FRMO On Increasing Difficulty in Trading OTC Listed Companies

In the most recent shareholder letter:

Indeed, the valuation disparities are not always caused by margin-related issues. For example, the Polestar Fund owns shares in a successful company that trades at 40% of book value with a very liquid balance sheet of considerable size. Recently, as an experiment, one of us tried to buy $600 worth for a personal account held at a major brokerage firm. This transaction could not be processed since it was asserted that the company did not disclose audited financials. Naturally, we objected that audited financials did exist and were available on the company website. The financial results are audited by one of the biggest, internationally recognized accounting firms. Unfortunately, we did not reckon with the definition of “available” in the modern cloud-based universe. Available means available on a certain database. Thus, to “protect us from ourselves” and to control risk, the purchase was prohibited.

Unleveraged Commodity Companies

The FRMO quarterly call [pdf] had some thoughts on optionality of unlevered oil producers:

"Let’s take oil as an example which, I should warn you, isn’t necessarily reflective of what we might have in this fund. Let’s say I wanted to buy an at the money call option on oil. Oil is $30 a barrel, and I want to buy a call option exercisable at $30, and I want it exercisable over the course of 20 years. The writer of the option would calculate the strike price as known, the option expiration period of 20 years, the volatility of oil and then ask some truly astronomical sum as a price for that option. But, effectively, you can buy that option in an unleveraged commodity company, and you get it for free. If you can find one that’s making some money, if you think about it, it’s actually a negative premium."

Thoughts on Private Equity and High Yield Bond Duration in Latest Horizon Kinetics Quarterly Letter

[pdf]

"If one reviews some broadly representative bond indexes, like the iShares Core Total U.S. Bond Market ETF (AGG), which emulates all the investment grade bonds in the United States, one will find that the average maturity is not much longer than six years. Or, taking the iShares iBoxx $ High Yield Corporate Bond ETF, the average maturity is just over four years.

In other words, even though there are buyers of 30-year bonds, looking at the bond market as a whole, it is clear that very few are interested in taking duration risk. Everyone is aware of the interest rate risk, and they are preparing for it. Bond buyers, especially those taking credit risk, certainly do not want to add duration risk.

However, there is one group taking the risk, but it just does not realize it. In that group are those institutions — and they are only institutions — that are placing large amounts of money in private equity. They think they are lowering risk. They are removing money from publicly traded equity, and even bonds in some cases, and placing it in private equity.

Of course, private equity is borrowing the money because it is only private equity in name. A more functionally accurate term would be leveraged equity. The idea behind buy-out private equity investing is to find a suitable public company, pay a control premium for it, and then bring it private with an extraordinary amount of debt. If the maturities on those borrowings are short (and, unlike the historical norm, there is much less availability of long-term high-yield lending to match the extended workout periods ordinarily required for private equity) and if interest rates rise, then the refinancing risk is entirely on the private equity investor. The bond buyer, assuming the company remains solvent, is going to get a higher coupon; the private equity investor is going to pay the higher coupon."

FRMO Corp 2014 Q3 Earnings Call

Highlights from the earnings call transcript [pdf].

Running an insurance company for "free float":

I would add to that, when we were seriously investigating, more than once, the possibility of establishing some kind of insurance subsidiary, I was given a long tutorial one afternoon by someone who had actually built one from the ground up for another investment firm that had done just what we were talking about. And, indeed, they had avoided—because they were also a conservatively-oriented firm, they wanted to avoid issues of undue periodic risk. And they went into a low-risk bread-and-butter type of insurance business, with short lives, just workaday niche type of insurance and so forth. And many purveyors will even send you a team that will do this for you.
And I think he did it successfully. But, as he explained it to me, what became apparent was there was so much effort involved not merely in setting it up and managing it, but you also have people involved, and you have your underwriters, and you have lawyers—the distraction clearly was great. And this fellow, who was very bright, who set it up for his boss, the head of this investment company, who was supposed to step into it once, set it up, and leave it—it is now his full-time job. So, he no longer is involved ininvestments; he is involved in insurance

Duration:

That fund became the Kinetics Alternative Income Fund, which is designed to be the lower-risk version—also lower return—of the Kinetics Multi-Disciplinary Fund. The idea is, to the extent that it has a bond exposure, it is going to have a very short maturity, let’s say in the one-to two-year range, something like that. By way of contrast, the Kinetics Multi-Disciplinary Fund uses a longer maturity.

