Embedded Optionality | FRMO Case Study

When people talk about the Quality of Earnings, what they usually mean is how well do current earnings predict future earnings. This is, literally, the textbook definition of earnings quality. The problem with this definition, however, is that it favours the stability of earnings above anything else. 

What if, as an example, a future stream of earnings is highly unpredictable yet has a reasonable likelihood to be orders of magnitude higher than it currently is? What if a stream of earnings has embedded optionality? An earnings stream with a free call option, you could say. I would argue that different businesses, with different business models, will produce earnings that have different qualities. 

In this article, I would like to explore this topic of embedded optionality in the context of earnings quality. I would like to do this through a case study of FRMO Corp, a small $250 million market cap stock that I see as a poster child of embedded optionality.

As this piece turned out to be way too long, let me start by highlighting a few embedded optionality ‘symptoms’ of FRMO Corp: 

• FRMO owns two different types of securities that derive their earnings from the same underlying asset, Horizon Kinetics Asset Management. 
• Over the last 8 years, FRMO has generated over $10 million in shareholder gains, that did not flow directly through the income statement. 
• Many of the investments that FRMO has made over the years, do not scale by consuming cash to create earnings. The biggest embedded optionality within FRMO is the earnings stream(s) they have yet to acquire.

FRMO has built up the network and cash balance that makes them someone to make a phone call to if you need to sell a particular type of financial service provider. In the words of dr. Richard Sandor, if you want to be on time, you have to be early.

Thinking about how companies create wealth

In Financial Statement Analysis and Security Valuation by the professor Stephen H. Penman, it says: “The “bottom line” measure of value-added to shareholders’ equity is net income, also referred to as earnings or net profit.” In other words, earnings should tell you how profitable a business is. But can a company create or capture value for its shareholders without showing earnings? 

The classic case of a company that created enormous value for its shareholders, without showing any earnings would be the cable company TCI under the tenure of John Malone. Due to factors such as the depreciation of capital goods, acquisitions and debt issuance, the value creation for shareholders was not directly visible from the income statement. 

As a result, business operators, investors and analysts use a variety of terms to describe the value creation (or destruction) of businesses. Some metrics focus on cash flows, some focus on the business itself, whilst others focus on the shareholders. 

Thinking about the Quality of Earnings

One metric frequently used is Earnings Quality. Whilst Earnings as a metric describes history, the Quality of Earnings attempts to prognosticate the future. Ask an accountant and he would tell you that the Quality of Earnings is the ability of past earnings to predict future earnings. 

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• New to finance and investing? Read this Primer on Earnings Quality
• I do most of my reading on a Kindle Paperwhite

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There is a great talk by Malcolm Gladwell, where he talks about Howard Moscowitz and his quest to find the perfect spaghetti sauce. As it turns out, there is no perfect spaghetti sauce in the singular tense, only perfect spaghetti sauces. In the same vein, I would posit that Earnings Quality is not a spectrum, but that there are different kinds of Qualities of Earnings. 

What kind of qualities are there? Predictability is perhaps the most obvious quality, considering the accounting definition of the term. A large addressable market or the scalability of a business model could be seen as indicators of the capacity of an earnings stream to grow in the future. Some income streams have defensibility and are likely to remain stable in an adverse environment. 

The Concept of Embedded Optionality

One earnings quality that is somewhat underappreciated is embedded optionality. You can visualize embedded optionality in the following way. Imagine you could calculate the Net Present Value of all the possible earnings stream of an investment. You would then take all those possible futures and organize them in a chart that would show the distribution of future outcomes. With embedded optionality, the distribution would be skewed, with a long tail on the positive end. 

Hence, an investment with embedded optionality will have a limited downside and a significant upside. Businesses with embedded optionality have the potential to grow significantly, without having to deploy meaningful capital to achieve those results. In other words, the outcome is not perfectly correlated with the invested resources. 

I can think of two business model qualities that can create a strong embedded optionality: 

• Strong Network Effects: Each additional user adds value to other users. Think security exchanges. 
• Other People’s Money: The business grows by leveraging resources that are external to the capital of the business. Think royalty companies or asset management companies. 

Which brings us to the main topic of this article. Let us explore the concept of investments with free call options by taking a closer look at FRMO Corp, a poster child of embedded optionality.

FRMO: A Matryoshka Doll of Call Options

FRMO Corp (OTC:FRMO) is one of those peculiar stocks you don’t come across very often. The company is controlled by Murray Stahl, Steve Bregman and Peter Doyle, who themselves are principals of Horizon Kinetics Asset Management. FRMO Corp has an economic interest in Horizon Kinetics (more on that later) and to a great extent, the investment philosophy of the asset manager is intertwined with that of FRMO Corp (also more on that later). If you are not familiar with the company, you can read up on FRMO’s background here. 

One of the more interesting and idiosyncratic things about the FRMO business model is that there isn’t much of a business. The company is a labyrinth of different investment strategies held directly and indirectly through various means and investment vehicles. 

In FRMO’s 2004 annual report, the company states its intended purpose:

FRMO Corp. is an intellectual capital firm. The experience of its management has been in the analysis of public companies within a framework of identifying investment strategies and techniques that reduce risk. The business will include identification of assets, particularly in the early stages of the expression of their ultimate value, and the participation with them in ways that are calculated to increase the value of the shareholders’ interest in FRMO. Such assets are expected to include, but are not limited to, those whose values and earnings are based on intellectual capital. Of the many varieties of capital upon which investors have earned returns, ranging from real estate to silicon, perhaps the highest returns on capital have been earned on intellectual capital. It is the goal of FRMO to maximize its return on this form of asset. The identification of any business opportunities will follow the process employed by Horizon Research Group to select and evaluate investment opportunities and strategies.

This is particularly peculiar (in a pleasing way), since as far as I can tell, the management of which the company derives its intellectual capital, seems not to be charging the FRMO for the right of use of their brainpower. As a testament to that, the compensation that Murray Stahl receives for sitting on the Board of the Minneapolis Grain Exchange is paid to FRMO and not to him personally. 

FRMO doesn’t trade on an exchange, but rather over the counter on the pink sheets. With a market capitalization of about $250-290 million (the difference between the bid and ask can be quite high), it would be hard to find a bigger pink sheet stock.

Price is What You Pay, Value is What You Get

FRMO’s shareholder’s equity was $128 million as per the latest filing. This means that the company is trading at around 2-2.5 times the stated book value. Since there is no operating business and the company is primarily a holding company, this might be seen as quite expensive. 

Some time ago, an investor whom I greatly admire posed the hypothetical question: “Why would you pay 2 times book if you can buy Renn at a discount to book?”

The question is very valid, so let me elaborate. Horizon Kinetics is the manager of Renn Fund, a closed-end fund that trades at a meaningful discount to Net Asset Value and is currently not being charged any management fees by Horizon Kinetics. FRMO also leverages research and investments strategies from Horizon Kinetics when it allocates its own capital. Hence, the question. 

