1001831818400200400204001,2001008001006002102001001,200100105100950200100200100116400300701151001,200
3,134.074,044.56595.261,862.4227.281,383.004,588.745,588.053,529.423,188.742,346.547.26479.16588.333,061.705,491.282,251.761,882.771,709.541,691.15144.00165.291,784.304,861.953,035.00254.884,208.034,095.851,474.542,723.161,562.763,960.001,237.901,229.493,285.435,535.502,356.151,119.151,450.98135.473,461.381,992.383,239.60729.482.192,378.3611,630.9010,466.652,214.102,909.45374.271,487.91
23,968.004,303.002,055.001,643.0094.202,875.005,981.0012,406.0080,928.002,537.703,160.001.51740.000.0020,880.006,685.00175.001,137.002,610.001,367.01139.50172.9815,640.0015,362.006,540.003.1829,000.0034,416.002,632.0025,488.002,240.0048,006.000.633,500.003,204.0083,592.002,230.00300.001,077.002,612.50326.003,125.008,650.00920.0011.1176.0033,000.009,579.002,501.104,197.6080.5044,544.00
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Warren Buffett’s Personal Holdings
EXHIBIT 9.4
(continued)
Investments
# Shares
Cost
Market Value
Level (3)Liberty Property TrustLiz ClaiborneLNR PPTYLoews Corp
1001002001003,000
1,596.663,000.553,513.001,868.798,635.50
670.003,460.007,050.003,740.00141,870.00
Aetna IncAlleghany CorpAllied Domecq PLCAllstateAltriaAmazon com IncAmerican ExpressAmerican FinancialAmerican International GroupAMLI Residential Pptys TrustAnheuser BuschAOL Time WarnerArcher Daniels MidlandArgonaut GroupAssociated Estates RealtyAtlantic AmericanBanc OneBear SteamsBedford PPTY InvWR BerkleyBoeingBombardierBurnham Pac PPTYS IncCAE IncCampbell SoupCamden Property TrustCar WaxChampion Enterprises IncChelsea Property GroupChubb CorpCircuit City StoresCiticastersCitigroupClaires StoresCoca Cola Bottling Co ConsCoca Cola COCoca Cola EntCoca Cola FemsaColonial Properties TrCommercial Net Lease RealtyCompania Cervercerias UnidasConsecoConsolidated Tomoka LandConverseCornerstone RealtyCostco
100136251842,4001006122002,3701002,4001,47041330100200100199100492002001002001,6001001251002006004001002,7371002002,4003003001001001001001003310026,575
3,475.002,111.68964.252,170.644,783.50856.492,636.761,400.5013,202.002,072.625,835.032,928.272,104.40300.001,282.782,635.602,572.131,610.771,703.16135.0010,969.611,525.83315.71841.505,095.402,716.56831.49222.532,991.643,894.421,675.26998.507,884.842,034.405,413.914,918.501,573.503,423.863,254.211,110.762,909.00542.001,346.451,635.34998.24200,324.55
6,020.0025,975.00567.256,559.60109,056.003,632.0025,587.724,560.0013,077.662,355.00122,520.0023,652.305,315.31369.90657.00494.003,718.0014,411.582,840.002,582.306,864.00972.0059.901,146.0039,200.003,495.003,768.75518.008,062.0036,000.003,520.003,000.00117,143.602,536.0010,920.00111,384.005,445.006,450.003,519.001,724.001,609.001,800.002,512.000.00731.00972,645.00
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Buffett Foundation Holdings as of June 30, 2003 Filing (continued)
Investments
#Shares
Cost
Market Value
Cott Corp QUECountrywide Credit IndCousins PropertiesCrown American Realty TrustCurtiss Wright Class BDaily Journal GoDanielson HoldingsDempster IndustriesDevelopers Diversified RealtyDisney
2002001001006100101501031,200
2,144.015,660.442,529.38644.5056.38700.001,941.405,000.003,393.6112,015.15
4,138.0013,914.002,790.001,074.00373.802,440.00161.601.002,929.3223,700.00
Thomson CorpTiffany & CoTimberlandTorchmarkTown&Country Trust SBITravelers Class ATravelers Class B21st Century Insurance GroupUnion PacificUnited Dominion Realty TrustUnitrinUS Air GroupUS BancorpUS IndustriesUST IncValhi, IncViacom. IncViacom Non-VolingVornadoVornado Realty TrustWalMart StoresWashington FederalWashington Post CoWells Fargo & CoWendy’s IntlWhitehall JewellersWhite Mountains InsuranceWilliams CoYumZale CorpZenith National Insurance Co
1671,2004003,65310011724280100100941003797100115808010200800133101,660100150100100180100110
1,582.004,026.762,145.5930,296.861,529.77166.74369.69377.503,879.491,011.36828.755,359.103,906.365.003,192.7576.73653.20240.0068.003,738.694,017.752,149.061,994.198,648.962,225.672,133.602,742.501,655.05258.211,247.772,730.00