The ultra-ETF trade

"If you look at the denominator, which of course is the market value of the securities sold short, on February 2013, which is a little bit less than $2.3 million, that is actually a very big rate of return, which actually leads me into strategic items, which is why I bring it up. There is no magic there. All we’re doing is selling short various of the so-called path-dependent—or dysfunctional as I call them — indexes and exchange traded funds. The academic term is ‘path-dependent,’ which I’ll define momentarily, but the word I us is ‘dysfunctional.’ In the academic literature, path-dependent means that, sooner or later, no one can tell exactly when, those securities will gravitate towards a price of zero. It is much like Zeno’s Paradox: it never really gets to zero but is goes down 99.99999%, which is really very bizarre. The reason I bring it up is not to show we made any money, but for strategic reasons."

Horizon Kinetics on "Corporate Risk Reduction"

From a new Horizon Kinetics research paper, "Corporate Risk Reduction" [pdf]:

Of course, the 12 companies—Apple, Exxon,Google, Microsoft, Johnson & Johnson, Chevron, Procter & Gamble, Pfizer, Verizon, IBM, AT&T, and Merck—are all very different businesses. On average, however, cash as a percent of total corporate assets is 23.3% for the group, and some companies, as one can see, are holding considerably more than that.

The 23.3% average is an interesting statistic. If portfolio managers were active and holding 23% cash in their portfolios, they would be considered reckless, at a minimum relative to their mandate to be invested in equities and to not assume other risks such as timing the market, and much worse than reckless, at a maximum. These companies, however, are holding cash at those levels. What is the difference, one might ask, if the companies hold a 23% cash balance and the managers hold a 23% cash balance? Is it not all the same? Actually, it is not, because the more cash on the balance sheet, the less volatile the equity is going to be. It is clear that the companies themselves are interested in reducing their volatility.

I like Horizon Kinetics, and I think his point is worthwhile as far as it goes. However, I am thinking something else about this corporate manager cash statistic. Unlike an investment manager, nobody cares if a CEO has a huge amount of cash or is underinvested. So they are more free to plan for low demand/deflationary trends. And that is what they appear to be doing.

Horizon Kinetics, Owner-Operators, Indeterminate World, and the Predictability Arb

I had never paid much attention to Horizon Kinetics, an asset manager run by Murray Stahl and Steven Bregman, but I've been reading their market commentaries and research reports and they seem like a good buy and hold manager. [The problem with buy and hold, of course, is that it has such big drawdowns unless you get out of the market during periods of overvaluation that can last for ages.]

The 2012 Q4 letter [pdf] presents a rather unique idea that the metrics most investors focus on (P/E, P/B, EV/EBITDA) could in some cases be a manifestation of availability bias.

"[T]he idea of assessing a varied set of companies via one or even several metrics, as if a portfolio of companies can all fit within a handful of pre‐defined boxes, is a very limiting, unidimensional way to view businesses. It can miss a great deal of information content. What about all the data that has not been predefined and made available as individual fields in the databases that produce those ready made reports? In a sense, for people who rely on those tools, that data doesn’t even exist—and it might be very important. Availability error can be very costly"

Unfortunately, they use this concept to justify owning the Beijing Airport operator, which apparently trades at half the valuation per passenger as Heathrow and the Paris airport. Although the Beijing airport is growing more quickly, the GDP/capita of England is 3x Beijing (and 6-7x China as a whole), so it's not immediately clear that this discount is unwarranted.

They do call attention to another very interesting metric, and that is the rate of share repurchases. There's a lot of academic research about the effect of net stock issuance on future returns [study pdf], and there is a clear inefficiency where the market is too slow to recognize the effect of repurchases (Conrad Industries) or new issuance (say, GMX Resources).

If I was going to buy and hold equities, I would be interested in a lot of the big share repurchasers they mention: Berkshire, Dundee, Leucadia, Liberty Media. The common themes that unite their equity holdings are: repurchases, "owner-operators" (managements with very large equity stakes, not free options), and conglomerate discounts. 

