Compound Mispricings

  • A “compound mispricing” is a situation where both a firm and a security or derivative security is mispriced
  • Can often look for compound mispricings in multifaceted corporate structures
    • Holding companies and derivative securities such as long-term equity anticipation securities (LEAPs) fit the bill
    • Voting and/or non-voting securities such as Korean or German preferred securities or Italian savings shares are also good examples
  • When approaching these securities, the market oftentimes misprices the underlying firm and/or securities in the firm’s capital structure
  • In complex capital structures, there are many permutations available to unlock hidden value:
    • The underlying firm value may be mispriced due to the influence of bad press on public perception, the effects often connected to short-term profitability, or a special situation such as a spin-off or merger
    • An excessive holding company discount which is a cut to prices directly related to the amount of overhead incurred by the holding company. Other factors include: distribution policy, the prospect of minority shareholders (versus management) realizing current and future value generated by the firm, if there is a controlling shareholder, and the liquidity of the holding company shares versus other firm shares
    • Excessive voting/non-voting discounts. Voting/non-voting discounts are directly related to whether they can make a difference (i.e., does someone already have a controlling position), the differential amount of the dividend, and the liquidity of the non-voting shares versus the voting share
    • Cheap leverage (e.g., low interest rate) embedded in derivative securities. This can happen in a short squeeze when it costs a lot to borrow the underlying security
  • To determine if each of these opportunities provides an opening to generate profit, benchmarks, normal discounts, and interest rates must be estimated
  • As it relates to firm value, the difference in multiples for comparable firms across countries adjusted for risk can be examined
  • Regarding holding company discounts, typical worldwide averages are 10-20%, but these discounts are proportional to management/overhead expenses. A capitalization of these expenses in comparison to the holding company’s NAV provides a floor value for this discount, with the qualitative factors mentioned above adding to this discount
  • For voting discounts, typical worldwide averages are 5-10% and proportional to the voting blocks held by others. If there is a controlling shareholder, then it is worth less; if there is no controlling shareholder, then it is worth more
  • For implied interest rates, Joel Greenblatt, in You Can Be a Stock Market Genius, refers to an interest rate with the equivalent of a B credit rating as being reasonable
  • An important caveat in investing in derivative products such as LEAPs is the expiration date. The date must be forward enough to capture the change in value of the underlying security (this is typically greater than 2 years)
  • Some of the key catalysts to reduce the discount include: better governance, growth, and corporate events such as spin-off, new management, death of a control member
  • Some of the key value traps associated with compound mispricings include: declining firm value, corporate malfeasance, and inflated real estate appraisals
  • Found success applying the below tools to uncover the mispricings (IDEEAS):
    • Identify other investors investing in the company
    • Determine where the controlling shareholder has the largest interest within the holding company
    • Estimate “look through” earnings, cash flow, and book value multiples
    • Estimate economic holding company discount based upon capitalized expenses
    • Adjust appraised value cap rates, if real estate appraisal cap rates are too low
    • Select a combination of compound asset/security discounts and “look through” earnings, cash flow, and book value multiples to assess cheapness
  • Example: NICE Information & Telecommunication (NICE I&T)
    • South Korean payment processing firm
    • Its specific function is an electronic payment processing value-added network (VAN) and payment gateway, and it currently is the leading domestic VAN with a 16% market share and the fourth largest payment gateway in the country
    • VANs generate revenue based on fixed fees per transaction and with the trend of the cashless economy and increased credit/debit card usage, revenues are expected to continue to grow
    • Trades at 3.1x EV/EBITDA, which is a significant discount to both domestic competitors (with an average of 13.2x) and international comparables (with an average of 23.6x)
    • Firm’s management/holding company owns a large stake at 42% of the shares and has modest yearly compensation, which indicates an alignment of interest
    • Pricing of the security accounts for country risk, currency risk, and structural difference of the industry in Korea
  • Compound mispricings are often found in complex companies which makes them more difficult to analyze but all the more rewarding to leverage in our investment strategy

Bonhoeffer Capital Management 3Q17 Letter, November 10, 2017

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