Description

Trading at only 54% of tangible book value, Hotung is a compellingly cheap investment opportunity. Hotung Investment Holdings (Hotung) is a Taiwan-based venture capital fund which was formed in 1987 and is currently the largest VC company in Taiwan. Hotung also owns a brokerage firm and a securities trading company which have demonstrated sporadic profitability over the past few years and are insignificant to the value of the company. At the end of the first quarter of 2006, the listed fair value of VC investments was approximately US$204 million. As of the end of 2005, Hotung had investments in 228 companies, nearly all of which were in technology-related fields. According to the company, 4% of the portfolio by dollar amount is in ‘start-up’ stage companies, 66% in ‘expansion’ stage companies and 30% in ‘mature’ stage companies. 65% of the investments are in Taiwanese companies and 24% are in North American companies with the rest spread throughout other Asian countries, primarily Japan and China.

Hotung is currently trading at about half of its book value which is primarily comprised (76%) of its venture capital investments recorded at estimated fair value. But after subtracting out the US$62 million of cash and liquid securities, Hotung’s VC investments are only valued in the public markets at approximately 40% of their estimated fair value.

Key Issues

1)   Fair Value - After the crash of the technology bubble, Hotung was forced to write-off and write-down numerous investments in recognition of their impaired value. Over the period from 2000 to 2003, excluding capital gains realized during the period, Hotung wrote down its book of VC investments by approximately 57%. During the same time period the electric company sub-index of the Taiwan Stock Exchange declined by about 53% with the overall Taiwan Stock Exchange index down about 40%. Hotung however, fared far worse then either index - the stock fell nearly 90% from its peak of approximately $0.62 per share (3x book value) in late 1999. It’s virtually impossible to know if the current fair value on the books is an accurate assessment. However, it appears the fair values are probably roughly in the ballpark given the similar movements of the Taiwan stock indices cited above. In addition, there is of course a fiduciary responsibility of the board of directors and the outside auditors to make a good faith attempt at being accurate. One could argue that when the company was in its write-off stage, the incentive would be to write-off too much rather than too little so as to boost future earnings. However there is no evidence one way or another that this has happened. Finally, and most importantly, approximately 67% of the book value of VC investments have fair values that are easy to ascertain because either the stock is publicly traded (26%) or a new financing or partial sale of at least 10% of the company has taken place in the last 12 months (41%). Thus we are relying on management’s judgment for only 33% of the portfolio. For that 33%, management has already taken a 52% haircut to the original cost of the investments. For what it’s worth, in its 10-K the company claims that they use “stricter controls than most other Taiwanese venture capital firms” when it comes to assessing impairments on investment values.

2)   Track Record - Another way to assess the portfolio is by examining the track record. As one might guess, their pre-bubble returns were as stellar as the recent post-bubble performance has been dismal. From 1992 to April 1997 (the date of the IPO), book value per share grew 4.7x, a CAGR of 44%. During that time period the Taiwan Stock Exchange index grew 2x and during the period 1993 – April 1997, the electric sub-index grew 2x versus Hotung’s 3-fold increase in book value. Roughly speaking, their long term returns have followed the overall Taiwanese market returns. In this context, their 57% write-down seems about right.

3)  Expenses – Hotung’s operating expenses are very reasonable and have come down significantly after a post-bubble restructuring. Annual expenses in the first quarter are at a 1.7% annualized run rate on capital, down from 4% in 2003 and nearly 6% in 1999. As opposed to many U.S. counterparts they are not options abusers. In fact, the share count has not changed in at least 5 years. By comparison, if one were to invest in a private VC firm, the investment would be made at 100% of the value of underlying investments, as opposed to the 40% price paid here, and investors would be charged an annual fee of 2% plus a carry of 20% or more as opposed to the 1.7% fee and no carry in this situation.

4)  Dividends – Hotung does not currently pay any dividends. However when times were better they did – from 1997 to 2001 they paid, in total, an amount roughly equal to half the current market capitalization of the company.

5)  Insiders – Inside ownership is about 31% of the company. Chairman Cheng-Wang Huang owns about 13% of the company.

6)  Outsiders – Third Avenue Value, run by renowned value investor Marty Whitman, owns approximately 9.9% of the company.

7)  Taxes – Hotung pays no taxes when realizing capital gains on investments in Taiwan based companies.

8)  Competitive Advantage – According to one analyst that follows the company, management’s reputation is “quite good”, the chairman and founder has an impressive background, and that Hotung’s position in Taiwan combined with the reputation of the senior executives basically allows Hotung to get in any deal they want in Taiwan. In addition, Hotung appears to be in the catbird seat when it comes to investing in Taiwan. According to the 2004 10-K, “Given the current tough venture capital business environment, we believe that many of Taiwan’s venture capital firms are now operating without an economy of scale and are, therefore, scarcely able to survive. These fund management companies are either seeking new fund managers to continue operation or are being forced to windup. We note that this climate is resulting in a consolidation trend within the local venture capital industry similar to that of other financial industries in Taiwan. As a pioneer in the industry, we are leading other venture capital firms to take proper action to take advantage of this trend.”

9)   Trading – Hotung is a Taiwan-based company incorporated in Bermuda that trades on the Singapore Securities Exchange in US dollars. This bizarre arrangement may explain why it has slipped through the cracks in recent years.

Catalyst