|Shares Out. (in M):||25||P/E||0||0|
|Market Cap (in $M):||680||P/FCF||0||0|
|Net Debt (in $M):||0||EBIT||0||0|
Central Securities Corporation
Every couple of years I find myself buying a closed-end fund; I wrote up the last one (BIF) on this site back in February 2016.
Central Securities Corporation is one of a handful of really long-tenured closed end funds that were established at the top of the bull market of 1920’s, and in the case of CET, they almost caught the top to the exact day as the fund was founded on October 1, 1929. Despite the inauspicious timing, CET has managed to survive to the present day. Another pretty interesting fact is that CET has been managed since 1973 by the same guy – portfolio manager Wilmot H. Kidd. As of this writing, the stated NAV of the fund is $32.44 and the market price is $27.09, such that the discount is roughly 16.5%. Stated another way, for every $100 one invests at the current price, you get about $1.20 worth of securities.
The primary reason I was compelled to buy CET is that I think this fund owns something unique and special that is not available through any other investing vehicle: a 17.6% position (23% ownership) in one of the really outstanding private insurance businesses in the United States called Plymouth Rock. I’ve known about this asset for several years, but it’s only been over the last year or two that I’ve had a chance to really come to appreciate what a fine asset Plymouth Rock is. I also believe that Plymouth Rock (I will abbreviate to PR going forward) is valued extremely conservatively on CET’s books, and that were there to be some sort of value-unlocking event at PR the business would likely be valued at a 30-50% premium to where CET has the position marked today.
I will come back to PR in just a moment, but first let’s look at CET’s performance, holdings, and investment profile. Other than the PR position, I don’t see any reason why CET should trade at such a large discount to NAV. CET’s NAV return for 2017 was 25.6%, and for 2016 the return was 20.44%. CET has essentially matched the S&P return for the 5 year and 10-year periods but has beaten the market over 15, 20, 25 and 40 years. Again, this is the same manager for that entire stretch, so I think the comparison is worthwhile. Total NAV at year-end 2017 was $825M, and the expense ratio in 2017 was 75 bps.
The portfolio (other than PR, which is the largest position at 17.5% of AUM) looks like a classic concentrated fund, though I wouldn’t say one is looking at a classic value investor portfolio. At December 31, 2017, the next largest positions were in Coherent (COHR) at 11.6%, Analog Devices (ADI) at 4.8%, Intel at 4.7%, Capital One Financial (3.5%), Motorola Solutions (3.3%) and Hess (3.2%).
CET’s largest publicly traded position at year end was Coherent, which is one of the biggest players in industrial and commercial lasers, and it looks like the stock went from about $70 in early 2016 to $135 at year end. In 2017, the stock went up to over $300 per share (and Kidd has been trimming a bit as the stock has gone higher) but after reporting Q4 earnings last week, the stock is now down back to $205 or so.
CET tends to hold on to positions for many years, though Mr. Kidd also tends to trim on strength and buy back on weakness. Still, some of the positions have been in the portfolio for decades (or at least the remnants of positions). CET bought its initial position in Plymouth Rock in 1982, and has only sold one batch of shares (in 2015, when it sold some shares back to PR to reduce the position size) in over 30 years. Kidd initially bought Intel in 1986 and Analog Devices in 1987. Currently, the Fund also owns smaller positions that include Amazon, Alphabet, Microsoft, and Keysite Technologies, among many others. So Mr. Kidd certainly has kept up with the times.
Before we move on and discuss Plymouth Rock, it bears mentioning the argument that I’ve encountered that CEFs like CET are precisely the types of assets that justify a 15% or greater discount because of low turnover and long holding periods for many of the larger positions. In the case of CET, the average annual turnover is roughly 15%; just because Intel has been in the portfolio since 1987 doesn’t mean that all the stock in there has been there that long, nor does it mean that the average cost is something akin to zero. But just as a thought experiment, assume that everything in the portfolio had a cost basis of zero and all the holdings went back many years. Even if the manager sold everything the year we bought it, the maximum amount of damage would be the 15% capital gains holding tax on the proceeds. Clearly this won’t be the case unless the fund liquidates, since the chances of Wilmot Kidd suddenly deciding to turn over every stock in the portfolio in 2018 is close to zero. Even if a new manager came on board, surely he or she would not be totally insensitive to taxes and wouldn’t sell everything in one tax year.
So my guess is that this isn’t a terrible worry. Some discount is probably justified, but I doubt it’s anything close to 15% for a well-managed fund with a reasonable expense ratio. Also, the same could really be said of any mutual fund (not just the closed end fund types) and people don’t seem to have problems buying their favorite actively managed mutual funds at 100% of NAV (oh wait, are those still around?)
Unlike BIF, CET doesn’t have a managed dividend policy. There appears to be a mid-year payout of 20 cents per share as a recurring dividend, and then there is a year-end distribution that is designed to pay out taxable gains just like a normal mutual fund. Shareholders have the option to receive shares or cash for the dividends as for normal mutual funds.