Another recent letter was about companies with dormant assets [December 2012 pdf]. For example, Dish Network has several billion dollars of wireless spectrum that the market doesn't really give it credit for; Icahn Enterprises had not really been getting credit for buying the $2b Fontainebleau resort for $156mm, etc.

The big discounts for conglomerates and dormant assets reminds me of Peter Thiel's "indeterminate world" idea from last summer. As he wrote, "any company with a good secret plan will always be undervalued in a world where nobody believes in secrets and nobody believes in plans." As HK put it in an earlier 2012 letter

"If one were to draw a Venn diagram of the critical, motivating elements in the financial markets today, two of the largest intersecting circles should be labeled Ultra-Low interest Rates/Reinvestment Risk and ETF Proliferation/Equitization of Asset Classes."

Think about what is really expensive in the market right now: fixed income and assets that share the salient property of fixed income: predictability. So in addition to bonds, that means utilities, REITs, MLPs, royalty trusts, apartment buildings, even single family rentals which investment managers are trying to scale for the first time (won't work).

Why is predictability so valuable? I'd argue that, just as Thiel says, investors have largely lost faith in the ability of managements to plan and execute for the benefit of shareholders. The opportunities for cash to disappear on the way to one's pocket are too numerous: poorly timed buybacks or capital expenditures, dumb acquisitions, obscene salaries and options grants.

So public markets put a huge premium on predictable, non-divertable cash flows and more attractive (lower) multiples on cash flows that are seemingly uncertain. As for conglomerates, nothing gets punished like moving parts. A bird in the hand is worth three in the bush.

[Obviously, there are various exceptions to the idea that investors don't believe in plans. For example, investors clearly believe in the Amazon plan. But it's clearly the case that there is a predictability premium.]

Think about this in relation to Conrad Industries. We know that shipyards are essentially booked for this year and next year, and that we are finally embarking on a number of years of steady GOM drilling again after the ban. Conrad will make at least $35mm EBITDA in a good year. The current enterprise valuation, net of excess cash and the probable BP settlement, is about equal to two years' EBITDA. It's as if the company gets no credit for the future years' earnings that aren't already known.

Hunger for predictability is also why the arb opportunity for David Einhorn's opportunistic use of preferreds exists. That hunger has created a wide disparity between the cost of capital of debt or preferred stock and the existing common stock of most companies.

A Conrad Industries preferred stock would trade at a single digit yield; say 6 percent. The earnings and cash flow yield on the common stock is much higher than that at the current share price. [For Conrad, it's something well north of 20 percent depending on whether you look at net income, EBITDA, or FCF; and depending on how much excess cash is on the balance sheet.] If the company issued preferred stock and used the proceeds to buy back common, it could capture that spread. So $20 million would mean several million dollars in additional annual income to common shareholders, assuming that many shares could be bought back near the current trading price.

Another arb that it creates is what I call the predictability arb. Chesapeake has thought of this because they mentioned it in an investor presentation.

"recognize the world is 'short yield' and [want to] provide various investment opportunities to yield-hungry investors who are willing to pay more for select assets than core E&P investors are willing to do."

It looks like E&Ps, like Chesapeake, can be thought of as a bundle of two dissimilar types of assets: producing properties that income investors would pay a huge multiple for, and undeveloped resources that investors are suspicious of because no one believes in plans. Rightly or wrongly, the claims of high potential IRRs on new wells seem to fall on deaf ears.

The predictability arb is to develop producting wells - with the predictible cash flows that investors crave - and spin them off into trusts. With each sale, use the cash flow for drilling new wells or share buybacks if that has a higher IRR.

If the public markets are skeptical of your plans, take anything predictable and drop it down into a REIT, an MLP, a trust and spin it off. Then decide whether the best use of the proceeds is stock buybacks, capex, or acquisitions.

What I find interesting about Horizon is that Stahl and Bregman seem to have this idea, and it is the most likely to work out of the ways that I see people allocating long-only capital. Oddball Stocks wrote a post about Investing in Horizon Kinetics through the back door with FRMO, which is an entity run by Murray Stahl and Steven Bregman that owns about 1 percent of HK.

Asset management is a fantastic business, and the end of the interest rate cycle will reorder the industry. Rising interest rates will be brutal for those who are too far out on the curve. But surviving asset management firms will be worth more in a higher interest rate environment.