the blog is dead

Long live the blog.

I've moved to wordpress because blogger software is terrible in comparison.  At the same time I changed the name.  Check out the new blog (well-conceived investments) here:
http://fowci.wordpress.com

I'm going to try to post more, and often with shorter posts, there.  I'm also going to concentrate on a lot of New Zealand stocks, as that's where I actually do most of my research.

Kiwifruit update

Seeka filed a few documents over the past few weeks since I wrote about the company.

The director selling his shares got rid of another 27,000.

The company released a "stakeholder" presentation essentially trying to explain why shareholders had done so badly over the past few years.

Worth reading if you thought about buying Seeka or Satara.  I still wouldn't.

Bargain fishing

Over the past week or so I’ve been looking at closed-end funds, prompted by this cool post by Brooklyn Investor.

A closed-end fund is a fund run by a portfolio manager that trades on a market.  Fund holders own shares in the fund, but the fund doesn’t allow redemptions nor new issuances of those shares.  In contrast, an open-ended fund allows holders to give their shares to the manager of the fund, who pays them out the “net asset value” (NAV) of their shares.  The NAV is simply the current market price of the underlying assets that the fund holds. 

The share price of a closed-end fund can trade at a discount or a premium to the NAV of the underlying securities. 

The very existence of a discount or premium calls into question the efficient market hypothesis.  If the efficient market hypothesis is true, then buying a basket of closed-end funds will provide a market return (minus fees).  Because no stock is known ex ante to outperform, buying a basket of closed-end funds simply gives you a diversified market portfolio.  If this were true though, there shouldn’t be such a high discount on some of these funds.  In New Zealand, the Marlin Global fund  trades at a (as of the end of last week) 17.6% discount.

Now, to tell you a secret, I really do want the efficient market hypothesis to be false.  If it is, all this blogging, reading, and investing might have a chance of succeeding and I won’t have been wasting all this time.  If you read Brooklyn Investor’s post on Phillip Goldstein, you’ll see one person who seems to be earning above market returns by investing in closed-end funds at a discount to their NAV.

Reviewing the finance literature of closed-end funds, there are effectively seven reasons why the discount might be rational.  If the discount is a rational feature, the market might be efficient and the discount might not a source of subsequent outperformance.

The seven potential reasons are:

• Built-in potential gain tax.
• Distribution policies
• Investments in restricted stock
• Holding of foreign stock
• Past performance
• Portfolio turnover
• Management fees

I’m going to through each one of these as it applies to the Marlin Global fund to see if any of them (individually or in combination) can explain the 17.6% discount.  If they can’t, my conclusion is that it might make sense to buy some shares in the Marlin Global closed-end fund.  As you’ll see if you read till the end, there seems to me a good catalyst for the closing of the discrepancy between the NAV and the market price for Marlin Global.

Built-in potential gain tax

This doesn’t apply.  For a New Zealander investor (like me) the fund is subject to the Portfolio Investment Entity (PIE) regime.  This taxes the fund by deeming five percent of the net assets to be income (on which tax is then charged).  As long as investors hold more than $50 000 of foreign assets (bit more complicated than this) in their personal portfolios, there is no tax advantage from holding assets directly as opposed through the fund.  There is no capital gains tax in New Zealand, so the explanations in the USA about investors no longer having an “option” to bring forward capital losses and delay capital gains cannot apply.

Distribution policies

I’ll come back to this at the end, but Marlin Global has a particularly attractive distribution policy that should reduce its discount.  Basically, Marlin Global pays out, quarterly, 2% of the net asset value of the fund.  Annually that’s 8%.  The pay-out ratio is almost 10% when you look at the current market price as compared with the NAV and the distribution policy.  One thing to keep in mind is that this is not a true “yield” because you’re not getting paid the income from the fund (or the dividends from the companies it owns).  You’re being paid 8% of the net asset value of the fund yearly.  You’re getting capital amounts back, not income amounts.