If you would want to get technical you could argue that Renn Fund currently still has about 50% of its capital in cash and hasn’t started applying the Horizon Kinetics strategies to its portfolio. Nonetheless, you could replace Renn Fund with any of the Kinetics Asset Management open-ended funds and the logic would apply just as well.

If you wanted to get exposure to the Horizon Kinetics investment strategies, you could just as well invest in the Paradigm fund at NAV and take the hit of management fees, rather than buying FRMO at over 2 times book?

To answer this question, we need to explore two separate aspects of it. The first one it to try to understand the difference of owning the asset manager and owning the assets directly. Does it give you exposure to different “Qualities” of Earnings? 

The second aspect is to understand if owning FRMO will give you exposure to assets that you won’t get through funds managed by Horizon Kinetics. And the answer there is a definitive yes.

The Mark-to-Market Assets

If you take a look at the most recent balance sheet of FRMO you will find that the company has about $194 million in assets. The company has about $54 million in cash and $64 million in marketable securities, although about $48 million of those actually belong to minority interests through Horizon Kinetics Hard Assets. In addition to that, the company has about $40 million invested into funds that FRMO is affiliated, net of a $7 million stake in LaSalle Partners, which we will save for later. 

Marketable Assets	(million USD)
Cash	$ 53.6
Securities, net	$ 63.8
t/o Minority Interest	$ (48.2)
Funds, net	$ 46.0
t/o LaSalle Partners	$ (7.1)
Total	$ 108.1

All in all, out of the $194 million in gross assets, about $163 million are priced mark-to-market or at a market attainable value. You could also factor in that there are deferred tax liabilities (capital gains due to asset appreciation), that would have to be paid if the company sold assets and paid out to shareholders. 

The point here, is that out of the $194 million in assets, $164 million are priced at fair value and should not be valued at a premium to book value. 

Assets without a Market Value

There are three key line items on the FRMO Corp balance sheet that are not accounted for on a mark-to-market basis: 

• Horizon Kinetics LLC Revenue Stream
• Horizon Kinetics LLC Equity stake
• Investments in Exchanges

These three items are on the books for about $30 million, so they would need to be undervalued by about $140 million for the current market capitalization of FRMO Corp to reflect fair value. Let’s take a closer look. 

FRMO’s Investment in Horizon Kinetics

Since the Stahl-Bregman Group took control of FRMO, the company has invested in various revenue streams tied to ventures that the group was affiliated with, mainly related to Horizon Asset Management and Kinetics Asset Management. In May 2011, these two companies merged. After the merger, FRMO owned a 4.95% stake in the combined entity. At that time, the total AUM of Horizon Kinetics was $9.8 billion. 

In 2013, Horizon Kinetics and FRMO Corp agreed to combine a number of revenue stream agreements that FRMO had acquired into a single revenue stream agreement. This entitled FRMO Corp to 4.2% of all revenues that the asset manager generated. At the time of the agreement, Horizon Kinetics AUM had contracted to about $7 billion. 

Horizon Kinetics operates both mutual funds as well as separately managed accounts and derives its revenues from two fundamentally different sources: 

• Management Fees: The company is entitled to a management fee based on assets within various funds that they manage. In most cases, management fees are around 0.85% of AUM. 
• Performance Fees: In some funds, Horizon Kinetics is entitled to a performance fee, based on the returns those funds active over a period of time. 

As a result, the fee-based revenue that Horizon Kinetics generates can fluctuate quite a bit.

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The State of Active Management

In the early days, Horizon and Kinetics grew their Assets under Management rapidly both through mutual funds as well as through separately managed accounts (from institutional investors and high net worth individuals). Over the last decade, however, active asset management has come under intense pressure from passive investment strategies, such as ETFs, which have been growing rapidly in Assets under Management. 

Actively managed mutual funds (funds that have in-house research teams that perform fundamental research on individual companies and base their portfolio on proprietary research) as an industry have therefore find themselves in secular decline. 

As passive management is rules-based, it does not require the same amount of research as active management. Hence the cost of running passive funds is much lower per unit. As a result, they charge much lower management fees. As a matter of fact, funds that have the capacity to scale charge fees very near to 0%. 

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As I said before, FRMO Corp holds two separate stakes in Horizon Kinetics. FRMO owns 4.95% of the equity of Horizon Kinetics. It also owns a revenue stream interest that entitles FRMO Corp to receive 4.20% of the revenues of Horizon Kinetics, prior to any costs the asset manager incurs. 

On the FRMO balance sheet, the Horizon Kinetics equity stake is carried at $11.8 million and the revenue stream at $10.2 million. Based on the somewhat limited information we have, we can try to reverse engineer those two streams of earnings, and come up with a valuation of our own. 

The Horizon Kinetics Revenue Stream

If you examine the fees that FRMO has received from the Revenue Stream, you will find that in the early years, fees grow extremely rapidly as investment strategies and funds, such as Paradigm Fund, gain momentum. 

In 2004, FRMO enters a dark period, in which the company is not able to report GAAP compliant financial statements (a hedge fund they owned a stake in and consolidated had a different reporting period and as a result, they were unable to reconcile and consolidate the FRMO accounts according to regulations). From 2009 and onwards, however, we have full visibility into fees generated. 

In 2009, FRMO receives over $6 million from revenue share agreements as Assets Under Management reached close to $10 billion. But the financial crisis of 2009 had a significant effect on Horizon Kinetics and the AUM. 

Year	Fees	Change
2001	3,500
2002	67,822	1837.77%
2003	103,953	53.27%
2004	125,758	20.98%
—	—	—
2009	6,097,923
2010	3,142,539	-48.47%
2011	2,960,906	-5.78%
2012	2,325,041	-21.48%
2013	2,417,836	3.99%
2014	4,799,208	98.49%
2015	3,215,379	-33.00%
2016	2,536,194	-21.12%
2017	1,994,465	-21.36%
2018	3,257,415	63.32%
2019	2,026,637	-37.78%

As a result, annual fees received over the following 10 years are less than $2.9 million on average. Since the revenue stream is valued at $10.2 million on the FRMO balance sheet, this is equal to a 3.5x multiple of average annual fees. 

Now, consider the earnings quality of the revenue stream. Are the earnings generated from the revenue stream predictable? Not really. The fees are highly volatile from year to year. Nonetheless, there are other qualities to consider. FRMO does not consume any cash to generate these earnings and gross margins are close to zero. Hence, the revenue stream is consistently profitable. It is mathematically impossible for the revenue stream to deliver earnings lower than zero.

How are revenue streams valued? What kind of multiples should we assign to it? One place to look for comparison would be with precious metals streaming companies. Wheaton Precious Metals, Franco Nevada and Royal Gold are all so-called streaming companies.

Although they are often referred to as miners of gold and other precious metals, they don’t actually mine the metal. Rather, what they do is provide financing to mining companies in exchange for a revenue stream deriving from the future mining output. Since the companies don’t actually incur the capital expenditures and operating costs of running a mine, the revenues that they generate have EBITDA margins around 80-90%. 

