What Excess Cash Is Really Worth

As I have mentioned before, I am a value investor. One school of value investing that I subscribe to is low-price-to-private-market-value, or resource conversion. It's the prime tool of Marty Whitman, Mason Hawkins and Staley Cates of Southeastern Asset Management and Mario Gabelli, among others.

A few of the concepts that I will cover here about resource conversion are borrowed from Marty Whitman, particularly from his excellent book, Value Investing: A Balanced Approach. "Resource conversion" is Marty Whitman's addition to value investing terminology, but it is only slightly different from private market value. Private market value asks what the equity of the firm, or a part of the firm, would be worth to the buyer who could best use the assets, assuming there are no restrictions to doing so.

The Price of Control

Whitman's additional insight on the topic of resource conversion (not unique, but he phrases it clearly) is that private market values are not always obtainable, because obtaining a change in control of the assets in question is difficult to achieve.

Most of us as investors are outside passive minority investors. We don't have the wherewithal or even the financial savvy to achieve the change in control needed to unlock value. Even those with the wherewithal and savvy may not be able to do so because of resistance from investors or managements that currently control the firm.

Those who control firms gain benefits that accrue to those who work for the firm (wages, share and option grants, expense reimbursements, etc.), as well as the benefits of share ownership. Controlling shareholders (and managements) also have the advantage of holding an option to change the capital structure of the firm, subject to constraints from covenants with other investors and minority shareholder lawsuits.

With advantages like this, control investors do not give up their position easily. There is a price, though. The greater the degree of discretionary control employed and value extracted, the less likely it is that outside passive minority investors will reward the stock with a high multiple. Also, it's less likely that lenders will lend without significant protection from loan covenants. The optimal strategy for those in control is usually to "blend in" and be no more greedy than the average player in a similar situation.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send your comments to [e-mail].

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.