To me, that’s a good news story as it should minimise the difference between the NAV and the share price. If the manager cannot grow NAV by 8% a year, reduces the assets under management.  In turn, this could force the fund to close and redeem at NAV as assets shrink.  Of course, if the manager can grow NAV at over 8% per year, the discount should shrink on its own as investors start to believe that the manager has some ability.  I conclude that distribution policies cannot explain the discount.

Investments in restricted stock

This is the idea that the NAV might be overstated because the fund owns “restricted stock” that it cannot sell.  From a quick review of Marlin Global’s holdings, that doesn’t seem to be the case.  However, it does hold positions in some very small companies.  If the fund tried to sell those quickly it would likely not receive the current market price.  I conclude that this might explain a very small discount.

Holding of foreign stock

This goes both ways.  Some posit (and this is borne out in plenty of evidence) that the holding of foreign stock should create a premium, as it is likely to be a much more cost-effective way to get exposure to foreign stocks than holding the stocks directly.  Inevitably a small investor will have larger trade and foreign exchange fees than a fund manager.  Marlin Global holds non-New Zealand or Australian investments.  This is one way to remove the “home bias” – invest in a foreign closed-end fund at a discount.  I conclude this doesn’t explain any of the discount.

Past performance

Everyone knows that past performance doesn’t predict future results, don’t they?  This explanation for the discount assumes that past performance does predict future results, and therefore poor past performance requires a discount.  This raises the inherent contradiction in looking at closed-end funds.  If we assume the market is efficient, then past performance doesn’t predict future results, and there should be no discount.  But we do see a discount.  But if we assume the market is inefficient, then past performance does predict future results, and there should be a discount. But is the discount evidence of market efficiency?  How can it be when one of the inputs explaining the discount is that the market is inefficient?  This is tough stuff. 

I’ve come to my conclusion that the market is inefficient on the basis of evidence that there do seem to be a category of investors and stocks that do outperform.  In short, value investors and “value stocks” do seem to persistently outperform. 

Let’s take the situation where past performance does predict future results.  How is the past performance of the Marlin Global fund?

It seems to be outperforming (in a very minor way) the MSCI Global Small Cap Gross Index (ie, it’s a smaller negative).  The fund manager is Fisher Funds.  Fisher Funds seems to have outperformed generally over quite a large time frame.  That’s from a quick scan of their website though.  These sorts of funds are notoriously difficult to compare, and any attempt to do so is riddled with survivorship bias so it’s hard to put much weight on this.

Let’s be conservative and say that the manager has no edge, and is throwing darts at a dart board and simply buying a less than optimally diversified random group of stocks that should, over time, approximate the market return.  In this case, the past performance cannot explain the discount.

Portfolio turnover

This is the idea that the expected portfolio turnover will be suboptimal (in most cases, too high) and fees will eat up the NAV.  The first bullet point of Marlin’s “investment philosophy” is:

·         The Company seeks to buy and hold shares in companies for the medium to long term.

There’s no evidence that the manager is buying and selling too often, and the manager’s philosophy is the antithesis of that.  So portfolio turnover can’t explain the discount.

Management fees

This is the hardest one to analyse.  The discount is justified if the net present value of the fees expected over the life of the fund equal the discount.  The Marlin Global Fund has a bit of a weird fee structure.  Basically, the management fee is 1.25%, but reduced by 0.1 percentage points for every one percentage point of underperformance against a benchmark, to a minimum of 0.75%. 

There is also a performance fee.

The performance fee is the 15% of the lesser of:

1. The "excess return" of the fund.
2. The difference between the NAV at the end of the year, and the highest NAV during the previous year.

The “excess return” is any amount over the NZX 90-Day Bank Bill Index plus five percentage points.

That’s a pretty odd comparator.  

One the one hand, it’s an absolute comparator, which has the advantage of only charging fees in years where shareholders get a positive return.  On the other hand, the manager gets a performance fee for a rising stock market. 

I’m sceptical the general increase in stock prices over the last century will continue at the same rate.  Because of this, I’m more comfortable with an absolute fee – the manager will have to work for it.

