Value Investors Club / Urbana Corporation (URB-A)

Description

Urbana Corporation is a Canadian closed-end fund with holdings in a variety of public and private securities and derivatives exchanges, which is now trading at a more than 40% discount to the market value of its holdings while continuing to complete significant share buybacks at attractive prices.

Urbana reports weekly updated net asset values at current market prices via its website (http://www.urbanacorp.com/NAV/). As of February 24th, NAV stood at $1.8233 per share, a discount of nearly 43 percent at the current asking price of $1.05 Canadian. The company also publishes regular updates regarding its ongoing share buybacks . Since August 2010, the outstanding Class A share count has contracted from 77.5 million to 64.4 million as of year-end 2011, over a 13 percent decline, and has shrunk by a further 500,000 shares thus far in 2012.

Urbana holds 1.6 million shares (30% of NAV) of the Chicago Board Options Exchange (CBOE). Interestingly, CBOE itself was the subject of a recent VIC recommendation by britt12, highlighting the firm’s attractive returns on capital, strong competitive position within its industry, and significant intellectual property, particularly vis-a-vis the VIX, the CBOE's killer app of market volatility which has begun generating increasing high-margin revenue from a profusion of derivative products and ETFs.

The company also owns 1.8 million shares (38% of NAV) of NYSE/Euronext (NYX). NYX shares remain substantially below their May 2011 highs above $40 after falling partly in response to investor concerns over a controversal planned merger with Deutsche Boerse. Recent opposition from European regulators now means that the merger will no longer proceed and in response NYX has announced a significant buyback of its own, but has so far recouped only a fraction of its decline and trades at attractive multiples given the dominance of its multiple securities and derivatives exchange assets, paying a 4% dividend yield which becomes even more attractive after considering the additional shares owned via purchasing Urbana at a deep discount to NAV.

Other significant holdings include 3.14 million shares (13% of NAV) of the privately held Bombay Stock Exchange (BSE), a strategic emerging markets asset which attracted a significant investment from George Soros at a premium to Urbana’s cost, and may finally go public within the next several years. The remainder consists of small positions (< 5% of NAV) in TMX Group, the Budapest Stock Exchange, and seats on the the Minneapolis Grain Exchange and the Kansas City Board of Trade.

The magnitude of the discount certainly looks attractive, and the current holdings appear to be fairly valued to undervalued, with NYX and CBOE providing decent cash dividend yields that can fund further buybacks at the holding company. Urbana's manager Tom Caldwell owns 5.6 million common shares including family holdings (7.5% of shares outstanding, or over $10 million in NAV) but does exert voting control through a dual class structure, and earns a management fee equal to 1.5% of NAV ($1.9 million at current levels, or roughly one fifth the amount of his invested capital). What has led to Urbana shares becoming so cheap, and are things likely to get worse or better from here?

Base rate or case rate: a behavioral finance perspective on timeliness and capitulation

Urbana may look cheap now, but it would have looked only slightly less cheap at most points in the recent past -- value investors buying for the discount during early 2011 would have been clobbered. The EMH would suggest that any discount or premium should be arbitraged away, yet ETFs can routinely trade at seemingly nonsensical prices for long periods. If these price movements are a result of systemic biases present in human behavior, what criteria might we use to judge when a particular discount may have reached a maximum?

I’ve been aware of Urbana for close to a year, but only began accumulating it at the end of 2011 as the discount to NAV widened to unprecedented levels and the behavior and narratives of URB investors began showing signs which to me are indicative of capitulation and a possible long-term bottom. Although the stock is up from my initial entry, increases in NAV per share leave the discount almost as wide as ever, and the persistent strength after the recent end to tax-loss selling (and continuing repurchases by the company) reinforces to me that Urbana may now have seen a long-term low.

The stock must have certainly been a painful holding for many value investors entering earlier in 2011, at which point the discount to NAV (although much narrower than today) was already undeniably attractive. When I had briefly corresponded with others regarding Urbana earlier in the year, responses were enthusiastic and most seemed to believe there was no way to lose. When I have mentioned it more recently, responses have been uniformly guarded to negative as investors have felt stung by the widening discount and recent price declines. One microcap value investor wrote: "I have looked at Urbana a bit, but I’m not convinced. The CEO seems to be a big obstacle."

Other comments culled from across the value blogosphere:

"Urbana, which I’ve written extensively about hasn’t worked out the way I hoped. The discount to net asset value has increased to nearly 50%. I’m partly disappointed because it’s an investment Buffett wouldn’t have taken. I knew management’s conflict of interest and their control with the non-voting shares but I was tempted by the discount. This was the last of my ‘poor business at a great price’ investments and I’ve been selling down the position."

