Investing vs. speculation
- Investors expect to profit from atleast 1 of 3 ways: from free cash flows that reflect in higher stock price or get distributed as dividend; from an increase in multiple; or by narrowing of gap between share price and underlying business value (book value?)
- Speculators essentially bid and look to sell to higher bidder - what if there isn't one?
- Investments vs. Speculations - Investments throw off cash flow for the benefit of the owners, speculations (such as art) do not. The returns to the owners of speculations depends exclusively on the vagaries of the resale market.
- Successful investors are unemotional, not being affected by market movements. Do not confuse the success of an investment with it's mirror of success in the stock market. Just because a stock rises does not mean company is doing well and vice versa.
- Do not allow the market to direct you (do not look to the market for guidance, look at it as a source of investment opportunities).
- Value in relation to price, not price alone, must determine investment decisions.
- Stock price can move i) to reflect change in business reality of company, or ii) to reflect shift in demand-supply. Most daily variation happens because of ii). However, determining the source of shift in demand-supply is difficult, therefore investor must look beyond to real business value.
Unsuccessful investors - role of emotion
- Unsuccessful investors respond to market fluctuations emotionally with greed and fear.
- They look to markets as a quick way to make money without working. Therefore, though they may spend a lot of time searching for the best deal on other things, they don't spend time looking for the best financial investment.
- Rather than looking to invest for the long term, they look to make money quickly by investing in hot tips (greed).
- Greed also manifests itself as undue optimism (future profit projections, 'new-era' thinking) or complacency in the face of bad news.
- Some investors invest in stocks when bond yields are low. However, lower bond yields are already incorporated into the stock prices (higher prices) and thus investors end up buying stocks near the peak.
- There is no simple formula that can be used to invest in something as complex as the stock market. No formulas like low P/E, technical analysis, etc. works everywhere - each security needs individual analysis.
- Wall Street's motivations are different from yours, so use your own analysis and judgment.
- Beware of new complex products brought out by Wall Street - in most cases, they will understand these products much better than you, so you cannot be sure the price you've paid is a good one.
- Beware of fads (embedded value, franchise value, new-age industries, etc.). They cause overpricing of securities and when they peter out, as they all do, there can be significant pain. However, it may be difficult to distinguish a fad from an opportunity with sound business fundamentals.
- There is a difference between investing in bonds of "fallen angels" trading at a discount and junk bonds issued at par with high implied interest rate. Bonds trading at discount have lesser downside risk.
- Junk bond issuers lure investors with high interest (cash-coupon or zero-coupon). But if the fundamentals aren't right, how will company service interest/principal?
- Most junk bond issuers assume perfect economic conditions in their financial projections to show that they can service the debt. However, a better analysis should include possibility of turning of economic cycle.
- Beware of companies with zero coupon bond issues which do not incorporate interest expense into financial statements - they are overestimating profits and may also be reckless in their plans since nothing is payable immediately.
- Provisions for interest rate reset may not help if the company fundamentals themselves are poor (even if you raise interest rate on the bond, if the company will be unable to service it then the price of the bond does not rise).
- Beware of illusions of safety created by the company having liabilities on its balance sheet junior to your investment. You need to analyze whether the company can service your investment or not.
- EBITDA is not the right measure for cash-flow - if depreciation is not compensated by similar amounts of capex then the company is essentially slowly going into liquidation. EBIT is a better measure, but only for evaluating current interest payments, not cash flow added to balance sheet for future use. PAT + interest is the best measure.
- Protecting capital is essential to getting gains on it. Need to focus on potential losses even if others are reaching out for gains.
- Power of compounding - even modest returns every year can lead to significant gains over the long-term. Corollary - it is very difficult to recover from even one large loss, which can destroy gains from years of success.
- The future is unpredictable. Thus, investors should be willing to give up some near-term gain as an insurance premium against unexpected and unpredictable adversity.
- Setting a goal of achieving X% return does not guarantee getting that return. Also, it leads to neglecting downside risk and focusing on upside potential. Therefore, investors must target risk (invest in a stock only if the expected returns over risk-free rate compensate adequately for the risk taken).
- Returns from stocks are not in terms of cash to investor from the business but primarily from stock appreciation (not predictable). Therefore, any stock price can be justified with appropriate projections - beware of this, especially in the short term.
- Value investing - buying securities at a significant discount from their current underlying value and holding them until more of that value is realized.
- Invest only in businesses you can understand or are not excessively risky.
- Invest only when a good opportunity comes by - this may mean standing by (and maybe remaining uninvested) until the right opportunity comes by.
- Also, compare your current holdings with potential new investment opportunities. If a more attractive one comes by, you may need to sell current holding and buy the more attractive one.
- Test of character when value investing opportunities are scarce - must exhibit great discipline and not lower standards for investment.