15% is high though.  

Keep in mind that the fee is the lesser of the two items above.  This effectively means there’s a “high-water mark” that the NAV must reach before a fee can be charged.  For the year ended 30 June 2012, the NAV high-water mark was $0.97.  The current NAV is $0.8281.  That’s a fair way to go before a fee is charged (+17% increase in NAV).  If the discount was rational, it would be the net present value of the expected value of fees.  

That’s the sort of maths that I can’t do. 

One way to test whether it is rational is to look at the discount over time and see if it increases as the NAV increases (and approaches the high-water mark), and decreases as the NAV decreases (and falls away from the high-water mark.  As the NAV increases, the expected value of the fees go up, and the discount should widen.  However, the opposite occurs.

  

The graph shows that the discount was widest at market lows (March 2009), in direct contradiction to any rational expected value of fees calculation.  The purpose of the graph is to show how the discount has reduced since the “distribution” policy. The “distribution” is really a return of capital.  I think it naturally keeps the discount within a band.  The other thing you’ll note from the graph is how volatile the discount is.  And that brings me to my conclusion.  After reviewing all these reasons, I see some support for a discount, but I can’t believe that the discount that regularly occurs is a product of rational pricing.  Therefore I expect to purchase shares at a substantial discount the next time I see it.  

As I mentioned a few times above, the distribution of 8% of the NAV is a form of a catalyst.  If the manager can't keep capital growth up with the distributions, funds under management start to dwindle, the NAV drops, and there's more and more pressure to wind the fund up (and less incentive to keep it going, given that fees are a function of the funds under management).  

The other option is that the manager stops the distribution policy and the discount widens.  While this is possible, the manager has also instituted a small stock buy back.  Given this, there seems evidence that the manager is likely to try other tactics to lower the discount, and there's investor pressure to do so.

I won’t purchase at anything smaller than a 20% discount.  That may take some time, but I'm not in a hurry.

High-frequency kiwifruit trading

The title of this post is a reference to how quickly I bought then sold this stock.  I bought yesterday and sold today.  

Seeka

Seeka is a New Zealand company concentrating on whole of production kiwifruit industry in New Zealand.  I first became interested in the stock when the stock price hit $1.00 and the book value was $3.99.  The stock is currently selling at an EV/EBITDA ratio of 1.42.

I purchased some stock at $0.92 but then quickly sold at $0.85 when I realised that my order filled part of a director’s sale order that made me think about this a second time.  Looking on past filings, I see that this director is the second largest insider holder and has been selling stock since a biological pest was discovered in New Zealand that could (and has already begun to) destroy the kiwifruit industry.  The price is now $0.81, and given the book value, I’m investigating at what price I would re purchase this company.

What does Seeka do?

Seeka is basically a vertically-integrated kiwifruit producer.  It leases orchards and grows kiwifruit (and manages orchards for others), harvests the fruit, processes it, and packs it ready for sale.

Seeka’s half-year report is sobering reading.  The conclusion of the Chairman’s address says it all:

This remains a testing time for the industry and Seeka. The pressure of the Psa-V outbreak alongside a challenging harvest and grower uncertainty has again demonstrated how Seeka’s dedicated leadership, dedicated people and its strategy, position the company well to deliver the best outcome to growers and shareholders in the current environment.

Below is a snap of their balance sheet as at 30 June 2012.  I draw your attention to three items.  The first is the bottom line.  Net assets come in at $59 million.  That is as compared with a market cap (today) of $11.7 million.  Net assets are currently 5 times market cap.  The second item is one item in current assets – trade and other receivables.  It’s a massive $28 million.  Its receivables are higher than its market cap.  The other large asset (non-current) on its balance sheet is property, plant and equipment, at $69 million.

