More Klarman Bargains - Liquidations, Holding Companies, and Hidden Assets

Some of the best investments are not elegant. They are messy. They involve complicated merger terms, hodgepodge asset pools, and companies that Wall Street would rather pretend do not exist. That is exactly where patient investors make their returns – in the wreckage that nobody else wants to sort through.

Three case studies. One involves a merger where the stock traded below its own cash balance. Another involves a liquidating trust so complex and obscure that it did not even have a ticker symbol. The third involves a defense spinoff trading at twelve percent of book value. All three demonstrate the same principle: complexity is not risk. Complexity is where the money hides.

Becor Western – Risk Arbitrage With a Safety Net

In June 1987, Becor Western sold its aerospace business for 109.3 million dollars in cash. After the sale, the company sat on 185 million in cash – more than 11 dollars per share – with only 30 million in debt. It also operated an unprofitable but asset-rich mining-machinery business under the Bucyrus-Erie name.

By December 1987, a bidder called B-E Holdings came in with a takeover offer. The terms were not simple. Becor shareholders could elect to receive either 17 dollars per share in cash, or a package of securities: one-year senior notes, fifteen-year debentures, preferred stock, and warrants. A maximum of 57.5 percent of shares could receive the cash consideration. Assuming everyone elected cash, each share would receive approximately:

• 9.78 dollars in cash
• 1.28 dollars in one-year notes
• 4.25 dollars in fifteen-year debentures
• 0.085 shares of preferred stock
• 0.255 warrants

The cash option was clearly worth more. Some shareholders still failed to elect it, which meant more cash for everyone who did.

Here is what made this interesting. After the 1987 crash, Becor shares fell below 10 dollars. Below the company’s own cash per share. Investors were literally getting paid to buy a company’s assets at a discount to cash on hand.

Even the non-cash components had real value. There was nearly enough cash on the pro forma books to retire the one-year notes at par. The fifteen-year debentures, based on comparable securities, were worth at minimum fifty percent of face value. The preferred stock conservatively was worth twenty-five percent of liquidation preference. Even if the warrants traded for almost nothing, the total merger consideration was at least 14 dollars per share.

But here is the part that separates a good trade from a great trade: you did not need the merger to complete. Book value was 12 dollars per share, nearly all in cash. Several large institutional holders owned Becor stock, making it likely that underlying value would surface one way or another. If the merger fell apart, a liquidation would have yielded similar value. The stock at 10 dollars was cheap regardless of what happened next.

The merger completed. Consideration was worth about 14.25 dollars at market prices. A 40-plus percent return in weeks, with minimal downside from the start.

The takeaway is this: the best risk arbitrage situations are the ones where you do not actually need the deal to close. If the stock is cheap on its own merits, the merger is just a bonus catalyst. When the only way you lose money is if value somehow evaporates from a pile of cash, you are in a good position.

City Investing Company – The Liquidating Trust That Tripled

In 1984, shareholders of City Investing Company voted to liquidate. This was a conglomerate with diverse assets, the most valuable being Home Insurance Company. When efforts to sell Home Insurance failed, it was spun off to shareholders directly. Everything left over went into City Investing Liquidating Trust.

What was inside the trust? A mess. Nine million in cash. Stock and warrants in General Development Corporation. 7.3 million shares of Pace Industries at cost. Fifty-five million in Pace Group Holdings debentures. Seventeen million in subordinated debt from Wood Brothers Homes. Eighteen million in Brazilian receivables. Fifteen million in miscellaneous notes and mortgages. Eleven million in miscellaneous investments. Thirty-five million in recoverable federal income taxes.

Total estimated net assets: 195.5 million dollars, or about 5.02 dollars per unit, even after known liabilities.

The units traded at 3 dollars. Forty percent below conservative estimated value. Why?

The selling pressure was relentless and came from every direction. Investors who had been through the original City Investing liquidation were disappointed with prior asset sales and dumped the trust units out of frustration. Many had bought City Investing shares only to get exposure to Home Insurance before it started trading independently – they never wanted the liquidating trust at all and sold their units immediately. The per-unit price was below institutional minimums, forcing large holders to sell. And after the Home Insurance spinoff, the trust was delisted from the New York Stock Exchange. It traded on the over-the-counter pink sheets with no ticker symbol. Quotes were unavailable online or in newspapers.

No ticker. No newspaper listings. No institutional buyers. Maximum selling pressure. This is what creates real bargains.

There was also a hidden asset that most investors overlooked entirely. The trust’s investment in Pace Industries was carried at historical cost. But Pace had been formed by Kohlberg, Kravis and Roberts – KKR – to buy several City Investing businesses in a December 1984 leveraged buyout. By September 1985, that buyout was performing well. Interest rates on government bonds had dropped several hundred basis points, and stock indexes had surged. The equity in Pace was almost certainly worth significantly more than cost. This pushed real value well above the already-conservative 5.02 estimate.

Half of the trust’s value was in liquid assets and marketable securities. For investors who wanted even less risk, they could short General Development Corporation shares to lock in that portion of the trust’s value.

