southwest.

Of course, many of Capital Southwest’s investments are not publicly traded. It’s a venture capital company that keeps the companies it invests in once they go public. So, it has some publicly traded investments. But it also has some very large investments that don’t trade.

That’s okay. I went through all of Capital Southwest’s top holdings that don’t trade. And I switched the value at which Capital Southwest carries the investment from what is shown on the books to a simple 15 times last year’s earnings. Overall, doing this would actually increase Capital Southwest’s intrinsic value. On a weighted basis, Capital Southwest is carrying its non-public investments at about 14 times last year’s earnings.

That sounds fine to me.

Remember, you are only paying 64% of Capital Southwest’s NAV when you buy a share in the market. So, while Capital Southwest may carry its non-public investments at 14 times earnings, you can buy them at 9 times earnings (14*0.65 = 9.1).

You can check the company’s publicly traded investments – like Encore Wire (WIRE) – for yourself.

It’s very easy to come up with an intrinsic value estimate for CSWC.

Like I said, Capital Southwest’s long-term record is better than the S&P 500. It has also outperformed the S&P 500 – in terms of its total return on NAV – about 60% of the time over the last 3 decades. I don’t find that a very meaningful figure. But the combination of an investment company that has a slight tendency to outperform the market year-to-year, a slight tendency to be a teeny bit less volatile than the market, and solid 10, 25, and 50 year records shouldn’t add up to something that sells at less than two-thirds of its net asset value.

While Capital Southwest may not be a lot better than the S&P 500 – it isn’t a lot worse either. It’s hard to find any evidence to support the idea that Capital Southwest will earn less on its NAV than you can earn in the stock market overall.

But last I checked, Capital Southwest was trading at 65% of its net asset value.

It’s worth buying if you’re looking for something to hold for a while. There’s no reason to expect Capital Southwest’s NAV performance to be inferior to mutual funds – and many investors already own a few of those – plus you’re getting in at a 35% discount.

In fact, I’d actually prefer Capital Southwest to mutual funds. Obviously, an open end mutual fund is very attractive to shorter term investors because they know they can get out at a gain or loss that reflects what the market did while they held the fund. To the extent these investors see buying or selling stocks as betting for or against the overall stock market – they aren’t going to be interested in Capital Southwest. They’ll want an open end mutual fund instead.

If you are looking to time the market, you shouldn’t buy Capital Southwest. There’s no guarantee you will get out at a lower discount to NAV in the future.

But, for longer term investors, I’d consider swapping Capital Southwest for one of your existing open end mutual funds. It’s a much better choice.

What about Urbana?

I wouldn’t compare Urbana to a mutual fund. I would buy it if I was interested in owning a publicly traded stock exchange. Buying shares of Urbana is obviously the best way to invest in stock exchanges.

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