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Contents
Cover
Series
TitlePage
Copyright
Dedication
Acknowledgments
IntroductionOURFOCUSCREDITWORTHINESSTHEAPPRAISALOFMANAGEMENTS
ACCESSTOCAPITALMARKETSANDWEALTHCREATIONTHEIMPORTANCEOFCONTROLTHEAVOIDANCE
OFINVESTMENTRISKMARKETEFFICIENCY?DEBUNKINGMYTHSYOUNEEDALOTMORETHAN
KNOWLEDGEOFALGEBRAANDTHEENGLISHLANGUAGETOUNDERSTANDOURAPPROACH.OTHERTOPICSWECOVERIN
THEBOOK
PartOne:TheFoundationsofModernBusinessandSecurityAnalysis
Chapter1:TheScope
ofFundamentalFinance,Investing,andtheInvestorLandscape
INVESTINGVERSUSSPECULATINGTHEOPMIDEFINEDACTIVISTS
SUMMARY
Chapter2:AShortIntroductiontotheGoingConcernandResourceConversionViewsofBusinesses
METHODSOFWEALTHCREATION
THEPUREGOINGCONCERNVIEWTHERESOURCECONVERSIONVIEWSUMMARY
Chapter3:SubstantiveConsolidationandStructuralSubordination
SUBSTANTIVECONSOLIDATIONNOTOFPRIMEIMPORTANCETHEACCOUNTING
FORSTOCKOPTIONSCONTROVERSYINLIGHTOFTHESUBSTANTIVECONSOLIDATIONDOCTRINESTRUCTURALSUBORDINATION
NOTASIGNIFICANTFACTORLACKOFPROGRESSINEUROZONECRISISRESOLUTION:THEFAILURETOUSE
SUBSTANTIVECONSOLIDATIONSUMMARY
Chapter4:TheSubstantiveCharacteristicsofSecurities
TYPESOFSECURITIES
FORANALYTICPURPOSESCONTROLVERSUSNON-CONTROLSECURITIESCONTROLANDNON-CONTROLPRICINGANDARBITRAGE
TERMSOFSECURITIESASOPTIONSWHATASECURITYISDEPENDSONWHEREYOUSITSUMMARY
Chapter5:PrimacyoftheIncomeAccountorWealthCreation?WhatAreEarnings,Anyway?
WEALTHOREARNINGS?INFLUENCEOFREPORTEDEARNINGSON
COMMONSTOCKPRICESTHELONG-TERMEARNINGSRECORDPARSINGTHEINCOMEACCOUNTSUMMARY
Chapter6:NetAssetValue:TheStaticandDynamicViews
THEGRAHAMANDDODDVIEWONNAVTHEFINANCIALACCOUNTINGVIEWONNAV
OURVIEWONNAVTHEUSEFULNESSOFNAVINSECURITYANALYSISTHEIMPORTANCEOFNAV
DYNAMICSNAVASONEMEASUREOFRESOURCESNAVASONEMEASUREOFPOTENTIALLIQUIDITYLIMITATIONSOFNAVIN
SECURITYANALYSESLARGEPREMIUMSOVERBOOKVALUEUSUALLYMEANHIGHP/ERATIOS:ITDEPENDSON
ROENETNETSREDEFINEDOPMIINVESTINGINCOMPANIESWITHGROWINGNAVSSUMMARY
Chapter7:Creditworthiness
CREDITWORTHINESSFROMTHEBORROWINGENTITYPOINTOFVIEWCAPITALSTRUCTURECAPITAL
STRUCTUREFROMTHECORPORATEPERSPECTIVEFACTORSAFFECTINGCAPITALSTRUCTURECONSERVATIVECAPITAL
STRUCTURESSUMMARY
Chapter8:WhatMattersIsInvestmentRisk
THEREISNOGENERALRISK—ONLYSPECIFICRISK
THECOMPONENTSOFINVESTMENTRISKSUCCESSFULPEOPLEAVOIDINVESTMENTRISKMETHODSTO
AVOIDINVESTMENTRISKSAFEANDCHEAPINVESTINGANDMINIMIZINGINVESTMENTRISK
SUMMARY
Chapter9:ShareholderDistributionsfromtheCompanyPointofView
CASHDIVIDENDSORRETAINEDEARNINGS
STOCKDIVIDENDSSTOCKREPURCHASESDISTRIBUTIONOFASSETSOTHERTHANCASHLIQUIDATIONSUMMARY
Chapter10:RolesofCashDividendsinSecurityAnalysisandPortfolioManagement
THETHREECONVENTIONALTHEORIESCASHDIVIDENDSASAFACTORIN
MARKETPERFORMANCETHEPLACEBOEFFECTOFCASHDIVIDENDSCASHDIVIDENDSANDPORTFOLIO
MANAGEMENTCASHDIVIDENDSANDLEGALLISTSCASHDIVIDENDSANDBAILOUTSTHEGOALSOF
SECURITIESHOLDERSSUMMARY
Chapter11:TheAppraisalofManagementsandGrowth:GARPversusGADCP
NEW
FRAMEWORKFORTHEAPPRAISALOFMANAGEMENTSMANAGEMENTSATTUNEDTOOPMIINTERESTSMANAGEMENTSASRESOURCE
CONVERTERSTRADEOFFSGROWTH:GARPVERSUSGADCPGROWTHATAREASONABLEPRICE(GARP)GROWTHATDIRTCHEAP
PRICES(GADCP)SUMMARY
Chapter12:TheSignificance(orLackofSignificance)ofMarketPerformance
MARKETPERFORMANCE
ANDTHECHARACTEROFAPORTFOLIOMARKETPERFORMANCEOFPORTFOLIOSVERSUSINDIVIDUAL
SECURITIESOUTSIDERS,INSIDERS,ANDMARKETPRICEPROFESSIONALMONEYMANAGERSANDBEATINGTHEMARKETPERSPECTIVE
ONBAILOUTSANDTHESIGNIFICANCEOFMARKETPERFORMANCESUMMARY
Chapter13:HowMuchDiversification?
PORTFOLIO
DIVERSIFICATIONVERSUSSECURITIESCONCENTRATIONCORPORATEDIVERSIFICATIONVERSUSCONCENTRATIONSUMMARY
Chapter14:TowardaGeneralTheoryofMarketEfficiency
THEDETERMINANTSOFMARKETEFFICIENCYEXTERNALFORCESINFLUENCING
MARKETSEXPLAINEDGREATECONOMISTSCANLEARNALOTFROMVALUEINVESTORSMARKETSWHERE
EXTERNALDISCIPLINESSEEMTOBELACKINGMARKETEFFICIENCYANDFAIRPRICESINTAKEOVERSSUMMARY
PartTwo:PuttingItAllTogether:SafeandCheapInvestingversusConventionalApproaches
Chapter15:SafeandCheapInvesting
THESAFEANDCHEAPAPPROACHBENEFITSOFTHESAFEANDCHEAPAPPROACHFORTHEOPMIRESTRICTIONSAND
DEMANDSOFTHESAFEANDCHEAPAPPROACHSUMMARY
Chapter16:GrahamandDoddPlacedinContext
THEOPMI
DEFINEDTHEOPMIPERSPECTIVEOFANALYSISTHEGOINGCONCERNANDINVESTMENTCOMPANYVIEWSOFBUSINESSES
PRIMACYOFTHEINCOMEACCOUNTANDWEALTHCREATIONPRIMACYOFTHEINCOMEACCOUNT,DIVIDENDS,AND
CORPORATEUSESOFCASHPRIMACYOFTHEINCOMEACCOUNTANDTHEAPPRAISALOFMANAGEMENTSPRIMACYOFTHEINCOME
ACCOUNTANDTOP-DOWNVERSUSBOTTOM-UPANALYSISPRIMACYOFTHEINCOMEACCOUNTANDDIVERSIFICATIONPRIMACYOF
THEINCOMEACCOUNTANDGROWTHSTOCKSMARKETRISKVERSUSINVESTMENTRISKANDMARGINOFSAFETY
THEIMPORTANCEOFMARKETPERFORMANCEUSESANDLIMITATIONSOFFINANCIALACCOUNTINGSUBSTANTIVECONSOLIDATION
COMPENSATIONOFPROMOTERSDOSTOCKMARKETPRICESREFLECTCORPORATEVALUES?TRADE-OFFS
MODERNCAPITALTHEORYVERSUSGRAHAMANDDODDSUMMARY
Chapter17:AcademicFinance:Modern
CapitalTheoryTHEMCTPOINTOFVIEWEQUILIBRIUMPRICINGISUNIVERSALLYAPPLICABLETHEOUTSIDEPASSIVE
MINORITYINVESTORISTHEONLYRELEVANTMARKETDIVERSIFICATIONISANECESSARYPROTECTIONAGAINST
UNSYSTEMATICRISKSYSTEMATICRISKEXISTSVALUEISDETERMINEDBYFORECASTSOFDISCOUNTEDCASHFLOWS
COMPANIESAREANALYZEDBASICALLYASGOINGCONCERNS;INVESTORSINMARKETABLESECURITIESARE
ANALYZEDASINVESTMENTCOMPANIESINVESTORSAREMONOLITHIC:THEIRUNITARYGOALISRISK-ADJUSTED
TOTALRETURN,EARNEDCONSISTENTLYMARKETEFFICIENCYMEANSANABSENCEOFMARKETPARTICIPANTS
WHOEARNEXCESSRETURNSCONSISTENTLYORPERSISTENTLYGENERALLAWSAREIMPORTANTRISKIS
DEFINEDASMARKETRISKMACROCONSIDERATIONSAREIMPORTANTCREDITORCONTROLISANONISSUETRANSACTION
COSTSAREANONISSUEFREEMARKETSAREBETTERTHANREGULATEDMARKETSTHEOUTSIDEPASSIVEMINORITY
INVESTORMARKETISBETTERINFORMEDTHANANYINDIVIDUALINVESTORMARKETSAREEFFICIENTORATLEAST
TENDTOWARDANINSTANTANEOUSEFFICIENCYSUMMARY
Chapter18:Broker-DealerResearchDepartmentsandConventionalMoney
ManagersHOWRESEARCHDEPARTMENTSANDCONVENTIONALMONEYMANAGERSTHINKPROBLEMS
FACEDBYRESEARCHDEPARTMENTSANDCONVENTIONALMONEYMANAGERSSUMMARY
PartThree:Real-
WorldConsiderations
Chapter19:UsesandLimitationsofFinancialAccounting
THECONVENTIONALAPPROACHES
FINANCIALACCOUNTINGREPORTSASOBJECTIVEBENCHMARKSGENERALLYACCEPTEDACCOUNTINGPRINCIPLESASDEFINING
REALITYFORCERTAINSPECIFICPURPOSESGENERALLYACCEPTEDACCOUNTINGPRINCIPLESASAROADMAPFORDUE
DILIGENCEANDLESSTHOROUGHINVESTIGATIONSSUMMARY
Chapter20:CompanyDisclosuresandInformation:FollowingthePaper
TrailintheUnitedStates
NARRATIVEDISCLOSURESINTHEUNITEDSTATESTHEDOCUMENTSANDHOWTOREADTHEM
WHATTHEPAPERTRAILDOESFORTHEOUTSIDEINVESTORWHATTHEPAPERTRAILDOESN’TDOHOWGOODISTHEPAPER
TRAIL?SUMMARY
Chapter21:BuyingSecuritiesinBulk
METHODSFORACQUISITIONOFCOMMONSTOCKSACQUISITION
OFVOTINGEQUITIESTHROUGHEXCHANGESOFSECURITIESACQUISITIONOFCONTROLWITHOUTACQUIRINGSECURITIESBY
USINGTHEPROXYMACHINERYSUMMARY
PartFour:UnderstandingResourceConversion
Chapter22:AShortPrimeronResourceConversion
LONG-TERMARBITRAGEBETWEENOPMIPRICESANDCONTROLVALUESMORE
AGGRESSIVEEMPLOYMENTOFEXISTINGASSETSMERGERANDACQUISITIONACTIVITYCORPORATECONTESTSFORCONTROL
GOINGPRIVATEANDLEVERAGEDBUYOUTSSUMMARY
Chapter23:RestructuringTroubledCompanies
THEFIVE
BASICTRUTHSOFDISTRESSINVESTINGREHABILITATIONOFTROUBLEDENTITIESSUMMARY
Chapter24:TheRoleofGovernmentin
ReorganizationsBAILOUTSORCAPITALINFUSIONS?TOOBIGTOFAILISAPHONYCONCEPTTHEGOVERNMENT
ANDPRIVATESECTORAREINPARTNERSHIPWHETHERTHEYLIKEITORNOTWALLSTREETPROFESSIONALSAND
CORPORATEEXECUTIVESAREALLINTHEBUSINESSOFCREATINGMORALHAZARDSTAXPAYERBAILOUTSAREAPHONY
CONCEPTAREVOLUTIONINCORPORATEREORGANIZATIONSANDLIQUIDATIONSMAYHAVEOCCURREDIN2009WITHTHE
CHAPTER11REORGANIZATIONSOFGENERALMOTORS,CHRYSLER,ANDCITCORPORATIONSTRICTREGULATIONOFFINANCIAL
INSTITUTIONSISABSOLUTELYNECESSARYSUMMARY
PartFive:ActiveInvestorsBuyandSellCommon
StocksonanAdvantageous
Basis
Chapter25:TheEconomicsofPrivateEquityLeveragedBuyouts
THE2005
ACQUISITIONOFHERTZGLOBALHOLDINGSANDSUBSEQUENTEVENTSASAPRIMEEXAMPLESUPER-
ATTRACTIVEACCESSTOCAPITALMARKETSCASHPAYMENTSTOSPONSORSANDSPONSOR-CONTROLLEDFUNDS
SPONSORSCONTROLOFHERTZSPONSORSATTUNEDTOTHENEEDSOFBANKERSANDTHEWALLSTREETUNDERWRITING
COMMUNITYQUESTIONSABOUTLBOSSUMMARY
Chapter26:TheUseofCreativeFinanceinaCorporateTakeover
THECASETHE
POSTSCRIPTINVESTMENTLESSONSTHEAPPRAISALOFMANAGEMENTSPOTTINGDOABLEDEALSSUMMARY
Chapter27:TheUseofCreativeFinancetoBenefitControllingStockholders
THEPROBLEMSFACEDINTHESCHAEFERCORPORATIONDEAL
THEBACKGROUNDOFTHEDEALDISCOUNTPURCHASESOFRESTRICTEDCORPORATESTOCKCORPORATION’SACQUISITION
OFBREWINGPROBLEMSANDWEALTHCREATIONPOTENTIALSFORTHEPARTIESININTERESTSUMMARY
GlossaryofAcronyms
AbouttheAuthors
Index
Foundedin1807,JohnWiley& Sons is the oldestindependent publishingcompanyintheUnitedStates.With offices in NorthAmerica, Europe, Australia,and Asia, Wiley is globallycommitted to developing andmarketingprintandelectronicproductsand services forourcustomers’ professional andpersonal knowledge andunderstanding.
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Cover Design: PaulMcCarthyCover Image: ©ASSALVE/iStockCopyright© 2013 byMartinJ. Whitman and FernandoDiz.Allrightsreserved.Published by John Wiley &Sons, Inc., Hoboken, NewJersey.Published simultaneously inCanada.
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intheversionyoupurchased,you may download thismaterial athttp://booksupport.wiley.com.For more information aboutWiley products, visitwww.wiley.com.Library of CongressCataloging-in-PublicationData:Whitman,MartinJ.Modern security analysis :
understanding Wall Streetfundamentals / Martin J.Whitman,FernandoDiz.pages cm.— (Wiley financeseries)Includesindex.ISBN 978-1-118-39004-7(cloth); 978-1-118-60265-2(ebk); 978-1-118-60301-7(ebk); 978-1-118-60338-3(ebk)1.Investmentanalysis.I.Diz,Fernando,1956–.II.Title.
HG4529.W4872013332.63′2042—dc232013000737
TotheDeans,Faculty,Staff,StudentsandAlumniofTheWhitmanSchoolof
Managementat
SyracuseUniversity
Acknowledgments
There are so many peoplewho contributed to ourknowledge, and to thespecifics of this book, that itis impossible toacknowledgeand thank all of them. Wehavesingledoutafewnamesbutindoingsohavenointentof shortchanging those
contributors who we fail tomention.At Syracuse University we
areespeciallygratefulforthehelp and advice given to usbyDeansMelStithandTomFoley; Professors Bill WalshandRandyElder; students inthe Orange Value Fundprogram—allat theWhitmanSchool of Management;University Trustees andalumni Dick Haydon, Steve
Ballentine, Bernard Kossar,MikeDritz,JohnCouri,SteveBarnes, Ken Goodman, andJayGenzer.At Third Avenue
Management, we benefitedmuch from advice renderedby David Barse, TomGandolfo,VinnyDugan, andHal Drachman. BridgetWysong also was helpful.This book never would haveseen the light of daywithout
the herculean efforts of BethConnor,executiveassistanttoMartin Whitman and BettyRoss, administrator of theBallentine InvestmentInstitute and the OrangeValue Fund programcoordinator at the WhitmanSchoolofManagement.One faculty member at
Syracuse University LawSchool, Gregory Germain,and two at the Yale
University School ofManagement, Stan Gartskaand Martin Shubik, have tobe singled out for theircontributions. Others worthyofmention areRonnieChan,Bruce Flatt, BruceGreenwald,andArnieJacobs.It ought to be noted that
bothofus learneda lot frompeople we came to believewere bad guys and withwhomwewould never again
invest.Wewon’tnamenamesbut rather just acknowledgethat one tends to learn morefrom one’s mistakes thanfromone’ssuccesses.Also, our students at
Syracuse, Yale, andColumbia contributed muchto our knowledge. Quitepossibly we learned morefrom them than they learnedfromus.Finally, thanks to our
families, especially LoisWhitmanandJosefaAlvarez.The errors and
shortcomings of this bookbelong to us alone, not at alltothevariouscontributors.
MartinJ.WhitmanFernandoDiz
Introduction
OURFOCUSThis book is different fromother books published aboutsecuritiesinvesting,securitiestrading,andacademicfinanceas embedded in moderncapital theory (MCT). Itseems to us that all other
books on investing andacademic finance—rangingfromPrinciples ofCorporateFinance (McGraw-Hill,2002) byBrealey and Myersto Security Analysis:Principles and Technique(America MediaInternational, reprinted 2003)byGraham,Dodd,andCottle(G&D), and to tracts ontrading techniques—focus onforecasting and explaining
short-run market prices,especially prices at whichsecurities are traded inmarketspopulatedbyoutsidepassive minority investors(OPMIs).Thisbook,insharpcontrast, focuses strictly onexplaining andunderstandingcommercial enterprises andthe securities they issue. Forus,short-runmarketpricesinOPMI markets are so-calledrandom walks except for the
specialcasesofsudden-deathsecurities such as options,warrants,certainconvertibles,and risk arbitrage situationswheretherewillberelativelydeterminate workouts inrelativelydeterminateperiodsoftime.It seems to us that our
approach became morerelevant as a consequence ofthe 2008–2009 meltdown,whereas MCT and G&D
approaches became lessrelevant.Inthisbooktheemphasisis
on creditworthiness ratherthanearningsandcashflows,the appraisals ofmanagements not only asoperatorsbutalsoasinvestorsand financiers, andunderstanding themotivations and practices ofactivists.
CREDITWORTHINESSThroughout the book weemphasize the importance ofcreditworthiness. Threeelements go into thedetermination ofcreditworthiness forfunctionalpurposes:
1.Amountofdebt2.Termsofdebt3. How productive aretheuseof proceeds from
incurringthedebtOf these,weargue that the
third element is the mostimportant.Also,therearethreetestsof
solvency,andmostentitiesdonot have to pass all three tobedeemedsolvent.
1.Does the fair value ofthe assets exceed theclaims against thoseassets (a balance sheettest)?
2. Does the entity havethe wherewithal to meetits obligations as theycome due (an incomeaccounttest)?3. Does the entity haveaccess to the capitalmarkets to meet cashshortfalls (a liquiditytest)?
THE
APPRAISALOFMANAGEMENTSUnlike others who viewmanagements solely asoperators of businesses, weappraise managements intheir competencies asoperators, investors, andfinanciers. Recently we havebeen acquiring the commonstock of Lai SunGarment, areasonably fast-growing and
reasonably well-financedcompany with assets (mostlyrealestate)inHongKongandMainland China. Thecommonstockat thiswritingis selling at about an 80percent discount from netasset value (NAV) and lessthan two times reportedearnings for the year endedJuly 30, 2012. The onequestion we have about LaiSun Garment management is
as financiers. With thecommonstockpricedthewayit is, why isn’t the companyeither buying in its owncommon stock or thecommon stock of its 47percentownedsubsidiary,LaiSun Development, whosecommon stock sells at asimilar discount from NAVand a similar price-to-earnings(P/E)ratio?Ifagoalof the business is to grow
NAV per share, at thosepricesitishardtovisualizeabetteruseofsurpluscashthanbuying in common stockrather than expanding theasset base or paying cashdividends.In examining NAV, it is
important to examine thedynamicsofNAVratherthanjustNAVasastaticconcept.For almost all corporations,NAVwill growyearbyyear
almost continuously. Thequality of NAV tends to bemuch more important thanthequantityofNAV.Certainassets contained in bookvalue reflect overheadunlikely toeverberecoveredthrough earnings or cashflow. Those are the types ofNAV common stocks we tryto avoid. There are valuablelessons to be learned fromG&D’sanalysisofnetnets.
Paymentstoshareholdersinthe form of either dividendsorstockbuybackshastobearesidual use of cash most ofthetimecomparedwithusingcash to expand corporateassets or reduce corporateliabilities. However, from acorporate point of view itsometimes makes sense topay large and increasingdividends, because that cangive the corporation better
accesstocapitalmarketsthanwould otherwise be the case.Also, managements mightconsider large dividendssimply because they aredesired by so much of thecompany’s OPMIconstituency.
ACCESSTOCAPITAL
MARKETSANDWEALTHCREATION
Another factor this bookdwells on deeply that othersseem to ignore is theimportance for companies tohaveaccesstocapitalmarkets—both credit markets andequity markets. As the bookpointsout,capitalmarketsare
notoriously capricious:sometimesnotavailableatall(see the 2008 creditmeltdown) and sometimeswilling to give companieswhat might be characterizedas “almost free money” (seethe 1999 initial publicoffering[IPO]boom).The goal of most
corporations and most (butnot all) OPMIs ought to bewealth creation, and it is
important to note that thereare four general ways tocreatewealth,notjustthetwoseeminglycitedbyMCTandG&D. MCT and G&Dbelieve in theprimacyof theincomeaccount(i.e.,creatingwealth by flows, whethercashflowsorearningsflows;earnings is defined ascreating wealth whileconsuming cash). For us thefourgeneralwaysofcreating
wealth—either corporate orindividual—are:
1. Cash flow fromoperations2. Earnings fromoperations3. Resource conversion(i.e., massive assetredeployments, mergersand acquisitions, liabilityrestructurings,changesofcontrol, spinoffs, andliquidations)
4. Having attractiveaccesstocapitalmarketsIt seems as if conventional
security analysis putsoveremphasisonfourfactors,which makes its approachmuchlessusefulinhelpingtounderstand a business. Thefour areas of overemphasisare:
1.Primacyoftheincomeaccount (to the exclusionof balance sheet and
financial positionconsiderations)2.Short-termism3.Emphasisontop-downanalysisandaconsequentdenigration of bottom-upanalysis4. Equilibrium pricing(i.e., the price at anymoment of timerepresents an efficientmarket, and that pricewillchangeasthemarket
digestsnewinformation)G&D seem guilty on the
first three accounts. MCTseemsguiltyonallfour.
THEIMPORTANCEOFCONTROL
Unlike others, control issuesand changes in control are a
major consideration for us.Control issues are prettymuch ignored by G&D andMCT. For us, controlcommonstocksandpassivelyowned common stocks arethe same in form, but thisbook dwells heavily on whycontrolcommonstocksare,infact, a vastly differentcommodity than non-controlcommon stocks, certainlypriced very differently in
their respective markets.Controlissuesarealsohighlyimportant in restructuringtroubled companies. Wesuspectthatsubsequenttothe2008–2009 economicmeltdown, an increasedpercentage of changes ofcontrol has occurred throughrecapitalization, asset sales,and capital infusionsinvolving troubled publiclyowned companies than has
occurred through acquiringcommon stocks or using theproxy machinery to effectchangesofcontrolofhealthycompanies.The book contains three
talesabouttheuseofcreativefinance to create highlyattractive returns for variousparticipants:
1. The 2005 LBO ofHertzGlobalHoldings.2.TheLeascoacquisition
of Reliance Insurance—getting control withoutputting up cash via thejudicious use of anoverpriced commonstock.3. Schaefer Brewing—letting controlshareholdersextractlargeamounts of cash from acompany while thecontrol shareholders stayincontrol.
THEAVOIDANCE
OFINVESTMENT
RISKIn Security Analysis1 G&Dopine on the differencebetween investment andspeculation. “An investmentoperation is one which upon
thorough analysis, promisessafety of principal and asatisfactory return.Operations notmeeting theserequirements arespeculative.” We agreewholeheartedlywithG&D.Inthis book we attempt toconvince the reader that asafeandcheapapproachisaninvestment operation, not aspeculation.Theavoidanceofinvestment risk is at the
center of the safe and cheapapproach.There are three general
measuresofinvestmentrisk:QualityoftheissuerTermsoftheissuePriceoftheissueFor us, diversification is
onlyasurrogate—andusuallya darned poor surrogate—forknowledge,control,andpriceconsciousness.
Valueinvestingaspracticedby OPMIs is one aspect offundamentalfinance(FF).FFcoversthefollowingareas:
ValueinvestingDistressinvestingControlinvestingCreditanalysisFirstandsecondstageventurecapitalinvesting
The most talented valueinvestors seem to graduateinto distress investing and
control investing. Suchgraduates include WarrenBuffett,SamZell,CarlIcahn,Bill Ackman, and DavidEinhorn.We find that there are
many, many value investorswho are quite competentcompetitors.Asfaraswecantell, however, none seem toput as much emphasis onstrong financial positions aswedointhisbook.
Safeandcheap investing isbasically a buy-and-holdapproach focused on theavoidance of investment riskthat buys growth withouthaving topay for it.Securitysales take place only whenthe security becomes grosslyoverpriced, when the analysthas made a mistake, whencorporate conditions change,or for portfolioconsiderations.
MARKETEFFICIENCY?
Toothers,thedefaultpositionembodies theMCTviewthatmarkets are efficient; to wit,the price is right. To us, incontrast,mostpricesarequitewrongmostofthetime.The conventional thinking
seems to be that one has totakehugeriskstoobtainhuge
rewards. In this book, wedemur. Rather, for us theroyal road to riches is not totake investment risks butrather to lay off theinvestment risks on someoneelse. Truly great fortuneshavebeenbuiltbythosewhohave successfully laid offinvestment risk on others.These success stories includethefollowingpeople:
Corporateexecutives
HedgefundoperatorsPlaintiffs’attorneysBankruptcyattorneysInvestmentbankersSecuritiesbrokersVenturecapitalists
We further postulate thatthe best—but far from theonly—way forOPMIs to layoff investment risk is toacquire securities that areboth safe and cheap. Theelementsthatgointosafeand
cheap investing in commonstocks encompass thefollowing:
Theissuerhastoenjoyasuperstrongfinancialposition.Thecommonstockhastobeavailableataminimum20percentdiscountfromreadilyascertainablenetassetvalue(NAV).Thecompanyhasto
providecomprehensivedisclosures,includingcompleteaudits,andalsobelistedortradedinmarketsinjurisdictionsthatprovidestronginvestorprotections(theUnitedStates,Canada,andHongKongbeingexamples).Afterthoroughanalysis,theprospectsappeargoodthatoverthenext
threetosevenyearsthecompanywillbeabletoincreaseNAVbynotlessthan10percentcompoundedannuallyafteraddingbackdividends.
We do recognize certainshortcomings in our safe andcheap approach. A strongfinancial position, especiallyin the 2012 low interest rateenvironment, means the
OPMI is dealing withmanagements willing tosacrifice return on equity(ROE) and return on assets(ROA) in exchange for theinsurance against adversityprovidedbyastrongfinancialposition and the opportunismfor companies that arises outofastrongfinancialposition.Also,theOPMImarketseemsefficient enough so that alarge discount from NAV
almost always indicates anabsence of catalysts thatcould result in immediatemarket appreciation. Forexample, in ourrecommended list ofsecurities in Chapter 6, noneseems likely to undergo achange of control in theforeseeablefuture.
DEBUNKING
MYTHSThe teachings in this bookrejectthoroughlyanumberofcommonly held beliefs,including theconceptof“toobig to fail”; the definition ofcorporate failure; the beliefthat creditworthy entities,corporate or governmental,ever repay indebtedness inthe aggregate; or the beliefthat a capital infusion into a
private enterprise by agovernmental agency is, ipsofacto,abailoutratherthananinvestment.Forus,thesebeliefsarejust
plainwrong:“Toobigtofail”ismeaningless.Thestandardhastobe“tooimportantnottobereorganizedefficientlyandexpeditiously.”Thereorganizationsand/or
capitalinfusionsafter2008intoGeneralMotors,Chrysler,CITGroup,Citigroup,andAmericanInternationalGroup(AIG)aregoodexamplesofefficientandexpeditiousreorganizationsofveryimportantcompanies.Wedefinecorporatefailureasarestructuringinwhichjuniorsecurity
holdersarewipedoutoralmostwipedout.Chapter11reorganizationdoesnotdefinefailure.Stayinginbusinessdoesnotdefinesuccess.After2008,AIGandCiticorpbothfailedusingourdefinitionsoffailure,thoughneithereverfiledforChapter11bankruptcyrelief.Intheaggregate,debtis
almostneverrepaidbyentities,whichneverthelessremaincreditworthy.Rather,debtisrefinancedandexpandedinsofarastheentity—whethercorporateorgovernmental—expandsitsborrowingcapacity(i.e.,becomesmorecreditworthy).Eachofthecompanieswhose
commonstocksarelistedinChapter6hadgreaterborrowingcapacityin2012thanithadfourorfiveyearsearlier.Bewaryofputtingdebtlimitsoncorporationsorgovernments.
The difference between abailout and an investment isthat a bailout constitutes acapital infusion without anyhope of a return, no matter
how return is measured. Ifthere are prospects of areturn, aswell as a return ofprincipal, thecapital infusionis an investment. TheTroubled Asset ReliefProgram(TARP)instigatedin2008 to rescue U.S. bankswas an investment by thegovernment,notabailout.Great economists Keynes,
Friedman, Hayek, andModigliani and Miller
probablycouldhavelearnedalotfromvalueinvestors.
YOUNEEDALOTMORE
THANKNOWLEDGEOFALGEBRAANDTHE
ENGLISHLANGUAGETOUNDERSTAND
OURAPPROACH.
A contrast in approachesbetween academic financeand us is contained in theintroduction to Brealey andMyers’s Principles of
CorporateFinance,a leadingfinance text, where theauthors state that “there areno ironclad prerequisites forreading this book exceptAlgebra and the Englishlanguage. An elementaryknowledge of accounting,statistics andmacroeconomics is helpful,however.”Togetalotoutofthis book, however, thereader ought to strive to
become knowledgeable inseveral fields—knowledgeable enough to bean informed client. Areaswhere knowledge isprerequisiteinclude:
SecuritieslawandregulationsFinancialaccountingCorporatelawwithsomeemphasisonDelawarelawIncometax
Otherdisciplinesthatmightcomeintoplay,dependingonthe particular situation beinganalyzed,arebankruptcylaw,insurance lawandregulation,banking law and regulation,andenvironmentallaw.
OTHERTOPICSWECOVERINTHEBOOK
Other views explained indepthinthebookincludethefollowing:
InFFthereisnosubstantiveconsolidationbutplentyofstructuralsubordination.Inparticular,thecompanyisastand-aloneentity:Itisnotthemanagement,anditisnotthestockholders.Everyconstituencyinan
economicentitycombinescommunitiesofinterestandconflictsofinterestinitsrelationshipswithotherconstituencies.Essentially,stockoptionsareastockholderproblem,notacompanyproblem.Itisaxiomaticthatifaneconomicentitycannotbemadecreditworthy,
soonerorlatertheentityhastobereorganizedorliquidated.ItseemstousthatnooneisreallydoinganythingonthesovereignfronttomakePortugal,Ireland,Italy,Greece,andSpaincreditworthy.Forstarters,ataminimumthereisaneedforefficiencyratherthanausterity.
Formostportfoliosofperformingloans,timecorrectstheerrorofhavingboughtattoohighaprice.Afairpriceisonethatwouldbearrivedatbetweenwillingbuyersandwillingsellers,eachwithknowledgeoftherelevantfactsandneitherunderanycompulsiontoact.Mostgoing-private
andleveragedbuyout(LBO)transactionsarecharacterizedbyacoercedsellerandawillingbuyer.However,OPMIsbecomewillingsellerswhenofferedpremiumsovermarketprices.
Instructors will findadditional aids atwww.wiley.com._______________
1BenjaminGraham,DavidL.Dodd,andSidneyCottle.SecurityAnalysis:PrinciplesandTechnique,fourthedition(NewYork:McGrawHill,1962)p.47.
PartOne
TheFoundationsof
ModernBusinessandSecurity
Analysis
CHAPTER1
TheScopeofFundamentalFinance,
Investing,andtheInvestor
Landscape
InvestingversusSpeculatingTheOPMIDefinedActivistsSummary
BenjaminGrahamandDavidDodd (G&D) were prolificwriters, publishing volumesin1934,1940,1951and1962andbyBenGrahamalone in1971. A principal problemwith G&D is that almosteveryone in finance talksabout G&D, but very fewseem to have actually readG&D.Becausesomanyhavesuch
asuperficialunderstandingofG&D, their names havebecomesynonymouswiththetermvalue investing.This, inturn, has led to someconfusionaboutwhatitisthatvalue investors do. Thoughwe are influenced by G&D,our methods are basicallydifferent.Value investing isonearea
of fundamental finance (FF).Value investing involves
commitments in marketablesecurities by non-controloutside passive minorityinvestors (OPMIs).1 Athorough discussion of howwe integrate the individualcomponents of fundamentalfinance investing, discussedin the first part of this book,into our safe and cheapapproachtovalueinvestingiscontainedinChapter15.The other areas of
fundamental finance involvethefollowing:
Distressinvesting2ControlinvestingCreditanalysisFirst-andsecond-stageventurecapitalinvesting
Modern capital theory(MCT), like value investing,also focuses on investmentsby OPMIs. Unlike valueinvestors, MCT focusesstrictly on near-term changes
inmarketpricesanditisatopdown approach rather than abottom up approach. In anumber of special cases thefactorsimportantinMCTarealso important in valueinvesting. MCT is discussedinChapter17.
INVESTINGVERSUS
SPECULATINGSince the five areas offundamental finance involvedifferent types of investingand value investing focuseson commitments inmarketable securities byOPMIs, we need to be surethat the reader understandswhat we mean by the wordinvesting.In the first and subsequent
editionsofSecurity Analysis,G&D devoted an entirechapter to the problem ofclearly defining the meaningof the word investing. Theirgoal was to come up with adefinitionthatwouldserveasan objective benchmark thatwould allow people todistinguish between financialoperations devoted toinvesting from those devotedto speculating. Although
people seem to have a clearidea of what the differencesbetween the two words are,G&D found that coming upwith a precise definition ofthe terms ran into“perplexing” difficulties. Wediscuss a few of thesedifficultiesormisconceptionsthat are still prevalent todaylaterinthischapter.The academic profession
has not provided any
guidance on this importantmatter, either. In fact, theyhave authoritativelycontributed to the ragingconfusion that still existstoday. For example, theprevailing view orconventional wisdom is thatin order to achieve largerreturnsbuyingsecurities,onemust undertake largeramounts of market risk. Ofthemanyimplicitmistakesin
this view, one of them is theacademic belief that allpurchases of securities areinvestments. Nothing couldbemoremisleading than thisbelief.
WhyaDefinitionforInvesting?
Whyis itworthwhiletohaveprecise definitions forinvesting and speculating?
First, without a precisedefinition, we cannotdistinguish betweenspeculative and investmentoperations. On Wall Street,every speculator is called aninvestor.Thisisbadandverymisleading semantics. Butwhy should we distinguishbetween investing andspeculating? This leads us tothe second and, perhaps,more important reason. We
do agree with G&D that thefailuretodistinguishbetweeninvestment and speculativeoperations was in large partresponsibleforthewipeoutornear wipeout of marketparticipantsduring the1928–1929 market crash. Thisfailure continued to play animportantroleinmorerecentexamplesofwipeoutsornearwipeouts of marketparticipants (OPMIs
generally) that occurred in1974, 1987, 1989, 2000, and2008–2009.One of G&D’s often
unrecognized and perhapsmost important contributionto fundamental finance wasthe clear articulation of aprecise definition for theconcept of investing that wereproducebelow:3
An investing operation isone, which upon thorough
analysis that can bejustified on bothquantitativeandqualitativegrounds,promisessafetyofprincipalandasatisfactoryreturn. Operations notmeetingtheserequirementsarespeculative.Thedifficultiesencountered
byG&Dincomingupwithaprecisedefinitionwererootedin common misconceptionsabout what an investment is.
The above definition ishelpful in the clarification ofmany of thesemisconceptions, a few ofwhichwediscussbelow.
TheTypeofSecurityDoesNotDefineWhat
anInvestmentIsThereisnothinginherenttoafinancial instrument thatmakesiteitheraninvestment
or a speculation. Thismisconception is alive andwelltoday.
EXAMPLETreasury securities arewidely viewed asinvestment vehicles. Thisview notwithstanding,purchasing a 2 percent 10-year Treasury note pricedatparin2012seemsasureloser.No credit instrumentever achieves a market
price much above its callprice nomatter howmuchinterestratesgodown,soitis hard to foreseemeaningful capitalappreciation for theTreasury note. If interestrates go up (seems areasonable possibility from2 percent), the marketpricesof theTreasurynotewilldecline.Purchasesof2percent 10-year Treasurynotes carry a large amountofinvestmentriskandthuscanhardlybeconsideredan
investment operation. Wediscuss investment risk atlengthinChapter8.
Inherent to a security areonlytherightsthatitsholdershave.Ownershipofasecuritygives its owners one of twobenefits:
1. Contractual rights toreceivecashpayments inthe form of interest,return of principal, andpremium.These rights in
the United Sates cannotbe taken away fromholders unless the holderso consents or in a courtofcompetentjurisdiction,usually a bankruptcycourt.2. Ownership rights,which may or may notprovide for payments toowners of dividends orsharerepurchasesthatarenot contractually
required, except for thecase of preferred stockswhere cash service isrequired before cash ispaid out to juniorsecurities. Theseownership rights can beoutright or contingent asinthecaseofoptionsandwarrants.Hybrid securitiesgive their
owners both benefits but atdifferent times. Owners of
convertiblenotes,convertiblepreferred stocks may havecontractual rights to cashpayments until they convertthose rights into ownershiprights.We discuss these
substantive characteristics ofsecuritiesinChapter4.
TheMethodofPurchaseandthe
HoldingTimeHorizonPurchasing a common stockoutright does not ispo factomake it an investment.Neitherdoesbuyingthestockof a strongly financedcompanyonmarginmakeitaspeculation. Similarly, thedistinction between apermanent holding ortemporary holding cannot beused to differentiate between
investment and speculation.For example, risklessarbitrage involves thesimultaneous purchase andsale of related securities, onmargin, and for a short timeperiod, but the transaction,properly executed, can be aninvestment operation, not aspeculation. Risklessarbitrage is defined as atransaction thatdoesnot takeany equity (or very little
equity), guarantees safety ofprincipalandapredeterminedreturninafixedtimeperiod.
EXAMPLEBy September 2012 goldcould be purchased in thecash market at $1,700 perounce. Suppose a forwardcontract can be written todeliver physical gold in ayear and get paid $1,800per ounce. The cost offinancing is 5 percent per
year. An arbitragetransactionwillinvolve:
Borrowsay$170,000forayearat5percent.Usetheproceedsoftheloantobuy100ouncesofgoldinthecashmarket.Simultaneouslyenterintoaforwardagreementtodeliver100ouncesofgoldinayearandgetpaid$1,800/oz.Inoneyear,regardlessofwhatthepriceofgoldin
thecashandforwardmarketsis,youwilldeliver100oz.ofgoldandgetpaid$180,000forit;andyouwillrepayprincipalandinterestonyourloanof$178,500andpocketarisklessprofitof$1,500.
The above operation doesnot have any investmentrisk, involves purchasinggold on a fully marginedbasis, for a short timeperiod, and provides more
than an adequate return onnoequity.
ForIncomeorforTotalReturn
One common misconceptionisthatpurchasesofissuesforincome or cash returnpurposes are also ipso factoinvestments. For marketparticipants seekingsatisfactory returns in mid-
2012, it seems no longerpossible to do so as a cashreturn investor. Interest ratesare just too low. Rather themarket participant has tofocus on being a total returninvestor; that is, income pluscapital gains. The futility ofbeingacashreturninvestorisdemonstrated by holding a 2percent10-yearTreasurynotepriced at par. As wepreviously discussed,
purchasing this instrumentseems a sure loser. Thus,although it has becomefashionable to talk aboutpurchasing Treasurysecurities as a “return ofcapital” operation, theoperation is fraught withinvestment risk and hardlycompensates the purchaserwith either an adequate cashortotalreturn.
InvestmentOperationRatherthananIssue
As we have alreadydiscussed, investmentcharacter does not inhere inan issue per se. Price isfrequently an essentialelement, so that a commonstock or preferred stock orbond may have investmentmerit at one price but not atanother. Along the same
lines, an investment may bejustified in a group of issuesthat could not be justifiedindividually. Moreover,certain typesofarbitrageandhedging commitments canalso be consideredinvestments. As we saw inthe riskless arbitrageexample, the element ofsafety in these types ofoperations isprovidedby thepurchase/saletransaction.
SafetyofPrincipalastheAvoidanceofInvestmentRisk
For analytical purposesinvestment risk for a securityhasthreecomponents:
1.Qualityoftheissuer2.Termsoftheissue3.PriceoftheissueInvestment must always
consider the price as well as
the terms of the security andthequalityoftheissuer:thereis no investment issue in theabsolute sense; that is,implying that it remains aninvestment regardless ofprice. This is important tounderstandbecausesemanticsoften obscure this fact. Thepurchase of a blue chipcommon stock is commonlyconsidered as an investmentat any price. Not so. An
investment operation focuseson the appraisal andavoidance of investment riskas shown in the followingexample.
EXAMPLEItisfeasibletodayasatotalreturn investor to buy intoblue chip common stocks,which have the followingcharacteristicsandwhichinour opinion probablyhaven’tbeenasattractively
priced as they are nowsincethemid-1970s:
Super-strongfinancialposition(qualityofissuer).Pricedatadiscountfromnetassetvalueof25percentormore(WheelockandCompanyatadiscountofabout50percent)(priceoftheissue).FullcomprehensivedisclosuresinEnglishwithauditsbytheBig
Four(thoroughanalysis,basedonbothqualitativeandquantitativegrounds).TradinginmarketswhereprotectionsforOPMIsarestrong(termsoftheissue).Prospectsseemgoodthatoverthenextthreetoeightyearsnetassetvalue(NAV)willgrowbynotlessthan10percentcompoundedannuallyafteraddingbackdividends.Ifsuch
growthisachieved,theinvestmentsseemverylikelytobeprofitablebecauseifnot,thediscountsfromNAVwouldhavewidenedtounconscionablelevels.
THEOPMIDEFINED
Some participants ininvestment operations are
OPMIs; others are activistshaving either control orelements of control overmarketsorcorporatedecisionmaking.OPMIsaremembersof the public and aredistinguishablefromothersinthreerespects:
1. Individually they haveno control or influenceover the businesseswhose securities theyhold or contemplate
holding.2. They do not haveaccess to informationother than that which isgenerallyavailable to thepublic.3. They are those whomthe U.S. securities lawsand regulations havebeendesignedtoprotect.4
Throughout the book, werefer to them as OPMIs, aswell as non-control and
unaffiliated security holders.The key is that they areinactive in management andnot connected with thecompany issuingsecurities inany way other than assecurity holders. OPMIs runthegamutfromdaytraderstomostinstitutionalinvestorstovalue investors who do notseekelementsofcontroloverthe companies in which theyhold securitiespositions.The
reason for using the termOPMI rather than investor isthat theword investor is oneof the most misused andmisunderstoodwordsonWallStreet and is often used todescribe what G&D and wewouldrefertoasspeculators.Non-control investors are
also supposed to be thebeneficiaries of various statelaws and regulations,including blue sky statutes
governing terms andconditions under which newissues may be offered;5 anti-takeover statutes; statutesaimed at controlling going-private transactions; moregeneralizedcommon lawandstate statutory requirementscovering the fiduciaryobligationsofthoseincontrolofcorporationstounaffiliatedcommon stockholders; andstatutes defining appraisal
remedies when stockholdersdissent from force-outmergers or similar force-outtransactions. OPMIs areadditionally protected byrules promulgated by quasi-publicbodies,particularlytheFinancial InstitutionsRegulatory Authority(FINRA).
ACTIVISTS
We regard as activists thoseparticipants in U.S. financialoperations who have eithercontrolorelementsofcontrolor influence over businesses,who have or can obtainnonpublic information andwhom federal securitiesregulations are intended tocontrol rather than toprotect.We believe the materials inthis book are of interest tobothactivistsandOPMIs.
SUMMARYThe concept of valueinvesting that is oftenassociated with Graham andDodd is only one form offundamental financeinvesting that involvesmaking commitments inmarketablesecuritiesbynon-control, outside, passiveminority investorsorOPMIs.The other forms of
fundamental financeinvesting are distressinvesting, control investing,credit analysis and first- andsecond-stage venture capitalinvesting. Clearlyunderstandingwhat investingisasopposedtospeculationisa sine qua non for runningfundamental financeinvesting operations, and thedefinition of investing is oneofGrahamandDodd’smajor
contributions to the field ofsecurity analysis. We clearlydefine the concept of theOPMI but warn the readerthat the concepts covered inthisbookcanbeusedandareused by all those who runfundamental financeinvestingoperations._______________1Sincemostconventionalapproachestoinvesting,e.g.,GrahamandDodd
(discussedinChapter16),moderncapitaltheory(discussedinChapter17),broker-dealerresearchdepartmentsandconventionalmoneymanagers(discussedinChapter18),arecenteredontheOPMI,weprovideamoredetaileddescriptionofthistypeofinvestorlaterinthischapter.2Thereaderisreferredtoa
bookwrittenbytheauthorsonthisareaoffundamentalfinance:MartinJ.WhitmanandFernandoDiz,DistressInvesting:PrinciplesandTechnique(Hoboken,NJ:JohnWiley&Sons,2009).3WethoroughlydiscussthemanysubstantivedifferencesbetweenourapproachandGrahamandDodd’sinChapter16ofthisbook.
4TherelevantlawsandregulationsarethefederalsecuritieslawsadministeredbytheSecuritiesandExchangeCommission:theFederalSecuritiesActof1933asamended,theSecuritiesExchangeActof1934asamended,theInvestmentCompanyActof1940asamended,theInvestmentAdvisersActof1940asamended,theTrust
IndentureActof1939,andtheSecuritiesInvestorsProtectionActof1970.5Blueskystatutesreferstostatestatutesgoverningthetermsandconditionsonwhichofferingstosellsecuritiestothepublicortobuythemfromthepubliccanbemadeinthatjurisdiction.
CHAPTER2
AShortIntroductiontotheGoingConcernandResource
ConversionViewsofBusinesses
MethodsofWealthCreationThePureGoingConcernView
TheResourceConversionViewSummary
Inthisbookweadvocatethatoutside passive minorityinvestors’ (OPMIs) commonstockportfoliosconsistoftheissues of well-capitalizedcompanies (strong financialpositions), which should be
acquired at prices thatrepresent meaningfuldiscounts from readilyascertainable net asset values(NAVs). Although this is anecessary condition forinvestment success (theavoidance of investmentrisk), it is not a sufficientcondition.The authors’ most
successful investments haverevolvedaroundbeinginbed
with superior managementswho were able to beopportunistic on a long-termbasis,sayfiveyearsorso, intaking advantage of theresources in the business. Inall cases, these resourcesincluded strong financialpositions. Obviously, thebusinesses benefited alsofrom the ability ofmanagementtocreate,ortakeadvantageof,otherresources,
including having highlyefficient manufacturingabilities (Toyota Industries);having the ability to makeattractive acquisitions(Brookfield AssetManagement, Wheelock &Company,andInvestorA/B);having the ability to employexcess capital, that is,surplus-surplus, profitably(regional and communitydepository institutions);
having the ability to accesscapital markets, especiallycredit markets, on a super-attractive basis (BrookfieldAsset Management, ForestCity); and having the abilityto maintain profit marginsduring periods of increasedcompetition and severeeconomic downturn(Japanesenon–lifeinsurers).The underlying
characteristic of these
superiormanagements,inouropinion, is that they seem tofocus on the same things wefocus on as buy-and-holdinvestors; that is, long-termwealthcreation. Unlikemoststockmarketparticipants, theprimary focus of thesemanagements is not on whatperiodicreportedearningspershare, or periodic EBITDA(earnings before interest,taxes, depreciation, and
amortization),mightbe.In creating wealth, these
opportunistic managementsrealize that there tend to bemany ways to create wealthbesides enjoying operatingearnings. These othermethods of creating wealthinclude:
1. Enjoying super-attractive access tocapital markets, bothcreditmarketsandequity
markets.2. Being able to makeopportunisticacquisitionsof other companies andotherassets.3. Being able toopportunistically launchnewbusinesses.4. Being able to takeadvantage of basicmispricings in securitiesmarkets inorder to, interalia, repurchase
outstanding commonstock,spin-offglamoroussubsidiaries, or liquidateassetsinwholeorinpart.Focusing on long-term
opportunism rather thanperiodic earnings per share,as reported, tends to not sitwell with most OPMIs. Acompany with a strongfinancial position either doesnot need access to capitalmarkets or else controls the
timingastowhentheywouldaccesscapitalmarkets.Giventhis, as a general rule, themanagementswill tend to benonpromotional,andattimes,hardly interested at all inwhatWallStreetthinks.On the opportunism issue,
we are convinced that it isvery difficult for mostmanagement to beopportunistic if theircompany’sfinancialpositions
aresuchthatthemanagementhas to be supplicants tocreditors—whether thosecreditors be financialinstitutions, trade vendors, orlandlords.
METHODSOFWEALTHCREATION
The above discussionhighlights a view ofbusinesses that is seldomarticulated either in GrahamandDodd (G&D) ormoderncapital theory (MCT). Howone views businesses has aprofound effect on how oneanalyzes businesses.Throughoutthebookweshallmake reference to the puregoing concern view ofbusinesses that is part and
parcel of most conventionalapproaches to business andsecurity analysis.We discussthis view below and explainwhy it has led to a myopicand very misleadingunderstanding of howbusinesses generate wealthbut nevertheless has becomethe conventional wisdom.More importantly, thismyopic view, turnedconventional wisdom, has
hadaprofoundeffectonhowmanyaspectsofbusinessandsecurityanalysisarehandled;that is, from howmanagements are appraised,to how accounting numbersare used, to whose needsaccounting rules mustaddress, to substantivelyconsolidating the interests ofthe company and itsshareholders forallpurposes.We contrast the conventional
view with the view we holdthat businesses and theirdynamics are betterunderstood as both havinggoing concern characteristicsas well as resourceconversion characteristics.This latter view, which is amuch more realisticrepresentation of how U.S.and other corporations createwealth,enablesustodevelopamuch richer framework for
appraising managements aswealthcreators,providesusaguide for using accountingnumbers for what theymeanrather than what they are,facilitatestheidentificationofcommunities and conflicts ofinterests among businessconstituents, and as a resultallowsusandthoseusingourapproachtohavemuchbetterchances at achieving long-terminvestmentsuccess.
THEPUREGOING
CONCERNVIEW
A pure going concern is abusiness that creates wealthby generating flows fromoperations (either free cashflows or earnings) byconducting its day-to-day
operations pretty much thesame way it has alwaysconducted them, managedprettymuch the sameway ithas always been managed,financed pretty much thesameway ithasalwaysbeenfinanced, and controlledprettymuch in the samewayithasalwaysbeencontrolled.Althoughwedonotpreciselyknow where this vieworiginated, we can at least
track it to Modigliani andMiller’s 1958 paper, “TheCost of Capital, CorporationFinance and the Theory ofInvestment,”1whichprovidesthe formulation of today’sconcept of enterprise value(EV) as the capitalized valueof after tax operatingearnings. Minor adjustmentstothisapproachhavealsoledto the discounted cash flow(DCF) valuation method.
Thisviewonhowbusinessesgenerate wealth, which isimplicit in most academicfinanceaswellas inGrahamand Dodd , has led marketparticipantstooveremphasizethree factors in conventionalsecurity and businessanalysis:
Primacy of the IncomeAccount, that is, theprimacy of flowsgenerated from
operations as a valuationdeterminant—whetherthose flows are earningsflow or cash flows.(Earnings flows arestreamsofincome,whichcreate wealth foreconomic entities whileconsuming cash. In thecorporate world earningsflows probably are morecommon than cash flowsavailable for securities
holders.)Primacy of Short-Termism—Predictionof,and reliance on,immediate market pricesand changes in thoseprices; these are crucialto equity pricing insecurities marketsdominated by OPMIs.Determining near-termoutlooks for a companytends tobe amuchmore
important variable inconventional analysisthan is determiningunderlyingvalue.2
Primacy of Top-DownAnalysis—The mostimportant element inpredicting market pricesin conventional analysisaremacrofactorssuchasgross domestic product(GDP), the level ofinterest rates, technical
market considerations,industry sectors, and thetrends in stock marketindices.For conventionalanalysis, micro factorslooked at from thebottom up, such as loancovenants, appraisals ofmanagement, strength offinancial positions, andaccess to capitalmarketsare down-weightedcompared to top-down
considerations.Moreover, under the
influenceofthisviewmarketparticipants tend to appraisemanagements only asoperators. Managements willtend to be judged by theirability to improve margins,increase sales, organicallygrow the business, reducecosts, and so on. This one-dimensional view ofmanagement appraisal
excludes other areas that arethe purview of managementincluding their abilities asinvestors (deal makers) andfinanciers. These activitiescan be orders of magnitudemore important thanoperations in the generationof wealth, and aresummarized in the saying“One good deal may createmorewealththan10yearsofbrilliant operations.” We
discuss the appraisal ofmanagementsinChapter11.Another area that has been
profoundly affected by thisnarrow view of businesses isfinancial reporting;specifically how marketparticipants and regulatorsview the role of GenerallyAccepted AccountingPrinciples (GAAP) orInternational FinancialReporting Standards (IFRS).
GAAP figures can serve twodifferent roles for outsidepassive minority investors.First, an accounting number—usually earnings per share—isatooltobeusedtohelppredict the price at which acommon stock will sell inmarkets just ahead.Alternatively, all accountingnumbers—the wholebookkeepingcycle—aretoolstobeusedtogiveaninvestor
objective benchmarks, cluesto aid him or her inunderstanding a business anditsdynamics.The vast majority of
analystsseemtoviewGAAPonlyinitsfirstrole,asatooltobeusedtohelppredict theprice at which a commonstock will sell in the periodjust ahead. The regulators inthe United States, whethergovernmentalasembodied in
the Securities and ExchangeCommission, or private asembodied in the FinancialAccounting StandardsBoard,seem to share the sameviewwholeheartedly. Estimatingthe market impact ofaccounting numbers is whatcounts for them. Thus, thereis a primacy of the incomeaccount. There has to be asaccurate a statement aspossible of quarterly reports
of income from operations;earnings before interest,taxes, depreciation, andamortization (EBITDA); andearningspershare(EPS).Forthose holding the view thatbusinesses are pure goingconcerns, the focus is on anincome account, or flow,number with full attentionpaidtowhatthenumbersare,as reported, rather than whatthe numbers mean. We
discuss these issues inChapters5,6,15,and19.
THERESOURCE
CONVERSIONVIEW
Weviewcompaniesnotonlyashavingpuregoingconcernattributes but, more
importantly,asbeingengagedin what we call resourceconversion activities. Theseactivitiesincludemergersandacquisitions, spinoffs,buyouts, recapitalizations,liquidations, changes ofcontrol, and other activitiesthat generate wealth byputting resources to otheruses, other ownership, andother control. Rather thanbeing strict going concerns,
virtuallyallbusinesseswhoseequities are publicly tradedcombine going concerncharacteristics with resourceconversion (investmentcompany) characteristics. Asan illustration of this point,Table 2.1 shows thefrequency of certain types ofresourceconversionactivitiesforthecompaniesintheDowJones Industrial AverageIndex for the fiveyears from
June2007throughJune2012.Table2.1ResourceConversionActivitiesofDowJonesIndustrialCompaniesfromJune2007toJune2012CompanyName Numberof
PrivatePlacements
NumberofMergers/Acquisitions
3MCo. 1 27Alcoa,Inc. 1 6AmericanExpressCompany
5 6
AT&T,Inc. 1 18
BankofAmericaCorporation
4 64
CaterpillarInc. 0 13ChevronCorporation
0 24
CiscoSystems,Inc.
14 44
E.I.duPontdeNemoursandCompany
2 16
ExxonMobilCorporation
1 36
GeneralElectricCompany
5 17
Hewlett-Packard 0 24
Company
IntelCorporation
1 27
InternationalBusinessMachinesCorporation
2 44
Johnson&Johnson
0 10
JPMorganChase&Co.
7 33
KraftFoodsInc. 0 8McDonald’sCorp.
1 6
Merck&Co. 2 16
Inc.MicrosoftCorporation
5 31
PfizerInc. 1 30Procter&GambleCo.
2 22
TheBoeingCompany
0 10
TheCoca-ColaCompany
1 12
TheHomeDepot,Inc.
0 3
TheTravelersCompanies,Inc.
0 0
United 0 3
TechnologiesCorp.VerizonCommunicationsInc.
2 4
Wal-MartStoresInc.
3 8
WaltDisneyCo. 0 9TablewasbuiltusingS&PCapitalIQ.
While income accounts,that is, flow data, areintegrally related to net assetvalue (NAV), for manycompaniesNAVandchanges
in NAV are far moreimportant determinants ofvalue than are earnings, orcash flows, from operations.Such NAV-centeredcompanies include BerkshireHathaway, almost all mutualfunds, most income-producing real estate entities(such as Forest CityEnterprises), most controlinvestors (such asBrookfieldAsset Management), and
most conglomerates (such asCheungKongHoldings).Whenoneviewscompanies
as businesses combininggoing concern characteristicsas well as resourceconversioncharacteristics,thefocus of analysis changesconsiderably since wealth isgenerated inamultiplicityofways. Substantive areaswhere the focus of analysischangesare:
1.Thereisnoprimacyoftheincomeaccountintheanalysis because wealthis created both throughgoing concern activitiesand resource conversionactivities. The weightapplied to the differentactivities in the analysiswill be case specific.There are no generalrules, only case-specificrules. We thoroughly
discuss this point inChapters5,6,7,and19.Accounting numbers areanalyzed for what theymean rather than whatthey are with a specialemphasis to the entireaccounting cycle not justone number. A thoroughdiscussionofthispointisgiveninChapter19.The quality and quantityof resources of a
company becomeimportant factors ofanalysis. As we said atthe beginning of thischapter, one example ofsuchresourceishavingastrong financial position.A strong financialposition offers theOPMI’s insurance(minimization ofinvestment risk) andmanagement the ability
to be opportunistic. Wediscuss these issues inChapters6and7.Managements are nolonger appraised only asoperators but also asinvestors and financiers.We discuss this point atlengthinChapter11.The focus of ourapproachistheavoidanceof investment risk notmarket risk, which we
discussinChapters8and12.There is no substantiveconsolidation of theinterests of the companywith those of theshareholdersoranyothercorporate constituency.These issues arepresentedinChapter3.Securities havesubstantivecharacteristics that must
be understood. Wediscuss the substantivecharacteristics ofsecuritiesinChapter4.Portfolios of securitiesusing our approach willtend to be concentratedrather than diversified.Diversification is asurrogate, and usually adamn poor surrogate forknowledge, control, andprice consciousness.
Diversification isdiscussedinChapter13.
SUMMARYTheremainderofthisbookisdevoted to explaining anddiscussingalltheelementsofour approach. A key tounderstanding where theseelements come from isrealizing that businessesgenerate wealth in a
multiplicityofways,ofwhichflows fromoperations (eithercash flows or earnings) areonlyone._______________1FrancoModiglianiandMertonH.Miller,“TheCostofCapital,CorporationFinanceandtheTheoryofInvestment,”AmericanEconomicReview48,no.3(1958):261–297.2Thisfacthadbeenalready
pointedoutasearlyas1936byJohnMaynardKeynesinChapter12ofhisGeneralTheoryofEmployment,InterestandMoney(CreateSpaceIndependentPublishingPlatform,2011).
CHAPTER3
SubstantiveConsolidationandStructuralSubordination*
SubstantiveConsolidationNotofPrimeImportanceTheAccountingforStockOptionsControversyinLightoftheSubstantiveConsolidation
DoctrineStructuralSubordinationNotaSignificantFactorLackofProgressinEurozoneCrisisResolution:TheFailuretoUseSubstantive
ConsolidationSummary
In fundamental financeinvesting; that is, valueinvesting, control investing,distress investing, creditanalysis, and venture capitalpromotions, securities areexamined from multiplepoints of view, including the
company itself and controlshareholders. By contrast,Graham and Dodd (G&D)and modern capital theory(MCT) look at securitiesanalysis almost solely fromthe point of view of outsidepassive minority investors(OPMIs).1 This difference inpoints of view leads to theasking of fundamentallydifferentquestions.One key question in
fundamental finance,including value investing incommonstocksis:What isabusinessworthlongterm?The key question in G&D
andMCT,however,is:At what price will asecurity trade today andtomorrow in an OPMImarket?In fundamental finance,
OPMIs and OPMI interests
are merely the tip of a hugeiceberg. To study financialphenomena by focusing onthe day-to-day tradingenvironment strictly from anOPMIpointofviewisakininmarine biology to studyingthe entire marine food chainbyrestrictingtheexaminationto the reactions of kelp andplankton floating on theocean’s surface. Kelp andplankton merely react;
beneath the surface, thereexist myriad actors, such asshark, tuna, cod, andwhales.These beneath-the-surfaceactors in the marine foodchain are similar to thegroups in the financialcommunity that we describein Chapter 14 when wediscuss promoters’ andprofessionals’compensations.MCT appears to be useful
in describing a special case
withtwocomponents:1. The sole object of themarket participant is tomaximize a (market)risk-adjusted total returnconsistently (i.e., all thetime) realizable in cashby sale to the OPMImarket.2. The need to examineonly a relatively fewvariables in analyzing asecurityorcommodity.In
the securities arena,issues analyzable byreference to only a fewcomputer-programmablevariables seem restrictedtothefollowing:
Credit instrumentswithout credit risk(e.g., U.S.treasuries).Derivative securitiessuch as convertibles,options, and
warrants. (Thevalues forderivatives aredeterminedbypricesof other securitiesrather than by anyanalysis of theunderlying valuesattributable to asecurity, such as acommonstock.)Risk arbitragesecurities where the
workouts are shortrun (i.e., there arerelativelydeterminantworkouts withinrelativelydeterminant periodsoftime).
The basic problem withMCTisthatittriestomakeageneral law out of what isreally a very narrow specialcase.MCT teachings are not
very helpful forunderstanding fundamentalfinance, where the analysisbecomes relativelycomplicated regardless ofwhether the object of theanalysis involves corporatecontrol factors or buy-and-hold passive investing.Indeed, the underlyingassumptions at the heart ofboth G&D and MCT areeither downright wrong or
just plain misleading forpurposes of understandingfundamentalfinance.In thischapterwefocuson
two of these implicitassumptions of G&D andMCT, which have createdimportant obstacles to theunderstanding of importantissuesofcorporatefinanceingeneralandvalueinvestinginparticular:
1. For G&D and MCT,
substantive consolidationisofprimeimportance.2. In G&D and MCTanalyses, everybody’sinterests are structurallysubordinated to those ofthe OPMI; that is,structural subordinationisasignificantfactor.
SUBSTANTIVE
CONSOLIDATIONNOTOFPRIMEIMPORTANCE
The ideas of substantiveconsolidation, in which theinterests of the company anditsstockholdersarecombinedandseenasoneandthesameand structural subordination,in which the company’sraison d’être is to serve the
best interests of itsstockholders, especially itsnon-control OPMIstockholders, are centralassumptions of both G&Dand MCT. The substantiveconsolidation and structuralsubordination doctrines soimportant toG&D andMCTarerelativeraritiesintherealworld,thoughtheydoexistinspecialcases.
EXAMPLEThe 1997 annual report ofGeorgia-PacificCorporation explains atlengththatcompanypolicyis to forgo returns oncorporate investments if itisdeemedthatstockholderscan use that cash moreproductively than thecompanyitself.
InG&DandMCT,though,the underlying assumption
seems to be that substantiveconsolidation and structuralsubordination are universal,not special cases. Theseassumptions seem based, atbest, on nothing more thananecdotal evidence. In anyevent, these approaches tosubstantive consolidation andstructural subordination arenot helpful concepts at all infundamentalfinance.The terms substantive
consolidation and structuralsubordination originated inreorganizations underChapter 11 of the U.S.BankruptcyCode.Substantive consolidation
occurswhen, for purposes ofareorganization,twoseparateentities are combined intoone; say, for example, asolvent parent companycreditors are placed in thesame class as the creditor of
an insolvent subsidiary aspartofareorganizationplan.Substantive consolidation
seems to occur onlyoccasionallyintherealworldand,contrarytotheteachingsof G&D andMCT, financialmanagers working forcompanies rarely makedecisions on how to employandredeploycorporateassetsonthebasisoftheriskprofileof the company’s OPMI
shareholders.However,thisisthe underlying assumption inG&DandMCTanalyses.
EXAMPLEThe idea of net presentvalue (NPV) revolvesaround discounting futurecash flows estimated for aproject atwhat RichardA.Brealey and Stewart C.Myers in Principles ofCorporate Finance call“the opportunity cost of
capital—that is, theexpected rate of returnofferedbysecuritieshavingthe same degree of risk asthe project.” To determinethisexpectedrateofreturn,“you look at prices quotedin capital markets, whereclaimstofuturecashflowsaretraded....”aAccordingtoMCT,iftheinternalrateof return implied in thefuture cash flows from aproject is greater than theopportunity cost of capitalfor OPMIs, the project
ought to go ahead; if it isnot,theprojectoughttobescuttled.aRichardA.BrealeyandStuartC.Myers.PrinciplesofCorporateFinance,FourthEdition(NewYork:McGraw-Hill,1991).
Tobeginwith,few—ifany—financialmanagersareinaposition to figure out anopportunitycostofcapitalforOPMIsonthebasisoffactorsthat are fundamental to thebusiness employing the
financial manager. Efficientmarket theorists suggest atechnical chartist approach todetermining an opportunitycost of capital; they do notstudy a business. Instead,they study the relativehistorical volatility of OPMIstock prices and ascertain anappropriate discount ratetaking into account thatvolatility. This is known asthebeta.
A project’s attractivenessfor a company and itsfinancial managers will bedeterminedinalmostallcasesby factors particular to thecompany and its financialmanagers. Substantiveconsolidation based onlookingatOPMImarketpricedata is unlikely to enter intocorporate decision-making.Corporate investmentdecision-making is instead
likely to revolve around theanswers to the followingquestions:
Doesexistingmanagementhavetherequisiteknow-howandknow-whofortheparticularinvestmentopportunities?Cantheinvestmentbefinancedattractively?Withseniordebt?Withmezzaninejunk?With
commonstock?Mighttheinvestmentgivethecompanymoreattractivefutureaccesstocapitalmarkets,especiallyequitymarkets?Doestheinvestmenthelporhinderexistingmanagementinmaintainingcontrol?Whataretransactioncosts,andwhopays
them?Givenlimitedchoices,mightanalternativeprojectbemoreattractive?Howbadcanareasonableworstcasebeforthemanagement?Thecompany?
Netpresentvalueisavalid,extremely useful conceptinsofarasitcomparesthecostofaprojectwith itsexpected
returns. It seems useless,however, when cost andreturns are measured in asubstantive consolidationcontext.
EXAMPLEBrealeyandMyers explainon pages 73 and 74 ofPrinciples of CorporateFinancethatthegoalofthebusiness ought to be tomake the shares “asvaluable as possible” and
that the company attitudeoughttobethat“insteadofaccepting a project, thefirm can always give thecashtoshareholdersandletthem invest it in financialassets.”
Almost no financialmanager, however, willbelieve that watching stockprices, as is implicit in beta,isawayofmakingsharesasvaluableaspossibleforlong-termOPMI shareholders and
control shareholders.Financialmanagers,too,haveagendas both for themselvesand their companies thatpreventthemfromjustgivingthecashtoshareholders.
EXAMPLEFormostcompanies—evenforgettingaboutrestrictionsonshareholderdistributionsthatwould be contained inloan agreements or bondindentures—tojustgivethecash toshareholderswouldhave a negative effect onthe company’s continuingrelationships with tradecreditorsandbanklenders.
Asanaside,moderncapital
theorists seem to measureattractive finance solely byinterestrates,deeming,say,a6 percent margin borrowingby an OPMI stockholder asmore attractive in asubstantive consolidationcontext than a corporateissuance of 12 percentsubordinated debentures. Thereal world is a lot morecomplex. Attractive financeincludes many factors other
than interest rates. In fact,you cannot analyze withoutlooking at all the terms andconditions attaching to aborrowing. A 12 percent 12-year subordinated debenturewithabulletmaturitymaybe(and probably is) muchcheapermoneythanamarginloanbearingacurrentinterestcostof6percent.Themarginloan may, in effect, be ademand loan, with the
possible negative cash flowconsequences beingdraconian, when comparedwith the 12-year non-amortizingbulletloan.Under MCT, the fruits of
attractive investments by acompany will be reflectedimmediatelyinanincreaseinOPMI market prices, if it isassumed that the market isefficient and the informationis announced. As stated in
Corporation Finance(McGraw-Hill College,2002), by Stephen A. Ross,Randolph W. Westerfield,andJeffreyE.Jaffe:Because information isreflected in pricesimmediately, investorsshould only expect toobtain a normal rate ofreturn. Awareness ofinformation when it isreleased does an investor
nogood.Thepriceadjustsbefore the investor hastimetotradeonit.(p.363)Although their statements
seem to have validity from aminute-to-minute or day-to-day trading point of view,there is no evidencewhatsoever that newinformation immediatelyaffects common stockvaluations from the point ofview of fundamental finance
investing. The academicevidence is grounded in thestatisticalproofthatnoOPMIor groups of OPMIsoutperform a marketconsistently (i.e., all thetime). From a fundamentalfinance point of view, thisobservation proves nothingoutside of an immediatetrading environment. Nolong-term fundamentalistever tries to outperform an
OPMI market consistently.Consistent outperformance isstrictly the domain of short-run speculators. Anunderlying credo of valueinvesting is that no one notengaged full-time in high-frequency trading, optiontrading, or risk arbitrage canbe expected to outperform amarket over the short run byconscious effort. Infundamental finance, there is
nofocusonbeing thefirst toknow.Ratherthefocusisnoton having superiorinformation but on using theavailable information in asuperiormanner.
THEACCOUNTINGFORSTOCK
OPTIONSCONTROVERSYINLIGHTOF
THESUBSTANTIVECONSOLIDATION
DOCTRINEItismuchmoreimportantfor
theU.S.economy tohave itsaccounting systems gearedtoward informingcreditors ina meaningful fashion than itistohaveaccountingsystemsdirected toward meeting theperceived needs of outsidepassive minority investors(OPMIs). First, there is a lotmorecreditoutstandingintheeconomy than there is networth. Second, creditors useaccounting to help determine
the creditworthiness of acompany by estimatingwhetherthatcompanywillbeable to generate cashinternally,bothlongandshortterm, to pay its bills, and byestimating whether thatcompany is likely to haverelatively continual access tocapital markets, especiallycredit markets. In contrast,OPMIs tend to placeoveremphasis on two
accounting numbers—reported earnings or cashflows from operations—inorder to predict what stockmarket prices in theimmediate future might be.Bluntly, accounting systemsdo not seem as if they canreally be very helpful as atool for predicting near-termequity prices in OPMImarkets.Asfaraswecantell,near-term market prices for
common stocks (where thereare no near-term terminalevents such as maturingoptions, tender offers,mergers) continue to be arandomwalk.From a creditor’s point of
view, cash payments by acompany are very differentfrom the issuance of stockoptions. Cash payments canaffect the creditworthiness ofa business. Cash payments,
therefore, are acompanyandcreditorproblem.Withminorexceptions, the issuance ofstock options has no effectwhatsoever on thecreditworthiness of acompany. Instead, stockoptions result presently, orprospectively, in the dilutionof existing stockholders’ownership interests. Stockoptions are not a companyand creditor problem. They
are a stockholder problem.This simple fact is whatpeople subscribing to thesubstantive consolidationdoctrinemiss.Thosewhothinkofoptions
as an expensehave itwrong,atleastfromthecompanyandcreditorpointsofview.
EXAMPLEWarrenBuffettisquotedassaying,“Ifoptionsarenota
form of compensation,what are they? Ifcompensation isn’t anexpense,what is it?Andifexpenses shouldn’t go intothecalculationof earnings,where in the world shouldtheygo?”Frankly, the Buffettstatement is anovergeneralization, eventhough most financeacademics, and amongothers, Alan Greenspan,seem to be wholly in
concurrence. Stock optionsare not compensation fromthe points of view of thecompany itself, or itscreditors. Stock optionscertainly are“compensation” whenlooked at strictly from thepoint of view ofstockholders. The issuanceof options results inpresent, or potential,dilution of commonstockholders’ interests.Giventhatoptionsresultindilution, they are best
accounted for by reportingtheir dilutive effect incalculationsofearningspershare (EPS) available forcommon stockholders,rather than as a theoreticalexpenseofthecompany.Stock options might wellbe accounted for using thetreasury stock method,whereitisassumedthattheproceeds from an exerciseofoptionswouldhavebeenused to purchase thecompany’s common stock
attheaveragemarketprice,and the incremental shareswould have been added tothe common stockoutstanding.Assume Company XYZhas 1,000,000 commonshares outstanding and hasnet income of $1,000,000,or EPS of $1. AssumefurtherthatCompanyXYZhas 100,000 executivestock options outstandingwith a $5 per share strikeprice and that the average
market price for thecommon stock is $20 pershare. Therefore, EPSwould be reduced from $1pershareto$0.93persharebecauseof theexistenceofin-the-money optionscalculatedasfollows:Event Calculation SharesSharesassumedissuedbycompanyuponexerciseofoptions
$500,000dividedby$5/sharestrikeprice
100,000
Sharesassumedpurchasedbycompanyatmarketpriceusingproceedsfromexercise
$500,000dividedby$20/sharemarketprice
25,000
Assumedincreaseincommonstockoutstanding
100,000–25,000
75,000
Newcommonstock
1,000,000+75,000
1,075,000
outstanding
EPScalculation
$1,000,000netincome/1,075,000shares
$0.93/share
Assumingstockoptionsareto be treated as a companyexpense, which is nowrequired under GAAP, whatshould that expense be?Under current accountingrules, the cost of options tothe company equals the
theoretical value of theoptions to the recipients.However, it is utterlyludicrous to suppose that thevalue of a benefit to arecipient has any necessaryrelationship to the cost to acompany to bestow thatbenefit.Itisasifasalesclerkwho has a 40 percent offemployee discount buys a$100 sweater from herdepartment store for $60 and
the store then states that itincurred a cost of $100because that is what thesweater isworth to theclerk,even though the company’sactual cost for the sweatermight be, say, $35. The realcostofanexecutiveoptiontothe company (rather than toits stockholders) equals theexpected present value thatthe option program willreduce the company’s future
access to capital markets,especiallyequitymarkets.Wewould not know how tomeasure such a cost. In fact,there should be an offset tothiscost,namelytheexpectedpresent value that the optionprogram increases theretention of talent and/ormotivates that talentproductively.Quantifyingthisbenefitisalsodifficult.The cases where stock
options become a companyproblem as well as astockholder problem seemfewandfarbetween.Optionsare a company problem longterm insofar as they eithercausethecompanytopayoutcash (orproperty); or if theirissuance reduces access tocapital markets. In general,those cases where stockoptions become a companyproblem seem to encompass
thefollowing:1. The company iscommitted, or required,to pay out an ultrahighpercentage of futureearnings as cashdividends to commonstockholders. Suchcompanies include realestate investment trusts(REITs) and manyintegrated electricutilities.
