Reverse Engineering Capital Southwest Corporation

In an effort to become a better stock picker, it helps to understand the thinking and reasoning of the best. Leucadia National has an excellent reputation for finding companies, both public and private, in distressed sectors, locations, or business situations and having the patience to see past the current troubles.

In that vein, I enjoy looking at its recent equity purchases and trying to figure out what is so appealing about each company. The most recent purchases for LUK include: CSWC, GEIO, and UWBK. These companies were purchased between August and November of 2007. GEIO went through a merger during that period making it difficult to know when LUK got involved. UWBK is a bank and I find it difficult to understand and value a blind pool of assets and its management. This leaves us with CSWC, one of Forbes’ “100 Most Trustworthy Companies”.

Capital Southwest Corporation’s Business
CSWC is classified as a close-ended equity fund but this is isn’t a complete description. CSWC acts as an equity investor, a venture-capital firm, a capital allocator, and manager of its wholly-owned subsidiaries. Formed in 1961, CSWC is now considered the largest public venture-capital firm. The company’s “Investments are focused on opportunities for capital appreciation derived from expansion financings, management buyouts, recapitalizations, industry consolidations and early-stage financings.” (2007 Annual Report) The company looks for proven companies with experienced management and they (unlike most venture capital) don’t go in with an exit strategy. This means they are seeking to form long term partnerships to last the lifetime of these companies. A quick look at annual reports shows that CSWC still holds positions in investments initiated in the ‘60’s and ‘70’s. The portfolio is relatively concentrated with 87.4% of its net worth ties to just eight companies; including: RectorSeal, Media Recovery, Lifemark, Whitmore, Heelys, Palm Harbor Homes, Encore Wire and the Alamo Group.

Figures
The traditional statistics for determining value would lead an investor to believe this company is being undervalued.
Debt = $0
Price/Book = 0.84
Current P/E = 3.5-4.5
5 yr. ROE = 17.2%
ROE = 28.5%
ROC = 28.5%
No analyst coverage
52 week low = $105.16

Purchase Reasoning
A company holding that holds a mix of private and public equity in profitable businesses is compelling when selling below book. This begs the question “Why?” A few factors are dragging CSWC’s short term prospects down. Investments in Palm Harbor and Encore Wire have to be adversely effected by the housing market; earnings will drop in the face of a slumping housing sector. Also, some of the company’s manufacturing interest will hurt from slow downs in housing, autos, and transportation. Another factor weighing on investors are several changes in management and a delay in the most recent quarter’s earnings. On top of that, the Company did only one major deal in fiscal 2007, claiming that their was too much money chasing too few deals. I view this as a long term positive.

The biggest material loss may be caused by the massive drop in the stock price of Heely’s since this summer, dropping from $25 to $6 and change. Heely’s provided the largest gains for CSWC in the most recent years. That’s a lot of uncertainty and negative news for a company that is delaying this quarters data. The suspense is painful.

So why buy now? While selling a discount to last quarter’s calculation of book value, the price is probably even with current book value. This price lets an investor own a diverse base of businesses at cost with potential for appreciation once the housing downturn eases. The free lunch is that you pay no premium for the skills of management who will thrive in a low-credit environment. For CSWC, this provides a situation where too little money chases a fair number of deals.

Buying CSWC in today’s environment is a high-uncertainty yet low-risk opportunity. It’s difficult to know how the company will perform in current market conditions but at it’s current price range, CSWC is supported by the values of its underlying businesses. Hopefully, over the long term, CSWC can prove to offer a strong upside with less risk. It may be worth waiting for the delayed quarterly data and buying on what many expect to be bad (short-term) news.