- Knowing everything about a business as well as business environment is impossible, therefore while investing: i) value securities conservatively, giving weight to worst-case scenarios too, ii) look for price at sufficient discount to value (especially in a deflationary environment) and iii) look for presence of a catalyst for the realization of underlying value (if you cannot tell whether or when you will realize underlying value, preferable not to get involved at all).
- Intangible assets hold little or no margin of safety - in worst case, some value can be derived from liquidation of tangible assets, but if something goes wrong with intangible assets (customer preferences/tastes change) then recouping any value is difficult.
- It is important to know not only whether but also why an asset is undervalued. When the reason for owning an investment no longer applies, you should sell it.
- Some of the reasons stock prices can deviate from underlying value:
- In the short term, stock prices are determined by supply and demand
- Many times, buyers and sellers may be motivated by reasons other than underlying value: an index investor will buy a stock added to the index irrespective of its value; technical analyst buys/sells based on price and volume charts; exclusive focus on earnings; margin calls; institutions investing in stocks/bonds only with certain characteristics (buy/sell when these characteristics change, irrespective of value)
- Some catalysts for realization of true value:
- Share issuance/repurchase
- Subsidiary spinoffs
- Recapitalization
- Liquidation
- Hostile takeover / proxy fight
- In a sense, value investing is arbitrage between price and value. However, realizing true value may be difficult depending on, among other things: difference between price and value; extent to which management is entrenched; identity and ownership position of major shareholders; availability of credit for takeover activities
- 3 central elements: bottom-up strategy, absolute-performance oriented, risk-averse approach
- Top-down approach involves making assumptions about the future, ascertaining its investment implications and then acting upon them. This approach is vulnerable to errors at every step. Also, need to do this analysis quickly to be able to make investments before other investors jump in. Bottom-up value investment strategy simpler because no need to make any forecasts. Also, top-down approach requires market timing while a value investor just waits for good opportunity to come along and then invests.
- In investing, it is never wrong to change your mind. It is wrong to change your mind and do nothing about it.
- Absolute performance is what is important (no use if portfolio declines 10% when market declined 15% - you still lost money). Also, absolute performance aids long-term thinking since not under pressure to better ant benchmark and not under pressure to remain fully invested.
- Since markets are not always efficient, choosing a risk profile does not ensure adequate return. Inefficiencies create opportunity for low-risk high-return scenarios.
- In investing, risk is a function of type of business as well as price paid (not only type of business as suggested by beta).
- Quantifying and knowing all sources of risk is difficult. Therefore, only strategy is to diversify, hedge at appropriate time and invest with margin of safety.
- Difference between short-term fluctuation in price (can cause losses if need to liquidate, but also create opportunities for investing) and risk due to permanent impairment in value - difficult but necessary to be able to distinguish between the two. Also, highlights importance of holding some cash or securities that throw off cash.
- Business value cannot be precisely determined and changes over time based on different factors. Thus, the need for margin of safety.
- NPV:
- involves predicting the future - works best when future cash flows are reasonably predictable and appropriate discount rate can be chosen. However, most businesses don't fit this criteria.
- Small changes in estimates can cause large variation in expected value - exaggerated effect in growth stocks (therefore need to be careful with optimistic forecasts just on the basis of recent strong growth).
- Easier to determine sources of growth/degrowth than the magnitude.
- Therefore, need to make conservative estimates and invest at discount to value derived from these estimates.
- PV can be applied to cash flows of business or cash flow that security-holders receive. Latter is more appropriate for bonds and former for stocks (since cash flow to shareholders are only in terms of dividends which are not substantial).
- When interest rates are low, high multiples are applied to share prices. Therefore, investors investing at those levels dependent on rates remaining low, which may not happen. Therefore in such times, better to invest in short term securities or hold cash.
- Private-Market Value
- Related to NPV - based on multiple paid by a sophisticated buyer for a similar business.
- Shortcomings: every company is different - need to take that into account; multiples vary over time; buyers do not necessarily pay reasonable prices (prices paid may depend on availability of funding, price of own stock, etc.).
- Liquidation Value
- Conservative value based on only resale value of tangible assets - more a theoretical exercise, value usually not realized this way.
- Breakup value - determine the highest value of each piece of the business as an operating entity or in liquidation.
- Orderly liquidation usually realizes more value than a 'fire sale'
- Cash valued at face value, investments at market value less transaction costs, receivables at close to face value, inventories - depends on type (type of inventory and chances of obsolescence), fixed assets - based on specificity and ability to generate cash flow.
- Approximation: net-net working capital = current assets - current liabilities - long-term liabilities (however ongoing business losses can erode net-net working capital)
- Need to consider off-balance sheet and contingent liabilities and also any charges that may be incurred in course of actual liquidation (plant closing, etc.)