2. The potential issuanceofcommonstockthroughthe exercise of stockoptions reduces thecompany’s future accesstocapitalmarketstoraisenewfunds.3. The company iscommitted to having theamountofcommonstockoutstanding relativelyfixed, and therefore,acquires for cash, or
property, enoughoutstanding commonstock to cover the newissuance of commonstock through theexerciseofstockoptions.On this last point, Fitch
Ratings published aninterestingarticleonApril20,2004, in which it recognizedthat stock options werebasically a stockholderproblem, not a creditor
problem;but thenwenton tostate, “Because of theirdilutive effect, manycompanies have a highpropensity to repurchaseshares issued upon exerciseofemployeestockoptions.Inthis context, from abondholder perspective,employeeoptionshaveatruecashcost andcanbe thoughtof as a form of deferredcompensation, which has the
effect of reducing availablecash to service debt andincreasingleverage.”2
Fitch Ratings seems to beinvolved in overkill. First,mostcompaniesissuingstockoptions probably don’t havestock repurchase programs.Second,anycompanymakingcash distributions toshareholdersforanyreason—whether such cashdistributions are in the form
of dividends or sharerepurchases—“has the effectof reducing available cash toservice debt and increasingleverage.” Indeed, from acreditor point of view, cashdistributions to shareholdersare helpful only insofar asthey enhance the debtor’saccess to capital markets.Third, share repurchases arestrictlyvoluntaryandthusdonot have as adverse a credit
impact as do required cashpayments to creditors forinterest, principal, orpremium.Finally,somesharerepurchases canbebeneficialtocreditorsandcompanies ifthe common stock beingrepurchasedpaysanultrahighcashdividend.Thecontroversyover stock
options, that is, whetheroptionsought tobeexpensedusingthefairvaluemethod—
FASB 123; or whetheroptionsought tobeexpensedusing the intrinsic valuemethod—APB 25, shedsmuchlightonthereachofthesubstantive consolidationdoctrineandtheresultingbaddirection for GAAP, whichdecided that FASB 123, ineffect, reflected economicreality.TheFASB123versusAPB
25 dispute was strictly about
form over substance.CompaniesthatusedAPB25,the intrinsic value method,wererequiredunderGAAPinfinancial statement footnotesto disclose the far greaterexpense of the fair valuemethodascontainedinFASB123. The whole disputerevolved around whetherdisclosure of an ephemeral“expense” ought to be madein the income account or in
the footnotes to the financialstatements. The question forthe serious investor who isnot a short-run stock marketspeculator is “Who cares?”except that in an overallappraisalofmanagementbyatrained analyst, informationabout management attitudescan be gleaned from lookingat management opting eitherforFASB123orAPB25.Aside from accounting
issues, stock options, likevirtuallyeveryotherfinancialpractice,aresubjecttoabuse.Andabuseswillbecommon.Management ownership ofstock options does not reallyalign management interestswiththoseofOPMIs.Rather,options give management asharing of the upside whileavoiding the risks of thedownside. Certain optionpractices—for instance,
repricing when the OPMIstock price falls—seemnotorious. Further, the taxtreatment of options forInternal Revenue Servicepurposes seems unfair fromthe taxpayers’ point of view.Ostensibly, to avoid doubletaxation,whenamanagementmember becomes subject toordinary income tax becauseof the exercise of an option,the company issuing the
option receives a full taxdeduction from its ordinaryincomeequalgenerallytothedifference between themarketvalueoftheexercisedoption and the executive’scost basis for the optionshares. Other parts of theInternal Revenue Codesometimes recognize a needfor relief from double (ortriple)taxation,butfrequentlythat relief is not 100 percent
relief.
EXAMPLEWhen a domesticcorporation less than 80percent owned by anothercorporation receivesdividends from the othercorporation, only 70percent,not100percent,ofthe dividend incomereceived is excluded fromtaxableincome.
STRUCTURALSUBORDINATION
NOTASIGNIFICANT
FACTORStructural subordinationoccurswhenaseniorclassofclaimants or interests aremade junior to a lower classofclaimantsorinterestseven
though, on the strict basis ofstated claims or interests’rights, the seniorclasswouldnormally enjoy priority overother junior classes; say, forexample, that because offindings of previousdomination and control,securedbankdebtismadethelowest class of claimant in aChapter 11 reorganizationplan.Investors interested in
fundamental finance rejectthe doctrine of structuralsubordinationasit isusedbyG&D and MCT as utterlyunrealistic.Eachconstituency—short-term stockholders,long-term stockholders,control stockholders, thecompany itself,management,creditors, vendors,employees, customers,financial professionals,governments, communities,
and so on—has bothcommunities of interest andconflicts of interest bothwithin itself and inconjunction with otherconstituencies. Unlike MCT,which views things as if allconstituents are structurallysubordinatedtotheneedsanddesires of the OPMI, infundamental finance it isrecognized that no oneconstituency is necessarily
senior to others in allcontexts, and no oneconstituency is necessarilyjunior to all others. Myriadgroups have relationshipscombining communities andconflicts;forexample:
CompaniesandmanagementManagementandcontrolshareholdersManagementandOPMIs(theuniversalityof
“sharkrepellents”entrenchingmanagementinofficeisevidenceofconflict)CompanyandOPMIs(e.g.,OPMIsmightwantdividendsorsharerepurchaseprogramseventhoughtheseshareholderdistributionsmaydiminishcorporatefeasibility)TradingOPMIsandbuy-
and-holdOPMIsCreditorsandcompanyandshareholdersSeniorcreditorandjuniorcreditorandpreferredstocksandlandlordsGovernmentandcompanyLaborunionsandcompanyWorkforceandlaborunionsCommunityand
companyCorporatevalueattheexpenseofsomestockholderconstituencies(e.g.,undertakinganinitialpublicoffering[IPO]atanultrahighpricedisadvantagesnewstockholderswhilegivingnewfinancialstrengthtothecompany)
TomCopeland,TimKoller,
and Jack Murrin, in their1996 text, Valuation:MeasuringandManagingtheValue of Companies (JohnWiley & Sons, reprinted in2010), incorrectly observethat“...shareholdersaretheonly stakeholders of acorporation whosimultaneously maximizeeveryone’s claim in seekingto maximize their own” (p.22). Creditors of companies
where there is pressure toincrease common stockdividends payable in cashwould undoubtedly be verysurprised to hear that theirclaimsagainstthecorporationare being maximized bypaying out corporate cash toequity owners. Equallysurprised would bemanagements and long-termbuy-and-hold shareholderswho are pressured by OPMI
shareholders who want thecompany to maximize short-run reported earnings pershare, evenwhen this entailsforgoing attractiveinvestmentsinprojectswithalong-termpayofforresultsinincome tax bills that arelarger than would otherwisebe the case. The Copeland,Koller, and Murrin view,though, is commonly held inacademic circles justifying
belief in the benefits ofstructural subordination.Suppositions that suchbenefits exist to anymaterialextent where OPMIs are thestockholders in question arebased strictly on anecdotalevidence.The MCT idea of agency
costs also is not helpful infundamental finance. Theconceptofagencycostsaroseasamodificationofstructural
subordination, givinggrudging recognition to theobservationthatacorporationbearscostsofmanagementatthe expense of shareholdersand that as a consequence,management interests maynot be aligned completelywith those of shareholders.The concept of agency costsis too deficient in scope todescribe adequately the real-world norm of pervasive
communities of interestcombined with conflicts ofinterest.Structural subordination, in
andofitself,isanonstarterinfundamental finance. Ross,Westerfield, and Jaffeincorrectly observed, inarguing that managementinfluencemaybe limitedvis-à-vis stockholders, that“shareholders determine themembership of the board of
directors by voting. Thus,shareholders control thedirectors, who in turn selectthe management team”(CorporationFinance,p.22).In the realworld, perhaps99percent of the time,membership of the board ofdirectors is actuallydetermined by those whocontrol the nominatingprocess, not by stockholdersvoting proxies. To suppose
otherwise is to elevate formcompletely over substance.The director-nominatingprocess also is controlled bymanagement in the vastmajority of cases even givennew rules that givestockholders owning 3percent or more of thecommon stock for over threeyears, the right to have theirdirector nominees listed inthe company’s proxy
statement.3
Insofar as markets areefficient, with efficiencydefined as each marketparticipant trying to do aswell as reasonably possible,structural subordinationwould exist only in thatspecial case in which themanagement was a solepractitioner who owned allthe outstanding equity of thebusiness. When separate
managements and separateshareholderconstituenciesareintroduced,especiallycontrolshareholders and non-controlshareholders, structuralsubordination becomesimpractical for fundamentalfinancepurposes.Fundamental finance
operateswithinthecontextoftrying to understand thediverse agendas of theimportant constituencies—
those constituencies withclout. Entrenchment isnormally very important formanagements. Managementshave succeeded generally inachieving a favorableenvironment formanagemententrenchment: Stateantitakeover laws thatinsulate managements inoffice have become virtuallyuniversalsincethe1970s.Dividend policy for many
corporationswillbedriven,ingreat part, by the taxpositions and liquidity needsof control shareholders. Theprice of the company’scommon stock may be amatter of indifference to acorporate management fromtime to time and fromsituationtosituation.Atothertimes, the OPMI stock pricemay be crucially importantinsofar as the company itself
or key stockholders want toaccess the capital market byselling common stock, eithernewly issued or held byexisting shareholders, or byusing common stock ownedby a key stockholder ascollateralforborrowing.Noneofthisistodenythat
many—if not most—managements feel strongcommunities of interest withOPMIs focused on the
immediatemarketpriceofthecommon stock. Manymanagements want buoyantOPMI prices simply becausethey would rather have theirstockholder constituencieshappy, even thoughshareholder unhappinesswould carry no downsiderisks for management. Invirtuallyeverycase,however,thesecommunitiesof interestaremodifiedbytheuniversal
existence of conflicts ofinterest.
LACKOFPROGRESSINEUROZONE
CRISISRESOLUTION:THEFAILURE
TOUSESUBSTANTIVECONSOLIDATIONWe think that euro bondsissuedandguaranteedby5ofthe 17 countries in theEurozone, Greece, Italy,Ireland, Spain, and Portugal(PIIGS) are destined tobecome nonperforming loanssooner or later. The
economists and politicians incharge seem to have noknowledge of what needs tobe done to restructure debt.Put simply, if an economicentity cannot be madecreditworthy, sooner or laterthat entity has to reorganizeor liquidate. It seems as ifnone of the rescue actionsbeing undertaken has anychance ofmaking any of thePIIGscreditworthy.
Creditworthiness probablycould be achieved if theEurozone had the equivalentof Chapter 11, which thencould result in restructuringeuro debt under a Plan ofReorganization (POR). ThePOR would have two basicelements:
1. Euro bonds would bemade the structuralequivalent of U.S.Treasuries, i.e., each of
the 17member countrieswould jointly andseparately guarantee theeuro bonds. This is thesubstantive consolidationelementoftheplan.2. Good euro creditwould be reinstated, andpoor credits would berequired to sacrificevalue. Thus, a PORmaylookasfollows:
Country Treatment Present
inthePOR ValueGermany,Netherlands,Finland
Reinstated 100%
France Impaired 90%Ireland Impaired 25%Italy Impaired 25%Spain Impaired 10%Portugal Impaired 10%Greece Impaired 5%
There are four approachestoreducingthepresentvaluesof an impaired credit. They
can be used separately or inconcert:
1. Reduce principalamount.2.Extendmaturities.3.Reduceinterestrates.4. Liberalize othercovenants.Liberalizingloancovenants
probablywouldnotworkinaEurozone POR. The firstthree might, provided that
creditors were coerced intoaccepting a POR. In aChapter 11 proceeding whatusually happens is that allcreditors are coerced intoaccepting a POR if eachcreditor class participating inaPORvotesaffirmativelyforthe plan. The required votefor each class is acceptanceby thosevotingof two-thirdsof the amount outstandingandone-halfinnumber.
SUMMARYThe terms substantiveconsolidation and structuralsubordination originated inreorganizations underChapter 11 of the U.S.Bankruptcy Code.Substantive consolidationoccurswhen, for purposes ofareorganization,twoseparateentities are combined intoone;say,forexample,solvent
parent company creditors areplaced in the same class asthe creditor of an insolventsubsidiary as part of areorganization plan.Structural subordinationoccurswhenaseniorclassofclaimants or interests aremade junior to a lower classofclaimantsorinterestseventhough, on the strict basis ofstated claims or interests’rights, the seniorclasswould
normally enjoy priority overother junior classes; say, forexample, that because offindings of previousdomination and control,securedbankdebtismadethelowest class of claimant in aChapter 11 reorganizationplan.Conventionalapproachesto
both business and securityanalysis systematicallysubstantively consolidate the
interestsofOPMIswiththoseof the company andstructurally subordinate theinterests of almost all othercorporate constituents to theinterests of theOPMI.Theseviews are utterly unrealistic.We show examples wheretheseviewsplayacentralrolein obscuring theunderstanding of importantissues including theaccounting for stock options
andthelackofprogressintheEurozonecrisisresolution._______________*ThischaptercontainsoriginalmaterialandpartsofthechapterarebasedonmaterialcontainedinasectionofChapter2ofValueInvestingbyMartinJ.Whitman(©1999byMartinJ.Whitman),andideascontainedinthe20022Qlettertoshareholders.
ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1TheconceptoftheOPMIanditsrelevancewasexplainedatlengthinChapter1.2AccountingforStockOptions:ShouldBondholdersCare?,FitchRatings,www.fitchratings.com,NewYork,April20,2004.
3Rule14a-11.
CHAPTER4
TheSubstantiveCharacteristicsofSecurities*
Typesof
SecuritiesforAnalyticPurposesControlversusNon-ControlSecuritiesControlandNon-ControlPricingandArbitrageTermsofSecuritiesas
OptionsWhataSecurityIsDependsonWhereYouSitSummary
Inhis1938book,TheTheoryof InvestmentValue (HarvardUniversity Press), John BurrWilliams stated that
“investment value [is] thepresent worth of the futuredividends in the case of acommon stock, or of thefuture coupons and principalin thecaseofabond”(p.6).Williams was right on themoney in describing theinvestment value of aperforming loan, whether abond, a trade credit, or alease.Forthatdefinitiontobefunctional, however, the
investment value of acommonstockhas tocontainmanymoreelementsthanthepresent worth of futuredividends. Thus, Williams’sdefinition ought to berestated: investment value isthe present worth of futurecash bailouts, whatever theirsource.There are several forms of
cashbailouts:Contractuallyassured
paymentsbyissuerstocreditorsintheformsofinterestpayments,principalrepayments,andpremiumsforperformingloans.Dividendstoholdersofequitysecurities,andrepurchasesofequitysecuritiesbyissuers.SaleofsecuritiestoamarketbyanOPMI,whetheranoutside
passiveminorityinvestor(OPMI)marketoracontrolmarket(e.g.,amergerandacquisition([M&A]market).Otherpeople’smoney(OPM),whichallowsborrowingwithoutdisposingoftheunderlyingsecurity.Thepresentvalueofbenefitsfromcontrolorelementsofcontrolthat
mightexistbecauseofsecuritiesownership.Favorabletaxattributesthatmightbecreatedoutofownershipofcertainflow-throughsecurities(e.g.,alimitedpartnershipinterestinataxshelter[TS]).
Since these bailouts attachto different types ofsecurities, it is instructive toconceptually define the
different types of securitiesforouranalyticpurposes.
TYPESOFSECURITIES
FORANALYTICPURPOSES
For analytic purposes, therearefivetypesofsecurities:
1. Performing credit
instruments, in whichcontracted-for cashpayments are beingmade; most performingcredits include loans,trade account payables,derivatives, leases, andmanypreferredstocks.2. Nonperforming creditinstruments, or debtsuffering present—ornear-termprospectsfor—money defaults; these
tend to have equitycharacteristics.3. Outside passiveminorityinvestor(OPMI)equity securities, whichinclude many preferredstocks, common stocks,options,andwarrants.4. Control securities,which consist principallyof common stocks,nonperforming creditinstruments, credit
instruments likely tobecome nonperformingcredit instruments, andgeneral-partner interestsinpartnerships.5. Hybrid securities,including convertiblesand units consisting ofcredit instruments withwarrants attached; thesesecurities are generallyOPMI securities ratherthancontrolsecurities.
CONTROLVERSUSNON-CONTROLSECURITIES
Probably the most importantthing to understand inexamining the substantivecharacteristicsof securities isthat control commonstock isessentially a different
commodity from OPMIcommon stock. Even thoughthey are exactly the same inform most of the time andOPMI common can beconverted into control (orelementsofcontrol)common,and vice versa, thedifferences between controlcommon andOPMI commonare far more important thanthesimilarities:
Theytendtotradein
differentmarketsatdifferentprices.Theytendtobeanalyzeddifferently.Theytendtobeboughtandsoldbydifferent,largelyunrelatedconstituencies.Thedifferentconstituenciesseekdifferentreturnsontheinvestment.MostOPMIsseemtoseekto
maximizetotalreturnmostlybysaletoanOPMImarketintherelativelyshortrun;theyseemtobeinfluencedbydailychangesinmarketprices.Mostcontrolbuyersseeksomethingoffthetop(SOTT),taxshelter(TS),theuseofotherpeople’smoney(OPM),entrenchment,andsaletoanother
controlmarket,orpartialcashoutinaninitialpublicoffering(IPO).Mostcontrolbuyersarenotheavilyinfluencedbyday-to-daypriceswingsinOPMImarketsunlesstheyareactuallyattemptingtobuy,sell,orborrowagainsttheirsecuritiespositions.Corporatelaw—especiallystatelawcourt
decisionsinleadingcorporatestates,andfederalbankruptcylaw—isdesignedtoentrenchcontrolgroupsandmanagementsinofficeattheexpenseofOPMIrights.Insmallpart,securitieslaws,asembodiedintheamendedSecuritiesActof1933andtheamendedSecuritiesandExchange
Actof1934,alsohavetheeffectofdeliveringmanagemententrenchmentattheexpenseofOPMIshareholders.Threesuchregulatoryareasentrenchingmanagementaresecurities’regulationsgoverningcashtenderoffers,exchangeoffers,andproxysolicitations.ThebulkofU.S.
securitieslaws,especiallyasembodiedinthevariousactsadministeredbytheSecuritiesandExchangeCommission(SEC),aredesignedtoanddoprotectOPMIs.Oneoftheareasofprotectionisagainstseveralformsofoverreachingbycontrolpeoplethroughprovisionof:
OrderlytradingmarketsDisclosuresOversightoffiduciariesandquasi-fiduciaries,includingthosewhocontrolpubliccorporations.
CONTROLANDNON-CONTROL
PRICINGANDARBITRAGE
Much of the substantivedifferences between controlpricingandOPMIpricingareresolved through long-termarbitrages,whicharetheveryessence of the tendencytoward efficiency that existsin all markets, specificallybetweenandamongdisparatemarkets. There are times
whenOPMImarketpricesaresuper-high compared withwhat businesses would beworth as private concerns. Inthat case, new shares aremarketed publicly in IPOsand in secondaryunderwritings and M&A inwhich newly issued commonshares, valued at or nearOPMImarketprices,arepartor all of the considerationpaid for an acquisition. At
other times, OPMI marketprices might be quite lowcompared with prevailingprices in control markets.Then, there is a tendency forcheap shares to be acquiredfor cash and debt, in M&Atransactions, in hostiletakeovers, and in theparticular form of M&Acalled leveraged buyouts(LBOs),managementbuyouts(MBOs),orgoing-privates.
There are built-inlimitations to this tendencytoward long-term arbitrages.OPMI stock markets tend tobe rather capricious, andcertain sections of OPMImarketstendtobeevenmorevolatile than others. Oneextremely volatile section istheIPOmarket.Theabilitytosell IPOs can be vigorouslyproscribed at times (as wasthe case from 1991 to 1993,
in the fall of 1998 and in2008–2009), although as ispointed out in Chapter 14’sdiscussion of promoters’ andprofessionals’compensations,thefinancialcommunityhasavestedinterestinencouragingIPOs.As for a control group’s
buying up common stocksfrom OPMIs, there are threekey factors that oftenameliorate this tendency
toward efficiency. First, thebusinesses involved have tobe reasonably well financed,haveaccess tocreditmarketsin order to whet the interestof most financial(nonstrategic control buyers),or both. Second, theentrenchment of incumbentmanagement is frequently ashowstopper preventing anyreal efficiencies from arisingin the market for changes in
control. Outsiders seekingcontrol from entrenchedmanagementsusuallyhave toincur huge up-front expensesand almost always are facedwith uncertainty as towhether control will beattainable. Finally, anyprocess involving changes ofcontrol entails considerableadministration (i.e., deal)expenses for attorneys,investment bankers,
accountants,taxadvisers,andothers.Inaverymeaningfulsense,
nonperforming loans aremuch like common stockeven though there probablyare less dramatic pricedifferences here betweenOPMI markets and controlmarkets. In the case ofnonperforming loans,obtainingelementsof controlusually refers to getting
influence over thereorganization process for atroubledcompanyrather thanto getting control of abusiness. Control overreorganization is key forcreditors, whether thecompany restructures out ofcourt or in Chapter 11bankruptcy.Astocontrolofoperations,
thetendencyseemstobethatthere is almost as much
management entrenchment introubled public companies asin healthy companies.Corporate governanceprovisions are an importantpart of virtually all Chapter11 plans of reorganization.Also, in dealing withnonperforming loans, loangovernance provisionsbecome crucially important,especially for out-of-courtreorganizations.Thekeyloan
governance player for bankloans tends to be the agentbank. For publicly tradedbonds,theindenturetrustee—almost always the corporatetrust department of a largecommercial bank—isimportant.In terms of corporate
governance, managemententrenchment provisions arenow well nigh universal. Ingeneral, though, it is far
harder, with publiccompanies, to remove ageneral partner of a limitedpartnership than to removethe management of acorporation. Usualmanagement entrenchmentdevices, both corporate andlimited partnership, includeoneormoreofthefollowing:
LimitedvotingforOPMIcommonStaggeredboard
SupermajoritiesPoisonpillsParachutesReincorporationinmanagement-friendlystates,suchasPennsylvaniaorIndianaBlankcheckpreferredstocksAlackofstockholderrightstocallspecialmeetings
Outside passive minority
investor market prices,whenever they exist, alwaysdeserve weight in anyanalysis.Howmuch dependson the objectives of theinvestor and thecharacteristics of theinvestment; weight mightrange from as high as 100percenttoaslowas2percent.Market price deserves 100percent weight when anOPMI has as a solitary goal
the risk-adjustedmaximization of total returnconsistently (consistentlymeans all the time). It maydeserve 100 percent weightalso when a moneymanager’s job depends onstock-market performance,where the moneymanager/analyst knows littleornothingaboutthecompanyinwhose securitiesheor sheis investing, or where the
portfolio is fully financedwith borrowed money.Finally, OPMI market pricesprobablydeserve100percentweightorclosetoitinoptiontrading and risk-arbitragesituations(i.e.,sucheventsaspublicly announced mergersin which there will berelatively determinantworkouts in relativelydeterminant periods of time).In all other instances, OPMI
market prices deserveconsiderably less than 100percentweight.Most of the 100 percent
situations involve trading byshort-run–orientedspeculators. When otherconditions are introduced—for example, the investor,operating without borrowedfunds, emphasizescontractually assured cashincome rather than total
return as an investmentobjective; the investorfocuses on long-term buy-and-hold;or theanalysisofasecurity involves greatcomplexity (e.g., mostcommon stocks)—weight toOPMI market prices in theanalytic mix has to bereduced.OPMI market prices are
often a lot less important inthe analysis of most
performingloansthanofnon-arbitrage common stocksbecause:
1.Holders of performingloans need look only toserviceon their loans forcash bailouts. Mostcommon stockholderswould instead look for acash bailout by sale to amarket.2. Performing loans areusually analyzed by
reference to far fewervariables (e.g., currentyield, yield-to-maturity,duration, collateral, andcovenants) than arecommon stocks. Outsidepassiveminority investorpricing for performingloans ismostoftenmuchmore realistic (i.e., closeto corporate values) thanis the case for commonstocks. Thus, with
performingloans,thereisusually little arbitragebetween OPMI pricesandcontrolprices.3. Time corrects manyerrors in holdingperforming loans. Suchnever has to happen forcommon stocks. Say aholder buys a 10-year 6percent bond with a 10percentyield-to-maturity.Assume the bond
continues to sell at a 10percentyield-to-maturity.The dollar price at theend of each year wouldbe as shown in thefollowingtable:
YearstoMaturity Price(%)10 75.429 76.908 78.667 80.536 82.585 84.84
4 87.323 93.062 96.361 100.00
For spread lenders OPMImarket prices probablydeserve considerable weight,though probably not as greatasthespreadbetweeninterestreceived and interest paid.Recent changes in GenerallyAccepted AccountingPrinciples (GAAP) requiring
portfolios to be marked tomarket, however, elevate theimportance of OPMI marketprices because accountingdata, as reported andunadjusted,becomeimportantforregulatoryorcreditratingpurposes.Forthosewhocarryperforming loans on margin,OPMI market prices maydeserve close to 100 percentweight.
TERMSOFSECURITIESAS
OPTIONSLoans made at interest ratesgreater than the risk-free rateof money are substantivelyequivalent tocredit insuranceand put options. The extrainterest rate is equal toinsurance premiums paid tothe lender for taking credit
risks. The extra interest canalsobeviewedashaving thelender sell a put option. Thelendercollectsapremiumforthe right to put to theborrower, or require theborrower to buy, certainassetsincertainevents.
EXAMPLEIn January 1996, ThirdAvenue Value Fundentered into a put
agreement with HellerFinancialforoneyear.ThefundsoldHellertheputfora 7 percent fee. The termsof the arrangement werethat in the event Kmartfiled for Chapter 11 reliefin the next 12 months,Heller had the right torequire the fund buy 100percent of the principalamount of Kmart payablesowned by Heller for 87percent. This transactionactuallywent forward as aloan. The fund acquired
fromHeller for 80 percentcash a one-year medium-term note bearing interestat Libor plus 10 basispoints(bips).IfKmartfiledfor Chapter 11 within theyear, Heller could satisfythe note at its option bydeliveringtothefundeither87 percent cash or 100percent inKmart payables.If Kmart did not file, thenote would be satisfied bypaymentof87percentcashtothefund.
Yield-to-maturity is anartificial calculation exceptforzero-couponbonds,inthatitassumescashreceivedoverthe life of the loan willalways be reinvested at theoriginalratesofreturn.Yield-to-maturity is an essentialtool, however, forcomparative analysis,comparing the theoreticalreturnsavailablebetweenandamongdifferentcreditissues.
It is the annual return to beearned on a performing loanover its life. The yield hastwocomponentswherealoanis priced at some price otherthan thepayment tobemadeat maturity. The firstcomponentistheinterestrate.The second component iseither the amortization ofdiscount if the bond wasacquired at a discount fromthe amount to be paid at
maturity or the amortizationof premium if the price is inexcess of the principalamounttobepaidatmaturity.Any term of a security
ought to be viewed as anoption, or privilege, grantedto an issuer or as anobligation imposed on anissuer or a holder. Here is abreakdown of the status ofvarioussecuritiesterms:
Callfeature:Anoption
totheissuer.Mandatoryredemption:Anobligationoftheissuer.Cashdividend:Onceitisdeclared,therecipientisobligatedtoreceiveit.Beforedeclared,anoptionoftheissuer.Stockbuyback:Anyindividualshareholderhastheoptionofsellingornotselling.The
companyhastheoptionofputtingasharerepurchaseprograminplace.Cashtenderofferorexchangeoffer:Individualsecurityholderhastheoptiontoacceptornotacceptit.Mergeroruseofproxymachinery:Iftherequisitevoteisobtained,itissubjectonlyto
perfectingdissenterrights(whichishardtodo);everysecurityholderisobligatedtoparticipate.ChangeoftermsofaloanagreementregardingcashpaymentsoutsideChapter11:Eachindividualdebtholderhastheoptionofgoingalong.
ChangeofanyothertermofaloanagreementoutsideofChapter11:Iftherequisitevoteisobtained,alldebtholdershavetogoalong.
WHATASECURITYISDEPENDSON
WHEREYOUSIT
In reality, there are few rigiddefinitions of a security’sclassification;whatasecurityis depends on where you sit.Subordinateddebenturesareagood example of a securitythatought tohavemore thanone definition. From thevantagepointofthecommonstock, subordinated
debenturesaredebt.Fromthevantage point of seniorlenders, however, to whomthesubordinatesareexpresslyjunior (that is whatsubordination means), thesubordinates are part of theborrowing base, akin toequity. Another examplewould be preferred stockissued by a subsidiarywherethe parent company’s soleasset is thecommonstockof
the subsidiary. The parentcompany’s principal sourceof cash would be dividendspaid on the subsidiary’scommon stock. Payment ofthe subsidiary’s commonstockdividendsrequirespriordividend payments to thesubsidiary preferred stock.Theproceedsofpaymentsonsubsidiary common stock areused to service parent-company bank loans. Thus,
absent any other covenants(such as the subsidiary’sassets’ being pledged toparent-company banks), thepreferred stock of thesubsidiary has a seniorposition vis-à-vis bankborrowings by the parent. Inthe consolidated financialstatements of the companyprepared in accordance withGAAP, however, thesubsidiary’s preferred stock
appears to be junior to theparentcompany’sbankdebt.
EXAMPLEBack in 1990, Ambase’sprincipalsubsidiarywastheHomeInsuranceCompany.Ambaseowned100percentoftheoutstandingcommonstock of Home InsuranceCompany, and it wasdividends on HomeInsurance common stockthat gave Ambase most ofits wherewithal to service
Ambase bank debt. HomeInsurance Company 14¼percentpreferredwas,inallmeaningfulrespects,seniorto the borrowings frombanks by parent companyAmbase.
Incertainacademiccircles,it has been argued that littlejustificationexists for issuingpreferred stocks rather thansubordinated debentures. Thereasoning is that interestpayablebythecorporationon
subordinated debentures istax deductible, but dividendpayments on the preferredstock are not tax deductible.In the real world, there aremyriad reasons justifying theissuanceofand theexistenceofpreferredstocks;hereareafew:
Qualifieddomesticcorporationsthatreceivedividendsfromless-than-80percent-owned
domesticcorporationscanexcludefromincome70percentofsuchdividendsreceivedunderSection243oftheInternalRevenueCode.Asapracticalmatter,thecombinedtaxbillsofthetwocorporationsmaybesmallerwhenthesecurityissuedisapreferredstockratherthanasubordinateddebenture.
Many—ifnotmost—corporationshavelayer-cakecapitalizations,andtheissuanceofpreferredstockenablessuchcorporationstoissueconsiderablymoreseniordebtthanwouldotherwisebethecase.Forexample,atypicalfinancecompanyholdingconsumerreceivablesmighthavethe
capitalization,shownfromthebottomuphere:
Assumethecompanycanincurseniordebtoffourtimesitsborrowingbase.Withoutpreferredstockbeingissued,suchseniordebtwouldamountto$800million.With
preferredstockoutstanding,theseniordebtissuablewouldamountto$880million.Inotherwords,theissuanceof$10millionofpreferredstockwouldallowthecompanytoincreaseitsseniorborrowingby$80million.Votingpreferredstocksareanessentialtoolfor
tax-freeexchangesinconnectionwithmergersthatqualifyasreorganizationsunderSection368(b)and(c)oftheInternalRevenueCode.Byuseofpreferredstocksandcommonstocks,itbecomesfeasibletosatisfythevariousneedsanddesiresofdisparatepartiestothemerger
transaction:Thosewhodesiretomaximizelong-termtotalreturnandcontrolwouldreceivecommonstockand/orsuper-voting-rightscommonstock.Thosewhodesirecashincome,relativeseniority,orboth,aswellassomethingofanequitykicker,
wouldreceiveconvertiblepreferredstock.Therefrequentlyareregulatoryandratingagencyreasonsforissuingpreferredsratherthansubordinates.
Preferred rights are spelledout in certificates ofdesignation,whicharepartofa corporation’s articles of
incorporation. Privatelynegotiated terms of preferredstocks can have quitemeaningful protections forholders; whereas protectionsforpublicly tradedpreferredstend to be sparse. The mostmeaningful protection forpublicly issued preferredstock seems to be onerequiringatwo-thirdsvoteofthe outstanding preferredclass if the company is to
issue a new preferred stockequalorseniortotheexistingissue as to dividends orliquidation.The right usuallygiventothepreferredtoelecttwo directors if six quarterlydividends are missed isnormallynotmuchofa rightat all, since the typicalpreferred holder has nospecial access to thecorporateproxymachineryorto the corporate treasury to
finance a proxy solicitation.An important right forpreferred stocks that usuallydoes not exist is the right tovote separately as a class onallmatters.In the case of troubled
companies, preferred stocksfrequently are in betterpositions, de facto, thansubordinates. Subordinateshaverightstoaccelerateifaneventofdefaultoccursandis
continuing. Given thesubordinates’ junior positioninthecapitalization,thisrightis often the right to commitsuicide.Thepreferred,ontheotherhand,pilesupdividendarrearages andmight be in abetter position to makereorganizationdeals.In pricing convertible and
other hybrid securities, thereare a few simple computer-programmable variables
resulting in a normalconvertiblecurve:
YieldYield-to-maturityPercentpremiumoverconversionparityPercentpremium(discount)fromcallBetaoftheunderlyingcommonstock
Inamarket tending towardinstantaneous efficiency fornew issues, convertibles
might be offered at pricesequal to 150 to 250 basispoints below comparablecredits in terms of yield-to-maturityandat25percent to45 percent premiums overconversion parity comparedwith the prices at which theunderlying common stocktrades.There are trade-offs in
comparing straight debtcharacteristics with
convertibles. A shortermaturity and strongmandatory redemptionrequirementstendtobemorevaluable for a holder ofstraight debt, provided thedebt does not trade at apremium over call price.Early maturity, earlyredemption, or the presenceof both qualities diminishesthe value of conversionprivileges. For any
convertible or option, longlife tends to be a highlyfavorable characteristic. Anyconvertible feature istranslatable into an optionfeature.Alienabilityreferstofactors
thatcauseasecuritytohaveafair value different from anOPMI market price. Ingeneral, there are fouralienabilityfactors:
1.Contractualrestrictions
on the sale of securitiesto an OPMI market, oranyothermarket.2. Securities lawsrestrictions on sale to anOPMImarket.3.Blockage—theamountof shares held isinordinately largecompared with tradingvolumes in the OPMImarket. Restrictions onresale and blockage are
mutually exclusive, sinceboth cannot be operativeat thesametime.If thereare contractual orsecurities lawsrestrictions preventingsale in anOPMImarket,theexistenceofblockagebecomes irrelevant whilethose restrictions are inplace. In a valuation, theexistence of restrictionsor blockage results in
discounts from OPMImarketprices.4.Control—ifacommonstock is control commonstock,itfrequentlyresultsin valuations reflecting apremium above OPMImarketprices.Alienability discounts for
restriction and blockage canrun from15 to 50percent ofOPMI market prices. It ishard to put a percentage
numberoncontrolpremiums,however; theywill vary casebycase.Securities Act restrictions
on resale can exist forsecuritiesnotregisteredunderthe Securities Act of 1933.The restraint against publicresale can be engendered byone of two conditions: theholder is an insider or thesecurities were neverregistered.Salescanbemade
in OPMI markets, however,pursuant to Rule 144 or aSection4(a)exemption.Securities Act restrictions
on resale have becomeconsiderably less onerousover the years as Rule 144has been liberalized.Presently, restricted sharesheldfullypaidforatleastsixmonths can be resold to theOPMI market withoutrestriction other than the
public informationrequirement. After one year,unlimited sales into OPMImarkets are allowed withoutany restriction. A holder ofrestricted stock may obtainrights of registration of thepiggyback,thetriggervariety,orboth.Many insiders have
incentivestohavelowOPMImarket prices and thus haveinherent conflicts of interest
with short-run OPMIspeculators. Such incentivesinclude:
Estatevaluationpurposes:ThelowertheOPMImarketprice,thelessthevalueoftheestateeitheratthedateofdeathorsixmonthsthereafter.Goingprivate:ThelowertheOPMIprice,thelessinsiderswillhavetopay
inagoing-privatetransaction.
Control insiders have basicadvantages over OPMIs inthat the insiders control thetiming of events. Forexample,thosecontrolpeoplewho seek to go private canwait for a bear market inOPMIprices.The fairnessofgoing-private transactionswill always be measured inpart by premiums paid over
currentOPMImarketprices.The concept of dilution is
never absolute. It is alwaysrelative to something: (1)OPMI price, (2) underlyingvalues, or (3) percentage ofcapitalizationowned.In examining securities
from the point of view ofcorporate feasibility, thecentral necessity is to beaware that a security issuedby a company has to deliver
oneoftwothingstoaholder:either the right to receivefrom the company cashpayments sooner or later, orownership interest in thecompany, present orpotential.The rights to receive cash
payments from the companythatattachtodebtinstrumentsand preferred stocks canconstitute a cash drain on abusiness and thus detract
from creditworthiness.Ownership interests—common stocks, warrants,and options—do not requirecash service from thecompany, although suchsecurities might not havemuchvaluetoaholderunlessthey held promise of a cashbailoutbyprospectsofsaletoa market or of deliveringcontrolbenefitstotheholder.Issuing ownership
securities that do not requirecash service (i.e., dividends)can detract from corporatecreditworthiness insofar asthe existence of non–dividend-paying equitiesdetracts from a company’sability to access capitalmarkets to sell new issuesofequity. In the past, this hasbeena factorcausingelectricutilities and many financecompanies to follow policies
ofpayingout60to80percentof net income as dividends.For the vast majority ofcompanies, though, dividendpolicyseems tohave littleorno impact on their ability toobtain access to capitalmarkets.Indeed,forhigh-techcompanies perceived asgrowthvehicles, thepaymentof regular dividends may belookedatasanegativefactor,detracting from growth, in
OPMImarkets.The fact that any security
hastodelivereithercashpayor ownership can becomequite important in thestructuring of appropriatecapitalizations in resourceconversion contexts, as inboth LBOs and thereorganization of troubledcompanies. The appropriatecapitalization ought to befeasible—not too heavy on
cash-payment instruments.Also,appropriate instrumentshave to be issued toparticipants in thecapitalization.Banks and lifeinsurance companies willdesire cash-paymentinstruments with seniorityandstrongcovenants.Controlbuyers couldwantownershipinstruments because thoseinstruments deliver elementsof control, especially when
theseparticipantsdonotneedcash-payment instruments toservice the debt they mayhave incurred in their ownentities. OPMIs and othernon-control investors couldwant ownership instrumentsbecause those instrumentshave promise of delivering acash bailout by sale to amarket.
SUMMARYThe investment value of amarketable security is thepresent worth of its cashbailouts whatever theirsource. We show manysources of cash bailouts thatareoutsideoftheradarscreenofconventionalapproachestosecurity analysis. We alsoshow that control commonstocks, while identical in
formtoOPMIcommonstock,are a totally differentcommodity, and the pricingbetween these two otherwiseidenticalsecuritiesisresolvedin long-term arbitrages. Foranalytical purposes weclassify securities into fivebroad groups: performingcredit instruments, non-performing creditinstruments, controlsecurities, OPMI securities,
and hybrids. Although ourclassification is useful foranalytical purposes, what asecurity really is depends onwhereyousit._______________*ThischapterisbasedonmaterialcontainedinChapter6ofValueInvestingbyMartinJ.Whitman(©1999byMartinJ.Whitman).Thismaterialisreproducedwithpermission
ofJohnWiley&Sons,Inc.
CHAPTER5
PrimacyoftheIncome
AccountorWealth
Creation?What
AreEarnings,Anyway?*
WealthorEarnings?InfluenceofReportedEarningson
CommonStockPricesTheLong-TermEarningsRecordParsingtheIncomeAccountSummary
We define earnings fromoperations by any economic
entity—whether corporate,governmental, or individual—as the creation of wealthwhile consuming cash. Thisseems to be how mostsuccessful economic entitiesoperate. Earnings cannotcreate lasting values for aneconomic entity unless thatentity, sooner or later, hasaccess to capital markets tomeet cash shortfalls. Noeconomic entity can rely on
having access to capitalmarkets, whether creditmarkets or equity markets,unlessthateconomicentityis,or can be made to be,creditworthy.Capitalmarketsare notoriously capricious;thereareeventimeswhennocapital is available from theprivate sector at any price.See, for example, theeconomic meltdown in thelasthalfof2008andthefirst
halfof2009.Wedefinecash flows from
operationsformostcorporateanalytic purposes as cashgenerated from operationsavailable to service debt andequity after deducting thenecessary expenditures notexpensed in the incomeaccount to increaseplantandequipment, receivables,inventories, non-expensedresearch and development as
well as other assets. Themodus operandi of manycompanies is todevelopcashflows from operations; forexample most companiesinvolved with incomeproducing real estate. Theidea of cash flows fromoperations is crucial tounderstanding projectfinance. For a particularproject to make sense, theforecasted present value in
cash to be derived fromoperations has to exceed thepresent values of the cashcosts to be incurred for theproject. The need for cashflows from operations is lessimportant in corporatefinance because many cash-consuming activities workdirectly to increase wealth.Theseother activities includeexpanding operations andbeing involved in resource
conversion activities such asmergers and acquisitions aswell as refinancing maturingobligations.Earnings and cash flow
from operations tend to beimportant, but not all-important, in a worlddedicatedtowealthcreation.Wealth creation comes
fromthreesources:1.Earningsand/orcashfrom operations
available to securityholders. Earnings aredefined as creatingwealth while consumingcash. This is what mostwell run corporations doand also what mostgovernments do.Earnings cannot have alasting value unless theentity remainscreditworthy. Also, inmost cases, in order to
maintain and growearnings the corporationorgovernmentisgoingtohave to have access tocapital markets to meetcash shortfalls.Corporations probablycreate cash flowsavailable to securityholders fewer times thanmostpeoplethink.2. Resourceconversions.Theseareas
include massive assetredeployments, massiveliability redeployments,and changes in control.Resource conversionsoccur as part of mergersandacquisitions,contestsfor control, the bulk saleor purchase of assets orbusinesses, Chapter 11reorganizations, out ofcourt reorganizations,spin-offs, and going
privates includingleveraged buyouts(LBOs) andmanagementbuy-outs(MBOs).3. Super-attractiveaccess to capitalmarkets. On the equityside, this includes initialpublic offerings (IPOs)during periods such asthe dotcom bubble. Onthe credit side, thisincludes the availability
of long-term, fixed-rate,non-recourse financingfor income-producingcommercialrealestate.Income accounts are
importantinanyfundamentalanalysisofcompaniesandthesecurities they issue.However, except in veryspecial cases, there is noprimacy of earnings orprimacyofcashflows: that ismyth, pure and simple. The
one special case where thereclearly is a primacy ofcurrentearningsandearningsestimates for the immediatefuture is in the trading ofcommonstocks.Inthischapter,weexamine
the reasons why, outside thelimited sphere of day-to-daystock trading, there tends tobenoprimacyof earnings inbusiness and securityanalysis. We also review
appropriate roles for currentreported earnings within thetrading environment. In thischapter, too, earnings areparsed in order to gaininsights into what earningsand incomemeananddonotmean, and how earningsought to be used as one toolin corporate and securityanalysis.
WEALTHOREARNINGS?
IntheUnitedStates,as inallsocieties that are beyond thesurvival level, the goal ofmost businesses is thecreationofwealthratherthanthegenerationofreportednetincome. Of course, thegeneration of reported netincome and the creation ofwealth are related: the
creation of reported netincome is just onemethod ofcreating wealth. There aremany other ways of creatingwealth that are separate anddistinct from the generationof net income fromoperations, which we groupunder resource conversionactivities and financingactivities.1
Where businesspeople notinvolvedwithoutsidepassive
minority investor (OPMI)stock markets have choices,the generation of reportedearnings from operationstendstobetheleastdesirablemethod for creating wealth,simply because reportedearnings from operations areless tax sheltered than areother methods of wealthcreation. This is one of thereasons why resourceconversion activities and
financing activities bycorporations seem to havegrown in importance at theexpense of ordinary goingconcernoperations.It ought to be noted in
passing that those marketparticipants most ready toanalyzecorporationsbasedonaprimacyofearningsconcepttend to be the same personswho in the management ofportfolios renounce primacy
of earnings in favor of stockmarketperformanceand totalreturn; the creation ofreported net income in theformofdividendsandinterestnet of ordinary expensestends to be secondary toachieving unrealized andrealizedappreciation.It is well known that
privately held corporations,even those that are strictgoing concern operations,
usually attempt to createearnings in a manner thatminimizes income taxes—animportant consideration tothese business people inrealizing wealth creationgoals.Publicly held corporations,
on theother hand, frequentlyattempt to report the bestearningspossible,theincometaxconsequencesbedamned.This is not because business
people think that currentearnings per se are so allimportant, but, rather,because the ability to reportfavorable current earningsmay have themost favorableimpact on stock prices andaccess to capital markets,whichinturnmayprovidethegreatest potential for wealthcreation.Highcommonstockprices provide insiders withopportunitiestorealizevalues
bysellingorborrowing.Theyalso give a companyopportunities to issue newequityinpublicunderwritingsfor cash, or to acquire othercompanies either for cash orby the direct issuance ofcommonstockorotherequitysecurities.Frequently,thebesttoolfor
projecting future earnings isthe structure and amount ofasset value at a given
moment.
EXAMPLESociety Corporation’sposition in the early 1960sis one example of this.Society Corporation was abank holding companybased in Cleveland, Ohio.At that time, banks ingeneral were earningbetween 8 and 12 percentof net worth annually.Society,withanetworthofabout $50 a share, was
earningabout$1.50asharefrom operations when itconverted from a mutualsavings bank to acommercial bank holdingcompany in 1962. Thisequaled a return on networthofonly3percent.Amarket participant couldreasonwithafairdegreeofconfidence that over timeSociety probablywould beearning a return on itsequity close to that whichwas being achieved in thecommercial banking
industry in general. Atleast, there did not appearto be any insurmountableproblems preventing this.Furthermore, book value,too, would be steadilyincreasing. The anticipatedresults occurred; reportedearnings increased year byyear,andby1966operatingearningswere$5pershareonayear-endbookvalueof$62. The prediction ofSociety Corporation’sfuture earnings could nothavebeenbasedonthepast
earnings record. Anexamination of the assetvalues and the belief thatsuchassetvalueswouldbeused much the way othercommercial bank holdingcompaniesusedtheirswerethe basis for the earningsforecast. This approach isprobably better describedas a resource conversionapproach to analysis ratherthana strictgoingconcernone.Why?Thekeyiteminevaluating SocietyCorporation was the
probability that it wouldconvert its assets to moreproductive uses, not that itwouldcontinueusing themin the same way as in thepast.
EXAMPLEIn 2012, the successor toSociety Corporation wasKey Corp. Analytically,Key Corp common stock,selling at $7.89 per sharehas several characteristicssimilar to Society
Corporation in the 1960s.At December 31, 2011,bookvaluewas$10.24pershare. Key Corp hadsuffered mightily after the2008–2009 economicmeltdown, attributablemostly due to disastrousbank acquisitions thecompany had made inSunbelt institutionsheavilyinvolved with residentialmortgagesandconstructionloans. In 2011 Key Corpwas on the road torecovery. For the 12
months to June 30, 2012,Key’s return on equity(ROE) was 8.6 percent.The calculation seemsreasonable though, ofcourse, uncertain. Theimportant thing about Keyseems to be thatmanagement avoids themistakes it made in theearly2000s.
Good regional commercialbankssuchasKeyhavebeenattractive acquisition
candidates in the post–WorldWar II period, and theaverage acquisition priceprobablyhasbeenatleasttwotimesbookvalue.Assume, Key for the next
five years enjoys an ROE of10 percent per year, pays anaverage annual dividend of20 cents per share, and afterfive years is acquired by amajor bank (perhaps anInternational) at 2 to 2.5
times book value. The totalreturns to the investorwouldbeasfollows:
Annualinternalrateofreturnexitingat2timesbook:34.7percent.Annualinternalrateofreturnexitingat2.5timesbook:40.7percent.Assumingnoacquisition,bookvaluepersharewouldgrowfrom$10.24attheendof2011to
$15.47attheendof2016(atan8.6percentgrowthperyear).Ifattheendof2016,keycommonstocksoldatbookvalue,theinternalrateofreturnbasedona$7.89purchasepriceand20centannualdividendswouldbe16.4percent.
INFLUENCEOF
REPORTEDEARNINGSONCOMMON
STOCKPRICESAlthough it is difficult togeneralize about the role ofcurrent reported earnings asan influence on commonstock prices, in buoyantgeneral markets the main
influences on common stockprices of companies that arestrictgoingconcernsseemtobe:
1. Current reportedearnings from operationsand/or cash flows fromoperations.2. Reported earningsand/or cash flowsestimated for theimmediatefuture.3.Sponsorship.
4. Industry identification.Greater weight tends to be
given to earningspaidout asdividends than to earningsretained by the firm. Therealso tends to be an emphasison trend, with great weightgiven to earnings that aregoingup.To these earnings, a
multiple—that is, a price-earnings (P/E) ratio—that isdependent on the above
earnings record plus industryidentificationisapplied.It is important in these
trading situations that notonly should the companyhave a growth record; for itsstock to attain a highmultiple, it should also besituated in an industry thathas a favorable image. Thus,a company with a less thangood earnings record mayattain a very highmultiple if
it is situated in a growthindustry,whereas a companywith steadily increasingearnings may sell at a verylow multiple if it has aninappropriate industryidentification.Sponsorship also tends to
contribute to the making ofcurrent stock market prices.Sponsorship means that acompany is well regarded orisactuallyownedbyinterests
with a history ofWall Streetsuccess. Sponsors can be allsorts of people andinstitutions, ranging frombroker-dealers and privateequity firms who have beenimaginative and successfulcreators, such as KKR,Carlyle,AllenandCompany,to people from outside thefinancial communitywhoaredeemed to have the magictouch, as, for example, John
Malone, Barry Diller, MarkZuckerberg. A company canattain a good industryidentification throughappropriate sponsorship, butsometimes such sponsorshipcan be substituted forindustry identification. Highlevels of compensation frompromotersandsalespeoplearean important reason forissuers toobtainsponsorship,such as the IPO phenomena
duringthedotcombubble.
EXAMPLEA good example of howeffective industryidentification can be isprovided by looking at thecomparative earnings ofBroadcom Corp. (adeveloperofsemiconductorsolutions for the wirelessindustry) as of December31,2011,whenitscommonstock was selling at 32.8times current earnings,
whereas at the same timeAECOMTechnologyCorp.(a provider of professionaltechnical and managementsupport services forcommercial andgovernment clientsworldwide) common stockwas selling at 8.4 timesearnings. Broadcomearnings record had beenvery spotty, but AECOMhad shown steady annualearnings increases for theprior six years. Acomparison of their
reportedper-share earningsin the six years toDecember 31, 2011, ispresentedinTable5.1.
Table5.1EarningsperShare
AECOMTechnologyCorp(NYSE:ACM)
BROADCOMCorp(NASDAQ:BRCM)
Year Earnings/Share2006 $0.87 $0.642007 $1.12 $0.372008 $1.51 $0.412009 $1.74 $0.13
2010 $2.13 $1.992011 $2.28 $1.65LatestPrice/LTMEarnings
8.3× 32.8×
Broadcom sold at over 32times earnings because ofits industry identificationwith the wireless industry,a growth industry.AECOM, on the otherhand, is a diversifiedprofessional and technicalservice provider tocommercial and
governmental clients, andeven though it hadamuchbetter earning power andgrowthhistory,itonlysoldjustover8timesearnings.
THELONG-TERM
EARNINGSRECORD
In fundamental analysis,special attention should begiven to the importance of afavorable long-term earningsrecord for a strict goingconcern—that is, acompany’s ability to haveenjoyed, at least foraccounting purposes, annualprofitsfromoperationsoveraperiod of three years, fiveyears, and longer. Such arecord or lack of it can be
extremely important inmanytypesofanalysis,eventhoughit lacks the universalsignificanceattributedtoitbysome analysts for allcorporateevaluations.Aswill bediscussed in the
next chapter, there is anintegral relationship betweenearnings records and assetvalues.Themajorcomponentof net asset value for mostpublicly owned businesses is
retained earnings—pastprofits that have not beenpaid out. There is a generaltendency, therefore, for pastrecords of profitability to bereflectedinthenetassetvaluereported in a company’srelatively recent balancesheets.Over and above this, there
are two types of analysis inwhichacompany’slong-termearnings record becomes
especially significant. In thefirst, the business to beanalyzedistobeviewedasastrictgoingconcern, likelytoconduct its operations in thefuture as it has in the past,and financed about the sameas in the past, withmanagement and controlgroupsessentiallyunchanged.Thesecondareaofanalysis
where a long-term earningsrecord becomes especially
significant is in gauging thequalityofanissuer.Whereanoperating business lacksconsistent profits—indeed,where an issuer lacks long-termprofitsthathavebeenona rising trend—it lacks acrucial attribute necessary torank as high quality.Securitiesofanissuerlackinga good earnings recordfrequently are highlyattractive—as are, for
example,resourceconversionissues selling at depressedprices—but they are notgenerally recognized as highquality.It should be reemphasized,
furthermore, that manyportfoliosshouldberestrictedin whole or in great part tohigh-quality issues(especiallywhentheportfoliomanagershaveneitherknow-hownor know-who)where a
principal objective has to bethegenerationofregularcashincome and where there arefiduciary obligations to theportfolio beneficiaries. Inthese instances, we suggestthat suitable securitiesconsist, at the minimum, ofthe issues of companieswhose financial statementscombinebothfavorablelong-term profits records andstrong present financial
positions. We would notemphasize the long-termearnings record at theexpense of the presentfinancial position, or viceversa.However, ifwehad topick one favorable factormost important in 2013, itwould be strong financialposition.Given a three-pronged
approach to the analysis of acompany and its securities,
certain shibboleths applied tostrict going concerns becomediluted when the business isanalyzed not only as anoperation but also as afinancier. One strongexample is the law ofdiminishing returns, whichseemvalidonlywhenappliedto strict going concerns. Assuch, companies keepincreasing earnings, or cashflows become vulnerable to
lower returns as the businessbecomes bigger and moreunwieldy, and, if highlyprofitable, it tends to attractnewcompetition.Thislawofdiminishingreturnsseemsfarlessapplicableandevennon-applicablewhenthecompanyis to be appraised not as anoperator but as an investorandafinancier.
PARSINGTHEINCOMEACCOUNT
Earnings sometimes seem tomean all things to allmarketparticipants.Yet earningsarelikely to bemost valuable asanalytical material insofar asmore appreciation is gainedof the various meanings ofearnings. It is important to
distinguishbetween thestaticequilibrium approach toearnings and the dynamicdisequilibrium approach toearnings.The static equilibrium
approachtonetincomelooksat current earnings and theearnings record as principalfactors in the determinationof what a current commonstock market price ought tobe.It isgenerallyagreedthat
there tend to be equilibriumprices at agivenmoment forcertain common stocks withcertain current earnings andindustry identifications,thoughineveryinstancethereare importantexceptions.Forexample, at thiswritingmostelectricutilitycommonstocksaresellinginarangebetween10 and 12 times latest 12months’ earnings; mostcommercial bank stocks are
sellinginarangebetween10and 15 times earnings; andmost savingsand loan stocksare priced at from 10 to 20times earnings. Say that amarketparticipantuncoversasavings and loan concernsellingat twotimesthelatest12 months’ earnings. Thisfact could be the basis forinvesting in the commonstockof thesavingsand loancompany, assuming it is
found after investigation thatother things are roughlyequal. This stock could havea reasonable appreciationpotential if the tendencytoward equilibrium pricestookholdandifitweretosellin linewith the P/E ratios atwhichothersavingsand loanstockswereselling.The static equilibrium
conceptisnotonlyimportantto outside investors, but also
has a significant role ininvestment banking.Considerable use is made ofthestaticequilibriumconceptin the pricing of new issueunderwritings. Managingunderwriters usually attempttoprice anew issue at aP/Eratiomoderatelybelowthatatwhich the seasoned issues ofcompanies in the same orsimilar industries are selling.Then,typically,thenewissue
is merchandised byemphasizing, among otherthings, that its earningsmultiple is below that ofcomparableissues.2
The dynamicdisequilibrium concept ofearnings involves the use ofthepastandcurrentrecordofreported earnings as a basefor estimating futureearnings. The projectedincrease in earnings is then
usedasabasis forpredictingafuturestockprice.Thus,ifasavings and loan commonstock is selling at 7 andearnings are $1 per share (orjust about in line with seventimes the industry P/E ratio),ananalystattunedtodynamicdisequilibriumandestimatingnext year’s earnings at $1.50mightconcludethatthestockwill appreciate from 7 to10.50, or seven times $1.50
pershareearnings.We have already discussed
in this chapter the uses andlimitations of this puredynamic disequilibriumapproach.Theanalystrelyingon earnings to evaluate abusiness or a common stockwillbehelpedifhehassomeappreciationof thedifferencebetween the role of earningsin a static equilibriumapproach and the role of
earnings in a dynamicdisequilibrium approach. Ithas been our experience thatmany analysts fail todistinguish between staticequilibrium and dynamicdisequilibrium.It ought to be noted also
that definitions of earnings,net income, or periodicearnings are usually notprecise. We give several ofthe definitions that are used
by various practitioners andscholarsindifferentcontexts.Ineachofthese,earningscanbedefinedas:
WhataccountantscomputingresultsinaccordancewithGenerallyAcceptedAccountingPrinciples(GAAP)reportthemtobe.Thisisthemostcommondefinitionofearnings
usedbyothers,andismostfrequentlybutnotalwaysrestrictedbythosewithastockmarketorientationtorecurringearningsafterincometaxesfromcontinuingoperations.WhattheaccountantscomputingresultsinaccordancewithGAAPreportthemtobe,asmeasuredbyoverall
performance,includingextraordinaryitemsandresultsofdiscontinuedoperations.Theincreaseinvalueofabusiness(afteraddingbackstockholderdistributions)fromoneperiodtothenext,withtheincreasemeasuredbyvaluationtoolsthatarenotsubjecttoGAAPassumptionsandGAAP
discipline.Thebestexampleofthisisinvestmenttrusts,where“true”earningsresultsaremeasuredbychangesinnetassetvalue,asmeasuredbystockmarketpricesadjustedfordividenddistributions.Theincreaseinabilitytomakestockholderdistributionsoverand
aboveactualstockholderdistributions,whichdonotreduceactualinvestedcapital.Suchdistributionstostockholdersareusuallyincashintheformofdividends,buttheydonotnecessarilyhavetobeso.Thealternativemethodofdistributingcorporatecashtostockholdersistohavea
companyrepurchaseitsownsharesforcash.Theincreaseinabilitytomakepaymentstoallsecurityholders,notjustequityholders,duringaperiod.Earningscanbemeasuredbyimprovementsintheoverallfinancialposition.Anexampleofthiscanbefoundinthecaseof
DPF,whichhadbeenacomputerleasingcompany.Fromfiscal1972throughfiscal1975,DPFreduceditsseniorsecureddebtfrom$28.3millionto$965,000.Duringthatperiod,aggregatelossesforaccountingpurposeswerereportedatover$4million.Forpracticalpurposes,itwasobvious
thatDPFwasprofitableinameaningfuleconomicsense,despiteitsreportedlossforaccountingpurposes,becauseofitsabilitytoachieveitsprimeobjectiveofbecomingbetteroffbyputtingitsfinancialhouseinorderthroughthereductionofseniorindebtedness.Theincreaseinabilityto
improvefuturesales,accountingprofits,and/orcashflowduringaperiod
Earnings might bemeasured for aperiod in thiscase not by any reference toaccountingresults,butrather,say, by the perfection ordevelopment of a newproduct that has gained tradeacceptance during its initialmarketing.
The achievement ofearningsasdefinedbyGAAPdoes not even necessarilycontribute to solvency. Forexample,intheearly1950sanew cigarette calledParliament, the original filtercigarette, was introduced byBenson and Hedges, then averysmallcigarettecompany.Parliamentswereinordinatelysuccessful, and Benson andHedges expanded by leaps
and bounds. Unfortunatelyfor Benson and Hedges,working capital requirementsballooned, since in itsindustry it was (and is)necessary that cigarettetobaccos be aged for anaverage of three years. ThefastertheBensonandHedgesbusiness expanded, the moredifficult it was to finance itsrequirements for largerinventories.ThemoreBenson
and Hedges expanded as asmallindependent,thegreaterits accounting earnings wereand the closer the companycame to insolvency. As asmall independent operator,BensonandHedges’earningswere not “real.” They couldbemade real only by sellingout to an entity that couldfinance Parliament’sexpansion. Eventually,Benson and Hedges merged
intoPhilipMorris, forwhomParliament’s earnings were,of course, completely real,because Philip Morris hadsufficient financial resourcesto benefit fully from theexpansion that was takingplace.Reportedaccountingresults
and stock prices obtain suchtremendous weight in manymarket calculations becausethey are the measurements
that are both precise andvisible. In an investmenttrust,oneknows thevalueofthe portfolio with precision,based on what the closingprices are and/or what themean between bid and askedis (where no stock sale hasoccurred). Equity real estateinvestmenttrusts,ontheotherhand, may have a portfoliothat would be readilyconvertible into cash over a
periodofamonthortwo,butbecausethereisnodailypricequotation for the real estateportfolio, its asset value canonlyberoughlyestimatedonanygivenday.Therefore,thevalue of the real estate assetportfolio is not given thesame weight as the value ofan investment trust portfolio,even though in the case oflarge investment trustsblockage would prevent
liquidationof theportfolio inless than a fewmonths’ timeatanypricesotherthanthosereflecting a large discountfrommarket.3
Precision and visibility,even if they do not reflectrealization values, deserve aspecial significance, becausetheyappearto(andinasensedo) reduce uncertainties. Anabsence of precision andmeasurability usually, and
understandably,detractsfromperceptionsofvalue.Given the varied economic
definitionsofearnings,itmaybe wise to distinguishbetweenearningsandearningpower.By earnings ismeantonly reported accountingearnings. On the other hand,in referring toearningpowerthe stress is on wealthcreation. There is no need toequateapast earnings record
with earning power. There isno a priori reason to viewaccounting earnings as thebest indicator of earningpower. Among other things,theamountofresourcesinthebusinessatagivenmomentislikely to be as good or abetter indicator of earningpower. In 2012, a chaoticeconomic period, it tends tobe highly important incommon stock investment to
pay special attention to theamount of resources in abusiness and how stronglythatbusinessisfinanced.
SUMMARYThe generation of reportednet income and the creationof wealth are related: thecreation of reported netincome is just onemethod ofcreating wealth. There are
many other ways of creatingwealth that are separate anddistinct from the generationof net income fromoperations, which we groupunder resource conversionactivities. Wherebusinessmen not involvedwith OPMI stock marketshave choices, the generationof reported earnings fromoperations tends to be theleast desirable method for
creating wealth, simplybecause reported earningsfrom operations are less taxsheltered than are othermethods of wealth creation.This is one of the reasonswhy resource conversionactivities and financingactivities by corporationsseem to have grown inimportance at the expense ofordinary going concernoperations. Publicly held
corporations, however,frequently attempt to reportthebestearningspossible,notbecause businessmen thinkthat current earnings per seare so all-important, but,rather, because the ability toreport favorable currentearnings may have the mostfavorable impact on stockprices and access to capitalmarkets, which in turn mayprovide the greatest potential
forwealthcreation.Althoughdifficult to generalize, inbuoyant markets the maininfluence on the commonstocks of companies that arestrictgoingconcernsseemtobe the following: reportedearnings, reported estimatesof future earnings,sponsorship, and industryidentification. These factorsare used by conventionalanalyses to price common
stock relative to others withthe same characteristics(staticequilibrium)orrelativetoforecastsoffutureearnings(dynamic disequilibrium).Given the varied economicdefinitionsofearnings,itmaybe wise to distinguishbetweenearningsandearningpower._______________*Thischaptercontainsoriginalmaterialandparts
ofthechapterarebasedonmaterialcontainedinChapter13ofTheAggressiveConservativeInvestorbyMartinJ.WhitmanandMartinShubik(©2006byMartinJ.WhitmanandMartinShubik),andideascontainedinthe20063Qlettertoshareholders.ThismaterialisreproducedwithpermissionofJohnWiley&
Sons,Inc.1TheconceptofresourceconversionisdiscussedinChapter2andatlengthinChapter22.2ExamplesaregiveninthediscussionofSchaeferCorporationinChapter27.3Blockageoccurswhenaholderofalargeblockoffreelytradablesecuritiesisunable,becauseofthinmarkets,todisposeofthat
blockatanypricesotherthanonesthatareatasubstantialdiscountfromprevailingmarketprices.
CHAPTER6
NetAssetValue:TheStaticandDynamicViews*
TheGrahamandDoddViewonNAVTheFinancialAccountingViewonNAVOurViewonNAVTheUsefulnessofNAVinSecurity
AnalysisTheImportanceofNAVDynamicsNAVasOneMeasureofResourcesNAVasOneMeasureofPotential
LiquidityLimitationsofNAVinSecurityAnalysesLargePremiumsoverBookValueAlwaysMeanHighP/ERatios:ItDependsonROE
NetNetsRedefinedOPMIInvestinginCompanieswithGrowingNAVsSummary
In the analysis of anyeconomic entity, a thorough
researcher will look atvaluations from both a staticpoint of view and a dynamicpoint of view. The staticapproach centers ondetermining what the valuesare at this time, probablyrealizablebysaletoamarketor markets. The dynamicapproach centers onestimatingwhat futurevaluesare likely to be for theasset(s) in question.Both the
static and dynamicapproaches are essential to anet asset value (NAV)analysis.In conventional security
analysis, it seems as if thedynamic view of probableand possible future changesin NAV is all but ignoredcompletely. This seems soeven though in conventionalsecurity analysis—certainlyin Graham and Dodd—the
most important things toestimate are future earningsfromoperationsand/or futurecash flows. Further, inclassical economics of thefirm the principal thing tomeasure isnotwhatexistsasof a moment in time, butratherwhatchangesaretobeforthcoming. This ineconomics is calledmarginalism.Book value is defined as a
corporation’s net asset value(NAV)pershareasshownonthe business’s financialstatements at a given date.Tangible NAV is definedexactly as is NAV, exceptthatintangibleassets(patents,copyrights, purchase goodwill, andsoon)areexcludedfrom assets. NAV iscalculated by dividing netassets, that is, total assetsminus total liabilities and
outstanding preferred stockstakenat redemptionvaluebythe number of commonsharesoutstanding.NAV, unlike reported
accountingearnings,seemstoplay little or no role ininfluencing day-to-day stockmarket prices. This isprobably the principal reasonwhy nearly all writers aboutfinancial accounting andsecurity analysis have
denigrated the importance ofNAV as a tool of valuation,emphasizing instead aprimacy of earnings.We, ontheotherhand,believethatinalmostall analysisoutsideofthe day-to-day stock-tradingenvironment, NAV is ahighlyuseful toolofanalysisfor a variety of purposes,including predictions offutureaccountingearnings.Inthischapter,wedetailreasons
why we think attention toNAV should be useful forcreditorsandinvestors.Asecondreasonwhyothers
treat asset values as lessimportant thanwedo here isthat they approach valuationsolelyfromthepointofviewof outside passive minorityinvestors (OPMIs)examiningstrict going concerns. Ourinterests, in contrast, aremuch broader, covering all
securities holders, creditors,activists, and passivists. Inaddition, as explained earlierin thisbook,mostbusinessesare rarely strict goingconcerns,buthavebothgoingconcern and resourceconversion attributes.Evaluations have to look atcompanies and managementsnotonlyasoperatorsofgoingconcerns, but also asinvestorsandfinanciers.
Insofar as the approach toanalysis is restricted to theevaluationofthesecuritiesofstrict going concerns byOPMIs, it is understandablethat there should be anemphasis on accountingearningsand/orcashflowsattheexpenseofNAV.Insucha situation, it is fair toconclude that the pastearnings record is the bestindicator of what is likely to
happen in the future. Theproblemwiththisapproachisnotthatitisnotapplicableincertain situations (forexample, with an electricutility), but that it may beapplied where it does notbelong, as, for example, inthe analysis of a domesticcrudepetroleumproducer.Beforepresentingourviews
abouttheimportanceofNAVin security analysis, its uses
and its limitations, itmay behelpful to review briefly theconventional views about therelationship between NAVand accounting earnings insecurityanalysisandfinancialaccounting. Typical amongthese conventional views arethose contained in the booksSecurity Analysis;1Accounting Principles;2Corporate FinancialReporting in a Competitive
Economy,byHermanBevis;3and Valuing a Company, byMcCarthyandHealy.4
THEGRAHAMANDDODD
VIEWONNAVGraham and Dodd, inSecurity Analysis5 recognizethatNAVisuseful incertain
cases. Nevertheless, in theanalysis of most companiesand in explaining stockmarket price behavior,Graham and Dodd placeNAV in a decidedlysecondary position,concentratingonearningsanddividends as the primemeasure of managementperformance and companyvalue.TheGrahamandDoddviews about asset value are
most definitively articulatedin Chapter 41 of SecurityAnalysis, “The Asset ValueFactor in Common StockValuation.”In describing stock market
behavior, Graham and Doddpoint out that NAVs “losevirtually all significance.”Specifically,NAVsappear tothem tohaveno relevance indetermining earning powerfor industrial companies or
railroads. Their studies showthatmarketpricesforrailandindustrialcommonstockshadno correlations with NAVs:Some were sold at highmultiples of NAV, others atdiscounts. Rather, Grahamand Dodd found that marketprices for these commonstocks depended on theearning power and dividendpaymentsofthecompany.For Graham and Dodd,
asset value is significant inspecial cases, not as a norm.For example, they find thatNAV is a significantpredictor of future earningsand stock prices for somecompanies; NAV is seen asan important stock pricedeterminant for financialenterprises such as banks,insurance companies, andsavings and loan holdingcompanies, because assets
used in thesebusinesses tendtobehighlyliquidandreadilyturned into cash. Similarly,asset values are important inregulated public utilitycompanies, where rates aresetatleastinpartonthebasisof asset value, so that thelarger the company’s assets,the higher its potentialearningpower.As a special case Graham
andDoddrecommend that in
evaluating risk or spottingunique opportunities,common stock investorsshould use NAV as abenchmark. They warnagainst common stockssellingatmanytimesNAVascarrying inordinate risk. Ontheotherhand,theypointoutthat a common stock sellingat only a “small fraction” ofits NAV may have“speculative possibilities
especially so if there is nosubstantial debt.” Commonstocks selling at a price wellbelow NAV, earning powervalue, and past averagemarket prices can be verypromising,accordingtotheseauthors. And if the stockpriceisbelowthevalueofthenet current assets alone, then“it is almost an axiom eitherthe price is too low or themanagement should change
itspoliciesinsomerespect.”
THEFINANCIAL
ACCOUNTINGVIEWONNAVFinancial accountantsuniversally seem tosubordinate NAV toaccounting earnings. Their
definition of a “fairpresentation” bottoms on aview that earnings ought toaccurately reflect results forthe accounting period. InAccounting Principles it isstated, “The informationpresented in an incomestatement is usuallyconsidered the mostimportant informationprovided by financialaccounting because
profitability is a paramountconcerntothoseinterestedintheeconomicactivitiesoftheenterprise.”6 Herman W.Bevis, former senior partnerof Price Waterhouse andCompany, states in his book,Corporate FinancialReporting in a CompetitiveEconomy,“Ifonewereforcedto choose from among thefinancial statements whichbears most directly upon the
stockholder’s primaryinterest, it would, of course,be the income statement.”7AndMcCarthyandHealy, intheir book, Valuing aCompany: Practices &Procedures, cite studies in asection titled “Lack ofSignificance of ‘BookValue’” which conclude thatbook values, or net equities,“lack...significance...asavaluationfactor.”8
OURVIEWONNAV
Wehaveadifferentemphasisfrom Graham and Dodd andthe financial accountants. Tous, NAV, in virtually allanalysis other thanpredictions of common stockprices for the immediatefuture, is at least assignificant as accountingearnings.Andinpractice,one
is not a substitute for theother. But in choosing astartingpointwithinfinancialstatements for an analysis,NAV seems to us to be thebetter starting point most ofthe time than accountingearnings.In part, our different
emphasis results fromdifferentperspectives.UnlikeGraham and Dodd and thefinancial accountants, we
believe that a very large partof American businesses areengaged in resourceconversionactivities:That is,they are not strict goingconcerns involved only inoperations that result inrecurring accountingearnings. Rather, manycompanies, in whole or inpart, are engaged in resourceconversionactivitiesthatgiverise to tax shelter, mergers
and acquisitions, changes incontrol, liquidations,investment activities, andmajor refinancings. Insupport of this view, wepresent historical informationabout the prevalence ofcertain types of resourceconversion activities for thecompanies in the Dow JonesIndustrial Average Index forthefiveyearsfromJune2007through June 2012 in Table
6.1.Table6.1ResourceConversionActivitiesofDowJonesIndustrialCompaniesfromJune2007toJune2012CompanyName Numberof
PrivatePlacements
NumberofMergers/Acquisitions
3MCo. 1 27Alcoa,Inc. 1 6AmericanExpressCompany
5 6
AT&T,Inc. 1 18
BankofAmericaCorporation
4 64
CaterpillarInc. 0 13ChevronCorporation
0 24
CiscoSystems,Inc.
14 44
E.I.duPontdeNemoursandCompany
2 16
ExxonMobilCorporation
1 36
GeneralElectricCompany
5 17
Hewlett-Packard 0 24
Company
IntelCorporation
1 27
InternationalBusinessMachinesCorporation
2 44
Johnson&Johnson
0 10
JPMorganChase&Co.
7 33
KraftFoodsInc. 0 8McDonald’sCorp.
1 6
Merck&Co. 2 16
Inc.MicrosoftCorporation
5 31
PfizerInc. 1 30Procter&GambleCo.
2 22
TheBoeingCompany
0 10
TheCoca-ColaCompany
1 12
TheHomeDepot,Inc.
0 3
TheTravelersCompanies,Inc.
0 0
United 0 3
TechnologiesCorp.VerizonCommunicationsInc.
2 4
Wal-MartStoresInc.
3 8
WaltDisneyCo. 0 9TablewasbuiltusingS&PCapitalIQ.
The analysis of businessesso engaged involvesassigning a relativelyincreased importance toNAV, or in any event a
marked decrease in thesignificance of accountingearnings from operations. Inaddition, Graham and Doddand the financial accountantsseem to view theirconstituency as OPMIs whoare relatively conscious of,andinfluencedby,day-to-daystock market pricefluctuations that are muchmore influenced byaccounting earnings as
reported than by NAV. We,on the other hand, view ourbasic constituency ascreditors and investors, andinsofar as we write forOPMIs, it is to recommendthattheyanalyzesecuritiesinmuch the same way as docreditors and investors whoareactivistsorpromoters.We also differ somewhat
from Graham and Dodd andfinancialaccountantsbecause
we have a differentfundamental view about therelationship between NAVand accounting earnings.Webelieve that wheneveraccounting earnings aresignificantinthefundamentalanalysis of a company, so isNAV. Indeed, in mostinstancesNAVisintrinsicallyrelated toearningsandexistsin great part becausecompaniesortheirconstituent
parts have enjoyed retainedearnings in the past. In fact,our studies of stock pricesshow that when commonstocks are selling at lowprice-earnings (P/E) ratiosrelative to average historicearnings, the same commonstocks tend to sell at lowerprices relative to NAV;conversely, high P/E ratiosbased on average historicearnings correlate with
commonstockpricesthatareat substantial premiumsaboveNAV.Ofcourse, thereare logical reasons why thisshouldbeso.In the bookkeeping cycle,
net income not paid out tostockholders becomes abalance sheet account, calledretained earnings or earnedsurplus. These past profitstend to be the principalcomponentofNAV.Thus,as
a rule of thumb, companieswith large NAVs relative tomarketpriceshavenetworthsthat consist in great part ofretained earnings. Suchcompanies tend also to beselling at very low priceswhencomparedwithaveragelong-termearnings.Forexample,Table6.2lists
the 30 companies thatcomprise the Dow JonesIndustrial Average, and
showstherelationtothepricefor each company’s commonstock on June 2012, of itsNAV and 10-year averageearnings.Figure6.1 is a plotofthedatainTable6.2.Table6.2RelationshipofPriceonJune15,2012,toReportedTen-YearAverageEarningsandLatestNAVfortheCompaniesintheDow-JonesIndustrialAverage
Figure6.1RelationshipofPriceonJune15,2012,toReportedTen-YearAverageEarningsandLatestNAVfortheCompaniesintheDow-JonesIndustrialAverage
This correlation betweenP/E ratios based onaccounting earnings and therelation of market price toNAV has not always been
fully appreciated. Forexample,seethecommentsofMcCarthyandHealycitedonpage184.Yet,wehavefoundthatthereisastrongtendencyfor stocks selling at highmultiples of historic earningsalso to be selling atsubstantial premiums aboveNAV. This correlationbetween P/E ratios and thespread between market priceand NAV is not perfect, of
course. The correlation doesexist, however, as a generalrule. Given the integralrelationship between historicaccounting earnings andNAV,wewouldbesurprisedifitdidnot.Tosay,then,thatearnings determine commonstock prices but thatNAV isirrelevant clearly makes nosense unless one is talkingonly about short swingtrading and stock price
movements.