"Ah, the old net-net with a controlling insider who will never move to realize value because the management fees are just too good. This is a classic situation. ... Will shareholders ever see the value? I wouldn’t count on it, since the CEO’s management company receives very generous and unending professional fees. A shareholder-friendly management in either of these situations would liquidate. I hope you crack the code on how to effect change at value traps like these. You would be doing capitalism a great service."

"Urbana - sold because I screwed up
Some lessons are expensive. I bought URB.to because it was trading at a discount to NAV and buying back shares. It seemed pretty good. I mean URB used to trade at a premium to NAV. Most recently NAV has dropped but the share price has dropped faster. So there is an even bigger gap. One would think that I should buy more, and maybe I should.So it begs the question"why?" Why would there be such a large gap between NAVPS and share price? I think there is no real confidence in management to execute or there is no real confidence in the sector as a whole. It may be true, things change and exchange market could look quite different from today. I am selling because I blindly bought URB without dissecting why it was so cheap. I feel that the lack of liquidity has something to do with it. I also have no real opinion of the future of the businesses in the fund. So I feel that there are companies out there with clearer visibility. There has been around a 20% discount to NAV since summer 2008. I am selling cheap to buy cheaper."

"It’s painfully obvious management just wants to collect management fees in perpetuity. They control too much stock for anyone to ever do anything about it. On a very quick look, if Bombay IPO’s it looks like 85% of URB’s holdings would be public. There would be no reason for this company to exist if so much of their holdings are public. After all, you could open an Etrade account, make a few trades and own almost all the assets they do, without having to pay management fees, and you would actually have control over the assets. Why would anyone pay NAV when you could do that? I think the best thing for the company would be if their public holdings went private. This company serves a purpose if the public cannot invest directly in the companies, and it deserves to trade at or near NAV if they serve a social purpose as an investment vehicle that is difficult to replicate. So to me, as an investor, the Bombay IPO would be a negative catylst (sic)"

"Seems like a lot of value guys have been through this revolving door already. Tom Caldwell is an (expletive). The best thing that could happen to shareholders is if he drops dead. (This is not a threat, just an observation.)"

Harsh words indeed. The price is certainly down from last year and the discount is up, but isn’t that supposed to make stocks more attractive rather than less? Are things truly so dire? With many value investors apparently having sold in exasperation over the growing discount (the very discount that was the initial reason to buy), an alternate viewpoint from behavioral finance would suggest these comments are in fact a bullish diagnostic sign of capitulation and revulsion, a decision based more on the insular cortex than on the balance sheet. Having initially bought at a much lesser discount to NAV with the expectation that it must immediately narrow, value investors experienced a classic case of dopamine disappointment and reversal learning when confronted with inexplicably falling prices for obscure Canadian smallcap closed-end dual-share-class financial holding companies during the autumn selloff.

With their habenulas (habenulae?) reacting against their prior hopes as these failed to be confirmed, investors have somehow became anchored to an expectation that the discount would continue to expand. By the representativeness heuristic, Urbana became labeled as a "bad stock" with "bad management", to be avoided at all costs; once this image has been formed, the thinking stops there, regardless of valuation or management’s actual behavior. An alternative to taking the heuristic shortcut of "Urbana = bad" would be to ask what range of returns would be reasonable to expect from a firm trading at a 40% discount and buying back 10% per year -- to look at the base rate, rather than the case rate.

Back to the numbers: anchors away

One conservative view of the base rate would be to assume 0% appreciation for the portfolio, $3MM of dividends from CBOE and NYX at current yields, and that another 9.5% or so of shares (~7MM) are bought back for $1.05.

CBOE 1.6MM *0.48=$0.8MM
NYX 1.8MM*1.2=$2.16MM
-$7.35MM buyback
-$1.9MM management
+$3MM dividends
= -$6.25MM NAV
($134.8MM current NAV - $6.25MM) / 66.94MM shares = $1.92/share

If buybacks continue near recent rates, we’re looking at roughly 10% returns on invested capital at current prices if the portfolio fails to appreciate at all. Each 10% appreciation in NAV would earn shareholders another ($1.82/$1.05) = $0.17 per $1 invested at current prices, an effective 1.7 times free upside leverage arising directly from the discount. (The firm itself also uses a modest degree of 1.1 times leverage, so the impact of any market move will be slightly greater).