7,478.2639,216.0021,144.00136,074.252,325.001,860.303,816 341,144.005,802.001,722 002,549.280.009,285.5020.003,503.001,106.303,496.003,492.806.508,720.0042,936.003,074.007,329.0083,664.002,897.001,360.5039,500.00790.005,320.004,000.003,135.00
762,729.50
3,736,207.91
C H A P T E R 10
Closed-EndFund Arbitrage
A
closed-end fund is a publicly traded investment fund. The managersof the fund raise money by going public on an exchange and thenusing the proceeds of the offering to make investments. The managers typically charge a fee—for instance, two percent of assets annuallyand 20 percent of annual profits. This is different from a mutual fund wherethe investors purchase shares in the fund directly from the fund itself. Amutual fund always values itself based on its net asset value (NAV), whichrepresents the fund’s total assets minus its total liabilities. For example, ifXYZ Fund has $100 million in stocks and no debt, then its NAV is $100 million. When mutual fund investors want to redeem their shares, they areable to sell their shares back to the mutual fund at the NAV price. A closedend fund investor sells his shares on the open market, so the shares may ormay not trade at NAV.Closed-end funds can invest in anything from bonds to illiquid stocks toprivate equity investments. At the time of this writing, many private equityfirms such as KKR or Apollo are starting up business development companies, which are a form of closed-end fund.Typically, a fund begins trading at a premium to its net asset value.Then, over time, a discount sets in so that the closed-end fund is trading ata lower price than that suggested by the net asset value. There are manyreasons a discount results:159
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• Closed-end funds are not popular investments. Many people donot even know they exist. After its initial IPO release, a closed-end fundmight languish and the shares slowly drift down, out of nothing butignorance.• Poor performance frightens off investors. If a closed-end fundbegins to underperform its indices, investors will begin to not trust themanagers and sell the shares accordingly despite the discount to NAV.• The NAV might include capital gains that have yet to be taxed.The shares will properly reflect this tax liability by trading at a discount.• There are too many illiquid or hard-to-value securities in theportfolio. For instance, many private equity firms will not be able toproperly evaluate their portfolio and this will cause investors to take amore conservative approach when evaluating the NAV.The benefits of investing in a closed-end fund are that they often payhigh dividends. In addition, many of the funds trade at a discount to theNAV. Closed-end funds typically dividend out all or most of their profits,much like REITs.There are then two reasons for investing in a closed-end fund that istrading at a steep discount to its NAV:1. The discount will potentially narrow. For instance, if an activist
buys many shares and then liquidates the fund, the discount willinstantly narrow.2. The high dividend that one gets at a discount.
Baker Fentress, now BKF Capital Group, was one of the oldest closedend funds. In 1923, they bought Consolidated Naval Stores, which laterbecame Consolidated-Tomoka Land Company. Consolidated owned 16,000acres of real estate in Daytona Beach, Florida, and, 76 years after Bakerfirst bought it, was one of the primary pieces of value that Baker owned. Atthe time, in May 1999, Baker was trading at a 26 percent discount to its netasset value, an extreme discount compared with its peers. At that point,they announced a partial liquidation plan and a distribution to shareholders. Shortly after this announcement, in August 1999, Buffett filed with theSEC that he owned more than five percent of the company. It also appearsthat he never reduced his holding so he may have continued to hold ontohis shares of Baker Fentress (now BKF Capital Group) after its partial liquidation. See Exhibit 10.1.