THEUSEFULNESSOFNAVINSECURITYANALYSIS
Since we place moreemphasisonNAVasatoolof
analysis than do most othercommentators, it is onlyappropriate that in reviewingits values and uses we alsocomment briefly on itslimitations.First,NAVisanaccounting
number, and in itsusefulnessand reliability it has to be aslimited a tool of analysis asfinancial accounting itself.Second,NAValonedoesnotmean much; it has to be
related to other numbers andother concepts in order tobecome significant. Third, inconventionalsecurityanalysisit seems as if the dynamicviewofprobableandpossiblefuture changes inNAV is allbut completely ignored. Themost important part of NAVanalysis is the understandingof its dynamics. Finally,NAV is a quantitativemeasureofnet assets: it tells
us how much. In using afundamental financeapproach,however,qualityofassets tends to be moreimportant than quantitativeconsiderations. Later in thischapter we discuss thecharacteristicsthatgiveassetsdesirable or undesirablequalitativecharacteristicsandprovide a “redefinition” ofGraham and Dodd’s conceptof net nets based on
judgments about the qualityand quantity of assetsseparate and distinct fromtheir classification on theGAAPbalancesheet.Net asset value (NAV) has
special merits both as adynamic tool of analysis anda static one. The merits ofNAV as a dynamic tool ofanalysisare:
Asacomprehensivemeasureofthewealth
creationcapabilityofabusinessAsanappraisalofcompaniesandmanagementsasoperators,investors,andfinanciers
The merits as a static toolareasfollows:
AsonemeasureoftheresourcesavailabletoabusinessAsonemeasureof
potentialliquidityavailabletoabusiness
THEIMPORTANCE
OFNAVDYNAMICS
In understanding a business,as distinct from predictingnear-term common stock
prices, predicting changes inNAVs tends to be far moreimportant than makingearningsestimates.Inmakingearnings estimates,companiesarebeinganalyzedand managements are beingappraised, solely as strictgoing concerns emphasizingonly recurringoperations.Tounderstand a business aresponsible analyst has toappraise an economic entity
and their managements fromthreeperspectives.
1.As operators of goingconcerns.2.Asinvestorsemployingand redeploying acompany’s assets inmergersandacquisitions,spinoffs, liquidations,changesincontrol.3.As financiers engagedin all sorts of activitiesranging from going
private, incurring debt,makingcashdistributionsto shareholders, goingpublicviaIPOs.To analyze businesses as
operators, investors, andfinanciers, the analyst has tolook at the entire accountingcycle—income account andbalance sheet—and just notplacegreateremphasisontheincome account. The bestaccounting measure of the
results of three activities arechangesinNAVafteraddingbackdividends.Inthestaticapproach,there
are certain types of assetswhere reported accountingnumbers give a goodindication of NAV andcertain types of assets wheretheaccountingnumbersseemunhelpful in estimatingNAVs. In attempting toascertain NAVs attributable
to a common stock, it seemsharder to get good estimatesof NAV where the businessbeinganalyzedhastoservicelarge amounts of debt. Arough list of where certaintypesof assets serve asgoodapproximation of NAV andwhere there are poorapproximations are asfollows:WhereAccountingDisclosuresAreaGood
MeasureofNAVsInvestmentcompanies.Income-producingrealestateespeciallywheretheaccountingdisciplineisInternationalFinancialReportingStandards(IFRS)ratherthanGAAP.UnderIFRSindependentappraisalsofincome-producingrealestatepropertiesisrequired.Insofarasthe
appraisalreliesontheincomeapproachtovaluation(asallappraisalsdo)thevaluationwillalsogivereasonableestimatesofwhatfuturecashflowsarelikelytobewiththeprincipaluncertaintyusuallyrevolvingaroundpredictingfuturecapitalizationratesratherthanfutureflows.
Portfoliosofperformingloanswhetheraccountedforasavailableforsaleoratamortizedcost(mostinsurancecompaniesandbankportfolios).Companiesholdingmarketablesecuritieswherethecompanyhascontrolovertheportfoliocompaniesorelementsofcontrol(Toyota
Industries,InvestorA/B,WheelockandCompany).
WhereAccountingDisclosuresTendtoBeaPoorMeasureofNAVs
Single-purposeassetsdedicatedtoagoingconcern(GeneralMotors,Chrysler,steelcompanies)Retailoperations(SearsHoldings,JCPenney)
ExplorationandproductioncompaniesespeciallythosewhosevaluesdependinlargepartonunprovedreservesandacreageholdingsExtractiveindustriesStart-upsNewinventions
A buy and hold investorfocused on owning thecommonstocksofcompanies
that will grow NAV afteradding back dividends, willtendtoacquiresuchcommonstocks after examining fourelements:
1.Does the companyenjoy a super-strongfinancialposition?2.Can the common stockbeacquiredatapricethatrepresents a meaningfuldiscount from NAV, sayatleast20percent?
3.Will the company beable to growNAV (afteradding back dividends)overthenextfiveyearsatno less than 10 percentperannumcompounded?4.Are there catalysts,such as possible changesof control, which willresult in a diminution orelimination of thediscountfromNAV?The first two factors are
easy for the analyst toascertain. The third factor—growth in NAV—requires alot of analytic judgment.However, many, manycompanies have met the 10percent growth bogey duringthe period 2007–2012, aperiod marked by the GreatRecession. Companies thathave grown NAV by muchmore than 10 percentcompounded (Brookfield
Asset Management andWheelockandCompanybothexceeded 20 percent) duringthis period include BerkshireHathaway, Brookfield AssetManagement, Hang LungProperties, Henderson LandDevelopment, POSCO,Wharf Holdings, WhiteMountains Insurance Group,andWheelock.For the investor, growth in
NAV can be an almost
assuredsourceofprofit,oranabsenceofloss.Theonewayto lose in owning suchcommonstocks,providedoneis reasonably good atestimating future growth inNAV, is if discounts fromNAV widen dramaticallyfrom the 20 percent discountat which the common stockswereacquired.
EXAMPLE
Acquire a non–dividendpaying common stock at 8whentheNAVis10.Holdthe issue for five years. Ifthe NAV growth is 20percent compounded forthe five-year period, NAVat the end of the five-yearperiod will be $24.88 pershare; at 15 percentcompounded, the NAVwould be $20.11 per shareandat10percenttheNAVwould be $16.11.The costbasis for an investment
would have been 8 pershare or a discount of 20percent from the openingNAVof10pershare.For the 20 percent growthissue to result in a break-evenat the endof5years,thediscountwouldhavetowiden to 67.8 percent; toresult in a break-even forthe 15 percent growthissue, the discount wouldhave to widen to 60.2percent; and to result in abreak-even for the 10
percent growth issue, thediscount would have towidento50.3percent.Such wide discounts seemrare, but they do occurfrom time to time giventhat the general marketseems to utterly ignoregrowth in NAV. At thiswriting, for example,Wheelock and Companycommon sells at a 50percentdiscountfromlatestreportedNAV,andLaiSunGarment common sells at
an 81 percent discountfromlatestreportedNAV.
EXAMPLECompanies like CheungKong Holdings Limitedand The Wharf HoldingsLimited (both Hong Kongissuers) are examples ofwhat we just wrote about.Table 6.3 shows thatCheung Kong HoldingsNAV per share has grownforthelastsevenyearsata9.2 percent annually
compounded rate, whileTheWharf HoldingsNAVper share grew at a 16.7percentperyearrate.
Table6.3AnnualperShareNAV,GrowthRate,perShareMarketPriceandPremium(Discount)toNAV,inHKD
Abasic reason for owningthese common stocks is
that we believe theprospectsappeartobegoodthat NAVs will grow overthenextfivetosevenyearsat ratesofnot less than10percent per annumcompounded.NAVgrowthprovides ample margin ofsafetyandpotentialmarketperformance as shown inTable 6.3. In 2009 aninvestorcouldhaveboughtCheung Kong Holdingscommon at a near 30percent discount fromreadily ascertainableNAV.
By 2011, Cheung KongHoldings NAV had grownby 28 percent, and themarket discount to NAVhad narrowed to only 6percentyieldingnearlya70percent return on theinvestment excludingdividends. In 2008, TheWharf Holdings commoncouldhavebeenpurchasedat an almost 49 percentdiscount from readilyascertainableNAV.By theend of 2011, NAV pershare had grown by 86
percent,butthediscounttoNAVhadremainedroughlythe same. The investorfollowing the fundamentalfinance approach andrestricting his investmentsto heavily discountedsecurities would havenettedan83percent returnon his investmentexcludingdividends.Even in cases when thegrowth projections forNAV fail to materialize,purchasing common stocks
at significant discountsfrom readily ascertainableNAV does provide ameaningful margin ofsafety.
EXAMPLEBy the end of 2006 aninvestor could havepurchased CapitalSouthwest Corporationcommon at a price thatrepresented almost a 34percent discount to NAVper share. Back then the
prospects seemed to favortheassumptionthatCapitalSouthwest would growreadily ascertainable NAVby at least 10 percent peryear for the foreseeablefuture. Over the followingsix years NAV did notgrowasexpectedasshownonTable6.4.
Table6.4AnnualperShareNAV,GrowthRate,perShareMarketPriceandPremium(Discount)toNAV
TheNAVper shareby theendoffiscal2012was16.4percent higher than it wasat the end of fiscal 2006,corresponding to a 2.6percent annualcompounded rate ofgrowth. Moreover, the
market discount to NAVhad widened considerablyfrom 34 percent to 44percent. Even in light ofthese adversedevelopments, thefundamental financeapproach provided theinvestor with a rathersubstantial margin ofsafety.Thepriceattheendof fiscal year 2012 wasaboutthesameasthepriceattheendoffiscal2006.
The outside investor who
purchases securitiesregardless of the immediateoutlookwill probably alwaysbe in a distinct minorityamong securities purchasers.Suchaninvestormustbeinastrong financial position. Hemust also be capable ofcurbing any tendenciestoward greed in hisinvestment: He cannotattempttobuypreciselyatthebottom of the market or to
maximize capital gains overshort periods. Finally, hemust be convinced that thereare important values in thecompany whose stocks heholdsthatarenotreflectedinthe market price and are notlikely to be dissipated.Without such conviction,almost any investor can beexpected to panic if themarket price of the securityhe holds declines. It tends to
be much easier for outsidersto gain some degree ofconvictionifacornerstoneoftheir analysis is an approachthat emphasizes high-qualityNAV acquired at a discountprice.Changesinearningscanbe
sudden and violent, andchanges in price-earningsratiosevenmoreso.Changesin NAV, on the other hand,by definition are almost
alwaysmoregradual.Alarge,relatively unencumberedNAV may be an anchor towindward, both for thecompany with honest andreasonably competentmanagement and for theOPMIwhoholdsitscommonstock. Under the conditionsprevailing in 2012–2013, forthe vastmajority of commonstock portfolios, werecommend that the investor
hold no less than 50 percentof his/her portfolios in thesetypesofissues.
NAVASONEMEASUREOFRESOURCES
Evenwherethepastearningsrecord of a company is asuperior indicator of future
earning power, we know ofno instance in which it hasbeen the sole indicator. Theamount of resources amanagement has available tocreatefutureearningsremainsan essential indicator offuture earning power. Andone measure of availableresourcesisNAV.This approach is more
commonlyusedinthecontextof corporate takeovers (such
as mergers and acquisitions)than it is in the context ofpassive investing by OPMIs.Corporate buyers tend to beacutely conscious of howtheyplantousetheresourcesoverwhich they gain controlinorder tomaximizeearningpower. OPMIs, on the otherhand,arenot inaposition toalter the way a corporation’sresources are used, andunderstandably are thus less
likely to use this resourceconversion approach inforecastingfutureearnings.Itdoes not follow from this,however, that an OPMIshould or can safely ignoreNAVinanalyzingacorporatesituation. If only becausecorporate acquirers are usingNAVanalysisinthisfashion,theOPMImaybeabletoreapa substantial benefit fromadopting this kind of
approach.NAV as a measure of
resources is also crucial inany kind of return oninvestment(ROI)orreturnonequity (ROE) analysis.9 ROIand ROE analyses areimportant tools in forecastingfutureearnings.
EXAMPLEHighROImaymeanthatacompany has a proprietary
positionthatwillallowittocontinue to enjoy above-average profitability;alternatively, it may be aninvitation for newcompetition to enter theindustry and drive downprofits for all. Conversely,low ROI may evidence anovervaluing of assets andinefficient management, oritmaybeanindicationthatthe business has a largeamountofunusedresourcesthat give it a margin ofsafety and thewherewithal
toexpandearningpower.
Many analysts recognizethe importance of ROI andROE analyses and placeconsiderable emphasis onthem while disclaiming theimportanceofNAV.Butyoucannot calculate a return oninvestment unless you knowtheamountoftheinvestment;norcanyouknowtheamountof the investment unless youknow the amount of the net
worth. Inasmuch as NAVmeasures common stockequity,whichisacomponentof net worth, it mustnecessarily figure in thiscalculation.
NAVASONEMEASUREOFPOTENTIAL
LIQUIDITYLiquidity is a qualitativecharacteristicofassets,andassuch isdiscussed later in thischapter. Conventional strictgoing concern analysisfocuses on balance sheetliquidity by relating currentassets—especially cash,marketable securities, andother assets readilyconvertible into cash—to
liabilities. Such analysis isappropriate only in the strictgoingconcerncase.However,in the real world of resourceconversion and the taxcarryback provisions of theU.S. Internal Revenue Code,large quantities of brick andmortar assets are frequentlytherawmaterialoutofwhicha great degree of liquidity iscreated.Withvariationstoallowfor
differences between financialaccounting and income taxaccounting,thebook-carryingbasis forassets isoftencloseto the tax cost-carrying basisfor those assets. If so and ifcertain other conditionsprevail: namely, that aprofitablebusinesshasbeenataxpayeratrelativelyhightaxrates, and the company’sassets that are used inoperations decline materially
in value, then opportunitiesexist touse taxcarrybacks tocreate cash benefits for thecompany and/or thestockholders of a companythat sells its assets, and for abuying entity and itsstockholders.Under the U.S. Internal
Revenue Code, in manysituations where a companysells to an unrelated partyassets used in the trade or
business (whether they arecurrent or fixed, from anaccountingpointofview)forless than the tax basis ofthose assets, the sellingcompanywillhaverealizedaloss for tax purposes subjectto offsets, namely, possibletax recapture of investmenttax credits and accelerateddepreciation. This loss afteroffsets is usually treatedunder Section 1231 of the
Internal RevenueCode as anordinaryloss,eventhoughtheassets are considered capitalassets.Withanordinaryloss,the company can then obtainaquickierefundunderthetaxloss carryback provisions oftheInternalRevenueCode.Aquickie refund results in acash payment to thecompany, within 45 daysafter the end of the tax year,up to the income taxes paid
for the current year and thetwo immediately precedingyears.During the 2008–2009meltdown the tax losscarryover provisions wereextendedtofiveyearssothatpreviously profitablecompanies that sufferedhugelosses in 2008–2009 (e.g.,homebuilders) could getmassive cash refunds fromtheInternalRevenueService.This tax loss carryback
feature is especially usefulwhen a profitable business isavailable for acquisition at aprice well below net assetvalue as shown on the taxrecords. In that case, theInternalRevenueServicewillprobablyprovideasubstantialamountofthecashneededtofinancetheacquisition.Examples of such
transactions abound. Theyinclude the purchase of
Cletrac byWhite Motors; ofAmerican Viscose by FMC;of New York Trap Rock byLazard Freres and Lone StarCement;andthe1975salebyIndian Head of its textileoperations to Hanson Trust.Budd Manufacturing boughtContinental Diamond Fiberassets in the late 1950s, andFiber used the tax carryoverto finance the expansion ofthe one small operation that
Budddidnotbuy.Thatsmalloperation became HavegIndustries, which waseventuallyvaluedatover$50million when it merged intoHercules.The mechanics of such a
taxlosscarrybacktransactioncan be best explained by arelativelysimpleexamplethatassumes there are norecaptureoffsets.
EXAMPLEAssume that the commonstock of Target Company,which has a NAV forfinancial statement and taxpurposes of $44, is sellingat $15, or 7½ timesearnings.Targethasearnedan average of $4 per sharebefore taxes ($2 per shareafter taxes, based on a 50percenttaxrate)forthelastfour years. The company’sassets include $3 cash per
share, and Target isvirtuallydebtfree.Let’s say that AcquirerCompany, which has hadno prior relationship toTarget, purchases afternegotiations all ofTarget’sassets except its cash, andalsoassumesallofTarget’sliabilities by paying toTarget $23 cash per share.Inordertoaccomplishthis,Acquirer is able to borrow$18 of the cash per sharefrom an insurance
company.Supposing that Targetincurs$1pershareexpensefor this transaction and itssubsequent liquidation,Target’sworkout value forthe common stockholderswillbe$31pershare.Thisis shown in Table 6.5.Target’sassetsavailableforliquidation consist of $23per share in cash receivedfrom Acquirer on the saleof its assets, plus $3 pershareofTarget’sowncash,
plus an extra $2 per shareofcurrent-year incomedueto tax savings, plus a two-year NOL carryback pluscurrent year’s taxes thatgenerates refunds of priorincometaxespaidof$2pershareperyearforatotalof$6pershare,minus$1pershare for deal expenses.The $31 per sharedistributedinliquidationtoTarget shareholdersamounts to a 107 percentpremium over the thenmarketpriceof$15.
Table6.5TargetCompanyWorkoutValueonLiquidation
From the buying entity’spointofview,AcquirerwasabletopurchasetheTargetbusiness at a price to it of$31, using only $5 of itsown resources. The rest ofthe purchase price wasotherpeople’smoney—$18borrowed from an
insurance company and $6obtained from the taxrefunds.Consummation of thistransaction and thesubsequent liquidationwould result in Target’sstockholders receiving asubstantial premium overthe market value of theirshares. If Target wants toliquidate, it can do so bydistributing $31 in cash toits stockholders. Thisliquidation would have no
taxconsequences toTargetitself, provided that underSection337of the InternalRevenueCodealiquidationwas substantiallyconsummated within 12months after the adoptionof a plan of liquidation.Rather, the liquidationwould be a taxable eventfor the stockholders: Eachstockholder would have acapitalgainor capital loss,dependingonthecostbasiseach had for his commonstockholdings. Target,
however, need notnecessarily liquidate. Ifmanagement wanted tocontinue in business,Target might become aninvestment trust,a or itmightbeabletobuycertainotherbusinesses.Target did not necessarilyhavetosellall itsassets toAcquirer. It could, forexample,haveretainedoneoperation and offset taxeson profits from thatoperation against the loss
carry forward created bythesaleofassets.On a pro forma basis,Acquirer’s equity boughtTarget’s net assets ataround three timesearnings, based onAcquirer’s equityinvestment of $5, althoughTarget’s P/E ratio as anindependent company was7.5×. Table 6.6 shows acondensed pro formabalance sheet forAcquirer,basedon theacquisitionof
Target’s net assets.Acquirer,ifitwereapubliccompany, might alsobenefitbecauseitspurchaseof Target’s net assets at apricebelowNAVenablesittoreporthigherearningsonthe operations than Targethad. This result is due toone factor: becauseAcquirer’s cost basis forthe assets is lower thanTarget’s.
Table6.6AcquirerProFormaBalanceSheet(OnaPerShareBasis)
Table 6.7 illustrates acondensed income accountfor Acquirer, based on itshaving the same operatingearnings beforedepreciation from Target’sassets that Target hadactually experienced in thepriorfouryears.
Table6.7TargetCompanyWorkoutValueonLiquidation
aTarget’s becoming aninvestment trust is aprincipal component of aformoftransactionthathascome to be known as themost common type ofleveraged buyout. In thistype of leveraged buyout,three elements are present.
First, assets are purchasedat, or below (hopefullybelow, so that tax refundsmaybeobtained), their taxcost basis, so that no taxliabilities are createdregardless of how low thecost basis for commonstock held by principalstockholders may be.Second, the acquiringcompany hires theoperating management ofTarget, giving themattractive long-termcontracts, to run the
businessrepresentedbytheassets the acquiringcompany has purchased.Third,Target converts intoan open-end investmenttrust,thatis,amutualfund,whose investments arerestricted to tax-freesecurities issued by cityand state governments.Target then offers toredeem shares at net assetvalue ($31 per share inTable 6.5), at which timemost public shareholdersredeem and principal
stockholders do not. Theprincipal stockholders thencontrol a mutual fundwhich has invested in tax-free obligations and whichflows through withouttaxation all interestreceived to the remainingshareholders of Target. Ineffect, then, principalshareholders haveconverted their activebusiness interests into aportfolio of tax-exemptsecuritieswithoutincurringany income tax liabilities
eventhoughtheircostbasisfor their common stockholdings may be zero orclosetozero.
LIMITATIONSOFNAVINSECURITYANALYSES
To repeat,we do not believe
in acquiring securities solelyon the basis of the earningsrecordofacompanyorontheoutlook for its reportedearnings.Neitherdowethinkthat an investment programbased on acquiring securitiessimply because they areavailable at large discountsfromNAVwouldnecessarilybe well advised. Availabilityatalargediscountfrombookdoes give a first
approximation that a securitymaybeabargain,oreventhatitmaybeattractiveaccordingto the fundamental financeapproach. But this firstapproximation ought to betemperedbyamorethoroughanalysis.InorderforNAVtobe a good indicator of thewealth or future earningpower of a business, otherfactorsmustbeconsideredaswell.
A company’s record ofprofitability is, of course,someindicationthatthebookasset value actually reflectsreal operating wealth, in thesense of assets that providethewherewithalforobtainingearnings. Earnings for thecurrent and the three prioryearsmayalsobeapotentialsource of liquidity if incometaxes have been paid or taxliabilityhasaccruedonthem.
The investor should alsoconsider such factors as thesize of the company’soperational overhead and theincentives for control groupsto work against the interestsof the outside stockholders.Also, since NAV is only anaccounting figure, it cannotbe more useful thanaccountingfiguresingeneral.In our view, the mostimportant limitation of the
usefulness of NAV as ananalyticaltoolisthatinitself,it does not measure thequalityofacompany’sassets,whichwebelieve tends tobesignificantly more importantthan the quantity of assetvalue. Unfortunately, qualityis a lessmeasurable and lesspreciseconceptthanquantity,involving what is essentiallyasubjectivejudgment.What do we mean by
qualityofassets?Wesuggestthat quality of assets isdetermined in a corporatesituationbyreferencetothreeseparate,butrelated,factors:
1.Assets owned free andclearofencumbrances2.Qualityofoperations3.Nature of assetsthemselvesAn asset or mix of assets
has high-quality elementsinsofarasitapproachesbeing
owned free and clear ofencumbrances. Conversely,the assets of debt-riddencompanies tend to be of lowquality. Note that thoughencumbrances that depressthe quality of assets (such aslong-term indebtedness) maybestated liabilities, theymayalso be off-balance-sheetitems, some of which, ofcourse, will be disclosed infootnotes to the company’s
financial statements. Theseincludesuchitemsaspensionplan liabilities, and suchcontingent liabilities aslitigation and guaranties ofthedebtsofothers.
EXAMPLEOver the period fromDecember 2007 to the endof calendar 2011, TheBoeingCompanypershareNAV(includingdividends)shrunk at slightly more
than 2 percent per yearwhile many other DowJones Industrials’components experiencedincreasesofupwardsof10percent per year for thesame period. Pension andother postretirementbenefits grew the othercomprehensive lossaccount by almost a 15percentperyear ratewhilewealth generated eitherthrough going concernoperations and/or resourceconversion activities
remained flat for theperiod.
Other encumbrances maybe disclosed elsewhere. Forexample, a steelmillmayberequired to installantipollution equipment thatdoes not generate revenue.Still other off-balance-sheetencumbrances may not bedisclosed in any publicdocument. A commonexamplewouldbetheneedto
substantially overhauloutdated plants andequipment in order for thebusiness to remaincompetitive enough tosurvive. Unless an investorhas know-how, and perhapseven know-who, he may beunable to find out that suchencumbrancesexist.The second factor to
consider in evaluating thequality of assets of a going
concern is its operations.Does it have amix of assetsand liabilities that appearslikely to produce high levelsof operating earnings andcash flows? Good operationsare an important creator ofhigh-quality assets and arelikely to contribute to acompany’s having a strongfinancial position. Lendersquite properly prefer tofinance businesses whose
operationsaresoundandwhoare likely to create thewherewithal for continuingdebt service on a long-runbasis.Thethirdfactortheinvestor
mustconsideristhenatureofthe assets themselves. Anassetormixofassetstendstohave high quality when itappears to be salable at aprice that can be estimatedwithamodicumofaccuracy.
Inmany strict going concernsituations, no separate valuesmay be assigned to specificassets as a practical matter,because they may be usefulonly as a part of theoperationsofthecompany.Amicrochip manufacturingplantmaybeveryvaluabletothe operations of a businessbut may have little or novalue as a separate asset forsale. On the other hand,
proved reserves belonging toanexplorationandproductioncompany can be valued witha modicum of effort and dohave value outside of thegoing concern either througha sale to a third party,monetization throughentering into volumetricproduction paymentagreements, or used ascollateral in securedborrowing.
Firstandforemost,then,foran asset to have independentvalue from the point of viewof the outside securitiesholder, it must be availablefor sale apart from theoperations of the goingconcern.Itmustbesomethingthat is not so related to thegoingconcernoperation,orifso dedicated, is separablefrom it in amanner thatwillnot have an adverse impact
on the operating earningspowerofthegoingconcern.Aside from this freedom
from a going concernencumbrance, there arecertain other characteristicsthattendtomakeassetsmoreattractivetolenders,andthusof higher quality.Assets thatare liquid and marketabletend to be more attractive tolenders than those that arenot. Liquid assets include
cash and equivalentmarketable securities,including restricted securitieswith meaningful rights ofregistration, proved oil andgas reserves, cutting rightsand timberlands, and varioustypes of real property. Inorder to be marketable, theassetsmusthaveavalue thatis readily measurable. In thecase of securities that aretraded in organized markets,
the market provides ameasure of value. Otherassets may have readilyascertainable values eventhoughnotso traded—as, forexample, income-producingrealestate.Ifanassetisonethatthird-
party lenders or guarantors(such as financial institutionsand governments) areexperienced in lendingagainst, the standards they
have developed for lendingmay also provide a measureof value, and the asset tendsto be more valuable than itwould otherwise be.Examples of such high-quality assets have includedoil and gas,maritime vesselsand certain types of realestate.Flexibility and scarcity are
factorsthattendalsotomakeanassetmorevaluable.Thus,
multipurposeassetstendtobemore valuable than single-purpose assets. Flexibility isespecially important in thecase of real estate:A factoryuseful for only one type ofassembly line productiontends to be less attractivethan, say, a downtown hotelthat can be convertedeconomically into efficiencyapartments. Assets that arescarce,atleastonalong-term
basis (such as copper minesor domestic oil), may havespecialvaluesalltheirown.Certainassetsthatappearto
have these characteristicsmay,ofcourse,nothavethembecause of legalimpediments. For example,U.S.marginregulationsmakepublicly traded commonstocks worse collateral thanotherassetsthatlackcommonstocks’ characteristics of
liquidity, marketability,flexibility, andmeasurability.Otherassetsmayhavespecialvalue because they can beused to create tax shelter.Because tax savings allowtheseassetstothrowoffmorecash,tax-shelteredassetstendto be most attractive in theeyesofcreditors.Thus,assetssuch as real estate,timberlands, to some extentoil and gas as well as other
natural resources, have beenoutstandingexamplesofthis.These three factors—the
amountofencumbrances, theoperations, and the nature ofthe assets themselves—tendtobeinterrelatedandmaybeoffsetting. Thus, a companythat is lessencumbered tendstobe freer to invest in assetslacking high quality. Theproperty and casualtyinsurance industryprovides a
goodexampleof this:Wherean insurer’s capital andsurplus are small relative tostated liabilities (and topremium income, which inturntendstoberelatedtothesizeofliabilities),thatinsurerwill concentrate itsinvestments in governmentand investment-gradecorporate debt instruments.Onlyascapitalratiosimproverelative to stated liabilities
(and premium income) willinsurers tend to invest aportionoftheirassetsinsuchlower-quality instruments asequity securities, especiallycommonstocks.High-quality asset
businessestendtobefarmoreattractive holdings at givenprices—say, when thecommonstocksare sellingatten times earnings—than arecomparable businesses with
lower-quality asset values.This is so because suchbusinesseshaveatendencytobesubject tocertaindynamicdevelopments. Andfrequentlythecommonstocksof businesses with high-quality assets may sell atlower P/E ratios thancomparable businesses withlower-quality assets. Thistends to happen when stocktraders desire to pay
premiums for aggressivemanagements, althoughcompanies with high-qualityassets oftentimes are run bycareful rather thanaggressivemanagers.High-quality assets are
most commonly used tofinance rapidgrowth,both inpresentproductlinesandintodiversified areas—as, forexample, in the case in 2012for Brookfield Asset
Management or CheungKongHoldings.Surplus liquid assets not
needed in a business(sometimes called surplussurplus10) may be extractedfrom these companies. Thiswas,forexample,thebasisofthe takeovers in 1968 and1969 of strongly capitalizedinsurers, such as RelianceInsurance and GreatAmericanHoldingCompany.
At the time of takeover, theworkouts for shareholderswere more than twice whattheshareshadbeensellingatoneyearearlier.A company’s high-quality
assetsmaybeusedtofinancethe takeoverof thatcompanyon a better price basis thanwouldotherwisebeavailable.An example of this—a casewhereamouseswallowedanelephant—was the 1962
acquisition by AlbermarlePaper ManufacturingCompany, a small company,of the entire capital of themuch larger and extremelywell financed EthylCorporation. Albermarle notonly swallowed the elephant,butalsoadopteditsname.When a company lacks
encumbrances as measuredagainst the amount ofobligationsitowes,thenature
of its operations and/or itspotentialtosellorconvertallorpartofitsassetstoamoreliquid or useful form, thatcompany is deemed by us tohave a strong financialposition,oneofthefourmaincharacteristics sought in anequity investment using thesafe and cheap approach.Generally, it is our view thatif a company has little or nooutstanding obligations, it is
inastrongfinancialposition,unless operating losses seemto have some prospect ofbeing so large that thecompany’s strength will beimpaired.Value investors, by
definition, are conscious ofthe relationship of securitiesprices to corporatefundamentals. In valueinvesting, asset allocation isdriven more by price
considerations and less bypredictingoutlooks.
LARGEPREMIUMSOVERBOOK
VALUEUSUALLYMEANHIGH
P/ERATIOS:ITDEPENDSON
ROEWhen common stocks aresellingatultra-highpremiumsoverbookvalue, it ishard toacquire securities atreasonable P/E ratios. Thiscan only be accomplished ifthe issuer enjoysunprecedentlyhighreturnson
equity (ROE), say well inexcessof30percent. In fact,most companies rarelyachieveROEsinexcessof25percent most of the time. Inour recommended list ofcommonstocksinTable6.11,the goal for the issuer, asmeasured by ROE is toachievegrowthof10percentper year after adding backdividends,overa3-to7-yearperiod.
The above can bedemonstrated by a simpleexample.Assuming amarketprice of 6× book value, P/EratiosatvariousROEswouldbeasfollows:Table6.8RelationshipbetweenROEandP/ERatiosundera6×BookPricingAssumption
The 6× book value might
be justifiableassuming thatacompany has such attractiveaccess tocapitalmarkets thatitcouldincreasetheirnumberofsharesoutstandingby31.5percent via the issuance ofnew shares at 5.25× bookeither in an acquisition or apublic offering. (Thisassumption is probablyunrealistic for mostcompaniesmostof the time.)In that instance book value
would increase to $2.02 pershare,11 and EPS and P/Eratios would be as shown inTable 6.9 for various ROEs(forgetting the probabilitiesthattheincreasedequitybasemight well precipitate adecline inROE).This is partofourthesisthatinthehandsof an astute management anoverpricedcommonstockcanbeamostimportantasset.Table6.9Relationshipbetween
ROEandP/ERatiosUnderaDoublingofBookValueAssumption
NETNETSREDEFINED
Net asset values are readilyascertainable insofar as thespecificassetsconsistofcash
and equivalents; investmentsin marketable securities andperforming loans; incomeproducing real estate; landsuitablefordevelopment;andintangibles such as mutualfund assets undermanagement. Rarely (exceptfor cash and equivalents) arethese readily ascertainableasset values classified ascurrent assets underGenerally Accepted
Accounting Principles(GAAP). Graham and Dodddescribe net nets in the 1962edition of Security Analysisonpages561and562:We feel on more solidground in discussing thesecases in which the marketprice or the computedvalue based on earningsand dividends is less thanthe net current assetsapplicable to the common
stock. [The reader willrecall that in thiscomputation we deduct allobligations and preferredstock from the workingcapital to determine thebalance for the common.]Fromlongexperiencewiththis type of situation wecan say that it is alwaysinteresting, and that thepurchase of a diversifiedgroupofcompaniesonthis
“bargain basis” is almostcertain to result profitablywithinareasonableperiodof time. One reason forcalling such purchasesbargain issues is thatusually net current assetvaluesmaybeconsideredaconservative measure ofliquidation value. Thus asa practical matter suchcompanies could bedisposed of for not less
than theirworkingcapital,if that capital isconservatively stated. It isageneralrulethatat leastenoughcanberealizedforthe plant account andmiscellaneous assets tooffset any shrinkagesustained in theprocessofturning current assets intocash. [This rule wouldnearly always apply to anegotiated sale of the
business to somereasonably interestedbuyer.] The workingcapital value behind acommon stock can bereadily computed.Consequently,byusingthisfigure (i.e., net-net assetvalue) as the equivalent of“minimum liquidatingvalue”wecandiscusswithsome degree of confidencethe actual relationship
between the market priceof a stock and therealizable value of thebusiness.Ourdefinitionofnetnetsis
taken from Graham andDodd’sSecurityAnalysis,butwith a few twists. GrahamandDodd relied on aGAAPclassified balance sheet todefine current assets in orderto ascertain if a commonstock was a net net.We use
ourownjudgmentratherthanGAAPclassificationtodefinecurrent assets in order todecide what is a liquid, thatis,acurrentasset.While Graham and Dodd
seem to have invented theidea of net nets, we use thatidea with a number ofmodifications based on ourdiscussions earlier in thischapter.First, we are not interested
in net nets unless thecompany is extremely wellfinanced.A large quantity ofcurrent assets, especially ifthey consist of inventories,costs inexcessofbillings,orreceivables from less thancreditworthy customers,probably cannot help thecommon stock of a companythat cannot meet itsobligations to its creditors.Second, many current assets
classified as current assetsunderGAAP are really fixedassetsof theworstsort.Takedepartmentstoremerchandiseinventories.Ifthedepartmentstore is to be liquidated,merchandise inventories areindeed a current asset,convertible tocashwithin12months at prices thatconceivablycouldbeclosetoNAV, although much lessthanNAVmayberealized if
the merchandise is disposedof in a GOB (going out ofbusiness) sale. On the otherhand, if the department storeis a going concern,merchandiseinventoriesareafixed asset of the worst sort.The merchandise inventorieshave tobe replaced, arehardto value, and are subject tomarkdowns, obsolescence,shrinkage, seasonality, andmislocation. The Toyota
Industries portfolio ofmarketable securities seemstobemuchmoreofacurrentasset than department storemerchandise inventorieseventhough, for GAAP or IFRSpurposes, Toyota Industries’marketable securities are notconsidered a current asset.Third, theGrahamandDoddformulation does not accountfor off-balance-sheetliabilities that may, or may
not,bedisclosedinfootnotes,nor do Graham and Doddtake into account excessiveexpenses or losses. Wecapitalize such expenses orlosses, and we add them toliabilities. Fourth, Grahamand Dodd only seem torecognize partially thatcertain fixed assets, such asproperty, plant, andequipment, can sometimescreate cash. For example,
under Section 1231 of theU.S. Internal Revenue Code,the sale at a loss of suchassets used in a trade orbusiness,usuallygivesrisetoan ordinary loss for incometax purposes. In that case, acorporation may be able toapply the loss first to reducecurrent year taxes and anyexcess lossmight be used togetquickiecashrefundsfromthe IRS with regard to taxes
paidinthepriortwoyears.The identification of net
nets does not appear to bethat difficult. Cheung KongHoldings, The WharfHoldings, and CapitalSouthwest, discussed earlierin this chapter, are clearexamples of Graham andDodd net nets. The toughestproblemby far, is to identifymanagements and controlgroups of these net netswho
are both able and consciousof the interests of outside,passive, minority investors.This problemnotwithstanding, the investorusing a fundamental financeapproach can obtain largemargins of safety byrestricting his purchases toissues selling at steepdiscounts from readilyascertainable NAVs fromhighly creditworthy issuers
with good prospects forincreasingNAVin thefutureat rates of 10 percent perannumorlarger.When all is said and done,
however, we owe anenormousdebtofgratitudetoGraham and Dodd forintroducingtheconceptofnetnets.
OPMI
INVESTINGINCOMPANIES
WITHGROWINGNAVS
Historically NAVs ofreasonably managedcompanies with reasonablystrong financesgrowyearbyyear, almost continuously.
This can be seen in Table6.10, which shows thechanges in book values forthe Standard & Poor’s 500stock index during the 18years ended December 31,2012. The book valuesincreased in 16 of the 18years failing todosoonly in2002, an aftermath of thebursting of the dotcombubble; and 2008, anaftermath of the onset of the
Great Recession. During the18 years period book valueper share increased from206to 661, or at a rate of 6.7percent per annumcompounded before addingbackdividendspaid.Table6.10SPXIndexHistoricalPricetoBookValueRatio
One of the things theincrease in book valueconnotes is that for those
companies that remainedcreditworthy, theirborrowingcapacity in 2012was greaterthat it had been in earlieryears.Thiscomportswithourthesis, both for corporationsand governments, that in theaggregate debt is neverrepaid.Ratheritisrefinancedand expanded by economicentities that remaincreditworthy.Bookvalueintheaggregate
seems tobeagoodsurrogateforNAV,buttheyarenotthesame thing in our view. Formany of the companiesmaking up the S&P 500Index, high book value forassets such as surplusautomobile assembly plantsor obsolescent steel millsrepresent overhead costs thatareunlikelytoevercontributeto operating earnings or cashflows (though as Section
1231assetstheymaygivetheownerof theassets favorableincome tax attributes).WhenwefocusonNAV,werestrictourselves to readilyascertainable NAVs ofcompanies that are wellfinanced. Determining whatis readilyascertainable isnotrocket science. Readilyascertainable asset valuesexist where corporate assetsconsists of cash, marketable
securities, performing loans,income-producingrealestate,and other income-producingassets such as infrastructureand many power generatorssuch as hydroelectricfacilities. Also included areintangible assets, whichappeartohaveareadymarketfor sale such as assets undermanagement (AUM) ofmutual fund managementcompanies.
In our analysis, we try toinvest in the common stocksof well-financed companieswith readily ascertainableNAVs selling at discountsfrom such NAVs of at least20 percent. Further, werestrict such investments tocompanies that we believe,after thorough analysis, havegood prospects to be able togrowthoseNAVsbynotlessthan 10 percent per annum
compounded over the nextthreetofiveyears.Obviously, the vast
majority of companies in theS&P 500 Index would notqualify for inclusion in ourlist of recommended NAVcommon stocks. As Table6.10 shows, the averagecommon stock in the S&P500 Index was selling at 2.2times book value (and wasprobablynotaswellfinanced
asourrecommendedcommonstocks). In contrast, we willnot pay more than 0.8 timesreadilyascertainableNAVforourrecommendedissues.At June 30, 2012, a list of
recommendedNAVcommonstocks would include theissues contained in Table6.11.Table6.11ListofRecommendedNAVCommonStocksBasedonOurCriteria
Assuming growth in NAVover the next three to fiveyears of 10 percent perannum, including dividends,the probabilities of losingmoney over this long term
don’t seem great. Wheelockoffers a good example. Overthe next three- and five-yearperiods, Wheelock’sDecember 31, 2011, NAVgiven a 10 percent annualgrowth would increase to$80.29 per share and $97.15per share respectively. Tohave a market loss onWheelockCommontheNAVdiscount would have tobecome greater than 64
percent after three years and70 percent after five years.Thiscouldhappenbut seemsunlikely. Wheelock’sprobabilities of growingearnings and cash flow overthe next three to five yearsseem to be very good. IfWheelock is not to achievethe10percentgrowthbogey,it may well be because ofincreased capitalization ratesbeing applied to income-
producing real estate as partof the independent appraisalsmandated by IFRSaccounting. Incidentally, inthe five years to December31, 2011, the average annualgrowth in Wheelock’s NAVafter adding back dividendswas20.4percent.Obviously not all the
companies listed in Table6.11 are going to achieve 10percent compound annual
growthover thenext three tofive years. We are just notthat competent as analysts tobe that accurate about somany predictions. However,itisinterestingtoseehowtheactual portfolio fared in thefiveyearsthrough2011.Onlythree common stocks, whichwere selling at NAVdiscounts five yearspreviously—CapitalSouthwest, InvestorA/B,and
Toyota Industries—failed togrowNAVbyasmuchas10percentcompoundedandone,Toyota Industries, actuallysuffered a small decline inNAV. Marketwise, the priceoftwoof thecommonstockswas up, and only ToyotaIndustries common stockmarket price declined, andthat only by 5 percent or so.The one issue in Table 6.11that suffered material price
depressioninthemarketafter2007 was Forest Citycommon. Prior to the 2008–2009 meltdown, Forest Citycommonwassellingataverylarge premium over NAV; itwas also not well financed.Neitherofthesefactorsseemsto exist for Forest City in2012.While investing in readily
ascertainable NAVs at adiscountmayprovideOPMIs
with considerable downsideprotections over the longterm, it seems to offer noprotection against short-termmarket risk, that is,fluctuationsinsecurityprices.Further, while investing inreadilyascertainableNAVsata discount may be a goodway to enjoy a reasonableabsolute return, it in no wayassures an OPMI thatfavorablerelativereturnswill
be achieved compared withother investment approaches.Inadditionsincetheapproachdoesnothingtoguardagainstnear-term market risk, itprobably is dangerous tofinance an NAV portfoliolargely with borrowedmoney. After all in ourrecommended approach weemphasize a factor—growthin NAV—that is almostcompletely ignored by most
marketparticipants.Growth in NAV is the
primemeasure of investmentresultsusedincertainpartsofthesecuritiesmarkets,suchasinvestment companies.Berkshire Hathaway,Brookfield AssetManagement and WhiteMountains Insurance. Butgrowth in NAV never seemsto be a factor for the vastmajorityofOPMIswhoseem
focusedontheprimacyoftheincome account, short-termism, and top-downanalysis.We think our approach is
particularlyusefulforpassivemarketparticipantswhohavelong-term outlooks andneeds,andwhodon’tfinancelargely with borrowings.Such investors includepensionfundsandindividualssavingforretirement.
In following our approach,U.S. taxpayersmightwant toavoidthosecompanies,whichfor U.S. tax purposes aredeemed tobepassiveforeigninvestment companies(PFICs). PFIC taxes areonerous.Among other thingsU.S. taxpayers holding PFICsecurities are subject toordinary income taxes eachyear on unrealizedappreciation. Such a tax has
the threeworstelementsofatax, to wit, the tax rate is atthe optimum; the taxpayerhasnocontroloverwhen thetaxcomesdue;andtheevent,unrealized appreciation,which gives rise to the taxdoesnotgiverise to thecashwithwhich topay the tax. InTable6.11onlyInvestorA/B,LaiSunGarmentandToyotaIndustriesappeartobePFICs.For almost all OPMIs, it
seemsveryhardtotrytobeatthe market consistently bytryingtobeatthemarket.Theactivity is just toocompetitive. Rather it seemsto us a more rationalapproach is to be valueconsciousrather thanoutlookconscious. Acquire thecommon stocks of well-capitalizedcompaniesatdeepdiscounts from readilyascertainableNAVs.We feel
comfortableinsofarasatleast50percentofacommonstockportfolio consists of safe andcheap equities such as thoselisted in Table 6.11, that is,the company enjoys a superstrong financial position; thecommonstockispricedat,atleast a 20 percent discountfrom readily ascertainableNAV; disclosures arecomprehensive; the commonstock is traded in well
regulated markets, and theprospects appear good thatover the next three to sevenyears,NAVwillgrowbynotless than 10 percentcompounded annually afteraddingdividends.Once acquired these
securities could be heldindefinitely unless thesecurity becomes grosslyoverpriced; the businessseems to have suffered a
permanent impairment (e.g.,using company cash for aninjudicious acquisition); orfor portfolio considerations,such as required redemptionsofownershipinterests.While not on our radar
screen,perhapsover the longterm, one or more of ourportfoliocompaniesaretobesubject to resourceconversion activity. Forexample,ifthereweretobea
change of control through anewpartyacquiringcommonstock, there seems aprobabilitythatOPMIswouldrealize a premium (maybe asubstantial premium) overNAV. Given a strongfinancial position and a deepdiscount from NAV, manyinsiderswouldconsidergoingprivate,includingaleveragedbuyout (LBO) at a premiumover market but probably a
discountfromNAV.
SUMMARYNet asset value or NAV,unlike reported accountingearnings, seems to play littleornoroleininfluencingday-to-day stock market prices.Thisisprobablytheprincipalreasonwhynearlyallwritersabout financial accountingand security analysis have
denigrated the importance ofNAV as a tool of valuation,emphasizing instead aprimacy of earnings. In thischapter, we detail reasonswhy we think attention toNAV should be useful forcreditors and investors. Webelieve that in almost allanalysisoutsideoftheday-to-day stock-tradingenvironment, NAV is ahighlyuseful tool of analysis
for a variety of purposes,includingasacomprehensivemeasure of the wealth-creation capability of abusiness, as an appraisal ofcompanies and managementsas operators, investors, andfinanciersandasonemeasureof theresourcesand liquidityavailable toabusiness.NAVanalysis can be extremelyuseful. We offer exampleswheregrowthinNAVcanbe
an almost assured source ofprofit or an absence of lossfor the fundamental financeinvestor and how NAVanalysis can be used to seewhether market pricing isway ahead of corporatefundamentals. We redefinetheconceptofnetnetsandindoing so highlight theimportance of understandingwhat accounting numbersmean rather than what they
are. Finally, we offer theOPMI a primer on investingin companies with growingNAVs._______________*ThischaptercontainsoriginalmaterialandpartsofthechapterarebasedonmaterialcontainedinChapter12ofTheAggressiveConservativeInvestorbyMartinJ.WhitmanandMartinShubik
(©2006byMartinJ.WhitmanandMartinShubik)andideascontainedinthe19983Q,4Q,19991Q,20033Q,and20061Qletterstoshareholders.ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1BenjaminGraham,DavidL.Dodd,andSidneyCottle,SecurityAnalysis:PrinciplesandTechnique
(NewYork:McGraw-Hill,1962).2AmericanInstituteofCertifiedPublicAccountants,AccountingPrinciples,Section1022.04.3HermanW.Bevis,CorporateFinancialReportinginaCompetitiveEconomy(NewYork:Macmillan,1965).4GeorgeD.McCarthyandRobertE.Healy,Valuinga
Company:PracticesandProcedures(NewYork:RonaldPress,1971).5Graham,Dodd,andCottle,SecurityAnalysis.Seeespeciallypp.551–552.6Op.Cit.,p.132.7Op.Cit.,p.50.8Op.Cit.,pp.103–4.9Returnoninvestmentisusuallydefinedasnetincomeasapercentageofnetworthandfundeddebt.
Returnonequityisusuallydefinedasnetincomeasapercentageofcapitalstockandsurplus;sometimeswhenpreferredstocksareoutstanding,ROEisdefinedasnetincomeasapercentageofnetworth(withthenetworthaccountincludingpreferredstock,commonstockandsurplus).10Surplussurplusisanamewethink,butarenotsure,
wasinventedbytheNewYorkStatesuperintendentofinsurancearound1969.11Sincethenewnumberofsharesrelativetotheoldnumberis1.315,theproportionofoldsharesatabookvalueof$1is1/1.315or76percent,whiletheproportionofnewsharespricedat$5.25is24percent.Thenewbookvaluepershareiscalculated
as(0.76*$1+0.24*$5.25),or$2.02.
CHAPTER7
Creditworthiness
CreditworthinessfromtheBorrowingEntityPointofView
CapitalStructureCapitalStructurefromtheCorporatePerspectiveFactorsAffectingCapitalStructureConservativeCapitalStructuresSummary
For thosewhoholdor investin junior securities—fromunsecured obligationsthroughcommonstocks—andfor those interested in thegeneral economy, it is hardnot to overemphasize theimportance ofcreditworthiness. Put simply,if an economic entity—corporate, government or
individual—cannot be madecreditworthy, sooner or laterit will have to restructure itsobligationsorliquidate.There are three tests of
creditworthiness:1.Does the fair value ofassetsexceed theamountof claims embedded inactual liabilities? Abalancesheettest.2. Is theresufficientcashflow from operations
and/or the sale of assetsto allow the economicentitytomeetitsrequireddebt service obligationsas they become due? Acash flow (or income)test.3. Does the economicentity have access tocapital markets, which itcan use to meet cashshortfalls? A liquiditytest.
Fewrealize that inorder toremain solvent—that is,creditworthy—an economicentity does not necessarilyhave to pass all three tests.Passing only one will oftendo. Paul Krugman, aneminent economist, wrotefrequently in 2008 and 2009about “zombie banks.” Azombie bank was one wherethe contractual obligationsembedded in liabilities
exceeded the fair value ofassets. The fair value ofliabilitieswas not, and couldnot be, the market value ofobligations.Rather itwas thedollar amount of claims thatwould have to be paid to allobligees, mostly depositors,both principal and interest.Krugman seems to havemissed the point that thesebanks were not insolventsincetheyseemedtohavethe
ability, however marginal, tomeettheirobligationsastheybecame due. Also the bankshadaccess tocapitalmarketseven as capital from theprivate sector froze up. Thegovernment could, and did,provide funds through itsTARPprogram.AsispointedoutinChapter
25onHertzGlobalHoldings,a highly leveraged company,barely profitable, remained
more or less creditworthyonly because the companyhadaccess tocapitalmarketsat all times subsequent to its2005changeofownership.From the point of view of
outside passive minorityinvestors(OPMIs),wedonotbelieve that most long-termcommon stock investingmakesmuchsenseunless thecorporation embodiesunquestioned
creditworthiness. Thus ourrecommended investmentsare in the common stocks ofcompanies that enjoyexceptionalfinancialstrength,sound operations and/orassets, and trustworthymanagement or controlgroups.Call itoverkill,but itisalsoquitecomfortabletobeinvested in the commonstocks of companies whosesolvency is not close to ever
beinginquestion.Besidestheinsurance provided to theOPMI holding juniorsecurities, creditworthinessalso affords managementoptions to be opportunistic;that is, use it as an asset inresourceconversionactivitiestocreatewealth.The only OPMIs we think
can safely ignorecreditworthiness are securedcreditors, where the value of
the security pledged farexceeds the amounts of theclaims against it, and whereloan covenants prevent adilutionofthatprotection.As bottom-up investors
following a fundamentalfinance approach, we havealways focused oncreditworthiness much morethan almost any other personor group writing aboutsecurity analysis or
economics.Thus,forusthereexists the strict discipline ofnot investing inanycommonstock knowingly unless theissuing company enjoys astrongfinancialposition.Thisis in contrast to almost allconventional marketparticipants who viewbusinesses as strict goingconcerns and as a resultemphasize a primacy of theincome account; that is,
principalweight in an equityvaluation goes to earningsfrom operations and/or cashflowfromoperations.Almostall other OPMIs seem todenigrate the importance ofstrongfinancialpositions.This tendency to downplay
the importance ofcreditworthiness is prevalentalso on the macro level,probably even more so thanforbottom-up investors.This
attitude has been wellsummarized by former VicePresident Dick Cheney, whowas quoted as saying,“Deficits don’t matter.” Forthe vast majority of people,the important economicsstatistics are gross domesticproduct, employment andunemployment levels,corporate earnings, andproductivity increases.Creditworthiness is pretty
muchignored.
CREDITWORTHINESSFROMTHE
BORROWINGENTITYPOINT
OFVIEWBased, as always, upon abottom-up, fundamental
finance approach to analysis,our view of what ishappening in the U.S.economy seems to be quitedifferent fromtheviewsheldbypoliticiansandacademics.Central to the economicdebate and discussionthroughout2011hasbeenthequestion of the solvency ofthe United Statesgovernment. Declaring theU.S. bankrupt is now in
fashionandhasbeenused tojustify investment decisionsand to sell investmentstrategies and products. Still,thequestionofU.S.solvency,or the solvency of anyeconomic entity whether agovernment, a corporation oran individual, is worthconsidering.The true testofsolvency is
the creditworthiness of theeconomic entity, not the
amount of debt that it owes.The amount of debt isimportant, and we discusscorporate capital structureand its determination later inthechapter.Debthowever, isonly one element indetermining creditworthiness.In fact, creditworthiness orcredit capacity, is a functionofthreefactors:
1.Theamountofdebt2.Thetermsofdebt
3.Theproductivityintheuse of proceeds arisingoutoftheborrowingsThe first factor is how
much indebtedness is beingincurred via balance ofpayments deficits, othergovernmental borrowing,corporate borrowings, andborrowingsbyconsumers.Ofitself,increasingindebtednessis not a huge problem,provided the use of funds
created by the borrowing isproductive, that is, createswealth. Insofar as the use ofproceeds does not result inwealth creation, or it createsonly modest increases inwealth—thatis,thereexistsanegative multiplier, or amodest multiplier—theborrowing entity, sooner orlater, has to face diminishedcreditworthiness (except iftheentitycansellassetsona
massivescale).The third factor—
productivity or growth—seems by far the mostimportantof the threefactorsfor the U.S. government.Historically, certain U.S.government uses of proceedshave been unbelievablyproductive, such as theHomestead Act of 1862 andthe Servicemen’sReadjustment Act of 1944
(theG.I.BillofRights).Whileitisrelativelyeasyto
measure the productivity ofuse of proceeds at thecorporate level—profitsand/or growth in net assetvalues—it tends to be muchharder (although notimpossible) to measureproductivity where theexpenditures are made by agovernment not motivatedprimarilybyseekingprofits.
EXAMPLEThe U.S. government didrunbudgetsurplusesinthemid to late 1990s, as adirect result of decades ofdebt-financed, productivespending. Much of thecredit for that performanceseems attributable to thedot-com bubble, madepossibleby thewidespreadadoptionoftheInternetandthe vast electrical andtelecommunicationsinfrastructureoftheUnited
States. Various newlyminted billionaires paidhuge amounts of capitalgaintaxes,andthetaxbasewas broadened, as a newindustry created demandfor highly skilled, andmostly well paid, workers.Muchofthegrowthinhightechduringthattimeseemsto have been triggered, inpart, by the initial publicoffering (IPO) Boom and,in part, by defensecutbacks,which compelledsmart engineers and nerds
togetinvolvedinattractivestart-ups,ratherthantakingjobswithLockheedMartinand General Dynamics.Thespeculativeexcessesofthe 1990s seem to havecontributed muchpermanent good to theeconomy with thedevelopment of extremelyable, extremelyproductive,high-tech industries.Allofthisoccurredwhilecausinghuge harm to passivemarket participants whospeculated in dotcoms and
did not sell theircommitmentsintime.
As investors using afundamental financeapproach, we measure thecreditworthiness of acompany by looking at theentity’sabilitytohaveandtocreateliquidityeither:
1.Fromsurpluscash2. From other assetsreadily convertible into
cash, such as a portfolioof blue-chip corporatecommon stocks andbondswhoseresaleisnotrestricted, Class Aincome-producing realestate,andsoon(qualityofassets)1
3. By an ability togenerate surplus cashfrom operations (qualityand quantity ofresources)
4.Byanabilitytoaccesscapital markets whenneeded:
a.Abilitytoborroworb. Ability to marketnew issues of equitysecurities2
5.Bytherelativeabsenceof liabilities either onbalancesheet,offbalancesheet, in the footnotes tothe financial statements,or out there in theworld
(qualityofresources)Since most conventional
approaches viewcreditworthinessonlythroughthelensofhowmuchdebttheeconomic entity has inrelation to the somemeasureof thevalueof its assets (thebalance sheet test), adiscussionofcapitalstructurefrom the corporate point ofviewwillbeinstructive.
CAPITALSTRUCTURE
Modern financial theorists,and Graham and Doddfundamentalists, for thatmatter, look at corporatecapital structure exclusivelyfrom the point of view ofwhat impact a capitalstructure is likely to have onthe market price of acorporation’s common stock.
In fundamental finance weview capital structure assomethingthatarisesoutofaprocessthatinvolvesmeetingthe needs and desires of amultiplicityofconstituencies,including various creditors,regulators, rating agencies,managements and othercontrol groups, outsidepassive minority investors(OPMIs), and the companyitself. Below we enumerate
factors that ought to beweightedinthedeterminationofcapitalstructure.Adopting the modern
capital theory (MCT)approach to appropriatecapital structure, whichtheorizes about the probableimpacts of capital structureon OPMI market prices, isakin to studying the solarsystem by assuming the sunrevolves around the earth. In
this analogy, the earth is anOPMI, and it is given animportance in the solarsystem completely out ofsync with readily observablereality. Although thisperspectivemight be fine foran OPMI, it is inappropriatefor an investor following afundamental financeapproach or anyone wishingto take a corporateperspective on capital
structure.
CAPITALSTRUCTUREFROMTHECORPORATEPERSPECTIVE
An understanding of thespecific factors affecting
capital structure requiresknowledge of the severalconceptual differences thatarise from taking a corporateperspective rather than thetraditionalefficient-marketorGrahamandDoddviews.
SubstantiveConsolidation
An underlying assumptionfoundinMCTandinGraham
and Dodd is that there is asubstantive consolidationbetween the interests of theOPMI and corporatefeasibility.3 These theoriesholdthattheexclusivewaytodetermine the value of acorporationistofindthetotalmarket value of all itsoutstanding equity securitiesandaddtothistheamountofcorporate obligationsoutstanding, either as
measuredbyclaimamountormarketvalue.From the value-investing
perspective, there is nosubstantive consolidation.Furthermore, OPMI desiresfrequently conflict withcorporate feasibility. Thereare three obvious cases inwhich such conflicts arecommon:
1. The short-run OPMIdesire for maximum
reported earnings even ifitmeanshighercorporateincome-tax bills thanwouldotherwiseexist2. The tendency ofOPMIs to have veryshort-run agendas, eventhough long-termexpensive projects mightenhance corporate valuesmaterially3. The OPMI desire forcash dividends or cash
distributions in the formof common stockbuybacks even whencorporations might havemuchbetterusesforcashretained for corporateuses
AccessingEquityMarkets
Corporate feasibility andOPMI stock price are
essentially equivalent whenthe corporation is seekingaccess to capital markets toraisefundsthroughthesaleofnew issues of equity,especially common stockequity. Here, though, thecloserelationshipismeasuredby whether the corporationcan access capitalmarkets atall,notbytheper-sharepricethe corporation will receiveforthesaleofanewissueof
common stock that does notpay a cash dividend. In thisinstance, per-share price canhave a more or less dilutiveeffectoncommonshares.Theprice has no real effect,however, on corporatefeasibility.
FinancingwithRetainedEarnings
For most corporations,
accessing equity markets fornew funds is a sometimething, rather capricious in itsdoability and almost alwaysvery expensive in terms ofoverall underwriting costs.Consequently, the vastmajority of publiccorporations fill their equityneeds through retainingearnings. Only a smallpercentage of earnings, ornone at all, are paid out to
shareholders as cashdividends. The indicatedpercentage payout forStandard&Poor’s(S&P)500Index in August 2011 was41.6percent.There are important
exceptions, though, tofinancing with retainedearnings. The most notableone has been the electricutility industry. From 1945through the late 1970s, most
companies in the industrywere experiencing averageannualgrowth in thedemandforelectrickilowattsofabout7percentperannum.Massivecapital expenditures wereneeded to produce $1 ofannual revenue (estimated atabout $5 of capitalexpenditures for every $1 ofannual revenue). Normalcapitalization consisted of 50to 60 percent long-term
mortgage debt, 10 percentpreferred stock, and30 to40percent equity.Equity had tobe increased relativelyregularly and in relativelymajor doses. The industryensured for itself access toequitymarketsbypayingoutasdividends70to80percentofearnings,whichthenmadetheir securities attractive toincome investors.Furthermore, per-share
dividends were increasedmodestly as often as once ayear.Every18 to24months,however, the companiesmarketed new issues ofcommon stock to obtainrequisite funds to financemassive capital expenditureswhile keeping debt-to-stockratios in line with mortgagedebt covenants and withindustry custom and usage.Thus, appeal to a
constituency that wantedregular and increasingdividends ensured thatutilitieswouldhaveaccesstoacapitalsourcetheyneeded.There remain a number of
companies inother industriesthat followtheelectricutilitymodel of paying outdividendsrepresentingahighpercentage of their earningsand then periodicallymarketing new issues of
common stocks. Real estateinvestmenttrusts(REITs)andmany finance companiesfollow such policies. Indeed,REITsarerequiredtopayoutat least 90 percent of netincome as dividends if theyare to remain REITs andenjoyaflow-throughincome-tax status, where the REITitselfisnotsubjecttoincometaxbecauseotherwisetaxableincome is paid out to
shareholders.The concept of high
dividends combined withfrequent access to equitymarketsthatisimplicitintheefficient market hypothesis(EMH) and Graham andDodd views of capitalstructures, however, is notcommon.
DividendPolicy
BenjaminGrahamandDavidDodd, in discussing dividendpolicy, focused onsubstantive consolidation.According to Graham andDodd and the EMH, acompany that enjoys a highreturn on equity (ROE)should retain earnings, and acompany with a low ROEshouldpayoutitsearningsasdividends when itsshareholderscouldearnmore
than the company could byreinvesting the net proceedsfromdividend payments. Forfundamental financeinvestors,dividendsare tobeviewed as a residual use ofcash,somethingtobepaidtoshareholders only after acompany’s needs to retaincasharemet.Thecompany’sreasonable needs come first.The company’s needs are ofthree types: toacquireassets,
to pay or otherwise satisfycreditors, and to provide amargin of safety against anunpredictable future. Manyhigh-ROE companies havelittleornoneedtoretaincashand can afford high dividendpayouts (e.g., money-management companies).Many low-ROE companieshad better retain most cashgenerated from operations ifthey are to survive (e.g.,
integrated aluminumproducers, discount retailers,and meatpackers). ROEshould not be a test for afirm’s ability to paydividends.
ConstituencyStakesinCorporateFeasibilityThereseemstobeaviewthatthe common stockholdercommunity has a consuming
interest in corporatefeasibility but that otherconstituencies (notablycreditors)donot.Creditors,itis postulated, just want toreceive back principal plusinterest even if it bankruptsthecompany,butsuchaviewis unrealistic. The vastmajority of creditors havecontinuing relationships withthe companies towhom theylend,sotheyareinterestedin
refinancing maturing debtand/or continuing to shipgoods or rent properties.Everyone—not just commonshareholders—has a stake incorporatefeasibility.
ConstituencyConflictswithCorporateFeasibility
Everyconstituency,includingOPMI shareholders, also has
conflicts with corporatefeasibility.Eachwants thingsfrom companies that detractfrom feasibility. Holders ofcommon shares wantdividends, creditors wantcash payments and toughcovenants, and managementswant huge compensationpackages.As is stated in previous
chapters, each constituencyrelated to a corporation has
objectives concerning thecompany that combinecommunities of interest andconflicts of interest. There isusually nothing special aboutOPMIs compared with otherconstituencies except thatmostOPMIsneednothaveapermanent or semipermanentstakeinthecompanyandthatonceanOPMIownscommonstock, the OPMI has nofurtherobligationtodothings
for the company. Thus,OPMIs are not smarter orbetter informed than otherconstituencies,andOPMIsdonothaveanexclusiveinterestin corporate feasibility. Twothings, however, dodistinguish many OPMIsfrom other constituencies:they have no particular needfor a cash return, and theyhavenoneedforelementsofcontrol. All other
constituencies tend to beintelligent, theirmarkets tendtoward efficiency, and theyeach seek to maximize theirfinancial interests. (Thesecharacteristics are notexclusive to OPMIshareholders; they are sharedwith creditors, regulators,rating agencies,managements, and controlshareholders.)Actually,otherthingsbeing
equal,OPMIs are often a lotless knowledgeable thanothers who have to relyexclusively on theperformance of the businessfor a cash bailout and whocannot, unlike OPMIs, lookto a sale to a market for acash bailout. Put simply, alife insurance companymaking a long-term private-placement unsecured loan toa company is probably a lot
more knowledgeable aboutthe company than are theOPMIstradingcommonstockon the New York StockExchange (NYSE). First, theinsurance company can dodue-diligence researchbeyond the public record.Second, the insurancecompanydoesnotwastetimeand energy analyzing factorsthat probably have norelationship to specific
corporate values (e.g., thelevelofinterestratesorofthegross domestic product[GDP], dividend policy, ortechnical marketconsiderations). Offsettingthis somewhat is thelikelihood that the insurancecompanyknowsthatthemoresenior the issue and theshorter its maturity, the lessthe corporate analysis thatneeds or ought to be
undertaken.
CapitalizationinResourceConversionCapitalization becomesextremely important inresource conversionactivities. The resourceconversion topics that arediscussed in this book—mergers and acquisitions(M&As), leveraged buyouts
(LBOs) or managementbuyouts (MBOs), initialpublic offerings (IPOs), andrestructuring troubledcompanies—all involvemajor recapitalizations. Forexample, LBO analysisinvolves first adeterminationof an enterprise’s value anddynamics and then anexamination of the cost ofmoneyandanapplicationofanew capitalization. Exactly
the same economicproceduresarefollowedwhenreorganizing troubledcompanies,eitheroutofcourtor inChapter 11. In the caseof LBOs, however, thecapitalizationisleveragedup,in that debt is substituted forequity. In the reorganizationof troubled companies, thecapitalization is leverageddown, in that equity, debtwith soft terms, or both are
substituted for senior debtand other onerousobligations.An easy way of
remembering the above is torecall that in thereorganization of troubledcompanies, recapitalizationtendstomakesickcompanieshealthy, whereas in LBOs,recapitalizationtendstomakehealthycompaniessick.
FACTORSAFFECTINGCAPITAL
STRUCTUREIn all financial activities,there is a tendency towardefficiency:Allparticipants ina process attempt to do aswell as they reasonably canunder the circumstances,
given their agendas and theagendasofotherparticipants.This certainly holds true forcapitalization. Creditorscomport, regarding thistendency toward efficiency,in the same way as doOPMIs,although theprimaryitem on a creditor’s agendamight be the avoidance of amoney default whereas theprimaryitemonanagendaofan OPMI involved in short-
term trading would be themaximizationoftotalreturn.Efficient corporate capital
structure, the financing layercakeofthecorporation,takesinto account myriad factors,includingthefollowing:
ThecompositionandcharacteristicsoftheassetsthatoffsetthecapitalizationTheneedsanddesiresoftheseveralclassesof
creditorsTheneedsanddesiresofregulatorsTheneedsanddesiresofratingagenciesTheneeds,desires,andproclivitiesofmanagementandcontrolgroupsCustomandusageTheprofessionaladviceofinvestmentbankers,attorneys,and
accountantsThedesiresofOPMIsandOPMIrepresentatives
Investorsusingabottom-upapproach should appreciateallofthese.
TheCompositionandCharacteristicsof
AssetsAsset management is mainly
a function of liabilitymanagement; by contrast,liability management ismainly a function of assetmanagement.What amount and types of
liabilitiesthatoughttobepartof a corporate capitalizationhas to be very much afunction of having assetsemployed in the business inways that produce sufficientresources to service the
liabilities. There are twosourcesfromwhichliabilitiescan normally be serviced:internal cash flow obtainedeither from employment ofassets or sale of assets, andaccess to capital markets fornew financings (this isusually a function of thebusiness’s having earnings—theabilitytocreatewealth).The overall insurance
industryprovidesagoodcase
study of how the characterand amount of liabilitiesinfluence—indeed, govern—the management of assetportfolios. Insurancecompanies’ assets consistessentially of investments indebt instruments and othersecurities. Liabilities consistessentially of estimatedobligations to policyholdersin the form of policyholderreserves (life companies) and
reserve for losses andunearnedpremiums(propertyandcasualtycompanies).In life companies, the
policyholderreserveisaverylongterm,reasonablycertain,and actuarially determined(on a year-to-year basis)liability. Given this type ofliability, life companies’investment assets usuallyconsist mainly of long-termprivately placed loans. By
contrast, property andcasualty companies aresubject to dramatic andrelativelyunpredictable (onayear-to-year basis) demandsforcashpayoutsarisingfrom,say, hurricanes orearthquakes. Thus, propertyand casualty companies’investment portfolios consistlargely of marketablesecurities,salabletomeetthebusinesses’ sudden needs for
cash to satisfy claims.Furthermore, property andcasualty companies generallyfund the dollar amount oftheirliabilitiesbyinvestingincredit instruments (debtsecurities). Common stockinvestments are only a smallportion of property andcasualty company portfolios,limited to dollar amounts nogreater than the firm’sstatutory surplus. Statutory
surplusisnetworthcomputedin accordancewith insuranceregulations, rather thanGenerally AcceptedAccounting Principles(GAAP). Each net worthfigure, statutoryorGAAP, isreconcilablewiththeother.The analysis of capital
structure is very much afunction ofwhere you sit. Insome contexts, consolidatedfinancial statements are
useful, but in other, parentand subsidiary financialstatements are key. From theperspective of commonstockholders in a holdingcompany, the consolidatedfinancialstatementspresentauseful indication of what theoverall results and overallresources are for thecompany. From the point ofviewofalendertotheparentholding company, however,
parent-company financialsare crucial to determiningcreditworthiness. The parentcompany directly owns onlythe common stock of itssubsidiaries, not the specificassets of the subsidiaries,even though these subsidiaryassets are reflected in theconsolidated financialstatements.Toservicetheirdebts,most
parent companies have to
receive cash from theirsubsidiaries. There areessentially four ways inwhich this cash can bereceived: dividends, home-office charges, tax treaties,andsalesbytheparentofthecommon stock owned. Salesof common stock of thesubsidiaries may beimpractical. If the holdingcompany is in a regulatedindustry (e.g., insurance or
banking), cash payments bythe subsidiaries to the parentmay be vigorouslyproscribed. If the subsidiary—say, a finance company ordepartment store chain—borrowsmoney,thentheloancovenantmay limitpaymentsto the parent. Thus, a parentcompanythatmayappear,ona consolidated basis, to bequite solid reallymaynot becreditworthyatall.
TheNeedsandDesiresoftheSeveralClasses
ofCreditorsCreditors as a group areprobably the most importantforce determining whatcorporate capital structureswill be. By and large,creditors are intelligent, andmany are relativelyknowledgeable about thebusinesses they finance. Put
otherwise, they operate in amarketwithstrongtendenciestowardefficiency.Credit markets seem to be
much bigger than equitymarketsandcanbedeemedtoincludeallpayablesowedbybusinesses including accruedexpenses, accounts payable,rents payable, taxes payable,and borrowing from banks,other institutions, and thepublic. Creditors are often a
lot more knowledgeableabout the business in whichthey invest than are OPMIs.They are much more seriousanalyststhanareOPMIs.Thisis understandable becausemostcreditorshavetolooktocorporations for theirbailouts. It is actual businessperformance that willgenerate cash to pay themprincipal and interest. It isquite understandable that
creditors tend to have strongviews about the amount ofmoney they will let acompany borrow. Bycontrast,mostOPMIslooktoa sale to a stock market fortheir bailout. Many, as forexample those with atechnical chartist approach,could not care less about thebusiness.Theirknowledgeofit can be as restricted asknowingwhatthestockticker
symbolis.Creditors of corporations,
when financing their ownbusinesses, often have fargreater access to borrowingsto finance their assets(portfolios of loans tocorporations) than would bethe case if their assets werecommon stocks. Portfoliosconsisting of performingloans generate contractuallyassured cash to service their
obligations, but commonstocksusuallydonot.Marketprice volatility isconsiderably less forperforming loans than forcommonstocks.Predictable cash return on
an asset has an importanceindependent of total return.Anassetholdercannotexpecttoserviceobligationsexistinginmostcapitalstructureswithunrealized appreciation;
service has to be made incash.Intelligent creditors usually
base investment decisionsmuch more on reasonableworst-case assumptions thanonbase-caseassumptions.Asknowledgeable and analysis-orientedascreditorsareaboutcorporatevalues,though,theyarenotimmunefrommakingbad decisions. This isprobably true because
throughout U.S. history,forecastsofcashandearningsflows have been notoriouslyunreliable. Witnesscommercial bank lending toless-developed countries(LDCs) in the 1970s, energylending before the oil bubbleburst in the early 1980s,commercial real estatelending prior to 1986, andsavings and loans’unacceptableinterestraterisk
and then credit risk in the1980s and residentialmortgage lending before2007. Still, theirunderstanding of corporatevalues tends to be muchbetter than is that of thetypical OPMI—bankers needto know how to read, butOPMIsdonot!
TheNeedsandDesires
ofRegulatorsCorporate capital structure ispartially determined bywell-informed analytic regulatorswhohaveasanagendaseeingthat corporate capitalstructuresarenot toorisky—thatthereiscapitaladequacy.These include bankregulators, insuranceregulators, the SmallBusiness Administration
(SBA), and securitiesindustries regulators,especially those workingunder the amendedInvestment Act of 1940 andalso the Financial IndustryRegulatory Authority(FINRA).
TheNeedsandDesiresofRatingAgencies
An investment-grade
imprimatur is essential formanycompaniesoperating incertain industries or seekingaccess to public markets fornew issuesofdebt securities.Agencies providinginvestment ratings includeMoody’s Investors Service,Standard & Poor’s RatingServices, Fitch InvestorsService,Duff&PhelpsCreditRating Company, and A.M.Best Company. Corporate
managements are very muchaware of how capitalstructure affects the opinionsoftheseagencies.Creditors, regulators, and
rating agencies tend to beefficient (and are probablysmarter than most OPMIs).Most corporate loans areperforming loans, and mostcorporations remain solvent.This remains generally truedespite the rating agencies’
ineptitudebefore2007,whichcontributedimportantlytothemeltdown after 2007 and totheGreatRecessionof2008–2010.
TheNeeds,Desires,andProclivitiesofManagementsandControlGroups
Once it is observed thatmanagements and control
groupshavemultipleagendasthat combine communities ofinterest and conflicts ofinterest with various of theirconstituencies, disparatefactors affect managements’andcontrolgroups’ influenceon what an appropriatecapitalization will be. Fewmanagements are likely toconclude that the appropriatecapitalization is thatstructurewhich will maximize the
trading price of the OPMIcommonstock.
CustomandUsageCustom is one of thestrongest determinants ofcapital structure. Industrycapitalstructures tend towarduniformity as the variousproviders of capital adoptcommon standards or norms.For example, historically,
electric utilities have oftenbeen financed 50 to 60percent with publicly heldmortgage debt, 10 percentwith preferred stock, and 30to 40 percent with commonstockandsurplus.In the LBO arena, senior
secured lenders will lendapproximately four to fivetimes operating income(minus the excess of capitalexpenditures over
depreciation plus a workingcapital facility) to finance adeal.Sometimessubordinateddebentures, preferred stockheld by the sellers or others,or both are available, thoughnowadays, almost alwayssome meaningful commonstock investment is made bythe purchasers. The purchaseprice for the business mightbe 7 to 12 times the above-mentionedoperatingincome.
Similar custom-and-usageratios exist for financecompanies, hotels, banks,cable companies, insuranceholding companies, airlines,and others. Good investorsbecome familiar with theseratiosindustrybyindustry.Most custom-and-usage
capitalizations are the mostefficient way to capitalizecompanies, but this is notalwaystrue.Takedepartment
store and discount-storecapitalstructures.Despitethegeneral economic prosperityof the 1990s, a plethora ofdepartmentstoreanddiscountstore chains (FederatedDepartment Stores, Macy’s,Caldor, Kmart, Wards,Bradlees, Zayre) have had toreorganize their capitalstructureeitheroutofcourtorin Chapter 11. The mainreason was too much credit
granted from three sources—financial institutions, tradecreditors,andlandlords.
