Buy one and get one free. Stay three nights and get one night free. Seductive, isn't it? There are stocks like that. Take Murphy Oil, which owns 59 percent of Ocean Drilling & Exploration Company (Odeco). Behind each share of Murphy is 0.83 share of Odeco. With Odeco selling at 30, that means a value of 25. With Murphy at 32, in effect you're paying $7 for Murphy's business if you deduct the $25 represented by Odeco.
Complicated? Not really.
Another example is British Petroleum, which owns 53 percent of Standard Oil of Ohio. Each American Depositary Receipt share of BP carries with it 0.28 share of Sohio. With Sohio at 50, the value of the fraction is 14. BP sells at 24, and deducting the 14 for the Sohio investment, you get the rest of BP for 10.
In Wall Street one often hears the axiom that the sum of the parts is greater than the whole. American Telephone, about to be fragmented, is considered by some sources to have a breakup value of 80. Now selling at 63, it would seem to be a real bargain. But the examples I've mentioned above give this theory a reverse twist.
These are companies with important investments in public markets which, after deducting the respective value of the investment, seem to be dirt cheap. After all, you really pay very little for the basic business of the parent company.
Let me cite one more example. Seibels Bruce Group (SBIG), a South Carolina insurance company, owns 51 percent of Policy Management Systems Corporation (PMSC). The latter has been enormously successful in developing computer software systems designed for companies in the property and liability insurance industry. Each of the 7-odd million shares of SBIG represents about 0.4 share of PMSC. With PMSC selling at 55, that means a theoretical value of 22. Since SBIG sells at 28, that means that one is only paying $6 for the regular business of SBIG.
This example was even more dramatic before a recent public offering of SBIG, and purchase by PMSC of shares owned by SBIG. Before these events one actually paid a negative price for SBIG, after assigning the value of the SBIG investment. That means the value of PMSC was greater than the price of one share of SBIG. That anomaly may help explain the discrepancy between theoretical or imputed value and reality. There are few free lunches on Wall Street. The market allows for such events as the issuance of more shares of PMSC and the partial sale by SBIG.
But how to explain the apparent modest price that one pays for the basic business of each of the parent companies?
First, while the parent owns the stock, it's unlikely that it will be distributed to the shareholders. Corporations are loath to diminish their size by such largess. Even if a distribution were to take place, it would be taxable to most shareholders, thus reducing its theoretical value.
What about the parent's selling the stock and using the proceeds in its own business? As SBIG has demonstrated, this does happen, but any gain resulting from a profitable sale is taxable, thus reducing the net proceeds.
Another factor is the skepticism shareholders have concerning the real value of an important investment like PMSC. With more than 4 million shares of PMSC, could they all be sold at 55, or would a sale of that magnitude flood the market and ruin the price?
Then there is the state of health of the basic business of the parent company. Seibels Bruce writes a broad line of property and casualty insurance. In common with the industry, which has suffered during the recession, SBIG underwriting operations have resulted in red ink in the recent past. While book value and dividends have been increasing with recent underwriting losses, one can't assign a high value to the basic business of SBIG until things turn around.
Investors who are lured to consider companies with a major stake in a public subsidiary would do well to determine what the basic business is worth. Since a spinoff or liquidation of the subsidiary is unlikely, a careful analysis of the parent is all the more important.
In years past, the closed-end investment funds, which usually sold at discounts from theoretical asset value, offered another form of buying assets at a bargain price. But liquidation was remote, and there would be taxes to pay on gains. Finally, markets for closed-end funds were typically thin, since there was little incentive for stockbrokers to promote them, with higher commissions available from the open-end funds.
Analyzing companies described above, and others like them, can be complex. Investors would do well to determine if the basic business of the parent is one which has positive value in its own right. It's best not to be swayed by the apparent bonus of a major stake in another company if its chances of realization by shareholders is remote.
But there are profits to be made by astute investors whose analysis of these piggyback companies is accurate, and whose timing is right.