The liquidation proceeded faster than expected. GDV shares surged and were distributed to unitholders. Wood Brothers Homes was sold. Receivables were collected. And the biggest win: Pace Industries sold its Rheem and Uarco subsidiaries at substantial gains, generating large cash distributions and early redemption of the Pace debentures. Meanwhile, contingent liabilities were extinguished at little or no cost.

By 1991, investors who bought at inception had received approximately 9 dollars per unit in total liquidating distributions. Three times the purchase price. Much of the value arrived in the early years.

The pattern repeats: when something is too complex for most investors, too small for institutions, and too obscure to find in any newspaper, prices get pushed far below intrinsic value. The complexity was the margin of safety.

Esco Electronics – A Defense Company Trading at Twelve Percent of Book

Esco Electronics was spun off from Emerson Electric in October 1990. Emerson shareholders received one Esco share for every twenty Emerson shares. If you owned a thousand Emerson shares at 40 dollars apiece – a 40,000 dollar position – you received fifty Esco shares worth 150 dollars. That is fifteen cents per Emerson share. A rounding error.

Most holders immediately sold.

Esco was a substantial business. Five hundred million in annual sales. Six thousand employees. 3.2 million square feet of facilities, over half of which the company owned. It had acquired Hazeltine Corporation in 1986 for 190 million dollars. But profitability had collapsed – from 36.3 million after-tax in 1985 down to a 5.2 million loss in 1990 after nonrecurring charges. Two pending contract disputes with the U.S. government created additional uncertainty.

The stock opened around 5 dollars and quickly sank to 3. At that price, the numbers were remarkable:

• Tangible book value: over 25 dollars per share
• Net-net working capital (current assets minus all liabilities): over 15 dollars per share
• Debt: only 45 million against almost 500 million in equity
• Stock price as percentage of tangible book: twelve percent

Twelve percent of book value for a viable company with positive cash flow and minimal debt. The stock could have risen 400 percent and still been below half of book value.

Multiple valuation approaches all pointed the same direction. A net present value analysis using nothing but goodwill amortization cash flow – 45 cents per share annually, rising to 90 cents after a special guaranty payment to Emerson ended in 1996 – produced a value of 4.70 to 5.87 dollars at discount rates of 12-15 percent. If free cash flow grew by just 20 cents per share annually for ten years, NPV jumped to 10.83-14.76 dollars. Either scenario was well above 3 dollars.

Liquidation analysis was less applicable since defense assets have limited alternative uses, but a gradual wind-down – completing existing contracts without seeking new business – would have returned at least 15 dollars per share from net-net working capital alone.

Stock market comparables told the same story. Other defense companies traded at 60-100 percent of book value. Esco traded at twelve percent. Even adjusting for depressed profitability, the stock was at three times earnings after excluding goodwill amortization and the special Emerson charge.

Shortly after the spinoff, Esco’s chairman bought shares on the open market for his personal account. The contract disputes were tentatively settled on favorable terms within months. By early 1991, Esco shares had risen to over 8 dollars – nearly a triple from the lows.

You did not need precise valuation. At 3 dollars, the price reflected absolute disaster. Anything other than disaster meant the stock was going higher. The margin of safety was so large that being approximately right was more than enough.

What These Three Investments Teach

Each deal had a different structure – merger arbitrage, corporate liquidation, defense spinoff – but the underlying mechanics were identical. Forced selling created prices below intrinsic value. Complexity discouraged competition. And a clearly identifiable floor limited downside.

Becor traded below its own cash. City Investing Liquidating Trust had half its value in liquid assets. Esco had 25 dollars of tangible book value backing a 3 dollar stock. In each case, you could calculate a minimum value with confidence, even if the maximum value remained uncertain.

The other commonality: these were not hidden from public view. The information was all in SEC filings, available to anyone. What was missing was not information – it was willingness. Most investors simply refused to do the work. Those who did were rewarded enormously.

Key Takeaways

The best arbitrage is the kind where you win either way. Becor had more cash per share than its stock price. If the merger closed, you made money from the spread. If it collapsed, you still owned a company trading below cash value. When there is no losing scenario you can identify, the risk-reward is as good as it gets.

Obscurity is the value investor’s best friend. City Investing Liquidating Trust had no ticker symbol, no newspaper quotes, no institutional buyers, and a per-unit price that was too low for most professional mandates. Every structural barrier to buying was a structural reason why the price was wrong. The more obscure the security, the wider the gap between price and value.

When a spinoff is trivial relative to the parent, expect irrational selling. Esco was worth fifteen cents per Emerson share. Nobody builds a position that small. The selling was mechanical, not analytical. And mechanical selling creates the widest mispricings because there is no one on the other side doing the math.

You do not need a precise answer. You need a directional one. Esco could have been worth 6 dollars or 15 dollars – the range was wide. But every scenario produced a number well above 3. When the price reflects catastrophe and the fundamentals do not, precision is unnecessary. Being approximately right and having the conviction to act is worth more than a perfect discounted cash flow model that you never execute on.

Complexity is not the enemy. It is the moat that keeps the competition away while you collect the returns.