Description

FF is a closed-end fund with a sector focus on financials, run by superstar investor Nicholas C. Adams since its inception in 1986.

Adams is widely recognized among sector specialists as one of the very best investors in financials.  An article in Fortune by Andy Serwer dated June 13, 2005 states that Adams' financial services hedge fund had CAGR'd at 40% over 10 years and describes Adams as "Wellington's secret weapon."

FF's long term performance is stellar.  Total return since May 2, 1986 of 12.85% annualized over 23+ years, outperforming the S&P 500 by over 400 bps per year.  And this is for a financials focused fund after the financials industry's catastrophic decline.  Looking at the performance from inception until prior to the financial service industry's collapse (arbitrarily defined as the period ending June 30, 2006), FF provided a total annualized return over 20+ years of 18.9%, outperforming the S&P by nearly 800 bps per year.  FF was also the #1 performing closed end equity fund (of any type, not just financials focused) for the 10 years ending 12/31/06, 12/31/05, 12/31/04.

Historically and not surprisingly, FF has tended to trade at a wider discount to NAV after poor recent performance and even a premium to NAV after strong recent performance.  Today it is trading at a substantial 19.7% discount to NAV.  This should enhance future returns as the NAV discount narrows, and returns would really be turbocharged if the stock were to trade back to a premium over NAV. 

Adams has opportunistically repurchased FF stock historically.  Between 11/13/08 and 3/31/09, FF bought back 1.6% of its outstanding shares at 28% discount to NAV.  FF repurchased nearly 4% of outstanding stock at 15% discount to NAV in 12 months ending March 2002.  Stock repurchases periodically in the 1990s were also done at discounts to NAV.

The combination of a small asset base and the closed end fund structure enables FF to invest more nimbly / opportunistically in smaller cap and less liquid situations.

Very substantial tax losses have been built up (both realized and unrealized), that should provide some protection from future gains.  Net unrealized losses were $86.4mm at 6/30/09, or roughly $3.01 / share.  And accumulated realized at 3/31/09 (not reported in 6/30/09 report) were $62.0mm, or another $2.16 / share.

Mean reversion lovers might argue that the financial services industry's recent carnage would make a financials focused fund all the more enticing today.

In total, I believe that the merits of an investment in FF are simple and straightforward.  It would be a no-brainer if not for the risks posed to minority public shareholders by a shareholder who controls 35.51% of the outstanding shares. 

Risks

The biggest risk relates to governance.  Entities affiliated with Stewart Horesji own 35.51% of the outstanding shares as of 3/31/09.   Since taking control of the board several years ago, I believe that Horesji has "succeeded" in raising fees modestly and in reducing the amount of the portfolio that must be invested in the financials sector to 65% under normal circumstances. 

Now, Horesji is trying to push through a proposal to become the fund's investment adviser, stagger the board, remove the fund's required investment in financials of 65%, enable the fund to invest in hedge funds managed by Nick Adams and others, and essentially open up the investment mandate to enable Horesji to invest FF's portfolio as he sees fit.

For a summary of some of Horesji's past forays, see Sandra Ward's article in Barron's dated July 7, 2003.  Past changes instituted by Horesji at other closed end funds suggest he may attempt to convert FF over time to a vehicle comprised largely of Berkshire Hathaway and other large cap blue chips.  That risk is mitigated in part by BRK itself and large cap blue chips generally being modestly undervalued today.  It may also be mitigated in part by Adams' historically strong track record in managing FF since 1986 and by Horesji's current "plans" of shifting 50% of FF's investment portfolio into hedge funds run by Adams should his proposal succeed to remove FF's investment mandate / restrictions.  It is also mitigated in part by the market-beating performance of the other 3 Horesji-affiliated funds (tickers BIF, BTF, DNY) in recent years (admittedly helped by large holdings of BRK and cash in the face of a bear market).

The risks are also mitigated by the current large discount to NAV.  In contrast to much of the time historically, today the "Horesji discount" factored into FF exceeds those of the other Horesji-controlled closed end funds -- FF's 19.7% discount to NAV compares to BIF, BTF, and DNY of 18.1%, 19.1%, and 16.2%, respectively.

There is always the risk that the discount to NAV could widen beyond the current 19.7%.  But while the discount reached epic proportions in the last 12 months in the midst of the markets melting down, the current discount is very wide relative to the fund's 23 year history.  The average discount to NAV since inception in 1986 is 6.1%. 

Volatility is also a risk (and opportunity).  Adams' track record is exceptional over long time periods, but highly volatile in the short term.

Conclusion

I am quite concerned that the Horesji ultimately succeeds with his proposal.  It would seem that if his current proposal fails, he would try again in the future.  That said, the downside in the event that he "succeeds" appears to be mitigated as described above.  And while the probability of realizing the upside case is diminished by the 35.51% shareholding, the enormous upside potential in the event that the upside case is realized appears to make FF an interesting opportunity if sized appropriately.

Catalyst

Strong underlying investment performance over time.

Large discount to NAV narrows, or even shifts to a premium.

Horesji's latest proposal fails (not something I'm betting on, but a very significant positive if it were to happen).