Check the arows, they point to matters I find of interest

Note 9 (on Trade and other receivables) states:

Note 9. Related party transactions

Seeka Growers Limited

In the normal course of business the Group undertakes transactions with Seeka Growers Limited, a related party which administers all post harvest operations and revenues from the sale of kiwifruit on behalf of growers with whom it holds a contract. In the current period the Group received $50,318,169 (2011: $51,195,190) for the provision of post harvest and orchard management services to Seeka Growers Limited. At balance date, a significant portion of receivables are due from Seeka Growers Limited. These receivables are funded by future fruit payments from Zespri Group Limited to Seeka Growers Limited.

I find this a pretty odd note.  Basically, Seeka  gets money from Seeka Growers Limited (a related party).  Seeka does all the post harvest work for Seeka Growers Limited, who have not yet paid for the work.  That all makes sense I guess.  It’s the last sentence that’s a bit weird.  “These receivables are funded by future fruit payments from Zespri Group Limited to Seeka Growers Limited”.  

So basically, Seeka Growers Limited can’t pay Seeka until Zespri pays Seeka Growers. 

Zespri is a legislated co-operative of kiwifruit growers. 

Basically, the way I read that note is that Seeka gets paid if Seeka Growers get paid.  Seeka Growers get paid if it can sell fruit to Zespri in the future.  But what if the Kiwifruit industry is finished? Zespri might not be able to pay Seeka Growers, and Seeka Growers might not be able to pay Seeka.

Psa

Zespri’s annual report (year ended 31 March 2012 - available on their website) states that 30% of New Zealand kiwifruit orchards have some Psa (Pseudomonas syringae pv. actinidiae) infection.

This news article from September 4 states that nearly 50 per cent of kiwifruit crops in New Zealand are on an infected orchard. 

A 13 August market update from Seeka contained the following ominous line:

Seeka continues to caution the market that the outbreak which is now in its second year has the potential to seriously impact on future earnings for the Company.

The question is, let’s say future earnings for Seeka collapse, what happens to the company?  Clearly if the Kiwifruit industry in New Zealand halves (not out of the question now that Psa is here – many orchardists may switch to another crop that doesn’t get hit by Psa), the assets that Seeka have won’t be worth anywhere near book value. 

Seeka has specialised factories for processing and packing kiwifruit.  Now of course those assets will have some value to another fruit company, or another kiwifruit factory out of New Zealand. 

But I imagine that shipping a factory from New Zealand to somewhere else that grows kiwifruit reduces the book value and sale price of that factory substantially.  Seeka says that its land and building assets were revalued at 31 December 2011 taking into account the Psa discovery.  When $69 million of assets is in “property, plant and equipment”, any further reduction to take into account the wider spread of Psa seriously erodes the $59 million net asset base.

A further aspect I haven't touched on (and won't in any detail) is that assuming that the kiwifruit industry isn't destroyed, merely decimated (in the original sense of the term - ie, cut by 10%), the excess capacity for processing and packing kiwifruit will drive the revenues from these activities down so that Seeka's margins (if they exist) will be suppressed indefinitely as the industry consolidates.

Seeka’s annual report for the year ended 31 December 2001 records revalued land (after initial Psa discovery) at $2.8 million.  It records buildings at $37 million, and plant and equipment at $31 million.  If land was worth $37 million vs a building of $2.8 million, then buying now might be a good move – the land is likely to be far less affected by changes in what can be grown on it, than a building or plant equipment can by what can be processed through it.  The land is fertile and can grow stuff; the buildings/plant are all geared for a particular crop.

But don’t rely on my opinion: director Stuart Burns has reduced his position in the company since 30 November 2011 to 150,000 shares from 300,000.  Finding that makes me happy to have exited the position (but kicking myself for ever initiating it).

I started this exercise asking at what price would I buy this company.  After undertaking this exercise, I can say that I won’t touch this company at any price.  There may be value here, but to see that you’d have to have stepped foot inside a kiwifruit processing factory and have an idea of how much you’d be able to get for the stuff in a liquidation.  Maybe a Psa resistant strain of kiwifruit will be found tomorrow – but I know as much about kiwifruit disease epidemiology as I do about kiwifruit factories so have no advantage there.