Aug 24

SHOULD I INVEST IN A HOLDING COMPANY?

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A Holding company is a parent, who invests in a working child who has the energy and temperament to work hard, earn and give something back to the parents without their physically working. That in a layman’s term is a holding company and a parent or operating company’s relationship.

One of my readers’ , Anshul, who is currently abroad, has posed this question, in the comments section. I am reproducing it because it will help all the readers:-

Sir,

I was revisiting the Primer on Holding Companies, once again and shall ask you the following once again:-

1. Growth. Growth of both the companies are tied together, but if operating coy X grows its PAT at 20%, the growth of the holding company Y is limited to growth in dividends, which may or may not be in line with growth of PAT. This was the original question I asked. Now I have the following obsns on this –

(a) The growth in sales or income of the holding company is affected directly by growth in dividends of X, but as the assets (and mkt cap) of Y are directly related to Mkt Cap of X, thus when earning rise for X (due to incr in PAT), it will translate into incr in share price of X, which will fuel the rise in share price of Y. However, such a view is only correct from a very long term pt of view, as there can be a long wait between incr in PAT translating to incr in Share Price. Am I correct?

(b) Further, how are incr in PAT and incr in EPS related – its roughly proportional but is it linear?

2. How to value a Holding company? Is it the sum of all the Intrinsic Values of the subsidiaries (in ratio of holdings obviously) or does the structure of a holding company gives an intangible asset? So can it be a classical SOTP based analysis or something else?

Sorry for pestering, but I am running against time and there is so much to learn sir ?

Regards
Anshul 

So let me answer it, point by point.  With a suitable example

The Parent or Enjoyer or Holding Company

 

The Child or Earner or Operating Company

The child is only as good as the parent. If the pedigree of the holding company is good, and it has imparted right values to its child, then  it will keep getting a substantial chunk of income as dividends. Now look at the financial ratios of the Operating Company and the Holding Company. A good operating company will keep constantlygiving a fixed percentage of its income to the parent holding company. Operating Company Dividend Payout except when it faces extreme problems. 

Point 1.

It is not necessary that PAT of both will be linked. The operating company may grow its PAT 6 times in 12 years but holding company may grow its PAT 12 times in 12 years. It will depend upon Revenue, Expenses, Taxes and Depreciation. The holding company may reduce all of these items in P&L statement and thus, generate higher PAT growth than the Operating Company . Logically it should be linked, but stock market is not the place for logic. It is the place for emotions. 

Point (a)

Yes, you are correct in the wait part. The markets may not do the correlation which your brain may do. Increased PAT may not result in increased market cap of companies. But this applies to a lot of companies. The markets have a moronic way, as I repeat ad nauseum, good profits may or may not convert to higher share price. And converse is also true. Bucolic  companies may have much higher valuations than they truly deserve.

The value of a holding company may remain far more subdued than the actual assets/ investments it holds. Since, when have markets been efficient? Stock Market has no brains. It is like a rubber gel ball. You can squeeze it anyway. Depends on which side pressure is more. But for some holding companies the market gives a better growth in valuation, when it realises that the holding company or parent distributes everything it gets. Have a look at this Dividend Payout as Percentage of PATof a holding company.

Point (b) 

PAT and EPS are same thing. They just depend on number of slices of a pizza which you make. PAT is Pizza, EPS is slices of that pizza. More shares outstanding will mean, less EPS and lesser shares for same PAT will mean higher EPS. 

Point 2. 

Ideally it should be a mathematical sum of the parts (SOTP). But markets are never mechanical. They have their own minds. They will never fairly value a business. A few years ago, Bajaj Fin Serve and Maharashtra Scooters were an example of this. The investments held by them in Operating companies were much higher than their own share price. But the markets were undervaluing them substantially. But eventually markets would recognise their error. But betweeen the error and its recognition, it could be a lifetime or a test of patience of a small investor. Eventually, 9 times out of 10, the small investor will sell out at marginal profit or no profit and the kicker in the stock may come after 2 years of the sale , making it a multibagger. 

My two penny worth — why f*@k around with holding companies, when you have equally good businesses to make money from. Follow Munger’s advice — three stocks in a life time are good enough to make you rich. Take Care. 

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