In a recent presentation by Wheaton Precious Metals, the company presented comparative multiples of the three main streaming companies. According to Wheaton, the streaming companies currently trade at multiples of 26-36 times operating cash flows and 51-66 times earnings. 

Although the underlying assets are quite different (precious metal mining vs. asset management), some parallels can be drawn between the revenue streams. 

• Neither the precious metal companies nor FRMO has any control of the market price of the underlying assets. 
• On the other hand, the mines have a finite lifespan while the HK revenue stream is (theoretically) perpetual.
• The streaming companies reinvest their cash flows into new mining streams, whilst Horizon Kinetics reinvests the cash flows from the revenue stream to other assets. 

Let us assume that we can apply the multiples from the streaming companies as a proxy to value the revenue stream. If we use the lowest multiple of 24.1, the value of the revenue stream would come in at $69 million dollars. Using the highest multiple would derive value in excess of $100 million. 

Revenue Stream Value	Multiple	$USD
Book Value	3.6	10,400,000
Conservative	10.0	28,675,620
Streaming Low	24.0	68,821,488
Streaming High	36.0	103,232,232

Valuing the revenues stream will always be challenging. You can effectively assign whatever multiple to the revenue stream that reflects your required return. If you think it should be valued at a 10% pre-tax yield to FRMO, the valuation would be just under $29 million, based on average historic fee generation.

Regardless, I think it is safe to say, that the revenue shares seems to be significantly undervalued on the balance sheet. 

The Horizon Kinetics Equity Stake

Since Horizon Kinetics is a private company and the size of FRMO’s stake does not require FRMO to consolidate Horizon Kinetics in its financial statements, we do not have access to financial statements of Horizon Kinetics. We can, nonetheless, make an educated guess on how the business looks like. 

There are a number of publicly-traded asset management companies out there but most are considerably bigger than Horizon Kinetics. To get a proxy of the operating metrics for Horizon Kinetics we can look at other active managers such as Gamco, Waddel & Reed and Napier & Manning. 

Horizon Kinetics is far from being the only active asset management company suffering from the flight to passive management. The last decade has been marked by significant reductions in Assets under Management at all three companies mentioned above.

As an example, Manning & Napier went from $40 billion in AUM to $20 billion in just 4 years. As most of the cost of a research-driven asset management company is compensation related, costs tend to lag if AUM is shrinking.

Even the superstars are suffering from outflows of assets under management. If we look at Mario Gabelli’s Gamco Investors, a similar trend is noticeable. Gamco saw its AUM peaking in 2014 at about $46 billion. As per 2018, AUM had shrunk to $34 billion, or to a similar level as was in 2011.

For Waddel & Reed, an asset management company that is also in the distribution and custody business, assets under management peaked in 2013. AUM went from over $120 billion in 2013 to just over $60 in 2018, a contraction of nearly 50% in 5 years. 

What is interesting though, is the fact that even though these companies have seen such dramatic outflows of capital, they have still managed to operate relatively profitably. In a sense, you could say that the asset management companies scale well in both directions. 

We can use Manning & Napier and Gamco Investors as proxies for Horizon Kinetics. Both managers are both, just as Horizon Kinetics, pure-play active asset managers. Gamco Investors is about 6 times the size of Horizon Kinetics in terms of AUM, while Russel & Napier is about 4 times the size. 

Looking at the income statement of Manning & Napier and Gamco, we can see that compensation is indeed the biggest cost factor. Compensation as a percentage of revenue is 54% at Manning & Napier and 27% at Gamco (inclusive of the management fee charged by Mario Gabelli).

At Manning & Napier, the high compensation costs are, to some extent, caused by the company not being able to scale down its workforce at the same pace as assets under management have been shrinking.

Op. Metrics	M&N	Share	Gamco	Share
Revenues	$ 161,331	100.00%	$ 341,455	100.00%
Compensation	$ 87,408	54.18%	$ 92,782	27.17%
Distribution	$ 18,175	11.27%	$ 39,194	11.48%
Other expenses	$ 32,366	20.06%	$ 22,692	6.65%
Total Expenses	$ 137,949	85.51%	$ 154,668	45.30%
NOI	$ 23,382	14.49%	$ 186,787	54.70%

The second thing you would notice is how profitability those entities operate, despite going through a contraction. Even with a significantly lower AUM, Gamco generated a Net Operating Income of 54.7% in 2018. Manning & Napier had an NOI of 14.5% in 2018. It’s also worth noting that Gamco’s revenue as a percentage of AUM was around 1%, while Manning & Napier’s revenue was around 0.8% of AUM. 

Since we can see the Revenue Stream on the FRMO income statement, we can easily extrapolate the Horizon Kinetics operating revenues. We can then estimate the earnings that Horizon Kinetics should be generating, using Gamco and Manning & Napier as proxies. 

For the purpose of being conservative, let’s assume that the Revenue Share cuts into the operating income of Horizon Kinetics, as opposed to being part of the compensation component. How would the Horizon Kinetics income statement look like if it resembles either Manning & Napier or Gamco? Since revenues tend to fluctuate from year to year, I have opted for using the 10 average fees as a proxy, rather than the most recent one. 

Horizon Kinetics	Manning & Napier	USD	Gamco Investors	USD
Revenues	100.0%	68,275,286	100.0%	68,275,286
Rev Share	4.2%	2,867,562	4.2%	2,867,562
Compensation	54.2%	36,991,069	27.2%	18,552,130
Distribution	11.3%	7,691,661	11.5%	7,836,996
Other expenses	20.1%	13,697,293	6.6%	4,537,356
Total Expenses	89.7%	61,247,584	49.5%	33,794,044
NOI	10.3%	7,027,701	50.5%	34,481,242

With an income statement that resembles Manning & Napier, Horizon Kinetics would be generating about $7 million in NOI or 10.3%. An income statement that resembles Gamco Investors’ operating metrics, would deliver just under $34.5 million in NOI or over 50%. Quite a difference. 

In a recent publication by Sandler O’Neill + Partners, 2018 Asset Manager Transaction Review & 2019 Forecast, the annual median EV / run-rate EBITDA Multiple of US-based Asset Management companies has ranged from 7.5 to 10.2 in private transactions from 2011 through 2018. During the same period, EV/EBITDA multiples of publicly traded asset management companies have ranged from 6.1 to 11. 

If we apply these assumptions to Horizon Kinetics, with Manning & Napier operating performance as a conservative scenario and apply the lowest multiple from the Sandler O’Neill report, FRMO’s 4.95% stake would represent NOI of about $350 thousand on average. With a multiple of 6.1, that would value the stake at just over $2.1 million.

This is considerably below the value on the balance sheet value of the stake. However, Horizon Kinetics also has over $80 million of liquid assets on its balance sheet. If we factor that in, it would add about $4 million to the value of the equity, assuming that there is no debt to net out against it. This would bring the pessimistic valuation of FRMO’s ownership to just over $6 million. 

