HFRO has had a nice bounce since my recent post and is +8% since I wrote about it. I think it still has upside from here, but if I’m honest, it depends to some degree on “known unknowns” and discount narrowing, which is always a tough story with no catalyst.
Full disclosure, this shift comes after talking to MDC of Clark Street Value. His posts on NHF were excellent and after he joined a Twitter Space I started, I though NHF was the better opportunity. Highly recommend you follow his blog if you’re not already.
HFRO is still fine! But NHF on the other hand:
Trades at a larger discount (~32% vs. 22% at HFRO). However, the Terrestar position is at 9%, which I had concerns about, so its close.
Has a better catalyst to close the discount: its converting to a REIT which will trade on FFO most likely and multiples are typically pretty high in REIT space. Therefore the chance the discount narrows is descent even ex-Terrestar whereas at best I was thinking HFRO would still trade at 85% of NAV.
Quick one, but the closed-end fund HFRO looks like an interesting idea. It currently trades at $10.21, yet NAV is $13.84 as of last reporting. That is a 26% discount to NAV. However, you may think the discount needs to be wider for some of the risks I outline. Either way, I think its an interesting one to watch.
Bottom line: If you give full credit for the liquid assets, the balance of the fund is trading at a 45% discount to reported NAV.
Should there be some discount? Maybe. But this large? Not so sure… Can you guess when they announced that they want to convert to a holding company?
For background, HFRO is a closed-end fund, but unlike typical funds that just own stocks and bonds, HFRO owns some esoteric assets. For example, they have a preferred stake is a timber REIT with a 10.25% coupon. That is 23% of the fund. Another 12% is a self-storage asset. Interestingly, ~5% of the fund is also MGM, which everyone knows is being acquired by Amazon. The balance is leveraged loans (12%), CLO equity (21%). Another 8% is a stake in Nexpoint Real Estate Finance, which is a public REIT.
Why does this opportunity exist?
To some degree, people have had trouble with Highland as a manager, which I’ll discuss with their TerreStar stake. Highland, the fund company, also declared bankruptcy and was embroiled in controversy, but that doesn’t mean the funds stopped, it was just the manager who continues to operate.
The Dallas-based firm founded by Jim Dondero helped pioneer trading of corporate loans rated below investment-grade and managed about $39 billion in 2007, but it took heavy losses during the financial crisis and has been embroiled in lawsuits ever since. The company had been trying in recent weeks to settle some of the litigation it faces, warning its adversaries that it would seek bankruptcy protection if they didn’t compromise, people familiar with the matter said.
Again, this is the manager, not the fund itself. The fund itself is not exposed to these lawsuits.
However, Highland is suing Credit Suisse for marketing some assets in 2007 in Vegas as very valuable that ended up quickly being zeroes. And this lawsuit outcome could be a massive right tail event for HFRO. This is marked at zero right now on the balance sheet of HFRO. However, a jury awarded HFRO, the actual fund, $211MM of damages. This was later knocked down to around $40MM. More detail is on the fund site. Either way, it’s marked at zero and anything above $1 is extra value.
Look, Dondero has some issues, but he does find some interesting opportunities. The lumber asset, the self storage piece, the REITs and other funds they’ve founded. He is in MGM because he loaned-to-own through their bankruptcy.
People don’t like this pivot. But the asset change over time (below) shows me they will actually be liquidating the assets that can be liquidated. We also know MGM will probably be sold, so there’s another 5%. This means that value will be quickly realized.
Buyback: The fund committed to a $10MM/month buyback program PLUS management buying $10-$20MM stake. $10MM is about 1% of the fund, so pretty significant. However, this only occurs if this approved, though. It also has some pretty damning qualifying language:
Under the terms of the Share Buyback Program, if, at any point during the Buyback Period, the Company’s common shares begin to trade at more than a 25% discount to NAV, the Company will buy back up to $10 million in aggregate value of the Company’s common shares per month
(But hint, voting against the deal is an upside event – if the NAV is widening because people hate this, it is possible this doesn’t go through and it snaps back)
Biggest Risk is Not Believing NAV
Obviously, the biggest risk with owning illiquid things is that no one can easily mark-to-market. However, we now have a quote on MGM. Lumber is obviously doing very well, and yields are super low, so selling a 10.25% coupon preferred does not seem tough to me. Self-storage, too.
This is the majority of assets. I think they could easily liquidate the CLO equity, leverage loans, and Nexpoint stake which are marked-to-market, so that’s 40% of assets alone. Each of these you can get a quote on Bloomberg each day.
