1 - Valuing Holding Companies - 2 Point 2 Capital
Key Excerpts
" Holding Companies (Hold Cos) that hold shares of other listed and unlisted companies. A large part of the value of these Hold Cos stems from their stakes in other businesses."
"Hold Cos trade at a discount to the underlying Net Asset Value (NAV)"
"HoldCos in India are unique because the HoldCo discount is sometimes exceptionally high, ranging from 50-80%"
Factors Affecting Holding Company Discount
"Poor Capital Allocation: The HoldCo is often not just a shell company. It either has a business of its own (Operating HoldCo), or it has investments in other businesses which require periodic infusions of capital. In either of the cases, investors of the HoldCo do not get full access to the dividends/capital gains received from the underlying holdings"
"While HDFC has investments in many good businesses and is itself a large NBFC, BBTC has investments in many poor and/or loss-making businesses such as Aviation, Plantation, Real Estate etc. "
"The investors in BBTC do not get access to the cash flows of Britannia. BBTC therefore trades at a whopping discount of 83%. The Hold Co discount for HDFC Ltd is estimated to be only 25% which is one of the lowest among all other Hold Co companies."
"Indirect control: The shareholders of a HoldCo do not directly exert control over the underlying holdings. This may not matter if the incentives of the shareholders of the HoldCo are aligned with the incentives of the shareholders of the underlying holdings."
"For instance, the interest of the shareholders of Ujjivan Financial (which owns 83% of Ujjivan SFB) is aligned with the shareholders of the SFB as there is no other business in the HoldCo. The voting on any corporate action (merger, de-merger, acquisition, dividend etc) will not be counterproductive to the interest of the Hold Co shareholders."
"The shareholders of the HoldCo get exposure to a set of companies in different sectors. Each of those businesses individually may trade at higher valuations as they each find shareholders who find the company and the sector valuable. The HoldCo however trades at a discount to the sum of the parts. a value investor who is bullish on the 2W space likes Bajaj Auto and may be willing to pay 16x P/E to invest in it but he may not like investing in Bajaj Finance at 5.4x P/BV. Therefore, he would want to buy Bajaj Holdings at a discount."
"Leakage due to Capital Gains: If there is a sale of the underlying holdings, the HoldCo would need to pay capital gains tax on the gains and the shareholder has to pay tax on the dividend income (as high as 43% in the highest tax bracket). For a HoldCo that has large strategic holdings, this discount may not be relevant as a sale would likely be done in a tax efficient manner by transferring shares of the holdings directly to the shareholders (For eg. Thomas Cook India transferring shares of Quess Corp directly to its shareholders)"
"Cascading impact of Dividend Distribution Tax (DDT): Until FY20, a HoldCo (holding less than 50% stake in a company) when it received dividends from the underlying holdings, had to pay DDT again upon remitting the same dividends to its shareholders. The shareholders of a Hold Co paid double the DDT – once at the holding level and again at the Hold Co level. Hold Co. could avoid double taxation only if it held 50%+ stake in the company in Holding. Hence earlier discount was higher"
"An investor who invested in Bajaj Holdings to get exposure to the underlying stocks (Bajaj Auto, Bajaj Finserv) was getting ~17% lesser dividends than if he owned the stocks directly. In the Dividend Discount Model of valuation, the value of a company is the present value of all the future dividends. Therefore, this 17% dividend leakage merited AT LEAST a 17% HoldCo discount.
"In the new tax regime, the HoldCo will get full credit for the dividends received from its underlying holdings if it pays out the same to its shareholders. In this scenario, it will not have to pay corporate tax on the dividends received."
Checklist to Invest in Holding Companies (Emphasis Mine)
Holding Company return = Underlying Holding/Investment returns + Dividend Yield (Holding Company) +/- Holding Company Discount (If discount will narrow this will increase returns and vice versa)
Quality of holdings should be great businesses
Non-Operating Holding Companies which majorly distribute all the cash they receive to the shareholders and simultaneously has high dividend yield
"Holding Company discounts amplifies dividend yield: the dividend yield of the underlying holdings of Tata Investment Corporation is 1.09% but for shareholders of Tata Investment it is 2.62% because of the 61% HoldCo discount."
"The high dividend yield also acts as a force that prevents the discount from expanding. If the HoldCo discount were to expand, the dividend yield differential would increase making it even more attractive for shareholders of the underlying holdings to shift to the Hold Co"
"Prefer to invest at peak discount: We track the discounts of HoldCos over many years. The discount moves between a wide range. We prefer to invest when the discount is at its peak or higher than normal, to benefit from the discount narrowing over time"
Read More: https://2point2capital.com/blog/index.php/a2020/07/07/investing-in-holding-companies/
2 - The Difference between Accounting Losses and Real Losses
Key Excerpts
"Who would invest in a company which reported 10 consecutive years of losses?”
"investing in losing companies, as long as you know which ones to choose, is very lucrative."
" In the U.S., during the booming decade prior to Covid, almost 50% of public companies reported annual losses (middle curve), and among high tech and science-based (pharma, biotech) enterprises the loss frequency was a staggering 70% (top curve)"
"Since the 1980s were characterized by a surge in corporate intangible investments: R&D, information technology, brands, etc. Whole industries, essentially intangible (without heavy physical assets)
"enhanced investment in intangibles―the main drivers of innovation and growth―characterized practically all industries, as managers realized that innovation is the key to competition"
"In the U.S., the aggregate investment in intangibles surpassed in the mid-1990s the investment in tangible, or physical assets"
"Up to the 1980s, the accounting distinction between an expense, like salary and interest payment, and investment, like buildings and equipment, was clear: expenses are payments for past services and therefore charged against revenues in the earnings (income) calculation, whereas investments generate future benefits and are therefore reported among assets on the balance sheet"
"Up to the 1980s, the accounting distinction between an expense, like salary and interest payment, and investment, like buildings and equipment, was clear: expenses are payments for past services and therefore charged against revenues in the earnings (income) calculation, whereas investments generate future benefits and are therefore reported among assets on the balance sheet"
"The absurd result: the more innovative the enterprise, the higher its accounting losses. This accounting treatment of intangibles explains much of the sharp rise of corporate losses"
"many of the presumed “losers” are in fact successful growth drivers, but most investors, fixated on reported earnings, don’t realize this"
"We thus undid accountants’ folly by capitalizing and amortizing the R&D, IT, and brand enhancement (the technical procedures of capitalizing intangibles are fully explained in our study “All Losses Aren’t Alike,” in https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3847359). The result: A full 40% of loss reporters would have been profitable without the expensing of intangibles. We term those companies “accounting losers,” in contrast with “real losers.”
#Valuations #Holding_Company_Discount #Valuation_Methods #Start_Up_Valuations #Intangibles