Dream Shorts

For a few months, I've been playing around with the idea of trying to do some arbitrage on Closed End Funds (CEF) relative to their Net Asset Values (NAV), an idea I got from SuperCash: The New Hedge Fund Capitalism. CEF's are like mutual funds with a fixed number of shares, which trade on the major exchanges. Since they trade, their market prices can fluctuate independantly of their NAV's. The basic idea is pay $9 for $10 worth of assets. A list of of Exchange Traded Funds (ETF) is available here: ETF Connect.

What worried me was the fact that some of these funds had sizable discounts to NAV which had persisted since inception. With no clear catalyst to remove those discounts, I would have to do a pairs trade, buying the fund and shorting the underlying portfolio. Considering slippage and frictional costs, the trade wouldn't have made economic sense for my funds. I used Munger's mantra of "Invert, always invert" and decided to look for funds with premiums to NAV. Three candidates stuck out from that list: CUBA, CRF, and CLM.

CUBA is the Herzfeld Caribbean Basin Fund. As of 1/25/2007, they were available for a 94% premium. Not only that, but management fees are a stunning 337 bps. Thats great work if you can get it. The only rationale behind this is technical trader mentality bidding this up to higher and higher prices. I've read some talk of people using this as a play on Castro's possible death, but I don't think that is a compelling thesis, especially given the price.

CRF and CLM are the Cornerstone Total Return Fund and the Cornerstone Strategic Value Fund. They have 86% and 58% premiums, and charge 150 and 120 bps fees. They are supporting higher and higher stock prices on a rapidly decaying NAV through return of capital. There are probably quite a few uninformed investors looking at the large yield, unaware they are just getting their own money back.

Personally I have not been able to find any shares available to short. These aren't the most liquid of stocks, and it can be scary to bet against human greed and optimism. For now, I've tabled to the idea in order to search for greener pastures, but might revisit this strategy in the future.

Premier Exhibitions, Inc.

Premier Exhibitions, Inc. (PRXI) has been on quite a tear lately, surging close to 70% since the beginning of 2007. Their Q3 conference call (1/10/07) announced another great quarter, and I especially appreciated the fact that written transcripts were available. Key takeaways:

• Revenues of $7.9M
  
• Titanic exhibits are fully booked.
• Considering three options for monetization of Titanic assets.
  
• Two Bodies exhibits to be added late spring.
  
• Scrims (fabric walls) should save $1M annually, (5 exhibits * $100K / exhbit * 2 setups / year)
• Growing cash of $10.2M and no debt.
• $3.3 M revenues during the week of 12/26/06 to 1/2/07, which promises an excellent Q4.

Just a week ago, they announced plans to open new Bodies Exhibits in Pittsburgh, and Sao Paulo, the 5th most populous city in the world.

As a side note, value investors generally don't try to time the market. I've held this stock for under a year, with little substantial movement until the past few weeks. It's hard enough to be right about a stock. I doubt there's any way I could've predicted the timing of this action. When time permits, will post my updated writeup.

FootStar, Inc.

Footstar, Inc. (FTAR) is a holding company and operates a retail business through Meldisco, which sells family footwear through licensed footwear departments and wholesale arrangements. Meldisco has operated licensed footwear departments since 1961 and is the operator of licensed footwear departments in the United States. FootStar was forced into bankruptcy by a problematic athletic shoe division which was later sold off. In February, they emerged from Chapter 11, with no debt.

Valuation of FootStar must take into account two separate scenarios. Under the current Kmart Settlement, FootStar is set to be liquidated at the end of 2008. The liquidation would be the worst case scenario, however, it still represents an attractive proposition. In the two quarters out of bankruptcy, FootStar has reported $20 MM and $6 MM in earnings. Assuming a conservative run-rate of $40 MM per year and $5 MM adjustment for D&A, FootStar will have accumulated an additional $90 MM in cash through 2008. On the balance sheet, FootStar has $68 MM in cash, $110 MM in inventory, a $20 MM headquarters building with an additional $135 MM in liabilities. FootStar could be worth approximately $153 MM at liquidation with some additional upside for their NOL's.

If FootStar is allowed to continue as ongoing concern past 2008, then we assume $40 MM annual earnings, or $60 MM of EBITDA and look at peer comparisons. With an industry P/E multiple average of 14 and EV/EBITDA average of 8 and the existing $68MM cash, this implies FootStar is worth between $548-628 MM.

Given 21 MM shares outstanding, we have approximately $7.28 per share in liquidation value and approximately $26-30 per share if FootStar continues to operate. I was lucky enough to purchase shares in February at $4.20 and October at $4.93 which represented a large enough discount to the worst case scenario. The shares have moved up substantially since then to the current price of $6.60. This currently only represents a small discount to liquidation, and I am not sure if I would recommend a purchase. However, I continue to hold as a free call on the possibility that they are an ongoing concern, either through renegotiation of KMart Agreement or pursuit of a different business model.

Additional Opinions:

• George Schultze
• Whitney Tilson
  

Valuation

I recently sharpened my valuation skills with these excellent programs provided by the school.

Wall Street Program
Training The Street

As of now, I feel most comfortable with using public comps, historical comps, and DCF. Some of the other valuation methods seemed a bit too speculative (especially LBO). These models can be highly sensitive to the inputs, so there is an art of choosing which model to use as well as using that model correctly. But it is important to have an investment thesis be so compelling that you are less sensitive to any biases. I hope to post up within a day or two writeups of some of my investments.

"Based on my own personal experience - both as an investor in recent years and an expert witness in years past - rarely do more than three or four variables really count. Everything else is noise."

-- Marty Whitman

"Usually, the success of an investment is highly dependent on only a few key variables ... and I can’t think of a single case in which one of those variables was the discount rate we used - whether 8, 9 or 10 per cent."

-- Whitney Tilson

Recommended Reading

"In my whole life, I have known no wise people (over a broad subject matter area) who didn't read all the time - none, zero."

-- Charlie Munger

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