If we apply the operating performance of Gamco to Horizon Kinetics, FRMO’s share of the NOI would be about $1.7 million. By applying the top range EV/EBITDA multiple we would get to a valuation of $22.7 million inclusive of the HK balance sheet assets. This is about two times the current valuation on the FRMO balance sheet. 

This should be taken with a grain of salt though. We don’t need to look far for a reality check on this valuation. Gamco Investors is currently trading at P/E-ratio below 6 and Manning & Napier are trading at a valuation that is lower than the cash of the balance sheet.

Just recently Franklin Resources announces a deal to buy Legg Mason for an enterprise value of a $6.5 billion. Legg Mason has $803.5 billion in Assets under Management, so the purchase price was about 0.8% of AUM. Considering that Horizon Kinetics has about $5.3 billion in AUM, a comparable valuation would render a purchase price with an Enterprise Value of $43 million.

The Enterprise Value of Horizon Kinetics will swing drastically depending on the assumptions that we use. The point I would like to argue is that even though they are valued at about the same amount on the FRMO balance sheet, the actual value of the revenue stream can be as much as 10 times higher than the value of the equity stake, as far as I can tell.

Investments in Securities Exchanges

Let’s assume just for a second that our analysis of the Horizon Kinetics revenue share and equity stake are within reason. And judging by that, we assume that the combined value of the revenue share and the equity stake are somewhere in the region of $90 million. 

If that were to be true, can sum up the following parts: 

• Cash and Cash Equivalents: $45 million ($53m less $8m in short sale liabilities)
• Horizon Kinetics stake: $90 million
• Investments in Limited Partnerships: $40 million (net of $7 million in La Salle Partners) 
• Equity Securities: $25 million (net of minority interest from HK Hard Assets)

By this count, we have now accounted for $200 million of value. This still leaves us more than $50 million short of the current market value of FRMO. 

But we haven’t finished counting.

Over the years, FRMO has made several private investments in companies that operate securities exchanges. During the 2018 annual shareholders meeting, Murray Stahl made the following statement: 

“You have two choices in exchanges. There are the ones that are at the leading edge in technology, and there are the ones that are not, yet they have a license or licenses. We invest in both, but mainly we invest in the ones that have licenses, but are not necessarily technologically developed. The Miami Options Exchange (MIAX) is at the leading edge of technology. Who knows where they could take that technology? It’s a totally fascinating subject. In my opinion, this area is going to move very, very rapidly in the next couple of years […]”

• Murray Stahl, during the 2018 annual shareholders meeting

In most cases, these investments have been insignificant considering the size of the FRMO balance sheet. This included investments in One Chicago, CNSX Markets, Miami International Holdings and National Stock Exchange Holdings for around $250,000 each,. Less than 0.25% of its equity for each of those investments (FRMO was forced to sell its stake in National Stock Exchange to the New York Stock Exchange in 2018 for an undisclosed amount).

But FRMO has also made bigger bets when it comes to securities exchanges.

Minneapolis Grain Exchange (MGEX)

FRMO operates a fund called South Lasalle Partners (a reference to South LaSalle street, which houses the historic Chicago Board of Trade building). The only asset held in LaSalle Partners is an investment in the Minneapolis Grain Exchange (MGEX). LaSalle owns 14.2% of the seats on the Exchange. The value of FRMO’s stake in South LaSalle was $7 million at the end of November 2019, with a cost basis of $5,7 million. Murray Stahl was elected to the Board of Directors at MGEX in 2013 and has held his seat since then. 

During the 2014 annual shareholders meeting, Murray Stahl elaborated on the MGEX investment: 

“One of the activities we have engaged in over the last year that you might not be able to get a sense of from reading the Annual Report has to do with our investment in a private fund that owns memberships in the Minneapolis Grain Exchange, which benefits from many factors, including two modern ideas. One of them stems from a policy change by the Canadian government. For many decades, it bought entire wheat crop of Canada each year. If you were a wheat farmer in Canada, the Canadian government would buy your crop and then sell it all in one lot. You would get your fair share of what was called the wheat pool. Not that many months ago, the Canadian government abandoned that practice. That change is important to the Minneapolis Grain Exchange, because it trades grain. Since the Canadian government closed the wheat pool, Canadian farmers have to hedge their grain. That necessity has led to a certain increase in trading volume for the Minneapolis Grain Exchange. 

Another factor that has led to increased trading volume is indexation. There are now commodity index funds that buy wheat. They do not want to make it into bread nor do they wish to trade it. They just want to hold it because, theoretically, it is an inflation beneficiary and that practice has led to some increased trading. As a business, the exchange is like FRMO in that more revenue, with very little incremental expense, goes right to the bottom line. I believe this is going to be a record year for the Minneapolis Grain Exchange. As discussed in the Letter to Shareholders, the Minneapolis Grain Exchange building is about 550,000 square feet. The first question is what is the value of a building? It is maybe a class B building, if you want to be generous, because it was built about 100 years ago. It is one-third vacant. I do not really know what it is worth. All I can tell you is that the current market value of all the Minneapolis Grain Exchange memberships is $80 million. If those 550,000 square feet were worth $100 a square foot, for example, the building would be worth $55 million. It shows you there might be some value in the real estate as well.”

It just so happens that on the website of the Minneapolis Grain Exchange, you can find historic transaction prices of MGEX exchange seats. Unfortunately, the most recent recorded price is from August 2019. 

Assuming that the price per seat is still the same as it was in August 2019, the Cumulative Annual Growth Rate in the price of exchange seats has been around 13.4% over a period of 14 years.

Miami Options Exchange and the Bermuda Stock Exchange

In 2014, FRMO also made a sizable $2.3 million investment in the Bermuda Stock Exchange (BSX) and added to that stake in 2015. In total, FRMO acquired 40% of BSX’s common shares.

There are a number of large global companies listed on the BSX through a secondary listing and the exchange has been profitable since FRMO got involved. But the primary reason FRMO got involved in BSX was the potential of the exchange to become the main venue for trading in so-called Insurance-linked bonds. We’ll get to that later. 

In 2016, FRMO acquired 50,000 shares of Miami International Holdings, Inc. (MIH) for $250,000. MIH owns and operates the MIAX Options Exchange. In the 2016 Annual Letter to Shareholders, Stahl and Bregman make a brief mention to the MIH investments:

“Another recent investment is the MIAX Options Exchange (“MIAX Options”). This is a different type of exchange investment in the sense that an enormous effort has been made by the exchange to develop world class trading technology. This technology is important since options are a much more precise method of risk transference than statistical arbitrage. MIAX Options currently has a 7.49% share of the options market. Year to date volume of 145 million contracts represents a 3% increase versus 2015. The company is unique inasmuch as its systems were designed entirely inhouse. Many potential economy of scale activities are possible with such technology.”

In September 2019, an acquisition of the Bermuda Stock Exchange by Miami International Holdings, Inc was authorised by the Bermuda Monetary Authority. As a result, FRMO received 603,293 additional shares in MIH, in exchange for their BSX shares. This brought FROM’s ownership in MIH to 653,393 shares or just about 1%. As a result of the transaction, FRMO recorded a gain of just over $1 million. The MIH stake is now valued at $4,322,905 on the FRMO Balance Sheet. 

