Description

Capital Southwest is an equity-oriented BDC that operates under the mantra "patient capital for exceptional businesses."  The company still owns large positions in several companies that it funded originally as VC investments in the distant past.  In the current portfolio, CSWC still owns shares of publicly traded companies such as Alamo Group (ALG) which it originally funded back in 1969, Palm Harbor Homes (which it funded in 1977) and Encore Wire (1989).  Of course, this strong loyalty to existing holdings has also been at times a double-edged sword for CSWC - the company would have been better served to more aggressively sell down its holdings in Heelys, for instance. And despite years of great results, the recent residential real estate debacle pounded the value of Palm Harbor Homes in the past couple of years.  Palm Harbor recently declared bankruptcy.

Despite the occasional set-backs, CSWC has demonstrated an ability to grow value at a decent clip over time.  Capital Southwest was, until 2007, led by William R. Thomas, who compounded investor money in the mid-teens on an unleveraged basis for a good 25 years while taking an unusually conservative and patient approach to the normally high risk / high reward business of venture capital investing. Overall, a $10,000 investment in CSWC made on April 1, 1962 grew to $5,472,000 by March 31, 2007, versus $880,000 for a similar investment made in the S&P500. That's an average annual growth rate of 15.0% over 45 years, versus approximately 10.5% for the S&P500. In July of 2007, Thomas passed the reigns of Chairman and CEO to Gary Martin. Thomas died in September 2008 at age 80.  Gary Martin joined Capital Southwest in 1972 and served as CFO until 1979. From 1979 to 2007, he served as the CEO of The Whitmore Manufacturing Company, a portfolio company of CSWC that makes specialty lubricants.

CSWC is an internally managed BDC, and keeps costs extremely low.  Most externally managed BDCs happily charge their investors the private-equity standard fees of 2% of AUM and two forms of incentive fees (one on income and one on capital gains) and many internally managed BDCs routinely run expenses above 4-5% of AUM when incentive fees are included.  CSWC, on the other hand, has kept its expense ratio at lower than 50 basis points of AUM for most of its history.  The company recently has somewhat expanded its investment team such that I expect annual expenses to run more like 100 basis points of stated NAV going forward. 

In addition, I believe that CSWC is extremely conservative in its approach to valuing its investments for purposes of NAV calculations. CSWC does not report its large publicly traded holdings at the quoted market prices, but rather uses a significant discount. It should be pointed out that there is a legitimate rationale for using a discount, that being that there are certain restrictions upon any holder of more than a 5% interest in a publicly traded security.  In addition, CSWC generally retains capital gains from portfolio exits and pays taxes on behalf of its shareholders rather than issue new shares as is typical for most BDCs.  As far as disclosure, CSWC provides decent disclosure about their large privately held businesses each year, though certainly not exhaustive. The company provides revenues and reported net income for each portfolio company in the top 12 holdings in each year's annual report. 

CSWC's investment performance tends to run in streaks. The company suffered a five year period from March 31, 1998 through March 31, 2003 that saw reported NAV per share decline by 31% (before distributions) on a cumulative basis. CSWC then had a wonderful run for the fiscal years from March 2003 to March 2007, as a number of their controlled companies did very well and several of their VC investments enjoyed exceptional outcomes through acquisitions or IPOs.  The 2008 and 2009 fiscal years, on the other hand, were tough for CSWC. The stated NAV per share dropped from $186.75 as of March 2007 to $110.98 as of March 31, 2009, a cumulative decline of about 40%. The drop in fiscal 2008 was mostly caused by the faltering of Heelys, which caused the value of CSWC's stake to decline from the $195 million at March 2007 all the way back to $35 million by March 2008, a loss of $160 million, or $41.33 per CSWC share.  NAV per share bottomed at the year ending March 31, 2009 at $110.98 per share.  As noted previously NAV per share has since rebounded to $136.92.

I will review very briefly the major constituents of CSWC's NAV.  The company has not yet issued a 10-Q for the December quarter, so I will be making rough approximations based on the September Q.

Cash net of all liabilities other then pension liability totaled about $74.6 million as of September 2010.  With 3.742 million shares outstanding, this is about $20 per CSWC share.  I expect most of this cash to be deployed in future investment opportunities.  CSWC has an overfunded pension plan so I disregard that entirely here.

The company has two wholly-owned businesses that are of material size, RectorSeal and Whitmore.  RectorSeal was acquired by CSWC in 1967 and manufactures specialty chemical products for HVAC, electrical, and industrial.  RectorSeal's subsidiary Jet-Lubt makes anti-seize compounds, specialty lubricants, and other industrial lubricants.  CSWC valued RectorSeal at $138.1 million as of Sept 30.  The company held up well in the downturn, reporting revenue of $102.1 million and net income of$9.6 million for the FY ending March 2010, down only slightly from FY 2009.  I expect considerably better numbers for the year ending March 2011. Also, I suspect that net income understates cash flow generation.  Keep in mind that cash generated by these two businesses are generally retained and occasionally used to do additional snap-on acquisitions at the subsidiary company level. Whitmore Manufacturing makes specialty lubricants for heavy equipment used in mining, railroads, and other industries.  The company also makes fluid contamination control devices under the Air Sentry brand as well as a coatings product for the automotive industry.  Whitmore also owns some undisclosed real estate assets.  Whitmore reported revenue of $26.8 million and net income of $3.7 million in FY2010 ending March 2010.  Again, I expect slightly better numbers for the upcoming fiscal year ending March 31 2011. CSWC valued this business at $49.4 million as of September 2010.  These two major holdings together comprise about $50 per CSWC share at stated NAV.

CSWC also owns shares in six publicly traded companies, which are shown in the table below. At September 30, 2010, CSWC had these assets valued at an aggregate of $157.6 million, which was a discount to the then public quoted values of about 16%.  I have updated the values as of mid-day on Jan 31^st below.  If we discounted these figures by 15%, we'd have about $185 million, or about $50 per CSWC share.

The combination of the cash (net of liabilities), two biggest wholly owned portfolio companies, and the stakes in publicly traded companies gets us to roughly $120 per CSWC share. 

Assuming that we wished to call this a reasonable deal for the $100 stock price today, there is another 20 or so portfolio holdings that CSWC values at about $95 million, or another $25 per CSWC share that we as investors get for free. 

Finally, I assume that CSWC is capable of producing a positive return on the investment portfolio.  The wholly and majority owned businesses are profitable and kick off cash that either gets retained at the portfolio companies (increasing their value) or is paid to CSWC in dividends, increasing the cash at CSWC.  I would like to believe the investment team at CSWC is capable of at least generating a positive return on the rest of the portfolio over a reasonable period of time.

Overall, I believe that investors are getting a decent collection of investments for 75 cents on the dollar with a free call option on reasonable growth from here.  The major downside is the illiquidity of the stock. The average daily dollar volume on the stock is less than $1 million per day.  Therefore, this is an investment that is only appropriate for small capital bases or for those who are willing to accept the risk of not being able to exit the position quickly or easily.

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