TheProfessionalAdviceofInvestmentBankers,Attorneys,andAccountants
Such fee-based advisors asinvestment bankers,attorneys,andaccountantsareimportant influences in
determining corporate capitalstructure. Investment bankerstendtohavegreatexpertiseinstructuring the terms ofsecurities so as to sell thesecurities in privateplacement and OPMImarkets.Attorneysarekeyindealing with securitiesquestions as they effect theterms to be included insecuritiesissues.GAAPistheprovinceofaccountantswhile
both attorneys andaccountantsdealwithincometaxissues.
TheNeedsandDesiresofOutsidePassive
MinorityInvestorsandTheirRepresentativesTheOPMImarketistheonlyconstituency addressed byGraham and Doddfundamentalism and
proponents of the EMH intheir discussions of capitalstructureanddividendpolicy.Indeed, the emphasis is evennarrowerbecausethefocusisalmost exclusively onestimated near-term impactsonOPMImarketprices.This emphasis seems
misplaced. It has validitywhen the company itself andcontrol shareholders areseeking access to capital
marketstosellcommonstockto an OPMI market. This isanoccasionaloccurrence,andthe interests of the companyitself revolve around beingabletomarketcommonstockat all rather than around theprice at which common canbe marketed (an OPMIinterest).ItisnotthatOPMIinterests
are ignored in determining acapital structure, but that
those needs are tempered byrequirements of otherconstituencies. In terms ofcapitalization, it is a goodrule of thumb that satisfyingcreditor requirements is a lotmore important thanmeetingOPMIdesiresinstructuringacapitalization.Risk is a word that should
not be used without anadjective in front of it. Justbecause a common stock
might have a lot of marketrisk (i.e., a plunge in OPMImarketprice)andacompanymight have a lot ofinvestment risk (i.e., thebusinessisunlikelytosurviveas a going concern) does notmean thatadequatelysecuredlenderstothecorporationaretaking any credit risk at all.Creditors can be confidentthat the loan will remain aperforming loan or that in a
reorganization, they willreceive a value of principalamount plus interest andinterest on interest. Generalriskreallydoesnotexist.
CONSERVATIVECAPITAL
STRUCTURESIn practice, many
corporations operate withconservative capitalizationsthat provide an insurancepolicy for holders of juniorsecuritiesand thecorporationitself. In addition, tradecreditors and publicbondholders are not madenervous. The cost of doingthis is a lower ROE (andperhaps stock price) thanwould otherwise be the casein buoyant periods when the
businessisprospering.Ifyoupay to insure your house,however,anditdoesnotburndown,thatdoesnotmeantheexpenditureforinsurancewaswasted.Conservatively capitalized
andwell-managedcompaniesare also more likelycandidates for hostiletakeovers. Raiders must relysolely on publicly availableinformation; therefore they
see good management and astrong balance sheet asinsurance against a badpurchase. Not surprisingly,increasing corporate leverageis a standard tactic used bycorporation managements tothwarttakeovers.Should OPMIs acquire the
commonstocksofcompanieswith conservativecapitalizations? Presumably,suchcommonstockswillsell
at lower prices, have greaterpotential for appreciation iftheyaretobecomeleveragedin the future, and are morelikelytargetsfortakeovers.Inaddition, such investmentswould be more conservativebecause if operations are notas profitable as expected,there should be lessdownside.Ontheotherhand,thereare
offsets to make an OPMI
want more leverage. If thecompany is unleveraged, theOPMI, as an investor, is notas likely to capture as muchof the upside. The OPMImight also be in bed withmanagements or controlgroups who do not needaccess to stock markets andwho do not care about thestock price in the short run.Investors on margin mightnot be able to wait an
indefiniteperiodoftimeforareturn;oriftheychangetheirmindandneed tocashout intheshortrun,theymaydosowithout appreciation.Professionalmoneymanagerswho are primarily assetallocators and are evaluatedon the basis of short-runperformance might not wanttotakethiskindofrisk.There is no universal
answer to the question of
whether to buy the stocks ofleveraged or unleveragedcompanies. It depends onwho you are and what youknow. If you are aconventional asset allocatorwhodoesnotknowtoomuchabout finance or companies,then you might be better offtaking themore conventionalapproach to choosing yourportfolio. On the other hand,if you read all the literature,
understand individualcompaniesandindustries,andcanappreciatethenuancesofcapital structure, then youmightbebetteroff going theunderleveraged investmentroute. If you believe in theprecepts of value investing,however, conservativecapitalizationsbecomehighlydesirableforOPMIs.
SUMMARYIf an economic entity—corporate, government, orindividual—cannot be madecreditworthy, sooner or laterit will have to restructure itsobligations or liquidate.There are three tests ofcreditworthiness: a balancesheet test, a cash flow orincome test, and a liquiditytest.Fewseemtorealizethat
in order to remain solvent,that is, creditworthy, aneconomic entity does notnecessarily have to pass allthree tests. Ignorance of thissimple fact was evident inmarket commentary aboutboth financial institution andsovereign discussions ofsolvency in the wake of the2008–2009 crisis. Focus ontheabsoluteorrelativelevelsof debt is misguided since
creditworthiness isa functionof the amount of debt, theterms of the debt, and mostimportantly, the productivityof the use of proceeds fromthe borrowing. Investorsusing a fundamental financeapproach,shouldmeasurethecreditworthiness of acompany by looking at theentity’sabilitytohaveandtocreate liquidity either: fromsurplus cash, from other
assetsreadilyconvertibleintocash,byanabilitytogeneratesurpluscashfromoperations,byanabilitytoaccesscapitalmarkets, and by the relativeabsence of liabilities. Weprovide a primer on capitalstructure from the corporatepoint of view to debunk thesubstantive consolidationview of capital structure thatis prevalent in Graham andDodd and modern capital
theory._______________*Thischaptercontainsoriginalmaterial,andpartsofthechapterarebasedonmaterialcontainedinChapter7ofValueInvestingbyMartinJ.Whitman(©1999byMartinJ.Whitman),andideascontainedinthe20073Q,20093Q,20113Qletterstoshareholders.Thismaterial
isreproducedwithpermissionofJohnWiley&Sons,Inc.1WediscussthequalityofassetsandhowusefulGAAPisintheappraisalofassetqualityinChapter6onnetassetvalues.2Wediscussaccesstocapitalmarketsonasuper-attractivebasisinChapter25ontheeconomicsofprivateequityleveraged
buyouts.3Corporatefeasibilityisaconceptthatoriginatesinthebankruptcycodeinthecontextofacourtapprovingaplanofreorganization(POR).AcourtwillnotapproveaPORifitmakesthedebtorunfeasible;i.e.ifitsimplementationwilllikelyleadthedebtortoseekanotherreorganizationinthefuture.
CHAPTER8
WhatMattersIsInvestment
Risk1
ThereIsNo
GeneralRisk—OnlySpecificRiskTheComponentsofInvestmentRiskSuccessfulPeopleAvoidInvestmentRiskMethodstoAvoid
InvestmentRiskSafeandCheapInvestingandMinimizingInvestmentRiskSummary
Onpages440and441of the1988 edition ofGraham andDodd’s Security Analysis
there is this remarkablestatement:Clearly, the bond contractis inherently unattractive.In exchange for limitedrights to share in futureearning power, thebondholderobtainsapriorclaimoncashgeneratedbytheborrowerandadefinitepromise of repayment at astated date. Profitablegrowth will bring
confidence to the investorbutnomaterialincreaseinreturn.Thedeteriorationofprofitability, however, willbring both anxiety and adownward marketvaluationoftheissue.2Why would a downward
deterioration in profitabilitynotbringevengreateranxietyand even greater downwardmarket valuation to theholders of that company’s
common stock issue? As amatter of fact, if the bond isadequately secured orotherwise well covenanted,no money defaults mightoccur, and bondholderswould feel no anxiety aboutholding the debt instrumentregardless of market price.Sophisticated bondholderswouldprobablyconcludethatthey were incapable ofpredicting bond prices in
OPMI markets for lower-rated issues to begin with;most people involved withvalue investing wouldcertainlysoconclude.Graham and Dodd were
probably right that there is alarge amount of market riskfor outside passive minorityinvestors (OPMIs) inholdingthe bonds of debtorsexperiencing deterioratingprofitability. It seems
obvious, however, that greatinvestment opportunities arecreated when market risk isignoredandinvestmentriskisexamined and guardedagainst. Assuming goodcovenant protections, is thebond form not inherentlyattractive when purchasesoccur after a downwardmarket valuation caused byanxietyandadeteriorationinprofitability? Were investors
unwilling to ignore marketrisk, they would missopportunities to acquire debtinstruments that seem utterlydevoid of investment risk(e.g., the GMAC seniorunsecureddebenturesin2009selling at a yield to maturityof around 50 percent). Theinvestment analysis of theGMAC Debentures revolvedaround the fact that it wouldhave been utterly
unreasonabletoconcludethatthese issues were beingacquired at prices thatrepresented a market bottomor even anything close to amarket bottom, because theOPMI consensus, whichcouldhaveproved right,wasthat the near-term outlookswere horrible and thatGMAC,asanoperation,wasindeeptrouble.
THEREISNOGENERALRISK
—ONLYSPECIFICRISKIn fundamental finance, thewordrisk is alwaysmodifiedby an adjective. There is nogeneral risk. There ismarketrisk, investment risk, interestraterisk,inflationrisk,failure
to match maturities risk,securities fraud risk,excessive promoters’compensationrisk,andsoon.In value analysis, the
tendency is to guard againstinvestment risk, the prospectthat thingswill gowrong forthe business in which theactivisthasinvestedor in thesecurities issued by thatbusiness. Market risk, theprospectforpricefluctuations
in OPMI markets, is usuallyignored. Put otherwise, thevalue analyst, in examiningthe risks in an investment,worries about permanentimpairmentsofcapitalbutnotabout unrealized marketlosses or a reduction in theamount of unrealized marketprofits.The analysis of Kmart
Debentures andKmart TradeClaims (together, Kmart
Credits) at the end of 1995serves as a good example ofthe difference betweeninvestment risk and marketrisk. In late 1995, it seemedimpossibletopredictwhetherKmart would seekreorganization under Chapter11 of the U.S. bankruptcycode. It seemed a certaintythat ifChapter11reliefweresought, interest paymentswould stop and there would
be no 18 percent yield-to-maturity. Further, theprobability seemed tobe thatKmart Credits would sell inthe OPMI market at dollarpriceswellbelowtheexistingpricesofaround$74,iffornoother reason than that theholders of debentures relyingon interest income, whichwould no longer be paid,woulddumptheirholdingsbyimmediatesaleintotheOPMI
market. Thus, Kmart Creditsseemedtocarryahighdegreeofmarketrisk.Despite the existence of
market risk, however, KmartCredits seemed to carry littleor no investment risk. IfKmartdidnotfile inChapter11, Kmart Credits wouldcontinue to be performingloans, affording a yield-to-maturity 700 to 900 basispoints above comparable
credits. Furthermore, itappeared that if Kmart wereto file for Chapter 11 relief,the company would bereadily reorganizable, andsinceKmart Creditswere, ineffect, the most senior issueof Kmart, the holders ofKmartCredits seemed boundto receive, in a Chapter 11reorganization,avalueinnewKmart securities of not lessthan 100—more likely 100-
plusaccruedpost–Chapter11interest.The previous analysis is in
sharp contrast to whatGraham and Doddrecommended as thetheoretically correctprocedure for bondinvestment in an approachfocusedonmarket riskratherthan on investment risk.Graham andDodd stated, onpage310of the1962edition
of Security Analysis, that“safety is measured not byspecific lien or othercontractual rights, but by theability of the issuer to meetall its obligations,” a validstatementifoneisfocusedonmarket risk rather thaninvestmentrisk.Onpage313,theywenton to say that“thetheoretically correctprocedure for bondinvestment, therefore, is first
to select a company meetingevery test of strength andsoundness, and then topurchase its highest-yieldingobligation,”3 which wouldusuallymeanits juniorratherthan its first-lien bonds. Invalue investing, there mightbe some merit to buying thejuniorissueonlyiftheanalystwere in a position todetermine thatacreditworthycompany would continue to
remain creditworthy untilafter the bond ownedmatured. Almost no one isthatgoodatpredictingfuturecorporate outlooks.Moreover,many—ifnotmost—companies issue juniordebtandpreferredobligations(i.e., mezzanine securities)because of senior lenderrequirements that thebusinesses have expandedborrowing bases. Put
otherwise,ifthesecompaniesweresocreditworthytobeginwith, they might never haveissuedmezzaninesecuritiesinthefirstplace.Fundamental finance
investors involved in creditanalysis are covenant driven,theexactoppositeofGrahamandDoddinvestors.
EXAMPLEFrom 1992 to 1997, Eljer
Industries Secured BankDebt represented a goodexample of the importanceof covenants. Eljer BankDebtwasaperformingloansecuredbyvirtually all theassets of Eljer and itssubsidiaries. A principalsubsidiary of Eljer, U.S.Brass,hadfiledforChapter11 relief, however, and itremained theoreticallypossiblethatahugeamountof product liability claimswould be perfected againstEljer. If so, those claims
would become unsecuredobligations, junior to EljerBank Debt. Overallcoverage for Eljerobligations could havebecome quite weak;furthermore, there mighteven have been somemarketriskinholdingEljerBankDebt.Givenitsseniorsecured position, however,it was hard to figure outhow the Eljer Bank Debtwould not bemadewhole,no matter what course thesubsidiary’s Chapter 11
took.
THECOMPONENTS
OFINVESTMENT
RISKThe result of the previousdiscussion is that for
analytical purposesinvestment risk for a securityhasthreecomponents:
1.Qualityoftheissuer2.Termsoftheissue3.PriceoftheissueTheanalysisof theGMAC
credits focused on all ofthese.GMACappeared tobereadily reorganizable (qualityof the issuer), in theeventofa money default the creditswere themost seniorGMAC
issue(termsoftheissue),andtheycouldbeboughtatpricesthat provided an adequatemargin of safety and totalreturn(priceoftheissue).When the focus is on
qualityoftheissuerandtermsoftheissueonly,asisabasicprecept of academic finance,a risk-to-reward ratio comesinto existence. For academicfinance,thehigherthequalityof the issuer and the more
senior the terms of the issue,the less risk of loss theinvestor is taking. Also, thehigher the quality of theissuerandthemoreseniorthetermsoftheissue,thelesstherewards are likely to be forthe investor, thus the risk-to-rewardratio.For academic finance, the
priceof the issue as it tradesin OPMI markets reflects auniversal price equilibrium;
that is, it is the correct pricefor all purposes and allparticipants. Insofar as theprice of the issue is too highortoolow,however,norisk-to-reward ratio exists; itcannot exist. Suppose theprice is too low. Thatmeansthat the issue carries areduced risk of loss and anenhanced potential forreward. In value investing,there usually is no risk-to-
reward ratio simply becausepriceoftheissuebecomessoimportant that it outweighsthe risk-to-reward equationthat appears to be validinsofarasananalysisisbasedon an assumption of theexistence of a priceequilibrium, so that the onlyfactorstoweigharequalityoftheissuerandthetermsoftheissue.
SUCCESSFULPEOPLEAVOIDINVESTMENT
RISKIn the book The Great RiskShift (Oxford UniversityPress, 2006), Jacob S.Hacker, a political scienceprofessor at Yale University,discusseshowinrecentyears
various risks—job risk,family stability risk,retirement risk, and healthcare risk—have been shiftedincreasingly fromcorporations andgovernments onto the backsof individuals. The raisond’être for the great risk shiftis to foster thecreationofanownership society where thebeneficiaries of, say, pensionplans and health plans take
the risks that go withownership by beingresponsible for investingfunds with no guarantees ofminimum returns. What theproponents of this type ofownership risk fail torecognize is that the mostsuccessful owners don’t takerisks. They lay off the risksonto someone else. Putsimply, the vast majority ofgreatindividualfortunesbuilt
in this country, especially byWall Streeters and corporateexecutives,were not built bypeople who took investmentrisks. Rather, the secret tobuilding a great fortune is toavoid, as completely aspossible, the taking of anyinvestment risk. In terms ofunderstanding corporatefinance, economists have itall wrong when they say,“There is no free lunch.”
Rather, the more appropriatecomment ought to be“Somebody has to pay forlunch—and it isn’t going tobeme.”As we have discussed,
investment risk consists offactors peculiar to a businessitself or to the securitiesissued by that business.Investment risk is a riskseparate and apart frommarket risk. Market risk
involves fluctuations in theprices of securities and otherreadily tradable assets. Adirectory of those in thefinancial community whobuild great fortunes byavoiding investment riskincludesthefollowing:
Corporateexecutiveswhoreceivestockoptionsorrestrictedstock.Ifthecommonstockappreciates,the
executivebuildsasubstantialnetworth.Ifthecommonstockdoesnotappreciate,theexecutivelosesnothing;indeed,theexecutivemayobtainnewoptionsatalowerstrikepriceornewrestrictedcommonstock.Membersoftheplaintiffs’barwhobringclassaction
lawsuitsinordertoearncontingencyfees.Theexpensesinvolvedinfinancingsuchlawsuitsareminimal,anditisseldomthatplaintiffs’attorneyseverincurcostsforsanctionsorforpayingadefendant’scostsandfees.Thefeeawardsobtainedtendtobehugeuponsettlementofsuchlawsuitsor,less
frequently,uponobtainingafavorableverdictfortheplaintiffaftertrial.Initialpublicoffering(IPO)underwritersandsalespersonnel.Ifyourunapromisingprivatecompanyanddesiretogopublic,youwillfindthatmanypotentialunderwriterswillcompeteforyour
business.However,asageneralruletheywon’tcompeteonprice.Thepricewillbea7percentgrossspreadplusexpenses.Thus,ona$10IPO,thegrossspreadwillbe$0.70pershare.Incontrast,tobuya$10stockinasecondarymarketliketheNewYorkStockExchange,acustomercannegotiatea
commissionrateof,say,$0.02to$0.05pershare.Bankruptcyprofessionals—lawyersandinvestmentbankers.Chapter11isnowsetupsothatbankruptcyprofessionalshavetobepaidincash,onapay-as-you-gobasis(withonlyminorholdbacks);suchpaymentsaregivena
super-prioritysothattheseprofessionalsveryrarelyhaveanycreditriskatall.Attorneys’feesbilledatover$1,000perhourandinvestmentbankingfeesofover$300,000permonth(plussuccessfees)arenotuncommon.Moneymanagers,mutualfundmanagers,privateequityand
hedgefundmanagers.Normalfeesmightrangefrom1percentofassetsundermanagement(AUM)to2percentofAUMplus20percentofannualrealizedorunrealizedcapitalgains(afterabogeyof,say,6percentpaidoraccruedtolimitedpartners).Thesefeesarepaidtoentitiesthatreceivethe
cashfeeswithoutincurringanycreditriskinbusinessentitiesthathavefewphysicalassetsandverylittlenecessaryoverhead.Mosthedgefundsarelimitedpartnershipswherethemoneymanageristhegeneralpartner(GP)andoutsidepassiveminorityinvestors(OPMIs)arethelimitedpartners
(LPs).AlimitedpartnershiphasbeenwaggishlydescribedasabusinessassociationwhereatthebeginningtheGPbringsexperienceandtheLPsbringmoney.Attheendofthebusinessassociation,theGPhasthemoneyandtheLPshavetheexperience.Venturecapitalists.
Thesepeoplefinanceaportfolioofstart-ups,andthenareabletorealizeastronomicalpricesonsomeoftheportfoliocompanieswhenthereoccurs,asitalwaysseemstodofromtimetotime,anIPOspeculativeboom.Realestateentrepreneurs,especiallyinvestment
builders.Twokeystomakingfortunesinlarge-scalerealestateprojectsaretheavailabilityoflong-term,fixedinterestrate,nonrecoursefinancingandincometaxshelter.
METHODSTOAVOID
INVESTMENTRISK
As an OPMI, it seemsimpossible to avoidinvestment risk altogether.The methods by whichOPMIs can attempt toalleviateinvestmentriskare:
Buycheap(priceoftheissue).WarrenBuffett,thechairmanof
BerkshireHathaway,describeshisinvestmenttechniqueastryingtobuygoodcompaniesatreasonableprices.Buffett,however,isacontrolinvestor,andwhileareasonablepricestandardhasworkedremarkablywellforBerkshireHathaway,thatstandardisnotgoodenoughforOPMIs.
OMPIshavetotrytobuyatbargainprices(i.e.,cheap).Thedefinitionofcheapinacquiringcommonstocksinthevastmajorityofcasesistoacquireissuesatpricesthatreflectsubstantialdiscountsfromreadilyascertainablenetassetvalues(NAVs),andsuchNAVislikelytoincreasebynotlessthan10
percentperyear.ReadilyascertainableNAVsmeansthatmostOPMIcommonstockportfolioswilltoalargeextentbeconcentratedinfinancialinstitutionsandcompaniesinvolvedwithincome-producingrealestate.ControlinvestorscanaffordtopayupversusOPMIs,becausetheyareinapositionto
undertakefinancialengineeringandtocausemanagementchanges.OPMIsprettymuchhavetoleavecompaniesas-is,andthereforeplaceparticulareffortsintobuyingintowell-managedbusinesseswithstable,butclearlysuperior,managements.Ininvestingindistresseddebt,too,theOPMI
investorhastobuycheap.Fortheauthorstherearetworulesofthumbin2012:iftheanalysisindicatestheprobabilitiesarethataloanwillbeaperformingloan,theminimumreturnsoughtisa15percentyieldtomaturityoryieldtoanevent.Coupledwiththisistherequirementthatiftheloandoesnot
remainperformingandparticipatesinareorganization,thelosstotheinvestorshouldbeminimal.Ifitseemslikelythattheperformingloanwilldefault,thedistressinvestorparticipatinginareorganizationoughttolookforaninternalrateofreturn(IRR)atleastof30percent.
Buyequityinterestsonlyinhigh-qualitybusinessesorwell-positioneddebtinstruments(qualityoftheissuerortermsoftheissue).OnereasonableruleforOPMIsistonotknowinglyacquirethecommonstockofanycompanyunlessthatcompanyenjoysasuper-strongfinancialposition.
Ifacompanydoesnotenjoystrongfinances,beacreditorowningwell-covenanteddebtinstruments.AlsotryasanOPMItobuyintoreasonablywell-managedcompanies.AnyrelationshipsbetweenOPMIsandcorporatemanagementscombinecommunitiesofinterestsandconflictsofinterest.
DiligentOPMIstrytorestrictthemselvestosituationswherethecommunitiesofinterestseemtooutweightheconflictsofinterest.Restrictcommonstockinvestmentstocompanieswhosebusinessesareunderstandabletotheportfoliomanagerandwherethereexistsfull
documentarydisclosure,includingauditedfinancialstatements.Indistressinvesting,thecreditorhasonlycontractrights.Thesecontractrightsoughttobestrongenoughtoprecludeoratleastdiscouragemanagementoverreaching.Ignoremarketrisk(priceoftheissue).
Fluctuationsinmarketpricesaremostlyarandomwalk,withchangesinmarketpricesnotinanywayameasureoflong-terminvestmentriskorinvestmentpotential.ItisasBenjaminGrahamusedtosay:“Intheshortrunthemarketisavotingmachine.Inthelongrunthemarketisaweighing
machine.”Mostcompetentcontrolinvestors—againWarrenBuffett—prettymuchignoremarketriskalso,inthatlittleornoweightisgiventodaily,orevenannual,markingtomarketforportfolioholdings.Ifdealinginequities,buygrowthbutdon’tpayforit(qualityofthe
issuer).Inthefinancialcommunity,growthisamisusedword.Mostmarketparticipantsdonotmeangrowth,butrathermeangenerallyrecognizedgrowth.Insofarasgrowthreceivesgeneralrecognition,amarketparticipanthastopayup.CheungKongHoldings,Wheelock&Company,
andBrookfieldAssetManagementappeartobegrowthcompanies.Noneoftheseissuesseemtoenjoygeneralrecognitionashavinggrowthpotentialinmid2012.Itisusuallyagoodideatobeabuy-and-holdinvestor(qualityoftheissuer,termsoftheissue,priceoftheissue).
Althoughanentrypointintoacommonstockisabargainprice,onecancontinuetoholdasecuritywheretheportfoliomanagerbelievesthatthebusinesshasreasonableprospectsthatitcanoverthelongrunincreaseannualNAVbyadouble-digitnumber,andwheretheportfoliomanagerdoes
notbelieveheorshemadeamistake.Mistakesaremeasuredbybeliefsthattherehasoccurredapermanentimpairmentinunderlyingvalueorfinancialposition.Sellifthereisabeliefthatthesecurityisgrosslyoverpriced.Alsosellforportfolioconsiderations—thatis,wheretherearemassive
enoughredemptionsoffundsundermanagementsothatliquidityisthreatened.Mostsalesinmostwell-runportfolioswilloccurbecausetheportfoliocompaniesaretakenover.Investingindistressedcredits,however,involveshavingsomeideaofaterminationdateexceptforcallfeatures.Acall
featuregivestheissuertherighttoredeemadebtobligationbeforematurity,usuallyateithertheprincipalamountoratarelativelysmallpremium.Ifaloanistoremainaperformingloan,theinstrumentwillcontainpaymentschedulesandamaturitydate.Ifthedistressedcreditistoparticipatein
areorganization,therewillbeanestimatedreorganizationdate;andifthedebtoristobeliquidated,therewillbeanestimatedwinding-update.
SAFEANDCHEAP
INVESTING
ANDMINIMIZINGINVESTMENT
RISKThe standards used tominimize investment risklimit the selection ofattractive securities.Adherence to the safe andcheap approach4 results in
missing many investmentopportunitieswheresecuritiesare attractively priced bystandards other than thoseused by value investors. Infollowing the approach, aninvestor, whether activist oran OPMI, will forgo manyequity investments regardlessof price if they do not meetall essential conditions forsafety.Conditions for an issuer to
besafeinclude:1. Strong financialposition:
a.Relativeabsenceofliabilities
i. On-balance-sheetii. Off-balance-sheetiii. Out there intheworld
b. Valuable assets
(cashornearcash)c. Free cash flowsfromoperations
2. Reasonably wellmanaged3. Understandablebusiness, which alwaysmeans comprehensivedisclosures and auditedfinancialstatements.
EXAMPLEAn emphasis on financial
position could prevent onefrominvesting:
Inairlineequitiesbecauseofabeliefthattheindustryisdangerouslyfinanced(anexampleofon-balance-sheetliabilities)andwouldbeevenifre-equipmentprogramsweremodified.Inintegratedsteelandaluminumcompanies;inmanyelectricutilities,becausetheymaybe
encumberedwithinordinatelylargecapitalexpendituresrequirements(anexampleofencumbrancesthatarenotdisclosedinaccountingstatements).Inlabor-intensivecompanieswithlargepension-planobligations(anexampleofoff-balance-sheetliabilitiesthataredisclosedinfinancial-statementfootnotes).
This does notmean that atcertain prices suchsecurities are not veryattractive investments formany. They just do nothappen to be attractive forus.
Under the safe and cheapapproach,securitiesofissuerscontrolled by those believedto be predators should beavoided, regardless of price,by both activists and
outsiders. The securitiesavoidedarebothequitiesanddebt instruments. Significantclues as to whom thepredators might be arepublicly available fromdocuments filed with theSEC. Especially pertinent inthese documents aredisclosures aboutmanagement remuneration,and transactions between thecompany and insiders. These
disclosures are containedeither in the annual-meetingproxy statement or in Part IIof the 10-K Annual Report.Disclosuresabout“litigation”inPart I of the 10-KAnnualReport, Part II of the 10-QQuarterly Report and infootnotes to audited financialstatements can also givevaluable clues to the caliberof management and controlgroups. Disclosure of
grievances by creditors orsecurities holders thatculminateinlawsuitsbroughtagainst companies andinsiders should serve aswarnings that a particularcompany may not be asatisfactory investment usingan investment riskminimizationapproach.Those using the approach
restrict investments tosituationswhere considerable
knowledge about companiescan be obtained. This is truefor both control and non-control investors. Whilereliance on publicinformation only is sufficient—or even more thansufficient forcertain typesofinvestments, such asinvestment companiesregistered under theInvestment Act of 1940 andpublic utilities—in other
areas required publicinformation frequentlyprovides insufficient data formaking intelligent decisions,as isusually thecasewhenacompany is engagedprimarily in mineralexplorationactivities.There is aclosecorrelation
between the usefulness offinancial accounting and theusefulness of publicdisclosures as tools for
making investmentdecisions.Asaccountingbecomesmorereliable,sodorequiredpublicdisclosures.Most important, since the
control and non-controlgroups value using the samestandards, there tend to beclear conflicts of interestbetween insiders andoutsiders. Insiders sometimeswill create additional valuesforthemselvesbyforcingout
outsiders via thecorporation’s proxymachinery that they control,by short-formmergers, or bythe use of coercive tenderoffers. Force-outs sometimescan be at extremely lowprices, because the insiders,by their actions (or lack ofactions), have contributed tothedepressionofstockprices.This conflict of interest
presentsa realistic threat that
limitstheappealofanumberof equity securities thatwould otherwise seemattractiveusingourapproach.Although attempted force-outs at prices we wouldconsider unconscionably lowarerelativelyinfrequent,theydohappen.
EXAMPLE*WilmingtonTrusthadthreecore businesses: (1)
regionalbanking(primarilycommercial and retailbankinginthemid-Atlanticregion);(2)wealthadvisory(wealth preservation,transferandestateplanningservices forhighnetworthindividuals); and (3)corporate client services(asset administration andmanagement, trustee andagency services forinstitutional clients).Wilmingtonalsoowned80percent of value equitymanagerCramerRosenthal
McGlynnand40percentofgrowthmanagerRoxbury.The company came underfinancial pressure in thewake of the 2008–2009credit crisis owing toproblemsinitsconstructionand mortgage loan books.Anticipating credit issuesandtheneedforshoringupitscapitalbase inQ42008the company had issuedpreferred stock along withwarrants and a smallamount of common stock.
In May 2010 Wilmingtonhad hired an outsideconsultancy to review itsloan book and to assist itwithafull-scoperegulatoryexamslatedtobegininlateJune. By September 2010,Wilmington appeared tohave adequate liquidity atthe holding company leveland a modest amount ofexcess capital at theregulated bankingsubsidiary. Wilmingtonseemed to be adequatelycapitalized for regulatory
purposesevenunderstress-case scenarios of heavylosses in the loan book. Asum-of-the-parts analysissuggested a range of valueforthecommonstockfrom$8to$14.By October 2010 marketrumors suggested thatWilmington had beencontacting buyers,including a number ofCanadian banks and wasseparately looking to raisecapital from private
investors to shore up itsbalance sheet. OnNovember 1, 2010,WilmingtonannouncedthatithadagreedtosellitselftoM&TBankofBuffaloinastock deal that valuedWilmington Common at$3.84, translating to a 46percent discount to theprevious week’s marketprice.The deal valuationapparently surprised manyobservers who suggested
thatM&TwasabletostealWilmington. M&Tmanagement maintainedthat the deal was struck atpro forma tangible bookvalue (pro forma foranticipated credit losses).Underestimating“regulatory risk” was onemainfailureoftheanalysis.Intheearlydaysfollowingthe Credit Crisis, the Fedsseemed to care little aboutshareholders’ interests oreconomic values butwanted to protect
depositors at all costs.When the Feds told themanagement team of aregulated entity to do thedeal, managements likeWilmington’s had noalternative. In this case,M&T offer appeared toascribe no value toWilmington’s non-bankingbusiness and affiliatedinvestment managementbusinesses.
*Thisexamplewasextractedfromareporttitled:“TakeunderCaseStudy—WilmingtonTrust,”by
CurtisJensen,ThirdAvenueManagement,August2012.
SUMMARYIn fundamental finance, thewordrisk is alwaysmodifiedby an adjective. There is nogeneral risk. There ismarketrisk, investment risk, interestraterisk,inflationrisk,failureto match maturities risk,securities fraud risk,
excessive promoters’compensationrisk,andsoon.In value analysis, thetendency is to guard againstinvestment risk, the prospectthat thingswill gowrong forthe business in which theactivisthasinvestedor in thesecurities issued by thatbusiness. Market risk, theprospectforpricefluctuationsin OPMI markets, is usuallyignored. Great investment
opportunities are createdwhenmarket risk is ignoredand investment risk isexamined and guardedagainst. For analyticalpurposesinvestmentriskforasecurityisafunctionofthreefactors: the quality of theissuer, the termsof the issue,and the price of the issue.Even though it is almostimpossible to avoidinvestment risk altogether as
anOPMI,weprovidealistofmethods by which an OPMIcan attempt to alleviate thistypeofrisk._______________1Thischaptercontainsoriginalmaterial,andpartsofthechapterarebasedonideascontainedinthe19994Q,20034Q,20062Q,20072Qletterstoshareholders.2BenjaminGraham,David
L.Dodd,SidneyCottle,RogerF.Murray,andFrankE.Block,GrahamandDodd’sSecurityAnalysis,FifthEdition,(NewYork:McGraw-Hill,1988).3emphasisadded4TheapproachisdiscussedatlengthinChapter15.
CHAPTER9
ShareholderDistributionsfromthe
CompanyPointofView*
CashDividendsorRetainedEarningsStockDividendsStockRepurchasesDistributionofAssetsOtherthanCashLiquidation
Summary
Abasicdifferencebetweenusand other analysts, includingGraham and Dodd, is thatothers believe an appropriatedividend policy is derivedfrom looking at payoutpolicies through thestockholder’s, rather than thecompany’s, point of view. Itis our view that for most
companies,theformulationofappropriate shareholderdistribution policies requiresthat stockholder needs anddesires be distinctlysubservient to the needs ofthecorporationitself.Others believe, at least by
implication, that the price atwhichastocksells,relativetoa company’s earnings andasset values, is somehowrelated to an appropriate
payout policy. We, on theother hand, believe thatdividend payouts must beregarded as a residual use ofcorporate cash and thatcompany requirements forcashinotherareasmusthaveprimacy.
CASHDIVIDENDSOR
RETAINEDEARNINGS
Dividend policy has to bedictated by company needs,both for funds for expansionandformaintainingamarginof safety. Furthermore, wethink the price at which acommon stock sells (exceptin special cases, of whichpublic utilities are the primeexample)shouldhavelittleto
do with a company’s payoutpolicy. The special caseexception is a going concerncompanythatknowsithastoperiodically obtain capitalfromthesaleofnewissuesofcommon stock, and usesdividendstosupportthepriceof its stock so that itwill beabletomarketsharespubliclyat a more assured price thanotherwise.Graham and Dodd, in
support of this other view,writeinSecurityAnalysis:The higher the averagemultiplier of earnings inthe stock list, the greaterthe proportion of issueswhich presumably shouldretain all or nearly all oftheir profits. . . . For—presumably again—therate of return onreinvestment willsubstantially exceed, in a
typical case, what thestockholder could earn onthesamemoneyreceivedindividends. A goodcorporate earnings pictureand opportunities forcapital expansiongenerally go together.Thus, the favorablebusiness and stock marketdevelopmentsofthe1950’shave greatly extended thefield of companies for
which, in theory at least,low dividends and highreinvestmentwouldappearthe best policy forstockholders.Carriedtoitslogical conclusion, thisanalysiswouldsuggestthatnearlyall really successfulcompanies should followaprogram of fullreinvestmentofprofits,andthat cash dividend shouldbe paid only to the extent
that opportunities forprofitable expansion ordiversification were notpresent.1We question the Graham
and Dodd analysis on threecounts. First, the high price-earnings ratio or multipleseemswhollyunrelatedtothebusiness’s needs for cash.The underlying assumptionGraham and Dodd appear tousehereisthatthemarkethas
been appraising thebusiness’s prospectsaccurately in the multiple ithas assigned to the shares.There is no empiricalevidence supporting such aview.Indeed,theonlylogicalconclusion to draw is thatcompanies should retainearnings when they haveopportunities for profitableinvestment, regardless of theprice of their common stock.
Second, whether or not theyhave opportunities forprofitable investment of thefundsisnotsomethingthatisgoingtobetoldtocompaniesor their managements by thestockmarketappraisalofhowtheirearningsarecapitalized.Finally, distributing cash tostockholders has to competewithusingthecashtoreduceordefeaseliabilities.The property and casualty
insurance industry serves asan example of the use ofretainedearningsasanengineof compound growth whenstocks generally sell at lowmultiples and steepdiscountsfromnetassetvalue.As a rule of thumb,
propertyandcasualtyinsurerspay out as dividends aboutone half of their netinvestment income andreinvest theotherhalf.These
reinvestedearnings,pluscashgenerated from increasingvolume of insuranceunderwriting premiums (andwhen available, insuranceunderwriting profits), areused to purchase income-producing securities. Thus,though the underwritingperformance of the industryfrom the mid-1970s on waspoor (generally little betterthan break-even), net
investment income increasedsteadily up until 2008. After2008 net investment incomestopped growing because theU.S. government pursued apolicy of ultra-low interestrates. This steady increase ininvestment income—despitean erratic underwritingperformance, is shown in thefollowingfigure,coveringtheyears 1967 through 2011,prepared from data in
Dowling&Partners.2
Figure9.1NetInvestmentIncomeandUnderwritingProfit(Loss)forP&CInsurers,1967–2011inBillions
Assuming that a companyhas superior uses for cash toexpand its productive assetbase and that the companyhas only uncertain access tocapital markets to sell newissuesofcommonstock, it isalways far more productivefrom a long-term point ofview if a company retainscash rather than distributes itto shareholders. For growthcompanies, distributions of
cashtoshareholderscanbeagood use of cash, but itfrequently is not thebestuseof cash. It was far moreproductive for IBM, Xerox,Intel, and Microsoft, in theirearlydays,toplowbackcashinto the businesses than itwouldhavebeentodistributethatcashtoshareholders.Insofar as the company
does not have profitable usefor the reinvestment of the
funds and is financiallystrong enough to have amargin of safety, fundsshould be distributed toshareholders.The characteristics of cash
dividendsareasfollows:Dividendsaremandatory;eachstockholderisrequiredtoacceptthecashpayment.DividendspaidbyqualifiedU.S.
corporationsaretaxadvantagedfornoncorporateU.S.taxpayers.Atthefederallevel,thedividendsaresubjecttoa15percenttaxrate.Fordividends,thereisatleasta70percentexclusionforstockholdersthatarequalifiedcorporations.ManyOPMI
stockholderslikedividends.BenjaminGrahamandDavidDoddwerebigfansofdividends.Dividendpaymentscanimproveaccesstocapitalmarkets,especiallycommon-stockmarketsforthosecompaniesthatneedrelativelyregularaccesstooutsideequityfinancing.Companies
thathaveneededrelativelyregularaccesstooutsidecapitalmarketsincludeelectricutilities,financecompanies,andrealestateinvestmenttrusts.Shareholdersreceivecashwithoutgivingupanyownershipinterest.
From the corporation’spointofview,itsometimesisimportant to have consistent,
sound policies of (a) payingregular dividends and (b)increasing dividendsperiodically. This occurswhenthemarketpricesoftheshares are determinedprimarily by the dividendreturn and when corporatecapital requirements are fartoohugetobefinancedeitherinternally or by debt.Consequently,newequityhasto be marketed every few
years. Thus, liberal dividendpolicies become an integralpart of corporate financialpolicy for such companies.These companies arecharacterized by greatoperational stability, so thatthe type of investor attractedcan depend on a steadydividend income continuallycovered by earnings.However, these corporatecharacteristicsdonotdescribe
the vast majority of publiclyheld companies, and there isno reason for supposing thatwhatmightbeanappropriatedividend policy for thesecompanies is also applicabletoothers.This is not to say that a
corporation in its owninterests and in itsmanagement and controllingstockholders’ interests doesnot frequently find it
desirable to maintainconsistent and even liberaldividendpolicies.Onereasonan incumbent managementmight want to pay liberaldividendsisthatlowdividendpayouts may result in lowstockmarket prices,with theconsequencethatthebusinessbecomes more susceptible toa raid.Higherdividendsmayprotect a management’sposition. This may be
especially true wherecorporate prudence woulddictate that a dividend bereduced or eliminated, eitherofwhichactionwouldtendtoresult in gross stockholderdissatisfaction.Influential stockholders,
including management, mayinfrequently have needs forthe cash return income thatcomes from dividends.Sometimes, too, an increased
dividend will result in anincreased stock price thatcouldbeimportanttoinsiders(or to the company itself)intendingtosellallorpartoftheirholdings.Occasionally, companies
havenopractical internalusefor cash, especially ifdiversification andacquisitions would result inantitrust problems for thoseoperatinginrelativelymature
industries.However, it isouranecdotalobservationthatthevast majority of publiccompanies are not onlyoperations but alsoinvestment vehicles. Viewedas an investment vehicle, thecompany has incentives toretain cash rather thandisburseittoshareholders.A long-run, consistent
dividend policy is frequentlyessential if a company is to
obtain general recognition inthe financial community as ahigh-quality issuer. Suchrecognition tends to result inbetterprices foracompany’scommon stock over the longterm,andmayattractoutsidestockholders who are stableinvestorsinterestedinincome(insurance companies forexample) rather than in-and-out traders or go-gospeculators.
STOCKDIVIDENDS
There is a school of thoughtthat asserts that there wouldbe benefits to corporationsand stockholders ifcorporations paying cashdividends would, as aconsistentannualpolicy,alsopay stock dividends toshareholders, the marketvalue of which would be in
an amount about equal toretainedearningsfortheyear.
EXAMPLEIf XYZ stock sells at 20,earns $2, and pays a cashdividend of $1.20, manypeoplerecommendthat the$.80ofretainedearningsbepaid out in the form of astock dividend—in thiscase 4 percent, or $.80divided by $20. If thefollowing year’s retainedearnings equal $1.10 and
the stock price is 34, thesuggested stock dividendwouldbe3percent.
Proponents of this policybelieve it benefitsshareholders. Shareholdersreceive on a tax-free basisnewstock that, if theydesireto do so, they can convert tocash by selling the sharesreceived, and they would betaxed at only capital gainsrates rather than at dividend
income rates. Because of thestock dividend policy, thecorporation would have lessneed to raise cash dividendsandconsequentlylessneedtoseek new equity financingfrom its existingshareholders. Viewed in thislight,thereissomethingtobesaid for a policy of periodicstock dividends and lessfrequentsubscriptionrightstoshareholders, compared with
the policy most publicutilities employ—of raisingthe common cash dividendperiodically to support theprice of the stock, and thenselling new shares tostockholders, often viasubscriptionrights.Althoughthismaybesoin
the special case of utilities,the advantages of regularstock dividends in mostsituations most of the time
seemhighly limited. Even inthecaseofpublicutilities,theadvantage of periodic stockdividends over periodicincreasesinthecashdividendrate may be limited. Autility’s need for outsideequity financing on acontinuing basis tends to beso huge as to dwarf intoinsignificance the amount ofcashthatcouldberetainedbypaying stock dividends
instead of periodicallyincreasing the cash dividend.Stockholders and the utilityare best served by the policythat results in the stock’sselling at the most favorablepricemostconsistently.Manycommentators feel thatperiodicincreasesinthecashdividend have a morefavorablemarket impact thanregular stock dividends, butwe do not know of any
definitive studies on one ortheother.One small utility, Citizens
Utilities,hadinthe1950sand1960s a two-issue commonstock capitalization: an Astock, which paid a cashdividend; and a B stock,which paid only a stockdividend in a market valueamount equal to the cashdividend on the A. The B isconvertible into the A, but
hasvirtuallyalwayssoldatapremium over the A.Duplication of the CitizensUtilities capitalization wouldbe impossible now, becauseInternal Revenue hasslammed the barn door shut,so that for any stock issuednowwithCitizensUtilitiesBfeatures, IRS holds that thestock dividend is theequivalentofacashdividend.One of the three things that
make a tax positionunattractiveisataxableevent—suchasthedistributionofaCitizens Utilities B stockdividend—where the eventthatgivesrisetothetaxdoesnot alsogive rise to the cashwithwhichtopaythetax.It is rare to find U.S.
companies paying regularstock dividends, especiallyamong those that also paycash dividends. Stock
dividend policies do makesome sense for companiesthat do not pay cashdividends but that do plowback cash: stock dividendsgive shareholders evidence,intheformofasalablestockcertificate, that corporateprogressisbeingmade.Stockdividends also make somesense, however limited, forcompanies with a publicutility type of dynamics, in
which new equity will bepublicly marketed on aregular, recurring, reasonablypredictable basis. However,most companies pay, orintend to pay, regular cashdividends, and most do nothave a public utility type ofdynamics. Most companiesseek outside equity financingon an irregular and highlyunpredictable basis, if at all.For such companies,
payments of stock dividendsresult in regular increases intheaggregateamountofcashpaid out, with possibly littleornobenefit toshareholders.Thiswouldnothavebeenthecase had the company raisedthe cash dividend rate, say,onceeverythreeyears.A simple example shows
how a company that desirestomaintainaregularratecanbelockedintoincreasingcash
outlays on a compoundingbasis if it also wants to payregularstockdividends.
EXAMPLEAssume Company XYZ’sdividend rate is $1 cashplus 5 percent stock, andthere are 1 million sharesoutstanding. If thisdividend situation ismaintained, XYZ’s annualcash dividend payout (inthousands) will be as
showninTable9.1.The payment of stockdividends gives rise to anumber of administrativeheadaches, too.Therehaveto be adjustments of pastper-share figures onearnings, dividends, andbook value, and ofcalculations in connectionwithantidilutionprovisionsinconvertiblesandwarrantinstruments; stockholdershave to be mailed newcertificates, and there may
be a tendency for XYZ’sstockholder list to becomeburdened with largenumbers of odd-lotshareholders, whom it isquite expensive to servicewith dividend andstockholder reportmailings, relative to themarket value of theirinvestment. If we wereadvising XYZ, we wouldsuggest to them that boththe company and theirshareholders would bebetter off if XYZ gave up
the 5 percent annual stockdividend and insteadincreased the regulardividend rate by, say, 5percent once every threeyears.
Table9.1AnnualIncreaseinCashOutlaysforCashDividendsCausedbyaStockDividendProgram
Year DividendCashExpenditure
AnnualIncreaseinCashOutlays
Present $1,000 $—1 $1,050 $502 $1,103 $103
3 $1,158 $1584 $1,050 $2165 $1,276 $2766 $1,340 $3407 $1,407 $4078 $1,477 $4779 $1,551 $55110 $1,629 $629
Stock dividends, too, poseadministrativeproblemsforstockholders, many ofwhomseemtobelieve thatretaining stock dividends
only results in theirhavingmore paper and morepaperwork.Thosewho sellthe shares received findthat their equity in thecompanyisdiluted.
STOCKREPURCHASESBoth dividends and stockrepurchases result in cashbeing distributed to the
stockholder. Despite stigmasorhangupsabout liquidation,buying in common stocks incertain instances can be aviable alternative forcompanies with the requisiteliquidity.Onanoverallbasis,buy-ins
have the following relativeadvantagesforstockholders:
Intheusualcase,suchreceiptsofcasharetaxedonlyonacapitalgains
basis.Onthepartofthestockholder,thereceiptofthecashusuallyisoptional,ratherthanmandatory(asisthecasewithdividendreceipts).Weakshareholderssellout,withpossiblefavorableimplicationsforfuturemarketprices.If,asisfrequentlythecase,buy-insareata
pricebelowthevaluebasedoncorporatereality,theper-sharecorporaterealityvalueofthesharesnotboughtinisenhanced.
There are advantages tocorporationsaswell:
Insofarasthecommonstockisdividend-payingand,asisusual,thecompanydesirestomaintainadividendrate,
cashrequirementsforfuturedividendpaymentsarereduced.Earningspershare,bookvaluepershare,andcorporate-realityvaluepersharemaybeenhanced.Aprogramcanresultintheeliminationofall,orvirtuallyall,publicshareholders.Wherethepriceofthe
stockcanbeatooltobeusedbythecompanyin,say,futureacquisitions,buy-inscanresultinamorefavorablepriceforsharesthatremainoutstandingthanwouldotherwisebethecase.
Buy-ins, of course, bringcertain relativedisadvantagestopublicshareholders:
Firstandforemost,ifthebuy-insareofmassive
size,investorsmaybeforcedoutofacompanyaltogether,atapricethatmaybeverylowcomparedwithcorporatereality,eventhoughsuchapricecouldbeatasubstantialpremiumovermarket.Evenifnotforcedout,theywouldfindthatthesharesremainingafterabuy-inmayhaveonly
verylimitedmarketability,sincebuy-insareusuallyonlyasometime,irregularsourceofcashtostockholders,whereasdividendscanbecountedonasaregular,continuingsourceofcashreceipts.Companiesbuyingincommon,otherthaninprivatelynegotiatedtransactions,
areinherentlyinaconflictedpositionwithpublicshareholders:thecompaniesarebuyers,andthepublicaresellers.Andpublicstockholdersunderstanddividends,butthereissomethingremoteandmysteriousaboutbuy-ins.
Buy-ins also bring certainother relative disadvantagestocorporations,eventothose
that unquestionably havesurpluscashandnobetteruseofitthantorepurchasesharesselling at prices that areattractiverelativetocorporatereality:
First,therearemanylegalstricturesagainstbuyingin,whetherbyopen-marketpurchase,3bytender,orbyuseoftheproxymachinery;thereevencanbe
difficultieswhenpurchasesaremadeinprivatetransactions.Besidesinherentconflictswithpublicshareholders,therealsomaybeconflictswithinsiderswhomightwanttopurchaseshares.Andtheremaybeappearancesofpayoffstoinsideshareholderswhodesiretosell.
Westressthatbuy-insarealegitimate use of corporatecash. As a practical matter,buy-insarelikelytoremainalimited activity simplybecause for mostcorporations, no matter howattractively priced theirmanagements think theirstockis,sharerepurchasesareimpractical—the companylacks either the liquidity orthe legal authority to
repurchaseorretireshares.Inmany cases, the companieswill have expansionopportunities—suchasXeroxandTexas Instrumentshad—whichmakeshare repurchaserelatively unattractive. Inother cases, laws preventrepurchases,asinthecasesofelectric utilities orcommercial banks. In mostcases,though,companieswilllack enough cash or
borrowing power toundertake meaningful buy-inprograms.However, thebuy-in program conducted byIBM Corporation thatcommenced in 1977 and hascontinued, gave buy-ins anewcachetandrespectabilitythat was lacking previously.IBM sought to acquire asmanyas5millionof itsownsharesviaacashtenderofferat $280 per share; the
corporation succeeded inacquiring2,567,564sharesinthattenderoffer.The repurchase of large
amounts of publicly ownedshares by companies, or thepurchase of such shares byinsiders,resultsinacompanygoing private or going dark.Foragoingprivateallpublicshareholders are cashed out.Thisusuallyoccursinacash-out merger situation. Not so
for going dark, which canoccur when the number ofshareholders of record isbelow 300. The regulationsmeant to control going darkare embodied in part inRule13e-3 of the SecuritiesExchange Act. A going-darktransaction is one that haseithera reasonable likelihoodor the purpose of producingdirectly or indirectly theelimination of any SEC
requirements that thecompanymakedisclosures toitsequityholders.
DISTRIBUTIONOFASSETS
OTHERTHANCASH
A company may be in aposition to distribute assets
other than cash tostockholders. Sometimesthoseassetsdistributedcanbedividends for tax purposesand can encompass suchthings as portfolio securities(distributed by Standard Oilof Indiana from 1948 to1963); chocolate inventories(by Rockwood Chocolate inthe1950s);andevenwhiskey(bySchenleyDistillersduringWorld War II). Such
distributions are rare becauseof possible disadvantages toshareholders, since thedividend event that gave riseto the tax does not providethecashwithwhichtopayit.For tax reasons, most
distributions to shareholdersthatareinkindratherthanincash are tax-sheltereddistributions. The mostfamous of such distributionswas that of DuPont’s
holdings in General MotorsCompany common stockduring1962,1964,and1965.By act of Congress, thesedistributions were exemptedfromtaxasadividend.The income tax code has
numerous provisions thatallow shareholders to receivedistributions in kind and incashona tax-shelteredbasis.Suchprovisionsareinthetaxcode sections dealing with
spinoffs, split-offs, split-ups,redemptions, reorganizations,and liquidations. Discussionof these is beyond thepurviewofthisbook.
LIQUIDATIONAword on liquidation seemsappropriate, however. Thecommon definition ofcorporate liquidationconcerns the payout in cash
and/or in kind of an amountgreater than the company’saccumulated retainedearnings. In some circles,liquidation seems to bear astigma as something that isnonproductive. Our view asto what liquidation is andwhat it means tends to bedifferent.Tous,anypaymentby a corporation to itsshareholders—even quarterlydividends—is a form of
liquidation. Whether or notpermanent capital other thanretained earnings is invadedisanaccountingquestion,notan economic one. Certainly,no stigma of nonproductivityoughttoattachtostockholderdistributions of any sort, inany amount, as long as thecompany distributing canafford to do so and believesthe distribution is a goodenough use of cash. In fact,
the vast majority ofcompanies are unable tomake any material-sizeddistributionnow,notbecausethey lack adequate retainedearnings, but rather becausethey lack adequate liquidity.Inmostcases, thecompaniesare prevented fromdistributing more than aportion of annual earnings toshareholders, both bycommon sense and by
restrictions in their variousloan agreements. In thebroadestandmostmeaningfulsense,wedonotbelievethereis any such thing asliquidation. Rather, there isonly asset conversion—aconversion of assets todifferent uses and/orownership, where much ofthe time they will be moreproductive.
SUMMARYIt is our view that for mostcompanies,theformulationofappropriate shareholderdistribution policies requiresthat stockholder needs anddesires be distinctlysubservient to the needs ofthe corporation itself.Furthermore, we think theprice at which a commonstock sells (except in special
cases, of which publicutilities are the primeexample)shouldhavelittletodo with a company’s payoutpolicy. We describe certaincharacteristics of cashdividendsandexplainwhyincertain circumstances havingaliberaldividendpolicymaybe beneficial either to thecompanyormanagementandinsiders. Finally, we discussother forms of distributions
including share repurchases,distribution of assets andliquidations._______________*Thischaptercontainsoriginalmaterial,andpartsofthechapterarebasedonmaterialcontainedinChapter15ofTheAggressiveConservativeInvestorbyMartinJ.WhitmanandMartinShubik(©,2006byMartinJ.
WhitmanandMartinShubik).ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1BenjaminGraham,DavidL.Dodd,andSidneyCottle,SecurityAnalysis:PrinciplesandTechnique(NewYork:McGraw-HillBookCompany,1962).2Dowling&Partners,industrystatistics,www.dowling.com
3Theprincipalstrictureagainstopen-marketpurchasesiscontainedinSecuritiesExchangeActRegulation13e-3.Mostwould-becorporateopen-marketrepurchasesabideby13e-3inordertoavoidrunningintoaccusationsofmarketmanipulationsthatareviolationsofantifraudstatutes,particularlyRule10b-5.
CHAPTER10
RolesofCashDividendsinSecurity
AnalysisandPortfolio
Management*
TheThreeConventionalTheoriesCashDividendsasaFactorinMarketPerformance
ThePlaceboEffectofCashDividendsCashDividendsandPortfolioManagementCashDividendsandLegalListsCashDividendsandBailouts
TheGoalsofSecuritiesHoldersSummary
Cash dividends are moneypayments to corporateshareholders paid out of acompany’saccountingearnedsurplus,madeinproportiontoeachshareholder’sownership
interest in the class of stockreceiving the dividend. Oncethe dividend is declared, thestockholder has no choiceother than to take it. Controlof the size and timing of thepayout is with the companyand not the outsidestockholder.As we pointed out in
Chapter 3, it is unrealistic toview finance and investmentproblems as if there existed
monolithic stockholders andmonolithiccorporations,orasif there were any necessaryrelationship between thevalue of a business and theprice of its common stock.Yet,insofarasthethreemostwidely accepted theoriesabouttherelationshipofcashdividends to value andcommon stock prices areconcerned, the underlyingassumptions appear to be
based on just suchmisperceptions. The threemostwidelyacceptedtheoriesarethosepropoundedbyJohnBurr Williams, Modiglianiand Miller, and Graham andDodd.It is importantforinvestors
relying on a fundamentalfinanceapproach to investingto understand the roles cashdividends play in securityanalysis, portfolio
management, and corporatefinance. We believe the realroles of cash dividends tendto be different from thosepostulated in traditionaltheories.Forus, therearesixprincipal roles of cashdividends:
1. Dividend levels andchanges in dividends, upor down, seem likely tohave impacts on stockmarketprices.
2. Cash dividends areimportant placebos fornon-control investorsinsofar as such investorslack confidence in themerits of the equitysecuritiestheyhold.3. Dividends are crucialin portfolio managementwhere prudent managersseekapositivecash-carry—that is, where theystrive to have income
from the holding ofsecurities exceed interestexpense (and possiblydividend costs, too)incurred in connectionwithobligationsorquasi-obligations assumed inconnection with theportfoliobeingmanaged.4.Thereceiptofdividendincome may be a legalnecessity for certainsecurity holders, such as
variousfiduciaries.5.DividendspaidtoU.S.taxpaying shareholdersby qualified U.S.corporations are taxadvantaged as comparedwith comparable interestincome paid bycorporations. For federalincome tax purposes,dividends received byindividuals are subject totaxation at capital gains
rates. Interest received istaxed at ordinary incometax rates. Qualifiedcorporations receivingdividends from qualifiedcorporations exclude atleast 70 percent of thedividend received fromany federal income taxwhatsoever.6. It is our view that forany investment to beattractivetheinvestorhas
to perceive a bailoutsooner or later, anddividendsareoneformofbailout.In a rational world, no
investment can be attractiveunless thereareprospects fora bailout. Bailouts can be oftwotypes:inthefirst,controlofabusinesscanbeobtained;in the second, there areprospects that the investmentwill become convertible into
cashinwholeorinpart.Non-control investments canbecome convertible into cashbecause:
Thesecuritiesaremarketable;theycanbesoldintheopenmarket;inprivatetransactions;pursuanttoacashtenderoffer;orpursuanttoacash-outmergerorcertainreversesplits.Theminorityinvestor
canhopetoexercisecertainrights,suchasrightsofappraisalunderstatelaw;and/orTheinvestorcanlookforwardtothereceiptofcashdividends.
We think it is important todistinguish between thesignificance of interestincome to typical holders ofsenior securities and thesignificance of dividend
income to commonstockholders. The goals ofcommonstockholders tend tobe lesswell defined than arethose of holders of creditinstruments.Twoofthethreetheories—
John Burr Williams’s andGraham andDodd’s—appearto be compatible with ourviews, provided theunderlying assumptions ofeach theory are modified to
fit in with our ideas ofeconomic and financialreality. The Modigliani andMiller theory, on the otherhand, may be useful as atheoretical exercise; it doesnot appear to have anypractical application and isindeed,misleadingbecause itignores completely theimportant concept ofcreditworthiness.
THETHREECONVENTIONAL
THEORIESThe first theory, propoundedby John Burr Williams in abook entitled The Theory ofInvestmentValue,1 states thatacommonstock isworth thesum of all the dividendsexpected to bepaidout on itinthefuture,eachdiscounted
to its present worth. Thesecond theory, propoundedby Franco Modigliani andMertonH.Millerin1958,2inan article entitled “The Costof Capital, CorporationFinance and the Theory ofInvestment,” states in effectthataslongasmanagementispresumed to be acting in thebest interests of thestockholders, retainedearnings should be regarded
as equivalent to a fullysubscribed, preemptive issueof common stock, andthereforethatdividendpayoutis not material in thevaluations of a commonstock. The third theory isdetailed in Chapter 35 ofGraham andDodd’s SecurityAnalysis,3 and states that inthe case of the vast majorityof companies, highercommon stock prices will
prevail when earnings arepaid out as dividends ratherthan retained in a business.Graham and Dodd feel thatthe only exceptions to thisrule are cases where acompany’s return oninvestments is unusuallylarge, and where thecompany’sstockssellathighmultiples of earnings and athuge premiums over bookvalue.
TheWilliams theorymightbe of use in an ideal world,but it is of little help in acomplex, wealth-creatingeconomy such as ours. TheWilliams theory, undiluted,wouldonlyapplyinatax-freeworld where the universalraison d’être for owningcommon stocks was toreceive dividends and theraisond’être of all corporateactivities was to pay
dividends to commonstockholders.TheWilliams theory, to be
realistic, could be restated toposit that a common stockheld by noncontrolstockholdersisworththesumof all the net after-tax cashexpected to be realizable inthe future fromownership ofthecommonstock,withsuchnet cash being realizableeither from cash
disbursements by thecompany (whether in theform of dividends orotherwise,suchasliquidatinginwholeorinpart),andfromsources outside the company(whether they are stockpurchasers or lenders willingto treat the common stock ascollateral for borrowings bythe shareholder). Such cashrealizations would bediscounted to reflect time
factors and the probabilitiesof realizations as well as taxconsiderations and tradingcosts. Purely and simply,such a theory equates withour bailout views ofinvestmentvalue.If one wanted to make the
realistic assumption that theultimate goal of all non-control investment is cashrealization,thentheWilliamstheoryaswehavemodifiedit
would fit in well with ourperceptionsoftherealworld.However,eventhathastobemodified. It would still notapply universally, since theultimate goal of allinvestment is not cashrealization. For manyinvestors (for example, acorporation that has nointentionofeverpayingcashtoitsequityholders),thegoalof its investmentmay not be
cash realization, but wealthcreation through control overthe growth of unrealizedinvestment values. Otherinvesting entities maycombine goals of ultimatecash realization andcontinuedreinvestment.Unlike the Williams
approach to evaluatingcommon stock, theModigliani and Millerassumptions seem utterly
unrealistic. There does notappeartobeanybasisinfactfor assuming either thatmanagements act in the bestinterests of stockholders orthat stockholders have anabsolute community ofinterests among themselves.The simple fact is thatrelationships amongmanagements andstockholders of publiccompanies are always
combinationsofcommunitiesof interest and conflicts ofinterest.Managements frequently,
even traditionally, pay lipservicetothepropositionthattheyworkinthebestinterestsofallstockholders,especiallyoutside stockholders.Increased managementsalaries and perquisites arejustified on the basis thatstockholders’ best interests
are served by using suchcompensation devices toattract and hold highlymotivatedpersonnel.Companies go private by
buying out their stockholdersat discounts from realizablevalues. This activity isjustifiedonthebasisthatitisin the best interests of thestockholders to force themtotake, in cash, a value thatrepresents a premium over
the prevailing stock marketprices—even though theprices may reflect a thinmarket in which very fewshares could be bought orsold without increasing ordepressing stock marketprices. This activity may infact be working in the bestinterests of many of theoutside stockholders, butcertainly not all. TheModigliani and Miller view
of the fiduciary managementselflessly toilingfor the idealstockholder simply does notaccurately describe how allmanagements of publiccompanies thinkandoperate.Nor does it accuratelydescribe theobjectivesof themany different types ofstockholders.That managements do not
tend toworkprimarily in thebest interests of all
stockholdershasbeenpointedout by John K. Galbraith inhis book The New IndustrialState.4 Management itselfcollectively and individuallyconstitutes a group thatalways has some conflict ofinterest with at least someoutside stockholders. Othergroupsofwhose interests themanagement is keenly aware(and whose interests are atleast partially adverse to the
interests of some of thestockholders) are othersecurities holders, such asinstitutional creditors, laborunions, suppliers, customers,and the staff of the companyitself.If there were any
generalization to be made, itwouldbethatmanagement,inbalancing the interests of thevariousgroups they feel theyhave to serve, tends to work
more in the best interests ofthose groups that bring themost benefits to themanagement. Activities inthese directions, though, aretempered by the need andsometimesthedesiretoguardthe interests of other groups,especially those whommanagementhastoconstantlydeal or negotiate with on aone-to-onebasis.Conversely,there is a tendency to guard
least the interests of thosewho are truly outsiders andpassive, with whommanagement rarely, if ever,deals personally.The outsidegroups that managements ofpublicly owned corporationstendtoviewimpersonallyarethe outside passive minorityinvestors (OPMIs) and theInternal Revenue Service,among other tax-collectionagencies.
Since managements havevirtually no community ofinterests with tax collectors,there isno tendency toguardthe interests of this group,exceptasrequiredbylawandin reaction to threatsofauditor other investigatoryactivity.True,overandabovethe law, outside stockholderstend to receive bettertreatment than tax collectors,even though they may be
more passive. Mostmanagements do not viewoutsidestockholderseitherasallies or as adversaries. Andthere are times whenmanagementswantwhatmostoutside stockholders want—for example, a high price forthe company’s commonstock. But this convergenceof interests may occur lessfrequently than many peoplesuppose.
Probably the bestindications thatmanagementsdo not, on themost practicallevel, work in the bestinterests of stockholders canbe found in the need for anelaborate legal structure toprotect outside stockholdersfrom predatory practices byinsiders. This legal structureiscontainedmostlywithinthesecurities laws as embodiedintheSecuritiesActof1933,
the Securities Exchange Actof 1934, and the InvestmentCompanyActof1940, all asamended. Enforcement ofstockholder rights againstinsiders is undertaken by theregulatory authoritiesthemselves and through theprivate bar, which bringsrepresentative and derivativeclass actions on behalf ofstockholder groups. Leftwithout these legal
constraints, we have littledoubt that manymanagements would be farless cognizant of thestockholder’s best intereststhanisnowthecase.5
The third general theory,that of Graham and Dodd,describes stock marketbehavior.Inbrief,itnotesthetendency for earnings paidout as dividends to have agreater market value than
earnings retained. GrahamandDoddnote:For the vast majority ofcommon stocks, thedividend record andprospects have alwaysbeen the most importantfactor controllinginvestment quality andvalue.In the majority of cases,the price of the common
stock has been influencedmoremarkedlybydividendrate than by the reportedearnings:Because(1)dividendsplaya dominant role in themarket price of a typicalcommon stock and (2) thediscounted value of neardividends is higher thanthepresentworthofdistantdividends, of twocompanies with the same
earning power and in thesame general position inanindustry,theonepayingthe larger dividend willalmost always sell at ahigherprice.6While these statements are
realistic, their thrustseemstous tobemisdirected.Amoreappropriate emphasis wouldbe not on where a stockwould sell in the near futurebecause of its dividend, but
rather on which stock—thelow dividend payer or thehighdividendpayer—ismoreattractive to which type ofinvestor.
CASHDIVIDENDSASAFACTORINMARKET
PERFORMANCEIf we were to generalizeabout the subject, we wouldapproach the stock marketimpact of dividend paymentsdifferently from the wayGraham andDodd do. Otherthings being equal, thecommon stock whose issuerisalowdividendpayerwouldbethebetterbuyforinvestorsseeking market appreciation,
rather than a cash-carry. AsGraham and Dodd agree, oftwocompanieswiththesameearning power and with thesame general position in theindustry, the lower dividendcompany should tend to sellat the lower price; this, byitself, shouldmake the lowerdividend payer a moreattractive buy for manyinvestors. Furthermore, thecompany whose common
stockisavailableatthelowerpricewillhavemoreroomtoincrease its dividend andeventually command thehigherprice.Itappearslikelythat market price actionmaybemoreaffectedbythetrendindividendpaymentsthanbythe amount of the dividends.The company paying thelower dividend will retainmore earnings and in thefuture be in a better position
toimproveitsindustrystatus,its financial position, andtherefore its earnings. It isentirely possible that,assuming the companies areinthesamepositionnow,hadthe company paying thelower dividend paid a higherdividend, it couldneverhaveachieved the position it nowhas.Areasonablecountervailing
argument can be made that
high dividend payers tend tobe the better buy because ahigh payout ratio mayindicate a management moreattunedtomeetingthedesiresofmostoutside stockholders.Webelievethisargumenthaselements of validity. Itsapplicability, however, islimited,sincedividendpolicydoesnotappear tous tobeaparticularly good measure ofeither management ability or
managementinterests.Insofaras there is a tendency forthere to be a strongrelationship between thelong-term economic interestsof a company and the long-termpricesofthatcompany’scommon stock, stockholdersare eventually benefited bysmall or no dividends, to thesame extent as companiesbenefited from profitablyreinvesting cash that would
otherwisehavebeenpaidoutasdividends.Graham and Dodd also
state:Longexperiencehastaughtinvestors to be somewhatmistrustful of the benefitsclaimed to accrue to themfrom retained andreinvested earnings. Invery many cases, a largeaccumulated surplus failednot only to produce a
comparableincreaseintheearnings and dividends,but even to assure thecontinuance of thepreviously established rateofdisbursement.7Thisstatementis,ofcourse,
true,butitisequallytruethattoo high dividends can hurtcompanies and stockholdersfar more than conservativedividend policies. There aremanycaseswherecompanies
paidhighdividendslongafteritwasprudentforthemtodoso, and as a consequence thestockholders sufferedmightily. Examples rangefrom CIT Corporation,GeneralMotors andChryslerCorporation prior to their2009 Chapter 11 filing, toMiddlesex Water, U.S. Pipeand Foundry, and UnitedFruit. These companies andtheir long-term stockholders
would have been better offhaddividendratesbeenlowerand had the companiesretained earnings to bothfinance necessaryexpenditures and provide acushion against businessadversities.The Graham and Dodd
approach has validity from astockholder’s short-runviewpoint, but does notappear to give much weight
to the legitimate long-termneeds of a corporation. TheGraham and Dodd approachdoes recognize corporate andstockholder long-term needsif it is assumed that highdividendsresultinhighstockpricesthatanissuerisabletotake advantage of by issuingnewstocksatpricesbasedonmarket values. But thisassumption is largelyunrealistic. Except for public
utilities,mostcorporations,asa practical matter, can issuenewcommonstockonlyveryoccasionally, either in salesfor cash or in merger andacquisitiontransactions.We are in agreement with
Graham and Dodd thatcorporate dividends andcorporate dividend policiesare likely to have ameaningful impact oncommon stock prices.Aswe
point out above, though,different assumptions bringdifferent results. For thebroadrangeofcompanies,wecannot conclude that highdividendsarebetter than lowdividends.If we were to generalize
about the subject, we wouldapproach the stock marketimpact of dividend paymentsdifferently from the wayGraham andDodd do. Other
things being equal, thecommon stock whose issuerisalowdividendpayerwouldbethebetterbuyforinvestorsseeking market appreciation,rather than a cash-carry. AsGraham and Dodd agree, oftwocompanieswiththesameearning power and with thesame general position in theindustry, the lower dividendcompany should tend to sellat the lower price; this, by
itself, shouldmake the lowerdividend payer a moreattractive buy for manyinvestors.We are in agreement with
Graham and Dodd thatcorporate dividends andcorporate dividend policiesare likely to have ameaningful impact oncommon-stock prices.Aswepoint out above, though,different assumptions bring
different results. For thebroadrangeofcompanies,wecannot conclude that highdividendsarebetter than lowdividends.
THEPLACEBOEFFECTOF
CASHDIVIDENDS
Cash dividends increase inimportance for securitiesholders insofar as the holderlacks confidence in theoutlookormanagementor inthe reliability of thedisclosuresusedbyhiminhisbuy, hold, or sell decisions.Put simply, for theuninformed or distrustfulstockholder, cash dividendsare a hedge against beingwrong. Truly a bird in hand
(cash return) for them isworth two, three, or fourtimesthebirdinthebush(theappreciation potential arisingout of a company’sreinvesting retained earningsanditscommonstock’sbeingavailable at a lower pricebecause of the lowerdividend).
CASH
DIVIDENDSAND
PORTFOLIOMANAGEMENTDividends increase inimportance with theshareholder’s need forimmediate cash income fromhisportfolio.Ofcourse,whenthe prime lending rate
exceeds 7 percent, and goodgrade common stocks returnno more than 6 percent, itmay be asked: Should thosein need of income invest incommonstocksatall?Suchaquestion misses severalpoints. First, manyshareholders desiring incomeare in locked-in positions,unwilling to sell commonshares they own because of,say, an ultra-low cost basis
for income tax purposes.Second, many investors seekinflation hedges—securitiesthat combine high cashreturns with appreciationpotential. Third, dividendreceipts may be taxadvantaged for shareholderssubject toU.S. income taxes.Specific common stocks arelikely to have substantiallymore appreciation potentialthan senior securities (either
because their prices areunusually depressed orbecause equity holders canparticipate in the long-termgrowth of a business),whereastheholderofaseniorsecurity without equityprivileges has a contractuallydefined limit on potentialappreciation. Although it istrue that the smallerappreciation potential ofsenior securities is made up
for,atleastinpart,bythefactthattheyareeasiertofinance,this finance factor may beacademic for the prudentoutside investor who abhorsborrowing on margin toinvest in the securities ofcompanies about which hisknowledge is limited, overwhich his control is nil, andwherehiscostsofborrowingmightexceedhisreturnonhisportfolio.
Dividends become anegative factor forshareholders who want taxshelter or who have no needfor income and are confidentthatmanagementwillreinvestretainedearningsonahighlyproductive basis. In a senseandexcept for thefact that itdoes not provide a cashreturn, unrealizedappreciationistheultimateinincometaxshelter.
Dividend income tends tobeunimportant,also,whereacompany is not essentially agoingconcern,butratherisina resource conversion or aworkout situation (that is,with prospects of beingliquidated, acquired, orreorganized), because of theexpectation by shareholdersthat realization will beobtained on a moreadvantageoustaxbasisthanif
dividendswerepaid.An attractive feature of
securities with a high cashreturn is the positive cash-carry.Asafehighcashreturnnot only eases any investor’spain where performance isdisappointing,butalsomakesa transaction eminentlymoreaffordable and easier tofinance thanwouldotherwisebe the case. This is sobecause of the benefits a
cash-carry brings to thefinancialpositionofaholder.
EXAMPLEBack in 1979, SourceCapital Preferred sold at24, and paid a $2.40dividend; it was amargin-eligiblesecurity.Assumingan investor could borrow50 percent of the cost of10,000 shares, incurring a7.5percentinterestcost,hiscash-carrywouldhavebeenasfollows:
10,000sharesofSourceCapitalPreferred@24net
$240,000
50percentofpurchasepriceborrowed
$120,000
Cashinvestmentrequired
$120,000
Annualdividendincomeon10,000shares
$24,000
Annualinterestcostonborrowingsof$120,[email protected]
$9,000
Cashandcarrygain $15,000Cashreturnon 12.50
investmentof$120,000
percent
We believed that theSource Capital Preferred$2.40 dividend wasexceptionally safe and thatthesecuritywasdefactoanAAA issue. It was thesenior security of a large,conservatively managed,registered InvestmentCompany, which wasforbidden by law to incurany material amount ofobligations that would be
senior to this preferredstockissue.
Against this backgroundand assuming our analysis isabsolutely correct, it may beinstructive to review for thereader those factors that aportfolio manager ought toconsider before determiningthat a cash-carry investmentin Source Preferred is bothattractive and suitable. First,the investorwhobelieves the
cost of borrowing willincrease may forgo a SourcePreferred investment. Sincethe investormay not be ableto control the cost of hisborrowing, there could beadverse cash-carryconsequences if interest rateson the bank borrowingsincrease to over 10 percentandtheinvestorisrequiredtoretire or pay down his bankloan at a time when he is
unable to refinance. Second,thereisariskofdepreciationinthemarketpriceofSourceCapital Preferred stock iflong-term interest rates risemarkedly or the marketbecomes irrational. Someindicationof thedepreciationpossibilities inherent inSource Preferred can begleanedfromthepricehistoryof the issue: in 1974, SourceCapital Preferredwas quoted
aslowas17 bid.Itoughttobe noted, too, that SourceCapital Preferred was notoverlymarketable;therewereonlyabout1.6million sharesoutstanding, and these weretradedintheover-the-countermarket insmallvolume.Anysecurity holder who mighthave to sell at any particularmoment might be able todispose of his shares only atdiscountprices.
While the positive 12.5percent cash-carry returnappeared attractive by itself,appreciation opportunitieswere limited for the issue.Commencing September 30,1977, the issue becamecallable at the option of thecompany at $30 per share,and the call price woulddecline each year until itreached $27.50 in 1982. Theissue would have not, in
rational markets, sold at anyappreciable premiumover itscallprice.Alternative opportunities
could have been moreattractive. We do not knowthe entire universe ofsecurities, but conceivablythere could have been otherissues that offered a bettercombination of cash-carrysafety of income and highreturn.