As far as share buybacks, CET has bought back shares in the past when value was there, and in early 2016 CET bought back about 275,000 shares at an average price of $18.49 per share. In 2017, there were fewer opportunities to buy back shares at a big discount, but CET did buy 74,000 shares. The ability and willingness to buy back shares – and the good sense to buy them back when discounts are wide – is an important factor in my own willingness to buy CEFs in general. In 2016 the average discount of the shares bought back was 20.4% and the average discount was 18.7% in 2017. In addition to buying shares at a discount, it also appears CET usually acts to buy when the market itself was weak, such that it bought back stock at a wide discount into a falling market.
A Hidden Gem – Plymouth Rock
I want to spend a little more time discussion Plymouth Rock because I think it is the special and unique asset that makes me want to own CET when it trades at a sizable discount. One way to think about CET is that since CET has a 17.6% position in PR in terms of percentage of NAV, and we are buying CET at roughly a 17% discount to NAV, we are essentially getting PR for free. But it appears to me to be even better than that because I think the valuation CET uses on it NAV for PR is likely far too low.
For one thing, Plymouth Rock itself issues a valuation appraisal each year (available on its website) done by third party appraisers. The appraiser valued the business at year end 2016 at $7,990 per share, and then used a 20% liquidity discount to reach an adjusted value of $6,390 per share. CET valued its shares of PR on its books as of March 31, 2017, at just $4,500 per share, for another 15% discount on top of the liquidity discount to the appraised value. At year-end 2017, CET valued PR at $5,100 per share. The year-end 2017 appraisal is not yet available.
Plymouth Rock issues excellent annual reports, and at year end 2016 the reported GAAP book value was roughly $436.95M, and there were just 122,823 shares total outstanding, for a BVPS of $3,557.62. However, I think PR’s actual book value is actually higher. For example, the company owns some real estate which, unlike bonds or stocks, isn’t reflected at fair market value in the financial statements. In this case, PR owns two office buildings in downtown Boston that are on the books for a combined $34.3M. In the 2016 annual report, we are told the two buildings are worth much more – roughly $101M at fair market value today. If this is accurate, if we added $67M to the shareholder equity of the company, we’d be closer to $504M, which increases the per-share BV to closer to $4,103 per share. Thus, CET valued its holdings in Plymouth Rock at about 1.1X adjusted BV as of year-end 2016. Again, we'll have to wait for the annual report and appraisal to know where we are for year end 2017.
At first blush, one might think that this 1.1X BV seems a reasonable figure for a decent, total return insurance company (and I personally routinely use 1.20-1.35X book value as fair value estimates for well run publicly traded “total return” insurers like Alleghany or Fairfax). But PR is different and I would argue should be valued on a different basis than those businesses because it is part insurance underwriter and part insurance agency. I would argue PR has more similarities in parts of its business to a State National (SNC, bought by Markel at ~3X BV) or even Erie Indemnity (currently valued at ~7X BV – though I don’t think this is a rational price) because such business aren’t valued by the market at book value; they are valued by cash flow or profitability because they are fee-based businesses and not risk-taking underwriting businesses.
PR’s CEO Jim Stone discusses the company’s targeted annual book value growth as being routinely between 10% (on the weak side) and 20% (on the strong side), and the figures over many years bear that out: in 2016 the BVPS growth was 12%, but as adjusted to reflect investment fair market value increases was closer to 18%. The annualized BVPS growth over the company’s 33 year history is also 18% (on a true GAAP BVPS basis and excluding unrealized real estate portfolio appreciation).
This is vastly superior to the recent growth profiles of Alleghany and Fairfax and much more comparable to Enstar or Markel, but I think much more likely to be sustainable given PR’s much smaller size. Reported earnings in 2016 were $342 per share, which doesn’t include MTM gains on some investments and the real estate portfolio. Also, it should be noted that CEO Jim Stone and CIO Jim Bailey are responsible for the common stock portfolio, which is unusually high for an insurance company at about half the total portfolio value. The stock investing record here is highly comparable to Markel or Fairfax or the other well respected total return insurance companies – better than 15% per year over more than 25 years. Stone and Bailey usually hold less than 10 stocks in the portfolio, so they are very concentrated. Importantly, the common stock return doesn’t include the two premier Boston real estate properties purchased in the downturn of the mid-90s, which have probably enjoyed similar appreciation in value.
