Books: Modern Security Analysis / Aggressive Conservative Investor
Author: Marty Whitman, Fernando Diz
Key takeaways: (a) A company should be analyzed for earnings and cash flows, but creditworthiness comes first. In addition, they should be analyzed not just as going concerns, but also as possessing resource conversion characteristics. (b) Management should be appraised not only as operators but also investors and financiers. There is a meaningful amount of discussion of NAV in the book, which though very interesting, I didn’t feel in my bones (maybe one day I will; for now, I still think the asset value discussion in the book Value Investing speaks the most to me; authors briefly discuss Value Investing in their book saying that NAV discussed in there is strictly from a going concern point of view). The authors take pain to distinguish their brand of investing from the most accepted form of Value Investing (what they call Graham & Dodd investing), and they believe that G&D Investing is a form of OPMI (Outside Passive Minority Investing), and other forms of Value Investing are–(a)Distress Investing, (b) Control Investing, (c) Credit Analysis, and (d)1st/2nd stage VC investing.
All OPMIs need to worry about credit-worthiness (except perhaps the secured lenders). Intelligent creditors base investment decisions on reasonable worst-case scenarios rather than the base-case scenario. There are three tests of credit worthiness (an entity does not have to pass all 3 to be credit worthy; oftentimes just one would do) –
- Does the fair value of assets exceeds the fair value of liabilities? (B/S test).
- Furthermore, just the amount of debt is not the only metric to consider. One also needs to worry about the terms of the debt, and productivity of the use of proceeds from that debt.
- Is there sufficient cash flow from operations (or, sales of assets) to service its debt? (C/F test)
- Does the entity have access to capital markets? (liquidity test)
There are four general ways of creating wealth –
- Cash flow from operations
- Earning from operations
- Resource conversion (asset redeployment, liability restructuring, M&A, spinoffs, and liquidations)
- Attractive access to capital markets (ala REITs in teens of 21st century)
If companies are analyzed as such, certain limitations fall aways. For example, the law of diminishing returns, which applies in a going concern (big companies get unwieldy and/or attract competition), is not a limiting factor if the operator is also a good investor/financier and can buy assets where (s)he can either simply buy a new stream of cash flows and/or buy an asset which (s)he can operate better. On the other hand, it is never worthwhile to buy securities controlled by predatory management. Disclosure of grievances by creditors or security holders that culminate in lawsuits is a clear warning. Authors that the vast amount of their misjudgments revolve around being in bed with the wrong management rather than purely financial factors. Having said that, bad management is easier to spot than it is to spot good management.
Most control buyers seek–tax shelter (TS), use of other people’s money (OPM), and something off the top (SOTT), entrenchment, and realization of cash/liquidity via sale to another control market or partial cash out in the public market. When one is doing control investing, one must remember that Corporate law (esp. state law court decisions in leading corporate states such as NY and DE, and federal bankruptcy law) is designed to entrench control groups and investors at the expense of OPMI investors (e.g. unlike class-action suits in federal court, appraisal procedures in NY/DE ask dissenting shareholders to not only pay for their legal costs, but also of the company’s), and Securities law are designed to protect OPMIs. There are four general ways of buying securities when looking for control –
- Open Market Purchase: no disclosure is required until 5% ownership is reached and no use of inside information is permitted. HSR applies when buying >$15 mm.
- Cash Purchase in Private Transaction: disclosure depends on privacy (Rule 10b-5 applies to check whether private transactions and sweep of OPMI markets is a masquerade for cash tender offers); the buyer can seek to know what the seller knows
- Cash Tender Offer: In this method, the securities laws are more onerous, but still less onerous than using proxy machinery/issuing new security. In hostile takeovers, only public information is allowed.
- Cash Merger Through Proxy machinery
What is NAV and How Does Third Avenue use it to invest in a Security?
