Hidden Assets on the Small Cap Balance Sheet

Christopher is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

A small cap value investor has to dig deep to find the hidden "value" that a publicly-traded company may possess on its balance sheet. This value may remain embedded in the stock until a catalyst unlocks it. The catalyst may be years, if not a decade or more away.

There are two small cap companies: GenCorp (NYSE: GY), and a company traded in Canada, known as Guardian Capital Group that have in my opinion this "hidden value" on their balance sheet. GenCorp is a ballistic missile system maker, trading as of September 21, 2012 at $10.10 per share, for a market cap of approx. 608 million dollars. The company was a spin-off from General Tire and Rubber in 1999. The hidden asset on its balance sheet is 12,000 acres of real estate in Sacramento, California, bought to buffer its manufacturing complex in that city. The company now plans to move forward with a monetization plan for 6000 of those acres which it no longer needs. The assets are on the balance sheet at a lower value than current fair market value.

Activist investors have gotten involved as a result, including Gabelli Funds, Steel Partners, and Marcato Capital. Gen Corp has all the elements necessary to intrigue the deep value investor, and unlike Guardian Capital Group, it appears that the stock voting structure allows activists to vote their shares for change, and/or ultimately take control. In addition, the plan to monetize the California acerage puts a near term catalyst on the horizon, versus a situation where you might have to wait a decade or more for value to be unlocked (More on this later with Guardian Capital Group).

Steel Partners once offered $17 a share for GenCorp in 2004. Today, Gabelli Asset Mangement assigns a private market value of no less than $25 to each GenCorp share. Only time will tell as to whether a valuation even close to $25 is ever reached.

Guardian Capital Group is another intriguing investment opportunity that allows an investor to acquire an indirect interest in a large cap Canadian bank, Bank of Montreal (NYSE: BMO) at a substantial discount. However, there are other attractive benefits to owning shares of Guardian Capital Group.

Currently, Guardian Capital Group trades for $10.25 CDN, has a market cap of $350 million CDN, a NAV of close to 500 million or more, and is profitable. 

One major difference is that unlike GenCorp which pays no dividend, Guardian Capital Group pays a dividend with a yield of approx. 1.8%.

The hidden asset at Guardian Capital Group is found through the Guardian investment portfolio which owns 5 million shares of the Bank of Montreal, with an approx. pre-tax value of $290,000,000 CDN when BMO trades at $58 per share. By my calculations, with close to 50 million non-voting Guardian shares outstanding, every ten shares of Guardian owned equals one share of BMO. For every one hundred shares of Guardian, you own the equivalent of 10 shares of BMO. 

The Bank of Montreal trades on both the Canadian and New York Stock Exchange as BMO, and sports an approx. price-earnings ratio of 10.0, and yields a hefty 4.9%. Value Line sees BMO shares trading at between $65-$90 dollars (U.S.) in the 2015-2017 timeframe. On Aug. 28, BMO reported that its third quarter net income had increased by 37 percent, while quarterly revenues improved to 3.88 billion from 3.32 billion.

Guardian acquired these BMO shares when BMO purchased its Guardian Group mutual fund business for 180 million dollars in 2001. BMO wanted all of Guardian, but settled for its mutual fund business only with Guardian keeping a contract to run certain mutual funds. Guardian Capital has held the shares ever since.  Thus, the fates of Guardian Capital Group and the Bank of Montreal are intertwined. The reason being is that for every 10% increase to BMO's share price, there is a 5% increase in the NAV of Guardian Capital. It has been said that these 5 million shares of BMO are a hidden asset in plain view on Guardian's balance sheet, just like the real estate on GenCorp's balance sheet.

This is illustrated by the fact that Guardian Capital trades at a whopping 45.4 % discount to its net asset value, and was named on or about August 24, 2012 as the top small cap value pick in brokerage Scotia Capital's small cap universe.

Let's compare closely these two "value" small cap investments: GenCorp and Guardian Capital Group.

GenCorp is traded on the New York Stock Exchange and all its outstanding shares are voting shares. It is probably more well-known than Guardian Capital Group, and its shares more liquid. This may make its "value" appealing to more investors across the board as its value will likely be unlocked sooner than the opportunity presented at Guardian Capital Group. As stated earlier, GenCorp's shares may be worth double its current share price.

In contrast, Guardian Capital Group only trades its non-voting Class A shares on the Toronto stock exchange as GCG.A. The U.S. pink sheet quote (GCAAF) as of Oct. 9 was $10.03. The non-voting share structure/US pink sheet listing is a big problem for certain U.S. institutional and retail investors alike. The non-voting structure is the key reason for the value gap. Yet on the positive side, Guardian's hidden value is in the form of liquid BMO shares and without the speculation of a real estate sale, as in the case of Gen Corp. Without a doubt, Guardian Capital Group is worth double its current share price.