Unlikemostotherdomesticpreferred stocks, SourceCapital Preferred had onlylimited special tax benefitsforcorporateholders,throughthe availability of an 85percenttaxexclusion(thetaxexclusionisatthetimeofthiswriting 70 percent). As aninvestment company electingtobe taxedunderSubchapterM of the Internal RevenueCode, Source Capital itself
was not a taxable entity, butinstead flowed through itsincome to the shareholders.Unless and until the bulk ofSource Capital’s investmentsare in qualified dividend-paying equities rather thaninterest-paying debtinstruments,onlyaportionofSource Capital Preferred’sdividend payments to itscorporate stockholderswouldbe tax-sheltered. Back in
1979, a corporate holder ofSource Preferredwas subjecttofull incometaxesonabouttwo thirds of the dividends,and only in connection withabout one third could thecorporate holder exclude 85percentofthepaymentsfromitstaxableincome.Finally, Source Capital
Preferred lacked generalrecognition by others as ahigh-qualityissue.Thisfactor
almost automaticallyexcluded the stock fromconsideration for all sorts ofinstitutional and quasi-institutionalportfolios.One of the pervasive
elementsofcorporatefinanceisdemonstratedby thiscash-carryexample.Howattractiveasecurityorsituationis,isinpart a function of howfinancially strong it is. Withthe prime lending rate of 7
percent, Source CapitalPreferred at 24 was in ourview a very attractive cash-carry situation for many;were the prime 10½ percent,not only would there be nocash-carry forSourceCapitalPreferred at 24, but in theabsence of the issue’s beingcalledortenderedatapriceinexcessof24,thestockwouldhavebeenunattractive.
CASHDIVIDENDSANDLEGAL
LISTSCash dividend income is alegal or quasi-legal necessityfor many securities holders.Legal lists in many statesrequire fiduciaries’ commonstock investments to be
restrictedtosecuritiesthatarecurrently paying dividendsandhavepaiddividendsforanumber of years in the past.The accounting practices forbusiness entity investors(such as insurance andinvestment companies)usuallypermit themtoreportas income on common stockinvestments where they holdless than 20 percent of theissue only the dividends
received. These stockholderscannot report as net incomeany equity in theundistributed earnings ofcompanies whose commonstocks they hold in theirportfolios. The accountingrule governing this iscontained in FASBAccounting StandardsCodification (ASC) 323,which states that there is apresumption that
undistributedequityinprofitsorlossesofcompanieswhosestocksareintheportfolioaretobeincludedinthebusinessentities’ accounts if 20percent or more of the stockofsuchacompanyisowned.
CASHDIVIDENDS
AND
BAILOUTSThe ability to convert assetsto cash tends to be a keyconsideration for manybuyers of securities forcontrolpurposes. Italways isa key consideration foroutsideinvestors.Companies with pools of
unencumbered liquidity tendto be looked upon asattractive acquisitions for
control buyers, in partbecause there is a lack ofuncertainty about minimumvalues to anyone.Furthermore, large pools ofcashmayfrequentlybeworthsubstantial stock marketpaper premiums to acquirersof corporate control whenthose acquirers pay in paperconsisting of warrants,common stocks, preferredstocks, and subordinated
debentures,notcash.
EXAMPLESchenley Industries’ cashwas worth a substantialpremium over stated valuetoGlenAlden in1968andagain in 1971 when GlenAlden acquired Schenleysecurities mostly by theissuance of subordinateddebentures.RoanSelectionTrust’scashalsowaswortha premium to Amax in1970.
Assuming that an investorcan have no element ofcontrol over the companyinwhosecommonstockhehas invested, thatstockholder will want tohave opportunities sooneror later to convert thatinvestmentintocash.Therearebutthreewaysthatsucha minority interest can beconvertedtocash:first,thesecurity can be marketed;second, the issuer canbecome involved in
resource conversionactivities, such as mergersand acquisitions,liquidations or going-private transactions; andthird,cashdividendscanbepaid to stockholders.Frequently, theprospectofcash dividends is the onlymeaningful assurance aminorityinvestormayhavethat a cash return will bereceived on an otherwiselocked-upinvestment.Without being exhaustive,
thereareafewsimplerulesabout minority interestinvestments of which anOPMI inpublic companiesought to be aware.Once acompany has becomepublic, it is required toremain a filing companywith the Securities andExchange Commission aslong as there are 300 ormore stockholders ofrecord of any class ofequity securities.a Forcontrol stockholders, thereusually are important
advantages to having 100percent control of acompany, compared withlessthan100percent.Also,there are usually importantadvantagesinbeingprivaterather than public.However, regardless of thestate of incorporation,majorities having a“businesspurpose”dohavethe right to force out theminoritiesthroughavoteofthe requisite number ofshares, or where themajority owns enough
shares, through a short-form merger, which doesnotrequireavote.Whethercompensation to theminority in the force-outhastobeadequatedependsin part on state law,including the adequacy ofappraisal rights fordissenting stockholders,and on compliance withappropriate disclosurerequirements under federalsecuritieslaws.Itisourexperiencethatthe
acquisitionofaportfolioofminority interests isattractive because of thelikelihood that parentswilleventually attempt toacquire, through mop-upmergers, 100 percentinterests in subsidiaries atpricesreflectingsubstantialpremiums above stockmarket prices (which aredepressed in part becausesuchsecuritiesareliabletolackmarketability).In acquiring these types of
minority interest securities,however, it frequently isimportant to the investorthat such securities paydividends, in part becausean investor may needincomeandinpartbecausethe receipt of dividendsmay be far more certainthan cash tender offers ormop-up mergers that maynever occur. Whensituations exist where theparent company finds itessential to receive cashfrom subsidiaries in the
form of dividends onoutstandingcommonstock,cash income may bevirtually assured for theoutside investor.Twosuchsubsidiaries were RelianceInsurance Company, 97percent owned by theReliance Group, andMountainStatesTelephoneand Telegraph, 88 percentowned by AmericanTelephone and Telegraph.Both Reliance Insuranceand Mountain StatesTelephone had relatively
liberaldividendpolicies.aSection12(g)(4)oftheSecurities
ExchangeActof1934states:Registrationofanyclassofsecuritypursuanttothis
subsectionshallbeterminatedninetydays,orsuchshorterperiodastheCommissionmaydetermine,aftertheissuerfilesacertification
withtheCommissionthatthenumberofholdersofrecordof
suchclassofsecurityisreducedtolessthanthreehundredpersons.
TheCommissionshallafternoticeandopportunityforhearingdenyterminationofregistrationifitfindsthatthecertificationis
untrue.Terminationofregistrationshallbedeferred
pendingfinaldeterminationonthequestionofdenial.CompaniesfilingwiththeSecuritiesand
ExchangeCommissioncomplywitheitherSection12orSection15oftheSecuritiesExchangeAct
of1934.Section15(d)haslanguagesimilartoSection12(g)
(4),permittingderegistrationwhenanissuerhasfewerthan300
shareholdersofrecord.
THEGOALSOF
SECURITIESHOLDERS
It is important within thefundamental financeapproach to distinguishbetweenthegoalsofvirtuallyallholdersofseniorsecuritiesand many holders of equitysecurities. A problem arisesbecause many commentatorsimpute to equity owners thesameultimategoalsthatexist
fordebtowners.Many owners of senior
securities,especiallyfinancialinstitutions, are interestedsolelyincashreturn—interestpayableincash,plusareturnof principal, also payable incash. Most senior securitieshave limited lives, so that ifrepayment of principal inwhole or in part cannot beobtained from sale in themarket, in time repayment
will be obtained from theissuer.In contrast, equity holders
may sometimes be interestedincashreturnsintheformofdividends and the ability tosell shares, not to the issuer,but to the market. However,some equity holders are alsointerested in an earningsreturn—inhavingaperpetualparticipation in an enterprisethat through the plowback of
earnings increases in valueover time.Such investorsareunder no illusion thatincreases in valuewill be, orare necessarily likely to be,reflected in stock marketpricesatanygivenmoment.It is probable that most
long-term equity investorshave a variety of goals,combining the pure cash-return goals characteristic ofmanyseniorsecurityholders,
and the earnings return goalscharacteristic of a person forwhom dividends havesignificant tax disadvantagesand who is not particularlyaware of stock market pricefluctuations. We think thatmany economic, accounting,andstockmarkettheoristsfailto recognize the existence ofthissecondtypeofinvestor.
SUMMARYIt is important for investorsrelying on a fundamentalfinanceapproach to investingto understand the roles thatcash dividends play insecurity analysis, portfoliomanagement, and corporatefinance. For us, cashdividends serve six principalroles: (1) dividend levels orchanges in levelsseemlikely
toimpactstockmarketprices;(2) dividends are alsoimportant placebos fornoncontrol purchasers ofcommonstockswho lack theconfidence in the merits ofthe equity securities theyhold;(3)theyareimportantinportfolio management whereprudent managers seek apositive cash-carry; (4) thereceiptofdividendsmaybealegal necessity for certain
fiduciaries; (5) they are aform of tax-advantageddistribution for U.S.taxpayers; and (6) they areoneformofcashbailoutfromholding common stocks. Wealso review the role ofdividends as postulated intraditionaltheories._______________*Thischaptercontainsoriginalmaterial,andpartsofthechapterarebasedon
materialcontainedinChapter14ofTheAggressiveConservativeInvestorbyMartinJ.WhitmanandMartinShubik(©2006byMartinJ.WhitmanandMartinShubik).ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1JohnBurrWilliams,TheTheoryofInvestmentValue(Cambridge,MA:Harvard
UniversityPress,1938).2FrancoModiglianiandMertonH.Miller,“TheCostofCapital,CorporationFinanceandtheTheoryofInvestment,”AmericanEconomicReview48,no.3(June1958).3BenjaminGraham,DavidL.Dodd,andSidneyCottle,SecurityAnalysis:PrinciplesandTechnique(NewYork:McGraw-Hill
BookCompany,1962).4JohnKennethGalbraith,TheNewIndustrialState(Boston:HoughtonMifflin,1967).5Theonegroupthatmightbeviewedinthebroadestperspectiveasdedicatedalmostsolelytotheinterestsofoutside,passiveinvestorsistheSecuritiesandExchangeCommission.Onapracticallevelthisisnot
whollytrue,butitisourviewthattheSecuritiesandExchangeCommissionhasbeenmorededicatedtotheinterestsofOPMIsthananyothergroupintheeconomy.6Graham,Dodd,andCottle,SecurityAnalysis,pp.480–481.7Ibid.,p.484.
CHAPTER11
TheAppraisalof
ManagementsandGrowth:GARPversus
GADCP*
NewFrameworkfortheAppraisalofManagementsManagementsAttunedtoOPMIInterestsManagementsas
ResourceConvertersTradeoffsGrowth:GARPversusGADCPGrowthataReasonablePrice(GARP)GrowthatDirtCheapPrices
(GADCP)Summary
The appraisal ofmanagements is, indeed,difficult. In a Graham andDodd primacy of the incomeaccount approach (or anyother primacy of the incomeaccount approach)managements are appraised
almost solely as operators ofstrict going concerns.Experiencetellsusthatthisisnot realistic. Superiormanagements seem to focuson the same things a valueinvestor focuses on as a buyand hold investor, that is,long-term wealth creation.The generation of reportedearnings from operationstendstobetheleastdesirablemethod for creating wealth,
simply because reportedearnings from operations areless tax sheltered than areother methods of wealthcreation. This is one of thereasons why resourceconversion activities bycorporations seem to havegrown in importance at theexpense of ordinary goingconcern activities. Alsohighly important for long-term wealth creation are
attractive access to creditmarkets and equity markets.Unlike most stock marketparticipants, the primaryfocus of these managementsis not on what periodicreported earnings per share,or periodic earnings beforeinterest, taxes, depreciationand amortization (EBITDA),mightbe.In creating wealth, these
opportunistic managements
realize that there tend to bemany ways to create wealthbesides enjoying operatingearnings. These othermethods of creating wealthinclude enjoying super-attractive access to capitalmarkets; being able to makeopportunistic acquisitions ofother companies and otherassets; being able toopportunistically launch newbusinesses; andbeingable to
take advantage of basicmispricing in securitiesmarketsinorderto,interalia,repurchase outstandingcommon stock, spin-offglamorous subsidiaries, orliquidateassetsinwholeorinpart.
NEWFRAMEWORK
FORTHEAPPRAISALOFMANAGEMENTSOnce it is recognized thatsuperior managements seeklong-term wealth creation,and that their businessesgenerate wealth by beingengaged in both goingconcern and resourceconversion activities, it
follows that managementsshouldbeappraisedbasedonthreeinterrelateddimensions:
1. Management asoperators of goingconcerns2. Management asinvestors, employing andredeploying the assets ofthebusiness3. Management asfinanciers, obtaining thenecessary capital on an
attractive basis toconduct companyactivitiesWewant the managements
ofthecompaniesinwhichwewould invest tobeattuned tothe interests of outsidepassive minority investors(OPMIs); to be competent asday-to-day businessoperators; and to becompetent as wealth creatorsas resource conversion
opportunities emergeopportunisticallyfromtimetotime.Experience tells us thatwe
haveachievedthebestresultswhenassociatedwithsuperiormanagements who were abletobeopportunisticonalong-term basis, and tookadvantageof theresources inthebusiness,whichincluded:
Strongfinancialposition(allthefollowing
examples)Efficientmanufacturingabilities(ToyotaIndustries)Abilitytomakeattractiveacquisitions(Wheelock,BrookfieldAssetManagement,BerkshireHathaway,CheungKongHoldings)Havingtheabilitytoemployexcesscapital(surplus-surplus)
profitably(BerkshireHathaway)Havingtheabilitytoaccesscapitalmarkets,onasuper-attractivebasis(BrookfieldAssetManagement,Facebook,Inc.)Havingtheabilitytouseasuperiorfinancialpositiontostrengthenacompetitiveposition(AVX)
Havingtheabilitytomaintainprofitmarginsduringperiodsofincreasedcompetitionandsevereeconomicdownturn(POSCO)
Experience has also taughtus that the vast majority ofmisjudgments often revolvearoundbeing inbedwith thewrong management, ratherthanpurelyfinancialfactors.
MANAGEMENTSATTUNEDTO
OPMIINTERESTS
As to being attuned to theinterests of OPMIs, it cansafely be stated that theredoes not exist any publiclytraded company where themanagement works
exclusively in the bestinterests of OPMIstockholders. Rather, allfinancial relationships,including those betweenmanagements and OPMIs,combine communities ofinterest and conflicts ofinterest.ThebestOPMIscanhope for is that there is adistinct bent by individualmanagements toward thecommunities of interest side.
Itwouldbenaïvetothinkthatanymanagementwouldforgomanagement compensation,and managemententrenchment, just becausesome of these managementprivilegesmightbeperceivedasgiving rise toaconflictofinterestwithOPMIs.It ought to be noted that
there tend to be conflicts ofinterest between short-run,market-sensitive OPMIs and
long-term, buy-and-holdOPMIs like us.We are verymuch against corporatebeefing up of quarterlyreported earnings per sharewhen, and if, the striving forperiodic earnings per sharediminishes opportunities forlong-term wealth creation.Striving for quarterlyearningspershareoftentendsto reduce wealth creationopportunities when
alternativemethodsofwealthcreation might be available.Goodexamplesofmanagerialemphasis on the short-termeffectsratherthanalong-termviewaremortgagelendingbyKeyCorp.andotherbanksin2005 and 2006, and themerger of AOL into TimeWarner in1999at theheightofthedotcombubble.
Example
Operating earnings aretaxable, and unrealizedappreciation isnot taxable.Not paying taxes increasesresources available forwealth creation. It makessense for corporationsinterested in wealthcreation to emphasizeearnings per share whensuchemphasiswillgivethecompany better access tocapital markets, especiallyequitymarkets, thanwouldotherwisebethecase.This,
however, has virtually norelevance for us since thecommon stocks in whichwewould invest are issuesof companieswith little orno need to access capitalmarkets, especially equitymarkets.
MANAGEMENTSASRESOURCECONVERTERS
Managements can and docreate wealth by acting asopportunistic investors. Thisopportunism is oftenassociated with theircompanies having a strongfinancialposition,whichtheycan use to effect attractiveacquisitions.
EXAMPLEWharf in 2012 made anattractive investment into
the financially strappedMainland Chinahomebuilder GreentownChina Holdings. Wharfinvested HK $5.1 billion(U.S. $654 million) intoGreentown, half incommonstockandhalfinaconvertible debenture.Upon conversion, Wharfwill end up with anapproximate 35 percentownership interest inGreentown equity.Greentown is one of theforemost residential
builders in MainlandChina. Its principalproblem seemed to haverevolved around a poorfinancial position. Thatpoor financial positionseems to have been curedbyWharf’sHK$5.1billioncapital injection. Thepurchase price will equalabout HK $5 perGreentown share.Greentowncommonat thiswriting sells between HK$8and$9pershare.
One example ofmanagement leavingsomething on the table thatcould have benefitedstockholders involves the2005 acquisition of InstinetbyNASDAQ.
EXAMPLEIn April 2005, InstinetGroup entered into amerger agreement withNASDAQ under whichInstinetshareholderswould
receive total considerationof $1.8 billion in cash. Aspart of the transaction,Silver Lake agreed to buyInstinet’sagencybrokeragebusiness for $207 million,which represented adiscounttothesubsidiary’stangible book value. InMay 2005, Third AvenueManagement submitted anacquisition proposal toInstinet inwhich it offeredto “stand in the shoes” ofSilver Lake and purchasethe agency brokerage for
$307 million, subject tolimited due diligence butno financing contingency.Instinet rejected theproposal as the boardconcluded that it was notreasonably likely toconstitute a “superiorproposal” for the entirecompany. In December2005, the merger withNASDAQ (and SilverLake) was completed. InFebruary, 2007, SilverLakesoldInstinet’sagencybrokerage business to
Nomura for a reportedpriceofnearly$1.2billionorapremiumofmorethanfive times its purchasepriceandnearlyfourtimesthe price offered by ThirdAvenue.
Mistakes by managementsinvolvedwithacquisitionsarealsocommon.
EXAMPLEOneof themoreegregiousmistakes might have
occurred when in 2008Bank of America acquired100 percent control ofCountywide FinancialCorp. in a mergertransaction. In thetransaction, Bank ofAmericashouldhavemadeabsolutely certain that itwas not assuming anyliabilities of Countrywide.Those liabilities wouldremain the obligations ofCountrywide but were notobligations that wouldattach at all to Bank of
America. This appears nottohavebeenthecase.
Assuming the liabilities ofpoorly financed subsidiariesought to be avoided like theplague by astutemanagement.
EXAMPLEIn 2012 questions wereraised by creditors ofResidential Capital LLC(ResCap) as to whether or
not all of Ally Bank(formerly named GeneralMotors Acceptance Corp)is tobe responsible for theobligations of ResCap awhollyownedsubsidiaryofAllyBank.TheBankruptcyCourt has appointed anexaminer to explore theissue.
Realizing current losses ona one-time basis is arecognized method formakingfutureearningsbetter
thantheyotherwisewouldbe.Many companies that takehuge write-downs—largelyon injudicious acquisitionsand on expansion undertakenduringaperiodofexcesses—serve as good examples.Taking those huge write-downs came to be known asbig-bath accounting.Examples of companies thattookbigbathsattheoutsetofthe2008–2009financialcrisis
included Merrill Lynch,Citigroup, and GeneralMotors.
EXAMPLEIn 2012, Tellabs took a$106 million charge-offwriting off completely itsinjudicious acquisition ofWiChorusin2009.
Most companies that takebig-bathwrite-downsaccountfor them as nonrecurring,
extraordinary events. Thisbothersmanywhofeltthatinreportingprofitsthebigbathsshouldbetreatedasanormal,recurring event. It seems tous, though, that much ofsecurityanalysisandmuchofaccounting isdirected towardappraising businesses andtheir managements solely asoperations and operators. Ifso, the big baths are indeednonrecurring. As we have
alreadypointedout,a featurethat differentiates us fromconventional business andsecurity analysts is thatconvention(beitGrahamandDodd or modern capitaltheory) seems to emphasizeoperations at the expense ofresource conversion factors,whereas we tend to de-emphasize operating factors,or rather, give resourceconversion factors greater
importance for mostcompaniesmostofthetime.Insofar as a company is to
be appraised as a goingconcern andmanagements asoperators,itislogicaltoviewthe big bath as nonrecurring.Insofar as a company and amanagement are to beappraised as investorsresponsible for obtaining areturn from the resourcesentrusted to them by being
operators, financiers, andinvestors in new productiveassets and by beingspecialists in mergers andacquisitions (that is, byviewing them as resourceconverters), there is no suchthingasnonrecurringchargesor expenses. Nonrecurringcharges are the method usedin Generally AcceptedAccounting Principles(GAAP)accountingtorecord
pastinvestmentmistakes.
TRADEOFFSNo management is perfect.The factors that allow themanagements to beopportunistic also bring tolight certain shortcomings, atleast from the viewpoint ofshorter-term stock marketspeculators. During goodtimes,when interest ratesare
low, the maintenance of astrong financial positionobviously translates into awillingnessofmanagementtosacrifice increased return onassets (ROA) and return onequity (ROE) in order toenjoy the safety benefits andthe opportunistic benefitsinherent in having a strongfinancial position. Focusingon long-term opportunismrather than periodic earnings
per share, as reported, tendsto not sit well with mostOPMIs. A company with astrong financial positioneitherdoesnotneedaccesstocapital markets or elsecontrolsthetimingastowhenthey would access capitalmarkets. Given this, themanagements tend to benonpromotional,andattimes,hardly interested at all inwhat Wall Street thinks. For
betterorworse,wewouldoptfor managements moreinterested in creditworthinessthanenhancedROE.The traditional focus on
strictgoingconcerns and theresulting view of managersonlyasoperatorsispervasiveandoftenleadstomisleadingconclusions about thedynamicsofwealthcreation.
EXAMPLE
In the book, ValueInvesting:FromGrahamtoBuffett and Beyond, byGreenwald, Kahn, Sonkin,and Van Biema (JohnWiley&Sons,2004),therearediscussionsofnetassetvalue(NAV).Animportantpoint in the book revolvesaround the view that if themarket price of a commonstock is well above thereproduction value ofassets,thecompanyandtheindustry, in the normal
courseofevents,willdrawnewcompetitionwhichwillresultindiminishedreturnsunless the company canbuild a moat to insulateitselffromnewcompetition(e.g., Coca-Cola, Gillette,andWD-40).Froma strictgoing concern point ofview, this observationseems quite valid. From acorporate managementpoint of view, though, itseems tobe incomplete. Inthe hands of a reasonablycompetentmanagement,an
overpriced common stocktends to be an importantasset with which to createfuture wealth by issuingthat common stock inpublic offerings, and inmerger and acquisitiontransactions.
On the opportunism issue,we are convinced it is verydifficult for mostmanagements to beopportunisticiftheirfinancialpositions are such that they
have to be supplicants tocreditors—whether thosecreditors are financialinstitutions, trade vendors, orlandlords. As we explain inChapter 7, a strong financialposition—that is, beingcreditworthy—givesmanagements options theywould not have otherwise.Opportunism is one suchoption.Wealsoexplainthatastrong financial positionmay
not be needed whenmanagement is associatedwith and the company iscontrolled by sponsors whoare extremely competent ataccessing capital markets ona super-attractive basis evenin the face ofweak financialpositions. We show anexample of this situation inChapter25.
GROWTH:GARPVERSUS
GADCPIn The Intelligent Investor,1Benjamin Graham defined agrowth common stock as aterm that applied to one thathadincreaseditsearningspershareinthepastatwellabovetherateforcommonstocksingeneralandthatwasexpected
to continue to do so in thefuture. He recognized thenthat these stocks would beattractive to buy and to holdprovided the price paid forthem was not excessive.Thus, Graham laid out thecurrent day concept ofGARP. GARP stands for“growth at a reasonableprice.” GARP is a usualstandardforgrowth investinginthefinancialcommunityby
OPMIs,suchasmutualfundsor individual investors.2 Incontrast we advocate theconcept of “growth at dirtcheap prices” or GADCP,which is what investorsfollowing a fundamentalfinanceapproachoughttotrytoaccomplishinmakingmostoftheirinvestments.GARP analysis tends to be
quite different from GADCPanalysisasweexplainbelow.
GROWTHATAREASONABLEPRICE(GARP)
GARP analysis focusesstrictly on forecasting futureflows,whethersuchflowsarerevenues, earnings, or cash.An attractive common stockpurchase is deemed to existwhere future forecastedgrowth rates are greater than
current ratios of price toflows.Thus,acommonstockis usually deemed attractiveunderaGARPanalysisifitisselling at 20 times earningsand the forecasted futuregrowth rate for earnings issomething more than20 percent compounded, say25 percent compounded.However, the same commonstockunderaGARPanalysiswould not be attractively
pricedat20timesearningsifthe future growth rate wereestimated to be somethingless than 20 percent perannum compounded. Asummary statistic commonlyusedinGARPanalysis is thePEGratio.3ThePEG ratio isthe ratio of theP/E ratio andthe expected future growthrate in earnings. A commonstock selling at a PEG ratiolower than one (expected
growth rate in earnings ishigher than the P/E ratio) isattractively priced under aGARPanalysis.Theconverseistrueifthecommonstockisselling at PEG ratiossubstantiallyhigherthanone.
EXAMPLEApple, Inc. common stockisoftencitedasonesellingat very attractive pricesunderaGARPanalysis.Atthe beginning of August
2012, Apple Computercommon was selling at aNTM PEG ratio of 0.55,which indicated that theexpectedshort-termgrowthrate in earnings for thecompanywasalmost twiceits market P/E ratio of 15times.
In GARP analysis, heavyweight is placed on the pastearnings record. Indeed, inmuchofGARP analysis it isassumed, in linear fashion,
that future growth rates willapproximate the growth ratesachievedoverthepastonetofive years. Rarely, if ever, isany weight at all given tobalance sheet considerationsin making forecasts, whetherthose balance sheetconsiderations involve thequality of resources in abusiness or the quantity ofresourcesexistinginafirm.GARP analysis tends to
revolve around a very short-run focus. If the immediaterevenue, earnings, or cashflow outlooks are poor,common stock investment isto be forgone regardless oflong-term prospects. Acorollary of this is that thetypical GARP securitiesbuyer is short-run orientedand tries to buy at, or near,bottomsforsecuritiesprices.Industry identification is
very important inGARP; thesecurities buyer wants to getinto industries that aregenerally recognized asgrowth industries in thefinancial community, saysocial media. Quite often,there is no independentanalysis of growth potential,butratheronlyanacceptanceof the generally recognizedconsensus. The underlyingproblem with going along
withthegenerallyrecognizedconsensus is that the investortends to buywhat is popularwhen it is most popular. Inotherwords, the investor hasto pay up. Historically,buyingwhat ispopularwhenit ismostpopularhasbeenaprescription for disaster forinvestors, whether it wasacquiring RCA Common in1929, real estate tax sheltersin1985, junkbonds in1988,
dotcom companies in 1999and social media companiesin2012.
GROWTHATDIRTCHEAP
PRICES(GADCP)
In GADCP, there is noemphasisonestimatingfuture
flows.Ratherit isrecognizedthatgrowthincommonstockprices can come, andfrequently does come, fromsources other than corporateoperations.Growthcancomefrom judicious acquisitions(Capital SouthwestCommon); creatingunrealized, and unrecorded,appreciation in asset values(Forest City EnterpriseCommon,HopewellHoldings
Ordinary); creating hiddenassetsintheformofincreasesin adjusted book value(Carlyle Group); havingcompanies taken over byothers at premium prices(Brookfield AssetManagement); and possiblyparticipating in corporaterestructurings (NaborsIndustries).In forecasting future flows
ofrevenues,earnings,orcash
flows, no exclusivity inmaking these forecasts isgiven to the past earningsrecord under a GADCPanalysis. It is recognizedunder GADCP that thequality of resources in abusiness and the quantity ofresources in a business tendto be equally important, andforsomecompaniesaremoreimportantthanthepastrecordin making reasonably
accurate forecasts of futureflows. This is simply givingrecognitiontoROEandROAas part of the forecastingprocess with Equity andAssets being balance sheetitems.
EXAMPLESociety Corporation’sposition in the early 1960sis one example of this.Society Corporation was abank holding company
based in Cleveland, Ohio.At that time, banks’ ROEwasbetween8percentand12percent.Society,with anet worth of about $50 ashare, was earning about$1.50 a share fromoperations when itconverted from a mutualsavings bank to acommercial bank holdingcompany in 1962. Thisequaled an ROE of only 3percent. A marketparticipant could reasonwith a fair degree of
confidence that over timeSociety probablywould beearning a return on itsequity close to that whichwas being achieved in thecommercial bankingindustry in general. Atleast, there did not appearto be any insurmountableproblems preventing this.Furthermore, book value,too, would be steadilyincreasing. The anticipatedresults occurred; reportedearnings increased year byyear,andby1966operating
earningswere$5pershare(or a 35 percent annualcompounded rate ofgrowth)onayear-endbookvalue of $62. Theprediction of SocietyCorporation’s futureearnings growth could nothavebeenbasedonthepastearnings record. Anexamination of the assetvalues and the belief thatsuchassetvalueswouldbeused much the way othercommercial bank holdingcompaniesusedtheirswere
the basis for the earningsgrowth forecast. Thisapproachisprobablybetterdescribed as a resourceconversion approach toanalysis rather thanastrictgoing concern one. Why?Thekey iteminevaluatingSociety Corporation wastheprobabilitythatitwouldconvert its assets to moreproductive uses, not that itwouldcontinueusing themin the same way as in thepast.
InGADCP,though,thereisstrong recognition given tothe fact that most forecasts,nomatterwhattechniquesareusedtomakethem,aregoingto prove to have beeninaccurate. It is just toodifficult to properly put intoforecasts factors such ascompetitive forces,technological innovations,inexperienced managements,business cycles, access to
capital markets and acts ofGod.Knowingoftheinherentunreliability of its forecasts,werestrictourcommonstockinvestments to issues thatenjoy very high-qualityresources where we canacquire its interests at pricesthat represent a meaningfuldiscount from the estimatedquantity of resources thatexistinabusiness.GADCPis inherently long-
term conscious. Indeed,securities markets tend to beefficient enough that aGADCP investor is unlikelyto find issues at attractiveprices unless the near-termoutlookispoortoclouded.Industry outlooks are as
importantforGADCPastheyare for GARP. However,under GADCP, industryoutlooks are based onindependent analysis rather
than conformity with ageneral consensus. Weconcluded a few years backthat semiconductorequipment companies wouldhavetoparticipatefullyinthegrowth of the Internet andtelecommunication industriessimply because the Internetand telecommunicationscould not come close torealizing their potentialsunless there also occurred a
dramatic increase in demandfor increasingly sophisticatedsemiconductor chips. At thattime, there was norecognition of this thesiswithin any Wall Streetgeneral consensus. Wetherefore could acquire thecommon stocks of well-financed semiconductorequipmentcompaniessuchasAppliedMaterials or Intel atprices that were probably
lower than a first-stageventure capitalist would paywerethesecorporationsbeingfinancedasstart-ups.Many of these growth
stocks do not have generalrecognition, and so they sellat very modest prices.Examples in mid-2012included Applied Materials,Intel, Brookfield AssetManagement, Cheung KongHoldings,HangLungGroup,
andWheelock&Co.A large variety of factors
enter into forecasts of futuregrowth in NAV. Each set offactors is particular to thecompanybeinganalyzed.Forexample, a principal elementfor forecasting growth forvarious Hong Kongcompanies in 2012 is thebelief that mainland China,where each company hasmassive presences, is more
likely to grow in the nextthreetofiveyearsthanalmostany other industrialized partoftheworld,whetherEuropeor North America. TheseHong Kong companies areWheelock & Company,Henderson Land, CheungKong Holdings, and HangLungProperties.Theforecastof growth for BrookfieldAsset Management, on theother hand, is based largely
on an appraisal ofmanagement, whom webelieve is super-skilled. Asimilar appraisal ofmanagement is key to ourbelief in the NAV growthpotential for CapitalSouthwestCorporation.
SUMMARYThe view of businesses aspure going concerns has led
to appraising managementsonly as operators. Once onerecognizes that businessesgeneratewealth both throughgoing concern and resourceconversion activities, itbecomes apparent thatmanagements should beappraised not only asoperatorsbutalsoasinvestorsand financiers. It is ourexperience that investmentsuccess ismore often related
to being associated withmanagements who areopportunistic and takeadvantageoftheresourcesofthebusinessthanbyanyotherfinancialfactor.The current paradigm of
growth investing isGARPorgrowth at reasonable prices.We identify limitations ofGARP, which stem from itsunderlying assumptionsincluding: the view that
businesses are pure goingconcerns, heavy weight isgiven to the past earningsrecord when forecastingfuture earnings growth,industry identification isimportant to GARP,acceptance of the generallyacceptedconsensusofgrowthpotentialsratherthanrelianceon independent appraisals ofgrowthpotentials,a tendencytowards buying what is
popular when it is mostpopular. In contrast, weadvocate using GADCPinvesting, or growth at dirtcheap prices investing. InGADCPwe give no primacyto flows in forecasting futuregrowthbutratherconsiderthequantity and quality ofresources in a business aswell as managements’appraisals as investors andfinanciers, and potential
resource conversionopportunities while beingextremely price conscious.Alarge variety of factors enterinto the determination ofgrowth potentials and weprovide examples thathighlightsuchfactors._______________*Thischaptercontainsoriginalmaterial,andpartsofthechapterarebasedonideascontainedinthe2004
4Qlettertoshareholders.ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1BenjaminGraham,TheIntelligentInvestor(NewYork:Harper&Row,Publishers,Inc.,1973).2TheGARPconceptappearstohavebeenpopularizedbyPeterLynchinhis1989OneUponWallStreet(NewYork:Fireside,
1989).3ThisratiowasdevelopedbyMarioFarinainhis1969bookABeginner’sGuidetoSuccessfulInvestingintheStockMarket(PalisadesPark,NJ:Investors’Press).
CHAPTER12
TheSignificance(or
LackofSignificance)of
Market
Performance*
MarketPerformanceandtheCharacterofaPortfolioMarketPerformanceofPortfoliosversus
IndividualSecuritiesOutsiders,Insiders,andMarketPriceProfessionalMoneyManagersandBeatingtheMarketPerspectiveon
BailoutsandtheSignificanceofMarketPerformanceSummary
There is a common beliefamong many stockholdersand lawyersandmuchof thejudiciary that stock market
prices are the one realisticmeasureofvalue,andthattheonly way to tell how aninvestorisdoingisbyvaluinghis securities portfolio fromtime to time, even daily,basedonstockmarketprices.As discussed in Chapter 3,this is the substantiveconsolidation view of theworld.Commonsensetellsusthat this approach heavilydistorts the facts of life
because market prices areconsiderablylessimportanttosome security holders andsomecompaniesthantheyaretoothers.For stock traders, there are
realistic reasons for makingstock market prices the onlyconsideration. At the otherextreme, for investorsinterested only in secureincome, weight to marketshouldbezerooronoccasion
even negative, because eventhough an investor has anownershippositioninacreditor a common stock, it isconceivable that he wouldobtain more benefits fromshort-term declining pricesthan from steady or risingmarket prices. In gauginginvestmentresultsforthevastmajority of people andinstitutions, marketperformance at any moment
should be given a weight ofconsiderably more than zeroandsomethingquiteabitlessthan100percent.Thepreciseweight, assuming that anyprecision isdesirableorevennecessary, should bedetermined by the individualinvestor.The concept of weight to
different elements of valuemay have originated inDelaware appraisal
proceedings, wherestockholdersdissentedfromamergerorsimilarproceeding.In the now outmodedDelaware block valuationmethodology, three elementsof value—market value,earningsor investmentvalue,and asset value—weredetermined, and separateweights were assigned toeach of the three elements,with weight for all three
elementstotaling100percent.Through thedeterminationofthe three elements, eachseparately weighted, anultimate value wasdetermined. In theWeinberger decision1 thecourt rejected this practice,holding that a propervaluation approach “mustincludeproofofvaluebyanytechniques ormethodswhichare generally considered
acceptable in the financialcommunity and otherwiseadmissible in court.” Themore liberal approachmandated by theWeinbergercourtledtheDelawarecourtsto consider a much broaderarray of factors indetermining the fair value ofatargetcorporation’sstock.Market performance as a
gauge of how an investor isdoing deserves 100 percent
weight when the particularinvestor does not knowanything about the companyinwhichheisinvestingotherthan the most superficialstock market statistics, suchasmarketpricehistory,recentearnings,dividendrate,stock-ticker symbol, allegedsponsors and the latestpopular “story.” It alsodeserves 100 percent weightwhen the investor’s financial
and/or personal position issuch that he is vitallyaffected, or he believes he isvitallyaffected,byshort-termmarket fluctuations. Onehundred percent weight tomarket also seemsappropriate for sudden deathsecurities; that is, issueswhere at a certain date, keyeventswilloccuraswhenanoption expires, a tender offerconcludes, or a merger
transaction is consummated.Suchpeopleorsituations,callfor instant performance.Itemsthatareperceivedtobecriticalareinsideinformationabout corporate events thattheybelievewillhavemarketimpact;technicalsystemsthatthey believe will assist inforecasting general markettrends and individual stockpricemovements;andtradinginformationthatcaneitherbe
reacted to or used. Perhapsthe most traumatic andsignificant event for thisgroup is to see stocks godown, or even in someinstances toseestocksfail togo up. Thus, there is a goodrationale for their credos,Don’tletyourlossesrun,andget out of stocks that are notmoving.2
To us, it seems foolish toaccept the short-term needs
cited in the previousparagraph as the norm forpurposes of promulgatingvarious securities regulationsand accounting rules, yetsome of these rules andregulations seem directedstrictlytowardthedesiresandneedsofthosewhothinkday-to-day market prices are all-important.Many market participants,
ofcourse,donotweightstock
market price as being of 100percent importance or evenanythingclosetoit.Examplesof investmentgroups thatareeither indifferent to marketprice fluctuations or hopefulthat they will go down onoccasion include individualstockholders who wouldbenefit from low marketvaluations for, say, estate taxor personal-property taxpurposes; investors who are
primarily interested inmaximizingtheircashreturnsand/or continually creatingcashfornewinvestmentfromnoninvestment sources; andthose desiring to accumulatelarge positions, either toexercise control or toinfluence controlshareholders.Itisourviewthatveryfew
outside investors ought toendow short-run market
performance with an all-consuming importance. First,formany,performancehastotake a back seat to otherconsiderations in terms ofrealizing such objectives asthe creation of a reasonablywell-assured regular cashincome from interest anddividend payments. Second,for those following thefundamental financeapproach, rarely if ever is
emphasis given to short-runconsiderations. Frequently,timing as towhen somethingwill happen is indeterminatewhen securities appearattractiveunderourapproach:Its four basic elements giveno clues whatsoever to whatnear-term marketperformance might be like.3Finally, the studies that arepartofmoderncapital theoryindicate that those who
attempt to beat the marketcontinuously do not usuallydo so when beating themarketisdefinedashavingatotal returnonamarket risk-adjusted basis in excess ofstockmarketaverages.We agree with themodern
capital theorists that it is alosing exercise for almost alloutsideinvestorstotrytobeatthe market by forecastingprice movements over any
particular length of time, saywithinthenextyear.Tous,itis true inaperverseway thatonecannotbeatthemarketbytrying to beat the market.Rather, superior long-termperformance comes about byindirection—for example, bybuying good values asdetermined under thefundamental financeapproach, and sticking withthoseholdingsintheabsence
of clear-cut evidence that asignificant mistake has beenmade. Evidence of suchmistakeswillbe found in theresults achieved by thebusiness rather than in theprice of the business’ssecurities, which at anymoment may or may notreflectbusinessreality.
MARKET
PERFORMANCEANDTHE
CHARACTEROFA
PORTFOLIOThe importance of marketperformance depends in parton the character of aportfolio, and other thingsbeing equal, market
performance will be moreimportantwhenaportfolio isof a fixed size or subject tonet withdrawals of cash, ascompared with a portfoliothat is thecontinual recipientof new cash to invest. Thislatterportfolioisinthenatureof a dollar averager, andprovided that it consists ofsound securities, marketperformance need not be anoverriding consideration.
Here, poor past performancemeans, at least in great part,that present purchases arebeing made on moreattractive terms than in thepast, whereas good pastperformances may spell lessattractivecurrentpurchasesifthe underlying value of thesecurity has not increased asmuch as the price of thesecurityduringtheinterim.Itshouldbenoted,too,that
dollar averaging diminishesthe need to beat inflation,because changes in the valueof money probably will, inthe long run, be offset bychanges in the returns onsecurities. This wasparticularly true during thefifteen years preceding 1978,when inflation wasaccompanied by risinginterestrates.Cashthatcouldhave been invested in
commercialpaper to return4percent in 1964 could beinvested the same way toreturn over 10 percent in1974andagainin1978.Cashreturns available to suchinvestors increasedconsiderably more than didthecostofliving.Amongthebeneficiaries from suchinflation-cum-interest-ratedevelopments werepermanent investors in high-
grade debt securities,provided new funds werebeing made availableregularly for investment andreinvestment. Such investorsincludedmany young peoplewith rising salaries andsavings, as well as varioustypesof insurancecompaniesand pension plans. Theopposite seems true in 2012.Because interest rates are athistoriclows,newfundshave
tobeinvestedfortotalreturn,notcashreturn.The typical well-run
property and casualtyinsurancecompanyis,inpart,an example of a dollar-averaging investor. Itsperformance is measuredessentially by its netinvestment income—incomefrom dividends and interestafter all investment expensesexcept taxes. The insurance
company’s investmentdepartmentsnormallyreceivecontinuous new injections ofcash from the underwritingdepartments, growing out ofincreases inpremiumvolumeand, it is hoped, fromunderwritingprofits.Forsuchcompanies,aslongasinterestisnotdefaultedanddividendrates on securities held inportfolios are not reduced oreliminated, the lower the
marketvalueoftheportfolio,thehigherthereturnsthatwillbe earned on the new fundsbeing invested. And thehigher the returns, the fasternet investment income willincrease. Property andcasualty investmentdepartments do have someinterest in upward marketperformance on individualsecurities,sincemanagementspreferthesecuritiestheyown
to rise in price and the newmoney tobe invested indebtor equities that are availableat attractive prices. But aslong as the business isadequately capitalized, suchconsiderations are distinctlysecondary to the primarypurposes of the portfolios—the protection of thepolicyholder. That tends torestrict investments togenerally recognized high-
quality securities that aremarketable, and to thecreation of net investmentincome.As a matter of fact, it was
thecontinuingdeclinesinthemarket value of portfolios ofbonds and mortgages thatmade up the bulk of lifeinsurance portfolios (sinceinterest rates were on agenerally rising trend) thatcontributed importantly
towardmaking life insurancestocks, ingeneral, oneof theoutstanding growthinvestments in the 20 yearsafterWorldWar II. Had themarket value of theirportfoliosnotbeendeclining,the increases in investmentincome would have beenmuch slower than wasactuallythecase.It is true that some
insurance companies tend to
be harmed in bear marketsbecause their capitaladequacy is measured byregulatory authorities on abasis that values commonstocks at market. This isnormally not a problem forinsurance companies sincethe vast majority of theirinvestmentsareinperformingloans. Huge increases in netinvestmentincomearisingoutof new money being
employedforhighcashreturncannot, in these cases,compensate for capitalinadequacy. Nonetheless, thenormal economic desires ofsuchinvestorsarethatweightto market will beconsiderably less than100 percent almost all thetime.
MARKET
PERFORMANCEOF
PORTFOLIOSVERSUS
INDIVIDUALSECURITIES
Market performance is amuch more important gaugeof investment results for a
wholeportfolioofmarketablesecurities than it is for anindividual security. Forexample, consider aninvestment program inunsponsored, specialsituationswhere theportfoliocompanies have high creditworthiness and wheresecuritiesaresellingatpricessubstantially (say, 50 percentor more) below what thecompanieswouldbeworthas
private corporations. At anyonetimetheremightbethreeto five such securities in aportfolio. The precise timingas to when any one of thesesecurities might enjoysubstantial price appreciationis indeterminate.However, ifover a period of, say, sixmonths to a year none ofthese securities appreciateseven in a generally decliningmarket, it is fair to conclude
that investment results arepoor. But the poor resultswouldbeattributablemoretopoor analysis (that is, thesecurities were not reallyattractivelypriced in the firstplace) than to other factorsthatexplainpoorperformancefor general market securitiesportfolios, such as weakgeneral market conditions oran uncertain economicoutlook.
The one timewhenmarketperformanceofportfoliosthatare attractive by fundamentalfinance standards seemsbound to be poor comparedwith the general market, nomatterhowgoodtheanalysisof the securities, is duringperiodsofragingbullmarketsin speculative-grade growthstocks,suchasoccurredfrom1961to1962,in1968,andinthe late 1990s. Even in this
situation, though, workoutportfoliosstillshouldshowatleast fair returns—say, notless than 10 percent—on themarket values of the fundsinvested.It is important to note that
one of the reasons outsidepassive minority investors(OPMIs) using our approachcannot give large weight tonear-term marketperformance is that the
factors that frequently willhave greatest near-termmarket impact are not whatthe investor believes altersthe fundamental outlook forthecompanyinwhichhehasinvested. These factors,which he may not deemparticularly important butwhich are likely to have astrong, immediate marketimpact,includethefollowing:
Cyclicalchangesinthe
economyChangesingeneralstockmarketlevelsChangesininterestratesQuarterlyearningsreportsDividendchanges
In considering the weightthat shouldbegiven to stockmarket prices, it is importantto remember that a stockmarket price is not businessor corporate value, but a
realizationvaluebasedontheprice at which a commonstock could be sold in anOPMI market. Therefore,market value as a realizationfigureisaveryrealisticfigurefor a shareholder who owns,say, 1,000 shares ofJPMorgan Chase & Co.common selling at 35.However, it does not followthat 35 represents a realisticvaluefortheentireJPMorgan
Chase common sharesoutstanding.There is nowayother than in a merger oracquisition that all theJPMorgan Chase shares canbesoldonthemarketfor35ashare or any other price.Thus, statements about anindividual’s present worth,obtained by multiplying hisholdings by the quotedmarket value of his stock,have limited operational
meaning in many contexts.Market mathematicians maymultiply numbers together,but frequently there is adifference between what thenumbers are and what theymean.
OUTSIDERS,INSIDERS,ANDMARKETPRICE
Indeed, for most investors,market performance as anelement in measuring trueinvestment results shouldhave a weight of less than100 percent. An outsiderholding a completelymarketable security of acompanywithaperpetuallifeshouldgiveweightofclosetozero to market performancewhenever he knows or hasreason to believe that the
security’s real worth is notclosely related to currentmarket prices, and when heknows that he will neitherneed to liquidate in the nearfuturenor touse the securityowned as collateral forborrowings.Thereisaschoolofthought
that seems to hold thatoutside investors with thatdegree of certainty aboutinvestments in companies
over which they have nocontrol are bound to beunsuccessful—that the realworld just never justifies somuch confidence in asecurity.Wedisagree.
EXAMPLEItappears thatmanyof themost successful outsideinvestments have resultedfrom having suchconfidence,whether itwasby buying and holding
General Motors commonthrough the 1933 decline,or by acquiring Japaneseinsurance stocks at thedepth of that country’sextremely sharp businessrecessionand stockmarketcrash of 1965, or even bybuying such Japanesesecuritiesin1970aftertheyhaddoubled,orXeroxandHoliday Inn when theywere emerging securities,or Chicago NorthwestRailway and BerkshireHathaway when they were
workout situations, ordeep-discount, high-yield,medium-grade bonds in1974, or Apple Computerwhen Steve Jobs resumedleadership of the companyin1997.
For insiders and quasi-insiders, as their securityholdings become lessmarketable because ofrestrictions on sale orotherwise, and as they attainpositions in which they can
exercise control over acorporation’s affairs, marketprice tends to become lessimportant than thefundamentalsofthebusiness.The purchasers of F. & M.Schaefer Corporation“restricted” common in 1968at $1 per share (see Chapter27)didhaveaninterestinthemarket price of Schaefercommon stock after thecompany went public, and
many obviously had to bepleased when the marketprice climbed to 59 in 1970.Yet what was happening tothe business was far moreimportant to them. For them,the key factor in 1970 wasnot the outstanding marketperformance of the commonstock, but evidence ofsluggish corporateperformance because ofcompetition from national
beerbrands.ThehighpriceofSchaefer stock would havebeen useful to these bargainpurchasers in anonpsychological sense onlyif they could realizesomething based on thoseprices by selling their stock,even at a discount frommarket(theydidnotandmostcould not), or if SchaeferCorporation used the highprice to issue more equity
securities, either to get cashinto the company or toacquireearningsproperties.
PROFESSIONALMONEY
MANAGERSANDBEATINGTHEMARKET
Certain economists believestrongly that the goal ofprofessionalmoneymanagersis to beat the market.4 Ifprofessionalmoneymanagersfail to beat themarket eitherindividuallyorenmasse, thisistakenasevidencethattheyareuseless.Indeed,itisstatedthat theoutside investordoesbest by investing only inIndex Funds or Indexexchange-traded funds
(ETFs)—that is, unmanagedcompanies whose portfoliosequal the Dow-JonesIndustrial Average orStandard and Poor’s 500StockIndex.The kindest word we have
forthispointofviewisthatitis amateurish. First, it oughtto be obvious that the vastmajority of professionalmoney managers havefiduciary obligations that
require them to do muchmore than beat the market.Among those duties aremaintenance of cash incomeand cash principal. Is itimportant that a stronglycapitalized insurancecompany outperform themarket even though its netinvestment income isincreasing at a compoundedrateof10percent ayear andeven though in no instance
had interest payments beenpassed or dividends cut oromittedonanysecurityinthecompany’s portfolio? Wethink not. The prime goal ofthe insurance company’sprofessional money manageris, of course, cash income,notmarketperformance.Many economists also go
one step further and say thatthereisnoneedforSecuritiesand Exchange Commission
disclosuresandotherinvestorprotections. This viewpointfails to observe the obvious.By and large, securitiesmarkets in the United Stateshave been healthier duringthepast80yearsthattheSEChas been in existence thanever before. Also, financialanalysis has become moreimportant. Furthermore, thequalityofsecuritieshasgoneup, at least as measured by
the ability of issuers toprovide securities holderswith cash returns, that is,payments of interest anddividends.Would this be thecase if there were noprofessionalmoneymanagersand no SEC? Who knows?Perhaps if the environmentwere what these economistsrecommend, the Dow JonesIndustrials in mid-2012wouldbecloserto5,000than
to 13,000. But if it were5,000, the average portfolioof marketable securitieswould have a marketperformanceaboutaverage—thesameasnow.Insummary,it is important
tonotethattheimportancetobe given to marketperformance or total returnvaries from situation tosituation. Sometimes totalreturn is all-important to an
outside investor; in otherinstances, it is hardly of anymoment. Unfortunately,many scholars and juriststend to give marketperformance thesameweightfor all investments that itdeserves in trading situations—100 percent. Thisunthinking emphasis isparticularly unfortunate,partly because it gives stockmarket prices an emphasis
thatalmostnooneoperatingabusiness agrees with, andpartly because it seems tofoster attempts to beat themarket on a relativelycontinuous basis—somethingmost outside investors willneverbeabletodo.
PERSPECTIVEONBAILOUTS
ANDTHESIGNIFICANCEOFMARKET
PERFORMANCEIn a meaningful sense,everyone who invests in asecurity seeks a return, orbailout, on that investment.Most of the time, bailoutrefers to the realization of
cash benefits, but this is notso in one case—whenownership of a securityresults in obtaining variousbenefits associated withcontrol of companies.Bailouts take many forms,only one of which is anability to sell, ormarketability.Insofarasotherforms of bailout areunavailable, marketabilityand therefore market
performance becomeincreasingly important. Andinsofar as alternativebailoutsareavailable,thesignificanceof market performancediminishes. These otherforms of bailout,which havealready been discussed inChapter 4, encompass cashpaymentstosecuritiesholdersbytheissueritself.Holdersofdebtinstruments
have a contractual right to
receive periodic interestincomeandeventualreturnofprincipal; therefore, cashbailouts tend to be far moreassured for them than forholders of common stocks.Accordingly, marketabilitytends to be significantly lessimportantforabondthanfora common stock. Indeed,most long-term debtinstruments, suchasmanyofthe tax-free obligations of
municipalities, privateplacements held by lifeinsurance companies, andmostmortgage loans held byvarious types of institutionalinvestors, are probably notmarketable at all. Thisdifference in the significanceofmarketabilitybetweendebtandequityisevenrecognizedin certain regulatory areas:insurance regulations requirethatdebtholdingsthatarenot
available for sale be carriedon the company’s books forstatutory purposes atamortized cost, whereascommon stocks are usuallycarriedatmarket.Insofar as common stock
ownership represents control,the importance of marketperformance andmarketability tends to bediminished significantly.Control usually allows for
two types of bailouts: first,cash bailouts through theability to control dividendpolicy and to obtain salariesand fees; and second,nonmonetarybailoutsthroughthe ability of controllers tocreate for themselves one ormore benefits that can bedescribedaspartof the threePs—power, prestige, andperquisites.In addition, there aremany
stockholders who buydividend-paying stocks andwhose primary objective isincome. As a matter of fact,many hold utility commonstocks on the theory thatpresent dividend rates aresafe and indeed are likely tobe increased periodically. Totheseholders,marketbailoutsare not important, and theyview their holdings in muchthesamewayasdoholdersof
debt instruments, with theessential difference that suchcommon stockholdersperceive themselves asholding a “bond” on which“interest”paymentsare tobeincreased periodically. Tosuch holders, marketperformance tends to be aminorconsideration.In contrast, there are
security holders for whommarketprice tends toassume
paramount importance,becausemarketiswheresuchholders are seeking theirbailouts. These types ofsecurityholders fall into fourgeneralcategories.Thefirstisthe common stockholderholding minority interests inwhich dividend income iseitherinsignificantornotpartof the holder’s investmentobjectives.Thesecondtypeisthe control stockholder and
company seeking to sellsecurities or to issue them inmerger and acquisitiontransactions. Third is theholder who does not have astrong financial position,especiallytheoutsideinvestoror trader who has borrowedor intends to borrow heavilyto finance his portfolio. Thefourth is the not very wellinformed trader who makesdecisions based on technical
market factors rather thanunderlying knowledge abouta company and the securitiesitissues.
SUMMARYThere is a common beliefamong many stockholders,lawyers, and much of thejudiciary that stock marketprices are the one realisticmeasureofvalue,andthatthe
only way to tell how aninvestorisdoingisbyvaluinghis securities portfolio fromtime to time, even daily,basedonstockmarketprices.Common sense tells us thatthis approachheavilydistortsthe facts of life becausemarket prices areconsiderablylessimportanttosome security holders andsomecompaniesthantheyareto others. Market
performance as a gauge ofhow an investor is doingdeserves 100 percent weightwhen: the particular investordoesnotknowanythingaboutthe company in which he isinvesting,whentheinvestor’sfinancial and/or personalposition is such that he isvitallyaffected,orhebelieveshe is vitally affected, byshort-term marketfluctuations,forsuddendeath
securities; that is, issueswhere at a certain date, keyeventswilloccuraswhenanoption expires, a tender offerconcludes, or a mergertransaction is consummated.In most other cases marketperformance deserves lessthan a 100 percent weight.Factors affecting how muchweight to attach to marketperformance include thecharacter of the portfolio of
securities,whether one looksat the performance of aportfolio or an individualsecurity, who the holder ofthesecurityisandwhattypesof bailouts the holder of thesecurityhasavailable._______________*ThischaptercontainsoriginalmaterialandpartsofthechapterarebasedonmaterialcontainedinChapter3ofTheAggressive
ConservativeInvestorbyMartinJ.WhitmanandMartinShubik(©2006byMartinJ.WhitmanandMartinShubik).ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1Weinbergervs.UOP,Inc.,457A.2d701(Del.1983).2Forexample,seeG.M.Loeb,TheBattleforInvestmentSurvival(New
York:Simon&Schuster,1965),p.57:“Lossesmustalwaysbe‘cut.’Theymustbecutquicklylongbeforetheybecomeofanyfinancialconsequence....Cuttinglossesistheoneandonlyruleofthemarketsthatcanbetaughtwiththeassurancethatitisalwaysthecorrectthingtodo.”3TheapproachiscoveredinChapter15.
4MyronScholes,“ProfessionalMeasurement—Past,PresentandFuture,”EvaluationandManagementofInvestmentPerformance(Charlottesville,VA:TheFinancialAnalystsResearchFoundation,1977).
CHAPTER13
HowMuchDiversification?
PortfolioDiversification
versusSecuritiesConcentrationCorporateDiversificationversusConcentrationSummary
Theconceptofdiversificationas a hedge against
unsystematic risk is a centraltenet of efficient portfoliotheory (EPT) and is part andparcel of the capital assetpricing model (CAPM) andthe more modern arbitragepricing theory (APT).Unsystematic risk is only afancy term to describe therisk of loss from trading orholding a security that arisesfromthemarketparticipant’s:
1. Ignorance about the
fundamentals of thebusiness2. Lack of control orelements of control overthebusinessof the issuerin whose securities themarket participantmakesfinancialcommitments3. Lack of understandingof the substantivecharacteristics of thesecurities in whichcommitmentsaremade
4.Lackofoutsidesuper-attractive access tofinancing (preferablynonrecourse)5. Lack of priceconsciousnessIf you are an outside
passive minority investor(OPMI) that belongs to theabove category of marketparticipant, you betterdiversify to the fullest extentpossible.Ifyoubelieveinthe
efficient market hypothesis(EMH) and believe thatuniversal equilibrium pricingexists, then you ought todiversify. The EMH isaddressedtothosewhostudysecurities market prices andhave no detailed knowledgeabout corporations, to non-controlOPMIs,andtopeoplewho utterly lack priceconsciousness because theyassumethattheOPMImarket
price is an equilibrium pricewithuniversalapplicability.Conversely, for market
participants following afundamental financeapproach, whether theinvestorshouldconcentrateordiversifywilldependon:
1.Howmuchknowledgeabout the fundamentalsof the business of theissuer and its securitiestheinvestorhas.
2. How much control orelements of control overthe business the investorhas.3. How much access tooutside finance(preferably nonrecourse)or access to capital onsuper-attractive terms theinvestorhas.4. How much bargainpricing the investor canobtain.
Like the concept ofinvesting, which is bestunderstood when contrastedwith the concept ofspeculation, the concept ofdiversification can also bebetter understood whencontrastedwiththeconceptofconcentration.
PORTFOLIO
DIVERSIFICATIONVERSUS
SECURITIESCONCENTRATIONIt is logical where measuresof risk are based on thequality of the issuer thatportfolios of such securitiesbe diversified, providingadded protection to
compensate for lack ofknowledge about individualsecurities. In contrast, theinvestor who, because ofknow-how or control, hasconfidence in an equityinvestment based on price ofthe issue, and who has afinancial position that willallowhimtosurvivetheshortterm,doesnotneed theextraprotection that comes fromdiversification. Such
protectioncomesfroma lackof encumbrances upon theinvestor. He stands to gainmost from concentrating hisinvestment in the areawherehis knowledge (and perhapscontrol) tips the risk-rewardratio for the particularsecurity very strongly in hisfavor.A simple framework that
illustrates this point and thatalso provides a means for
calculating the degree ofdiversification orconcentration needed toachievethemaximumgrowthrate of investment capitalover time was developed byJohn L. Kelly Jr. in 1956.1Although developed toaddress a different problem,what is known as the Kellyformula can be used todetermine thesizeofaseriesof investment commitments
relative to availableinvestment capital that willyield the maximum growthrateofcapitalovertime.The Kelly formula is
presentedbelow:
where:fisthefractionofcurrentcapitaltocommittoaparticularinvestmenttomaximizecompounded
returnsovertime.pistheprobabilityofmakingmoneyontheparticularinvestmentwithinanestablishedtimeperiod.brepresentstheoddsorwin/lossratiofortheinvestment.
Since f represents thefraction of available currentcapital that must be devoted
to a particular investmentcommitment, it is theequivalent of a portfolioweight. A large portfolioweight means a concentratedportfolio since the totalnumberofinvestmentstakingupallavailablecapitalwillbethe reciprocal of f. Forexample, an f of 0.25 wouldmeanthattheinvestorshouldcommit 25 percent of his orher investmentcapital to that
particular investment. Aninvestor following the Kellyrulewillhaveonly four suchinvestments in his or herportfolio(i.e.,1/for1/0.25).Let us now use the Kelly
formulatoillustratetheissuesthat we have discussedbefore. We start with anOPMI that believes in theEMH and universalequilibrium pricing, lacksknowledge of the
fundamentalsofthebusiness,lacks control, is priceunconscious, and is likely tohave very small odds ofmakingmoneyon any singlesecurity selection. Wecharacterize this particularOPMI as having odds of50.5/49.5 or 1.0202, and anevenchanceofeitherpickingawinningsecurityoralosingone; that is, p:1/2. Usingthese two numbers in the
Kellyformulayieldsf=0.01.Faced with these oddsresulting from no skills inbusinessanalysisandsecurityselection, this particularOPMI should only commit 1percent of his or herinvestment capital to anysinglesecurity.Iftheinvestorweretoinvestallofhisorhercapital in similar securities,his or her portfolio shouldcontain100securities;thatis,
awidelydiversifiedportfolio.Take an investor following
the fundamental financeapproach, with excellentknowledge about thefundamentals of thebusinesses he or she investsin, possessing the disciplineto only buy securities atprices representingmeaningful discounts fromreadilyascertainablenetassetvalues,but lackingcontrolor
access to super-attractivefinance. Being priceconscious and havingknowledgeaboutthebusinessimprovesthisinvestor’sodds.In this case, theoddson anysingle security purchase aremore likely to be 52/48 or1.08, and the probability ofselecting the winning issuersand securities accurately isp:0.52. Using the Kellyformula with these realistic
values yields f = 0.0769suggesting that the investorshould commit almost 8percent of its investmentcapital to any individualsecuritysoselected.Weretheinvestor to invest all his orher available capital, theportfolio would contain only13securities.Finally, we look at an
investor possessing controland access to attractive
finance (say, an LBOsponsor) for whom the oddsonhisorher investmentsaremore likely to be 60/40 or1.5, and for whom theprobability of picking thesewinninginvestmentsisp:0.70since sponsors are affordedthe possibility of conductingextensive due diligence onthecompanies they invest in.The Kelly formula for thecase of a leveraged buyout
(LBO)sponsoryieldsf=0.5,that is, the sponsor shouldcommit 50 percent of itsavailable capital to any suchidentified opportunity. WeretheLBOsponsortoinvestallof its currently availablecapital it would have twodealsinitscurrentportfolio.Wehavesimplyshownthat
investors wishing to growtheircapitalovertimeathighrates should choose their
diversification levelbasedonthe criteria that we haveoutlined. These examplesserve to remind the readerthat diversification is asurrogate,andusuallyadamnpoor surrogate, forknowledge, control and priceconsciousness.The Kelly formula is also
very useful in helping usunderstand the importance ofthe right amount of
concentration ordiversification on both theultimateperformanceand thelumpiness or volatility ofsuchperformance.Oneoftheargumentsusedtosupportthevalidityof theEMHis that itis impossible to beat marketaverages consistently, that is,most of the time. We havearguedelsewherethatthetruetest of superior performanceis total return over long time
periods and not whether amarket average is beatconsistently. In fact, we canusetheKellyformulatoshowthat the performance of amanager using the rightamount of concentration willbesuperioroverthelongtermbut very lumpy and volatileduringanyspecific,relativelyshort period of time chosen.Bythesametoken,amanagerthat may be restricted in the
amountofconcentrationused(saybecausethemanagerisaregistered investmentcompany (RIC) and mustabide by strict diversificationrules) could significantlyunderperformrelativetowhathis/her investment approachcould yield over long timeperiodsiftherightamountofconcentration is used. InFigure 13.1 we present theresults of an investment
operation having a win/lossratio of 1.5 where theprobability p of findingwinning investments is ½.Using these assumptions intheKelly formulayields an f= 0.1667, which would leadto a highly concentratedportfolio of only sixinvestments. Theperformance of thisinvestment operation shownas the growth of capital over
timeislabeled“concentrated”on Figure 13.1. We alsograph the performance of aportfolio that is built usingthe same approach toinvestmentselectionbutover-diversifies four times morethan the concentratedportfolio.Figure 13.1 tells the story.
Twofactsstandoutfromthisexercise: (1) theperformanceof the concentrated portfolio
is far superior than the onecorresponding to theoverdiversified one, and (2)the concentrated portfolioperformance is quite a bitmore volatile than theoverdiversified one over anyarbitrarytimewindow.
Figure13.1GrowthinCapitalandPerformanceLumpinessWhenFollowingtheOptimalConcentrationRuleversustheDiversifiedRule
An investment operationcanbereducedtotheproblemof forming a portfolio ofinvestments. The two issuesinformingaportfolioare:
1. What to include in it(security and businessanalysis).2. How much of theavailable capital shouldbe committed to eachparticular investment(concentration versus
diversification).Inthisbookweaddressthe
first issue. The Kellyframework highlights thesubstantive importanceof thesecond one. As is almostalwaysthecase,conventionalwisdom is rather misleadingonthetopicofdiversification.For those investors followinga fundamental financeapproach to investing, toomuch diversification can
mightily detract fromperformance. Concentrationandlumpinessinperformanceare to be expected fromfollowing the rightinvestment approach. Forthose OPMIs lackingknowledge, control, andbeingpriceunconscious, (i.e.the market participant thatEMH and MCT address)substantial amounts ofdiversification must be used.
Specifically,webelievethatacommon stock portfolioconsisting of investments incompanies enjoying strongfinancialpositions,pricedatarelatively large discountsfromreadilyascertainablenetassetvalue(NAV),wherethemarket participant hasavailable comprehensivedisclosures, should berelatively more concentratedandrelativelylessdiversified.
We feel comfortable insofaras at least 50 percent of acommon stock portfolioconsists of issues issued bycompanies where: thecompany enjoys a superstrong financial position; thecommonstockispricedat,atleast, a 20 percent discountfrom readily ascertainableNAV; disclosures arecomprehensive; the commonstock is traded in well
regulated markets, and theprospects appear good thatover the next three to sevenyears,NAVwillgrowbynotless than 10 percentcompounded annually afteraddingdividends.
CORPORATEDIVERSIFICATION
VERSUS
CONCENTRATIONCorporate diversification canbe viewed as a contributoryreasonforacquiringanequityas well as for not acquiringone.Certainmanagements incertain situations seem to doextremely well by having asingleness of purpose—thatis, by pouring all theirresources into one industry.McDonald’s is a good
example of a highlysuccessful, primarily single-purpose business. Othercompanies that haveconcentrated on one line ofendeavor seem to havesuffered mightily for havingdone so. Companies in thecement and steel industriesprovide examples ofbusinesses that might havefared much better had theydiversified. Correspondingly,
certain companies have beenhighly successful because ofaggressivediversificationintoother businesses andindustries. Examples includesuch diverse businesses asCheung Kong Holdings andBrookfield AssetManagement.Butattemptsatdiversification have beenanywherefromunsatisfactoryto disastrous for such othersas Boise Cascade, Beck
Industries, CommonwealthUnited,LittonIndustries,andTimeWarner.Thereisnoaprioriwayfor
concluding that corporatediversification isperse goodor bad. As we discussed intheprevioussectionusingtheKelly framework,diversification usuallyrequires a high order ofmanagerial ability, inoperations as well as in
investing. Many authoritiesapparently believe thatconcentration ondiversification was a primecause of the Penn Centralbankruptcy.ThefactsarethatthePennCentralmanagementhad some degree of successas investors on behalf of therailroad;theyapparentlywereabominable at operating arailroad. The contribution ofcashtotherailroadoperations
generated by Penn Central’sinvestmentskeptthebusinessalive longer than otherwisewould have been the case.The theory that the PennCentral management wouldhave been better railroadoperators had they notconcentrated so much oninvestments may have somevalidity.
SUMMARYHow much diversificationshould be used in theconstruction of investmentportfolios? Itdepends. Ifyoubelieve in the EMH and inuniversalequilibriumpricing,thenyoushoulddiversify.Forthe fundamental financeinvestor, however,diversificationisadamnpoorsurrogate for knowledge,
control, and priceconsciousness. Fundamentalfinance investors’ portfolioswill tend to be concentratedrather than diversified. Weuse the Kelly formula toillustrate why this should bethecase._______________1JohnL.Kelly,Jr.,“ANewInterpretationofInformationRate,”BellSystemTechnicalJournal
35(1956):917–926.
CHAPTER14
TowardaGeneralTheory
ofMarketEfficiency*
TheDeterminantsofMarketEfficiencyExternalForcesInfluencingMarketsExplainedGreatEconomistsCanLearnaLotfromValue
InvestorsMarketsWhereExternalDisciplinesSeemtoBeLackingMarketEfficiencyandFairPricesinTakeoversSummary
The worst misconceptionsabout dealing in corporatefinance are promulgated bytheacademicliteratureonthesubject. One suchmisconception is thedefinitionxofamarket.Mostacademicians seem to definea market as the New YorkStock Exchange, NASDAQ,or some other forumpopulated by outside passive
minority investors (OPMIs).For the purposes of ourdiscussion it is helpful toprovide a general definitionofamarket:A market is any financialor commercial arenawhere participants reachagreement as to price andother terms, which eachparticipantbelievesarethebestreasonablyachievableunderthecircumstances.
Myriad markets exist andincludethefollowing:
OPMImarketssuchastheNewYorkStockExchange,NASDAQ,andthevariouscommodityandoptionexchanges.Marketsforcontrolofcompanies.MarketsforconsensualreorganizationplansinChapter11.
Institutionalcreditormarkets.Marketsforexecutivecompensation.
For the past 50 years,financial academics havemostly operated on theassumption that financialmarkets are highly efficient.In a highly efficient market,the price of a common stockmultiplied by the amount ofsharesoutstandingreflectsthe
underlyingequityvalueofthecompany issuing thatcommon stock. This isembodied in the efficientmarket hypothesis (EMH).Recently, behaviorists havechallengedEMHbasedonthetheory that investorssometimes make emotional,irrational, and stupiddecisions. But evenbehaviorists seem to concedethatifinvestorswererational,
financial markets would behighlyefficient.Wedisagree.Certain markets will alwaysbe inefficient versus EMHstandardsofefficiency.A basic problem faced by
financial academics, whetherefficient market theorists orbehaviorists, is that they arestrictly top-down—studyingeconomies, markets, andprices, not the underlyingbottom-up fundamentals that
really determine what abusinessmight be worth andwhat are the substantivecharacteristics of thesecurities issued by thatbusiness.1 Put simply, theacademics are best describedas chartist-technicians withPhDs. Insofar as academicstrytobevalueinvestors,theyseem tobelieve to aman (orwoman) that value ismeasuredonlybypredictions
of future discounted cashflows (DCF). They don’tgraspthefactthatmostfirmsand market participants havean overriding interest inwealthcreation,notDCF,andDCF is only one of severalpathsusabletocreatewealth.In bottom-up analysis,
conclusions are drawn basedon detailed analyses ofindividual situations—securities, commodities,
companies—to ascertainwhether gross mispricingexists or persists. As ageneralrule,suchmispricingscan arise out of one ormorewealth-creation factors thataresometimesinterrelated:
Freecashflowsfromoperations.Earnings,definedascreatingwealthwhileconsumingcash.Formostfirms(and
governments),earningscanhavelong-termvalueonlyinsofarastheyarecombinedwithreasonableaccesstocapitalmarkets.Assetand/orliabilityredeploymentsviamergersandacquisitions(M&A),contestsforcontrol,assetredeployments,refinancings,capital
restructurings,spin-offs,and/orliquidations.Accesstocapitalmarketsonasuper-attractivebasissuchassellingcommonstockissuesintoasuperheatedinitialpublicoffering(IPO)market(e.g.,the2012FacebookIPO)orhavingaccesstolong-term,nonrecoursedebtfinancingatultralow
interestrates(e.g.,financing80percentofthecostofaClassAbuilding,fullyoccupiedunderlong-termleasesenteredintobycreditworthytenants).
Markets run an efficiencygamut. Some markets tendtoward instantaneousefficiency, therebycomporting with thestandardsthataretheessence
of the EMH. Other marketstend toward a long-termefficiency but may neveractually reach EMHefficiency.Asasubsetofthis,itshouldbenotedthatapriceefficiency in onemarket, saytheOPMImarket, is usually,perse,apriceinefficiencyinanother market, say thetakeover market. Somemarkets are inherentlyinefficient. Or to put it in
another context, an efficientmarket in these situationsmeans that certain marketparticipants are virtuallyassured of earning verysubstantial excess returns onarelativelycontinualbasis.
THEDETERMINANTSOFMARKET
EFFICIENCYFourcharacteristicsdeterminewhether a market will tendtoward EMH-likeinstantaneous efficiency ontheonehandoritwilltendtobe inherently inefficient byEMH standards on the otherhand, or something inbetween.
CharacteristicI:
MarketParticipantInsofar as the marketparticipant is unsophisticatedaboutvalueanalysis,financedwith borrowed money, andlacks inside information, thatparticipantwillfaceamarkettending strongly toinstantaneous, EMH-likeefficiency. Insofar as aninvestor is well trained, wellinformed, and not influenced
by day-to-day or short-runprice fluctuations, thatinvestor avoids being subjecttoanEMH-likeefficiency.
CharacteristicII:Complexity
How complex, or simple, isthesecurityorotherassetthatis the object of the marketparticipant’s interest? Insofarasthesecurityissimple(i.e.,
it can be analyzed byreference to a very fewcomputer-programmablevariables), the asset pricingwill reflectastrong tendencytoward instantaneous, EMH-like efficiency. A furthercondition for EMH-likeefficiency is that there be aprecise ending date, such aswhen indebtedness matures,options expire, or a mergertransaction is consummated.
EMH-like efficiencies cannotexist if one concentrates onanalyzing the common stockof a going concern with aperpetual life, or if oneanalyzesatroubleddebtissuethat will participate in areorganizationand the timingon the completion of suchreorganization is relativelyunknowable.Insofarasspecificsecurities
are concerned, three types of
issues tend to becharacterized byinstantaneous, EMH-likeefficiencies:
1. Credit instrumentswithout credit risk (e.g.,U.S.Treasuries).2. Exchange-tradedderivatives, includingoptions, warrants, andconvertibles.3.Riskarbitrage—thatis,situationswherethereare
relatively determinateworkouts in relativelydeterminate periods oftime, as, for example,tendtoexistaftermergertransactions areannouncedpublicly.Insofar as the analysis of
the security entailscomplexity, EMH-typeefficiencies tend to becomeunimportantfactors.
CharacteristicIII:TimeHorizons
If theparticipant isanOPMIinvolved in day-to-daytrading, that participant will,in all probability, be facedwith EMH-like efficiencies.If,however,theparticipantisamanagerofawell-financedcompany and has a five-yeartime horizon during whichtime the company might
choose to access capitalmarkets (credit markets orequity markets), thatparticipantwillbeinvolvedina market that is inherentlyinefficient by EMHstandards. The manager whocancontroltimingofwhentoaccesscapitalmarketsoverafive-year period knows thatthere will be times whencredit markets are veryattractive for the company
(i.e., interest rates areultralow), and there will betimes when it will be ultra-attractive to issuenewequityin public offerings and/ormergers(i.e.,anIPOboom).EMHefficienciesexistonly
for participants in outsidepassive non-control marketswho are heavily involved indaily, and even hourly, pricemovementsofsecurities.Thebasic EMH concept is that
market prices at any timereflect equilibrium. The oldequilibriumchangestoanewequilibrium only as amarketabsorbs new information.Thus, even securities that areanalyzable by reference to afew computer-programmablevariables are not pricedefficiently if those securitieslack very early terminationdates. No EMH efficienciescanexist for investorswitha
long-termtimehorizon.Again, in an efficient
market, market pricesdetermine the value of thecompany for all purposes. Itis as William F. Sharpe, aNobel laureate and a typicalefficient market believer,stated in his bookInvestments: that if you canassume an efficient market,“every security price equalsits investment value at all
times.”2
Where there are noreasonably determinateterminationdates,marketsforsecurities can be grosslyinefficient even though theanalysis is simple and fewvariables are involved. Agoodexampleofthisrevolvesaround the common stockssellingathugediscountsfromnet asset value (NAV) ofcompanies that are extremely
well capitalized, highlyprofitable, and with glowinglong-term records ofincreasing earnings,increasing dividends, andincreasing NAVs. Theprincipal assets of thesesimple-to-analyze companiesconsist of private equityinvestments, marketablesecurities, and/or Class Aincome-producingrealestate.ThemarketdatainTable14.1
areasofJuly6,2012.Table14.1Simple-to-Analyze,ExtremelyWell-Capitalized,andHighlyProfitableCompaniesSellingatDiscountsfromNAV
The same analysis waspertinent for certaindistressed securities onSeptember 30, 2008, albeitthat analysis was not as
simple as that which existsfor the high-quality commonstocks cited in Table 14.1.The authors’ analysesindicated strongly that theprobabilities were thatGeneral Motors AcceptanceCorporation (GMAC) seniorunsecured loans were likelytoremainperformingloans.Ifnot, upon reorganization orrehabilitation, the holder oftheseobligationslikelywould
receivethecommonstockof,by then, a well-capitalizedfinance company or bankholdingcompany.GMAC notes due in 15
monthswere selling at 60, ata current yield of 13 percentandayield tomaturityof55percent.InthecaseofGMACnotes, it is important tomention that market price isunimportantforaholderwhohas not borrowed money to
carry the securities. To earnexcess returns here, all theanalyst has to do is be rightthat the great weight ofprobabilities is that the noteswould remain performingloans.
