When 2 plus 2 does not add up to 4

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Basic math

4419478788_14fe4dbe3e_oEvery trading day at around noon, I review the market capitalization of Formula Systems (1985) Ltd. (traded on Nasdaq as FORTY and on TASE as FORT,) Matrix IT Ltd (traded on TASE as MTRX,) Magic Software Enterprises Ltd. (traded on Nasdaq and TASE as MGIC,) and Sapiens International Corp. NV (traded on NASDAQ and TASE as SPNS.)

These four companies are remarkable for their profitability, their growth, and the pedigrees of their listings, with Sapiens International being a part of TASE’s MidCap-50 Index and BlueTech-50 Index, Magic Software being a part of TASE’s 75 Index and BlueTech-50 Index, Matrix IT being a part of TASE’s 75 Index and BlueTech-50 Index, and Formula Systems, and Formula Systems

They are also related in that Formula Systems, in essence a holding company whose operations consists solely of maintaining and managing controlling positions in subsidiaries and managing cash that is has on hand, holds a 56.6% share of Sapiens International, a 52.3% share of Magic Software, and a 50.11% share of Matrix IT.

So every day I look at these numbers, and, frankly, I do it mostly to ensure that the capital market (also known as The Market — normally pronounced with a deep somber voice by market pundits) has not — overnight — become rational. Here is the numbers for today, which are not in their interrelationship substantially different than the numbers from yesterday, last week, last month, or last year — well except in that (warning… spoiler-alert) the market discount is actually smaller than it has been for the last years:

(c) Per Jacobsen, 2013 and 2014. All rights reserved

(c) Per Jacobsen, 2013 and 2014. All rights reserved

This market discount is enormous, and, in fact, it is larger than what the market capitalization computations reflect, since it does not account for the (non-consolidated) cash on hand at Formula Systems.

Holding Company Discount

A market discount is not unusual for holding companies. In fact it is so common that there is a name for it, Holding Company Discount, and an entire investment discipline set up to capture the value released when the discount shrinks. In this discipline, the issue of the Holding Company Discount boils down to issues related to composition of the basket of subsidiaries and trust in the management of the holding company, and, generally, the question of whether the discount increases or decreases is a question of whether or not the subsidiaries over time are shown to be investment worthy and the question of whether or not the management of the holding company over time are shown trustworthy.

Holding companies are not unusual either. Rather, they are the norm. For instance, Berkshire Hathaway, perhaps the world’s most successful company, is a holding company. In Berkshire Hathaway there is clearly no discount (in fact, in Berkshire Hathaway’s case there is a premium, with the value of the sum (the holding company) exceeding the value of the parts (the subsidiaries,) which is predicated on a decade long establishment of trust in the investment worthiness of the subsidiaries and the integrity of the principal managers, Mr. Warren Buffett and Mr. Charlie Munger.

For Formula Systems, the question of the investment worthiness underlying assets has been overwhelmingly answered over the last years, with the consolidated revenues growing from $549.69 million in 2010 to $744.73 million in 2012, while the company achieved aggregated consolidated net income of $145.61 million and enormous appreciation in the market capitalization of the individual subsidiaries over these three years — and maintained near zero debt. Likewise the management of Formula Systems, principally the CEO, Mr. Guy Bernstein, has shown to have excellent operational abilities (Mr. Bernstein is also the CEO of one of the subsidiaries) and has done nothing to give the common shareholders pause.

Holding Company Discount by design?

Remarkably, the rate of decrease of the Holding Company Discount has over the last years been extremely slow for Formula Systems, and only recently has started accelerating (as I wrote about in a posting on February 16th, 2013 (here,) at a per share price of $18, the capitalization of Formula Systems was $244 million and the associated discount was 30%.

The reason for this slowness is not clear, but a factor, for sure, is the almost complete lack of promotion by Formula Systems of its equity, traded as FORTY and FORT. Simply put, while, for instance, Sapiens International’s management team participates in investor conferences and are quite active with investor-centric press releases and so forth, Formula Systems’ management, for the most parts, flies under the radar when it comes to promotion of the company’s equity.

One possible reason for this is that the Formula Specific incentive package for Mr. Bernstein, quite possibly one of the most lucrative CEO incentive packages that I have ever seen, is not geared towards increasing the market capitalization of Formula Systems in the short run (in the long run it is… providing for millions of shares over a decade at an exercise price of fraction of cents for an equity that at this moment is trading at $22.21,) but, rather, geared towards net and operating income (Mr. Bernstein is paid a yearly bonus of 3.3% of the company’s net profit after tax — a bonus that can easily amount to millions of dollars each year.)

This, of course, creates interesting dynamics where, clearly, Mr. Bernstein has not treated increase in the share price of Formula Systems as a priority (he should later, as he close in on the full vesting, but, so far, he has not,) and, so, it is, I think, a testament to the strength of Formula Systems that the discount has decreased and continue to decrease. Moreover, because of the phenomenal performance of the subsidiaries and their capitalization, the capitalization of Formula Systems continues to be drawn higher in spite of the near-total lack of investor promotional activities.

If you are on-board the Formula Systems holding company bandwagon, you pretty much are on for the ride, and the ride is designed to be a long one. This is fine for me, but I still look at the discount each and every day, dreaming of the corresponding increase in per share price of FORTY if the market value gap would just close (had the gap closed today, for a valuation increase of 22%, the per share price would have increased from $22.21 to $27.10.)

One can dream, can’t one?

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