Saturday, January 26, 2013


After years of being shunned, suddenly stocks are a hot asset class again with the Wilshire 5000 index (broad total market index) hitting a new all time on January 24, 2013.  Will retail investors finally return to the market?  What companies may profit from a broad shift from bonds back into stocks?

One such company is FRMO Corp, an "intellectual capital" firm headed by Steven Bregman and Murray Stahl of Horizon Kinetics fame.  FRMO can be thought of has having two sleeves, one sleeve includes various investment product revenue streams and a 0.87% interest in Horizon Kinetics, which is an investment boutique formed in 2011 through a combination of Horizon Asset Management and Kinetics Asset Management.  The second sleeve is cash and securities managed by Bregman and Stahl, including investments in several of the hedge funds managed by Horizon Kinetics.  FRMO's book value per share has grown at an incredible pace, starting at just under $50k in 2001 and as of 11/30/12 it stands at $58.3 million.

2011 Shareholder Letter
Horizon Kinetics
Back in February 2002, FRMO acquired a 8.4% interest in Kinetics Advisers for 315 shares of FRMO stock, then valued at $204.75, clearly an incredible investment for FRMO.  Today, Horizon Kinetics is a private investment company that manages roughly $7 billion in a variety of separately managed accounts, mutual funds, and alternative investments.  It manages primarily equity based portfolios that have faced constant redemption pressure across the entire industry for the past several years as investors have fled equities (and in particular active managers) for bonds and alternative investments.  While its nearly impossible to know when the bond "bubble" will end, at some point interest rates will rise causing bond prices to fall.  Pension funds who have return targets are unlikely to meet their objectives given the low return potential of bonds, while bonds prices might not crash, they won't earn what they have in the recent past likely pushing investors into riskier asset classes.

Several of the "Bond Kings" have recognized the potential shift into equities broadly and have begun opening up equity strategies: U.S. Bond Stars Bet Big on Equities Revival.  One change Kinetics Funds (Horizon Kinetics' mutual fund arm) recently made was to adjust the strategy of their Water Infrastructure Portfolio into an alternative fund strategy that tries to create bond like returns and volatility with stocks and stock options, the new fund is called Alternative Income Fund.  Horizon Kinetics hopes the fund will become popular with current bond investors as they realize past returns are no longer achievable in the current bond market.

Below is a breakdown of the firm's current AUM.  However, not all AUM is created equal, for instance alternative investments while a small piece of AUM contribute a disproportionate amount of the revenue in Horizon Kinetics compared to rather vanilla separately managed accounts that charge lower fees.

FRMO Q1 '13 Earnings Transcript

Many of FRMO's intellectual capital consultancy and revenue sharing agreements are based on the assets under management.  Below is what FRMO provided in their Q1 '13 earnings call transcript to provide a little more color on the portfolios:
FRMO Q1 '13 Earnings Transcript
For example, one of FRMO's revenue streams is a 20% interest in all the management and performance fees of Horizon Multi-Disciplinary Fund.  The Multi-Disciplinary Fund's strategy involves selling six month at-the-money put options on equities that they would otherwise be comfortable holding.  It only takes a little success and investor recognition for assets to multiple rapidly off of a small base generating revenue for FRMO.

Another one of their revenue streams could be on the verge of improving.  As mentioned on the latest conference call,  the Horizon Global Advisers Multi-Strategy Fund which founded in 2007, right before the credit crisis and at one point dropped 70% from peak to trough.  However instead of closing the fund, the managers stuck with it despite needing to return 400% in order to earn performance management fees above the high water mark.  Well as of this past weekend, the Multi-Strategy Fund finally crossed that high water mark and FRMO could potentially start earning a incentive performance management fee going forward in addition to the percent of assets management fee.  FRMO also has $5.2 million invested in the Multi-Strategy Fund, so they continue to benefit from the turnaround from an investor perspective too.  Management also noted similar circumstance at Polestar where it has recently cross the high water mark and will start earning performance fees.

Unique Business Structure
The beauty of FRMO's structure is the revenue streams are like royalties in there are no associated operating costs.  By nature, the intellectual capital business doesn't have operational costs as the costs are borne by the entity that FRMO is advising.  The level of business activity can thus be increased without the creation of expenses.  Bregman and Stahl have been successful in purchasing these interests before they are proven successful, and thus are generally inexpensive to the point where failures should not meaningfully harm the company.  Should such an investment prove successful, as the initial Kinetics Advisors interest was, the returns could be many multiples of the original investment.

FRMO also has no paid employees (the entry on the income statement is non-cash for audit reasons) and from the sounds of it, they don't intend to as long as they maintain the current structure, pretty shareholder friendly considering how much value management has created.

FRMO has $21.7 million in cash and below are their disclosed investments in limited partnerships, and their bond and equity securities.  It's difficult to find information on the hedge fund strategies, but both Bergman and Stahl are related to the two main holdings, Horizon Multi-Strategy Fund and Polestar Fund.  I tend to be skeptical of hedge funds and their ability to generate alpha due to high costs, but since FRMO is entitled to a portion of the management fees, the costs of FRMO's investments are essentially slightly subsidized as a result.
FRMO Q2 '13 10-Q

Shareholders equity is at an all time high of $58.3 million as of November 30, 2012 and virtually no real debt, the liabilities on the balance sheet mostly represent deferred taxes due to their investment holdings and their portfolio of securities they've sold short.  

The question of valuation for FRMO comes down to how you value the intellectual capital side of the business.  Backing out the book value of the cash, securities, and other investments, the market is valuing the intellectual capital side at $23.87 million.  Seems reasonable, but hard to really judge with the limited information and reporting that FRMO currently provides.

Potential Catalysts
FRMO has recently made efforts to increase its visibility with investors by holding very candid quarterly investor calls where they specifically make an effort not just to read the quarterly earnings report.  FRMO will also soon be eligible to start filing with the SEC again following two years after their reverse-forward split and the switch to the cost method of accounting of Horizon Kinetics after the merger.  Filing with the SEC will allow FRMO to leave the OTC Markets and once again list on a national exchange, opening FRMO up to a new investor base.

Additionally, FRMO is also exploring transactions that would add an operating business within the context of FRMO to provide cash flow for investments.  Management has stated that they are actively exploring such transactions, so something could be on the horizon in the near future.

FRMO is a unique company that is difficult to peg an intrinsic value, but you can't argue with the record of Bregman and Stahl as capital allocators.  I believe we could be on the cusp of a big shift into equities, and FRMO is well positioned to capture that trend.  I'm in the midst of selling a few legacy positions as their stories are playing out, so I'll likely allocate some of that raised cash to FRMO shortly.

Disclosure: No Position

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