CharacteristicIV:ExternalForces
How powerful are theexternal forces seeking to
impose disciplines on themarket participants and onthe companies that aresecurities’ issuers? Insofar asthe external forces are verypowerful, prices will tendtoward EMH-likeinstantaneous efficiencies.Competition among marketparticipants,suchasexistsonthe floor of the New YorkStock Exchange or onNASDAQ, represents
powerful external forcesimposing restraints onOPMIday traders so that theirreturns will likely reflectEMH-like efficiencies.Insofar as the external forcesare weak, markets will beinherently inefficient. Boardsof directors are an externalforce imposing discipline onthe compensation of topmanagement executives.Boards tend to beweak, and
thus corporate executivestend to earn excess returnsconsistently. Indeed, whenexternal forces are weak,certain market participants(not only corporateexecutives) will earn excessreturns consistently. This ispart and parcel of thedefinition of a market whereeach participant strives toachieve the best returnsreasonably achievable under
thecircumstances.
EXTERNALFORCES
INFLUENCINGMARKETSEXPLAINED
Markets and marketparticipants are very much
influenced by external forcesthat impose disciplines onstockholders, companies, andmanagement. The principalonesare:
CompetitivemarketsRegulatoryagenciesGovernmentsFinancialIndustryRegulatoryAuthority(FINRA),aself-regulatoryorganizationTaxsystem
CreditorsControlstockholdersBoardsofdirectorsRatingagenciesCommunitiesLaborunionsPlaintiffs’barFederalandstatecourtsPassivestockholdersAuditorsCorporateattorneys
When external forcesimpose very strict disciplines
(e.g., government regulators,senior creditors, credit-ratingagencies, and the plaintiffs’bar), such strict regulationorcontrol tends to stifleinnovation and productivity.It is important to note thatgovernment does not have amonopoly on actions thatstifle innovation andproductivity. The samedisease exists in the privatesector, where, say, financial
institutions follow overlystrictlendingpractices.When external forces
impose little or no discipline(e.g., boards of directorsrubber-stamping topmanagement compensationand entrenchment packagesor passive shareholders’proxy votes), there tends tobe created an environmentthat will be characterized bycorporateinefficiency,frauds,
and a gross misallocation ofresources.Whocandeny that there is
a need for balance in theimposition of disciplines?They should be neither toostrict nor too soft. There is aschoolof thoughtstating thatgovernmentregulationisipsofacto nonproductive and thatprivate sector regulation isipso facto productive (exceptfor the plaintiffs’ bar).
Nothing could be furtherfromrealitythansuchbeliefs.
GREATECONOMISTSCANLEARNALOTFROMVALUE
INVESTORS
After reading three volumesauthoredbygreat economists—The General Theory ofEmployment, Interest andMoney (originally publishedin1936,reprintedin2011byCreateSpace) by JohnMaynard Keynes, The Roadto Serfdom (originallypublished in 1944, reprintedin 2007 by University ofChicago Press) by F. A.Hayek, and Capitalism and
Freedom (originallypublished in 1962, reprintedin 2002 by University ofChicago Press) by MiltonFriedman—one comes awaywiththeimpressionthateachwas observing the earthwithhis naked eyes from 80,000feetup.Theymisseda lotofdetailsthatarepartandparcelof every value investor’sdailylife.To begin with, the three
seem to recognize only threemajor forces directing theeconomy: capital (privateowners, managers, orentrepreneurs), labor, andgovernment.Infact,therearemyriad othernongovernmental forcesdirecting any industrialeconomy, including, amongothers, management controlpersons (separate and apartfrom private owners);
creditors; rating agencies;boards of directors;professionals, especiallyattorneys and accountants;trade associations; and self-regulatoryorganizations suchasFINRA.For the three great
economists, governmentsperform four functions:controltheeconomy;regulatesectors of the economy; setfiscal policies (budget
surplusesordeficits);andsetmonetary policies (interestrates and the quantity ofmoney). In the twenty-firstcentury, it seems a lot moreproductive in determininghow the nation’s resourcesare to be allocated by theprivate sector to look atgovernments as engaged alsointhefollowingactivities:
1.Bearegulator.2.Levyandcollecttaxes,
with both tax rates andthe specific methods oftaxationbeingimportant.3.Providecredit.4. Provide creditenhancements.5.Provideinsurance.6.Providesubsidies.7. Provide infrastructureframeworks,physicalandprocedural, includinghaving reliable judicial
systems.8.Beacustomer.9.Beacompetitor.10. Provide publicprotection via themilitary,policeandother.F. A. Hayek wrote The
Road to Serfdom in the1940s.Thebookwasrelevantforitstime.Thegravamenofits arguments was thatcommand economieswithout
a private sector, such as theSovietUnionthen(andNorthKorea and Cuba today), justdonotwork.Theydenytheirpopulaces not only economicwell-being but also freedom.Of course, Professor Hayekwas 100 percent right aboutthis. However, in no waydoes it follow, as manyHayek disciples seem tobelieve, that government is,perse, bad and unproductive
while the private sector is,per se, good and productive.In well-run industrialeconomies, there is amarriage betweengovernment and the privatesector, each benefiting fromthe other. Since World WarII, there have been asignificant number of largecommand economies thathaveworkedwellbyutilizinganincentivizedprivatesector.
Such economies includeJapan after World War II,Singapore and the otherAsian Tigers, Sweden, andChinatoday.For the value investor, the
issue is not governmentversus the private sector.Rather, it is that, inaccordance with AdamSmith’s invisible hand, thosein control, whoever they are,should be incentivized
appropriately. Governmenthas a necessary role indetermining how controlpersons are incentivized; andwhere the private sector willallocate resources inaccordancewith the invisiblehand so that private controlpersonscanmaximizewealthfor themselves, and also, byindirection, their constituentswhoareusuallytheownersofprivate enterprises. Whether
one likes it or not, how andwhere Adam Smith’sinvisible hand allocatesresources through actions byprivate enterprises will bedetermined in large part bywhatgovernmentactionsare.Should these governmentreactions be random, or atleast in small part a productof planning? In the UnitedStatestodayitseemsasifthefederal government directs
resourcesmostly bywhohaspolitical clout. There is noquestion but that privateenterprise, in its actions, isparticularly sensitive to whatthe federal government doesintermsof:
Taxpolicy,bothquantitativelyandqualitativelyCreditgrantingandcreditenhancing
Controlpersons in theU.S.
private sector are extremelysensitive to, and react veryefficiently to, governmentpolicies in terms of taxationand in terms of creditgranting and creditenhancing. Put in MiltonFriedman’s context, AdamSmith’s invisible hand turnsout to bemore than random.Itwillbedirected,at least ingreat part, by thegovernment’s tax policies,
and the government’s credit-granting policies. Putotherwise, what governmentpolicies contribute isimportant to the privatesector’s determination ofwheretheprofitsare.Professor Hayek, however,
seems to miss the oppositepoint that a free marketsituation is probably alsodoomed to failure if thereexistcontrolpersonswhoare
not subject to externaldisciplines imposed byvariousforcesoverandabovecompetition: governmental,quasi-governmental andprivate sector. This isprobably truer for financialmarkets than it is forcommercial markets, but thepoint seems valid for bothmarkets.Putsimply:Competition by itself tendsnot to be a strong enough
externaldiscipline tomakemarketsefficient.Where control persons are
not subject to meaningfulexternal disciplines, thefollowingseemstooccur:
Exorbitantlevelsofexecutivecompensation,ashortcomingrampantintheUnitedStatestodayPoorlyfinancedbusinesseswithstrongprospectsformoney
defaultsoncreditinstruments,e.g.,lookattheinsolvenciesinrecentyearsofEnron,GeneralMotors,Chrysler,LehmanBrothers,andothersSpeculativebubbles,forexample,the1998–2000IPOboom,the2008–2009burstoftherealestatebubbleTendencyforindustry
competitiontoevolveintomonopoliesandoligopolieswherethecompaniesinvolvedhavealargedegreeofinsulationfromcompetitiveforcesCorruption:forexample,Enron,WorldCom,Refco
It ought to be noted, too,thatmanyhighlycompetitiveindustries happen not to be
subject to meaningful pricecompetition. Two suchindustries are moneymanagement and investmentbanking. In the investment-bankingarena,thereseemstobeauniversal7percentgrossspread involved in bringingmostnewissuespublic.Also,a principal disadvantage ofinvesting in distressedsecuritiesrevolvesaroundtherip-offofprepetitioncreditors
by professionals, mostlylawyers and investmentbankers. Competition toobtain professionalengagements is intense. Butno professionals in thedistressed world, with veryminor exceptions, ever seemtocompeteonprice.Disciplines are imposed on
control persons operating infreemarkets bymany,manymore entities than just
governmentsandcompetitors.The great economists mostlyfailtorecognizetheexistenceof these other forcesimposing discipline. Sometend to be harshdisciplinarians—creditorsandrating agencies; and someseem to be very weakdisciplinarians—passiveowners of common stocksandboardsofdirectors.Theseother forces imposing
disciplinesoncontrolpersonsincludethefollowing:
OwnersBoardsofdirectorsCreditors—especiallybanksRatingagenciesLaborunionsTradeassociationsCommunitiesAuditorsAttorneys
Compared with value
investors, great economistsfrom Keynes to Modiglianiand Miller seem largelyoblivious to the veryimportant rolecreditworthiness plays in anyindustrialeconomy.The monetary and
regulatory authoritiesinfluenced by the greateconomists seemed focusedonly, before the 2008–2009meltdown,ongrossdomestic
product and the control ofinflation-deflation. They didnotappeartoworry,much,ifat all about creditworthiness.Creditworthinessshouldhavebeen the third leg of theiranalytical stool along withGDP and the control ofinflation. Post 2009, this nolonger seems true.Creditworthiness is now arealworry.As far aswe cantell in mid-2012,
corporations, in general(perhaps excludingdepository institutions),probably have never beenmore strongly financed. Onthe other hand, governments—federal, state, and local—andconsumersprobablyhavenever been less creditworthythan they are now. Theongoing crisis in theEurozone in 2012 seems toreflect an absence of any
useful ideas by economistsand political figures to bringcreditworthiness to nationalsovereigns—Portugal, Italy,Ireland, Greece, and Spain.Theydonotseemtobeeventrying to createcreditworthiness in thevarious rescue plans they areformulating.Milton Friedman is gung-
ho for free markets,unfettered by government
intervention. As he states onpage 22 of Capitalism andFreedom,“To the liberal, theappropriate means are freediscussion and voluntarycooperation, which impliesthat any form of coercion isinappropriate.” ProfessorFriedman also states on page13,“Fundamentally,thereareonly two ways ofcoordinating the economicactivities of millions. One is
control direction involvingthe use of coercion—thetechniqueofthearmyandthemodern totalitarianstate.Theother is voluntary co-operation of individuals—thetechnique of the marketplace.”Professor Friedman,
unfortunately, seems to haveno background, orexperience, in corporatefinance. If he did, he would
understand that publiccorporations just would notwork unless, in therelationship between controlpersons and owners, certainactivities would encompassvoluntary exchanges whileother activities wouldencompass coercion. So it isalso on the national andgloballevels.Also, given a background
in corporate finance,
Professor Friedman wouldhaveunderstoodthattherearethree general ways forcoordinating the economicactivitiesofmillions,nottwo:
1. Central directionwithouttheexistenceofaprivatesector.2. Complete voluntarycooperation without theexistence of manycoercive externaldisciplinary forces,
whether governmental orprivate, influencing themarketplace.3. The real-worldsituation wheregovernments and otherexternal forces have aninfluence on, andfrequently direct theactivitiesthattranspireinthe marketplace. Indeed,the various marketplacesintheUnitedStatesseem
to be ultrasensitive tocertaindirectionstheygetfrom governmentsthrough tax policies,credit granting, andregulation.In public corporations,
therearecertainactivitiesthatare essentially voluntary andothers that are essentiallycoercive from the point ofview of noncontrol securitiesholders.
Voluntary activities, whereeachpersonmakeshisorherowndecisionwhethertobuy,sell,orhold,encompassopenmarket trading activities,certain cash tender offers,private purchase and saletransactions, and mostexchanges of securities,including the out-of-courtrestructuring of troubledcompanies.Coercive activities, where
each individual securityholder is forced to go alongwith a transaction or event,provided that a requisitemajority of other securityholders so vote, encompassproxy voting for boards ofdirectors; most merger andacquisition transactionsincluding reverse splits andshort form mergers; certaincash tender offers; calls ofconvertible bonds or
preferred stocks; thereorganization of troubledcompanies under Chapter 11of the Bankruptcy Act; andthe liquidation of troubledcompanies under eitherChapter 7 or Chapter 11 oftheBankruptcyAct.We are as one with
Professor Friedman that,other thingsbeingequal, it isfar preferable to conducteconomic activities through
voluntary exchange relyingon free markets rather thanthrough coercion. ButCorporateAmericawouldnotwork at all unless manyactivities continued to becoercive; security holdersmaygetarighttovote(whichvote may be pro forma andmeaningless),butthesecurityholders are coerced intogoingalongwhethertheylikeitornotoncearequisitevote
has taken place. Incidentally,appraisal rights under statelaw, can be prettymeaninglessintheschemeofthings in merger andacquisitions, and can hardlybe thought of as voluntary.Without some element ofcoercion, two undesirablethingsareboundtooccurinafreemarket:
1.Adverseselection,i.e.,individuals who believe
they are benefitedeconomically by atransaction go along,while those who believeotherwise opt out of thetransaction. If this werepermitted,therewouldbeno mergers and noChapter 11reorganizations,something highlydestructive to corporatewell-being and the well-
being of the generaleconomy.2. There would beunsolvable hold-outproblems. For example,voluntary bondexchanges to make acompany morecreditworthy wouldfrequently be doomed tofailurebecausethosewhohold out know thatbecauseoftheirhold-out,
theirbondpositionwouldbe credit enhanced ifmost of the otherbondholdersexchange.Assuming that the goal of
an economy ought to be tomaximize the average percapita income, and wealth,for its citizens (or residents),then adverse selection andhold-out problems have tomodify, in certain areas,reliance solely on voluntary
exchangesorthefreemarket.Specifically, there are areaswhere, because of adverseselection and hold-outproblems, the United Statesshould not rely wholly onmarket mechanisms. Theseareasincludethefollowing:
MedicalCare:Thereisonegoodmeasureofhowwellcaredforapopulationis;towit,theaverageageofdeath.
Here,theUnitedStatesperformsworsethanmostindustrialeconomies.Thisseemsashamebecausetheverybestmedicalcareintheworldexistsinthiscountryforthosewhocanaffordit.Thecountrywouldbemuchhealthierifallitsresidentshadaccesstodecentmedicalcarewithoutadverse
selectionopt-outs.SocialSecurityandPensionPlans:Clearly,theadverseselectionproblemwillloomlargeiftheseretirementmechanismsaremadewholly,oralmostwholly,voluntary.Education:Thiscountryseemstobefallingbehindmuchoftherestoftheindustrialworldin
elementarythroughhighschooleducation,eventhoughtheUnitedStatesprobablystillhasthebestuniversitysystemintheworld.Thereseemstobearealproblembetweenallowingallparentstopicktheschoolthattheirchildrenshouldattendandtheproblemofadverseselection.Toughchoice;wedon’thave
anyeasyanswers.Government regulation is
not, per se, good or bad.There is good regulation andthere is bad regulation. Anexampleofgoodregulationisthe InvestmentCompanyActof 1940 as amended. Anexample of bad regulation isthe Sarbanes-Oxley Act of2002.It ill behooves any
successfulmoneymanager in
the mutual fund industry tocondemn the very strictregulation embodied in theInvestment Company Act of1940. Without strictregulation,we doubt that theindustrywouldhavegrownasit has grown, and also be asprosperousas it is formoneymanagers. Because of theexistence of strict regulation,the outside investor knowsthat money managers can be
trusted.Withoutthattrust,theindustry likely would nothave grown the way it hasgrown. Outside investorsknow that the moneymanagerscannotsteal,cannotbe involved in self-dealing,are limited in causing thefund to borrow money, feescharged are controlled, andthe mutual fund mustdiversifyasapracticalmatter.All of this occurs for the
benefitofshareholders,whilestill permitting the moneymanager to prosper mightilyfrom the receipt ofmanagement fees. This is anexample of good, intelligentregulation. Messrs. Hayekand Friedman probably donotrecognizetheexistenceofsuchbeneficialregulation.On the other hand,
Sarbanes-Oxley, or SOX, isan example of stupid, non-
productive regulation. Itseems to be regulation basedon the belief that everycompany, every chiefexecutive officer, and everychief financial officer, isassociated with Enron,WorldCom, or Refco. Everycompany, therefore, shouldbe subject to onerousregulation although suchregulation does not seem todo anything, or much at all,
aboutinvestorprotection.Theupshot of SOX is that itdetracts mightily from theattractiveness of U.S. capitalmarkets. No CEO or CFOlikes being subject toliabilities that arise out ofSOX. Smaller publiccompanies cannot afford tocomply with SOX. Fewforeign companies are goingto subject themselves toAmerican jurisdiction unless
theyabsolutelyneedaccesstoAmerican capital marketstrading publicly ownedsecurities. It is likely thatMessrs.FriedmanandHayekbelieve most regulation isSOX-like. We do not. Someregulationisgood;somebad.It’sallcasebycase.Put otherwise, actions or
expenditures by governmentsare not necessarilyunproductive, and actions or
expenditures by the privatesector are not necessarilyproductive. Actions andexpenditures ought to begauged for usefulness on acasebycasebasis.
MARKETSWHERE
EXTERNAL
DISCIPLINESSEEMTOBELACKING
MerchantBankers(Promotersof
LeveragedBuyouts)Normally, people who puttheir own money into dealsare known as principals, and
those people who put dealstogether for fees but who donothave their ownmoney inthe deal are known asbrokers. Merchant bankersare often brokersmasquerading as principals.Theyusuallyinvestnone—orvery little—of their ownmoney in the deal, but theyboth collect their fees forputting deals together andobtain an equity interest in
deals without any—or anymaterial—money investment.Merchant banking hasbecome a main activity forsuchmajorWallStreetnamesas Kohlberg Kravis Roberts& Co.; Forstmann Little;Morgan Stanley; TheGoldman Sachs Group, L.P.;andCiticorpVentures.Until the 1980s, principal
broker-dealers, such asGoldman Sachs and Morgan
Stanley, believed that theirbest use of capital—bothhumanand financial—was toemploy capital in their ownbroker-dealer activities ratherthan to become involved inowning non–broker-dealerequities on a permanent orsemipermanent basis. Thisattitude no longer exists, andmuch capital is nowemployed in structuringLBOs so that the merchant
banker becomes a permanentor semipermanent investor ina corporation in which themerchant banker hasmeaningful elements ofcontrol.Merchant banking has
become increasinglycompetitive in recent years.This is to be expected, giventhe tendency towardefficiency that seems toexistin all markets. As far as can
bedetermined,however,mostof the better merchantbankers continue to earnexcess returns as dealpromoters, in part becausethere is so much outsidemoney, run by passivists,suchaspensionfundsthatareeager to participate inLBOs.Merchant bankers structurefeesforsuchinvestorssothatthey receivecompensationashedge-fundoperators.
A typical setup formerchantbankingactivitiesisa limited partnership, a formalso used for hedge fundsengaged in venture capitalinvesting, arbitrage, distress,and trading activities.Although terms may vary, ausual relationship is that thepromoter—the generalpartner (GP)—receives anannual management fee of 1to 2 percent of funds
committed plus a profitparticipationof20percentofgains, sometimes accrued orpaid only after the limitedpartners (LPs) receive apreferred return of 6 to 10percent. For most limitedpartnerships, the final termsare arrived at afternegotiations with a leadinvestor. In powerful limitedpartnerships (e.g., KohlbergKravisRoberts),theGPtends
to dictate the GP-LParrangements. Sometimes theGP gets to keep for itselfvariousbenefits, suchasdealfees,ratherthanturningthemovertothepartnership.
Hedge-FundOperatorsNormally, hedge-fundoperators run limitedpartnerships as GPs. Therecannotbemorethan100LPs
if the business entity is toavoid becoming a registeredinvestment company (RIC);also, the partnership cannothavemorethan35LPsifitisto avoid becoming aregistered investment adviser(RIA). Compensation to GPusually follows themerchantbankermodeloutlinedabove:anup-frontcontinuousfeeof1 to 2 percent of assetsmanaged per annum, plus a
profit participation after thelimitedpartnershiphasearneda bogey of, say, 6 to 10percent per annum. Profitparticipation can range from20 to 50 percent. Thosewhodo such hedge-fund dealsinclude:
Merchantbankers–LBOpromotersRiskarbitrageursVulturefundsVenturecapitalists
RealestatesyndicatorsOilandgassyndicatorsMovieproducers
There is probably someuniformity in the financialhedge-fund market revolvingaround1 (a 1 percent annualmanagement fee) and 20 (a20 percent profitparticipation). Promoters’compensations may bedifferent in nonfinancialareas:
Before1986,realestatelimitedpartnershipshadmorelike3to5percentmanagementfeesand50percentparticipationinprofitspluspropertymanagementfees.Itseemsthatsincetherealestatetax-shelter(TS)debaclesbetween1986andtheearly1990s,promoters’compensationhasgravitatedmoreto
theeconomicequivalentof1and20,whethertherealestatepromotersarebeingcompensatedasGPsorasmanagersofrealestateinvestmenttrusts(REITs).Oilandgassyndicationsusedtohavepromoters’participationsbasedontheconceptofonethirdforonequarter:Putup25percentofthemoney
investedfora33percentinterest,plusmanagementandoperators’fees.Thereprobablyarenormsforpromoters’compensationsinshowbusinessandmoviedeals,usuallyundertherubricofproducer’scompensation.
Governance of limitedpartnerships is almost always
strictly in the hands of GPs.The norm is that LPs havefewer governance rights thanexist for OPMI shareholdersof corporations. This isespecially true for publiclytradedlimitedpartnerships.In raisingfunds, it isbetter
from the promoter’s point ofviewtoraisefundsforablindpool: After funds arecommitted, the promoter caninvest in whatever he or she
chooses. This is not alwayspossible,sincemanypotentialLPs want to invest only inspecificdeals.The limited partnerships
referred to here are privatesexemptfromSECregistrationunder Regulation D becauseeach has fewer than 35investors. In the 1980s,publicly registered limitedpartnerships were common,especiallyinrealestateandin
oilandgas.3
BailoutsforLPsarevaried.For example, the sales pitchfor real estate tax shelterspriortothe1986amendmentstotheInternalRevenueCodewas that returns would bemade up of tax losses,perhaps some cash incomefollowedbysaleataterminaldate, whereas for a venture-capital limited partnership,the bailout revolves around
taking portfolio companiespublic at super prices infuture initial public offerings(IPOs).
InvestmentBankersInvestmentbankersearnhugefees providing services inthreeareas:
1. Advisory, includingfairness opinions, othervaluations, financial
strategies, and litigationsupport.2.Mergerandacquisitionactivities (i.e., businessbrokerage).3. Distribution ofsecurities through publicunderwritingsandprivateplacements.
SecuritiesSalespeopleSince the advent of
competitivecommissionratesin 1975, an increasingemphasisofWallStreetsalesforces has been to offerexclusiveproductswith largegross spreads rather than toemphasize the purchase andsales of securities insecondary markets. Forexample, the fairly typicalgrossspreadonthe1986IPOof Boston Celtics, L.P. was$1.29 per unit, which would
compare with a commissionin the secondary marketcharged a customer of, say,anywherefrom2centsaunit,where the customer obtaineda discount to a maximum of40 cents per unit for 1,000units acquired from a full-service nondiscountingbroker-dealer. Of the $1.29gross spread, anywhere fromone third to one half mighthave ended up as security
salesperson’s compensation.It seems that for someyears,many security salespeopleearned excess returnsmarketing exclusive productswith large gross spreads,including real estate and oiland gas limited partnerships,loadmutual funds,andIPOs.There are probablytremendous institutionalpressureswithin the financialcommunity to keep coming
up with products that willcontinue to permit salesforces to earn excess returns.NotonlyarethecommissionsearnedonIPOslarge,butalsomostIPOsaredesignedtobeeasy sells in that at the timeof initial offering, demandexceedssupply.
MoneyManagementControloffundsforbasically
passive investments is aninordinately profitablebusinesswithverylittlepricecompetition, whether suchcontrol is through registeredinvestment companies orregistered investmentadvisers. There are threeprincipal sources of excessreturnswhenafirmhasassetsunder management: salesload, management fees, andcontrolofportfoliotrading.In
addition, those who controlfunds are in a position todeliverexcessreturnstoothercontrollers, by, for example,appointing outside directorsand choosing attorneys andaccountantsforfunds.Thereisareadymarketfor
the sale of companies withfunds under management atprices,which in 2011 rangedfrom 2 to 5 percent of fundsmanaged. Table 14.2 shows
funds under management forselectedparticipants.Table14.2FundsUnderManagementforSelectedCompanies(AsoftheEndof2011—ApproximateFigures)Company Billionsof
DollarsBlackRockGlobalInvestors
$3,650
StateStreetGlobalAdvisors
$2,000
TheVanguardGroup $1,700FidelityInvestments $1,500
PIMCO $1,400DreyfusCorporation $1,260
PromotersinTradingEnvironments
Adiscussionof promoters intradingenvironments ismoreoften the purview of thoseinvolved with academicfinanceandEMHrather thanof value investors. Playersearning excess returns
persistently from tradingactivities include thefollowing:
MarketmakersUsersoffreeoralmostfreecreditbalancesatbroker-dealersCertainspreadlenders
There is confusion in theacademic literature onwhether excess returns areearned on sunk costs orpresentvalues.Asapractical
matter, stock exchangespecialists can earn excessreturns forever, as can theowners of television stations,because once they have thefranchise to earn excessreturns,nooneisinapositiontoenterthemarketandcauseentrenchedplayerstogiveuptheirreturns.
TopCorporate
ManagementsIf boards of directors do notimpose discipline on topmanagements’ compensation,no other entity will. Thesteepestslopeintheindustrialworld seems to be in theUnited States between theearningsofmanagementsandthoseofemployees.Controlling management
compensation is the province
of boards of directors, butdiscipline imposed onmanagement compensationsby boards of publiccompanies seems virtuallynonexistent. De facto, boardappointments are made bymanagements that areunlikely to appoint eitherpeoplewhoarenotfriendsorwho are troublemakers.Delaware is the leadingcorporate state. There are
virtually no cases inDelaware involvingallegations of excessivemanagement compensation.There is an InternalRevenueService (IRS) rule denyingcorporate tax deductions forcertain managementcompensationinexcessof$1million per year perindividual, but the rule iseasilycircumvented.Top executive
compensation has severalcomponents:
SalariesPerksNo-riskorlow-riskequities,especiallythroughstockoptionsCertaintransactions,includingleasingpropertiestocompanyorprovidingotherservicesforcompensationParticipationinmerchant
bankingactivities,suchasmanagementbuyouts(MBOs)ThechancetoemployfriendsandrelativesThecontrolofcorporategovernance,includingmanagemententrenchment
OtherProfessionalsWhoTendtoEnjoy
ExcessReturnsOther professionals can earnwhat seem to be excessreturns:
DefenseattorneysPlaintiffs’attorneys(intheUnitedStates,theexistenceofclassactionsandabsenceofsecurityforcostshelpspromoteexcessreturns)Managementconsultants
TaxadvisorsBankruptcyattorneys
Otherprofessionalswhoareprobably less wellcompensated than investmentbankersandattorneysincludethefollowing:
BusinessbrokersAppraisersProvidersoflitigationsupport(expertwitnesses)
Two groups ofprofessionals that providetruly essential services, yetseem to be grosslyundercompensated areauditors and indenturetrustees.Auditing has been anotoriously unprofitableprofession in this country,given the legal developmentsinaccountants’liability.Withthe prerequisite ofindependence, auditors are
held to far higher standardsthan are other professionals,especiallyinvestmentbankersand attorneys. Such highstandards are essential.Without reliable auditstandards, the U.S. economyprobably would cease tofunction because it wouldprobably be impossible tograntcommercialcredit.
CorporateMonopolies
andOligopoliesMany corporations—theCoca-Cola Company,Google, Apple Computer,Intel—earn superior returnsconsistently, relativelyinsulated from competitionandotherexternal forces thatcouldimposedisciplines.
MARKET
EFFICIENCYANDFAIRPRICESIN
TAKEOVERSFair is defined as that price,and other terms, that wouldbe arrived at in a transactionbetween willing buyers andwilling sellers, both withknowledge of the relevant
facts and neither under anycompulsiontoact.Theproblemisthatinmany
transactions for companieswhose common stocks arepublicly traded, especiallyMBOs, the real worldsituation is one of willingbuyer–coerced seller; wherethe buyer is also an agentwho issupposed to representtheinterestsoftheseller.Theseller, whose interest is
supposedtoberepresentedbythe buyer, is the publicshareholder, or OPMI. Thebuyer, at least in part, isusually corporatemanagement and/or controlshareholders.Coercion of OPMIs occurs
intwoways:1. In amerger, anOPMIis bound by the requisitevote (anywhere from50 percent of those
voting to two thirds ofthe outstanding shares)wherethevoteprocessisrigged in favor ofmanagement and/orothers who control theproxy machinery andwhose proxy solicitationis financed by thecorporate treasury. Ittends to be utterlyimpractical forOPMIs todissent from transactions
and then perfect theirrightsofappraisal, in theevent that relevant statestatutesevengiveOPMIsrights to seek anappraisal.2. In tender offers (oroccasionallyothermarketpurchases), OPMIs mayface the threat of thecompany going dark inthat the nontendering (ornonselling) OPMI
commonstockholderwillbe left owning a securityfor which there is nopublic market. Oncedark, there may be noreal market for thecommon,andtherecouldbe a lack of manysecurities lawprotectionsfortheOPMI.Therefore, the purpose of
fairness opinions, andfairness in general, ought to
be to simulate a willingbuyer–willing sellerenvironment even thoughthere tends to be in the realworld, a willing buyer–coerced seller environment.Many appraisals byinvestmentbanks,andothers,do not recognize this, andmarketpriceoftenwillbetheprincipal determinant of thetransaction price even wherethere is a willing buyer–
coerced seller situation. Putotherwise, in renderingmanyfairness opinions, little or noconsideration is given to theimportant question: What isthe company worth to thebuyer? For example, inDelaware, the leadingcorporate state, there are noappraisalrightsforOPMIsintransactions involving anexchange of common stockswherebothissuesofcommon
stock are publicly traded.Also inDelaware courts, fairvalue excludes considerationof values arising out of themergeritself;ineffect,donotconsider or weigh what thedeal might be worth to thebuyer.What makes an OPMI a
willing seller? A premiumovermarket.What makes a control
person a willing buyer? A
price that represents adiscountfromwhatthebuyerthinks the business is reallyworth to him, or hisinstitution.Thus, EMH
notwithstanding, therefrequently is a huge gapbetween the price thatwouldsatisfyawillingsellerandtheprice that would satisfy awillingbuyer.Given that OPMIs are
willing sellers and controlpersons arewillingbuyers, itislogicaltoassumethatmostof the time there will be awide disparity between whatawillingsellerwillassumeisafairpriceandwhatawillingbuyer will assume is a fairprice. Each group tends tofocus on different factors.TheOPMIsellerwill tend tofocus on those corporatevariablesmostlikelytoaffect
near-term market prices, towit, short-term outlooks forearnings, earnings beforeinterest, taxes, depreciation,and amortization (EBITDA),dividends and industryidentification.Controlbuyers,on the other hand, tend tofocus on how they canfinance the transaction, thequality and quantity ofresources in a business, andlong-termoutlooks.
Obviously, takeover pricestend to be a lot morefavorable for OPMIs whenthe price arrived at is theresult of competitive bidsrather than only negotiationsbetween parties. A sale ofassetsunderSection363 inaChapter 11 case is always abidding contest where openbiddingmoreorlessassuresafair price. The problem formost healthy companies is
thatmostcorporateendeavorshave to be negotiated—transactions are complex.Contracts for negotiatedtransactions almost alwayscontain no shop, break-upfee, and topping fee clauses.These discourage theconversion of negotiatedtransactions into biddingcontests.The argument is made by
OPMI representatives,
including the Plaintiff’s Bar,that in an MBO-typetransaction, the controlpersons should be obligatedto pay the OPMIs that pricewhich represents what thebusiness is actually worth tothebuyer.We disagree. If control
persons were unable to buybusinesses at prices thatrepresent discounts for them,then buying interest by
controlpersonswoulddryup.
SUMMARYAmarket is any financial orcommercial arena whereparticipants reach agreementas to price and other terms,which each participantbelieves are the bestreasonably achievable underthe circumstances. Fourfactors determine whether a
market will tend towardEMH-like instantaneousefficiencyontheonehandorit will tend to be inherentlyinefficientbyEMHstandardson the other hand, orsomething in between.Thesefactorsare(1)whothemarketparticipant is; (2) howcomplex, or simple, is thesecurity or other asset that isthe object of the marketparticipant’s interest; (3) the
time horizons of theparticipants; and (4) externalforces imposingdisciplineonthe participants. We revieweachof these factors andusethem to highlight misleadingsimplifications that greateconomists have brought tobear in the conventionalunderstanding of severaleconomic problems.We alsoprovide a list of examples ofmarkets where external
disciplines seem to belacking, and illustrate ourframework in the analysis offairmarketpricesintakeovertransactions._______________*ThischapterisbasedonmaterialinChapter7ofDistressInvesting:PrinciplesandTechniquebyMartinJ.WhitmanandFernandoDiz(©2009byMartinJ.Whitmanand
FernandoDiz),andideascontainedinthe20054Qand20071Qletterstoshareholders.ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1ThesesubstantivecharacteristicsofsecuritieswerediscussedatlengthinChapter4ofthisbook.2WilliamF.Sharpe,Investments,3rded.(Upper
SaddleRiver,NJ:PrenticeHall,1985),p.67.3SeetheexcellentbookbyKurtEichenwald,SerpentontheRock,whichwaspublishedin1995(NewYork:HarperCollins)anddescribesbusinesspracticesatPrudentialBacheSecurities.
PartTwo
PuttingItAllTogether:SafeandCheap
InvestingversusConventional
Approaches
CHAPTER15
SafeandCheapInvesting*
TheSafeandCheapApproach
BenefitsoftheSafeandCheapApproachfortheOPMIRestrictionsandDemandsoftheSafeandCheapApproachSummary
It has been our observationthat the most successfulactivists have had much thesame approach to investingthat the most sophisticatedcreditors have had towardlending. Essentially, thesepeopleapproachatransactionwith two attitudes, the firsthaving todowith their orderof priorities. In looking at atransaction, the single most
important question seems tobe:What have I got to lose?Only when it seems thatinvestment risks can becontrolledorminimizeddoesthesecondquestioncomeup:HowmuchcanImake?The second attitude has to
do with a basic feeling thatinvestment risk—how muchone can lose—is essentiallymeasured internally, notexternally. The possibilities
ofunsatisfactory results froman investment or loan are tobe found internally in theperformance of theunderlying business and theresources in thebusiness,notexternally in the marketprices at which a company’ssecurities might trade.Successful activists andcreditors, while notunmindful of the valuemessages that are delivered
by markets, tend not to beoverly influenced by suchmessages. Their attitude is:As far as my objectives areconcerned, I know muchmore about the situations inwhich I invest or in which Ilend than the stock marketdoes.
THESAFEAND
CHEAPAPPROACH
Abasicpremiseof thisbookis that many noncontrolinvestors ought to adopt thesame standards of valuationthat are used by successfulactivists, creditors, insiders,and owners of nonpublicbusinesses.First and foremost, they
must gauge the investmentrisk.Key variables for doingthisare the financialpositionof the business beinganalyzed and/or the financialposition of the securitiesholder. Businesses withstrong financial positions arethose that have access toenough liquid funds so thatthey can pay for whateverreasonable requirements theymight have and still have
access to a comfortableamount of surplus liquidity.Earnings, even accountingearnings, are, of course,frequently an importantelement in determiningfinancial strength orcreditworthiness,but this isafar cry from the positionusually expounded—that forunaffiliatedsecuritiesholders,earnings are the primaryfactor and, in fact, determine
value.Companies with strong
financial positions tend to beless risky than those not aswell situated. Furthermore,they tend to be moreexpandable because of theirgreater ability to obtain newfunds. These companies alsoare the most attractivecandidates for resourceconversion activities such asmergers and acquisitions,
liquidations, sharerepurchases, takeovers, andotherchangesincontrol.Our views as developed in
this book are that attractiveequityinvestmentsforoutsidepassive minority investors(OPMIs) ought to have thefollowing four essentialcharacteristics:1
1.Thecompanyoughttohave a strong financialposition, something that
is measured both by thepresenceofqualityassetsand by the absence ofsignificantencumbrances,whether apart of a balance sheet,disclosed in financialstatementfootnotes,oranelement that is notdisclosed at all in anypart of financialstatements. Strongfinancial positions or
creditworthiness provide“insurance” to investorsand opportunism tomanagement. (Safety oftheissuer)2.Thecompanyoughttobe run by reasonablyhonest management andcontrolgroups,especiallyin terms of howcognizanttheinsidersareof the interests ofcreditors and other
security holders. Thecompany must alsooperate inmarketswhereregulators providesignificantprotectionsforminority investors.(Safety of the issuer andissue)3. There ought to beavailabletotheinvestorareasonable amount ofrelevant information,although in every
instance this will besomethingthatisshortof“full disclosure”—theimpossibledreamforanyinvestigator, whetheractivist, creditor, insider,or outside investor.(Disclosures of enoughquality to performthorough appraisals ofthe safety of the issuerandissue)4.Thepriceatwhichthe
equity security can beboughtoughttobebelowthe investor’s reasonableestimate of net assetvalue (NAV). (Price oftheissue)Thesefourelementsarethe
sine qua non for aninvestment commitmentusing the safe and cheapapproach, because theirpresence results in aminimization of investment
risk.But they are not simplyby their presence sufficientreasons for an investmentcommitment. The absence,however, of anyoneof themisreasonenoughtoforgoanypassive investment,regardlessofhowattractiveitmight appear based on otherstandards.The environment within
which an investor can searchmeaningfully for these four
characteristics is a good one.The required disclosuresunderthesecuritieslawsgiveinvestors good insights intothe first three characteristics.Audited financial statements,including footnotes, areparticularly useful indescribing and enumeratingmany of a concern’sencumbrances, albeit somepotential encumbrances, suchas necessary or desirable
capitalexpenditures,maynotbedisclosed.Proxy-statementdisclosures aboutmanagement compensationand “certain transactions”with insiders, as well asnarrative from Form 10-Kand financial-statementfootnote disclosures aboutlitigation, aid in determiningthe degree of considerationinsidersarelikelytohaveforthe interests of security
holders.Businessdescriptionsin annual reports, mergerproxy statements,prospectuses,and10-Kshaveneverbeenbetter inenablinginvestors to understand anenterprise.In addition to the four
essential characteristics,supplementary factors thatcan make an equity securityattractivecanbe sovariedastodefyanyone’simagination.
In fact,most of these factorsinmostanalyseswillexist invarious combinations. Togive the reader some insightintowhatthesecanconsistof,we merely enumeratepossible factors under threesubheadings:
1. Primarily goingconcernfactors2. Primarily resourceconversionfactors3.Primarilystockmarket
factorsAnyoneorcombinationof
thesefactorscouldserveasatrigger to buy securities thatthe investor has alreadydetermined are attractive,based on safe and cheapstandards.Primarily going concern
factorsarethosethatrelatetothe operations of a business.They encompass thingsranging from investor beliefs
that profitability in theimmediate future willincrease dramatically, totenets about dividendincreases; from views thatcurrent high dividends aresafe,tobeliefsinthepotentialof new developments or newresearch; from optimismabout an industry outlook tofaithinmanagementabilities.Primarily resource
conversion factors that can
serve as a trigger to buy canbemorepreciselyenumeratedthan can factors that relateprimarily to the goingconcern or to the stockmarket. Such resourceconversionfactorsencompasspossibilities or probabilitiesof major refinancings,mergers and acquisitions,liquidations, certain commonstock repurchases or otherlarge-scale distributions to
common stockholders,changes in control,reorganizations, andrecapitalizations.Primarily stock market
factors encompass variablesranging from beliefs that acommon stock based onexisting price-earnings (P/E)ratios is priced belowcomparable issues, to viewsthat the common stock looksgoodtechnically,andtoideas
that the company or industrymay obtain Wall Streetsponsorship. Under primarilystock market factors, wewould also include themyriad macro variables thatencompass investorperceptions about theeconomy, about interest-ratelevels and about predictedmovements in the generalstock market or majorsegmentsofit.
BENEFITSOFTHESAFEAND
CHEAPAPPROACH
FORTHEOPMI
Investment-Risk-Resistant
Commitments
Outside investors using thisapproach buy and holdsecurities because issuesappear at the time ofpurchase, and continue toappear while held, to beinvestment-risk resistant,based on the four essentialelements. Incontrast tootherinvestment approaches, littleor no attention is paid tostock market pricefluctuations or to predictions
about the immediate outlookforequityprices.When purchasing equity
securities,anOPMIusingourapproach will not acquire aposition for his portfoliounless he believes that thevalue represented by theparticular security is goodenough, based on the fouressential elements. He doesnot consciously try tooutperform the market over
the short run. Thus,investigation in areas otherthansafeandcheapwill tendtobe emphasized less than itwouldbeiftheinvestorwerestriving for more immediateperformance.First, little or no time is
spentattemptingtogaugethegeneral market outlook,examining technicalpositions,ormakingbusinesscyclepredictions.Putsimply,
thereisnoattempttoholdoffbuying until the investorbelievesstockpricesarenearbottom. Rather, the primarymotivation for purchases isthat values are good enough.Second, comparativeanalysis, though always auseful tool, tends to be lessimportantthaninotherformsof fundamental analysis. Thereason, of course, is that theinvestmentgoalforOPMIsis
to concentrate on acquiringreasonable values rather thanon getting the best possiblevalues.
ConfidenceinInvestment
CommitmentsSuchinvestorstendtohaveadegree of confidence in theircommitments that justcannotexist for those who are
significantly affectedbyday-to-day or even month-to-month stock marketfluctuations, or who believethatvaluesaredeterminedbyelements based on soft, oralways shifting, factors, suchas earnings estimates, P/Eratios, and technical marketconditions. This confidencefactor can afford significantrewards in the usual (thoughfar from universal)
investment instance wherethere has been nofundamental deterioration inthe position of companieswith strong finances whosecommonstocksarepartoftheinvestor’s portfolio. Therewardscomebecause:
Onlyaninvestorconfidentinthefundamentalmeritsofasecurityfindsitrelativelyeasytoholdoraverage
downattimeswhenpricesaredepressedbecausethereisabearmarket,becauseearningshavedeclinedorforwhateverreason.Ifthereisconfidenceinfundamentalmerits,itbecomesrelativelyeasytoestablishpositionsincommonstocksatattractivepriceswhenmarketsaredepressed
becauseofeventssuchaspanicsortightmoney,orbecauseofbeliefsthatnear-termoutlooksarepoor.Onlyaninvestorconfidentinthefundamentalmeritsofasecuritywillholdand/orbuildconcentratedpositionsinthatsecurity.
It isourobservation that inbear markets, equity
securities that are attractivebyourstandardsmaydeclinein price as much as, if notmore than, many generalmarket securities and marketindexes.Also,incertaintypesoffrothymarkets(suchasthenew-issueboomwhichendedin 2000) price performancefor securities attractive bysafe and cheap standardstends to be much lessfavorable than is thecase for
many market indexes. Yet,we have no doubt that overtime and over all types ofmarkets, the average diligentunaffiliated investoremphasizing this approachwill obtain much moresatisfactory results, and ahighertotalreturn,thancouldbe obtained using any othermethod of investmentavailabletohim.Thatiswhythe approach generates
confidence and comfort, andwhy almost all deal men,creditors, major investmentbankers, insiders,andownersof private businesses withwhom we have dealtemphasize it in committingtheirownfunds.Obviously, most passive
investments will be betterinvestigated if publiclyavailable documents can besupplemented with other
information derived fromtalking to people known tothe investigator (know-who)and from using theinvestigator’s specialknowledge about particularcompanies and industries.Nonetheless, in a widenumber of instances thepublic record alone can bequitesufficient.
Availabilityof
MultipleExitsOne of the huge advantagesthat safe and cheap has overother investment styles isthat,onalong-termbasis,theinvestor can look confidentlyto a multiplicity of exitstrategies. In contrast, inother investment styles theonly exit on which toconcentrate is the sale in theopenmarket to other passive
minority investors. Safe andcheap investors ought tobenefit not only from openmarket price improvements,but if their basic analysis isclose to right and openmarket prices remaindepressed, values forstockholders would still getcreated because companieswill continue to grow overtime, increasing NAV yearoveryear;will be takenover
at prices that represent apremium over market; willrefinanceandrestructure;andcompanies with strongfinancial positions will makeacquisitions that enhancefutureearningpower.The safe and cheap
approachcallsfortheholdingof securities for a permanentor quasi-permanent basis.Exitsfrompositionsaremade(a) through resource
conversion events (tenderoffer, merger, liquidation,etc.); (b) when the price ofthe security trades at asubstantialpremiumoverandabove NAV; (c) when apermanent impairment ofcapital occurs (somethinggoes wrong with either thecompanyorthesecurity);and(d) when the analysissupportingthecommitmentisfoundtobewrong.
RESTRICTIONSAND
DEMANDSOFTHESAFEAND
CHEAPAPPROACH
ActivistsandSafeandCheap
For activists and certainaggressive non-controlinvestorsusingthisapproach,finding securities that areattractively priced based onthe standards we havediscussedisnotasdifficultasfinding doable deals,situations where resourceconversions can be made totake place, or where thereseem to be probabilities thatresource conversions will
take place, in the context ofcash tenders for control,mergers and acquisitions,going private, andliquidations. Thus, foractivists in particular, theemphasismaybeon spottingattractively priced doabledeals where a resourceconversion event may bemade to occur. For thesepeople, safe and cheap maybe only a secondary
consideration; they are morewilling to balance the risk-reward equation. In thatsense, they differ from us inthat they do not necessarilymake potential risk a moreimportant measurement thanpotential reward. Doability,which most often entailsobtaining control of abusiness, may become themostimportantconsideration.
SafeandCheapandKnow-Who
Thesafeandcheapapproachto investing is but oneapproach. It is not a magicformula suitable for alloutside investors or even allactivists.Therearetrade-offs,and the approach hasdisadvantages, especially forOPMIs. It requires hugeamounts of work, especially
reading and understandingdocuments. Know-who—personal relationships withthosewhoaretheshakersandmovers—is also helpful, andincertainsituationsessential.Using know-who does not
connote using insideinformation. Those who useinside information for thepurposeofbuyingandsellingsecurities are violating bothspecific securities laws and
more generalized antifraudprovisions of law. Insideinformation embodies factorsthat are not generally knownbut that, if known,would belikely to have a materialeffect on immediate marketprices. This type ofinformation might includeforthcomingearningsreports,disclosures of naturalresource discoveries, or apending takeover at a price
wellabovecurrentmarkets.The use of know-who in a
safe and cheap approachpermits an investor who ispersonally acquainted withinsiders to make intelligentjudgments about, say, thecharacter and ability ofmanagement, corporate long-rangeplans,orreasonswhyabusinesswould orwould notbe vulnerable to competitiveinroads.
MissingofAttractiveOpportunities
The standards used tominimize investment risklimit the selection ofattractive securities.Adherence to the approachresults in missing manyinvestment opportunitieswhere securities areattractively priced bystandards other than those
used by fundamental financeinvestors. In following theapproach, an investor,whether activist or outsider,will forgo many equityinvestments regardless ofprice if they do not meet allfour essential conditions. Forexample, an emphasis onfinancial position couldpreventonefrominvestinginairline equities, because of abelief that the industry is
dangerously financed (anexample of on-balance-sheetliabilities)andwouldbeevenif re-equipment programswere modified; in integratedsteel and aluminumcompanies; in many electricutilities,becausetheymaybeencumberedwithinordinatelylarge capital expendituresrequirements (an example ofencumbrances that are notdisclosed in accounting
statements); and in labor-intensive companies withlarge pension-planobligations (an example ofoff-balance-sheet liabilitiesthataredisclosedinfinancialstatement footnotes). Thisdoesnotmean that at certainprices such securities are notvery attractive investmentsfor many. They just do nothappen to be attractive foradherentstoourapproach.
AvoidanceofPredatoryControl
GroupsUnder our approach,securities of issuerscontrolled by those believedto be predators, should beavoidedregardlessofpricebyboth activists and OPMIs.The securities avoided areboth equities and debtinstruments.Significantclues
astowhothepredatorsmightbearepubliclyavailablefromdocuments filed with theSEC.Someofthesecluesarediscussed in Chapter 20 oncompany disclosures andinformation. Especiallypertinent in these documentsare disclosures aboutmanagement remuneration,insider borrowings from thecompany, and transactionsbetween the company and
insiders. These disclosuresare contained either in theannual-meeting proxystatement or in Part II of the10-K Annual Report.Disclosuresabout“litigation”inPart I of the 10-KAnnualReport, Part II of the 10-QQuarterly Report and infootnotes to audited financialstatements can also givevaluable clues to the caliberof management and control
groups. Disclosure ofgrievances by creditors orsecurities holders thatculminateinlawsuitsbroughtagainst companies andinsiders should serve aswarnings that a particularcompany may not be asatisfactory investment usingan investment riskminimizationapproach.
Restrictingthe
InvestmentUniverseThose using the approachrestrict investments tosituationswhere considerableknowledge about companiescan be obtained. This is truefor both control and non-control investors. Whilereliance on publicinformation only is sufficient—or even more thansufficient forcertain typesof
investments, such asinvestment companiesregistered under theInvestment Act of 1940 andpublic utilities—in otherareas required publicinformation frequentlyprovides insufficient data formaking intelligent decisions,as isusually thecasewhenacompany is engagedprimarily in mineralexploration activities. There
isaclosecorrelationbetweenthe usefulness of financialaccountingandtheusefulnessof public disclosures as toolsfor making investmentdecisions. As accountingbecomesmorereliable,sodorequired public disclosures.We also discuss thiscorrelation in Chapter 19 onthe uses and limitations offinancialaccounting.Most important, since the
control and non-controlgroups value using the samestandards, there tend to beclear conflicts of interestbetween insiders andoutsiders. Insiders sometimeswill create additional valuesforthemselvesbyforcingoutoutsiders via thecorporation’s proxymachinery that they control,byshort-formmergers,2orbythe use of coercive tender
offers. Force-outs sometimescan be at extremely lowprices, because the insiders,by their actions (or lack ofactions), have contributed tothedepressionofstockprices.This conflict of interestpresentsa realistic threat thatlimitstheappealofanumberof equity securities thatwould otherwise seemattractiveusingourapproach.It is our observation that
attemptedforce-outsatpriceswe would considerunconscionably low arerelativelyinfrequent.Basically, we think most
control groups in mostsituations attempt to treattheir stockholders fairly orare forced to do so bycircumstances. Nonetheless,outside stockholders aresometimes treated unfairly,and legal recourses available
tostockholdersarefrequentlyinadequate. First, those whooverreach at the expense ofstockholders have theindependent appraisalweapon in their arsenal.Major or second-tierinvestment banking housescan be retained either torecommend a force-out priceor to approve one chosen byboards of directors. Manyindependent appraisals seem
tobebasedonatheorythatifstockholders are given morethan they could realize bysaleofthesharesontheopenmarket,thenthedealispersefair.3Norealreferenceisevermade to any standards otherthanstock-pricestandards.Stockholder claims of
violationsoffederalsecuritieslaw may be of only limitedhelp, since inmost instancessuch suits are controlled by
attorneys for stockholderswho frequently have to beprimarily interested inpromoting settlements ratherthan obtaining full dollarvalue for stockholders.Federal securities laws arebasically concerned withdisclosuresandwithfulfillingfiduciary obligations, notfairness. The Supreme Courtdecision in Ernst & Ernst v.Hochfelder,4 however, raised
somequestionastowhatcanbe brought to bear by theprivate bar againstprofessionalssuchasauditorswhofailtofulfillprofessionalobligations insofar as federalantifraud securities laws areconcerned.InHochfelder,theCourtsaidthatanauditorwasnot responsible underantifraudstatutes forhisown“inexcusable negligence”when conducting an audit,
but, rather, he may or maynot be responsible wherethere is “reckless disregardfor the truth,” and that theauditorisclearlyliableunderthe antifraud statutes only ifhe is “an intentionalparticipantinascheme.”Resort to appraisal rights
under state law whereavailable is of only limitedusefulnessbecause in leadingstates(a)considerableweight
inarrivingatvalueisusuallygiven to market prices, and(b) costs of litigation fordissenting stockholders canbeenormous.5
State law can be helpful inaffording some protection tooutsidestockholdersinforce-out situations. This hasbecome true especially sincethe supreme court of theleading corporate state,Delaware, ruled in 1977 that
force-out transactions oughtto have “business purposes,”and that stockholders areentitled to “entire fairness.”Nonetheless, overallprotection for minoritystockholders seems to belimited.Despitethelessthanstrong
legal posture of OPMIs, wethinkthatingeneralthethreatofforcingoutstockholdersbypredatory managements and
control groups is not arealistic deterrent to aninvestmentprogrambasedonthesafeandcheapapproach.We think that a crucial
reasonwhyourapproachhasbeen largely ignored in theaccounting and economicliteratureisthatthosewritingon the subject tend toattribute the perceivedinformation and analyticneeds of traders seeking to
maximize total return to allinvestors. Along with others,webelievethat it isfutileforOPMIs to strive for themaximization of total return.It is our thesis that by nottrading and by concentratingon an investment risk-minimizingapproach,outsideinvestors can achieve good-enough results, probablybeating themarket fromtimeto time and on an overall
basis,butneverconsistently.6For the vast majority ofnoncontrol investors, thebestwaytowealthisnottotryforcontinuous short-termmaximization, but to aim fora performance that is goodenoughoveralonghorizon.Inordertouseourapproach
well, both activists andpassiveinvestorsshouldhavepractical perspectives aboutrisk and uncertainty.
Investors using the approachneedpatienceandfortitudeiftheir investment operationsare to succeed. After all, theunderlying thesis for theinvestor is that, given theelementsthatdeterminevalueforhim,heknowsmuchmoreabout the particular securityhe is interested in than thestockmarketdoes.
Understanding
MotivatingFactorsPeople and companies rarelyact unless they expect aresulting benefit, either forthemselvesor forotherswithwhom theyhave identitiesofinterest. In making suchdecisions, the actors aim totake advantage of certainfactors that seem to bepresent in many resourceconversion activities.
Understandingthesefactorsishelpful for those using ourapproach. There are threeacronyms that serve as aslang shorthand indescribingthese factors: TS, OPM, andSOTT. TS stands for TaxShelter, OPM (pronounced“opium”) forOther People’sMoney, and SOTT forSomethingOffThe Top. Wediscussthesefactorsatlengthin Chapter 22 on resource
conversionactivities.The normal academic
assumption is that,managements work in thebestinterestsofstockholders.We believe that relationshipsbetween managements andstockholders, betweenmanagementsandcompanies,between companies andstockholders and betweenstockholder groups are bestviewed as combinations of
conflicts of interests andcommunitiesof interests.Weprovide a framework forappraising managements inChapter11.
DismissaloftheConventionalWisdomThe normal security-analysisassumption is that certainfinancial factors, such aslarge returns on investment,
are good per se, and suchothers as intense competitionare bad per se; we demur.Appropriate judgments aboutmost analytical factors,includinghighprofitmarginsor rapid expansion, dependuponcontext.In minimizing investment
risk, it is important todistinguish among variables,depending upon the types ofcompanies being evaluated.
Oil companies are notanalyzed in the same wayelectric utilities are, nor areprimarilyresourceconversionbusinesses analyzed as goingconcerns are. As we statedelsewhere in this bookmuchofconventionalanalysis,suchas thatofGrahamandDodd,modern capital theory(MCT), and conventionalmoney managers seem to beimplicitly based on taking
tools especially applicable toa relatively narrow, specialcase—theequitysecuritiesofpure going concerns forexample—and then trying tofit those standards to theanalysisofalmostevery typeofbusinessandsecurity.Suchan approach allows earningsto become a commondenominator and point ofdeparture. We, in contrast,consider a strong financial
position (safety) to be themore appropriate commondenominator and point ofdepartureformostinvestors.Financial statements
provide the basis for thedetermination of financialposition. In determiningfinancial position, it must benoted that the severalfinancial statements areintegrally related to eachother: there are necessary
relationships between bookasset values and accountingearnings as well as betweenestimated asset values andestimatedearningpower.As stated previously, we
discount the importance ofthe concept of primacy ofearnings for anyone otherthan total-return traders andpossibly also investors incompanies that are specialcases,suchaspublicutilities.
It is our view that thoseemphasizing reportedearningsare,foranumberofreasons, out of step withalmost everybody in theUnited States aiming atwealth creation. First, whenprimacy of earningsadvocates refer to earnings,theytendtomeanearningsasreported for accountingpurposes, with a view togiving such a number a high
degreeofprecision,preciselyreflectiveofoperating resultsfor a past period; investmentresults, for example, arenormally excluded by thesepeople from earnings.Second, these reportedearnings tend to be stressedfor two purposes: they arethought to be the single bestindicator of what futurereportedearningsarelikelytobe (here again we do not
agree), and earnings asactually reported are deemedto be at any given momentthe single most importantcontributorindeterminingthemarket price of a commonstock.Wealsotendtobelievethat earnings as reported atany time will impact stockprices. We, however,conclude that in general anysuch impact lacks significantrelevance in an investment
risk minimizing approach toinvestments.Corporatecashandtheuses
to which it can be put,including distributions toshareholders, are, of course,important to investors. Thereis an inherent conflictbetween stockholder needsand benefits from cashdistributions,andtheneedsofcompaniestoretaincash.There are various methods
of distributing cash andproperty to shareholders,including dividends, sharerepurchases, liquidationdistributions and stockdividends. Stockholders arefar from constituting amonolithicgroup,andamongthem there are varied andsometimes conflictinginterests concerning cashdistributions.In the management of
securities portfolios, apositive cash-carry isfrequentlyimportant—thatis,the cash return from holdingsecurities ought to be greaterthan the cash cost of owningthesecurities.Thissometimescan also be important underour approach because bothpatience and theuseofotherpeople’smoney are easier tocome by if the cash returnfrominvestmentsexceedsthe
cashcostofowningthem.A basic point about loss
companies is thatwhile suchcompanies are sources of taxbenefits, for them to havevalue they have to be cleanshells—companies in whichbenefits to be derived fromthe absence of liabilities forincome taxes outweigh theencumbrancestobeassumed,either already existing orlikely tobecreatedby future
activities. This caveat, ofcourse, is part and parcel ofour approach, and it givesessentiallythesameadvicetoactivists buying lossbusinesses as is given tooutside, passive investorsbuyingcommonstocks.In conventional analyses
today, there is almost nounderstanding of risk. Theprime example of this is theconventionalbelief that long-
term U.S. Treasury Notes,selling near par, are safe andfree from risk. Not so. TheU.S. Treasury Notes, payingsay 2 to 3 percent, do notcarryanycreditrisk;but,theyare repletewith several othertypesofrisk,suchasinflationrisk and capital depreciationrisk, while at the same timethere are no prospects forcapital appreciation. Thehugeamountsofrealisticrisk
inherent in owning U.S.Treasuries today is offsetgreatly if the portfolioholdingtheseinstrumentsisadollar-averager and willcontinue toacquirenewU.S.Treasuries as interest ratesfluctuate. Nonetheless, formost portfolios in 2012, theway to guard againsteconomicrisk is tobea totalreturn investorusing the safeandcheapcriteria rather than
tobeacashreturninvestorinU.S.Treasuries.Short-termism is rampant
among market participants.Much of short-termism isappropriate, justifiable, andessential for many marketparticipants.Itjusthappenstobe irrelevant largely for safeand cheap investors focusedmostly on buy-and-hold,long-term purchases ofsecurities.
One had better be veryshort-term conscious wherethe portfolio is highlyleveraged; where the marketparticipant doesn’t knowmuch about the company orthesecurities it issues;wherethe market participant usestrading systems, or atechnical approach to themarket; and where the moreimportant variable in ananalysis is what is the near-
term outlook, rather thanwhat are the underlyingvalues existing in thecompany and the company’ssecurities.Even for the largest
institutions, it seems to beimpossibletohaveunderlyingknowledge about anindividual securitywhere theportfolio consists of a hugenumbers of securities (sayover 500 different common
stocks) and those securitiesare traded frequently. Thisincludes high-frequencytrading portfolios. If that’swhere one’s interest andattention lies, one should beshortterm.
UnderstandActivitiesandMotivationsof
ActivistsWe think that any person
involved with fundamentalfinance can function better ifhe understands the activitiesandmotivationsofactivists.OPMIs following the
preceptsoutlinedinthisbookstrive to achieve above-average long-term returns byacquiring thecommonstocksof strongly capitalizedcompanies at bargain prices.Activists, on the other hand,frequently can achieve super
returns inotherways, that is,without necessarily acquiringinterests in companies withstrong finances or strongoperations bought at bargainprices. In Part Five of thisbookwe describe three dealswhere activists made outextremely well by usingfinancetechniquesratherthanmerely being a buy and holdinvestor. The three examplesareasfollows:
1. The 2005 leveragedbuyout (LBO) of thecommon stock of HertzGlobal Holdings at arelatively high P/E ratioand a substantialpremium above bookvalue. Despite mediocreoperating resultssubsequent to the LBO,the Hertz GlobalHoldings Transactionseems tohavebeenquite
remunerative for theLBO sponsors and theirinvestors. In our viewthis success isattributablemostly to thefact that time and againthe sponsors enabledholders of Hertz GlobalHoldings common stockto obtain super-attractiveaccesstocapitalmarkets.Also sponsors andinvestors received two
largedividendswherethefunds for paying one ofthe dividends came froma loan with liberalcovenants, and for theother, from the proceedsof an underwrittencommonstockofferingtothepublic.2. The 1969 acquisitionof Reliance InsuranceCompanybyLeascoDataProcessing Company.
Thisisagoodexampleofasmallbusiness,almostastart-up, obtainingcontrol of a majorproperty and casualtyinsurance companywithout having to investany material amount ofcash unless control wasactually obtained. In thiscase we examine themethods by whichLeasco Data Processing
Company financed thepurchase for cash of theblocks of shares ofReliance InsuranceCompany, which Leascobelieved it needed toacquireifitwastoobtaincontrol of Reliance. Thecase is of interest in partbecause of the extremelyattractive considerationthat was given toproviders of cash so that
they obtained (a) a safe,above-average return ona tax-privileged basis aswellas(b)anopportunitytoparticipate inpotentialmarketappreciation.Thiswas the epitome of aninvestment that could bedeemed to be attractiveusing the safe and cheapapproach. Yet, thetransaction was alsohighly attractive for
others,especiallyLeasco,because it enabledLeasco to tie up keyblocks of common stockwithout risking cash,unless it was to obtaincontrol of Reliance, andalso to use pooling-of-interests accountingtreatment in the future,with consequentbeneficial effects onLeasco’s reported
earnings to itsstockholders.(Theabilityof a company to usepooling-of-interestsaccounting in connectionwith an acquisitiontransaction no longerexists).3.The1969goingpublicoffering of the commonstock of the parentcompany of the F & MSchaefer Brewing
Company. In this case,theapparentobjectofthevarious transactions wasto extract as much cashas possible from thebusiness for the controlgroup and still retaincontrol of the businessfor that group. Althoughnone of the securitiesissued to noninsiders inthat transaction weresuitable for safe and
cheap investors, the caseis still useful. First, itdemonstrates that profitscan be obtained inmanywaysbyinvestors,as,forexample, the profitsgarnered by thosemembers of the publicfortunate enough toobtain SchaeferCorporation commonstock on the initialunderwriting who then
soldtheirstockwithintheensuingeighteenmonths.Second, because thetransaction was socomplex, much isdemonstrated about whatmotivates variouspurchasers of securities,from life insurancecompanies to total-returntraders,andaboutvariousclasses of securities thatcan be issued. Thus, the
case is instructivebecause it demonstrateshow insiders used thefinancial strengthinherent in a profitable,almostdebt-freebusinessas a basis for extractingmaximum cash forthemselves, with theresult that the successorbusiness became heavilyencumbered. TheSchaefercasealsobriefly
touches on matters thathavetobetheconcernofany promoter or would-be promoter, includingblue sky laws, theNational Association ofSecurities Dealers(NASD) Rules of FairPractice, Rule 144 andRegistrationRights.Understanding these types
of transactions ought to behelpful to OPMIs in gaining
insight into howWall Streetoperateseventhoughthevast,vast majority of OPMIs willnever become activists orpromoteesofactivists.
SUMMARYSafeandcheap investing isavalue investingapproach thatgives primacy to theavoidanceof investment risk.The four main components
used in the selection ofcompanies and their equitysecuritiesare(1)thecompanyought to have a strongfinancial position, somethingthat is measured both by thepresenceofqualityassetsandby the absence of significantencumbrances,whetherapartof a balance sheet, disclosedin financial statementfootnotes, or an element thatis not disclosed at all in any
part of financial statements;strong financial positions orcreditworthiness are acompany resource, whichprovides “insurance” toOPMIs and opportunism tomanagement; (2) thecompany ought to be run byreasonably honestmanagement and controlgroups and must operate inmarkets where regulatorsprovide significant
protections for minorityinvestors; (3) there ought tobe available to the investor areasonableamountofrelevantinformation, although inevery instance this will besomething that is short of“full disclosure”; and (4) theprice at which the equitysecurity can be bought oughtto be significantly (say 20percent or more) below theinvestor’sreasonableestimate
of net asset value. Thebenefitsanddisadvantagesofthe approach are alsodiscussed._______________*ThischaptercontainsoriginalmaterialandpartsofthechapterarebasedonmaterialcontainedinChapter1ofValueInvestingbyMartinJ.Whitman(©1999byMartinJ.Whitman);andChapter2of
TheAggressiveConservativeInvestorbyMartinJ.WhitmanandMartinShubik(©2006byMartinJ.WhitmanandMartinShubik),andideascontainedinthe19992Q,20014Q,20053Q,20084Q,20091Q,and20121Qletterstoshareholders.ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.
1WealsodiscussthesefactorsinChapter8oninvestmentrisk.2Inashort-formmerger,stockholderscanbeforcedoutofacompanyinamergerorreversestocksplit,andhavenorighttovoteonthetransaction.3SeeourdiscussiononfairpricesintakeoversinChapter14.4Ernst&Ernstv.
Hochfelder,425U.S.185(1976).5Unlikeclass-actionsuitsinfederalcourt,inappraisalproceduresinstatessuchasDelawareandNewYorkdissentingstockholdersmaybeliablenotonlyfortheirowncourtcosts,includingattorneys’andexperts’fees,butalsoforsimilarcostsincurredbythecompany,inthediscretionofthecourt.
6Thereaderisremindedthattheoptimizationofperformanceisdependentnotonlyonsecurityorinvestmentselectionbutalso(andmostimportantly)onthedegreeofconcentrationordiversificationoftheinvestor’sportfolio.SeeChapter13.
CHAPTER16
GrahamandDoddPlacedin
Context*
TheOPMI
DefinedTheOPMIPerspectiveofAnalysisTheGoingConcernandInvestmentCompanyViewsofBusinessesPrimacyofthe
IncomeAccountandWealthCreationPrimacyoftheIncomeAccount,Dividends,andCorporateUsesofCashPrimacyoftheIncomeAccount
andtheAppraisalofManagementsPrimacyoftheIncomeAccountandTop-DownversusBottom-UpAnalysisPrimacyoftheIncomeAccountand
DiversificationPrimacyoftheIncomeAccountandGrowthStocksMarketRiskversusInvestmentRiskandMarginofSafetyTheImportance
ofMarketPerformanceUsesandLimitationsofFinancialAccountingSubstantiveConsolidationCompensationofPromoters
DoStockMarketPricesReflectCorporateValues?Trade-OffsModernCapitalTheoryversusGrahamandDoddSummary
BenjaminGrahamandDavidDodd (G&D) were prolificwriters, publishing volumesin 1934, 1940, 1951, and1962 and by Ben Grahamalonein1949andsubsequentrevised editions.1 A principalproblem with G&D is thatalmost everyone in financetalks about G&D but veryfew seem to have actually
readG&D.Thisdiscussionisbased on the 1962 edition ofSecurity Analysis Principlesand Technique (McGraw-Hill) by Graham, Dodd, andCottle; and the 1971 editionofTheIntelligentInvestor,byGraham.Becausesomanyhavesuch
asuperficialunderstandingofG&D, their names havebecomesynonymouswiththetermvalue investing.This, in
turn, has led to someconfusionaboutwhatitisthatvalue investors do. Thoughwe are influenced by G&D,our methods are basicallydifferent.Aswehavealreadypointed
out, value investing is onearea of fundamental finance(FF). It involves investmentsin marketable securities bynon-control outside passiveminority investors (OPMIs)
using a fundamental financeapproach to analysis. Theother areas of fundamentalfinanceinvolvethefollowing:
DistressinvestingControlinvestingCreditanalysisFirstandsecondstageventurecapitalinvesting
Modern capital theory(MCT), like value investing,focuses on investments byOPMIs. Unlike value
investors, MCT focusesstrictly on near-term changesinmarketprices.Inanumberof special cases the factorsimportant in MCT are alsoimportant in value investing.MCT is discussed briefly atthe end of this chapter anddiscussedatlengthinChapter17.G&D made four very
important contributions tovalueinvesting:
1.Distinguishedbetweenmarketpriceandintrinsicvalue(aconceptthatstillseemsalientoMCT).2. Provided a clear andusable definition ofinvesting as opposed tospeculation.3. Pioneered the conceptof investing with amarginofsafety.4.Promulgatedthebeliefthat investment decisions
ought to be based onascertainable facts. (Thiswas before the modernera—say after 1964—when for OPMIs theamount of factualmaterialexplodedandthereliability of factualmaterials became muchenhanced).Any so-called value
investorfollowsthebasicrulepromulgatedbyG&D:
acquireatattractivepricesthe common stocks issuedby primary companies intheirindustries.In this chapter we briefly
summarize and discuss thedifferences between ourapproach to value investingand that of G&D. Many ofthe differences arefoundational in nature, andthese foundations have beenexplained in detail in Part
Oneofthisbook.
THEOPMIDEFINED
Some participants ininvestment operations areoutside, passive minorityinvestors(OPMIs);othersareactivists.OPMIsaremembersof the public and aredistinguishablefromothersin
three respects. First,individually they have nocontrol or influence over thebusinesses whose securitiesthey hold or contemplateholding. Second, they do nothave access to informationother than that which isgenerally available to thepublic. Third, they are thosewhom the U.S. securitieslaws and regulations havebeendesignedtoprotect.2
Throughout the book, werefer to them as OPMIs, aswell as non-control andunaffiliated security holders.The key is that they areinactive in management andnot connected with thecompany issuingsecurities inany way other than assecurity holders. OPMIs runthegamutfromdaytraderstomostinstitutionalinvestorstosafeandcheapinvestorswho
do not seek elements ofcontroloverthecompaniesinwhich they hold securitiespositions. The reason forusing the term OPMI ratherthaninvestor is that thewordinvestor is one of the mostmisused and misunderstoodwords on Wall Street and isoften used to describe whatG&D and we would refer toasspeculators.Non-control investors are
also supposed to be thebeneficiaries of various statelaws and regulations,including blue sky statutesgoverning terms andconditions under which newissues may be offered;3antitakeover statutes; statutesaimed at controlling going-private transactions; moregeneralizedcommon lawandstate statutory requirementscovering the fiduciary
obligationsofthoseincontrolofcorporationstounaffiliatedcommon stockholders; andstatutes defining appraisalremedies when stockholdersdissent from force-outmergers or similar force-outtransactions. OPMIs areadditionally protected byrules promulgated by quasi-publicbodies,particularlytheFinancial InstitutionsRegulatory Authority
(FINRA) and the PublicCompany AccountingOversightBoard(PCAOB).Weregardasactiviststhose
participants in U.S. financialoperationswhohaveelementsof control or influence overthe businesses in which theyinvest, who have or canobtain nonpublic informationand whom federal securitiesregulation is intended tocontrol rather than toprotect.
We believe the materials inthis book are of interest tobothactivistsandOPMIs.
THEOPMIPERSPECTIVEOFANALYSIS
Both G&D and MCT focuson the investment operationfromthepointofviewof the
OPMI.Little,orno,attentionispaidtootherpointsofviewand the particular factorsneeded to understand thedynamics driving individualcompanies, particularindustries, control persons,and putative control persons,as well as creditors. Thisemphasis on the OPMI is insharp contrast to other areasof FF—control investing,distress investing, and first-
and second-stage venturecapital investing. Here, theanalysis does not focus onOPMI needs and decisions,but is rather a four-leggedstool:
1. Understanding theOPMI’s needs anddesires2. Understanding thecompanyinsomedepth3. Understanding theneeds and desires of
control persons andentities, present andfuture4. Understanding theneeds and desires ofcreditorsAs value investors, our
analytic techniques, unlikeG&D’s, are the same ascontrol investors, distressinvestors, and creditors. Theemphasisisonunderstandingindepth,fromthebottomup,
the company and thesecurities it issues; and alsothecharacterandmotivationsof managements, othercontrol entities, and otherssenior to the common stock,rangingfromsecured lendingbycommercialbankstotradecreditors to holders ofsubordinated debentures toholders of preferred stocks.There is a de-emphasis oftop-down factors emphasized
byG&DandMCT,aprimacyof the income account,general stock market levels,near-term stock pricemovements, a primacy ofdividend income, quality orgrowthasdefinedbygeneralrecognition of such in thegeneralmarket.Many of the best value
investors graduate into otherareasoffundamentalfinance,especially control investing
anddistressinvesting.Namesof such “graduates” whichcome to mind are WarrenBuffett,SamZell,CarlIcahn,Bill Ackman and DavidEinhorn.A subgroup of control
investing is what we call“Pain in the Ass” (PITA)investing. PITA investingseems to be carried on veryskillfully by Messrs. Icahn,Ackman, and Einhorn. PITA
investing involves eitherbuying small- to medium-sized stakes in the equity ofunderperforming,undervalued companies, orshorting securities that areoverpriced and wheremanagements lack integrityor where there might besuspicions of fraud orunsoundaccountingpractices.The PITA investor in thesesituations has access to large
amounts of publicity andusing that publicity tries toinfluence market prices inOPMI markets. PITAinvesting involves elementsof control, but most of thetime, the PITA investor doesnotseekactualcontrolof thebusiness.Our modus operandi is to
think like owners, privateacquirers, or creditors,emphasizing elements of FF
that differentiate us fromG&D.Intheiranalysisofcommon
stocks, G&D emphasize thefollowingfactors:
Aprimacyofthegoingconcernviewofbusinesses,andtheOPMIviewoftheinvestor,whichleadsto:
Aprimacyoftheincomeaccount—forecastfuture
earningsrelyingheavilyonthepastearningsrecordAprimacyofdividenddistributionsfortheOPMIAprimacyofappraisingmanagementsonlyasoperatorsAprimacyoftop-downfactors:
Thegenerallevel
ofsecuritiesmarketsOutlookfortheeconomyIndustryidentificationsGeneralmarketopinionastothequalityand/orgrowthprospectsofanissuer
Aprimacyofdiversificationover
concentrationAprimacyofgenerallyrecognizedgrowthAprimacyofmarketriskoverinvestmentriskAprimacyofmarketperformanceratherthanbusinessperformanceAprimacyofwhattheaccountingnumbersareratherthanwhattheymeanAprimacyoftheOPMI
intheanalysisreflectedasaprimacyofsubstantiveconsolidation
As we highlighted, tworeasons underlie their focuson these factors of analysis.Withminorexceptions,G&Dhadonlyonetypeofinvestorinmind, theOPMI, and theyviewed businesses as puregoingconcerns.