NAV is an accounting number (Asset – Liabilities) and its usefulness is as limited as accounting is limited as a tool of financial analysis (e.g. current assets may appear easily marketable but they can be the assets of the worst kind–old or seasonal inventory or inventory being sold in a going-out-of-business sales, while a good real estate asset can be much more marketable; off-balance sheet liabilities etc). It doesn’t mean a whole lot by itself and needs to be used alongside other measures (does the company have a record of profitability, will control group work with OPMIs in mind etc.), and although it is a quantitative measure of net assets, the quality of assets (free and clear of encumbrances, marketable, quality of operations, free for sale apart from operations of the going concern, 3rd parties’ familiarity with the type of asset to lend against, scarcity) is more important. Having said all that, Third Avenue invests in a security when –
- Issuer has a very strong financial position
- Company provides a lot of disclosures (Since the ’70s, independent auditors have had to bear the burden of damage awards in securities lawsuits claiming accountant liability. This is why accountant press management to make admissions against interest. Auditors are not careful only with GAAP but also GAAS–General Accepted Auditing Standard which covers the procedures to be followed in preparing an audit.)
- Company is run by reasonable honest management and control groups
- Common stock is trading at >20% discount to reading ascertainable NAV (as of 6/30/12, S&P was selling at 2.2x book), and after thorough analysis, one believes that the company will increase NAV at >10% CAGR over the next 3-7 years
Having these characteristics do not make for an automatic investment, however lack of any of these 4 criteria is reason enough to forgo a passive investment in the company. An important point is that a NAV portfolio cannot be financed with meaningful borrowed $s, as there is no way to ensure that favorable relative returns in a given period.
Authors says that the type of companies where NAV is a good guide include the following:
- Almost all mutual funds / portfolio of performing loans
- Income producing real estates assets
- Control investors such as Brookfield Asset Management
- Most conglomerates such as Cheung Kong Holdings
They add that single-purpose assets dedicated to a going concern (car/steel companies, retail operations, exploration/production companies and extractive industries, start-up etc are poor candidates for a NAV analysis.
General risk does not exist. Risk is a useless term without an adjective in front of it. When people say “risk” they usually mean “market risk”, which is significantly different from “investment risk”. Investment opportunities are created with market risk is ignored and investment risk is guarded against. Three general measures of investment risk are- (a) quality of the issuer, (b) terms of the issue, (c) pricing of the issue. It is impossible to avoid investment risk, but one can alleviate it by buying cheap (pricing of the issue), buying equity interests only in well-financed companies (quality of the issuer), or well-positioned debt instruments (terms of the issue), and investing only where communities of interest outweigh conflicts of interest with control investors/management. Again, ignore market risk.
Diversification: According to the authors, diversification is a poor substitute for knowledge, control and price consciousness. Investors should concentrate/diversify based on the following factors–(a) how much knowledge that they have about the business, (b) how much control that they have, (c) how the investor will finance the purchase, and (d) how much of a bargain price is the investor getting. Authors talk about the Kelly formula here.
Capital Structure: Custom is one of the strongest determinants of capital structure (because various providers of capital are comfortable with certain standards); e.g. electric utilities are often financed with 50-60% publicly held mortgage debt, 10% preferred stock, and 30-40% common stock and surplus. In LBOs, Sr. Secured lenders will lend 4-5x (EBITDA – capex).
Miscellaneous – Why Have a Preferred Stock vs. a Subordinated Debenture?
Companies may issue it for various reasons, including (a) the combined tax bill of the company issuing it may be lower, and (2) issuance of preferred stock may help companies issue more senior debt (and thus lower overall interest expense). As for why it makes sense for investors, (a) privately negotiated preferred stock can have meaningful protections such as a 2/3rd vote if the company were to issue a more senior/equal stock (though this is rare for publicly issued preferred stock), (b) in case of troubled companies, preferred stock is often in a better position than subordinated debt, as preferred stock can pile on dividend arrears and might be in a better position in making organization deals. Separately, preferred stock owners have right to elect two directors to the board if 6 dividend payments are missed, but since they don’t have access to the corporate Treasury or the machinery, this is not much of a right at all.
Miscellaneous – Why Wall St Sponsorship Can be Bad?
Problem with companies in industries that have good sponsorship by the financial community is that they because they can attract capital relatively easily, it attracts an inordinate amount of competition, which dooms the industry with overcapacity in the longer run.
Nice one. Makes me regret I read the whole book.