Capital Southwest Corporation: Deep Value BDC That's Currently a 'Fat Pitch'

by: Philip Mause

I initially became interested in Business Development Companies (BDCs) because they offered an opportunity to buy debt instruments in the equity market at deep discounts to book value. For several quarters in 2008 and 2009, each quarterly financial report included a write down of debt instruments and investors became terrified so that BDC stocks were selling at huge discounts to book value on the assumption that further write downs were inevitable.

The discounts continued after the write downs slowed down and stopped and a window opened up to buy debt instruments at a huge discount at the very time that the market for debt instruments was improving (the second quarter of 2009 through the Fall of 2010). Unfortunately for investors but fortunately for the economy, that window has pretty much closed.

I tended to stay away from "equity" BDCs (BDCs whose assets consist primarily of common equity) because the book value of privately held common equity is extraordinarily difficult to ascertain and because BDCs had somewhat of an incentive to overstate book valu (in some instances because of ratio problems; in other instances in order to demonstrate strong performance).

Capital Southwest Corporation (NASDAQ:CSWC) is an equity BDC (although roughly 3 percent of its portfolio consists of debt instruments). However, an analysis of its balance sheet reveals that it provides investors with an opportunity to acquire assets at a truly enormous discount to book value. CSWC holds equity interests in a number of publicly traded companies: Encore Wire (NASDAQ:WIRE), Heelys (NASDAQ:HLYS), Hologic (NASDAQ:HOLX), Alamo Group (NYSE:ALG) and Texas Capital Bankshares (NASDAQ:TCBI). This provides an investor with a mechanism for valuing these positions by using that notorious device we heard so much about a couple of years ago: "mark-to-market."

Using this methodology, an investor can determine how much he is paying for CSWC's "other" assets - the equity in companies that are not publicly traded. CSWC's market cap at Wednesday's closing stock price (95.50) was $358.4 million. Backing out $74 million of cash on the balance sheet, $14 million of debt instruments, and the $227 million market value of CSWC's holdings of publicly traded companies, an investor is actually paying $43 million for "the rest" of CSWC. The "rest" of CSWC has a current book value of $259 million and so an investor is getting it at 16% of book value.

Nothing is easy in investing, and there are some important caveats. Most of CSWC's stock in publicly traded companies is not registered and so cannot be sold on the open market, and CSWC carries the stock at a price below market value on its books. CPSC appears to have considerable deferred tax liability and, on many of its positions, taxes would have to be paid by someone if the positions were sold because the original cost is very low.

One tax issue was described in a recent quarterly report and it appeared to be more complex than the proof of Fermat's Theorem. A very large proportion of CSWC's portfolio of non-publicly traded companies is tied up in one position. Because it does not earn much interest or dividend income and because it almost never sells a position, CSWC doesn't generate much cash and it pays a very low dividend.

CSWC's management philosophy is quite different from the approach one would ordinarily encounter in BDCs or private equity firms. CSWC is a "patient" investor and can hold an equity position for decades, hanging in there even after the portfolio company goes public. CSWC has stubbed a few toes on certain positions; there certainly were times when HLYS could have been sold for a lot more than the current market price. On the other hand, something seems to be working well here because the long term track record of the company is very strong. On balance, this appears to be a company with responsible, trustworthy management which has a good nose for value. An investor in a company which is a "patient" investor must be patient as well. There is no obvious catalyst which will "unlock" value here; this is a deep value position that may not move much for several years.

I generally don't buy items like lawn furniture, large stuffed animals, complex kitchen hardware, exercise equipment, etc. just because they are selling at a huge discount and I can "save" money be filling my garage with the stuff. In the stock market, however, discounts like this one command attention. When the discount is combined with what appears to be strong management and with a very impressive historical track record, we begin to have the key elements of what Warren Buffet calls a "fat pitch." Investors should take a hard look at CSWC and, if they buy, should be patient because they will likely be well rewarded.

Disclosure: I am long CSWC.