Closed-End Fund Arbitrage
EXHIBIT 10.1
161
BKF Capital Group Inc. from June 1999 to July 2004
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
Although closed-end funds usually trade at a discount, the discountnormally stays consistent and seldom varies. Dominic Gasbarro and J. Kenton Zumwalt of Murdoch University, along with Richard Johnson from Colorado State University, discuss that while the discount remains, it doestend to mean-revert.1 In other words, if the discount quickly gets larger, ithas a tendency to snap back to historical norms. In their paper, they evenuse Baker Fentress as an example.However, discounts in closed-end funds do not necessarily eventuallynarrow (unless they hit an extreme as just described). In the 2004 paper bySean Masaki Flynn of Vassar College, the author discusses that blindly playing a portfolio of going long discounted funds and going short funds tradingat a premium is not a successful strategy and often offers negative returns.2At the end of this chapter I interview two hedge fund managers, Zeke Ashton and Mohnish Pabrai, who specifically play this strategy and discusshow the average retail investor can get an edge.1
“Evidence on the Mean-Reverting Tendencies of Closed-End Fund Discounts” byDominic Gasbarro, J. Kenton Zumwalt, and Richard Johnson, The FinancialReview Volume 38, 2003.2“Arbitrage in Closed-End Funds: New Evidence,” Sean Masaki Flynn, Vasser College Dept of Economics working paper, 2004.
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Buffett, as usual, did not simply play a blind closed-end fund arbitragestrategy but always had an “out.” There are not many examples, but theBuffett strategy in the closed-end fund world was:1. Find funds trading at a discount to the NAV.2. The components by themselves were deep value situations that were
also possibly hard to value (as in the Baker Fentress example), thussuggesting why the discount was larger than it should have been.3. Look for a catalyst that would get the funds trading closer to the NAV.a. One possible catalyst would be if there were a change in manage-
ment where the new management had ideas about stock-pickingcloser to Buffett’s.b. Another catalyst would be if there were a possible liquidation thatwould get fund assets distributed to shareholders at prices closer tothe NAV.c. A third catalyst would be if Buffett (or Munger, in the case of theFund of Letters described below) were planning to take control ofthe fund in order to initiate either “a” (since he would be the manager) or “b,” or both.Two other examples of Buffett taking advantage of severe discounts inNAV occurred in the 1970s. In the first instance, Buffett and Munger beganbuying up shares of the “Fund of Letters.” The Fund of Letters had its startin the go-go 1960s, precisely when Buffett was winding down his partnership because of a dearth of opportunities in the stock market. The boomingeconomy of that time period plus the rise of the notion of conglomeratesfueled the fire of speculation. Gerry Tsai with his Manhattan Fund and FredCarr with his Enterprise Fund were among the “market wizards” of the day,with Carr racking up gains of 177 percent in 1967 and 44 percent in 1968,while the S&P 500 went up “only” 25 percent and 11 percent, respectively.Carr started the closed-end fund Source Capital in 1968 to take advantageof the public’s demand for this type of speculation.The strategy was to simply keep the money moving and go from one hotstory to the next, hence the term “go-go.” This was momentum investing atits finest, only seen again in the late 1990s when anything with “dot-com” init attracted the momentum dollars. When the market for go-go investing fellapart in the early 1970s, Carr and his funds were greatly discredited andinvestors fled. Source Capital, which had an NAV of $18 per share, was trad-
Closed-End Fund Arbitrage
163
ing at a 50 percent discount of $9 per share when Blue Chips Stamps, controlled by Buffett and Charlie Munger, began accumulating shares.They eventually owned 20 percent of the fund and Munger took a placeon the board of directors. After Carr left, Source Capital became a haven ofvalue investing under the leadership of George Michaelis, featured in JohnTrain’s book The Money Masters.3 Michaelis became known for his methodof valuing companies, called the Michaelis Ratio:4Michaelis total return = Yield + Growthwhere:
Yield = (Return on equity × Payout ratio) / Priceto book valueGrowth = Return on Equity × Reinvestment ratePayout ratio = Dividend per share / Earnings per shareReinvestment rate = 100% − Payout ratio