Stone writes outstanding annual letters (comparable to Jamie Dimon or Prem Watsa) and is also a published author, as he wrote a book published in 2016 called Five Easy Theses: Common Sense Solutions to America’s Greatest Economic Challenges. For future reference, here is the link for PR’s financial information:
In terms of the 2016 letter, Stone mentions that PR was also the founder of home insurance company Homesite Group (with an investment from Morgan Stanley Private Equity) that was also an investment of Alleghany’s until it was sold to American Family Mutual and where it now books over a billion dollars per year in premium. PR was also involved in founding CAT Limited, a reinsurance company based in Bermuda that was since bought by Chubb. In fact, PR has a long record of incubating newer insurance businesses that eventually get bought by big players at good prices. For 2016, Stone mentioned PR’s relatively new insurance brokerage business called InsuraMatch as one of its growth initiatives, and it also mentioned that it will be expanding its homeowners’ insurance business from one state to five states beginning in 2017.
I will not go into a lot of further detail as those who are interested can check out the PR annual reports for themselves. However, hopefully this description offers some reasons why I think PR is a real hidden asset.
The problem with CET’s stake in PR is that there is no way of knowing if Plymouth Rock will ever go public and it probably won’t given that it has been run for 30+ years as a private company. So it may be that CET never gets that full public market value for its position. There is a possibility that PR might remain a “stranded asset” inside CET so long as it is private and CET may never be able to sell its shares for true market value. The only time, in fact, that CET has ever sold shares in 32 years was in 2015 when it sold some shares back to CET, probably in order to reduce the Fund’s large position in an illiquid security. The other issue is that if CET ever does sell, it will have a very large long-term taxable gain given that its cost basis is a tiny fraction of the current market value. So perhaps in this case the discount is more justified on the tax factor than most. However, my sense is that given CET reduced its position by about 20% in 2015, it will likely not feel the need to liquidate further unless it does get a really good price, and I do think that value ultimately finds a way to be realized. I think that any sale will generate a much higher price than is currently reflected in the NAV and will more than compensate for the 15% long term capital gain tax that would result.
I personally don’t expect any heroics from the rest of the portfolio. I basically just consider it fungible long exposure and of course the risk there is largely broad market risk. I don’t mind owning the CET portfolio because I don’t see a lot of stuff I hate and I do think there is a possibility it can beat the market on the way down (particularly if CET is buying back stock at large discounts to NAV). One can obviously hedge it very easily with SPY or other broad market instruments. If one really hated COHR, one could hedge that out by shorting 10% of one’s CET position.
The last risk worth mentioning is that Wilmott Kidd is well into retirement age and any change at the portfolio manager position could result in higher turnover and taxes if any transition were not done carefully.
|Entry||02/19/2018 08:56 PM|
Thanks for your comment and question. I mentioned in my write-up how I think about the discount related to taxes, and that assuming every holding had a cost basis of zero, they were all held in the portfolio for many years, and then you bought it right before the portfolio manager decided to liquidate EVERYTHING, the maximum damage to the portfolio would mathematically be 15%. Obviously, that is the worst case and any realistic scenario will result in much less economic value leakage.
I can tell you that I would expect taxable gains for CET to be consistent with roughly a 10-15% annual turnover rate going forward. If CET happens to monetize PR, my guess is that the value CET will receive might be 30-50% higher than the current mark, and PR will pay 15% LT capital gains on the full profitability. I still think current investors are better off even after the tax hit (as long as I am directionally correct on the magnitude of the gain from the current mark).
In the quite likely case where PR is not monetized for several years, you'll just get a 1099 like you would for an actively managed mutual fund, and the taxable gains will be distributed out to you at year end (you can choose to receive cash or reinvest, just like for a normal mutual fund). I can't predict how much tax liabilities are going to be, but it will not be zero and it will obviously cause some after-tax slippage versus just holding an S&P500 index fund.
The general answer to your question from my perspective is that some discount is warranted for the tax liability. I don't know how to determine exactly what the appropriate discount is, but I don't think it's 16.5% for a well run, relatively low turnover portfolio like CET. From my perspective, adjusting PR value to reflect true market value might make the current discount greater than 20% and I feel like that is certainly too much.
Finally, I would just say that in my personal case, I only invest in CEFs (regardless of how large the discounts) that I have some personal affinity for. After taking the time to read the historical PR annual reports, I really developed an admiration for that business, and I am also pretty impressed by Wilmott Kidd's long term record of beating the S&P500 by a decent spread over 40 years. I would certainly understand (and would not try to convince) anyone who did not find something admirable in CET / PR to buy merely due to a 16% discount. But in an environment where most assets that I would covet trade at prices that I can't justify owning, I was pleased to find one that I believe actually trades at a sizable discount to what it might be worth. This was also the case with BIF two years ago, when one could buy a portfolio that held a 30% position in Berkshire, traded at a 24% discount to NAV, and where I felt the portfolio manager was committed to making shareholder friendly decisions that would likely help close the discount within a reasonable period of time. Of course, a bull market always helps!
Hope that is useful.
|Subject||Re: Re: Re: Taxes|
|Entry||02/24/2018 08:45 PM|
I'm afraid I don't have the story on succession. I am reasonably confident the younger Kidd won't be running the portfolio.