Paying Nothing for Upside
Board: Jim Royal
When I think about investing in special situations, especially spinoffs, I think about optionality. Specifically, I consider how much I'm paying for upside. I like to pay nothing -- or even better, actually be paid to take on upside. The way I usually conceptualize this is as follows:
If I gave you a lottery ticket every day for free, would you take it? Of course, you would. What if you learned later that the government would take a slice of whatever you earned? What if some greedy lottery official stole some of those winnings as it was being delivered to you? While those excisions hurt your overall upside, you paid nothing for that upside. And it could even make sense to pay a little something for that lottery ticket, sufficiently well below expected value such that you're well compensated for your investment if it's a winner.
That's largely how I viewed Extendicare when we began purchasing a year ago. We were paying very little -- perhaps nothing -- for upside in a business where management had already committed to splitting the business. Management's decision to cut the dividend helped give us this free option. We paid nothing or almost nothing for the option value of the American business.
Sometimes you scratch off the lottery ticket and it's $5 and sometimes it's $100. Sometimes it's a $0. But if you're paying nothing for that upside, you should keep taking these chances all day long. Eventually one will hit big. The great investors focus on downside first. Klarman preaches this to no end.
We've seen similar situations with VOD, where Einhorn pounded the table and argued that the value of its VZ Wireless stake was virtually free. How did a huge megacap, covered by dozens of professional sell-side analysts and thousands of others besides, get priced only on the value of its European unit? At $27, investors paid very little, perhaps nothing, for the VZ unit.
Similarly, in 2012 I looked at United Online, a terrible business in a rapidly declining industry. They had purchased FTD in 2008 because the investment bankers -- fonts of investing wisdom that they are -- said that diversifying their business away from dial-up internet would make the market value them more highly. Instead and predictably, the market just continued to see the rapidly dwindling value in the dial-up business and continued to punish the stock. (This is not unlike what we're seeing now with broadcasters spinning off publishing arms and getting a valuation boost.) Well, come 2012, management decided to split the businesses. Ha. I valued each unit separately, and lo and behold, I was actually being PAID to take the declining dial-up unit. That is to say, the enterprise of the whole business was about 25% less than the purchase price of stand-alone FTD in 2008, despite the fact that FTD looked pretty much like it had back then (solid if unspectacular). The upshot was that the market was valuing the dial-up unit at -$200 mn even though it was still cash-generative and would have ~$100 mn in cash. In 13 months the stock -- which I would never have purchased EVER except for the special situation -- was up 70%. That's the value of a free call option. My biggest mistake was putting just 2% of my capital in this free call option at UNTD. That's why you've seen me put so much of my own assets into EXETF this time. In fact, EXETF is a much better deal than UNTD, there's clearer value in its assets, its industry is not going away, and we get paid a very nice dividend to wait.
At the prices we paid for Extendicare late last year between $6 and $6.50, we set up a similar situation as we saw with UNTD. Can management destroy value from here? Absolutely. But we paid so little for upside that we're almost bound to make money, and even if management makes suboptimal moves, we're still probably getting great upside for the risk that we've taken. But let's be clear: at today's prices we are paying something for option value of the American business. But it's unclear how much.