- Stock market value
- Applies well in some situations - when valuing close-ended funds or in assessing quickly the value of a subsidiary or JV or spinoff
- NPV works well in businesses with stable or regulated cash flows
- Liquidation value when company is incurring losses and trading well below book value
- Stock market value for close-ended fund or company that primarily owns marketable securities
- Better to use a mix of methods and take the conservative value
- Reflexivity
- Stock price affects underlying value of business
- Undercapitalized company with high stock price can issue more stock and become adequately capitalized, however, co with low stock price may find this difficult, which may lead to stress/bankruptcy (self-fulfilling prophecy)
- Same holds for debt
- Similarly, if company management thinks low stock price is right reflection of value, they may dilute shareholder value by issuing more stock at low prices or in merger.
- Success for reorganization plan of a company may depend on market prices of securities (if prices are depressed, creditors may not realize expected value, leading to further stress/liquidation)
- 3 categories of value investing
- Securities selling at discount to liquidation/breakup value
- Rate-of-return situations
- Asset-conversion opportunities
- Securities selling at discount to liquidation/breakup value
- Find opportunities through computer-screening or similar methods
- Rate-of-return situations
- Known returns and approximate timeframes - situations such as risk arbitrage and complex securities (e.g. mergers, tender offers, etc.)
- Find info in newspapers and specialized newsletters and periodicals
- Asset-conversion opportunities
- Investors' existing holdings are exchanged for one or more new securities - distressed and bankruptcy cases, corporate recapitalization, exchange offers, etc.
- Find info in financial press, periodicals, published financials and court documents (bankruptcy)
- Other opportunities - check stock listings in newspapers for highest percentage declines, new lows, etc.
- Find out why price is depressed below value - is it due to poor business fundamentals or other factors such as:
- constraints on institutional ownership?
- information inefficiency (e.g. small stocks)?
- year-end tax selling?
- Value investing is contrarian in nature
- However, contrarian investing helps only when majority thinking has effect on price of security (if herd is buying and only this is pushing up prices, not fundamentals, only then it makes sense to sell)
- Knowing every little detail about a company is near-impossible. Therefore, investors may be rewarded for moving quickly with less than perfect knowledge rather than delaying to find out the last small detail, by which time prices may have moved.
- Insiders usually have most information about company - therefore insider buying is a good sign to pick up a stock. Also, stock options to managers increases their incentive to act and bring undervalued stock in line with value.
- Catalysts
- Catalysts for realization of value reduces dependence on market fluctuations or adverse business developments. Therefore important to look for catalysts.
- Catalysts can include internal forces (management decision to sell out/liquidate) or external (fear of external party taking controlling stake in company can drive management decision to enhance value), emergence from bankruptcy (catalyst for creditors)
- Catalyst can lead to realization of complete value (sell-off/liquidation) or partial (spinoffs, asset sale, share buyback, recapitalization)
- Corporate liquidations
- Motivation for liquidation can be: preempting total wipeout of shareholder equity, tax considerations, undervaluations or escaping grasp of a corporate raider.
- Single business companies prefer to sell out (tax considerations), while conglomerates prefer to liquidate the different businesses
- Investors prefer not to invest in liquidating companies (lack of clarity on value, timelines) - thus creating possible attractive opportunities.
- Complex securities
- Unusual cashflow patterns (sometimes, contingent on some events, etc.)
- Investors do not like to do intensive analysis and may prefer to stay away from such securities, creating opportunities
- Rights offerings
- Unsubscribed portions of underpriced rights offerings can create opportunities (if the company offers an oversubscription provision based on unsubscribed portion)
- Rights offerings can be used to bring a part of the company / subsidiary public. Can create opportunities due to lack of information.
- Risk Arbitrage
- Opportunities created from takeovers, spinoffs, liquidations and corporate restructurings.
- Profit dependent on successful completion of transaction. Downside is fall in share price if transaction fails.
- However, professional arbitrageurs may have edge here since they can employ lawyers and other experts to evaluate the deal and implications.
- Individual investors have better change in large transactions, where arbitrageurs may invest available capital pretty quickly, still leaving some money on the table for individuals.
- Spinoffs
- Companies may divest themselves of businesses that no longer fit their strategic plans, are faring poorly, adversely impact image of the parent, businesses involved in litigation, having extremely volatile results or requiring extremely complex financial structure. Goal of spinoff is: combined market value of parts greater than the present whole.
- Spinoffs may create opportunities because: investors sell the shares received from spinoff for the same reason the company is divesting, they may not know much about the spun-off business, spun-off entity may be too small for institutional investors and analysts, index funds sell the shares since it is not part of the index
- Some spinoff companies may prefer a depressed price initially so management can get low priced stock options
- Information about the spun-off companies may reach computer databases a few months late, leading to investors who use these databases to neglect these stocks
- If spun-off entity is large / main business of the parent, opportunity may be created in the parent company shares
- Stigma attached to distressed and bankrupt companies. Also, reorganization process is tedious and uncertain, leading to shunning of such securities by investors, creating opportunities.