In other words, there was a heavy emphasis on buying return on equityand steady growth, possibly at a discount to book value. This was an interesting compromise between Graham-Dodd–style investing and the growthinvesting with which Buffett and Munger often wrestled.By 1975, the shares had doubled, and Buffett and Munger began to liquidate their position. They did this not because of any feelings about Michaelis(who ended up returning an average of 18 percent annually during his reign),but more as a result of the efforts to simplify their holdings. It was during thisperiod that Buffett and Munger, to appease the SEC, began to merge theiroperations in Berkshire, Diversified Retailing, and Blue Chips Stamps intoone unified public company under the umbrella of Berkshire Hathaway.Another example of Buffett’s investments in closed-end funds was the“Fund of Letters” in the late 1960s (see Exhibit 10.2). I say Buffett here, but itwas really more Charlie Munger and one of Buffett and Munger’s closestfriends, Rick Guerin.The Fund of Letters started in the late 1960s as a public venture capitalfund. Because of the fees that brokers made during the public offering, the fundhad started with $60 million in assets but immediately went to $54 million inassets when the brokers took their fees. This type of laissez-faire manage-
3
John Train, The Money Masters, Harper Business, 1994.See www.psarasratio.com for more information.
4
164
EXHIBIT 10.2
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Stock Certificate for 100 Shares of Fund of Letters, Inc. Issuedin 1969
ment style caused shareholders to ultimately bail, with the fund ending uptrading at a severe discount to NAV. At this point, Munger and Guerin boughtup the shares and became activists, ultimately taking control of the fund.They immediately changed the name of the fund to “The New AmericaFund” and changed the style to value investing. It is through this vehiclethat they made purchases in Capital Cities and the Daily Journal, which isnow the collection of legal newspapers in California that Munger still ownsand runs. (It is public on the Nasdaq small-cap exchange under the symbolDJCO, as shown in Exhibit 10.3.)Ultimately, New America Fund went from a low of $3.75 to a high of $100per share by the time Munger and Guerin liquidated the fund in the late 1980s.The story of New America Fund was repeated (but without the help ofBuffett and Munger) during the dot-com boom as well, most notably withthe closed-end fund MeVC, started by the venture capital (VC) fund DraperFisher Jurvetson. Draper had had many successes in the late 1990s withearly stage dot-com investments, most notably with free email providerhotmail.com, sold to Microsoft for $400 million shortly after the companystarted, when it had zero earnings.
Closed-End Fund Arbitrage
EXHIBIT 10.3
165
Daily Journal, 1992–2004
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
The fund went public with much fanfare in June 2000. The idea wasthat retail investors could now participate in all of the rich gains that theirwealthier peers enjoyed during the late 1990s. At last, there was a high-tech,high-profile, VC firm available to the public! The stock opened above $19and ultimately hit a low of $7.10 in August 2002, despite having an NAV atthat time of approximately $12—a 40 percent discount to NAV!Hedge fund Millenium Capital, run by Izzy Englander, began buying upshares of MeVC, ultimately ousting management and taking over the company. Shares have since rebounded to over $9 and now trade at a slight premium to NAV. Exhibits 10.4 and 10.5 demonstrate the premium/discounthistory of MeVC since its inception.EXHIBIT 10.4
Premium/Discount History of MVC
Source: ETF Connect.
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EXHIBIT 10.5
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Share Price/NAV History since Inception of MVC
Source: ETF Connect.
If closed-end funds trade so often at a discount to their net asset value,then it stands to reason that there might be shorting opportunities with fundsthat trade at a premium. This is particularly the case at IPO time for a closedend fund, since no fund will set its IPO at a discount to the net asset value.A recent example is Apollo, the private equity firm run by Leon Black,who used to work for Michael Milken at Drexel Burnham. Apollo IPOed abusiness development corporation called Apollo Investment Corp on May 5,2004, selling shares at $15. The stock immediately traded down and hasbeen below NAV ever since (see Exhibit 10.6).EXHIBIT 10.6
Apollo Investment Corp.