Since the exchanges investments are in private companies, their financial statements are not available to us. According to the most recent filings, the exchange investments are valued at $12 million in total. MGEX and MIH, have recent valuations but investments in One Chicago, CNSX Markets and American Financial Exchange are valued at cost. 

But even though the MIH stake was recently revalued, it does not necessarily mean that it represents the true value of the stake. According to the current valuation, MIH inclusive of BSX is valued at a total market capitalization of about $450 million.

The Miami International Securities Exchange (MIAX) now lists and trades options on over 2,600 multi-listed classes and had in January 2020 an 11.48% share in the options market. Compare this to Cboe Global Markets (CBOE), which had a 34.17% market share. Although this is not a like-for-like comparison, since CBOE derives much of its valuation from its ownership of the VIX volatility index, it is worth noting that the current market cap of CBOE is over $16.5 billion. 

Whatever the real value of the securities exchange investments, all of these companies have one thing in common. They are all developing financial products that, if they were to become adopted in the capital markets, have the potential to be value accretive, to the extent that they would multiply the current valuations of those companies. Furthermore, these products would not need significant amounts of capital to drive that growth. 

In that sense, these investments have, what was described at the beginning of this article as an embedded call option. In their current state, these companies are likely to do well for their owners, but if the products they are developing take off, they are likely to do extremely well. 

Before we delph deeper into these embedded call options, there is one other line item we need to discover: FRMO’s short-selling strategy. 

Short Selling Strategy and the Renn Fund

One of the investment strategies that has been developed within FRMO is focused around the short-selling of certain ETFs. What these ETFs have in common is that they are path-dependent. What makes them path-dependent is that they are leveraged. 

These ETFs are designed and marketed for purposes of trading within very short time horizons. The instruments have a fixed leverage ratio (2x, 3x, etc) and the ratio is rebalanced after every trading session. The side-effect of this structure is that the value will decay over time. 

It is my understanding that the instruments that FRMO shorts are mostly leveraged ETFs that track tangible assets, such as gold and silver. Examples would be the Daily Bear and Bull 3X ETFs from Direxion (tickers DUST and NUGT). There is a talk available online where Murray Stahl explains the short-selling strategy, called Value Creation from Value Destruction. 

It is somewhat of a mystery to me how FRMO is able to find counterparties to these trades or how they are able to roll these short positions over an extended period. Although these instruments are path-dependent in the long run, over shorter periods, they can go either way. 

Nonetheless, the numbers tell their own story:

FRMO Margin Release from Short Selling

Year	Proceeds	Covered	Difference
2019	8,055,556	-5,107,374	2,948,182
2018	6,748,085	-4,952,773	1,795,312
2017	1,748,099	-1,808,560	-60,461
2016	6,622,781	-3,832,578	2,790,203
2015	995,285	0	995,285
2014	1,333,768	-582,857	750,911
2013	3,387,346	-726,043	2,661,303
2012	2,326,492	-871,326	1,455,166

Over the last 8 years, FRMO has received an aggregate amount of $13 million from this short-selling strategy. When there is a margin release and FRMO essentially gains the capital (net of taxes), that gain does not flow through the income statement and as a result does not show up as earnings. 

The tricky part is to figure out how to value this strategy to FRMO’s shareholders. We can see that the strategy has added on average $1.5 million a year of incremental free cash flows. FRMO was required to commit capital in the form of collaterals. Yet, by selling the securities short, they received cash once they borrowed and sold them. Then they used the cash to invest in other securities. In a sense, the strategy has provided FRMO with a form of credit that carries a negative yield. 

Another factor to consider is how FRMO will implement this going forward. FRMO tends to test out potential investment strategies before they implement them through Horizon Kinetics. We can see from the recent 4th Quarter 2019 commentary from Horizon Kinetics, that they have started implementing this strategy in their separately managed accounts. 

Another interesting development took place on the 29th of January, when the Renn Fund filed an 8-K current report with the SEC, notifying the public that “Effective immediately, the Fund has revised its principal investment strategies to allow the Fund to engage in selling stocks, exchange traded funds (“ETFs”), and exchange traded notes (“ETNs”) short.” 

I have written about the Renn Fund previously, but until now, it has been unclear how Horizon Kinetics is planning to develop it. The fund has been relatively inactive since Horizon Kinetics took over as investment manager, with half of its funds sitting in cash. 

The Renn Fund controls about $12 million in net assets, but Horizon Kinetics will only earn management fees on assets over $25 million. It is, therefore, safe to assume that the Renn Fund will be a dormant asset for Horizon Kinetics and FRMO for some time.

However, these moves indicate that Horizon Kinetics sees the short-selling strategy as being scalable and if successfully implemented, it could start having a positive impact on the Horizon Kinetics revenue through fee generation. 

Embedded Call Options

Suppose we assign a valuation of $10 million to the short-selling strategy (which could be debated as double counting) and we assign a $15 million valuation to the exchange investments. This would bring our back of the envelope calculation up to $225 million, which leaves us about $25 to $65 million short of FRMO Corp’s recent market cap. 

If we flip this around and assume that the market is pricing FRMO correctly. If the current market cap reflects the fair value, then what are we missing in our summary? We are missing the embedded optionality, the free call options (technically not free, if the market is assigning value to them). 

There are several small options and a couple of big ones.

Ameribor (American Financial Exchange)

It was by coincidence, rather than by design, that the London Interbank Offered Rate (Libor) became the main benchmark for short term interest rates. Libor has an enormous reach. It is estimated that it touches over $370 trillion worth of financial instruments per year.

But 2012 was the beginning of the end for Libor. A widespread plot was discovered, in which multiple banking institutions were manipulating the interest rate benchmark. After news of the Libor scandal hit, dr. Richard Sandor started the American Financial Exchange. His aim was to build a new dollar-based short term interest rate benchmark, Ameribor. 

Sandor, who had just sold Chicago Climate Exchange to the Intercontinental Exchange (ICE), is a living legend in the world of electronic exchanges and derivative markets. He literally came up with the term ‘derivatives’. 

For anyone interested in studying the history of electronic trading, I recommend Richard Sandor’s book Electronic Trading and the Blockchain. Perhaps not so coincidentally, the foreword of the book includes a short testimonial by Murray Stahl. 

Ameribor is different from Libor. Ameribor is derived from actual funding transactions between U.S. institutions and is designed to more accurately reflect their cost of funds. Libor, on the other hand, is generated by polling market participants, making it more vulnerable to manipulation. 

The market for US Dollar based short term interest rates is big. The Alternative Reference Rates Committee (ARRC) said that around $200 trillion in U.S. dollar-based derivatives and loans are based on Libor, with derivatives accounting for around 95% of the exposures. 

