Weekend stock pick: Craven House Capital

I posted recently about how I was having more difficulty finding good investments these days. So I have been researching a few investment trusts to try and park some money and reduce my workload. By coincidence I came across an investment trust that not only seems to be making wise decisions, but that also has many attractive properties from a special situation perspective. As I mentioned in my half year results I’m very bullish on it.

I first came across this stock when reading one of Wexboy’s posts on Emerging Markets. It is a tiny investment company called Craven House Capital (AIM:CRV) which focuses on emerging and frontier markets. It has a very short history, originally being split off from an operating company in 2010. In 2011 a Hong Kong based investment company called Desmond Holdings invested a large sum in it and subsequently became the largest shareholder and the investment manager. Unfortunately the investing history of Desmond is too hard for me to find but the annual report contains some of the recent investments they have made.

Illiquid shares

One important thing to note here is that the company is a penny share, or rather it trades for 0.28p currently. Not only does this mean the bid/offer spread is enormous (30%!) but it is subject to wild swings. Take a look at the 12 month history on the LSE website. The good news is that it currently trades near its 52-week lows and near what appears to be resistance at the bottom for anyone that believes in technicals.

The stock is highly illiquid, that means you must use a limit order if you plan on buying shares. Penny shares are open to manipulation. Also don’t invest any money in this company that you aren’t prepared to leave in for a long time as selling can be just as difficult and it may take a long time for this companies true value to be recognised in the market price.

Share issues creating value for shareholders!?

Craven is constantly issuing new shares and expanding its balance sheet, to raise funds for new investments it finds. Usually that puts me off, but it currently only has £2m to invest. These share issues though are what interested me the most. Take a look at one of its recent LSE announcements. It issued 50 million new shares for a price of 1.25p each. Its not only then either, its happened frequently in the past with all its placements of new shares, and is included as a condition in the conversion of its debt to equity. If you are buying shares for 0.28p then you are making money simply with every rights issue, and there will be many more to come. I would be surprised if it doesn’t expand its balance sheet by at least a factor of 10 in the future via share issues. Remember that Desmond is the investment manager, increasing the investments under management is in its interest, and it is quite willing to do this selling shares at 1.25p.

I will also briefly mention that there are outstanding warrants, exercisable at 1.25p also, so nothing to worry about but something to consider it the price gets up there.

Investments

Its investments also appear attractive. Take a look at this latest acquisition of a distressed asset. They purchased bonds for €0.7m, being the only secured lender against a property worth at least €3.5m. The interest payments are €0.25m per annum and Craven believes it can restructure the operations to generate cash flow and then collect these interest payments. Even if it fails it will get its money back. Win win.

But this deal also highlights something that makes me even more interested in this company, and that is the financing. Desmond loans Craven the money to fund this deal, with interest payable. However, Craven can also convert this loan into shares. This presents a win-win for Craven, if the investment doesn’t make any money then Desmond gets its money back in terms of shares (priced a 1.25p!) with interest. If it does make money, it can pay back Desmond the original loan. This arrangement isn’t unique and has happened a few times in the last few years.

Unfortunately not all its investments have performed. The Company has a holding of 200,000 shares in Farm Lands of Africa which were acquired at a cost of USD$5.00 each (together with warrants) and were listed on the relevant exchange at the close of business on 30/11/12 at USD$0.60. However, Craven House’s investment in FLAF is currently held at book value of $1.55 per share. This represents a decrease of USD$690,000 in total investment value. The Company has a further holding of 517,350 shares in Farm Lands of Africa which were acquired at a cost of USD$1.55 each. No adjustment in value has been recognised.

So in total that is 717,350 shares of FLAF which should have $0.95 written off. But Craven has an anti dilution clause working in its favour and is still discussing with FLAF how many shares it will be issued to compensate for a dilution that affected the value of its holdings (that is why they still hold it at book value). In May 2012 Craven was actually sitting on a 60% profit on FLAF (which it didn’t recognise) and this subsequent fall in value is due to the subsequent merger and dilution of the shares. A director of Craven is now the CEO of FLAF so you would expect this to be resolved.

Performance Fee

I want to highlight this in particular as it is so unusual in this day and age of fixed management charges. Many of you will be familiar with the 2 and 20 rule for hedge fund charges, 2% annual charges with 20% of fund profits to the manager. Well Craven House doesn’t work like this, its terms are much better:

“the Company agreed to pay Desmond, as Investment Manager, an annual Performance Fee equal to 20% of the increase in the Net Asset Value of the Company, subject to a hurdle rate of at least 5%. In accordance with this agreement, Desmond has been awarded a performance fee of £552,368 for the financial year ending May 2012, representing 20% of the increase in the Net Asset Value per share in the Company during the year. Desmond has confirmed that this fee will be paid in shares of the company, priced at 1.25p per share”

So not only does Desmond only get paid if returns are above 5%, but they are currently being paid in shares for almost 5 times the current market price.

Cravens Value

Unlike other Investment Trusts, Craven doesn’t publish a daily Net Asset Value (NAV) which makes it hard to value it as a company (I don’t see that as an automatic negative, did Warren Buffett publish a daily NAV in his partnership days? No). In fact the latest accounts date back to November 2012. Its Net Assets at that point were £2.4m. Since then it has also raised £621k from a rights offering at 1.25p a share. That takes Net Assets to £3m. It has also realised gains in loans to other companies which were repaid but the amounts are small.

However we need to write off $681k (£448k) for the true value of FLAF. That brings Net Assets to £2.6m. According to the latest regulatory filing they have 592,695,959 shares outstanding which gives a book value of 0.44p per share. That means Craven currently trades at 64% of its fair value, with scope for an increase when (if?) it is issued new shares in FLAF. And for every new share issue and expansion of Cravens net assets at 1.25p per share, that is increasing the book value per share for current shareholders!

But, given this is a small fund we must also assess how its fixed costs affect NAV. Investment managers fees are paid in shares so will not decrease book value (they are only paid when book value per share increases by >5%). However there are also costs with being a listed company and having a board . Admin expenses were £261k in 2012. No investment management charges were included. £261k is over 10% of Net Assets in 2012 (£2.4m). This is very high and shows another reason that issuing new shares is beneficial for current shareholders. Costs wont scale much with net assets, so as net assets are increased, costs as a proportion should fall dramatically. Also remember that management is incentivised to reduce costs as a % as it makes it very hard for them to beat its 5% gain hurdle!

Conclusion

I believe this is a remarkable special situation. Buying a company for not only less than its Net Assets (calculated conservatively) but also when it is issuing new shares for 5 times the current market price. Management has stated its intention to keep issuing new shares at no less than 1.25p and even takes its fees in shares valued at 1.25p! Its recent purchase of a distressed asset shows me that they are willing to invest in the kind of situations that I myself find very attractive.

Don’t expect an easy buck. These shares have bounced between 0.2p and 0.5p for a year. The market doesn’t agree with managements valuation clearly. Who knows how long it will take until the market agrees with the 1.25p value, if at all. But in the meantime I am happy with the investments made and how they raise capital.

I have already bought shares in Craven House having 12% of my portfolio in it and intend to continue doing so up to possibly a third of my portfolio.