Or let’s assume NAV suddenly plunges by 40% on a massive decline in the stock market, that no shares are bought back, and that dividends fall by 30% to barely cover the management fee:
1.8233 NAV * 0.6 = $1.094/share
Damn, now our assets are only worth 4 percent more than we originally invested!

These examples emphasize that value investing through share repurchases at a deep discount to market can be an intrinsically attractive opportunity with an immediate asset-based margin of safety. Of course, they do not consider market price fluctuations of the CEF itself based on the future discount to NAV, which is largely unpredictable, although I believe it may now have reached a nadir for the behavioral reasons outlined above. Another way to attempt to reach a less biased estimate of likely outcomes would be to assess the base rates for discount to NAV. At CEFconnect.com, only 5 of the 373 funds listed have a discount to NAV greater than 20%. Holding all else equal, a narrowing of the discount to 20% would result in a nearly +40% return from current prices, without considering dividends, buybacks, or portfolio appreciation.

Buybacks: the forgotten catalyst for discounted CEFs

In the past, I have occasionally had great success in investing in closed-end funds at a discount to NAV (often considerably less than Urbana's 43%), but one difficulty I've often encountered has been the reluctance of management to actually undertake or complete any significant net buybacks at all, even when it makes a great deal of sense to do so. Since management often personally owns few to no shares in their fund, they are frequently very poorly aligned with shareholders (a problem which also exists at most open-end funds, but is less apparent due to redemption at NAV). Taking out yearly fees as a percent of assets while not benefiting directly from gains in NAV per share, they are very disinclined to shrink the share count even slightly, no matter how much sense it would make for owners. At Urbana, Tom Caldwell actually owns a significant amount of stock, on an absolute basis and relative to management fees. Conversely, one drawback is that he has voting control; so further buybacks are effectively dependent on his good graces. For what it's worth, a contact who has spoken with Caldwell at length described him as a principled and religious person with a strong sense of fairness, although his ambition for "managing money" makes a total liquidation unlikely.

While it has not liquidated (or you would not be reading this writeup) Urbana has been genuinely completing buybacks at a higher rate than I have generally seen in most discounted CEFs trading at much lesser discounts. According to Toronto Stock Exchange rules, an issuer can repurchase through a normal-course bid up to the greater of 5% of its outstanding shares or 10% of its public float (outstanding shares excluding shares held by insiders) in a 12-month period, but not more than 2% of the shares in any 30-day period.

Urbana actually appears to be repurchasing and retiring shares at close to the maximum rate allowed. A large block tender offer at above market prices would be possible and desirable, but the same argument could have been made at higher prices. As the PPS declined below $1, Urbana has continued to buy back significant blocks at increasingly attractive prices without incurring a premium to market or the legal expense of a tender.

Shareholders would clearly be far better off if Urbana were to liquidate tomorrow (instantly realizing a more than +70% return). Realistically, this is arguably the case for nearly all closed-end funds, which generally trade at a discount to NAV, but all too often refuse to buy back shares at all unless under duress. Because the extremely attractive returns to liquidation seem so obvious to value investors, the failure to entirely liquidate is taken as a sign of much worse than average corporate governance, putting aside the fact that management does continue to buy back and retire a significant amount of stock when they’re under no obligation to do so. From my perspective, the fact that management is continually buying back a substantial amount of stock is a significant plus in governance and capital allocation relative to most CEFs, and in my view fails to justify the magnitude of the present discount -- especially since shares are cheaper to a much greater degree than funds that are much more inefficient and shareholder unfriendly. I’m hard pressed to say that repurchasing over 13 million shares at attractive prices is really such a disastrous state of affairs deserving of such a deep discount to NAV.

As one former shareholder wrote above, "this was the last of my ‘poor business at a great price’ investments and I’ve been selling down the position." Time will tell whether the buyback will continue at its recent healthy clip, and I may be wrong about timeliness and capitulation, perhaps fated to later post my own dismay as the discount widens again.

But actually, buying back shares in a portfolio of reasonably valued securities exchanges at a 40% discount to market is exactly the kind of business that I'm quite happy to be in.

Catalyst

continued share buybacks

free leverage to portfolio appreciation and dividends

mean reversion of discount to NAV

show sort by

			2012	2013
Price:	1.05	EPS	$0.00	$0.00
Shares Out. (in M):	74	P/E	0.0x	0.0x
Market Cap (in $M):	77	P/FCF	0.0x	0.0x
Net Debt (in $M):	0	EBIT	0	0
TEV (in $M):	0	TEV/EBIT	0.0x	0.0x