There is ample competition though. The money-centre banks are working on the Secured Overnight Funding Rate (SOFR) which will compete with Ameribor. The Intercontinental Exchange, which currently manages Libor, is also expected to come out with a Libor 2.0 benchmark. 

Sandor’s strategy is to focus on smaller regional banks. Currently, the AFX has 178 members across the U.S. that include 137 banks, approximately 1173 correspondent banks and 41 non-banks (broker-dealers, hedge funds and other finance companies). An interesting development was announced in 2019 when AFX and CBOE Global Markets announced the launch of the cboe Ameribor futures. 

FRMO made a $250,000 investment in the American Financial Exchange (AFX) in 2019. If Ameribor fails, the loss of FRMO will be minuscule. if Ameribor, however, gets widely adopted, AFX could grow to become a meaningful investment for FRMO. This is what Stahl and Bregman mean when they talk about owning investments with call options or embedded optionality. 

Spikes Volatility Index (MIH & MGEX) 

Another interesting development and a potential free call option is the SPIKES Volatility Index. The Spikes Volatility Index is intended to compete with the VIX Index, which is essentially a benchmark for volatility, also known as the Fear Index.

VIX measures the stock market’s near-future expectations of volatility implied by S&P 500 index options. It is owned and operated by the Chicago Board Options Exchange (CBOE). The VIX is by far the biggest volatility index.

CBOE facilitates trades in VIX futures and VIX options. It charges a fee per contract and generates about $0.75 per contract. In 2018, VIX futures and options had a combined average daily volume of around 960 thousand contracts over 259 trading days. The revenues that CBOE generate is very profitable, with EBITDA margins north of 65%. CBOE common stock trades at a multiple of almost 5 times revenues. 

The SPIKES volatility index measures the expected 30-day volatility in the SPDR S&P 500 ETF (SPY), which is one of the most actively traded securities in the world. The index was created by T3 Index and SPIKES™ is a trademark of T3 Index. But certain aspects of the methodology and related functionality of the SPIKES is owned by MIH.

In February 2019, SPIKES Options began trading on the MIAX Options Exchange. On May 1, 2019, MIH and the Minneapolis Grain Exchange announced an agreement under which the MGEX will serve as the exclusive listing, trading, and clearing exchange for SPIKES futures. 

The SPIKES futures began trading on MGEX in November but got halted after a few trading days. There is a jurisdictional dispute between the CFTC and the FCC regarding SPIKES. Since the SPIKES index tracks the S&P SPIDR ETF, it is technically just tracking a single stock. It is therefore not clear which of the two regulators should be regulating the futures as it is debatable whether this is a broad-based index or not. 

FRMO’s exposure to MGEX is much higher than to MIH. The potential success of the SPIKES futures should, therefore, have more impact on FRMO than SPIKES Options. Can we scope the potential?

MGEX charges about $0.45 per SPIKES contract. If we pick an arbitrary number and assume that they get to 100,000 contracts in average daily volume, it would translate to a little less than $12 million in implied revenues for MGEX. I’m not saying that selling 100,000 contracts daily is a realistic number, I don’t really know. But it’s a huge market and as a comparison, the average daily volume for VIX futures has ranged between 200 to 360 thousand contracts a day. 

The current total market value of MGEX is around $85 million, and this includes the value of the Grain Exchange Buildings. Assuming that revenue is worth a multiple of 4 in market value for MGEX, that would add $47 million to the Enterprise Value of MGEX or about $3.3 million to FRMO shareholders. FRMO itself owns about $7 million worth of MGEX. If the SPIKES futures fail, there will still be a lot of value in the rest of the MGEX business. 

One interesting development that is worth mentioning is that in October 2019, Thomas Gallager, the Chairman and CEO of Miami International Holdings was elected to the board of directors at the Minneapolis Grain Exchange. It is not unthinkable that at some point in the future, MIH and MGEX might consolidate its partnership even further.

Insurance-Linked Securities (ILS)

Since FRMO exchanged their stake in Bermuda Stock Exchange for shares in Miami International Holdings, their exposure to the Insurance-Linked Securities (ILS) is much smaller (they owned 40% in BSX but now own about 1% in MIH). Nonetheless, I will still include ILS as a minor embedded call option. 

Insurance-Linked Securities are essentially bonds that are issued by insurance companies, that are tied to specific insurance pools. Effectively, ILSs are a form of reinsurance, that are structured as bonds and can, therefore, be sold to investors. It allows the insurance to transfer risk from their balance sheet for a price. 

According to Artemis, a leading firm providing data on ILS, the market had reached a size of about $37.8 billion in 2018. Markel Corp, a Berkshire-Hathaway-style conglomerate with a value investing philosophy, has grown to become a leader in the space. For a primer on ILS, I recommend reading Markel’s 2018 Letter to Shareholders by Tom Gayner and Richard Whitt. 

Since many reinsurance companies are operated from Bermuda, it is fitting that the BSX is the primary exchange for these securities. The problem, however, is that even though the issuance of ILS and Cat Bonds has been growing, the secondary market for ILS trading is less developed.

During the 2019 Annual Meeting, Murray Stahl was asked about this by Avi Fisher of Long Cast Adviser (anybody looking to park capital at a micro-cap focused manager should check him out). In Murray’s reply (page 8 in the transcript) he says:

“The challenge in making insurance-linked securities an investible asset class is that you clearly have to be very diversified. In other words, if you’re going to invest in them, you have to be as diversified as the insurance company. A property casualty company, for instance, might insure millions of buildings. But your bond might be in a pool that is exposed to a certain sector of a city, and what if there is a calamity in that sector of the city? You need to be in lots of insurance-linked securities pools, and just the operational infrastructure to make these securities tradable and liquid, to set up exchanges that actually engage in this asset class with the appropriate technology, is coming, but it’s not there yet.“

I believe this is the primary reason for BSX to join MIH. The Miami Stock Exchange has a much more advanced technology, which might help BSX further build out the ILS exchange facility.

The Wealth Index

The Horizon Kinetics ISE Wealth Indexes are a suite of unique indexes that track the investment performance of public companies managed by some of the world’s most successful investors, businessmen and entrepreneurs.

The main index is the Horizon Kinetics ISE Wealth Index (RCH). To be eligible for inclusion in the Index, a security must meet the following criteria:

• The component security must have a wealthy individual in a control position, defined as a position that allows for substantial decision-making authority (e.g., Chief Executive Officer, Chairman of the Board). A wealthy individual is defined as a person whose level of personal assets generally exceeds $500 million, as measured by public data, although this minimum threshold is subject to change based on market conditions, which can greatly impact the value of personal assets (e.g., public stock holdings).
• The wealthy individual must own at least $100 million of the common equity;
• The component security must be listed on a U.S. exchange;
• In the case of initial public offerings, the component security must have been
  publically listed for at least two years;
• The component security must have a market capitalization of at least $200 million;
• No single component may represent more than 24% of the weight of the Index, and
  the cumulative weight of all components with an individual weight of 5% or greater
  may not, in the aggregate, account for more than 50% of the weight of the Index.
  This particular requirement will be satisfied at the conclusion of each of the quarterly rebalance periods; and,
• The trailing 3-month average daily value traded, as calculated on a trimmed basis
  whereby 10% of the daily observations are eliminated from the sample, must be
  greater than $2,000,000 at the time of rebalancing in order to be included. For the
  purposes of exclusion, the trimmed trailing 3-month average daily value traded must either i) be below $1,000,000, in which case such constituents are removed in
  conjunction with the periodic rebalancing process, or ii) be greater than $1,000,000
  and below $2,000,000 for four consecutive quarters, in which case such constituents
  are removed in conjunction with the periodic rebalancing process.