- Companies get into financial trouble for at least one of three reasons:
- Operating problems - severe business deterioration leading to financial distress, etc.
- Legal problems
- Financial problems - excessive debt, etc.
- Financial distress typically characterized by shortfall in cash to meet operating and debt servicing needs
- Effect on operations:
- Short-term liabilities may not be refinanced, suppliers cease shipment or demand cash on delivery, customers and employees may abandon ship. However, note that these effects on operations may be limited to period in which co is in distress.
- Operations with capital-intensive businesses are relatively immune to financial distress over the long run
- Businesses dependent on public trust or image may be damaged irreversibly.
- Capital structure affects degree to which operations are affected:
- If operating company are removed from holding company by a couple of levels, distress at holding co may not affect operating company
- Issuer response to distress - 3 options:
- Continue to service debt - cut costs, sell assets, get infusion of capital, cut back inventory, stretch payables, etc. (need to check if any of these activities affect long term value of the business)
- Exchange outstanding securities for new securities - exchange debt and preferred stock for new, less onerous, securities. Difficult to do since creditors are being asked to setttle for less than what they are owed.
- Default and file for bankruptcy - if all other methods fail
- On filing for bankruptcy:
- Payments of principal and interest other than due on fully secured debt is suspended. Payment to trade creditors and employees is suspended.
- Interest of company and creditors may diverge - company may want to minimize debt and maximize cash build up to emerge stronger from bankruptcy, creditors will want distribution of cash. Creditors may oppose 'excessive' capex to mazimize cash distribution.
- Company may use bankruptcy to void leases and supply arrangements, etc. struck at above market prices. Due to this and other reorganization activities (closing of unviable facilities, etc.), a co may come out of bankruptcy as a strong low-cost competitor.
- Cos in bankruptcy may build up substantial cash due to:
- reduction of costs due to renegotiation of contracts or other efforts
- Suspension of payment of interest and principal on unsecured debt and dividends
- Less taxes due to carry forward losses
- Curtailed capital spending
- Divesting of unrelated or unviable businesses / plants
- Compounding of interest on this cash buildup
- Can lead to simplifying/quickening of process of reorganization, since cash is valued at face value by all.
- Attraction for investing in bankruptcy cases
- Catalyst for realization of value (whether debt or equity)
- Liquidity of debt holding may increase as debt is exchanged for cash/equity
- Senior debt of bankrupt companies does not fluctuate much with market but rather with the progress of the reorganization (more like a risk arbitrage investment)
- 3 stages of bankruptcy investing:
- 1st: immediately after chapter 11 filing - highest uncertainty, highest opportunity. Maybe no recent information on financials available. Many holders may be forced to sell regardless of price.
- 2nd: negotiation of reorganization plan - muh more information about debtor's financial situation, statements, etc. Considerable uncertainly still over reorganization plan.
- 3rd: time between finalization of reorganization plan and emergence of bankruptcy. Most closely resembles risk arbitrage investment.
- Risks in investing in financial distress cases:
- Illiquid market - uninformed buyer may overpay
- Rate of return highly dependent on timing
- Be wary of holding fixed income securities of rapidly deteriorating businesses. If the company is losing cash even before interest payments, then distress may be accelerated.
- Process of investing
- Focus on balance sheet
- First step: value the assets. Divide assets into 2 parts - assets of ongoing business, and assets available for distribution to creditors on reorganization (cash, investments, assets held for sale, etc.)
- Value company using all the different methods (NPV, liquidation value, stock market value)
- Pay special attention to distortions in earnings and cash flow because of the chapter 11 process - e.g. interest earned on excess cash build up, interest expense suspended, costs related to bankruptcy proceedings, etc.
- Make note of off-balance sheet items such as real estate not carried at true value, patents, overfunded/underfunded pension plans, government claims, claims from rejected/renegotiated contracts, etc.
- Next: Assess liabilities in descending order of seniority
- Senior secured securities get paid first, anything left goes to the next level and so on
- "Fulcrum securities" - securities not fully secured by proceedings from assets - change in value directly according to change in value of assets, and may give good opportunities for investing
- Avoid common stocks of bankrupt companies, mostly overpriced
- Reorganization is a process of negotiation - opportunity for investor who takes controlling stake in certain security to get favourable terms (sometimes due to nuisance value)
- Arbitrage opportunities - sometimes bonds and stocks may be in misstep with each other (say, stock too expensive as compared to bond). In such cases, investor can go long one security and short the other.
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