Nothing is more tempting to a value investor than spotting a dollar bill that looks like it sells for 15 cents (Thanks Tupac). I’ve gotten into more trouble and been stuck in more value traps by falling for this.
I’ve already mentioned Scheid Vineyards and its tempting real estate assets in a past post (The Perils and Pitfalls of Investing in Microcaps), but I wanted to share another example of an asset play that has not worked out well.
Safeguard Scientifics (NYSE: SFE) seems like an interesting undervalued “sum of the parts” opportunity. The company owns a portfolio of several middle to late stage startups in healthcare and digital media, as well as several more mature startups with over $10 million in annual revenue. The cost of their venture investments is $236 million, and yet Safeguard only has a market cap of $112 million. In other words, an investor can invest at half of the value of what Safeguard put into these companies five to eight years ago. Surely, a mature venture portfolio shouldn’t trade at half of invested capital, right? If one were to assume that this portfolio returns 2-3 times invested capital, an investment in SFE may be worth more than three times the current stock price. In 2018, this thesis got activists involved and now one of those activists is running the company. And yet, look at what has happened to the stock price:
There are a few principal problems for me. First, many of the companies in their portfolio need more capital and Safeguard has to keep putting in money and has public company expenses, yet only has $13 million in cash left. Second, selling companies prematurely is not the most optimal way to receive top dollar. The company has mentioned as much saying that they have received bids, but they are too low.
The investment becomes a question of timing. How much money will Safeguard need to continue its investments and stay public? Will it take Safeguard three years to liquidate? Maybe it will take five or more years. I have no strong opinions about any of the companies it owns stakes in, nor have any insight as to whether they have value or not. I’m not sure I would want to be an investor in any one company in Safeguard’s venture portfolio.
One day this may work out, but who knows when. Realizing that I do not have any special insight into Safeguard’s portfolio companies, helps me move on to other opportunities and not get caught in something that I have no real edge in figuring out.
Let me now share a counter example that I think is a “sum of the parts” investment I believe in: Nelnet (NYSE: NNI). I wrote up a research report on Nelnet: The Quiet Technology Compounder.
I continue to believe Nelnet is worth at least $90 per share based upon the sum of the parts of its holdings. How is this different than Safeguard? First, Nelnet’s main asset is a large student loan portfolio that is not only 97.5% backed by the Federal government, but also spits off a ton of cash flow. The bull thesis for Nelnet is that this massive asset is now in runoff and that cash will cascade on to the company’s balance sheet. This big valuable cash flowing asset actually masks something even better, an incredible fast-growing education technology business that is creating enormous value. There are a few other assets including a fast growing fiber network and a stake in a soon to be unicorn (HUDL), but the education technology business is what I am focused on.
And this is the big difference between Nelnet and Safeguard. I want to own Nelnet’s education technology business with its 40% market share, 32% operating margins and 20% revenue growth with still lots of room to grow.
But more than that, Nelnet also has top notch capital allocators in charge. Management has been increasing book value by 17% a year for fifteen years, bought back 4% of the company in the second quarter, pays a dividend and has a history of creating value for shareholders.
You may notice that Nelnet is awfully similar to Berkshire Hathaway, but instead of using insurance to make investments, Nelnet is using student loans.
I think the lesson that I have learned after over two decades of investing is that sum of the parts investment theses are only worthwhile if there is a cash flowing asset driving the thesis, otherwise it may be a trap instead of the bargain you think it is.
P.S. I would love to hear from anyone with a bullish view on Safeguard or any of its portfolio companies.