Capital Southwest Is Worth More With Less

By Will Ashworth | July 23, 2008 AAA

The markets are doing so bad even Warren Buffett's Berkshire Hathaway (NYSE:BRK.A) is hurting. It's down about 16% year-to-date, and it seems even an investment company with large holdings, both private and publicly traded, can't avoid the malaise that is the current markets.

Imagine if you will a much smaller version of Buffett's behemoth. Capital Southwest Corporation (Nasdaq:CSWC) is a Texas-based company investing in businesses that are both publicly traded and private. Its aim is to produce long-term capital appreciation through venture capital investments in companies it deems to have strong growth potential. While it's done a good job since 1961 making money for shareholders, one New York investor, Ned Sherwood, feels it could do better. I agree. (To learn more, read Seek An Adventure In Venture Capital.)

Undervalued Assets
As of March 31, 2008, Capital Southwest's 12 largest investments, with a value of $499.87 million, represented 91.3% of the total portfolio, an unrealized gain of $456.37 million. That's sound. So, why is the largest independent shareholder, Ned Sherwood, CEO of ZS Fund L.P. and ZS Crossover II L.P., which owns 6.9% of the company, challenging the company in court over its handling of its investments? Well, to be specific, he's questioning the publicly traded investments, not the private equity.

Sherwood asserts that the company discounts the investments on its balance sheet at rates much too high, hurting the stock price. It currently trades at a 35% discount to net asset value. At the end of May, Sherwood delivered a proposal to the board of directors that would unlock some of the value in Capital Southwest. In it, Sherwood recommends two things:

1. That CSWC sell all its stock holdings that are unrestricted and distribute the cash to shareholders; and

2.
Register and distribute its holdings in the Alamo Group (NYSE:ALG), Palm Harbor Homes (Nasdaq:PHHM), Encore Wire (Nasdaq:WIRE) and Heelys (Nasdaq:HLYS) to shareholders.

Unlock The True Value
These moves would deliver $82 in cash and stock to shareholders while retaining CSWC stock worth $85 in value plus $8 in cash for a total of $93. Sherwood estimates a value on the stock of $175 a share, despite the fact each of the four stocks are down significantly in the past year. Alamo, Palm Harbor, Encore Wire and Heely's are in the red 12%, 54%, 25% and 78% respectively. No wonder CSWC is itself down 21% in the last 12 months.

At the end of March 2008, it reported net assets per share of $150.09, 19.3% lower than $186.75, its value one year earlier. However, it's up 7.7% from the value at the end of 2007. On May 20, the SEC ruled the company could exclude the proposal discussed above from its proxy vote. The company believes it best can handle these assets and doesn't need to include shareholders in investment decisions. (To learn how proxy voting works, read Proxy Voting Gives Fund Shareholders A Say.)

Who's Right?
One hundred dollars invested in Capital Southwest stock at the end of fiscal 2003 was worth $275.62 at the end of March 31, 2008. This compares with $169.51 for the S&P 500. Over the last five years despite the company's publicly traded holdings woes, it still more than doubled the performance of the S&P 500. Company management feels its mandate is to produce long-term appreciation on its investments, and it isn't going to make short-term decisions on any of its holdings.

In a gesture to shareholders, it will buy back $45 million in stock or 10% of the shares outstanding. As of June 2, the District Court of Dallas County ruled Capital Southwest must provide ZS Crossover II L.P. with a shareholder list by June 6, 2008. Sherwood, who heads the fund, indicated that management and the board should realize the true value of its assets. As a dissident shareholder, I'm sure Sherwood will continue to solicit additional support in order to move the board of directors to action.

Bottom Line
Heely's stock was as high as $40 in the beginning of 2007 now it trades around $5.50. Back then, when the wheel-in-the-shoe was all the rage, Capital Southwest's holdings were worth approximately $372 million, 87% higher than today. Would Sherwood be as interested in unlocking shareholder value if Heely's were still high flying? I think so. His problem is not necessarily with the investments themselves but the company's method of valuing them on its balance sheet. This is a story that will continue to unfold in the coming months. Stay tuned.

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