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
Closed-End Fund Arbitrage
EXHIBIT 10.7
167
Capital & Income Strategies Fund
Source: Reproduced with permission of Yahoo! Inc. © 2004 by Yahoo! Inc. YAHOO!and the YAHOO! logo are trademarks of Yahoo! Inc.
Another interesting example is with closed-end bond funds such as Capital & Income Strategies Fund that usually IPO around $20 when their NAV isaround $18. The stock usually hovers around $20 until finally breaking down.The stock held steady at $20 until finally the bid was dropped and thestock immediately fell to its NAV and lower (see Exhibit 10.7).Many critics of Berkshire Hathaway consider Berkshire a closed-endfund that should trade at a discount to its net asset value. Nothing could befurther from the truth. Berkshire is an active business with over 50,000employees spread out through its many subsidiaries and holdings.
C H A P T E R 11
Interviews withTwo Buffett-StyleHedge FundManagers
INTERVIEW WITH ZEKE ASHTONZeke Ashton is a hedge fund manager at Centaur Capital, and a contributorto The Motley Fool investment Web site.JA: Can you tell me a little about your background and how you got intothe hedge fund business?ZA: I started out in the risk-management business. I went to work aftercollege for a little company called Wall Street Systems that specialized in basically treasury financial systems, mostly global financialrisk management—things like foreign-exchange risk and interest-ratederivatives. We did various things like risk metrics, which was a bigrisk-control package that JP Morgan developed.I lived in Europe for about five years, most of it in Germany, andspent some time in Italy and Switzerland.JA: What were you doing there?ZA: Basically consulting work, building and installing these risk-management systems for the treasuries of large banks. In my case, my clientwas Siemens, which is kind of the General Electric of Germany.It has a tremendous amount of financial and various other risks tomanage centrally there because it has plants in 80 countries and cus169
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TRADE LIKE WARREN BUFFETT
tomers in 100 currencies, and it has to make sure that when it converts all that stuff back to its home currency, it doesn’t lose a gazilliondollars in the process.Interestingly enough, one of my coworkers gave me a Peter Lynchbook back when I was an intern with the company, when I was still astudent. I read that book in about four hours, and when I put it down,I thought to myself, “You know, in a perfect world, this is what Iwould love to do.” That was just before the Internet became a popular phenomenon, and I didn’t really know exactly how one got intothat line of work.I had this opportunity in front of me because I’d been overseas asa student and spoke some German, and this company needed somebody who was eager to learn and was willing to move to Germany andspoke a little bit of the language.They hired me to do that out of school, sent me over to Europe andkind of threw me in there, and it was a great experience because Ilearned a tremendous amount about how the global financial markets—the foreign exchange market and the money market, interest ratederivatives market, the equities markets—are all sort of connected in acertain way. They’re all assets that generate streams of cash flow.That was helpful to me when I finally picked up some books tofollow up on my interest in stock market investing back in ’97 or ’98.I picked up some books about Warren Buffett. I was a reader at thetime of The Motley Fool, which was a very accessible source ofinvestment information. So I got very serious about it as a hobbyist inearly ’98 and began to run my own portfolio, and I was so anal aboutit that I even wrote myself quarterly letters.Buffettology was one of the first ones I read, and then AmericanCapitalist by Roger Lowenstein, which is probably the best book onWarren Buffett.You have one view of what Buffett is like, and then when youstart to dig deeper, you realize that the way he runs money now andthe way he sort of projects himself now as kind of this grandfatherly,“buy and hold ’til death do us part” sort of investor has really beentaken to extreme lengths by the media.And it’s diametrically opposed to what he was doing earlier in hiscareer, when he was really compounding money at the 20 percent to25 percent range in sort of a bear-market environment from ’56 to, youknow, at least ’73, ’74, when the bear hit its kind of bottom.
Interviews with Two Buffett-Style Hedge Fund Managers
171
He was out there