In 2013, Horizon Kinetics and Virtus Investment Partners launched the Virtus Wealth Masters Fund (VWMAX), a mutual fund that tracks the Horizon Kinetics ISE Wealth Index. In 2015, Virtus Wealth Masters alone now had over $130 million in assets under management. Last years environment has not been very favourable to owner-operator stocks and the fund’s AUM has retreated to about $45 million.

There are three other indexes that belong to the Wealth Index family:

• The International Wealth Index
• The Global Wealth Index
• The Asia ex-Japan Wealth Index

There are no index funds that track these 3 funds, but Horizon Kinetics offers exposure to them through separately managed accounts.

Currently, the Wealth Indexes have to be defined as a dormant asset in our valuation as their current fee generation is marginal to Horizon Kinetics. It remains to be seen how the indexes will perform, particularly during a down market.

Cryptocurrency Mining 

I have up until now left out all discussion on FRMO’s involvement in cryptocurrencies. It has been interesting to follow the progression of FRMO into this space. If you read the transcripts from the quarterly call or the annual meeting, you would be inclined to think that FRMO was pretty much a pure-play cryptocurrency company by now. Especially in the most recent calls, the majority of the questions that management receives concern Cryptocurrencies. 

Many of the funds managed by Horizon Kinetics and at least some of the separately managed accounts have exposure to cryptocurrencies, mainly through the Grayscale Bitcoin Trust. FRMO itself also holds various cryptocurrencies, although it’s not a significant amount relative to the FRMO balance sheet.

FRMO also had the opportunity to invest in Digital Currency Group, which is a leading investment company in the cryptocurrency space, invested in over 150 projects. The company has also built up Grayscale Investments, the asset management company of Bitcoin Trust mentioned earlier. Grayscale currently has over $2 billion in assets under management. FRMO acquired 0.05% of Digital Currency Group in 2016 for $76,261. 

But the main focus of FRMO has been towards cryptocurrency mining. In 2017, Stahl and Bregman laid out the premise for cryptocurrency mining in the Letter to Shareholders:

It should come as no surprise that one can be paid for being a node in a cryptocurrency system. Essentially, since one is paid by newly created cryptocurrency, it might be tempting to say that one is engaged in seigniorage. This term generally refers to the profit made by a government when currency is issued. This profit is given by the difference between the production costs and the face value of the money. For most of history, governments shared this profit with private businesses.

For example, although the Bank of England was founded in 1694, it was privately owned by stockholders until 1946. Some central banks, such as the Bank of Japan, the Swiss National Bank, and the Banque Nationale de Belgique are still partially owned by individuals and they actually trade on stock exchanges.

In the cryptocurrency case, this “seigniorage,” so to speak, can be a profitable activity, and it is called mining. Horizon has actually been engaged in such mining. Recently, Horizon raised about $4.5 million of outside capital in an LLC to offer this activity to outside investors. This entity is known as HK Cryptocurrency Mining LLC. It was not designed as a fee-paying vehicle, since we would like to establish to investors that this can be a rather lucrative exercise. One day we hope to have a number of fee-paying vehicles of this variety. This entity is a completely different type of investment from holding cryptocurrency in a fund, since the cryptocurrency received is sold very shortly after receipt, and the proceeds, after allowance for the depreciation of equipment and related expenses, is simply distributed to shareholders in the form of a dividend.

Horizon Kinetics used to publish a podcast called Consensus Money, covering thoughts on cryptocurrencies. In one of the episodes, Murray discussed his views on the economics of cryptocurrency mining. For some reason, they have removed it from their website, but you can access a transcript of the podcast on How to Value Stuff.

According to the latest quarterly filing, FRMO now carries $1.3 million worth of cryptocurrency mining assets on its balance sheet. This includes both building and computer equipment utilized for mining operations. In addition to that, FRMO has investments in 4 other mining entities, valued at about $370 thousand.

During the 2018 annual meeting, I asked Murray about their intentions with the Renn Fund. The latter part of his reply may have given some indication on how they intend to structure future mining investment products:

…and [the third option] is that we could create another closed-end fund, now that we believe we understand the legalities around closed-end funds, because we’re in that business.

For instance, I’m sure you can see why cryptocurrency would be much better in a closed-end fund than in an open-end fund, because you wouldn’t have the operational expenses of an open-end fund. We might be able to create a very inexpensive fund. So, rather than take the operational risk and pay the insurance for people getting in and out every day, like an ETF, it may well be that, unlike with conventional securities, the closed-end fund dominates in cryptocurrency.

It would be very hard to assign a value to the current cryptocurrency mining operations or its future potential. But if they find the correct structure that allows them to scale up assets under management through those ventures, it could become very valuable.

Big Call Options 

Here is the paradox of FRMO. Although the small position sizing has aggravated some investors, Stahl and Bregman do exhibit great conviction in some of their investments. If you were to take a look a the top 10 positions in any of the Kinetics mutual funds, you would see that they tend to be much more concentrated than the average mutual fund. 

This still does not mean that they take big bets. This is more a reflection of their long time horizon and them being tax conscious. Therefore, they tend not to trim their winners and average down their positions.

From the vantage point of FRMO shareholders, I would posit that there are two big call options that shareholders are pricing into the stock: Texas Pacific Land Trust and a transformative acquisition.

Texas Pacific Land Trust 

I’m not sure when Murray Stahl discovered Texas Pacific Land Trust. I have in my possession an investment write up on TPL from 1995 which I think is written by Murray Stahl for Madison Avenue Associates. From what I hear, Murray’s initial investment in TPL predates FRMO and might have been sometime in the eighties. On the Horizon Kinetics website, there is a copy of a senior thesis on TPL written in 1954.

Texas Pacific Land Trust is a fascinating case of embedded optionality in itself. The trust was founded in 1888 after the bankruptcy of the Texas & Pacific railroad. got bankrupt. The bondholders received shares of a trust that received 3.5 million acres of land that the railway owned, making the trust one of the biggest landowner in Texas. The trust was governed by 3 trustees who would lease out land for gracing and sell parcels of land. The trust would then return the proceeds to shareholders through dividends and buybacks.

As luck would have it, close to half a million acres of TPL’s land would have oil and gas under it. In 1920, the first well in the Permian Basin started producing oil. A few years later, the first pipeline was built. The mineral estate was spun out of TPL in 1957, with TPL retaining royalty interests in future production. In 1962, Texaco purchased the mineral estate which at the time held over 2 million undeveloped acres.

