Value investors can often profit by following the KISS principle: Keep It Simple and Straightforward. In other words: Look for companies trading below their fair value, buy them, and wait for the market to catch up. Once in a while, though, a company's own complexity can help you find even better values hiding just below the surface. Companies that have multiple classes of shares are a good place to uncover such value; sometimes a bit of digging through their relationships can uncover a tremendous diamond in the rough.
Believe it or not, it's quite common for companies to have multiple classes of stock. Rather than split his Berkshire Hathaway (NYSE:BRKa) stock in response to its five-digit stock price, CEO Warren Buffett created a second class of shares, Berkshire Hathaway Class B (NYSE:BRKb), which has 1/30th the financial interest of Class A but 1/200th of the voting rights. As would be expected for a highly followed company led by one of the world's greatest value investors, Berkshire's Class B shares don't tend to drop much below 1/30th of the Class A share price, though a conversion feature keeps the Class B shares from rising beyond that level.
Baby brother on sale
Sometimes, however, Class B shares offer a compelling value opportunity for investors. Take, for example, homebuilder Lennar (NYSE:LEN), a company I stumbled upon last August while searching for value investments. Impressed with the business, its geographic and price range diversity, and its related product offerings, I felt it would be well positioned even if the long-expected housing downturn were to finally arrive. Trading dramatically below its fair value at the time, Lennar looked like the perfect value investment opportunity. As it turns out, however, there was an even better value waiting in the wings -- a chance to buy the same company at an even better discount. That discount came in the form of LennarClass B (NYSE:LENb), a different stock for the same company.
Some features of the Class B shares include:
- Ten times the voting rights of the Class A shares for most issues.
- Convertibility to Class A shares upon a vote by a majority of Class B shareholders.
- Less liquidation rights than the Class A shares.
Aside from those differences, the Class B shares appear virtually identical to the Class A shares. Call me naive, but I'm not expecting Lennar to be liquidated any time soon. The key difference between the two is the 10-times voting rights of the Class B shares.
You can argue that corporate voting rights aren't worth a hill of beans for individual shareholders, but that doesn't explain the fact that the Class B shares trade at a pretty consistent 6.5% to 7.5% discount to their Class A counterparts. For the same investment, an investor would receive about 970% more voting rights and around 7% more dividend income by purchasing the Class B shares (instead of the Class A shares) of the exact same company! Talk about taking advantage of the fine print.
The Gordian knot of corporate complexity
As complex as Lennar's structure may be, it pales in comparison to that of energy distribution giant Kinder Morgan (NYSE:KMI). Among its assets is the general partner stake of Kinder Morgan Energy Partners (NYSE:KMP), one of the largest pipeline companies in the United States. That general partner stake gives Kinder Morgan complete control over the partnership's operations. The limited partners (owners of the publicly traded KMP units) have no say in the operations of the company, but they have an incentive to own the units because of the partnership's approximately 6.5% yield, its history of raising quarterly distributions, and management's public statements indicating that the trend is expected to continue.
As a partnership instead of an ordinary company, Kinder Morgan Energy Partners is a tough investment for many ordinary investors to hold. The headaches of ownership include a Schedule K-1 at tax time, dividends that are taxed as ordinary income, and the potential of filing and paying tax in all the states where the partnership does business. Another headache is that IRAs, 401(k)s, pension plans, and other ordinarily tax-deferred or tax-free investment vehicles are exposed to taxation on their partnership income, if that income exceeds $1,000 for the year.
For investors looking for income growth and a high yield without the headaches of partnership ownership, Kinder Morgan's operations include a third company, Kinder Morgan Management (NYSE:KMR), which is tied to the other two firms. Kinder Morgan Management pays its quarterly distributions based on comparing the partnership's distributions to its own stock price, and it pays the distributions in additional shares of stock rather than in cash. It's similar to an automatic dividend reinvestment plan, only without cash being paid. Because of its structure and stock dividend policy, Kinder Morgan Management is much friendlier to IRAs and other tax-advantaged investment accounts, as well as to ordinary investors who would otherwise reinvest their distributions.
Cutting through the clutter
In spite of being inextricably linked to the partnership and its payouts, Kinder Morgan Management trades at a discount to Kinder Morgan Energy Partners. Part of that discount may be explained by the fact that in the event of a liquidation of the partnership, investors would depend on Kinder Morgan to deliver on its mandatory purchase agreement to receive their piece of the remainder of the business. The rest, however, is likely a result of automated screening tools overlooking Kinder Morgan Management because its unique structure tends to confound automatic analysis.
With folks overlooking it and screening tools misrepresenting it, Kinder Morgan Management trades at a discount to its more popular counterpart. That discount translates directly to a higher current yield and a better value for investors willing to untangle the complexity and look at the fundamentals behind the business -- the very same business as the higher-priced partnership! Once again, it's an opportunity for value investors to take advantage of the fine print.
Help is on the way
I admit it -- I'm a data junkie. I've spent way too many hours digging through corporate filings, looking for cases like Lennar Class B and Kinder Morgan Management, where an excessively complex structure or a short-term hiccup have caused the market to unreasonably discount a stock. My colleague and friend Philip Durell has a similar passion for uncovering the market's analysis and pricing problems. As the lead analyst for Motley Fool Inside Value, he's willing to do the heavy lifting for you -- to help you find stocks trading for less than they're worth and to take advantage of the opportunities presented when the market can't quite come to terms with a company's true value. For a limited time, he's offering you a choice: a 30-day free trial to Inside Value or a 25% discount off the subscription price.
Fool contributor and Inside Value team member Chuck Saletta owns shares in Lennar Class B and Kinder Morgan Management. The Motley Fool has a disclosure policy.