THEGOINGCONCERNANDINVESTMENTCOMPANYVIEWSOF
BUSINESSESWe differ from G&D andmost others writing aboutfundamentalsecurityanalysis
and corporate finance. Otherfundamentalists have atendency to apply to allcompanies tools of analysisthat in fact are applicableonlytothatsmallminorityofbusinesses that are strictgoing concerns—that is,companies that are engagedin a particular type ofoperation to be financed,managed, and controlled inthe future in about the same
way they have been in thepast. The analysis of strictgoing concerns is of limitedhelp when applied tobusinesses that are alsoinvolved in what we callresourceconversionactivitieslikemergers, acquisitions, orthe purchase, sale, ordistributionofassets inbulk;major financial restructuringsor recapitalizations; sales ofcontrol or contests for
control;orthecreationoftaxshelter. Since mostcompanies, to a greater orlesser extent, are involved inthese types of activities,analysis must take intoconsiderationboththeirstaticand dynamic investmentvehicleattributes.There are crucial
differences between theanalysis of companies asgoing concerns and the
analysis of companies asinvestment vehicles. Mostcompanies have both goingconcern characteristics andinvestment companycharacteristics. In goingconcern analysis, greatweight is given to flows,whether cash or earnings. Ininvestment vehicle analysis,greatweight isgiven toassetvalues, especially realizableasset values. For both going
concerns and investmentvehicles, creditworthiness isparamount for the companyand its securities holders(except perhaps foradequatelysecuredcreditors).G&D emphasize goingconcerns except for a shortdescriptionofnetnets,whichfocuses only on classifiedbalance sheets and nevermentions creditworthiness orprospects for resource
conversion, especiallychanges of control or goingprivate.
PRIMACYOFTHEINCOMEACCOUNTAND
WEALTHCREATION
For G&D values forstockholders are created byearnings that are then valuedin the market by a price-earnings ratio (orcapitalization rate) and/ordividends, which are valuedby the market on a currentreturnbasis.In FF, stockholder values
flowoutofcreatingcorporatevalues. There are fourdifferentmethods of creating
corporatevalues:1.Cash flows availableto security holders.Corporations probablycreate this fewer timesthanmostpeoplethink.2. Earnings, withearnings defined ascreating wealth whileconsuming cash. This iswhat most well runcorporations do and alsowhat most governments
do.Earningscannothavea lastingvalueunless theentity remainscreditworthy. Also, inmost cases, in order tomaintain and growearnings the corporationorgovernmentisgoingtohave to have access tocapital markets to meetcashshortfalls.3. Resourceconversions.Theseareas
include massive assetredeployments, massiveliability redeployments,and changes in control.Resource conversionsoccur as part of mergersandacquisitions,contestsfor control, the bulk saleor purchase of assets orbusinesses, Chapter 11reorganizations, out-of-court reorganizations,spin-offs, and going
privates includingleveraged buyouts(LBOs) andmanagementbuyouts(MBOs).4. Super-attractiveaccess to capitalmarkets. On the equityside, this includes initialpublic offerings (IPOs)during periods such asthe dotcom bubble. Onthe credit side, thisincludes the availability
of long-term, fixed-rate,nonrecoursefinancingforincome-producingcommercialrealestate.G&D do not distinguish
betweencashreturninvestingand total return investing. Incash return investing, returnsaremeasuredbycurrentyield(or dividend return), yield tomaturity, yield to a worstcase, or yield to an event. Intotal return investing, returns
are measured in price paidrelative to cash returns plus(or minus) capitalappreciation(ordepreciation)in given periods of time.Many portfolios have to beinvested only for cash returninto high-grade credits, suchas bank securities portfolios;insurance companyportfolios, at least as to theamount of liabilities; certainpensionplans. (In thecurrent
low-interest environment, itseems almost impossible tobe a rational cash-returninvestor.) For G&D, thehigher the dividend, thehigher the price at which acommon stock would sell.G&D imply that the higher-dividend issue should beacquired. G&D ignore thatthelower-pricedsecuritymaybemoreattractivetothetotalreturninvestorbecauseofthe
lower price and the largeramountofretainedearnings.Two facts stand out in
comparing dividend incomein the U.S. with interestincome:
1. Dividends aregenerally tax-advantagedin the U.S., withindividuals currentlysubject to a maximumfederal tax rate of 15percent on qualified
dividends; and corporatetaxpayers are generallyentitled to a 70 percentexemption from incometax on qualifieddividends from domesticcompanies.2.IntheUnitedStates,asapracticalmatter,noonecan take away acreditor’s right to acontracted interestpayment (or other cash
payment) unless thatindividual so consents ora court of competentjurisdiction, usually abankruptcy court,suspendsthatpayment.
PRIMACYOFTHEINCOMEACCOUNT,
DIVIDENDS,AND
CORPORATEUSESOFCASHG&D emphasize theimportance of dividends forOPMIs. Incontrast,FFs lookinstead at the corporationoptimizingitsusesofcash.Ingeneral,corporatecashcanbe
dispensedinthreeareas:1.Expandassets2.Reduceliabilities3. Distribute to equityowners:
a.Viadividendsb.Viastockbuybacks
There are comparativeadvantagesanddisadvantagesfor dividends and buybacks,whichareneverdiscussedbyG&D, because they only
mention the stock buybackalternative as it relates tostock options formanagement. There is nodiscussion by G&D of stockbuybacks as a method ofenhancing a common stock’smarket price over the longrun, giving the managementtheflexibilitytoretaincashintroubled times, and alsoincreasing the percentageownership interest of each
nonsellingstockholder.From a corporate point of
view, distributing cash toshareholders has to be aresidual use of cash,comparedtoexpandingassetsorreducingliabilitiesmostofthe time. Probably the mostimportant exception to thisexistswhere thepaymentsofcommon stock dividends incashgiveacorporationbetterlong-term access to capital
marketsthanwouldotherwiseexist. This seems to be thecaseforcompanies,whichbythe nature of their operationsconsume cash in order tocreatewealthandarerequiredtoraiseoutsideequitycapitalperiodically, such asintegrated electric utilitiesand certain financialcompanies.
PRIMACYOFTHEINCOMEACCOUNTAND
THEAPPRAISALOFMANAGEMENTSIn a G&D primacy of theincome account approach (orany other primacy of the
income account approach),managements are appraisedalmost solely as operators.For FF, managements areappraised using a three-prongedapproach:
1. Management asoperators2. Management asinvestors3. Management asfinanciersIn appraisingmanagements
as financiers, the emphasisought to be on a primacy ofcreditworthinessforeitherthecompany or for varioussecurities in the capitalstructure.G&D agree that the
securities of secondarycompanies and workoutsituationscanbeattractiveforEnterprising OPMIs, whomthey distinguish fromDefensive OPMIs. However,
very little is reallyvoicedbyG&D as to how secondarysituations and workoutsituations ought to beanalyzed, compared withtheirviewsonhowtoanalyzethe securities of primarycompanies,otherthantostatethat secondary commonstocksshouldnotbeacquiredexceptatpricesof two-thirdsorlessofunderlyingvalue.
PRIMACYOFTHEINCOMEACCOUNTANDTOP-DOWNVERSUS
BOTTOM-UPANALYSIS
G&Dismostlyatoolfortop-
down analysis; while FF, incontrast,isalmostcompletelybottom up. G&D describehowtoforecastearningsforacoming5-to-10-yearperiod:
Formulateaviewastothegeneraleconomicclimate.AnticipatefutureearningsfromtheDow-JonesIndexandtheS&P500.Forecastearningsfor
individualcompanies.InFF,theessentialanalysis
is of the individual companyand the current price of thesecurity versus its estimatedintrinsicvalue.Insteadofjustforecasting earnings, in FF,prognostications are madeabout:
OperationsPotentialresourceconversionsAccesstocapitalmarkets
PRIMACYOFTHEINCOMEACCOUNTANDDIVERSIFICATIONDiversification, quiteproperly, is key in a G&Danalysis. It is an OPMIanalysis,whichreliesheavilyon predicting future earningsand future dividends,
something extremely hard todowell. In FF there ismuchless need for diversificationwhich is viewed as only asurrogate,andusuallyadamnpoor surrogate, forknowledge,control,andpriceconsciousness. Non-controlvalue investors need amodicum of diversification,but nowhere near to thedegree emphasized byG&D,MCT, and academics in
general.
PRIMACYOFTHEINCOMEACCOUNTAND
GROWTHSTOCKS
In writing about growthstocks, G&D seem to define
growth as that which isgenerally recognized in themarketplace as growth.Growth analysis focusesstrictly on forecasting futureflows,whethersuchflowsarerevenues, earnings, or cash.An attractive common stockpurchase is deemed to existwhere future forecastedgrowth rates are greater thancurrent ratios of price toflows.
In FF there is no emphasison estimating future flows.Rather we recognize thatgrowth in common stockprices can come, andfrequently does come, fromsources other than corporateoperations.Growthcancomefrom judicious acquisitions;creating unrealized, andunrecorded, appreciation inassetvalues,creating“hiddenassets” in the form of
increases in adjusted bookvalue; having companiestaken over by others atpremiumprices;andpossiblyparticipating in corporaterestructurings.Manyof thesegrowth stocks do not havegeneral recognition, and sothey sell at very modestprices.Examplesinmid-2012included Applied Materials,Brookfield AssetManagement, Cheung Kong
Holdings,HangLungGroup,andWheelock&Co.
MARKETRISKVERSUS
INVESTMENTRISKANDMARGINOFSAFETY
G&D believe it is importantto guard against market risk,thatis,fluctuationsinsecurityprices. Thus, it becomesimportant in their analysis tohave views about generalstock market levels. FFpractitioners guard onlyagainst investment risk, thatis,theproblemsofcompaniesand/or the securities theyissue. In FF analysis, marketrisk ismostly ignored except
when dealing with suddendeath securities—derivativesand risk arbitrage securities;when dealing with portfoliosfinancedbyheavyborrowing;andwhen companies have toaccess capital markets,especiallyequitymarkets.In the analysis of
performingcreditsacquiredator near par, emphasis byG&D is on quantitative datarelevant to overall interest
coverage, rather than anyemphasisoncovenantsand/orcollateral. FF emphasizescovenants and collateral incredit analysis. No matterhow favorable thequantitative data, such ascoverage and debt ratios, FFpractitioners examining mostcorporate credits assume thatthe quantitative facts arelikely to deteriorate over thelong-termlife (saya5-to-15-
year life) of a debtinstrument. Such anassumption creates a marginofsafetyforacreditor.Analystsreallyoughtnotto
use the word risk withoutputting an adjective in frontof it. G&D really do notdistinguish often enoughbetween market risk andinvestment risk, even thoughthey recognize in measuringmarket risk that Mr. Market
tends to be utterly irrationalsomeofthetime.Marketriskrefers to short-termfluctuations in securitiesprices. Investment risk refersto something going wrongwith the company issuingsecurities or with thesecurities(suchasdilution).We largely disagree with
G&Das towhen lowpricingcreates a margin of safety.For G&D the margin of
safety is created mostly bydepressed prices in thegeneral market. For FF, themargin of safety is derivedlargely from micro factorsaffecting a company and itssecurities, not general stockmarket levels. G&D seem tohaveavalidpointintermsofguarding againstmarket risk.FF is involved withinvestment risk, not marketrisk.
THEIMPORTANCEOFMARKET
PERFORMANCEThe importance of marketprice depends primarily onthreefactors:
1. The form ofinvestments in theportfolio
2. Who the marketparticipantis3. How the portfolio isfinancedGenerally, market prices
are much less important if aportfolio consists ofperforming loans. Indeed, insomeportfolios,suchashigh-grade municipal bonds heldby individuals, almost noattention is paid to marketprices. Market prices are
almost always important inevaluating common stocks,exceptininstanceswherethecommon stocks are beingaccumulatedwith the idea ofobtainingcontrolor elementsof control.Market prices arealmost always of criticalimportance where theportfolio is financed bymarginborrowingswhere thecollateral for the borrowingare the securities that make
uptheportfolio.Sometimes analysis takes
funny turns. In a poorlyfinancedcompany,wouldoneprefer to have had thecompany issue subordinateddebentures or a preferredstock, which is, of course,subordinated to thedebentures? If there is afailure to pay interest orprincipal on a subordinateddebenture, the one remedy
available to the subordinatedcreditoristodeclareaneventof default. Then, either theindenture trustee, or usually25 percent of thesubordinated creditors, canaccelerate the debt, declaringit due and payable. For asubordinateclass, therighttoaccelerate most often is theright to commit suicide,because this action wouldlikely result in a
reorganization or liquidationwhere almost all, or all, thevalue will go to seniorcreditors. In contrast to aneventofdefault,thepreferredshareholder accumulatesdividend arrearages. Thecompany has less need toreorganize or liquidate. If aninvestor is making a capitalinfusion into a troubledcompany, the investorfrequently is much better off
from a safety point of viewby having the issuer issue apreferred stock, rather than asubordinate.
USESANDLIMITATIONSOFFINANCIALACCOUNTING
Invaluingassets,G&Dseem
to relystrictlyonaclassifiedbalance sheet produced inaccordance with GenerallyAccepted AccountingPrinciples (GAAP). Thus,inventory is viewed as acurrent asset and realproperty as a fixed asset. InFF, we focus more on whatthenumbersmeanratherthanwhat they are, and theanalysistendstogetdifferentresults. In thecaseofa retail
chain, which is a goingconcern, inventories usuallyarea fixedassetof theworstsort—subject to markdowns,shrinkage, obsolescence, andmisplacement. On the otherhand Class A, fully leasedincome-producing officebuildings tend to be currentassets, probably an areawherepriceagreementcanbereachedviaonephonecall.For FF, GAAP in the
United States is an essentialdisclosure tool, the bestobjective benchmarkavailabletotheOPMIanalystin the vastmajority of cases.However, GAAP and relatedaccounting measures,unadjustedbytheanalyst,arealmost alwaysmisleading, inonecontextoranother.G&Dstress the importance
of adjusting GAAP todeterminetrueearnings fora
period. In FF, the analystalways adjusts GAAP, notonly to determine earningsfrom operations, but also todetermine creditworthinessandassetvalues.GAAP recognizes three
classifications on the right-hand side of the balancesheet: liabilities, redeemablepreferred stock, and networth.Ineconomicfact,therearemany liabilities that have
anequitycomponent.Itisupto the analyst to decidewhatpercentages of certainliabilities are close toequivalent to payables andwhatpercentagesareclosetoequivalenttonetworth.Takethe liabilityaccount,deferredincome taxes payable, in agoing concern. If the cashsaved from deferring incometaxes is invested indepreciable assets, the tax
may never become payable.However, the deferred taxpayableaccountcanneverbeworth as much as tax paidretained earnings (part of networth) because the tax maysomeday become payable,especially if the companyengages in resourceconversion activity, such asbeingacquiredinachangeofcontrol transaction. So,maybe there is asmuch as a
90percentequityvalueinthedeferred income taxaccountspayable. On the other hand,deferred income taxespayablecanneverbeasmuchof a liability as currentaccounts payable or interest-bearing debt. Maybe, at themaximum, there is a 5 to 10percentequityinthedeferredtaxpayableaccount.GAAPisbasedonarigidsetofrules;itisno longerprinciplesbased.
The appraisal of an account,suchasdeferredincometaxespayable, is intheprovinceofthe users of financialstatements, not the preparersoffinancialstatements.
SUBSTANTIVECONSOLIDATIONMost OPMIs involved withcommon stock believe in
substantively consolidatingthe company with itscommon stock owners. Theybelieve they are buyingGeneral Electric (GE), notGEcommonstock.InFF,thecompany is a standalone,separate and distinct from itsshareholders, itsmanagement, its controlgroup, and its creditors.Essential for understandingthe dynamics of many
companies are not onlyconsolidated financialstatements but, also, howfinancial statements areconsolidated. In many cases,itisimportanttoknowwhichliabilitiesofparticularparentsorsubsidiariesareassumedorguaranteed by othercompanies,which are part ofaconsolidation.
COMPENSATIONOF
PROMOTERSG&D seem utterly silentabout the compensation ofprofessionals and promoters,whichhastobeunderstoodifone is to understand WallStreet and/or corporatemanagements. Nothinghappens in the financial
community that does notentail huge transaction costsfor clients, whether thoseclientsareretail,institutional,or corporate. Hugetransaction costs for clientsmean huge transactionincomes for certain WallStreet participants who incurrelativelysmallcoststocreatethose incomes (i.e., theearning, by these promotersand professionals, of excess
returns).Excess returnsare far from
the exclusive province ofWall Street. Excess returnsalso seem to be earnedrelatively persistently by topcorporate executives. Theseexecutives include not onlyprincipal owners, or soleownersofbusinesses,butalsoprofessional managementsthat may not be significantcorporatestockholders.
Economists have it wrongwhen they say, “There is nofreelunch.”Whattheyshouldsayis,“Somebodyhastopayfor lunch.” Those who mostcommonlypayareOPMIs.
DOSTOCKMARKETPRICES
REFLECTCORPORATEVALUES?
While ignored by G&D, weareof thestrongopinion thatcommon stock prices neverhave to be rational in theabsence of catalysts that arethe bedrock of resourceconversion. The mostimportant catalyst seems to
be changes of control and/orpotential changes of control.In a conservative, non-control, FF investment, thecommon stocks thatwe havepurchased are those of blue-chip companies selling atsubstantial discounts fromreadilyascertainablenetassetvalues (NAV). The exitstrategies are based on thebelief that NAVs will growover the next three to seven
years and that the discountsfrom NAV will not widenmaterially.Without catalysts,though, it appears as if thediscounts fromNAV are justa random walk at anyparticulartime.Where there are no
prospects for changes ofcontrol or no Wall Streetsponsorship (induced bygenerous compensationarrangements for managers
and securities sales persons),prices in OPMI markets canbe utterly irrationalpersistently. The very bestcompanies whose commonstocksarepubliclytradedandwhere no catalyst existsusually sell at discounts toNAV. Sometimes thesediscountsfromNAVreach60percentorgreater.Many of these companies
are extremely well financed
and have most impressivelong-term records ofincreasing NAVs andearnings per sharepersistently. Such companiesinclude Brookfield AssetManagement, CapitalSouthwest, Investor AB, andCheung Kong Holdings. Incontrast, there is a hugemarketforprivateequitythatOPMIs spend billions ofdollarstogetintoandthatare
priced at substantialpremiumsaboveNAV.Theseare the hedge funds.Typically their premiumsabove NAV are reflected inthepresentvalueofpromotespaidtohedgefundmanagers.Thosepromotesnormallyrunto 2 percent of assets undermanagement plus 20 percentof annual profits after theOPMIs receive a preferredreturn of, say, 6 percent.
Further, lengthy lock-upperiods tend to exist forOPMIs owning hedge funds,while the publicly tradedcommon stocks cited aboveare all marketable. From avalue point of view, theredoes not seem to be anyrational reason why thepublicly traded issuesmentioned above should sellat steep discounts, while thehedge funds are priced at
premiums.In FF, potential resource
conversions, catalysts, andaccess to capital markets areincluded in the valuationprocess. FF puts a greatpremium on the value ofcontrol,somethingignoredbyG&D. Asset values are veryimportant insofar as they arereadilyascertainableandexistin well-financed companies.Asset values are of limited
importance incompanies thatare not well financed andwheretheprincipalassetsaresinglepurpose,usefulonlytoa going concern. These assetvaluescanhaveapositiveornegativeeffectonunderlyingvalue. They can help predictthat future earnings will behigh based on an ROEanalysis (book value equalsE), or they can indicate, andoften do, very high overhead
and very high fixed costs. Alargebookvalueisanegativefactor where the book valueconsists largely of single-purpose assets, which arecostly to keep open, surplus,or obsolete. In the early2000s this described manyU.S. automobile assemblyplantsandsteelmills.
TRADE-OFFS
Therearealwaystrade-offsinFF investing. For example, astrong financial position in2011 means one is dealingwithamanagementwillingtosacrificereturnsonequity,forthe safety and opportunisminherent in a strong financialposition. Also, and this is apossibility that G&D do notconsider, there are incentivesfor certain control people topreferlowpricesforpublicly
tradedcommonstocks:1. Those doing estateplanning.2. Those contemplatingtaking the companyprivate, including LBOs.Going private entailscashing out publicshareholders. To goprivate two conditionshavetobefulfilled:
a.Low-to-reasonableprice.
b.Strong finances—usually by thecompany itself, or itcouldbeby thebuyerorboth.
3. Control person isinsulatedfromchangesincontrol.
MODERNCAPITAL
THEORYVERSUS
GRAHAMANDDODD
MCT, like G&D, is focusedon looking at economic andfinancialphenomenafromthepoint of view of OPMIs.UnlikeG&D,theentirefocusof MCT is on near-term
changes in market prices.MCT operates on the falseassumption that markets areefficient for all participants.Unlike one of G&D’s greatconceptual teachings, MCTdoes not distinguish betweenmarket price and intrinsicvalue.Whenitcomestocorporate
finance, MCT offers avaluable approach to projectfinance, but contributes little
to corporate finance asvisualizedbyFFparticipants.The concept of net presentvalue (NPV) is essential forunderstanding projectfinance.Foraprojecttomakesense,estimatesofthepresentvalue (PV) of cash flowsgeneratedbytheprojecthaveto exceed the PV of cashcosts of the project. In termsof corporate finance, therecan be other reasons for
undertaking (or notundertaking) a project thanpositive(ornegative)netcashgeneration.In terms of capitalization,
mostMCTbelievers sign offon the Modigliani-MillerTheorem that if amanagement is working inthe best interest ofshareholders, thecapitalization is a matter ofindifference.TheModigliani-
MillerTheoremisanabsolutenonstarter in FF. One can’tmeasure creditworthinesswithout also appraisingcapitalizations.In FF, quarterly earnings
reports tend to lacksignificance. However, thereare instanceswhere quarterlyearnings reports can beimportant. This tends to bethe case for most poorlyfinanced companies, which
need virtually continualaccess to capitalmarkets. FFand MCT tend to coalescewhendealinginsudden-deathsecurities or absolutelycreditworthydebtobligations.Suchsecuritiesseemaspecialcase and encompass thefollowing:
1. Credit instrumentswithoutcreditrisk2.Derivatives3. Risk arbitrage, with
risk arbitrage defined assituations where there islikely to be a relativelydeterminantworkout inarelatively determinantperiodoftimeInmuchofwhatMCTand
G&D do, the goal is toestimate the probable effectofcertain itemsonnear-termmarket prices in OPMImarkets. Thus, G&Demphasize the importance of
determining “true” earningsfor a period. In contrast, forFF, the possible or probableeffectonOPMImarketpricesis pretty much ignored inmost, but not all, cases.Rather, the goal is tounderstand the underlyingvalues of a business as wellas the business’s dynamics.Suchunderstandingrequiresastudy not only of flows—whether cash or earnings—
but also, resource conversionpossibilities,access tocapitalmarkets, and the quality andmotivations of managementandcontrolpersons.As we practice it, value
investing is a component ofFF that stresses intellectualrigorandalongtimehorizon.The contributions ofGrahamand Dodd to this approachhave been valuable, but theyareonlypartofamuchricher
story.
SUMMARYValueinvestingisoneareaoffundamental finance (FF). Itinvolves investments inmarketable securities bynoncontrol outside passiveminority investors (OPMIs)using a fundamental financeapproach to analysis. TheotherareasofFFaredistress
investing, control investing,credit analysis, and first- andsecond-stage venture capitalinvesting. Graham and Doddmade four very importantcontributions to valueinvesting: (1) they clearlyarticulatedausabledefinitionof investing as opposed tospeculation; (2) theydistinguishedbetweenmarketprice and intrinsic value (aconcept that still seems alien
toMCT); (3) they pioneeredtheconceptof investingwitha margin of safety, and (4)they promulgated the beliefthat investment decisionsought to be based onascertainable facts. In thischapterwebrieflysummarizeand discuss the substantivedifferences between the safeand cheap approach to valueinvesting and the approachadvocated by Graham and
Dodd._______________*Thischaptercontainsoriginalmaterialandmaterialcontainedinthe20114Qlettertoshareholders.1BenjaminGraham,TheIntelligentInvestor:AGuidefortheGeneralReadertoWiseInvestmentPracticeUnderToday’sFinancialConditions,First
Edition(NewYork:Harper&Brothers,1949).LaterrevisededitionswererenamedasTheIntelligentInvestor:ABookofPracticalCouncil.2TherelevantlawsandregulationsarethefederalsecuritieslawsadministeredbytheSecuritiesandExchangeCommission:theFederalSecuritiesActof1933asamended,the
SecuritiesExchangeActof1934asamended,theInvestmentCompanyActof1940asamended,theInvestmentAdvisersActof1940asamended,theTrustIndentureActof1939,andtheSecuritiesInvestorsProtectionActof1970.3Thetermblueskystatutesreferstostatestatutesgoverningthetermsandconditionsonwhich
offeringstosellsecuritiestothepublicortobuythemfromthepubliccanbemadeinthatjurisdiction.
CHAPTER17
AcademicFinance:
ModernCapitalTheory*
TheMCTPointofViewEquilibriumPricingIsUniversallyApplicableTheOutsidePassiveMinorityInvestorIstheOnlyRelevant
MarketDiversificationIsaNecessaryProtectionagainstUnsystematicRiskSystematicRiskExistsValueIsDeterminedby
ForecastsofDiscountedCashFlowsCompaniesAreAnalyzedBasicallyasGoingConcerns;InvestorsinMarketableSecuritiesAre
AnalyzedasInvestmentCompaniesInvestorsAreMonolithic:TheirUnitaryGoalIsRisk-AdjustedTotalReturn,EarnedConsistently
MarketEfficiencyMeansanAbsenceofMarketParticipantsWhoEarnExcessReturnsConsistentlyorPersistentlyGeneralLaws
AreImportantRiskIsDefinedasMarketRiskMacroConsiderationsAreImportantCreditorControlIsaNonissueTransactionCostsAreaNonissue
FreeMarketsAreBetterthanRegulatedMarketsTheOutsidePassiveMinorityInvestorMarketIsBetterInformedthanAnyIndividual
InvestorMarketsAreEfficientoratLeastTendTowardanInstantaneousEfficiencySummary
Aswehaveexplainedearlierin thisbook,our approach tovalueinvestingentailsbuyingwhatissafeandcheapbyanoutside passive minorityinvestor (OPMI). Thetechniques used in valueinvesting are the same orsimilar to those used incontrol investing and distressinvesting. All three involvefundamental finance (FF).Two areas of FF involve
passive investing: valueinvesting and credit analysis.TheotherareasofFFinvolveactiveinvestingandobtainingcontrolorelementsofcontrolin distress investing, controlinvesting, and primary andsecondary venture capitalinvesting. In contrast tofundamental analysis,academic finance is focusedonmarketpricesinorganizedmarkets rather than
fundamental analysis wherethefocusistheunderstandingof a business and thesecurities issued by thatbusiness.InFF,what is refers to the
use of analytic techniquesthatconcentrateontheknownsituation of a company—thequality and quantity ofresources inacompany,withlittle or no concentration onforecasts of relatively near
termflows(say,overthenext12 months), except forsudden-deathevents.Safe refers to the
survivability of a business asa business (or securitiesissued by the business)without any referencewhatsoever to price volatilityofthesecuritiesissuedbythatbusiness. Safety is measuredmostly by strong financialpositions; by the quality of
resources, if the investor isinterested in such juniorsecurities as common stocks;by strong covenantprotections; and byreasonable quantitativecharacteristics in terms ofasset coverage or earningscoverage, or both, if theinvestor is interested inowningcorporatedebt.Cheapmeansanacquisition
priceforacommonstockthat
appears to represent asubstantial discount fromwhat the common stockwould be worth were thecompany a private businessor a takeover candidate. Inthecaseofadebtinstrument,cheap means an estimatedyield-to-maturity,oryield-to-workout, that is at least 500basis points greater thancould be obtained from acredit instrument bearing
about the same level ofultimatecreditrisk.InNovember1998,Toyoda
AutomaticLoomWorks,Ltd.(since renamed ToyotaIndustries) common stock,listed on the Tokyo StockExchange, appeared to be agood example of a commonstockthatwassafeandcheapbasedonwhat is because thecompany was well financedand represented a way of
buying into the commonstock of Toyota Motor, ablue-chip automotivemanufactureratadiscountofperhaps 35 to 40 percent.Toyota Industries commonwas trading at about 2,300yenpershare,orabout$16.5to $17 U.S. dollars. Itsadjusted balance sheet,expressedinU.S.dollars,wasasshowninTable17.1.Table17.1BalanceSheetfor
ToyotaIndustriesCorporation(AdjustedNAVin$000s)
In 2012, many commonstocks of well-financedcompanies were selling atreadily ascertainable
discounts. Such commonstocks included CapitalSouthwest, Investor AB,Cheung Kong HoldingsCompany, Henderson LandDevelopment, and Wheelock& Company as well asToyotaIndustries.Believersinmoderncapital
theory(MCT)asembodiedinthe efficient markethypothesis (EMH) andefficient portfolio theory
(EPT) never would havevalued Toyota Industriesoperations and the ToyotaIndustries portfolio ofmarketable securities in thefirst place. That is not whatthey do. EMH and EPTanalysis would have beenrestricted to studyinghistorical market prices forToyota Industries commonand perhaps historical ratiosof price to earnings or cash
flow. If the discount ofmarket price for ToyotaIndustriescommonrelativetoToyota Industries net assetvalue (NAV), which wasbased largely on the marketvalue of securities held inToyota Industries’ portfolio,were to be explained, theexplanation would probablyrevolve around investorexpectations. Furthermore,the discount would probably
be viewed as irrelevant, notrelatedatall toeitherToyotaIndustries cash flows or theoutlook for the Tokyo StockMarket. These two factorswould have been deemedmuchmorelikelytoinfluencethe near-term priceperformance of ToyotaIndustries common thanwould be the existence of alarge discount from workoutvalue.
In November andDecember 1995, Kmartsenior unsecured debenturesandtradeclaimsseemedtobegood examples of creditinstruments that were safeand cheap based onwhat is.On average, these seniorissues traded in public andprivate markets at pricesaveraging around $74. Theseinstruments had averageyields to maturity of around
18percent inamarketwhereBB industrial credits weretrading at yields to maturityofaround9percentandBBBobligations were trading atyieldstomaturityofaround8percent. BBB is the lowestgrade credit that Standard &Poor’s, as a rating agency,defines as InvestmentGrade.Standard & Poor’s defines aBBB credit as follows: “AnobligationratedBBBexhibits
adequate protectionparameters.Howeveradverseeconomic conditions orcharging circumstances aremore likely to lead to aweakened capacity of theobligor to meet its financialcommitmentontheobligation(as compared with creditsrated AAA, AA, or A).Obligations rated BB, B,CCC,CC,andCareregardedas having significant
speculative characteristics.”BB is the highest-gradeobligationtobecharacterizedasspeculative.It was problematic at the
time as to whether Kmartwould have to seek reliefunderChapter11of theU.S.Bankruptcy Code. If KmartdidseekChapter11relief,allcash service on the Kmartunsecured debt would cease.The odds, however, seemed
good that if Kmart ever didenterChapter11,theworkoutvalues for these Kmartinstruments in areorganization would be atleast $100 or more likely$100 plus accrued interest.This confidence in theultimate workout was based,ingreatpart,on the seniorityenjoyed by these unsecureddebentures and trade claims.Therewerenosecuredcredits
outstanding.MCT probably would not
be involved at all in thespecific analysis of KmartDebt—or other issues ofdistressed debt—in terms ofdetails about covenants andreorganizationprocesses.TheMCT analysiswould revolvearoundstudiesofthemarketsfordistresseddebtandmacrostatistics about overall ratesofmoneydefaults.1
THEMCTPOINTOFVIEWThe previous section is onlyan example of the vastdifferences in approachbetweenavalue investorandthosewhosubscribetoMCT.In value investing, securitiesare examined from multiplepoints of view, including thecompany itself and controlshareholders. By contrast,
MCT looks at securitiesanalysissolelyfromthepointof view of outside passiveminorityinvestors(OPMIs).MCT appears to be useful
in describing a special casewithtwocomponents:
1. The sole object of themarket participant is tomaximize a (market)risk-adjusted total returnconsistently (i.e., all thetime) realizable in cash
by sale to the OPMImarket.2. There is a need toexamineonlyarelativelyfew variables inanalyzing a security orcommodity. In thesecurities arena, issuesanalyzable by referenceto only a few computer-programmable variablesseem restricted to thefollowing:
Credit instrumentswithout credit risk(e.g., U.S.treasuries).Derivative securitiessuch as convertibles,options, andwarrants. (Thevalues forderivatives aredeterminedbypricesof other securitiesrather than by any
analysis of theunderlying valuesattributable to asecurity, such as acommonstock.)Risk arbitragesecurities where theworkouts are shortrun (i.e., there arerelativelydeterminantworkouts withinrelatively
determinant periodsof time such aswhere there is anoutstanding tenderoffer, anoutstandingvoluntary exchangeof securities, or amerger transactionsubject to ascheduledstockholdervote).
The basic problem withMCTisthatittriestomakea
general law out of what isreally a very narrow specialcase.MCT teachings are notvery helpful for valueinvesting, where the analysisbecomes relativelycomplicated regardless ofwhether the object of theanalysis involves corporatecontrol factors or buy-and-hold passive investing.Indeed, the underlyingassumptions governing the
EMH and EPT are eitherdownrightwrongorjustplainmisleading for valueinvesting purposes. Sincemany (if not all) of thesebeliefsaresopervasiveintheaccepted conventionalwisdom, we had to discussmany of them in otherchapters of this book.However, we thought thereader would benefit from abrief discussion of many of
them.Suchbasicassumptionsof MCT focus on thefollowing20differentbeliefs:
1. Substantiveconsolidation is of primeimportance(Chapter3).2. Structuralsubordination is asignificant factor(Chapter3).3. Equilibrium pricing isuniversallyapplicable.4. The OPMI market is
the only relevant market(Chapter14).5. Diversification is anecessary protectionagainst unsystematic risk(Chapter13).6.Systematicriskexists.7.Valueisdeterminedbyforecasts of discountedcash flow (DCF)(Chapters2,5,and6).8. Companies are
analyzed basically asgoingconcerns;investorsin marketable securitiesare analyzed asinvestment companies(Chapter2).9. Investors aremonolithic:Their unitarygoal is risk-adjusted totalreturn, earnedconsistently.10. Market efficiencymeans an absence of
market participants whoearn excess returnsconsistently orpersistently(Chapter14).11. General laws areimportant.12. Risk is defined asmarketrisk(Chapter8);13.Macro considerationsare more important thanbottom-upanalysis.14. Creditor control is a
nonissue(Chapter7).15. Transaction costs areanonissue.16. Free markets arebetter than regulatedmarkets(Chapter14).17. The OPMImarket isbetter informed than anyindividualinvestor.18. Markets are efficientoratleasttendtowardaninstantaneous efficiency
(Chapter14).19. Focus is onimmediate outlooks, thatis, short-termism.(Chapter2).20. There exists aprimacy of the incomeaccount as measured byearnings or cash flows(Chapters2,11,19).
EQUILIBRIUM
PRICINGISUNIVERSALLYAPPLICABLE
William F. Sharpe, a Nobellaureate and a typicalefficient-market believer,stated in the third edition ofhis book Investments that ifyou assume an efficientmarket, “every security’sprice equals its investment
value at all times”.2 Thisobservation could notpossiblybemoreincorrectormore misleading for value-investingpurposes.Forvalueinvesting, an OPMI marketprice, especially for acommon stock, does notnecessarily have anyrelationship to the price thatought to prevail were thesecurity to be analyzed asissuedbyacompanythatisto
be involved in mergers andacquisitions (M&As), hostiletakeovers, going-privatetransactions, or liquidations.Notonlyistherenonecessaryrelationship between pricesthatprevail inOPMImarketsand prices that prevail inothermarkets(e.g.,leveragedbuyout [LBO] markets), butthere ought not to be anyrelationship because by andlarge, different factors (e.g.,
borrowingabilityversusnear-term reported earnings) areused to determine value inthese discrete markets, andinsofarasthesamefactorsareused (e.g., availability ofcontrol versus dividendpolicy), they are weightedquitedifferently.There are even differences
in pricing within valueinvesting itself. Appropriateprices will differ depending
onwhetherthevalueinvestorisinvolvedwithpassivevalueinvesting, risk arbitrage, orcontrol investing. Withincontrol investing, pricingparameters tend to varydepending on whether thecontrol buyer is primarily afinancial buyer or a strategicbuyer. Strategic buyersgenerally can afford to paymore.Value investing is an
offshoot of control investing.In value investing, a passiveinvestor makes use of thesame variables andphenomena in makinginvestment decisions as doesthe activist, except that thepassive investor is not goingto have any elements ofcontrol thatwouldpermit thecreationofextravaluefortheinvestor in the forms ofvarious edges described in
Chapter22:somethingoffthetop (SOTT), such as salariesand perks; an ability tofinance personal positions onan attractive basis, as withotherpeople’smoney(OPM);and an ability to undertakeattractive income taxplanning through tax shelters(TSs). The value investortherefore ought to be a lotmorepriceconsciousthanthecontrol investor, since the
latter isofteninapositionofbeing able to create excessbenefits and excess returnseven when overpaying, bymanystandards,forparticularassets.Putotherwise,asfarasprice is concerned, controlinvestors andOPMIs operatein different markets withdifferentpricestructures.To assume equilibrium
pricing for all purposes andallmarkets is to put yourself
in a straitjacket precludingyourundertakinganyanalysisof most of what goes on inthe financial community—M&As, IPOs, LBOs, andcontestsforcontrol.To be involved with value
investing, whether as acontrol person or a valueinvestor, you had best obtaindetailed knowledge aboutbottom-up fundamentalfactors affecting companies,
aboutsecurities,aboutcapitalmarkets, and aboutgovernment regulations andlaws. Moreover, in manysituations, you should alsoobtain elements of controlover companies; over theprocesses companies gothrough,oroverboth,orelsedecline to make anyinvestment at all. Forexample, getting someelements of control over the
reorganization process, evenifonlyanegativeveto,canbealmostessentialforsuccessinChapter 11 investing. This isin contradistinction to MCT,in which the focus is on thebehavior of securities pricesand markets rather than onobtainingdetailedknowledge(and maybe even influence)aboutthecompaniesinwhichyoumightinvest.Risk arbitrage is an
investment process involvingworkoutsofsecuritiesthatareexpected to create relativelydeterminant values inrelativelydeterminantperiodsof time. One feature thattends to distinguish riskarbitragefromvalueinvestingis that although both arepassive, investors would beunable to participate in riskarbitrage markets in generalunlesstheyarewilling topay
up. Risk arbitrage marketstend to have pricing muchmore attuned to MCT-typeefficiencies than do valueinvesting markets. In valueinvesting, a buy-and-holdstrategywithoutdeterminableworkouts, investors desiringto earn excess returnspersistently might not bewilling to pay more than 50percent of what they believethe present value of the
security would be in aworkout or takeover. Bycontrast, persistent excessreturnsmightbeavailableforrisk arbitrageurs whosepricing is equal to 90 to 95percentofanestimatednear-termworkoutvalue.In MCT, there is a belief
that markets are efficient or,moreaccurately,thatmarketstend toward an instantaneousefficiency.Invalueinvesting,
thereisalsothebeliefthatallmarkets tend towardefficiency. In numerousmarkets, though, thattendency toward efficiencymay take a long time tobecome effective, and thereare frictions that maypreclude those efficienciesfrom ever becoming evident.For example, investors thinkthere are long-termtendenciesthatoughttoresult
inamaterialshrinkageinthediscount at which ToyotaIndustriescommonsellsfromits NAV, but they do notknow about how long it willtake for the discount tonarrow, the form it will take(could or would ToyotaIndustries spin off into aninvestment company itsportfolio of marketablesecurities?), or if it willhappenatall.Here, thelong-
term tendency towardefficiencyisquiteweak.Asamatter of fact, in ToyotaIndustries–typesituations,thesecurity is deemed to beattractive not because of aprediction that the marketprice will become efficient(i.e., reflect underlyingvalues) but rather because atthe price paid, theprobabilities that excessreturns will be earned over
the long term with relativelylittleinvestmentriskoughttobeprettygood.In simple trading situations
(e.g., risk arbitrage), thetendency towardefficiency isvery strong and tends verymuch to be instantaneous.Concerningthestatementthatcertain markets tend towardinstantaneous efficiency,thereisnoargumentbetweenvalueinvestingandMCT,but
abouttheMCTstatementthatall or most markets tendtoward instantaneousefficiency, value investorsdisagree.IntheEMH,thedescriptive
adjective is consistently; invalue investing, it ispersistently. Persistentlymeans amajorityof the timeand on average over a longperiod;consistentlymeansallthe time. In value investing,
the participant deals inprobabilities, never incertainties.In academic finance, there
seems to be just one rightprice for a security, but invalue investing, the rightpricecancoverawidegamut.Afairpriceinvalueinvestingwould be defined as thatprice, and other terms, thatwould be arrived at afterarm’s-length negotiations
betweenawillingbuyerandawilling seller, both withknowledge of the relevantfacts and neither under anycompulsion to act.3 The onesine qua non that causes anOPMIstockholder tobecomeawilling seller is a premiumabove OPMI market price;the one thing that causes acontrol buyer to become awilling buyer is a value forthe control of the company
that is more than the all-inpricethecontrolbuyerhastopay. Often the spreadbetweenawillingsellerpriceandawillingbuyerpricecanbe—andoughttobe—huge.Trying to gauge timing,
especiallyaboutgeneralstockmarket levels, seems animportant consideration inMCT. In value investing, theinvestor does not gaugetiming but rather takes
advantage of whatever themarket situation happens tobe at that time. For MCT,timing is crucial; investorsmust gauge when pricesmight change in OPMImarkets. One of the greatadvantages of valueinvesting, especially forcontrol people involved withwell-financed companies, isthat as activists, they tend toobtain complete control of
timing in terms of decidingwhentogopublicorwhentogo private. For noncontrolinvestors holding a portfolioof securities selected usingvalueanalysisprecepts, thereseemstobeastrongtendencytoward being indifferent totiming. If the fundamentalanalysis is good enough,market performance will beokay, if not for individualissues, then for portfolios
consisting of five or moredifferent issues. Putotherwise, if marketperformance for the portfolioisunsatisfactory,itwouldnotbe because of poor markettimingbut ratherbecause thespecific analyses using valueinvesting techniques wereflawed.Special problems exist for
the EMH given theconcentration on OPMI
market price as a universalmeasureoftruevalue:
TheEMHfailstodistinguishbetweenanunrealizedmarketlossandapermanentimpairmentofcapital.InEMH,theyareoneandthesame.TheEMHfailstodistinguishbetweenapaperprofitandaninabilitytocashinon
gainsformanynon-OPMIactivists,suchasmanagementsofcompaniesthathavejustgonepublicviaanIPO.TheEMHfailstounderstandthehugepopulationofOPMIinvestorswhoseneedsaremetbyacontractuallyassuredcashincomefrominterestpaymentsrather
thanfromtotalreturn.Forexample,thevastmajorityofinvestorsintax-freebondshaveaprimaryinterestintheincomegeneratedfromholdingthosebondsratherthaninmarketprice.Indeed,mostinvestorsintax-freebondsholdsuchinstrumentsaslockupsandtendtobeoblivious
towhatmarketpricesmightbe.Tax-frees,alsoknownasmunis,areahugemarket.Thesearebondsissuedbystateandlocalgovernmentsandtheiragencies.AsofMarch2012,approximately$3.7trillionprincipalamountofmuniswereoutstanding.4TheEMHadopts
unrealisticviewsinsuchmattersasemployeestockoptions.Invalueinvesting,andaccordingtocommonsense,thevalueofastockoptionbenefittoarecipientofthoseoptionsclearlyhasnonecessaryrelationshiptothecosttothecompanytoissuetheoptions.IntheEMH,thereisa
failuretounderstandthatmarketpricesself-correctovertimeforperformingloanswithcontractualmaturitydates.
Forvalueinvesting,agivenprice for a security canrepresent both a tendencytoward inefficiency in onemarket and a simultaneoustendencytowardefficiencyinanothermarket.Forexample,examine the price behavior
for the 6265 publicly tradedclosed-end investmentcompanies registered underthe InvestmentCompanyActof 1940, as amended as ofDecember 31, 1997. These626 issuers’ assets consistedby and large of onlymarketable securities. Mosthave all common stockcapitalizations, their expenseratios are limited because ofregulation, and many, if not
most,aremanagedbymutualfund managers. Prices formutual fund shares arealwaysatleastequaltoNAV(as measured by the OPMImarketpricesof assets) or atpremiums of up to 9 percentaboveNAV because of salesloads.Over80percentof theclosed-end investment-trustcommon stocks in contrasttradeatadiscountfromNAVand have traded at discounts
consistently. This stronglydemonstrates a tendencytoward inefficiency in theOPMI market. If the OPMImarket were efficient in allcontexts,themarketpricesofthe closed-end commonstocks would equal preciselythemarketvalueoftheassetsoftheclosed-endfunds,sincetheseassetsconsistwhollyofmarketable securities just asis the case formutual funds.
This is the case for no-loadmutual funds, not because ofany external marketefficiencies but because themutual funds offer andredeem common shares atNAV; there are no othermarkets for mutual fundshares. At almost no time,however, have any of theseclosed-end investment-trustcommon stocks sold at adiscount of as much as 35
percent below NAV. Thisdemonstrates a tendencytoward efficiency in thehostile takeover marketbecause if shares wereavailable at much greaterdiscounts, hostile takeoversmight make sense, evengranting that it appears thatevery closed-end fundcurrently in existence hasadopted significant sharkrepellents (management
entrenchment devices thatinsulate incumbent controlpeople).Academic theories that
OPMI prices are right, orcorrect,pricesinnonarbitragemarkets and therefore goodallocators of resourcesrevolveinpartaroundaviewthat if the OPMI price iswrong, sophisticatedinvestors who know realvalue will come into the
OPMI market and, throughtheir buying, make the priceright or correct. Such a viewignores the fact thatmany, ifnot most, sophisticated long-term investors and insidersviewuntrainedOPMIs tryingto outperform the marketconsistently as a populationto be exploited in going-public or going-privatetransactions and in providingto insiders SOTT, such as
huge executive compensationpackages. Such a view alsomisconceives whatsophisticatedinvestorsdoanddo not do. First, they do notnecessarily buy in OPMImarkets.Manyacquireequitypositions not by buyingcommon stocks in OPMImarkets but rather byreceiving, for no monetaryconsideration,executivestockoptions exercisable at the
OPMI market price existingat the date the options weregranted. Insiders generallywant OPMI market prices tobelowonthedateoptionsaregranted, but most wouldprefer to receive optionswhen a company is privateand the exercise price of theoption might be book value,ratherthanafterthecompanygoes public in an IPO at aprice that might be 5 to 10
times book value. Mostsophisticated controlinvestors probably wouldnever be interested inpurchasing any commonstock in theOPMImarket atany price if that commonstockdidnotdeliverelementsof control over the business.Rather, these people, andinstitutions, engage incontrol-type transactionsawayfromtheOPMImarket,
which gets for thempromoters’ compensations inthecontextof:
MergersandacquisitionsHostiletakeoversGoingpublicGoingprivate,LBOs,managedbuyouts(MBOs)RestructuringtroubledcompaniesCompensationforpassivemoney
managementIn contrast to the
conventional other financialdisciplines, an underlyingtenetofvalueinvestingisthatformostpurposesmostofthetime, many common stockprices in OPMI markets areeither going to be far aboveliberal estimates of whatcorporate values would be ifnoOPMImarket existed andthat many other common
stockpricesinOPMImarketsare going to be far belowconservative estimates of thecorporate values that wouldexist for private businessesand takeover candidates. Inan active world, controlpeople and quasi-controlpeople arbitrage thesedifferences between OPMIpricing and corporate values.When very high OPMImarketpricescanberealized,
newissuesaresoldtoOPMIsas IPOs and, say, real estatetax shelters. The dotcombubble, before it burst inearly 2000, was an exampleofcrazyhighpricesforIPOs.In 1996, it seemed as ifmedical device companiesthathad receivedpreliminaryFood and DrugAdministration (FDA)approvalmightreceiveapre–public offering value, based
on the price at which theissuer was to go public, fortheir equity of as much as$100million,eventhoughthebusinesses had virtually norevenues and were reportinglosses.WhenverylowOPMIprices exist (probably incombination withcorporations’ beingreasonably well financed),existingcommonstockissuesare acquired from OPMIs in
going-private, M&A, andhostile takeover transactions(e.g.,the1990LBOofBigVSupermarkets).For the vast majority of
firms(electricutilitiesusedtobe a notable exception), thevariables used to value abusiness are different fromthose used to evaluate acommon stock trading in anOPMI market. When thesame variables are examined
—say,thenear-termearningsoutlook—their importance isweightedquitedifferently,sothere is no basis forconcludingthatOPMImarketprice is the best or even areasonable measure ofcorporatevalue.
THEOUTSIDEPASSIVE
MINORITYINVESTORISTHEONLYRELEVANTMARKET
ForMCT, there seems to bebut one relevant market: theOPMI market. In valueinvesting, there are myriadrelevant markets, including
thefollowing:Outsidepassiveminorityinvestortraders’marketOutsidepassiveminorityinvestorinvestmentmarketsMarketsforcontrolofcompaniesLeveragedbuyoutmarketsConsensualplanmarketsinChapter11reorganizations
CreditmarketsInitialpublicofferingmarketsMarketsforsettlementoflitigation
Efficient pricing in onemarket—the OPMI market,for example—is per seinefficient pricing in anothermarket—the takeover marketin value investing, forexample.Almost any controlbuyer seeking to obtain
control of a company whosecommonstockistradedinanOPMI market will have tooffer a premium over theOPMImarket prices if he orshe is to attempt to acquirecontrol using a cash tenderoffer or exchange ofsecurities. A premium, too,probably(butnotnecessarily)has to be paid by a controlbuyer acquiring large blocksof common stock for cash in
the open market or privatetransactions, or by a buyerusing corporate proxymachinery and acquiringcontrol through a voting,rather thandirectpurchasing,mechanism.The importance of market
pricevarieswiththesituationin value investing. Althoughmarket price may be all-importanttotheOPMIholderof common stock, it tends to
be far less important to theholder of control commonstock or to the unleveredholderofaperformingloan.
DIVERSIFICATIONISA
NECESSARYPROTECTION
AGAINSTUNSYSTEMATIC
RISKDiversification as a hedgeagainstunsystematic risk isacentraltenetofEPT.Itispartandparcelofthecapitalassetpricing model (CAPM). Forvalue investing,diversification is only asurrogate—usuallyapoorone
—for detailed knowledgeabout the corporation and itssecurities, control, and priceconsciousness and also, insome cases, ability to obtainattractive financing for atransaction.Whether a value investor
ought to concentrate ordiversify depends on howmuch knowledge, control,outside (preferablynonrecourse) finance, and
bargain pricing the investorcan obtain. Certainly,followers of the EMH oughtto diversify. The EMH isaddressedtothosewhostudysecurities market prices andhave no detailed knowledgeabout corporations, tononcontrol OPMIs, and topeoplewhoutterly lackpriceconsciousness because theyassumethattheOPMImarketprice is an equilibrium price
with universal applicability.That diversification seemsparticularly appropriate forMCT passivists, however,does not mean thatdiversification is alsocompletely inappropriate forothers. Following is aninvestormatrixdescribing, ingeneral terms, groups andindividuals that shouldconcentrate (top) to those(bottom) that should
diversify:Businessschoolgraduateusingallhisorherresources—personalandfinancial—tostartupanewbusinessheorshewillheadAcompany,nowinonelineofbusiness,thatisundergoinganM&ALeveragedbuyoutfundVenturecapitalfundInvestorsinhigh-grade
performingloansseekingreasonableamountsofcashincomeKnowledgeablevalueinvestorsKnowledgeableriskarbitrageursTypicalOPMIsInvestorsusingtheteachingsofMCT
SYSTEMATIC
RISKEXISTSPartofEPT is thebelief thatsystematic risk—commonfactors that will affect allcompanies whose commonstocks are publicly traded—exists. Such factors includethebusinesscycle,changesinmarketindexes,interestrates,and inflation.Systematic riskalso is a nonstarter for valueinvesting. Each of the above
factors has different effectson different companies andthe securities issuedby thosecompanies. A severeindustry-wide depressionhelped rather than hurtNabors Industries in the late1980s. Nabors, whichenjoyed strong finances, wasabletoacquireahugefleetofoil and gas drilling rigs on abargain-basement basis, ingreatpartbecausevirtuallyall
its competitors hadquestionable financialstrength. Reduced marketpricesinthe1970s,causedbyweak general markets,permitted Crown Cork andSeal to repurchase its owncommonstockatmuchmoreattractive prices than wouldhaveotherwisebeenpossible.General inflation and the
increased costs associatedwith it probably would
prevent a lot of newcompetitorsandevenexistingcompetitors from spendingthehugeamountsofmoneyitwould take to become a newentrantoranexpandedentityin diesel engine manufacturein order to compete withCumminsEngine.Itissimplya gross oversimplification toassert that there existcommon factors that wouldaffect all American
businesses. This is the tenetunderlyingsystematicrisk.Systematic riskmay in fact
exist in a nonfinancialcontext.All corporations andall investors might farepoorly if the areas in whichtheyare located are rifewithpolitical instability andphysicalviolence.Thesehavebeen unrealistic scenarios forindustrialized countries,especially the United States,
which, it is hoped, willcontinuetobethecase.
VALUEISDETERMINEDBYFORECASTS
OFDISCOUNTEDCASHFLOWS
For MCT, the worth of acommon stock is the presentvalueoffuturedividends.Forvalue investing, by contrast,theworthofacommonstockis the present value of afuture cash bailout,whateverthe source of the bailouts.Cashbailoutscancomefromthebenefitsofcontrol,saletoan OPMI market,distributions to shareholders,orvariousconversionevents,
including sale of control ofthebusinessorrefinancingonattractiveterms.BrealeyandMyersstatedin
Principles of CorporateFinance,that“onlycashflowisrelevant”(p.96).6Theyarewrong, certainly for valueinvestingpurposes.Copeland,Koller, and Murrin stated inValuation—Measuring andManaging the Value ofCompanies, “the manager
who is interested inmaximizing share valueshould use discounted cashflow (DCF) analysis, notearnings per share, to makedecisions”(p.72).7
The vast majority ofprojects that make sensecreatepositivecashflowsfora corporate owner over thelifeof theprojectsviewedasstandalones. Very fewcorporations operating as
going concerns, however,ever create cash flowsconsistently.Indeed,mostarerelatively consistent cashconsumers that have tofinance thecashdeficits theycreate by obtaining outsidecapital, usually borrowings,on a regular basis. In valueinvesting, there are fourapproaches to wealthcreation,whicharediscussedin more detail in Chapters 5
and6.In any event, value
investing is founded on abalanced approach. Herethere is no primacy offorecasted future flows,whether cash or earnings.Rather, the interrelatedelements needed to ascertainvaluearequalityofresourcesin the business, quantity ofresources, and long-termwealthcreationpower.There
are four general interrelatedways to create corporatewealth using a valueinvestingapproach:
Cashflowsavailabletosecurityholders.Corporationsprobablycreatethisfewertimesthanmostpeoplethink.Earnings,withearningsdefinedascreatingwealthwhileconsumingcash.Thisiswhatmost
wellruncorporationsdoandalsowhatmostgovernmentsdo.Earningscannothavealastingvalueunlesstheentityremainscreditworthy.Also,inmostcases,inordertomaintainandgrowearningsthecorporationorgovernmentisgoingtohavetohaveaccesstocapitalmarketstomeet
cashshortfalls.Resourceconversions.Theseareasincludemassiveassetredeployments,massiveliabilityredeploymentsandchangesincontrol.Resourceconversionsoccuraspartofmergersandacquisitions,contestsforcontrol,thebulksaleorpurchaseofassetsorbusinesses,Chapter11
reorganizations,out-of-courtreorganizations,spinoffs,andgoingprivatesincludingLBOsandMBOs.Super-attractiveaccesstocapitalmarkets.Ontheequityside,thisincludesinitialpublicofferings(IPOs)duringperiodssuchasthedotcombubble.Onthecreditside,thisincludesthe
availabilityoflong-term,fixed-rate,non-recoursefinancingforincomeproducingcommercialrealestate.
COMPANIESARE
ANALYZEDBASICALLYAS
GOINGCONCERNS;
INVESTORSINMARKETABLESECURITIES
AREANALYZEDASINVESTMENT
COMPANIESFor modern capital theorists,businessesaretobeanalyzedas strict going concerns,engaged in continuingoperations, managed prettymuch as they always havebeen managed, financedpretty much the way theyalways have been financed.Valuations are based ondeterminingthepresentvalue
of estimated future flows,whethercashorearnings.Forvalueinvesting,though,
businessesaretobeanalyzedboth as going concerns andresource conversion vehiclesengaged in deploying assets,in redeploying assets, and inrefinancing activities,including M&As. Valuationsare based not only ondetermining cash or earningsflows but also on examining
the company’s separable andsalableassetsandgaugingthecompany’s prospects foraccessing capital markets atultra-attractivepricing.Corporate analysis is
complicated by theassumptionsthatnouniversalprice equilibrium exists; thatmost businesses areappropriately analyzed asboth going concerns engagedin day-to-day operations and
resource conversioncompanies employing andredeploying assets andfinancing and refinancingliabilities; and that mostbusinesses are likely, overtime, to engage (or beengaged) in such conversionactivities as M&As, hostiletakeovers,andgoings-private.Once a corporation is
viewed as a resourceconversion complex rather
than a strict going concern,then estimating future flows,whether cash or earnings,tends not to remain the sole,or principal, factor in avaluation. Rather, measuringthe quality and quantity ofresources existing at aparticular moment becomesimportant.Once it is assumed that no
universal price equilibriumexists, the form of
consideration paid maybecomemuchmoreimportantthan the nominal value of atransaction, as measured byOPMI market prices. Whichwould bemore valuable to acontrol seller, $100 millioncash or $180 million marketvalue of restricted commonstock of the acquiringcorporation?Besidesprice,inany merger or LBOtransaction, the following
factorswillalmostalwaysbeimportantconsiderations:
TaximpactonimportantpartiestothetransactionAcquirer’sabilitytofinancethetransactionAccountingtreatment,especiallyifthesurvivingcompanyistoremainpublicRepresentationsandwarrantiesofeachsideOthercontractterms
(e.g.,bust-upfees)ControlissuesastheyaffectcorporateexecutivesProbabilityandtimingofclosingthetransactionTransactioncostsFeasibilityofthesurvivingcorporationFinancialincentivestoinsidersProbableimpactsonOPMImarketprices
ProbablereactionsoftheriskarbitragecommunityMinorityshareholderlitigationGovernmentapprovals
In MCT, there seem to betwo principal exceptions toviewing the firm as a strictgoing concern. The firstexception is when the valueofacorporation’sassets(andsometimes liabilities) can bemeasured by reference to
OPMImarketprices.Thus,inthe EMH, a portfolio ofperforming loans will bevaluedatmarket insofaras itisdeemedtobe“availableforsale.” In this case, the futureinterest income potential oftheportfoliois ignored.Eventhough assets that trade inOPMI markets are almostalways marked to marketunder the EMH, there areexceptions when OPMI
marketpricesarenotinsync,as is the case for closed-endinvestmentcompanies,whichalmost always trade atdiscounts from the OPMImarket values of theirportfolios.The second exception
concerns M&A accounting.Purchase accounting is aresource conversion conceptthat blends into the financialpicture not only results from
operations but also results ofthe price paid to acquireanothergoingconcern.Ifthatprice is ultrahigh comparedwith the acquired company’sNAV,futureincomeaccountsmay be burdened by anoncash charge for goodwillimpairment, which wouldreflect management’smistakes in their role asinvestors as opposed tooperators.
In MCT, there does notappear to be any recognitionthatanalysisbasedonagoingconcern approach results indifferent, and often opposite,conclusions from those thatarise out of a resourceconversionapproach.Invalueinvesting, this dichotomy isrecognized. Both goingconcernanalysisandresourceconversionanalysisarevalid.Which should be weighed
more highly depends on thesecurity being analyzed andthe position of the investorundertakingtheanalysis.Although noninvestment
companies are evaluated,under academic finance,mostly as going concernsstriving only to create cashflows from operations,investors in the securities ofthose concerns are evaluatedon the basis of total-return
concepts—flows plusvaluation of portfolioholdings at market. UnderMCT, however, investors aretreated as the equivalent ofinvestment companies eventhough many investors mayhave as their principalobjective the creation ofincome from interest anddividendpayments,which,ofcourse, for analyticpurposes,makesthemtheequivalentof
goingconcerns.
INVESTORSARE
MONOLITHIC:THEIR
UNITARYGOALISRISK-
ADJUSTEDTOTALRETURN,EARNED
CONSISTENTLYInvestors are anything butmonolithicinvalueinvesting.Most will have multiple—orat least a mixture of—investmentobjectives:
CashreturnversustotalreturnLong-termOPMIversustradingOPMIControlversusOPMIControltotalreturn,usuallyincludingbenefitsintheformsofSOTTandaccesstoattractivefinancing
Successful value investorsas part of their analysis,understand other relevant
pointsofview:thoseoflong-term buy-and-hold OPMIs,trading OPMIs, thecorporation itself,managements, controlshareholders, governments,vendors, lenders, employees,investment bankers,accountants, and localcommunities.Theyknowitisimportant to figure out whohasthecloutandwhathas tobedonetosatisfythecloutas
partoftheprocessofearningexcessreturns.Investors and investment
advisers concentrating onasset allocation anddiversificationseemperse tobe speculators who start outwith the followingassumptions:
Outsidepassiveminorityinvestorpriceisanequilibriumprice.Outsidepassiveminority
investorpriceswillchangeasconditionschange;therefore,focusonbuyingwhatispopular,whenitispopular,orlikelytogetpopular.Donotobtainmuchknowledgeofthespecificcompanyorthesecuritiesitissues.Benervous.
Asset allocators who
believe in academic financeallocateinvestmentsinequityportfoliosbyconcentratingonoutlooks for particularindustriesandonoutlooksforspecificgeographiclocations;the better the near-termoutlook, the more funds areallocated in that direction. Invalue investing on the otherhand,assetallocationispricedriven rather than near-term-outlook–driven; the cheaper
an equity appears to be, onthebasisofthethree-prongedbalanced approach, thegreater the proportion offundsinvestedthere.
MARKETEFFICIENCYMEANSANABSENCEOF
MARKETPARTICIPANTSWHOEARNEXCESSRETURNS
CONSISTENTLYOR
PERSISTENTLY
MCT’s underlyingassumption that marketefficiency means noconsistent or persistentreturns for any oneparticipant has no basis inreality, except for OPMIswhoanalyzeandinvestusingMCT precepts. Indeed,control investing is aboutgetting something out ofbeinginvolvedwithsecuritiesoverandabovetherightsand
privileges that flow frombeing the passive owner of acommon stock, a fee interestin real estate, a preferredstock, a loan, a tradereceivable, or a leaseholdinterest. How that somethingextra isobtained incorporateAmerica and in the financialcommunity is a subjectworthy of systematic studyand is examined in Chapter14’sdiscussionofpromoters’
and professionals’compensations.Theonlyrationaldefinition
of efficiency for markets inwhichlittleornodisciplineisimposedbyexternalforcesisthatexcessreturnshavetobeearned persistently and evenconsistently in that marketandthatabuseswillsurface.It can be theorized that no
excessreturnsareeverearnedin any market in which an
asset value is marked tomarket. Earnings heredetermine the market value,soanytimeearnings increase,market value increasescorrespondingly. Thus, noexcess returns are earned, atleast as a percentage of themarket value of the earningsattributable to those assets.This may not be a usefulconcept, however, whenassets that give rise to the
excess returns are notmarketable (e.g., topmanagement salaries arisingoutofmanagementcontrolofproxymachinery,pluscharterand bylaws full of sharkrepellents entrenchingmanagement in office). Forvalue investing, it is equallyrelevant to measure excessreturns both by examiningreturnsasapercentageofcostor by depreciated cost, and
also by examining returns asapercentageofmarketvalue.Weightingassignedtocostormarketisdictatedbyspecificcircumstances.ForMCT,efficiencymeans
thatallinformationaffectsanOPMI market price, so thatno participant in an OPMImarket earns excess returnsconsistently. For valueinvesting, efficiency meansthat therearenotonlyOPMI
trading markets in whichMCT-type efficiency existsbut also myriad markets inwhich little or no externaldisciplines are imposed, sothat participants in thosemarkets earn excess returnspersistently. Indeed, in thesemarkets with little or noimposed external disciplines,if excess returns were notearned persistently, thosemarkets, under value
investing would beinefficient.Activists seeking to earn
excess returns persistentlyoughttoseekoutthosefieldsin which external disciplinesare weak or absent. Thefollowingforcesaresupposedto impose disciplines that inturn impose curbs onmarketparticipants’ earning excessreturns:
Competitivemarkets
BoardsofdirectorsCustomersVendorsLaborunionsCommunitiesSocialandreligiousconsciousness
The following marketsseem to be the leastdisciplined areas in theUnitedStatestoday:
Topmanagementcompensations
Plaintiffs’attorneysInvestmentbankersBankruptcyprofessionalsLeveragedbuyoutpackagersandpromotersMutualfundmanagementcompaniesHedgefundoperators
There are problems withU.S. financialmarkets, albeitthey appear to be far andaway the best that have everexisted.Hereareafewofthe
problemareas:Promoters’compensationseemsfartoohighundertheU.S.financialsystem.Debtors,especiallydebtormanagements,gettoomuchentrenchment,protection,andcompensationwhenrestructuringpubliccompanieseitheroutofcourtorinaChapter11case.
Initialpublicofferingstendtobegrosslyoverpricedfortheiractualbusinessvalue.Overwhelminginstitutionalpressuresexisttogiveresourcestoissuersabletodeliverlargegrossspreadstothefinancialcommunity,themeritsofaparticularissuenotwithstanding.Regulationoftrading
marketsisonerous.Investmentcompanyregulationisparticularlyonerous.Thetaxcodeisanightmare,albeitadministrativelyhighlyefficientcomparedwithothereconomies.Thecode’ssheercomplexityisaburdensomeproblem,buttheInternalRevenueService(IRS)
codemustbecomplextoproduceonefinalresult:whatthetaxbillwillbe.Othermeasurementsystems,especiallyGenerallyAcceptedAccountingPrinciples(GAAP),donothavetobecomplex.GAAPdonotgivefinalresults;rather,theyareonlyobjectivebenchmarksthatanalystsuseasone
tooltodetermineapproximatevaluesandaidinexaminingalternativecoursesofaction.Fromataxpayer’spointofview,ataxableeventhasthreeelements:(1)Whatisthetaxrate?(2)Doesthetaxpayercontroltimingastowhenthetaxmightbecomepayable?(3)Doestheeventthatgivesriseto
thetaxalsocreatethecashwithwhichtopaythetax?
GENERALLAWSAREIMPORTANT
MCT and indeed economicsin general place primaryemphasis on promulgating
generallaws.Althoughother,more mature social sciences,such as law and psychology,admit to the importance ofgeneral laws, they focusinstead on individualdifferences that exist on acase-by-case basis. Valueinvesting does promulgategeneral laws, but they haveimportant exceptions. A firstexample is this:Asagenerallaw in value investing,
quarterly earnings reports areunimportant; however,reported earnings for aquartermay be paramount tocompanies seeking to issuecommon stock in a publicoffering or in a mergertransaction. A secondexample concerns price: Invalue investing, the generallaw is to try tobuybargains;that is,donotpaymore than50 to60percentofwhatyou
believethesecuritywouldbeworth were the business aprivate entity or a takeovercandidate. The exception isthatyououghttobepreparedto pay up (i.e., have adifferent pricing standard) ifyou are involved with riskarbitrage. Here, the 50 to 60percent guideline mightbecome90to95percent.To the user, the ultimate
value of a value investing
approach compared with thevalue of academic financedependsonhowrealisticanduseful the variousassumptions are. Dependingon context—say, day tradingcomparedwithapassivebuy-and-hold strategy—eachapproach has validity. Fordaytrading,aMCTapproachseems a lotmore useful thana value investing approach;for a passive buy-and-hold
strategy, value investingseemsmoreusefulthanMCT.Obviously,thisbookisbasedon the belief that for mostparticipants in mostinvestmentprocessesmostofthe time, value investing ismorevalidanduseful than isacademic finance.Furthermore, it stronglysupports the belief that valueinvesting ought to be thecontext of choice from a
public policy point of viewwhenpromulgating securitieslaw and regulation, whendeciding lawsuits involvingvaluation and disclosureissues, and whenpromulgating accountingprinciples in accordancewithGAAPorIFRS.In any specific value
investing analysis, theindividual differencesbecomemuchmoreimportant
than the general laws. Thus,this book refers to “most ofthe time,” not “all of thetime.” For example, in themanagement of corporateaffairs, it is most productivemost of the time to takeactions based onmanagement’s beliefs aboutthe long-term consequencesof those actions; in mostcases, this would entailignoring near-term
considerations insofar asthose factors detract fromcreating cash flows or long-term corporate values. If thecorporation needs to financeby seeking outside equitycapital, however near-termconsiderations might have todominate. Specifically, mostof the time, corporatemanagersoughttomanagesoas to increasecashflowsandbasiccorporatewealthevenif
thismeanssacrificingcurrentearnings per share aswell asreported earnings per sharefor the quarterly periodsimmediately ahead. If thecorporation or its insidersneedtoraiseequitycapitalinthe short term though—say,over the next 12 months—itmightbebetter tomanage toincrease earnings per shareand to do thingsWall Streetanalysts like, such as having
the company operate as apureplayinanindustryratherthan be diversified. The riskof not being short-runconscious here seems to benot so much the prices atwhich issues of equitysecurities might be marketedby corporations or insidersbut whether such issues canbesoldatall.In addition, in value
investing, what you think of
underlyingfactorstendstobemore important than whatyou think other people thinkmostof the time.Whatotherpeople think—theconventional OPMI marketwisdom—does tend,however, to become ofcritical importance to suchactivists as issuers andpromoters when they seekaccess to outside capitalmarkets, especially equity
markets.Seekingsuchaccesstends to be an irregular,occasional event for mostcompanies, rather than acontinuous process, exceptfor certain types of issuers—which now seem to be aminority of issuers—such aselectric utilities, growingfinancecompanies,andmanyreal estate investment trusts(REITs).Trade-offs are tricky in the
value investing scheme ofthings. In a simple world, itmight be said that super-pricing for IPOs results in amisallocation of resourcesbecause it results inoverinvestment in growthcompanies in hot industriesand underinvestment in otherpartsoftheeconomy.Perhapsthis is so, but it seemsobviousthatthesuper-pricingavailable for IPOs has in
effect created a ratherdynamic venture capitalindustry in theUnitedStates.During the 1990s, suchinvestments, possibly incombination with anincreased supply oftechnically competent peoplefreed up because of defensecutbacks, seem tohavemadethis country the premiereconomy for innovation andstart-upsassociatedwithsuch
high-tech areas as digitalcommunications andbiotechnology. Certainly, theIPO phenomenon has mademany of these high-techcompanies real businessesbecause as a result of thegoing-public process, theyhave become extremely wellfinanced.Also,thepopularityof IPOs has resulted indedicated managements.Most IPOs raisemoney only
forthecompany.Forinsidersto realizeacashbailoutafteran IPO, the businessgenerally has to prosper.Initially,allanIPOat$10pershare does for insiders whoacquired common stock at 2cents a share is give themcocktail party points indiscussingtheirnetworth.Toconvert that paper net worthto a meaningful realizationprobably requires in most
cases that the underlyingbusinessactuallyprosper.For most existing public
companies, the sale of newissues of common stock hastended to be a marginalundertaking in terms ofamounts of funds raised ascompared with seeking othersources of outside capital invarious credit markets,ranging from bank loans toother institutionalborrowings
to public debt offerings.Selling new issues ofcommon stock is quiteimportant, however, in thatequity funds provide aborrowing base permittingmore senior borrowings onmore favorable terms for anissuer than would otherwisebe the case. Probably mostimportant, most activistmanagers properly believethat OPMI markets are
capricious in terms of (1)pricing at any given timeversusbusinessvalueand(2)the availability of OPMImarkets as a source of newequity capital on a reliablebasis. Raising equity moneyby accessing capital marketstends to be quite expensive,ranging from, say 2 to 8percent of the funds raised.Most of the new equitycapital for businesses is
therefore derived fromretained earnings rather thanthe sale of newly issuedcommon stock. In doing so,most active managersproperly focus first on theneeds of the business, bothaggressiveanddefensive,andonly second on the needs ordesiresofOPMIs.Thereisnosubstantiveconsolidation.
RISKISDEFINEDASMARKETRISKForMCT,riskmeansmarketrisk—whatwillhappentotheprice of a security—but forvalue investing, risk meansinvestment risk most of thetime—what will happenwithinthebusinessandtotheterms of the securities it has
issued without regard to themarket price of thosesecurities. Value investorsbasically calculate risk bymeasuringwhatcangowrongwith the business against thepricepaidforabuy-and-holdsecurity. For passiveinvestors acquiring securitiesusing a fundamental financeapproach,therearefourstepsin the analysis of a security,shown below in descending
orderofimportance:1. Compare price withprivate business ortakeovervalue.2. Consider what canreasonablybeexpectedtogo wrong with thebusiness from aninvestment—as distinctfrom a market—point ofview.3. Speculate on whatreasonable exit strategies
mightexistthree,five,orsevenyearsinthefuture.4.Factoringeneralstockmarketconsiderations.Formost analystsmost
of the time, steps 1, 2,and 3 will be soimportant that step4 canbeignoredcompletely.
MACRO
CONSIDERATIONSARE
IMPORTANTGiven the political stabilitythat prevails in the UnitedStates and most of theindustrial world, it is rareindeedinvalueinvestingthatmacroconsiderationsbecomeimportant in analyzing andinvesting in the deal. Macro
considerationswere probablyimportant in 1929, 1933,1937, 1974, and 2008–2009.Draconianmacroeventsseeminfrequent enough that thevalue investor can safelyignore them. Another reasonto ignore them is thatnooneseems to be able to forecastthem.In academic finance, it is
believed that such macrofactorsasthelevelofinterest
rates, the level of variousstock indices, gross domesticproduct (GDP), employmentdata,andinflation,indicesarevirtually always extremelyimportant inputs into mostvaluation processes. Forvalue investing, individualbusiness performance hasalways been more importantin determining securitiespriceperformanceoneitherabuy-and-hold or a control
basis than have been macrofactors, except in maybe theaforementioned specificyears.In considering general
conditions invalue investing,itisapparentthatsinceWorldWar II, industry-widedepressions have occurredwith amazing persistency.The difference between nowandthe1930s,though,isthatnow there is little or no
domino effect from thesedepressions. Between 1973and 1998, almost every U.S.industry went throughdepressions as severe asanything experienced by theparticular industry during the1930s, even though the U.S.economy was generallyprosperous. These severedepressions affected, amongothers, the automobileindustry, aluminum, steel,
machine tools, energy,banking, real estate, savingsandloans,rowcrops,airlines,water transportation, retailtrade, and nuclear-dependentelectric utilities. Typically,many of the publicly tradedcommonstocksofcompaniesin depressed industriesbecome ultracheap, asmeasuredbyboth thequalityand quantity of businessresources, even as they
appear quite expensivemeasured by price to currentearningsandpricetoearningsforecast for the period justahead.
CREDITORCONTROLISANONISSUE
In MCT, the appropriate
capitalization seems to bedriven by OPMI needs anddesires, whereas in valueinvesting, it is driven byneedsofthecompany,bailoutof the clout, or both.Capitalization is discussedmore fully in Chapter 7 oncreditworthiness.Most corporations borrow
money. They will begoverned verymuch in whatthey do about shareholder
distributions because ofwhattheir contractual agreementsare with lenders as well astheir probable sensitivity tolenders’ needs and desires.Such lenders are bothfinancial institutions andprovidersoftradecredit.Alsoincreasingly affectingshareholder distributions inrecent years has been theemergence of mutual fundsandindividualsholdinghigh-
yield junior corporate debtandpreferredstock.
TRANSACTIONCOSTSAREANONISSUE
In academic finance,transaction costs seem to beall but ignored except forbankruptcy costs. For value
investing, there are virtuallyno financial transactions inany arena with which WallStreet is involved—exceptmaybe discount brokerage(and that is doubtful)—thatdo not involve hugetransaction costs. For certainparticipants in financialprocesses, huge transactioncosts mean huge transactionincomes,evenafteroverhead.
FREEMARKETSAREBETTERTHANREGULATEDMARKETS
Lots of people—maybemost—would deny that resourceallocation is the primaryjustification for the existenceof the investment processes.