The downside to this silver lining is that the Guardian Capital Group is controlled by the Christodoulou family through Guardian's voting B shares (remember that the trading A shares are non-voting, which many investors refuse to be a part of). Family patriarch John Christodoulou died in July 2011, having led the company since its founding in 1962. Christodoulou's death sparked a short-lived interest in the stock and a 16% spike in share price to the $12.00 range.

The shares have now settled back into the $9.50 to $10.50 range. The spike in the stock price was due to renewed discussion on the company being placed for sale by Christodoulou's heirs. The questions are now: Will the next generation sell the whole company to another financial institution at a price close to or exceeding its NAV? Will the BMO shares be "spun off" to shareholders?

The Christodoulou family has denied such interest and maintained in July 2011 that ownership would "likely" be transferred within the family. That all said, the Guardian Capital Group is what speculations are made of. A patient value investor often reaps rewards. In example, Nexen (NXY) shareholders who patiently waited since 2008 for a sale or takeover at full value were unexpectedly rewarded in July 2012 by a buyout that took the share price up some 65% to its Net Asset Value, overnight. But to date, nothing has materialized as far as a sale of Guardian, or the spin-off the BMO shares.

Nonetheless, the stock has garnered since July 2011, three "top pick" selections by three respected Canadian money managers (Veronica Hirsch on Toronto's BNN, Gavin Graham on Toronto's BNN, Daniel Goodman and Effie Wolle in Canada's Financial Post) 

All agree that if not for anything else, it would be next to impossible to lose your capital by investing in the Guardian Capital Group A shares.

Let's further compare GenCorp and Guardian Capital Group.

GenCorp is a defense/military play, with low cost basis real estate on its balance sheet, whereas Guardian Capital Group is an investment management company (running institutional money and owning a mutual fund dealer), with a substantial investment portfolio as a kicker.

GenCorp's "hidden asset" is real estate that needs a buyer or some format of development/sale to be realized. As we all know, real estate is speculative and the cycle is still on a slow upturn. 

The "hidden asset" on the Guardian Capital Group balance sheet is very real, and just needs to be "distributed" in some format to shareholders.

Guardian Capital Group, can be broken down into two parts: its investment management operations, and the investment portfolio. 

Scotia Capital, in a recent report (8/24/12), has estimated the net asset value of the investment portfolio with BMO shares, net debt and other securities alone as having a value of $9.01 CDN a share. 

This almost equals the market cap of the whole company! With Guardian trading at approx. $10.25 CDN  a share, the market is valuing the investment management business at just .33 CDN  cents a share!

Scotia estimates the net worth of the investment management business at $8.11, giving the prudent investor in Guardian a practically free call option on this investment management business, as well as a proverbial "margin of safety" in the event of a market downturn, etc.

As mentioned hereinbefore, more North American funds are flocking to GenCorp because the perception is that the value will be unlocked in the near-term by either a monetization of the real estate or a takeover by shareholders, with the company being split in two with the 6000 acres of California real estate being severed out into a separate company.

On the other hand, a skeptic can see Guardian Capital as a classic example of a value trap.

It is also possible that because Guardian Capital is Canadian-based and not traded on the New York Stock Exchange,  fewer institutional and retail investors are aware of its extreme "hidden value" asset in the form of the 5 million BMO shares. 

The value is there, yes, skeptics argue, but you will never see it with no ability to control the company through shareholder votes.

The investors in GenCorp may be facing the same scenario althought the voting structure of GenCorp makes such an outcome unlikely. 

GenCorp has some major institutional players betting on a value creation event in the near-term. On the downside, the company has to worry about reduced defense/military spending which can effect its core business, as well as the treacherous route to monetizing its 6000 acres of Sacremento real estate.

Likewise, Guardian Capital Group has its backers, but many have been waiting over a decade for the balance sheet value to be monetized. The death of its patriarch has had no immediate effect on unlocking the "hidden value."

The purchase of Guardian Capital Group shares will provide the investor with capital preservation, a market-competitive yield, and indirect Bank of Montreal (BMO) exposure. There is also the possibility of an overnight capital gain if the Guardian Capital Group is ever sold by the Christodoulou family at a price some 50% or higher from its current share price.

In conclusion, a value investor may want to invest in both GenCorp and Guardian Capital Group as part of a diversified portfolio.

An investment in GenCorp is a small cap play on real estate, defense/military spending, and takeover/spinoff/asset arbitrage. 

An investment in Guardian is a small cap play on asset management/large cap banking, value and income, and speculation/takeover/asset arbitrage.

Both have pros and cons as to the "hidden assets" found on their balance sheets.


ulysessjr is long GUARDIAN CAPITAL GROUP.. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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