A holding company is a company that owns all or a substantial part of a variety of different businesses. These businesses may be private companies, or publicly traded. Holding companies may own all, or a majority or a minority, of companies in which they invest. The one thing most holding companies have in common is that they trade for less than the combined value of their holdings.
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A holding company discount comes into play when holding companies sell assets or break themselves up into their constituent parts. In other words, holding companies can usually sell their assets for fair market value, rather than at a discount. In addition, fair market value may turn out to be more than analysts figured they were worth. The holding company discount lets you prosper from a holding company breakup—although it may take years or even decades for that value to be realized.
Meanwhile, though, even without a break-up, buying a holding company at a discount to its asset value puts more assets to work for you for each dollar you invest.
Why holding companies trade at a discount to their asset value
Over the years, many academics have tried to identify the reasons why holding companies so often sell at a discount to their asset value.
Here are some common explanations:
Holding company managers are stretched too thin, and may have to run businesses they don’t really understand. As a result, they may make less than optimal use of the holding company’s assets.
It costs money to break up a holding company and sell the pieces. Investors may fear these costs will exceed gains from the elimination of the discount. Uncertainty over these costs can expand the discount all the more.
Some holding company assets are invested in private companies, which can be difficult to value.
Asset variety can lead to perverse incentives. Managers may starve their best businesses so they will have funds available to rescue failing divisions.
In the end, though, one of the main reasons holding company discounts occur is because these companies have a poor reputation. Today’s investors prefer so-called “pure plays”—companies that focus on a single business area. So if a holding company owns two or more distinct pure plays, it may trade for 15% to 35% less than the combined value of its assets.
Big change from the 1960s
This is a reversal of the pattern from the 1960s. Back then, investors sometimes paid a premium for holding companies or conglomerates that owned a variety of businesses. The idea was that these different businesses would profit from “synergy,” a term borrowed from biology. It implies that the various businesses can work together and be worth more as a whole than as individual companies.
Like most investment fashions, synergy wound up costing investors money. Many 1960s-era conglomerates ran into serious problems in the 1970s and 1980s. That was mainly due to the #1 drawback of holding companies, mentioned above: their managers were stretched too thin, and were in businesses they didn’t really understand.
Just two of holding company discounts that have paid off for us
We’ve had a number of big successes recommending stocks with holding company discounts over the years. Here are two top examples:
1) Canadian Pacific Railway (symbol CP on Toronto) has been one of our long-time favourites. We recommended the stock in our first issue of The Successful Investor in January 1995. It moved up for us in late 1990s, though much more slowly than Internet and technology stocks. However, CP held up well in the market downturn of the early 2000s. It set out to eliminate its holding company discount by splitting up its five subsidiaries in October 2001.
CP’s reorganization removed the holding company discount that had weighed on the stock for years. The company was trading at about a 30% discount to its net asset value before the announcement, and the breakup closed that discount. This, though, was just the start of a series of big gains for CP investors.
The five publicly traded companies CP split into were CP Rail, CP Ships, Fording Coal, PanCanadian Energy and Fairmont Hotels. In 2002, PanCanadian merged with Alberta Energy to form EnCana, which split into Encana and Cenovus in December 2009. As well, CP Ships, Fording Coal and Fairmont Hotels were all taken over at substantial premiums. All of these mergers, breakups and takeovers unlocked significant shareholder value.
2) Maple Leaf Foods (symbol MFI on Toronto and another Successful Investor recommendation) announced in October 2013 that it planned to break up by selling its undervalued 90% stake in Canada Bread, Canada’s second-largest producer of baked goods after Weston Bakery. Canada Bread supplied a third of Maple Leaf’s sales. The remaining 10% interest was publicly held.
In February 2014, Maple Leaf accepted a $72.00-a-share takeover offer for its shares of Canada Bread from Mexican bakery giant Grupo Bimbo SAB.
Maple Leaf used the $1.8 billion of proceeds to complete an ambitious restructuring plan begun in 2010. This included unloading less profitable businesses and modernizing its meat-processing plants. The company also used the cash to pay off its $1.5-billion debt.
When you pick a solid holding company, what are some of the criteria you look for? Share your experiences with us in the comments section below.
This article was originally published in 2017 and is regularly updated.
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