In 1995 write-up, it says:

Texas Pacific Land Trust is a publicly traded enterprise that is slowly but steadily buying itself out of public ownership. It is accomplishing this by consistently applying its cash flow to the repurchase and retirement of its own shares. Although this process has been ongoing for over a century, it may now have reached a point at which this dynamic begins to naturally accelerate versus the experience of recent decades. It is quite conceivable that, over the next decade or so, the company’s assets could become concentrated in the hands of a few share owners. As the shares in question represent some 1 million acres of rural Texas, the magnitude of this accumulation of per-share value could be extraordinary.

At the time of the write-up, TPL was valued at $20 per share. This was prior to a 5-1 split, so it would equal $4 per current shares. A decade later, TPL was trading at $32 per share, a compound annual growth rate of 23.11%.

What Murray could not have foreseen in 1995 was that in around 2010, technological advancements in horizontal drilling would unlock tremendous amounts of oil reserves in the Permian Basin, that had previously by bringing down the cost of extraction significantly.

This led to rapid development across much of TPL’s acreage, dramatically increasing the royalty revenues for the Trust. Talk about embedded optionality.

Sometimes, a picture can tell more than a thousand words:

If you are not familiar with TPL and recent developments, you are likely asking yourself if there is any more optionality left in there. A P/E-ratio of 18 seems pretty fairly valued, even for a royalty company.

The first thing to note is that TPL still seems to have plenty of runway left to create value. According to recent TPL management presentations, only 7% of the companies royalty acreage is developed. The trust estimates that it has around 19 years of inventory under $40/bbl breakeven. At the same time, West Texas Intermediate Crude Oil prices have gone down from over $100 per barrel in 2014 to about $53 per barrel today. 

There is also a catalyst. Throughout last year, Horizon Kinetics was involved in a proxy fight with the incumbent trustees of TPL. Horizon Kinetics came out somewhat victorious from the battle, with the trustees agreeing to establish a committee that would explore the feasibility of converting TPL from a trust to a C-Corp.

Currently, TPL is still being governed by its initial articles of association from when it was established as a liquidating trust. Hence, the trust is run by three trustees with lifetime appointments, there are no annual shareholder meetings and practically no accountability to shareholders. When one of the trustees was forced to retire due to illness in 2019, Stahl and Bregman seized the opportunity and got involved in activist investing for the first that I’m aware of.

On January 22nd this year, the committee concluded its exploration by recommending that TPL convert from a trust into a Delaware c-corporation. Aside from drastic improvements in corporate governance, there are other implications to this event.

Many institutional investors do not have the mandate to invest in something like a liquidating trust. Converting to a Delaware c-corporation means that TPL will become accessible to a significantly larger pool of potential investors. It might even mean that TPL could be included in popular indexes. Consider this: H&R Block and Capri Holdings both are S&P500 constituencies with a market cap below $5 billion. TPL’s market cap is close to $6 billion with no insider ownership (most index funds are float-adjusted).

FRMO holds TPL stock both directly as well as a limited partner through various funds. On a look-through, the amount of exposure to common shareholders of FRMO in TPL is about $27 million. This would be equal to about 10% of the FRMO market cap. But these holdings are market-to-market. So, even if you would argue that there is optionality within TPL, it wouldn’t feel right to factor that in.

However, there is a bigger exposure here. All in all, Horizon Kinetics and its affiliated entities own 1,750,858 shares. This is equal to 22.6% of the total outstanding shares of TPL. Horizon Kinetics holds $1.34 billion worth of TPL stock based on its current price of $765 per share. If Horizon Kinetics still has around $5.3 billion in assets under management, then 25% of it is in TPL. Even Bruce Berkowitz would blink before committing to this amount of exposure.

Let’s ask ourselves what would happen if TPL, for whatever, reason gained 50% in market value by the end of 2020, with all other factors remaining unchanged. This could be from free cash flows continuing to increase, an increase in valuation multiples or even just the price of WTI Crude Oil reverting back to previous levels.

Without accounting for tax effects, the value of the direct holdings would increase by about $13.5 million. But the Horizon Kinetics AUM would also increase by about $670 million. If we assume that the incremental fee generation from management fees and potential performance fees to be at 1.29%, this would correspond an incremental revenue for Horizon Kinetics of about $8.6 million.

Assuming that the net operating income after tax of the incremental revenue is 25%, this would be equal to about $100 thousand in additional earnings of the 4.95% stake that FRMO owns in Horizon Kinetics. The revenue share, at the same time, would increase by about $360 thousand on an annual basis.

Source	Value	Multiple	Value Added
TPL Direct Stake	$13,500,000	1	$13,500,000
Increment. Rev Share	$362,845	25	$9,071,130
HK Increment. Earnings	$106,910	15	$1,603,646

But with all factors staying the same, that would mean that the AUM is permanently higher. Therefore the fee generation and profitability of Horizon Kinetics is also higher. So the incremental profitability of the revenue share and equity stake should be assigned a multiple to reflect the full economic value added. You can debate what those multiples should be, but assuming a multiple of 25 for the revenue share and 15 for the equity stake, would add over $10 million in additional value to FRMO shareholders.

The Optionality of Cash

Murray Stahl has repeatedly stated that eventually, FRMO will become an operating business. With the cash on the balance sheet, in addition to cash held at Horizon Kinetics as well as in other vehicles, FRMO now has meaningful firepower. The company also has creditworthiness and could, if the opportunity would arise, finance an acquisition of a significant scale. 

This has been brewing for a number of years now, but either the right opportunity has not surfaced yet or the price has not been right. At some point in time, the opportunity arises and they pull the trigger. When this happens it might fundamentally alter the way the company is valued.

There are 44,032,781 shares of FRMO outstanding, but only 13.5 million are unrestricted and part of the float. I assume that a large part of the float is held by long term holders that have little on no intention of selling. So, in a sense, one could argue that the current market cap reflects the value of the call option of participating in an eventual acquisition. 

The optionality of a potential value creation that a big acquisition might bring is to some extent factored in the price of FRMO. Once it does happen, I would expect it to be priced into the stock almost instantaneously. So, in the words of the previously mentioned dr. Richard Sandor: “if you want to be on time, you have to be early.”

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More on FRMO:

• FRMO Corp | Investing along Murray Stahl & Steve Bregman
• Renn Fund | Enter Horizon Kinetics
• Winland Holdings Corporation (WELX)
• Texas Pacific Land Trust (TPL)

More on Optionality and Quality of Earnings

• Quality of Earnings
• Return on (re)Invested Capital | TripAdvisor Case Study
• Stock Exchanges | Beautiful Business Models
• TCI and the Becoming of the Cable Cowboy

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The Fundamental Finance Playbook is a publication dedicated to the Fundamental Research of Stocks and Security Analysis. We publish thoughts and opinions on individual publicly traded stocks as well as our thinking on methodologies for finance and investing practices in general.

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