I typically spend my time analyzing small cap, underfollowed stocks. But I’ve been drawn to closed-end funds for a long time, so I wanted to write a quick post on Central Securities Corp, where we are getting a blue-chip stock portfolio PLUS a top notch insurance company for free.
Most investors have crossed passed with closed-end funds: They’re alluring because they can trade at discounts to NAV, meaning if they liquidated tomorrow, many would result in 10%+ returns just from the discount narrowing (i.e. I can buy a dollar for 90 cents). Unfortunately, discounts often persist without a clear catalyst.
However, there’s one closed-end fund that I’m not buying for a discount to narrow over the next year or even 10 years. I’m owning the Central Securities for (i) the manager who has a great track record, (ii) who owns great companies with low turnover (personally, I get Akre / Phil Fisher / Buffett vibes), and (iii) a hidden insurance asset on the books that makes the discount even more steep.
I think I’m literally “being paid to wait” through an outstanding manager while its largest asset compounds at what I expect will be better than market.
The really interesting thing about CET’s performance is that they own a concentrated fund and the turnover is very, very low. Check out these holdings from the report.
I have to admit – It would be extremely difficult for me to hold Motorola for this long. Or Analog Devices. But at the end of the day, these are largely blue chip stocks. Other top holdings include Charles Schwab, Berkshire Hathaway, Intel, Capital One, Liberty Latin America, Kennedy Wilson, and so on.
Who is this manager? Central is one of those closed-end funds that started back in the 1920’s. However, the track record is owed to Wilmot H. Kidd III and he’s been at Central for almost 50 years. His son, Kidd the IV, also works at Central. Eventually the baton will be passed on (Kidd the III is 77) and that may be a catalyst for Central in one way or another.
Plymouth Rock is a P&C insurer, providing home & auto insurance. However, the manager of the insurer makes me just as excited as Kidd the III. Despite being a private company, they have a financial information section of their website.
Here you’ll find the annual letters from Jim Stone, the chairman and founder of Plymouth. Now this is some Buffett-esque letters. Plymouth, like Geico, invests its float in equities. And their track record is also amazing.
Below are some of the comments in the 2019 letter. I personally can’t wait for the 2020 letter.
Here’s the track record of Plymouth book value over time — it’s a 13% CAGR over 23 years!
One thing you’ll notice about this table is that the value is discounted for “lack of marketability”. The value is appraised by a third party, Shields & Company, as “the price at which the relevant shares would change hands between a willing buyer and a willing seller, both in the possession of reasonable knowledge of all relevant facts, with neither party being under any compulsion to act or not act.” That is the value presented in the table above which is then discounted.
This is where it gets interesting: Central DOUBLE Discounts.
I pulled the Plymouth Rock values from Central Securities and then compared it to the appraisals from Plymouth. Central is valuing Plymouth Rock at an extreme discount.
Central provides reasoning. They use market comps as well as a massive discount to the appraised value. I’m not sure a 30-40% discount makes sense…
It seems pretty clear to me that CET is just using 1.2-1.3x Book Value for valuing Plymouth. (Note, we don’t have the valuation yet for 2020)
Honestly, paying 1.3x book value for a company that has compounded capital so greatly seems cheap, but currently this is roughly where P&C insurers are trading (Allstate, Travelers, though Progressive is 3x for its growth).
As of 9/30/2020, the value of Plymouth on CET’s books was $206MM. This foots to a price of ~$7,250/share for Plymouth Rock (down about 5% from 2019 value of $7,600). This also means that Plymouth is worth about $8/share to CET’s NAV, again 22%. But CET trades at a significant discount to NAV. So if we invert and say Plymouth is worth the reported value, then at the market price Plymouth is worth 25% of NAV.
Appraised value is obviously more compelling: If we assume the discount is about what the average has been since 2015 (36%), that means Plymouth would be appraised at $11,316/share, or $322MM vs. what CET reported at $206MM. This means Plymouth actually makes up 31% of NAV or nearly 40% of market price.
So invert what I just said before: you believe in the value of Plymouth then you are getting a lot of blue chip stocks for free!
How will Plymouth Rock asset be monetized? I frankly don’t care – I’m fine owning it for 10+ more years if it can compound BV at its current rate and am currently getting it for free. (In the meantime, I also own other blue chip stocks under Will Kidd’s management.)
However, I think insurance will continue to consolidate over time, so it’s possible they do sell it eventually. A strategic would likely pay in excess of 1.5x due to synergies. I don’t think an IPO is likely given its been private for 30+ years.
CET has sold shares in Plymouth in the past. However, with hindsight, those have been mistakes in my view given Plymouth has continued to compound book value at such a high rate.