[Note: this piece was also posted at Seeking Alpha]
For most of my thirty years in the investment business, I’ve been skeptical of closed-end investment funds. Then I flew to Dallas and shared a plate of barbecue with Gary Martin, the personable, soon-to-be-retired president of Capital Southwest Corporation (CSWC). Martin was in a good mood during our lunch meeting, and not just because it was a Friday. As he described the company’s history and its current outlook, he had the relaxed, calmly confident look of an executive with nothing to hide, sell, or prove.
“We let our numbers speak for us,” he said.
Those numbers are quite persuasive. Since Cap Southwest’s initial IPO raised $15 million in 1961, it has quietly grown 13 percent a year by buying into well-managed private companies and holding onto them for long periods of time, even after many of them go public. Like Martin and his fellow executives at Capital Southwest, the businesses they invest in are not flashy. They make things like industrial lubricants (Rectorseal), farm equipment (Alamo Group), and copper wire (Encore). They also make a lot of money, which Capital Southwest frequently shares with its stockholders. Last year, it passed along a capital gains distribution of $17.59 per share. CSWC is also surprisingly undervalued. As Philip Mause persuasively documented several months ago, the stock trades at a significant discount to the company’s net asset value.
But none of these factors explain why I set aside my longtime doubts about CEF’s and bought $3 million worth of CSWC shortly after my lunch with Gary Martin. The real reason I’m long on Capital Southwest is that familiar refrain from the real estate industry: location, location, location. Or, to be more specific, Texas, Texas, Texas.
There are three ways to make money on the long side in my experience. The first is to discover fast-growing companies before Wall Street finds out about them. The second is to buy already well-studied companies before they surprise investors with better-than-expected earnings. The third is to get in front of wide secular shifts in society. You could make an argument that Cap Southwest fits into the first category. It shuns publicity. It does not have and does not want Wall Street coverage (its senior management does not even conduct conference calls). But, for my money, CSWC is the best opportunity I’ve seen in years to profit on the third method of successful long investing: buying into big societal shifts. We’re already well into the shift I’m referring to, but I’m confident that most investors have not sufficiently priced in its far-reaching effects.
Put simply, Texas is experiencing a population boom equal to or greater than any region has seen in generations, and there’s no safer, more prudent way to profit on this demographic tsunami than CSWC. Of its twelve largest investments, nine are located in its home state, which is not only growing internally with a high birth rate but also drawing massive amounts of both people and businesses from around the country.
From 2000 to 2010, the population of Texas grew by more than 20 percent, and that trend has only accelerated. Last year, eight of the fifteen fastest growing cities in the U.S. were in Texas, and Dallas and Houston are now the fourth and fifth largest MSA’s, Metropolitan Statistical Areas, in the country. Scores of large, profitable public companies have relocated to the state or expanded existing facilities. That influx of both human and business capital has resulted in major economic growth. According to the Bureau of Economic Analysis, from 2009-2012, Texas’s real GDP jumped 13 percent. Last year alone, it rose almost five percent, second only to North Dakota for the highest in the country. But Texas is in a much better position for long-term economic health than North Dakota, or any other state.
I started my career as an investment manager in the mid-1980s at Texas Commerce Bank, the largest bank in the state at the time. Back then, Texas–like North Dakota today–was almost wholly dependent on the energy industry. I got to witness firsthand just how destructive that kind of dependence can be during the Great Oil Bust of 1986. The whole economy of Texas imploded after the price of crude dropped. But since then, the state’s economy has diversified, and Capital Southwest’s portfolio reflects that. While several of its investments serve or supply energy companies, it has no exposure to the highly volatile oil and gas exploration sector, and its other major Texas-based holdings specialize in everything from media production (Extreme International) to industrial cleaning agents (Cinatra).
There’s another, less-appreciated reason why Texas’s current boom will carry forward into the future. Unlike other so-called “business friendly” states with attractively low corporate and income taxes, Texas offers employers an increasingly well-educated workforce. In large part, this is thanks to its higher education system. Private institutions like Rice and TCU rival schools on either coast in producing smart, job-ready graduates, and thanks to oil and gas rights in the Permian Basin and elsewhere, the University of Texas system boasts the richest public endowment in the country and the third largest overall, behind only Harvard and Yale. That fact was almost as important as Texas’s raw economic numbers in my decision to buy CSWC. It shows that, like Capital Southwest, the state is investing its resources wisely and is poised for steady, sustainable growth for a long time to come.