Holding companies: A real life example of complexities involved

I would like to share a 'live' case from my personal portfolio on the subject of investment in holding companies.

On August 6^th, 2004 I sold Sterlite and bought MALCO to take advantage to disparity in the prices.

http://in.groups.yahoo.com/group/lawarrenbuffet/message/809

When Sterlite came out with rights issue, I was concerned that MALCO would increase its debt to unsustainable levels(it later renoucned its right and pruned its debt). A month after the swap I reversed this transaction. Though we made 14% gain in this, the swap was a mistake because the LWB Special portfolio was not supposed to take risky bets for small arbitrage gains.

http://in.groups.yahoo.com/group/lawarrenbuffet/message/891

However in my personal portfolio I continued back and forth swap between Sterlite and MALCO depending upon which looked expensive relative to other. Over next year I completely swapped Sterlite with MALCO. MALCO became my single biggest investment and it was the only stock where my personal portfolio differed from LWB Special. Sterlite continued its rise and MALCO couldn't keep pace. Consequently I was underperforming compared to market.

Considering the fact that MALCO's market capitalization was less than the value of stake it owned in Sterlite, I had every reason to remain patient but as I've explained elsewhere holding companies test the limits of your patience.

The following table shows the movement of the stocks from starting value of 100. Its clear that although in long term the value of holdings is taken into account, it can take years. One might get frustrated and sell(or may be die in the meantime!). When the revaluation takes place its sudden and abrupt. MALCO gained 76% in 5 months in 2004. After this it became dormant while Sterlite continued to rise. On April 7^th, 2006 Sterlite had risen by 353% whereas MALCO was up by only 127%. At this point MALCO's market capitalization was 625 crs. whereas the value of 4.61% stake it held in Sterlite was 1057 crs.

Date	MALCO	Sterlite
28-Jul-04	100	100
21-Dec-04	176	128
7-Apr-06	227	453
19-Apr-06	372	516

View chart of relative price movements

I was obviously frustrated with this situation and broke my prudent limits on maximum exposure to single stock. To my pleasant surprise the price of MALCO rose 64% in last 10 days. Even today it was locked at upper circuit breaker at Rs.458. (consequently last 10 days turned out to be most profitable 10 days of my investing career)

Coming back to original question. Was I right about swapping Sterlite with MALCO? May be not. Sterlite rose from 416% since July 04 whereas MALCO rose only 272%.

I know what you are thinking! If I had swapped from Sterlite to MALCO on July,2004, back to Sterlite on Dec, 04, back to MALCO again on 7^th April 06 then I would have made 920% gain. Such perfect timing works only in theory.

The reasons which compelled me to buy MALCO remained valid throughout the period from July 04 to date. So in such case if I did a swap it was logically correct decision. In spite of a correct decision I haven't made anything more than what I would have made by just sticking to Sterlite, the way we did in LWB Special.

To summarize, exploiting the inefficient valuation of holding companies remains a perennial attraction for many value investors. Many of us underestimate the complexities and timeline involved in correction of these inefficiencies. The purpose of holding company is to hold the stock..forever. Isn't it irrational to expect that `unlocking of value' in such cases?

On the other hand it is easy to get impatient in such cases and miss those 10 days when the inefficiencies are corrected. As a rule most value investors would be better of staying away from complicated situations like this.

This rule may not apply if you are willing to hold INDEFINITELY. In those cases its always advisable to swap as soon as you see a sizeable advantage. If you try to time your entries and exits you may end up getting returns lower than either of the stocks involved.

Regards
Kamlesh