Mostwouldprobablysaythatthe primary purpose for theexistence of the financialcommunity is to provideinvestorprotection,especiallyforholdersofOPMIcommonstock. They seem to reasonthat if such investorprotection were provided, itwould, a priori, result inefficient resource allocation.Thisbookdoesnotagreewiththis view. It cannot be
assumed that efficient assetallocation will result ifinvestment decisions aremade by the investingequivalent of kelp andplankton of the marine foodchain—uneducated passivereactors whose goal ininvesting is to outperform amarketconsistently.The most important things
to realizeaboutany financialsysteminanyeconomyisthat
it is going to be repletewithelements of inefficiency,misallocation of resources,frictions,andbasicunfairnessand that therewill alwaysbetrade-offs.Forexample,itisasummum bonum for aneconomy to operate in anenvironmentwith high levelsof integrity for securitiestrading markets, butoverwhelming evidenceindicates such integrity
cannot be attained withoutonerous regulation, whichobviously hascounterproductive elements.Thehighdegreeofregulationof tradingon the floorof theNYSE isbutone exampleofthis.Asfarascanbeseen,theU.S. financial system’sallocation of resources isgood enough, even if it isacknowledged that from along-term company-oriented
pointofview,OPMImarketsgrosslymisprice a very largenumber—probablyamajority—ofcommonstocks.Nonetheless, a historical
focus on investor protectionhas had tremendoussecondary benefits for allU.S.capitalmarkets:
TheintegrityofU.S.tradingmarketsissuperb.TheU.S.public
disclosuresystemissuperb.Oversightoffiduciariesandquasi-fiduciariesisprettygood.Seniorcreditmarkets,bothpublicandprivate,tendtobeprettyefficient,partlybecausecorporatedisclosures,especiallyaudits,havebecomesogood.
Conversely, the focus on
investor protection (i.e.,OPMI protection) has alsohadunfortunateconsequencesintheUnitedStates:
Generallyacceptedaccountingprincipleshavebeenbastardized.Theyareusedtoseektruthinreportedearningsratherthantoprovideknowledgeableinvestorswithobjectivebenchmarkstobeusedas
essentialtoolsofanalysis.Crazylegaltheories,haveproliferated,exemplifiedbyfraud-on-the-marketlawsuits,whichpostulatethatplungesinOPMImarketpricesareevidenceofinsiderfraudbecausethecommonstockneverwouldhaveachievedhighpricesinefficient
marketsinthefirstplaceifinsidershadmadefulldisclosures.Stockholderlitigation,drivenbyattorneys’feesratherthanmerits,hasbecomecommonplace.Manycorporatemanagementsandactivistshavebecomefarmoreorientedtowardshort-runresultsthanisreallyproductiveforthe
economy.Forissuersthatneedaccesstocapitalmarkets,theretendstobeaprimacyofreportedearnings;thatis,whatthenumbersarebecomesmoreimportantthanwhatthenumbersmean,especiallyshortterm.
Efficient-market theories,based on a view that theconstituency to be served is
the short-run–conscious,unsophisticated OPMI, havecaused numerous problems.They were the proximatecause of the derivativesdebacle of 1987 because ofthe failure to distinguishbetweencredit riskandotherrisks. Also, they fostered anenvironmentinwhichOPMIsdo not believe they have toknowanything.There are three principal
roles of the Securities andExchangeCommission(SEC)and these involve someconflictswithfreemarkets.Ifthe Securities and ExchangeCommission did not fosterregulation in these areas, theclimate forOPMI investmentmight be as poor as it seemsto be in most emergingmarkets.Theserolesare:
Toprovidefairandorderlytradingmarkets
ToprovidedisclosurestoinvestorsToexerciseoversightoverfiduciariesandquasi-fiduciaries
THEOUTSIDEPASSIVEMINORITYINVESTOR
MARKETISBETTER
INFORMEDTHANANYINDIVIDUALINVESTOR
Value investing is uselessunless practitioners assumethat for their purposes, they
are better informed than theOPMImarket.This is not anunrealistic assumption, sincemost passive value investorsare long-term buy-and-holdinvestors. Short-run marketconsiderations, the lifebloodof theEMH,areunimportantin value investing. It is notthat the value analyst hasaccesstosuperiorinformationvis-à-vis the OPMI marketbut rather that the value
analyst uses the availableinformation in a superiormanner.
MARKETSAREEFFICIENTORATLEAST
TENDTOWARDAN
INSTANTANEOUSEFFICIENCY
Efficient markets are afundamental precept of theEMH. In value investing, allmarkets tend towardefficiency. Occasionally,there are markets, like theOPMI trading market thattends strongly towardinstantaneous efficiency.Insofar as a market is
characterized byinstantaneous efficiency,thereisnoargumentbetweenvalue investingandacademicfinance, butmostmarkets donot seem close to obtaininginstantaneousefficiencymostof the time. Because this isso, there is actually a widechasm between MCT andvalue investingevengrantinga universal tendency towardefficiency in all markets. In
many markets (e.g., mutualfundmanagement feesor topmanagementcompensationinmany public companies), thetendency toward efficiencyseems so weak that it mightberealistictoignoreit.
SUMMARYThere are substantivedifferencesbetweenacademicfinance as embodied in the
efficient market hypothesis(EMH) and modern capitaltheory (MCT), andfundamental finance (FF) ingeneral, and value investingin particular. We provide anexhaustivediscussionofeachand every substantivedifference pointing out thenarrower and more limitedfocusoftheacademicfinanceapproach to investmentproblems.
_______________*Thischaptercontainsoriginalmaterial,andpartsofthechapterarebasedonmaterialcontainedinChapter2ofValueInvestingbyMartinJ.Whitman(©1999byMartinJ.Whitman),andideascontainedinthe19991Q,and20032Qletterstoshareholders.Thismaterialisreproducedwith
permissionofJohnWiley&Sons,Inc.1SeetheworkofProfessorEdwardI.Altmanasaprimeexampleofthisschoolofthought.2WilliamF.Sharpe,Investments:AnIntroductiontoAnalysisandManagement,ThirdEdition(EnglewoodCliffs,NJ:PrenticeHall,1985).3SeeChapter14.
4“VolkerRuleCouldProvetoBe‘Devastating’forMunis,”InvestmentNews,March13,2012.5AsofFebruary,2012.DatafromtheClosedEndFundAssociation.6RichardBrealeyandStuartC.Myers,PrinciplesofCorporateFinance,FourthEdition(NewYork:McGraw-Hill,1991).7ThomasE.Copeland,Tim
Koller,andJackMurrin,Valuation:MeasuringandManagingtheValueofCompanies(McKinsey&Company,Hoboken,NJ:JohnWiley&Sons,Inc.,1992).
CHAPTER18
Broker-DealerResearch
Departmentsand
Conventional
MoneyManagers*
HowResearchDepartmentsandConventionalMoneyManagersThink
ProblemsFacedbyResearchDepartmentsandConventionalMoneyManagersSummary
In November 1998, ToyodaAutomaticLoomWorks,Ltd.(since renamed to Toyota
Industries) common stock,listed on the Tokyo StockExchange, appeared to be agood example of a commonstockthatwassafeandcheapbased on “what is” becausethe company was wellfinanced and represented away of buying into thecommon stock of ToyotaMotor, a blue-chipautomotivemanufacturer at adiscount of perhaps 35 to 40
percent. Toyota Industriescommonwastradingatabout2,300yenpershare,orabout$16.5 to$17U.S.dollars. Itsadjusted balance sheet,expressedinU.S.dollars,wasasshowninTable18.1.Table18.1BalanceSheetforToyotaIndustriesCorporation(AdjustedNAVin$000s)
Research departmentanalysts and conventionalmoney managers probablywouldhavehadnointerestin
Toyota Industries commonstock in November 1998unless they had someevidence thatwouldhave ledthemtobelieve:
1. That therewould be adramatic improvement inreported earnings forToyota in the currentfiscalyear.2. That some actionmight have beenimminent, such as an
acquisition of ToyotaIndustries by ToyotaMotor, which wouldresult inaworkoutvaluefor Toyota Industriescommon at a substantialpremiumoverNovember1998marketprices.3. That the outlook forcommon stock prices onthe Tokyo StockExchange (TSE) wasquitebullish.
Moreover, in December1995, research departmentanalysts and conventionalmoney managers probablywould have concentrated onhaving an opinion as to theprobability thatKmartwouldseek Chapter 11 relief.Analysts who thought KmartwaslikelytoseekChapter11relief would have avoidedacquiringKmart debt even ifthey believed that the
ultimate workout in areorganization would be notless than 100. They wouldhave focused on the beliefthat if Kmart did file forChapter 11 relief, themarketprice of Kmart debt woulddecline, probablydramatically; for thoseanalysts, the time to acquireKmart debtwould have beenafter aChapter 11 filing, notbefore.
In previous chapters wediscussed the characteristicsand limitations of therecommended approach ofvalue investing, thecharacteristicsandlimitationsinherent in the efficientmarket hypothesis (EMH)and all other academicapproaches, and thecharacteristicsandlimitationsof fundamental analysis aspromulgated in the works of
BenjaminGrahamandDavidDodd and their predecessors.Inviewoftheendlessreportsput out by Wall Streetresearch departments and thecountless presentations, bothwritten and oral, made byconventional moneymanagers, it is instructive tolook at the analytic approachthat most researchdepartmentsandconventionalmoneymanagersfollow.This
chapter serves two purposes:First, itdescribestheanalytictechniques that are followedby research departments atmost broker-dealers—the sellside—and also by mostmoney managers responsiblefor the noncontrol passiveinvesting of funds entrustedto their care—the buy side.Second, it discusses thelimitations—problems—inherent in usual research
department–conventionalmoneymanagerapproaches.
HOWRESEARCH
DEPARTMENTSAND
CONVENTIONALMONEY
MANAGERSTHINK
Research departments andconventional moneymanagers seem to follow astrict going concernapproach.A firm is analyzedonlyasagoingconcerntobeoperated in the future prettymuch as it has been in thepast, in the same industry ithas always been in, and
financed as it has beenfinanced traditionally. Themarket value of commonstocks is deemed to bedeterminedbyfuturereportedearnings,cashflows,orboth,appropriately capitalized. Aweightofalmost100percentisgiventothisgoingconcernapproach,one that is forwardlooking because it impingeson financial statementanalysis. It emphasizes a
primacy of the incomeaccount unmodified byconsiderations of the currentquality of either acorporation’s financialposition or the net assets thecompany employs. Indeed,both high-quality assets andlarge net assets, or bookvalues, tend to havenegativeconnotations for valuationpurposes for many researchdepartment/money manager
analysts. A strong financialposition indicates to theseanalyststhatmanagementhasnot employed assets asaggressivelyastheymight.Ahighbookvalue,too,tendstobe a negative because suchnumbers,apriori,spelllowerreturnsonequity(ROEs)andreturnsonassets(ROAs)thanwould otherwise be the case.Putotherwise,thestrictgoingconcernapproachof research
department analysts andconventional moneymanagers seems to viewfinancial factors that arethought of as positives in aresourceconversionapproachor value investing approach(i.e., strong financialpositions and high assetvalues)aseitheranegativeorunimportant.Research department
analysts and conventional
money managers tend tobelieve that their objective isto estimate prices atwhich asecuritymightsellatafuturedate in the outside passiveminority investor (OPMI)market. When considerationis given to underlyingcorporate values, it is notthesecorporatevalues,persethat count but rather howmuch,ifatall,theunderlyingcorporate values ought to fit
into the estimate of futureprices in OPMI markets.Other considerations in theestimation of market pricesinclude dividend policies;technical chartist marketconsiderations, includingsupply and demand forsecurities; industry outlooks;opinions about generalmarket levels, interest rates,and gross domestic product(GDP)growth;insiderbuying
and selling; and Wall Streetsponsorship.Research department
analysts and conventionalmoney managers tend to betremendously influenced byshort-run corporate revenueand earnings reports.As partof estimating market prices,they tend very much to betrend players, especially onthe buy side, refusing toacquire securities if they
believe near-term outlooksforpricesareunfavorable.Aspart of being short-runconscious, researchdepartmentsandconventionalmoney managers tend toplacemuchgreaterweightonthe prospects that thedevelopment of a catalystmightresultincommonstockpriceappreciationthanontheacquisition of securitiessolely because the price
appears, on the basis ofstatistical considerations, tobecheap.Theyseeatrade-offbetween catalysts and lowprices inOPMImarkets.Themore likely that a catalystwill come into existence,other things being equal, thehigher the price atwhich thecommonstockwillsell.Afterall, OPMI markets, like allmarkets, do tend towardefficiency even though those
efficienciescanbequiteweakat times.1 For many researchdepartmentsandconventionalmoney managers, low pricealone is not a sufficientcondition for making asecurities purchase. Rather,theessentialconditionforthepurchase is the perception ofarelativelynear-termcatalystthat will result in priceappreciation, whether thatcatalyst is embodied in
prospects for improvedearnings, for earnings inexcessofconsensusforecasts,or for sucha transactionasamerger and acquisition(M&A), amajor refinancing,oraliquidation.For research departments
and conventional moneymanagers, a common stocktends to be deemed to becheap statistically if price-to-earnings (P/E) ratios (or
price-to–cash flow ratios)seem modest relative tocomparables. The earnings(or cash flow) figures usedfor these P/E ratiocalculations are the mostrecent reported earnings, theearnings forecast for theperiod just ahead, or both,with the period just aheadbeing either the next quarterorthenext12months.Rarelyare other measures of being
statisticallycheapused;whenthey are, the tendency is tonot give them much weight.Other measures of beingstatistically cheap mightinclude price-to–net assetvalue(NAV)ratios, inwhichNAV is determined byreferencetoeitherbookvalueorappraisedvalue,andprice-to-average annual earningsratiosforthelastthreeorfiveyears.
Research departmentanalysts and conventionalmoney managers tend to bevery conscious ofcomparative analyses. Theygive great weight to acomparison betweenquarterly earningsas actuallyreported and consensusestimates of quarterlyearnings and consider intra-industrycomparativerevenueand earnings performance to
be important. Many alsoattachmaterialsignificancetogrowth trends compared toP/E ratios. For example,assuming a company’searnings per share areforecasted to grow at 30percent compounded, a P/Eratio of 30 times is justified;25 percent growth wouldjustify a P/E ratio no greaterthan 25 times. This is calledgrowth at a reasonable price
(GARP)2 and gave rise towhat analysts call the PEGratio; that is, the ratio of theP/E ratio and the expectedgrowthrateinearnings.3
In using analytictechniques, researchdepartmentsandconventionalmoney managers rely muchmore heavily on fieldwork(e.g., managementinterviews) than they do onintensive document reviews
(e.g., in-depth analysis ofaudited financial statementsorofcourtrecords).Of the vast majority of
research department reportsin recent years, only a veryfewseemtoprovideexcellentunderlying analyses that arehelpful for value investing.Thethrustsofvirtuallyallthereports,boththeexcellentandthe not so excellent, are asfollows:
Estimatefutureearningspershare(EPS),earningsbeforeinterest,incometaxes,depreciation,andamortization(EBITDA),orboth.Attheendof2011,suchestimateswouldbedonebyyearsfor,say,2012,2013,and2014.ApplytothoseEPSand/orEBITDAestimatesanappropriate
P/EratioorEVtoEBITDAratiobasedonthefollowing:
IndustryidentificationGrowthtrendOtherfactors,suchasmanagementappraisal,sponsorship,returnonequity,oreconomicvalueadded(EVA)
Almost 100 percentweighttends to be given to this
approach—estimating futureflows, whether cash orearnings, and applying anappropriatecapitalizationrateto these estimated flows toarrive at a target price for acommon stock. A change inquarterly earnings estimatesis deemed to be veryimportant news and veryfrequentlyresultsinachangeinthetargetprice.Research department
analysts almost neverrecommend outright sales orselling short. Manyconventional moneymanagers sell frequently—when they believe that asecurity does not have short-run appreciation prospects orthat an alternativecommitmenthasbetter short-runappreciationpossibilities.
PROBLEMSFACEDBYRESEARCH
DEPARTMENTSAND
CONVENTIONALMONEY
MANAGERS
TheDifficultyofForecastingEarningsFor most companies in mostindustries, it is very difficulttopredictfuturerevenuesandearnings and cash flowresults. Future events havealways resulted in largenumbers of such forecasts’being plain wrong.Traditionally,therehavebeenindustries in which such
forecastscouldbemadewithreasonable accuracy (e.g.,integrated electric utilities orreal estate propertiesbenefiting from long-termleases to creditworthytenants). For most othercompanies, though,predictionsfrequentlywillbein error by relatively widemargins whether thosecompanies are automobileassemblers, aluminum
producers, semiconductorequipment manufacturers,health-care providers, banklenders, pharmaceuticalfirms, retailers, buildingproduct suppliers, or, as amatterof fact, just about anykindofU.S.corporation.When research department
forecasts prove to be overlyoptimistic, as many do, theanalystoftenhasnoanchortowindward, as would exist
werethesharesrecommendedon some other basis thanmerely estimates of futureflows. One such other basis,rarely relied on by researchdepartmentsandconventionalmoney managers, is theacquisitionofcommonstockswhen those issues are sellingat prices representing somesortofreasonablerelationshipto NAV. Another such basisis the restriction of common
stock investments tobusinesses that enjoy strongfinancialpositionssothat thecompany will have stayingpower, possible comebackability, and no likelihood ofdefaults on corporate debtobligations, in the event thatfutureresultsaremuchworsethantheanalyst’sforecast.Ameliorating to some
extent this lack of an anchoris the fact that research
department analysts andconventional moneymanagers tend to be traders,not investors. Losses can becut by early sales, especiallyif securities holdings areconfined to relativelymarketable issues. Trading,though, does tend to limitprospectsforsuper–long-termprofits, whether realized orunrealized, available to thosefollowing a buy-and-hold
strategy.
TheCompetitivenessofConventional
AnalysisAttempting to forecast futureflows and applying anappropriatemultiplier theretois an extremely competitiveactivity within the financialcommunity. There areprobably thousands of
analysts,onboththesellsideandthebuyside,tryingtodopretty much the same thing,andmanyareverybrightanddiligent.
TheLikelihoodThatItIsImpossibletoDoTop-DownAnalysis
RationallyAlthoughpredictingEPSandEBITDA for companies may
be difficult, predicting theP/E ratios that might beassigned to that EPS orEBITDA in a future OPMImarket may well nigh beimpossible.Making forecastsabout future general OPMImarket levels probably ismuch more in the realm ofabnormal psychology than offundamentalfinance.Thereisno evidence that the generalmarket and large sectors
withinitaregovernedbyanyprice behavior other than arandom walk. Put otherwise,noonereallypredictsmarketlevelsaccurately.Indeed,itisprobable that no one reallycan identify those macrofactors likely to influenceOPMImarket prices, and theweights that might beassignedtoeachfactor.For many analysts, too,
including G&D, predicting
futureearningsforacompanystarts with top-downestimates of the outlook forthe general economy, forinterest rates, and forinflation. Historically,making accurate estimatesaboutthesemacrofactorshasbeenhardtodo.Beingunable topredict the
levels or direction of generalmarkets is ameliorated to aconsiderable extent, for
conventional moneymanagerswithamodicumofintelligence, throughdiversification. Thus, ifforecastsofEPSorEBITDAcome through for a goodpercentage of the companiesin a portfolio of commonstocks,thatportfoliooughttoperform satisfactorily(certainly incomparisonwithotherportfolios)regardlessofwhat happens in the general
market.Allbetsaboutabilitytowithstandmarketdropsareoff, however, for thosemoneymanagerswhooperatewithborrowedmoney.With highly leveraged
portfolios, money managershadbetterberight,orclosetoright, about future marketpricesagooddealofthetime.Fortunately, in the field ofinstitutional equityinvestment, most portfolios
are not highly leveraged,whethertheyaretheassetsofinvestment companies (e.g.,mutual funds), or definedbenefit pension plans, or ofinsurancecompanies.
FightingfortheHeavyweight
ChampionshipwithOneHandTiedbehind
YourBack:PredictingFutureEarningswhileIgnoringtheExisting
BalanceSheetAnalystswhofocusontrendstendtothinklinearly:thepastis prologue; therefore, pastgrowth trends of EPS orEBITDA will continue intothe future or even accelerate.Thetruth,however,isthatthecorporate world is rarely
linear.Thefactisthatformany—
if not most—companies,analysis of the amount andquality of resources that amanagementhastoworkwithisasgoodasoranevenbettertoolforpredictingfutureEPSor EBITDA than is the pastearnings record. It appearsmost research departmentanalystsandmoneymanagersignore this tool, especially
when it indicates a strongfinancialposition.Thisistrueeven though theoretically, noanalystinterestedinROEandROAcansafelyignoreequityor assets, both of which arebalance sheet items.Improved returns, if appliedto larger equities and assets,will give securities investorsa much bigger bang. Theelementary fact is that boththe past earnings record and
the present balance sheet aregood and frequentlynecessary tools forpredictingfuture flows for manycompanies.It is much easier for a
management to improvereturns if the company has astrong financialpositionwithwhich to work. A primeexample of this was NaborsIndustries, an oil servicecompany with which the
senior author has beenassociated for many years.Nabors emerged from aprepackaged Chapter 11reorganization in mid-1988with an all-equitycapitalization. At that time,Naborswasvirtuallytheonlycontract driller not burdenedby large amounts of debtincurred during the pre-1983boom time in the oil drillingindustry. Given its financial
strength, Nabors was able tospend the next few yearsacquiringcontractdrillersandcontract drilling assets atbargainprices;other industryparticipants did not have thefinancial wherewithal to bidagainst Nabors for theseassets.In1987,Nabors’scashlossfromoperationsprobablywasinexcessof$20million;in 1997, Nabors’s positivecash flow from operations
was well in excess of $200million and in 2011 it wascloseto$1.5billion.Theearningsrecordandthe
presentbalancesheetarebothhelpful tools for predictingfutureearnings,butoneisnota substitute for the other.Whichofthetwooughttobemore important in any givensituation is a matter ofanalytic judgment. Givingblanket priority to income
account considerations andthereby denigrating theimportance of balance sheetitems, however, seems todisadvantage many researchdepartment analysts andconventional moneymanagersbecausetheyignorequalitative and quantitativebalance sheetdataas sourcesfor estimating future flows,whethercashorearnings.
LackofAwarenessoftheRelationshipbetweenIncome
AccountNumbersandBalanceSheetNumbersandofAnalyticConflictsbetweenandamongRelatedNumbers
Whenanalysts focusonlyon
forecasting future earningsand do not take into accountbalance sheet considerations,as is the case for manyresearch departments andconventional moneymanagers,thereisnoneedtoexamine the relationshipbetweenincomeaccountsandbalance sheets. When theyinstead look at presentbalance sheets as either ahelpful tool for predicting
futureearningsorasamarginof safety in case earningsforecastsdonotworkout,therelationships between theincome account numbers andbalance sheet numbersbecome important—andsometimes result in analyticconflicts.
EXAMPLEAssume that an analyst isseeking amargin of safety
for a common stockholding by having therecommended stock sell ata price that is in areasonable relationship toNAV.Itwillbeimpossibleto obtain that margin ofsafetyif thecommonstockin question sells at a highP/E ratio and the companyenjoys a much aboveaverage ROE. Say thatXYZ common sells at 30times earnings and thatXYZ’sROE is 20 percent.Then, a fortiori, XYZ
common will trade at 6timesNAV.(XYZearns$1pershare,makingthepriceof XYZ common 30; anROE of 20 percent onearningsof$1resultsinanNAV of $5 per share; $5NAVdivided into30priceequalsapricetobookratioof 6 times.) Researchdepartment analysts andconventional moneymanagers interested incompanies that theyperceive to be rapidlygrowing and also that earn
high ROEs had betterignorethemarginofsafetythatcouldbeinherentintheprice of a common stockbeingclosetoNAViftheyaregoingtooptforgrowthandhighROEs.Furthermore rapidlygrowing earnings in pastyears mean that averageearnings for those pastyears are less than theywould have been hadearnings grown lessrapidly. Thus, growth
investors tend not to lookfor any margin of safetythatmight be inherent in acommon stock selling at aprice that represents arelative modest P/E ratiobased on average annualearningsforapastperiod.The following tablepresents the earnings pershare of a rapidly growingcompany:Year EPS1 $1.002 $2.00
3 $3.004 $4.005 $5.00Averageearnings $3.00
Supposethecommonstocksells at 10 times year 5earningsof$5.00pershare,or $50. The issue alsowould be selling at 16.7times five-year averageearnings.
It should be noted that thefact that the relationship also
works the other way is notparticularly relevant formostresearch department analystsand conventional moneymanagers. The trade-offbetween high P/E ratios andhigh ROEs on the one handandreasonablepricesrelativeto NAV on the other handfunctions in such a way thatan analyst wanting to focuson common stocks sellingclosetoNAVwillnotbeable
to invest in common stockswhen the issue is sellingat ahigh P/E ratio based oncurrent earnings and thecompany enjoys an above-averageROE.
EXAMPLEAssume Company XYZhasaNAVof$10.ROEis20 percent, which meansthat earnings per share are$2. IfXYZ common stocksells at 20 times earnings,the price in the OPMImarket would be $40 orfourtimesNAV.
It is quite feasible toacquire common stocks atprices closely related to
presentNAVand at lowP/Eratios based on what acorporation’s earnings arelikely to be when currentdifficulties, which aredepressing current earningsand earnings forecast for theperiod just ahead, areovercome.TheOPMImarket,though, tends to be tooefficientfortheretobemanyopportunities to acquiresecurities when both prices
are reasonable relative topresent NAV and the P/Eratios are low relative tocurrent earnings andimmediate future earnings.Analysts and moneymanagers focused on currentearnings, forecasted earningsfor the period ahead, andROE must virtually ignorepriceasrelatedtoNAV.Asamatteroffact,theydoignoreNAV. Given the inaccuracy
of most forecasts, however,theydosoattheirownperil.
UseofanApproachAntitheticaltoThoseUsedbyPrivate
BusinesspeopleandControlBuyersNotSeekingImmediateAccesstoEquityMarketsforNew
CapitalThebasicobjectiveofprivatebusiness people and controlbuyers is to create wealth(and sometimes cash flowsfor themselves) in the mostefficient manner, whichusually involves followingcourses of action thatminimizethepresentvalueofcorporate income taxespayable.Researchdepartment
analysts and conventionalmoney managers have theopposite agenda: They wantcorporations whose commonstocks they are holding orrecommending to reportmaximum amounts of near-term earnings fromoperations,earnings that tendto be currently taxable atmaximumtaxrates.Theyalsodesirecompanies
whose common stocks they
are recommending to beshort-term oriented. In theirview, managements ought toforgo projects with possiblehuge long-term pay-offs ifthat entails sacrifices increating near-term operatingincome.Given theirdruthers,most managements notseeking near-term access toequity markets probablywould opt for the long-termviewofwealthbuilding.
Research departmentanalysts and conventionalmoneymanagersalso tend tobemoreinterestedinwhatthenumbers are, especiallyearningspershare,ratherthanwhatthenumbersmean.Furthermore, given the
emphasisonagoingconcernapproachtoanalysis,analystsandmoneymanagers tend towant the companies whosecommon stocks they are
recommending to have asingle industry focus, at leastin 2012. They view thosecompanies as operationsrather than as converters ofresources to other, andpossiblyhighervalueuses. Ifcompanies diversify intoother industries, they nolongerare seenaspureplays—theyarehardertofollow.Many good managements,
left to their own devices,
would view the companiesthey control as both goingconcerns creating operatingprofits and resourceconversion vehicles creatingwealth by investing indifferentandsometimesevenunrelatedindustries.The current anathema of
research department analystsand conventional moneymanagers to corporatediversification does have
considerable long-termmerit.Too many companies havesuffered because ofdiversification into industriesnot well understood bymanagements. Nonetheless,analysts’apparentdistastefordiversification contrasts withwhat many managementswouldliketodoprovidedthatthey do not find it necessaryor desirable to placate WallStreet.
Analysts and moneymanagers also tend to usedifferent approaches toanalysis than do controlbuyers of corporations.Rather than focus on a strictgoing concern approachwithan emphasis on near-termoperating results, businessbuyers, such as leveragedbuyout (LBO) specialists,tend to concentrate on threeissues:
1.Howcana transactionbefinanced?2.What is the long-termoutlookforthebusiness?3. What are the variousexit strategies that mightbeavailable?
TheLackofaBalancedFocus,
ResultinginCommonStockPricesthatAre
MuchTooHighorMuchTooLow
By concentrating almostexclusively on earnings orcash flow forecasts andcapitalization rates, analystshave no safety net whenprices get way out of line.ThereisastrongtendencyforpricesinOPMImarkets,bothhigh and low, to haveelements of irrationality that
donotexisttoanywherenearthesameextent innegotiatedtransactions betweenreasonably knowledgeablebuyers and sellers. Innegotiated transactions, thereisa tendency toconsiderandweight a whole gamut offactors in arriving at atransaction price, rather thanjust applying a capitalizationrate to current earnings (orcashflow)andpredictionsof
earnings (or cash flow) fortheimmediatefuture.Given access to capital
markets, though, anoverpriced stock can be animportant asset for acorporation run by amanagement with skills inM&As. See example thatfollows.
AnalysesThatFocus
onBaseCaseForecastsRatherthanAlternativeScenariosAn investor putting $100millionormoreofhisorherown funds into an equitysituation in which the fundswill be tied up on apermanent or semipermanentbasisusuallydoesnotrelyasheavilyonbasecaseforecastsas do research department
analysts and conventionalmoney managers. This isunderstandable because thelatter groups enjoymarketabilityandcan,atleasttheoretically, undoinvestments rapidly. Oneconsequence of this, though,is that there is far less needand desire for researchdepartment analysts andconventional moneymanagerstoconductin-depth
investigations: Given highportfolioturnover,itbecomesterribly unproductive to doin-depth investigations.Furthermore, it becomesimpossible for even thelargest organization toconduct in-depthinvestigations when thenumber of securities in aportfolio runs to hundreds ofissues.
EXAMPLEThe market price of acommon stock can beenhanced by using thesecurity in mergers,especially when analystsconcentrate solely on P/Eratios, as in this samplescenario:XYZcommonsellsat60,or 60 times earnings of$1 per share, or $10million on 10 millionsharesoutstanding.
ABCearns$3million.XYZ acquires ABC in atransaction by issuing800,000 shares of XYZcommon, which wouldhave a market value of$48million.
The post-merger incomeaccount is shown in Table18.2.
Table18.2TheNewIncomeAccount
Variable Value(000)
Netincome $13,000.00
Numberofsharesoutstanding
10,800
Earningspershare $1.20Price-to-earningsratioatpriceof60
50.0x
IfthenormativeP/Eratiois60, post-merger XYZcommon should sell not at60butat72.
Bycontrast, large investorsholding equities on apermanent or semipermanentbasis tend to investigate
relatively thoroughly on twobases: the base case and thereasonable worst case. Mostalso put the optimistic caseintotheinvestigationsmix.
ExternalPressuresThatCanCompromise
AnalysesResearch departments ofbroker-dealers that also havean investment banking
presencecanfacepressurestorecommend the commonstocks of investment bankingdepartment client companies,especiallythosewhosepublicissues were underwritten bythe firm. Sometimes, even ifonly in a small minority ofinstances, theserecommendations are basedmoreonthegoodof thefirmrather than the good of theclient. Money managers
frequently are under pressurefrom their firm’s marketingdepartment to undertakeportfolio window dressing.Probably the most commonscenario is that goodmarketing may require thatthe portfolio consist largelyof the most popular issues,insteadofemphasizingissuesthat, although less popular,are more attractivefundamentalvalues.
TheDifficultyofConcentratingonOperatingRatiosBasedonFinancialAccountingStatisticsGiven their emphasis onviewingcompaniesstrictlyasgoing concerns, researchdepartment analysts andconventional moneymanagers tend to place great
worth on the analysis ofoperating margins—grossprofit margins and operatingincomemargins.Thistypeofanalysis has limitedusefulness inmany industriesbecause the data are derivedfrom short-form (i.e., nodetail by specific items)financial statements, ratherthan long-form corporatecost, or managerial,accounting data. For most
companies, if analystsdonothave access to cost-accounting data, it becomesextremely difficult tounderstand the nitty-gritty ofoperations. Profit-marginanalysis based on financialaccounting can be a helpfultool, but it is a limited one.Also, comparative numberscanbetricky.
EXAMPLE
Company ABC andcompany XYZ each haveoperating income of $1million from conductingthe exact same activities.ABC claims to have salesrevenueof$50million,andXYZ, for the sameactivities, booksconsultingrevenues of $10 million.On the basis of thesenumbers, ABC’s operatingprofit margin is 2 percentand XYZ’s is 10 percent.Furthermore, ABC might
treat,say,rentexpenseasacostofgoodssold,whereasXYZ might treat rentexpense as anadministrative or generalexpense,whichwouldbeacomponent of operatingexpense.
HeavyRelianceonFieldworktothe
ExclusionofReadingDocuments
Reading the documents is nosubstitute for fieldwork—interviewing managements,competitors, customers,government regulators, andothers who can contributeinformation to an analysis.The reverse is also true:Doing field work is not asubstitute for carefullyreadingrelevantdocuments—Securities and ExchangeCommission (SEC) filings,
stockholder mailings, courtrecords, competitors’documents, and industrypublications. Indeed,fieldwork and documentreading go hand in hand.Those who read andunderstand documentcontents tend to be muchmore skillful at fieldworkthan are analysts who askquestions before they have agood documentary
background for asking thosequestions.Documentstendtobegiven short shrift, though,bymanyresearchdepartmentanalysts and conventionalmoneymanagers.Inpart,thisis understandable: Much ofwhatisindocumentsappearsto have little relevance topredicting what near-termOPMImarket prices will be,and reading documents isvery time intensive, hardly
worthwhile for those tradingin and out of large numbersof securities in a portfolio.Finally, interpretingdocuments, especiallyfinancial statements, takes afairamountoftraining;whichmanyanalystsseemtolack.A principal problem for
analysts who choose not torely on documents they haveintensely scrutinized,especially audited financial
statements, is that manyanalysts involved in passiveinvesting have beendefrauded or otherwisevictimized, by promotersselling stories with no hard-nosed backup. This was truefor public holders of U.S.corporate bonds before theTrust IndentureAct of 1939,true in the1960swhensmallcompanies went public, trueinthe1970sand1980swhen
tax-sheltered limitedpartnershipswerealltherage,true in the1990sforanalystsrecommending commonstocks of companies inemerging markets withvirtually nonexistentdocument disclosurerequirements, and true in the2000s when institutionsboughtAAAratedresidentialmortgage-backedsecurities.
HeavyRelianceonPerceptionsofWhat
OthersThinkAll rationalanalysts involvedwith passive noncontrolinvesting are probablyinfluenced to some extent bywhat they perceive are theopinions of insiders or smartmoney. For example, ifinsiders and 10 percentshareholders are selling
commonstock,thatisafactorto put into the mix ofinformation.Thatinformationbecomes far moremeaningful, though, when itbecomes a supplemental partof thebuy-and-holdanalyst’sindependent judgment aboutwhatthefirmmightbeworthor what future dynamics forthat firm might be.Depending on the individualsituation, insider selling
mightmean on the one handthat a security is overpricedor,ontheotherhand,thatthecompany is now a moreattractive takeover candidate,inpartbecauseinsider-ownedblocks of stock can bepurchased or otherwise tiedup.Theanalyst isunlikelytobe able to make goodjudgments on this issuewithout having independentopinions about corporate
valuesanddynamics.A rationale for relying
solely on perceived opinionsof insiders and smart moneyis that theanalyst’s solegoalis to predict the prices atwhich a security will sell inthe immediate future. If youare going to try to predictnear-term prices, you hadbetter focus on what youbelieve influential othersthink: buy and sell
recommendations of majorresearch departments,consensus forecasts ofquarterly earnings, andinsider trading. This in factseems to be what a lot ofresearch department analystsand conventional moneymanagersdo,especiallythosewith no interest or littletraining in fundamentalanalysis. Relying heavily onthe perceived opinions of
others, to the exclusion ofindependent fundamentalanalysis, seems a tough waytomakealiving,though.The focus of broker-dealer
research departments andmoney managers may behelpful in predicting near-termmarketprices.However,this same focus tends tomislead in imparting deepunderstanding of a businessand the securities it issues.
Such deep understanding isessential for OPMIsinterested in long-terminvestments; for controlinvestors; formost distressedsecurity investors; and forcreditanalysis.Itseemstousthat these misperceptionsarise out of an overemphasisonfourfactors:
1.Abeliefintheprimacyof the income accountand a consequent
downgrading of balancesheet–related elements.This belief rests on amyopic view of howbusinesses generatewealth.2.Abeliefinequilibriumpricing.Itisbelievedthatprice changes occur onlyas the market receivesnew information. Theprice of a security isalways right, and
securities, therefore, arenever overpriced orunderpriced in OPMImarkets.3. An overemphasis ontop-down factors and aconsequent downgradingof bottom-upconsiderations.4.Anemphasisonshort-termism. This bias is anatural consequence ofalltheabovebeliefs.
SUMMARYIn summary, there are hugeproblems involved inobtaining satisfactory long-term performance byfollowing what appear to bethebasicpreceptsofresearchdepartment analysts andconventional moneymanagers. Both valueinvestingandtheteachingsofBenjaminGrahamandDavid
Dodd also have problems.Nonetheless, it appearsmucheasier and basically muchmore productive to adhere tovalue investing standardsrather than researchdepartment and conventionalmoney manager approaches.Still, it is obvious that some—though probably asubstantial minority of—portfolios run byconventional money
managers perform quitesatisfactorily on average andover the long term. This canbe attributed to the fact thatmany money managers arevery smart. Even so, whateven the best conventionalmoneymanagersdoseemstobe the hard way to achievesatisfactory results comparedwith the results of analystswho lean more toward valueinvesting.
_______________*ThischaptercontainsoriginalmaterialandmaterialcontainedinChapter4ofValueInvestingbyMartinJ.Whitman(©1999byMartinJ.Whitman).ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1SeeChapter14.2Theconceptappearstohavebeenpopularizedby
PeterLynchinhis1989OneUponWallStreet(NewYork:Fireside,1989).3ThisratiowasdevelopedbyMarioFarinainhisbookABeginner’sGuidetoSuccessfulInvestingintheStockMarket(PalisadesPark,NJ:Investors’Press,1969).
PartThree
Real-WorldConsiderations
CHAPTER19
UsesandLimitationsofFinancialAccounting*
TheConventionalApproachesFinancialAccountingReportsasObjectiveBenchmarksGenerallyAcceptedAccounting
PrinciplesasDefiningRealityforCertainSpecificPurposesGenerallyAcceptedAccountingPrinciplesasaRoadMapforDueDiligence
andLessThoroughInvestigationsSummary
Corporate reporting of “thenumbers” has become soimportant, and so publicized,it might be helpful to ourreaders if we commentedbrieflyabouthowweuseand
think about financialstatements prepared inaccordance with GenerallyAccepted AccountingPrinciples (GAAP) and withInternational FinancialReporting Standards (IFRS).We are quite different frommostothers inhowwemakeuseoffinancialinformation.First, financial statements
are always of utmostimportance in our analysis.
This, perhaps, may be themost significant reason whywehaveneverbeen involvedwithpureplayInternetissues.Here, corporate numbers didnot seem tocount at all.Theonly important thing seemedto be to gauge short-terminvestor psychology—something to which we payscantattention.GAAPor IFRS figurescan
serve two different roles for
outside passive minorityinvestors(OPMIs):
1. First, an accountingnumber—usuallyearnings per share—is atool to be used to helppredictthepriceatwhichacommonstockwillsellinmarketsjustahead.2. Alternatively, allaccountingnumbers—thewholebookkeepingcycle—are tools to be used to
giveaninvestorobjectivebenchmarks, clues to aidhim or her inunderstanding a businessanditsdynamics.The vast majority of
analystsseemtoviewGAAPor IFRS only in their firstrole, as tools to be used tohelp predict the price atwhich a common stock willsell in the period just ahead.The regulators, whether
governmentalasembodied inthe Securities and ExchangeCommission, or private asembodied in the FinancialAccounting StandardsBoard,seem to share the sameviewwholeheartedly. Estimatingthe market impact ofaccounting numbers is whatcountsforthem.Thus,forthemajorityofusersof financialaccountingthereisaprimacyoftheincomeaccount.1There
has to be as accurate astatement as possible ofquarterly reports of incomefrom operations; earningsbefore interest, taxes,depreciationandamortization(EBITDA); and earnings pershare (EPS). The focus is onan income account, or flow,number with full attentionpaidtowhatthenumbersare,as reported, rather than whatthenumbersmean.
We belong to the secondschool in our use of GAAPand IFRS. We believe thatfinancial accounts areessentialtoolsgivinganalystsobjective benchmarks, cluesthatwillaidinunderstandinga business and its dynamics.Inequityanalysis,accountingcannot, and should not, beexpected to tell real-worldtruths. Rather, the limitingassumptions of GAAP—for
example, depreciation isbased on original cost ratherthan current value—meansthat what the numbers are,are not what economic truthis. Many of the underlyingassumptions of GAAP haveto be unrealistic as forexample property values arebased on historic cost lessperiodicdepreciationcharges,rather than estimated marketvalues for properties like in
IFRS.2 Additionally, if onewants to understand abusiness and its dynamics,one has to focus on aconsiderably greater numberof factors than merely flows—whether income fromoperations,EBITDA,orEPS.Equally important, and
usually more important thanflows, in a fundamentalfinanceanalysis,isthequalityand the quantity of resources
(relative to the price beingpaid for a common stock)existinginabusiness.Qualityof resources and quantity ofresources are essentiallybalance sheet, rather thanflow,considerations.Further, in a fundamental
finance analysis, there is noprimacy of anything such asearnings, but rather arealization that any numberwithin thewholeball ofwax
can be important. Everyaccounting number is afunctionof,derivedfrom,andmodifiedbyotheraccountingnumbers.Moreover,therearenotop-downrulesfortheuseofGAAP thathaveuniversalapplicability,contrarytowhatseems to be the case withconventional approaches.Rather, each accounting itemis evaluated from the bottomupinspecificcontexts.
The analytical techniquesthat we use, while differentfrom those that seem to beused by most moneymanagers, seem to be quitesimilartothoseusedbymostactivist investors, or thoseinterestedinobtainingcontrolofcompanies.Forus,GAAPand IFRS reports serve threepurposes:
1. To provide analystswith objective
benchmarks, essentialtools of analysis thatanalystsuse todetermineone or more economicrealitiesortruths2. To define reality forcertainspecialpurposes3.Toprovidearoadmapfor analysts both in due-diligence investigationsand in less thoroughinvestigations, in whichanalysts rely exclusively
onpublicrecordsIn this chapter we briefly
discuss the conventionalapproaches to using financialaccounting information first.We then discuss financialaccounting reports preparedunder GAAP or IFRS asobjective benchmarks, nottruth. For certain specificpurposes,GAAP does definereality. We discuss thesespecific cases next. Finally
we illustrate how eitherGAAP or IFRS provide aroad map for due-diligenceinvestigations and lessthoroughinvestigations.
THECONVENTIONALAPPROACHES
The conventional roles
visualized for financialaccountingappeartobequitedifferent from the rolesaccounting has infundamental finance.Conventional approaches tofinancialaccountingarethosethat seem to be followed bymost broker-dealer researchdepartments and mostinvestment-company moneymanagers. The conventionalapproach is endorsed also in
theliteraturerecommendedinstudy guides for thoseseeking the designationchartered financial analyst(CFA). Three volumes makeupthebulkoftheCFAstudyguide literature coveringfinancialstatementanalysis:
FundamentalsofCorporateFinance,ThirdEdition,byStephenA.Ross,RandolphW.
Westerfield,andJeffreyF.Jaffe(Irwin,1995)InvestmentAnalysisandPortfolioManagement,FifthEdition,byFrankK.ReillyandKeithC.Brown(DrydenPress,1997)TheAnalysisandUseofFinancialStatements,SecondEdition,byGeraldI.White,AshwinpaulC.Sondhi,
andDovFried(JohnWiley&Sons,1997)
The roles of GAAP underconventional approachesappeartobeasfollows:
Accountingdatashouldreflectthetruth,oreconomicreality,tothemaximumextentpossible.Theimportantfigureforwhichtruthistobeascertainedisthefirm’speriodicnet
incomefromoperations,orothermeasuresofafirm’sperformanceduringaperiod.ThereactionofOPMItradingmarketstothedisseminationofaccountinginformationasmeasuredbyOPMImarketpricesisamatterofcrucialimportance.TheonlymarketthatcountsistheOPMI
market.White, Sondhi, and Fried
discuss, inChapter5of theirbook, “Empirical Research:Implications for FinancialStatement Analysis,” theprincipalavenuesfollowedinthe conventional approach:the classical approach,market-based research, andpositiveaccountingresearch.They point out that the
classicalapproach
attempts, using atheoretical perspective, todevelop an optimal, or“most correct”accountingrepresentationofsometrue(but unobservable) reality.(p.216)In describing market-based
research,theywrotethatIts primary focus is themarket reaction to (orassociation with) reportedaccounting data. Market
based research usesobservable relationshipsbetween reported earningsor other measures of firmperformance) and marketreturntodrawconclusionsabout the role ofaccountinginformation.(p.216)The “positive” accounting
theory approach, they wrote,adapts much from market-basedresearchbutrecognizes
further that accountinginformation as reporteddefines reality for a wholegamut of non-OPMI marketcontexts,includingmanagement compensationplans, debt agreementswithcreditors,andthehostof regulatory bodiesinteracting with the firm.More important, itrecognizes that sincefinancialstatementsimpact
these other environments,there are incentives foraccounting systems to beused not only to measuretheresultsofdecisionsbut,in turn, to influence thesedecisionsinthefirstplace.(pp.216,218)The classical approach and
market-based research seembased on the followingunderlying assumptions thathavelittleornovalidityfrom
a fundamental finance pointofview:
Firmsarestrictgoingconcernsandaretobeappraisedassuch.Thusitfollowsthatthereexistsaprimacyoftheincomeaccountandaconsequentdenigrationofotherelementsthatmakeuptheaccountingcycle.Thismakessensebecauseifacompanyisa
strictgoingconcern,thepastearningsrecordoughttobethebesttoolforpredictingfutureearnings.3Predictingpricesfornear-termOPMItradingmarketsisananalyst’sprimaryorprincipaltask.Thus,thereexistsaprimacyoftheincomeaccount.OPMImarketsclearlyseemtoreact
moretocurrentearningspersharereportsthananyotheraccountingnumber,especiallybalancesheetnumbersforsolventcorporations.Thisfocusisthedirectresultofviewingbusinessesaspuregoingconcerns.4PricesinOPMImarketsareuniversalequilibriumpricesthatreflectall(or
almostall)availablepresentinformation.Priceswillchangeasnewinformation,bothaccountinginformationandnon-accountinginformationbecomesknown.5MarketisdefinedastheOPMImarket.Othermarkets(e.g.,theleveragedbuyout[LBO]market)areignored.
ThepresenceorabsenceofpricevolatilityinOPMImarketsisdeemedimportantforallinvestors,evenbuy-and-holdfundamentalistswhodonotfinancetheirholdingsusingborrowedmoney.
In summary, the purposesand uses of accounting infundamental finance seemquite different from those in
conventional approaches.Weview financial accounting asa tool to help analystsapproximate:
TheperformanceofabusinessduringaparticularperiodThequalityandquantityofresourcesexistinginacompanyatanyonemoment
Over and above thesefactors, financial accounting
is also a tool used to makejudgments about manynonfinancial (i.e.,nonnumeric) factorsincluding:
AppraisalsofmanagementFindinginformationaboutmaterialdocumentssuchas
1.Leases2.Loanagreements3.Pensionplans
4. Employmentagreements
Inconventionalapproaches,one key role of financialaccounting, albeit not theonly one, is to measure thetrue performance of abusiness during a periodwhile emphasizing thereactions of traders to newaccounting information asmeasured by changes insecuritiesprices.
FINANCIALACCOUNTINGREPORTSASOBJECTIVE
BENCHMARKSGAAP is a system in whichreports are made within arelatively rigid code whosedescriptions of reality arelimited because the
underlyingassumptionsofthesystem frequently areunrealistic. Among theGAAP assumptions that areunrealistic in many contextsarethat:
Property,plant,equipmentaretobecarriedathistoricalcostasdepreciated.Constantpricelevelsexist.Currentassetsandlong-
termassetsaretobedefinedinastandard,inflexiblemanner.6Allaccountsontheright-handsideofabalancesheetareeithernetworthorabove-the-lineequivalentsofpayables.Accrualconceptsaretobeusedinmostcontextsinwhichcostsandexpensesarematched,evenwhensuchaccruals
areatoddswiththecashexperienceofthecompany.Sometimesliabilitiesareburdenedwithacostofmoney,andsometimestheyarenot.Thereexistnoliabilities(e.g.,deferredincometaxes)thatmayhavealargeequitycomponent.
Furthermore, even giventhelimitednumberofchoices
available to corporatemanagements under GAAP,none of those choices needreflecteconomicreality:
InventoryaccountingAccountingforlong-livedassetsOn-balance-sheetandoff-balance-sheetliabilitiesAccountingforlong-termemployeebenefitsAccountingforincome
taxesAccountingforbusinesscombinations
GAAP originally weredesignedasasystemtoreportontheresultsandthepositionof a consolidated corporationas a standalone. In the late1990s, there were trendsdesigned to consolidatesubstantively reports of thecompany with stock-marketmeasures pertinent to others.
This was exemplified byproposals later turned intorules to charge a company’sincome account with theestimated value of stockoptions issued to employees.This seemsutterlyunrealisticbecause it assumes that thevalueofabenefitreceivedbyanemployeetothatemployeeequals the cost to thecompany of granting thatbenefit. It is a basic concept
of fundamental finance thatthe company is a standaloneconstituency. The value of anoncash benefit to anemployee ought not to beequated to a cost to acompany. The corporation isa separate and distinctconstituency from thecorporation’s stockholders inalmostallcontexts.7
Because GAAP imposesrelatively rigid sets of rules
and are overseen andreviewed by independentprofessionals who renderopinions(publicaccountants),audited financial statementsare often the only numericreports available to securityanalysts that give themreliable, objectiveinformation prepared in adisciplinedsetting.GAAParenottruthorreality,butatoolanalysts use to determine
their own versions of truth.By contrast with GAAP,other numeric reports (e.g.,investment bankers’ opinionsandappraisers’ reports)oftenlack objectivity andindependence. These otherreports tend to be derived insettings lacking professionalstandards or disciplines, andthe other professionalsrendering them usually areinfluenced, sometimes
heavily, by who has hiredthemandwhoispayingtheirfees and expenses. This doesnot seem to be the case,however,forthevastmajorityofindependentaudits.As has been pointed out,
reality tends to be one thingwhenacompanyisexaminedas a going concern but quiteanotherwhenthesamesetofnumbersisused,forresourceconversionvaluations.
EXAMPLEFor a going concern, retailinventoriesareanythingbuta current asset; a retailchain had better maintainor even increase itsinvestmentininventoryifitis going to remain inoperation, because suchinventory is a fixed, long-term asset. On the otherhand,iftheretailchainistogo out of business(resource conversion),inventory becomes a true
current asset, convertibleinto cash over the next 12months.
In the real world, whywould anyone expectfinancial accounting todisclose truth or reality formost analyses? In fact,though, GAAP data seem toreflect economic reality inquite a number of specialcases.
EXAMPLEThe balance sheets ofinvestment companiesregistered under theamended InvestmentCompany Act of 1940reflect reality based onvaluingportfoliosatOPMImarketpricesinaccordancewithGAAP.
Furthermore,itseemslikelythat for most credit analysis,GAAP are realistic enough.
Here, GAAP are not used tovalue, per se, but rather togive analysts enoughinformation to gauge theprobabilities that a debtinstrumentwillbeservicedinaccordancewithitsterms.By contrast, and as is
pointed by White, Sondhi,and Fried, “the ultimateobjectiveofequityanalysisisvaluation” (p. 932). From afundamental finance point of
view, when analysts areinterested in the quality ofresources existing in abusiness, especially if theyareevaluatingaseniorcredit,the one crucial disclosure tothem would not necessarilybe corporate valuation butrather the existence—ornonexistence—of liabilitiesthat might be equal to orseniortothecreditinstrumentbeing evaluated. This latter
information is readilydisclosedinmostaudits.As we have repeated ad
nauseam, in fundamentalfinance the focus is mostoften on what the numbersmean rather than what thenumbers are. FundamentalfinanceanalystsdonotexpectGAAP numbers to reflecttruth or reality; rather, theyviewGAAP numbers as rawmaterials to be used, so they
adjust the numbers toapproximate reality. Truth orreality is something to bedetermined by analysts, notby accountants who preparefinancial statements inconformity with thatrelativelyrigidsetoflimitingassumptions known asGAAP.
EXAMPLEIn examining the property,
plant, and equipmentaccounts of a hotel-motelchain, mainstream analystslikely would look atdepreciation as a noncashcharge against the incomeaccount. By contrast,although value investorswould view depreciationattributable to buildingscharged against thecompany’s incomeaccountas being a noncash chargegiving rise to cash flowsfrom operations, theywould likely view any
depreciation chargedagainst the company’sincomeaccountattributableto furniture and fixtures asbeing the equivalent of acurrent cash expense orexpenditure. Put simply,well-maintained, well-located bricks and mortardo not suffer much if anyeconomic depreciation, butfurniture and fixturesdecline in value becausethey are used daily andhave to be replaced withrelativeregularity.
In almost any analysis, wewill be interested innotonlyperiodic results fromoperationsbutalsothequalityand quantity of resourcesavailable to the companywhosecommonstockisbeinganalyzed. We realize thatevery accounting number isderivedfrom,ismodifiedby,and is a function of all theothernumbersthatarepartof
theaccountingcycle.Income-account numbers can be nomore accurate or meaningfulthan balance-sheet numbers.Each group is derived from,is modified by, and is afunction of the other.White,Sondhi,andFried’sviewthat“the usefulness of thereported balance sheet forinvestment decisions islimited”(p.933),seemstobein error from our point of
view. A more appropriatestatement might be that thereported balance sheet andthe income account areintimately related to eachother for investment decisionpurposes but that theusefulness of the reportedbalance sheet for day-to-dayor hour-to-hour stock-markettrading decisions is muchmorelimitedthanisthestatusofcurrentor forecast income
accounts.When analysts want to
forecast future earnings for abusiness relying on GAAPresults, they frequentlyconclude that the quality andquantity of a business’sresources at the end of arecentperiodmayrepresentabetter tool for predictingfuture results than does thepast earnings record—eventhe earnings record of the
very recent past. Moreimportantly, neither presentresources nor past earningsare tools to be usedexclusively to forecast futureearnings; both can and mostoften should be used inconcert.
EXAMPLEIn early 1960, SocietyCorporation was a bankholding company based in
Cleveland, Ohio. At thattime,banksingeneralwereearning between 8 and 12percent of net worthannually. Society, with anet worth of about $50 ashare, was earning about$1.50 a share fromoperations when itconverted from a mutualsavings bank to acommercial bank holdingcompany in 1962. Thisequaled a return on networthofonly3percent.Amarket participant could
reasonwithafairdegreeofconfidence that over timeSociety probablywould beearning a return on itsequity close to that whichwas being achieved in thecommercial bankingindustry in general. Atleast, there did not appearto be any insurmountableproblems preventing this.Furthermore, book value,too, would be steadilyincreasing. The anticipatedresults occurred; reportedearnings increased year by
year,andby1966operatingearningswere$5pershareonayear-endbookvalueof$62. The prediction ofSociety Corporation’sfuture earnings could nothavebeenbasedonthepastearnings record. Anexamination of the assetvalues and the belief thatsuchassetvalueswouldbeused much the way othercommercial bank holdingcompaniesusedtheirswerethe basis for the earningsforecast.
We do not subscribe to aprimacy-of-earningsapproachto analysis, becausewe haveobserved that few if anybusinesses whose commonstocks arewidely held are infact strict going concernsengagedintraditionalday-to-day operations managed asthey always have been andfinancedas theyalwayshavebeen financed. We assume
thatvery fewcompanieswillgo as long as five yearswithout being involved inmergers and acquisitions(M&A), restructurings,massive refinancings,changes in control, andliquidations in whole or inpart.When companies are not
strict going concerns,managementappraisalsoughtto assess managements not
only as operators but also asinvestors employing andredeployingassetsandalsoasfinanciers,who are financingand refinancing businesses.8These investor appraisals arenot possible for analystsfocusedstrictlyonthatpartofGAAP or IFRS concernedwith reporting the results ofoperations, with emphasisonly on recurring revenuesandprofits.
Although it is toomuch toexpect GAAP or IFRS toreport truth or economicreality forpurposesofequityvaluations, GAAP or IFRSarethebasictoolsneededformaking judgments about themanagements of mostcompanies either asoperators, investors, orfinanciers. For us theinvestment and financierfunctions tend to be much
more important than theoperating function eventhough operating skills arenot usually divorced frominvestment skills.Nonetheless, one goodinvestment deal can havemore significance than 10years of brilliant operations.Look at the histories ofBerkshire Hathaway Inc. orNaborsIndustries.Market-based research is
concerned exclusively withthe trading environment inOPMI markets. In terms ofGAAP, market-basedresearch attempts to fathomhow new accountinginformationis likelytoaffectOPMI prices. In followingthis approach, analysts missmuchabout theusefulnessoffinancial accounting forequity evaluations inmarketsother than OPMI markets—
say,LBOmarkets,ormarketsfor venture capitalinvestments, or markets forthe senior debt of troubledissuers.A numeric example of
differential pricing for LBOmarkets compared withpricing in OPMI marketsdemonstrates that largeamountsofrealvaluestendtobemissedby thosewho lookto market-based research.
Assume common stockXYZistradingintheOPMImarketataround16,perhapsbecauseXYZ’s near-term earningsoutlookispoororbecausethemarket prices for companiesin XYZ’s industry sector aredepressed. Assume furtherthat a control buyer, relyingin part on audited financials,believesthatXYZcommonisworth not less than 35because:
1. XYZ has a favorablelong-term operatingoutlook based on bothbase-case and reasonableworst-caseforecasts.2. The control buyergauges that a strongabilityexists to financeatransaction attractivelygrounded largely onperceptions that XYZenjoys strong financesand might have certain
assets that could be soldwithout interfering withgoingconcernoperations.3.Thebuyerbelievesthatvarious benefits, such asmanagement salaries andfees,canbeobtained.9
The control buyer theneither makes a cash tenderofferforXYZcommonat21or else proposes a cashmerger at 21 with a shellcorporation set up for the
express purpose of acquiringXYZinamergertransaction.The control buyer group canconsist of outsiders,incumbent management, orcombinationsthereof.Market-based research
focuses strictly on thearbitrage that would existbetween the OPMI marketprice of 16 and the takeoverpriceof21orperhapsslightlyhigher.Thequestionaskedin
marketbased-researchishowtheOPMImarketwillreactintermsof tradingprices to theannouncement (or leak) of atakeover at a price of 21.Market-based researchwouldbe completely oblivious tothe use of accountinginformation by potentialcontrol investors and othersto determine that XYZcommon might have atakeover value of
approximately 35. Thatanalysisseemstobethestrictprovince of fundamentalfinance investing. Indeed, theefficient market hypothesis(EMH), the fatherofmarket-based research, is concernedonly with OPMI tradingmarkets, ignoring completelylong-term buy-and-holdfundamentalism.The use of GAAP in
fundamental finance is
similar to the use of theInternal Revenue Code byskilledtaxpractitioners.Boththe fundamental financeanalyst and the taxpractitioner are essentiallytranslators. Both takerelatively rigid reportingsystems: GAAP and therevenue code, and using therules embodied in thosesystems, convert them intosomething usable. For the
fundamental finance analyst,thegoalistotranslateGAAPinto something reflecting theeconomic realities pertinentto the business beingexamined. For the taxpractitioner, the goal is totranslate the revenue code sothatthepresentvalueoftaxespayable by clients isminimized. For example, taxprofessionals attempt toreportastax-deductiblelosses
those items that haveeconomic profits built intothem; the well-maintainedbricks and mortar owned bythe hotel-motel chain citedpreviously may in factappreciateinvalueovertime,yet depreciation chargesagainst thebricksandmortararetaxdeductible.Theskilledincome tax professional doesnot seek economic truth butuses, to the extent permitted
by the revenue code,accelerated depreciationmethods,shortenedlives,andminimal salvage values incharging the income accountprepared for tax purposeswith depreciation deductionsfor the buildings owned bythehotel-motel chain.Weonthe other hand, take thedepreciation figures used fortax purposes and try totranslate those figures,
overstated in terms ofeconomic reality, intoeconomicreality.When an analyst is dealing
withwhatthenumbersmean,whatisimportantisonlythatitems be disclosed. There isno emphasis whatsoever onwhere and how items aredisclosed. This is antitheticalto all conventionalapproaches, in which theperceived primary goal of
financial accounting is astatement of periodic incomefrom operations that is ascorrect as possible.Subscribers to thisconventionalviewoftheroleof GAAP include academicfinance, Graham and Doddfundamentalists, andaccounting authoritiesranging from the FinancialAccounting Standards Board(FASB) to the Securities and
Exchange Commission(SEC). Since the 1970s,however, accountingdisclosureshave improvedsomuch, that it is hard tocomplain merely becauseaccounting authorities givemuch time and attention totheforminwhichaccountingdata is disclosed rather thanto substantive disclosures.Thefactisthatimprovementssincethe1970sinthequality
and quantity of substantiveaccounting disclosures havealsobeendramatic.Important goals in the
conventional approach arethat accounting statementsexhibit comparability andconsistency. More importantthan comparability andconsistency, when financialsare viewed as objectivebenchmarks, isreconcilability. Analysts
ought to be given enoughinformation so that they canmake financial statementscomparableandconsistentfortheiranalyses.
GENERALLYACCEPTED
ACCOUNTINGPRINCIPLESAS
DEFININGREALITYFORCERTAINSPECIFICPURPOSES
When using GAAP as anobjective benchmark, whatthe numbers mean is mostoftenfarmoreimportantthanwhatthenumbersare.GAAP
numbers as reported moreoften than not do not reflecteconomic reality, but this isfar from always the case.Good fundamental financeanalysts are always aware ofthose instances in which theGAAP numbers actually dodefine certain realities—inwhich what the numbers areactually does become moreimportant than what thenumbers mean. This section
of the chapter reviews thosespecial circumstances whenthe reported accountingnumbers define economicreality,legalreality,orboth:
TheOPMItradingenvironment.Here,onereportednumber—EPSquarterbyquarter—seemstodefinereality,especiallyinrelationtowhenthatEPSnumberequals,exceeds,orfalls
shortofconsensusforecasts.Thosetimeswhencorporationsorinsidersareseekingaccesstocapitalmarketstosellequityissues.Intheseinstances,andfromthepointsofviewofthecorporationandinsiderswhomightsell,reportedEPSusuallyhaveabiginfluencenotonlyonthe
priceatwhichanequityissuemightbemarketedbutalsoonwhethertheissuecanbemarketedatall.Testsastowhethercorporationsaremeetingloancovenants,requirements,orothercontractualrequirements.ThesefiguresareusuallybasedonreportedGAAP
results.SuchresultstypicallycovermanythingsotherthanEPS,includingminimumnetworth,EBITDAtodebtratios,earnings’coverageofinterest,cashflowcoverageofdebtservice,stock-to-debtratios,andworkingcapitalratios.Capitaladequacytestsforregulatedfinancialinstitutions.These
usuallydealinGAAPnumbersasreportedorincodifiedadjustmentstoGAAPnumbers.Thisisthecasefordepositoryinstitutions,insurancecompanies,andbroker-dealers.Ratingagencies.TheserelyagreatdealonreportedGAAPfinancials.
GENERALLYACCEPTED
ACCOUNTINGPRINCIPLESASAROADMAPFORDUEDILIGENCEANDLESS
THOROUGHINVESTIGATIONSAudited financials, interimfinancials, and themanagement discussion andanalysis (MDA), availableeither in company Internetpostings or SEC filings,provide a comprehensivedisclosure framework thatenables a fundamentalfinance analyst to understand
much about most—but farfrom all—businesses and thesecurities, both credit andequity that they issue.Financial statements coverthe accounting cycle throughthebalancesheet, theincomeaccount statement, thestatement of cash flows, andthestatementofstockholders’equity, all as supplemented,especiallyinannualauditsbyfootnote disclosures and the
independent accountant’sopinion. The MDA, issuedquarterly and unaudited, isrequired to discuss thefollowing:
Resultsofoperations,includingtrendsinsalesandcategoriesofexpenseCapitalresourcesandliquidity,includingcashflowtrendsOutlookbasedonknowntrends
A convenient way to get ahandle on all of the types ofinformation disclosed underGAAPistoexaminethetableof contents of the 2012edition of the GAAP Guide:Interpretation andApplication of GenerallyAccepted AccountingPrinciples, by Steven M.Bragg(JohnWiley&Sons):GenerallyAcceptedAccountingPrinciples
PresentationofFinancialStatements
DiscontinuedoperationsBalancesheetStatementofshareholdersequityComprehensiveincomeIncomestatementStatementofcashflowsNotestothefinancialstatements
VariousFinancialReporting,Presentation,and
DisplayMattersAccountingchangesanderrorcorrectionsChangingpricesEarningspershareInterimreportingLimitedliabilityentitiesRiskanduncertaintiesSegmentreporting
Transaction-RelatedTopicsCashandcashequivalents
ReceivablesNonrefundablefeesandothercostsLoansanddebtsecuritiesacquiredwithdeterioratedcreditqualityTroubleddebtrestructuringsbycreditors
Investments—debtandequitysecuritiesInvestments—equity
methodandjointventures
Partnershipsandunincorporatedjointventures
Investments—otherInvestmentsininsurancecontractsBeneficialinterestsinsecuritizesfinancialassets
Inventory
Deferredcostsandotherassets
CapitalizedadvertisingcostsInsurancecontractsthatdonottransferinsurancerisk
Intangibles—goodwillandother
GoodwillGeneralintangiblesotherthangoodwill
Internal-usesoftwareWebsitedevelopmentcosts
Property,plant,andequipment
RealestatesalesLiabilities
ExtinguishmentofliabilitiesInsurance-relatedassessments
Assetretirementand
environmentalobligations
AssetretirementobligationsEnvironmentalobligations
ExitordisposalcostobligationsDeferredrevenueCommitmentsContingencies
Losscontingencies
GaincontingenciesGuaranteesDebt
DebtwithconversionandotheroptionsParticipatingmortgageloansProductfinancingarrangementsModificationsandextinguishmentsTroubleddebtrestructuringsby
debtorsDistinguishingliabilitiesfromequityEquity
StockdividendsandstocksplitsTreasurystockQuasi-reorganizationsEquity-basedpaymentstononemployeesSpinoffsandreversespinoffs
RevenuerecognitionProductsServicesMultipleelementarrangementMilestonemethodRightstouseConstruction-typeandproduction-typecontractsGainsandlossesPrincipal-agentconsiderations
Customerpaymentsandincentives
CostofsalesandservicesCompensationCompensation—nonretirementpostemploymentbenefitsCompensation—retirement
DefinedbenefitplansOtherpostretirementbenefitplansDefinedcontribution
plansMultiemployerplans
Compensation—stockcompensation
AwardsclassifiedasequityAwardsclassifiedasliabilitiesEmployeestockownershipplansEmployeesharepurchaseplans
OtherexpensesStart-upcostsInsurancecostsContributionsmadeRealandpersonalpropertytaxesAdvertisingcostsElectronicequipmentwasteobligationsBusinessandtechnologyreengineering
Researchand
developmentResearchanddevelopmentarrangements
IncometaxesIntraperiodtaxallocationOtherconsiderationsorspecialareas
BroadTransactionalCategories
Businesscombinations
Identifiableassetsandliabilities,andanynoncontrollinginterestGoodwillorgainfrombargainpurchase,includingconsiderationtransferredReverseacquisitionsRelatedissues
CollaborativearrangementsConsolidation
ControlofpartnershipsandsimilarentitiesResearchanddevelopmentarrangements
DerivativesandhedgingEmbeddedderivativesHedgingFairvaluehedgesCashflowhedgesNetinvestmenthedges
Contractsinentity’sownequityWeatherderivatives
FairvaluemeasurementsRegistrationpaymentarrangements
ForeigncurrencymattersTranslationoftransactionsTranslationoffinancialstatements
Interest
CapitalizationofinterestImputationofinterest
LeasesOperatingleasesCapitalleasesSale-leasebacktransactions
NonmonetarytransactionsRelated-partydisclosuresReorganizations
Quasi-reorganizationsSubsequenteventsTransfersandservicing
SalesoffinancialassetsSecuredborrowingsandcollateralTransferstoqualifyingspecial-purposeentitiesServicingassetsandliabilities
Industry/UniqueTopicsAgricultureAirlinesContractors—construction
ContractcostsContractors—federalgovernment
ContractcostsDevelopmentstageentitiesEntertainment—
broadcastersEntertainment—cabletelevisionEntertainment—casinosEntertainment—films
Otherassets—filmcosts
Entertainment—musicExtractiveactivities—miningExtractiveactivities—oilandgasFinancialservices—
brokersanddealersBrokeranddealeractivities
Financialservices—depositoryandlendingFinancialservices—insurance
InsuranceactivitiesAcquisitioncostsClaimcostsandliabilitiesforfuturepolicybenefits
PolicyholderdividendsPremiumdeficiencyandlossrecognitionSeparateaccounts
Financialservices—investmentcompanies
Investmentcompanyactivities
Financialservices—mortgagebankingFinancialservices—title
plantFranchisorsHealthcareentitiesNot-for-profitentities
FinanciallyinterrelatedentitiesSplit-interestarrangements
Planaccounting—definedbenefitpensionplans
Accumulatedplan
benefitsNetassetsavailableforplanbenefitsTerminatingplans
Planaccounting—definedcontributionpensionplans
TerminatingplansPlanaccounting—healthandwelfarebenefitplans
Netassetsavailableforplanbenefits
PlanbenefitsobligationsTerminatingplans
RealestateRealestate—commoninterestrealtyassociationsRealestate—realestateinvestmenttrustsRealestate—retaillandRealestate—timesharingactivitiesRegulatedoperations
Discontinuationofrate-regulatedaccounting
SoftwareCostsofsoftwaretobesold,leased,ormarketed
U.S.steamshipentitiesThese topics do not tell
analystseverythingtheywantto know about a company,but for most companies, the
GAAP-required disclosuresprovide a road map that notonly tells analysts what isimportant to understanding acompanyand thesecurities itissues but also—and perhapsmore importantly—givesthem clues about importantthings they do not know.Admittedly, there probablywill not be GAAP-relateddisclosures, at least early on,that a new product being
developed by a competitormight negatively affect anissuer, as for example, whenMicrosoft’s Internet Explorerwon market share fromNetscape. Nonetheless, thetendency toward makingnegative disclosures underGAAP is a strongone.Sincethe 1970s independentauditorshavebeendevastatedby damage awards insecurities lawsuits claiming
accountants’ liability. It canbetakenforgrantedthatlargeaccountingfirmsaregoingtopress managements, whichare responsible for preparingthe financial statementsreviewedbyauditors,tomakeany negative disclosures thatare admissions againstinterest. Independentauditorsof the statements ofcompanies with publiclytraded securities are usually
very careful in comportingwith not only GAAP rules,which cover what is to bedisclosed in financialstatements,butalsoGenerallyAcceptedAuditing Standards(GAAS), which cover theprocedures to be followed inpreparing an audit. Theclimate fostered bydevelopments inaccountants’liability may not be overlyproductive for society as a
whole. Nonetheless, theenvironment created issomething that prudent valueinvestors recognize and takeadvantageof.HowistheGAAProadmap
used by fundamental financeanalysts in most of theiranalyses?
Asadisciplinedsettinginwhichtounderstandtheoperationsandtheinvestmentpotentialsof
thebusiness.Asahugeaidinflaggingcontingencies,risks,anduncertaintiesofallsorts.Asagoodtoolforappraisingmanagements.Forexample,whenmanagementshaveaccountingchoices(e.g.,accountingforoilandgasexplorationbyusing
eitherfullcostaccountingorsuccessfuleffortsaccounting),analystswilllookatthechoicesmadebymanagementtogaugewhethermanagementisbasicallyconservativeorpromotional.Asuper-strongbalancesheetmaybeevidencethatamanagementisextremelyconservative.
Asagoodtoolforascertainingwhichdocumentsarematerialandoughttobereviewed:long-termloanagreements,leases,pensionplans,laborcontracts.Thesewill,toagreaterorlesserextent,bedescribedinfinancialstatementfootnotes.Asagoodtoolforlookingatthequalityof
acompanyanditssurvivabilityasgaugedbytheauditors’opinion.Acleancertificationisatleastasmallsourceofcomfort;aqualificationinthecertificateaboutacompany’sabilitytosurviveasagoingconcernshouldbeasourceofcautionforholdersofparent-
companycommonstockandperhapsforotherholdersofjuniorsecurities—say,subordinateddebentures.
Formanytypesofanalyses,GAAParenotallthathelpful,although it is always anessentialtool.When the quality of a
corporation’s resources ismeasured in part by thepresence or absence of
liabilities either on thebalancesheetor in footnotes,GAAParecrucial.When a business’s success
is measured by newdiscoveries (e.g., oilwildcatting) or newinventions (e.g., an advancedcomputer chip not yetmarketed),GAAPdisclosuresare far from central to ananalysis from the point ofview of an OPMI
stockholder.Generally accepted
accounting principles have anumber of basicshortcomings:
MostGAAParedirectedtowardtheinterestsofparent-companyshareholders.Forsuchconstituents,consolidatedfinancialstatementsaremostmeaningful.For
creditors,thereisoftenaneedforconsolidating—ratherthanconsolidated—financialstatementssothatthecreditorscanassesshowcashmightflowfromoperatingsubsidiariestoparentsaswellasexaminethebalancesheetsofmaterialcorporateentities.GAAPbasedonaccrual
accountingfrequentlyrunintodifficultiesexplainingcorporatecashexperiences.Cashaccounting,bytheway,hasconsiderableproblemsinfailingtodisclosecorporatewealthcreationandoperatingresults,asmeasuredbyaccrualprinciples.GAAPareoftennothelpfulwhenbusinesses
createwealththroughhavingunrealized—andthereforeunreported—appreciationofassetsforwhichtherearenoreadilyascertainablemarketvalues.Companieswithlargeholdingsofundevelopedacreageareexamplesofthesetypesofbusinesses.GAAPareprobablynotveryhelpfulforinvestors
focusedstrictlyonforecastingfuturegrowthtrendsinincomeorcashflowwithoutlookingtotheleaveningprovidedbynon–incomeaccountGAAPdisclosures.GAAParesomethingofavaccineagainstsecuritiesfrauds.Itseemslogicalthatmostpeopleengagedinunscrupulousstock
promotionsoroutrightfraudswouldchoosetopromoteasinvestmentvehiclesthoseentitieswherethefalsesizzleisastoryunrelatedtoGAAP.Taxshelters,pennystocks,emergingmarketequities,tradingsystems,commodityplays,newdiscoveries,andnewinventionsaretherawmaterialsusedbymost
unscrupulouspromoters.ThefactortheseinvestmentvehicleshaveincommonisthatGAAPdonotweighheavilyaspartoftheinvestmentstory.
The road-map aspects ofGAAP are crucial tomakinginvesting decisions. Auditedstatements, includingfootnotes and theaccountant’s opinion letter,
constitute comprehensivedisclosures within adisciplined setting. Thoseresponsible for preparing thestatements have strongfinancial incentives to havethose statements flag certainbusiness problems—say,potential environmentalliabilities.In fundamental finance
investing byOPMIs, there isfrequently a primacy of the
quality of resources in acompany. A major factor ingauging the quality ofresources is the presence orabsenceofliabilities,whetheron the balance sheet, in thefootnotes, or undisclosedaltogether. Auditors willmakegreateffortstoflaganddescribetheseliabilities:
Long-termdebtEnvironmentalcontingencies
LitigationcontingenciesPensionplansandotherlong-termemployeeobligationsMaterialleases
Footnote topics include thebasis of consolidation, fixedassets, inventories, incometaxes, pension and otherpostemployment benefitplans, debt, lawsuits andother loss contingencies,marketable securities and
other investments, significantcustomers, sales to relatedparties,andexportsales.UnderGAAP,acorporation
isrequiredtoaccruealossonbalance sheet when (1) it isprobable that an impairmenthas occurred and (2) theamount of the loss can bereasonably estimated.Moreover,footnotedisclosureis required when a loss isreasonably possible. Having
these loss disclosures isusuallyquiteimportant.Risks and uncertainties are
also part of a GAAP audit.Under GAAP, a company isrequired to disclose thefollowing:
Thefirm’smajorbusinessactivitiesandmarkets.Thefirm’suseofestimates.Certainsignificant
estimates.Pensionexpenseandrelatedliabilitiesaresignificantlyimpactedbytwokeyestimates:(1)theexpectedfuturerateofreturnonplanassets,and(2)thediscountrateusedtodiscountthefuturepensionliability.Anexampleofanextremelyaggressive
useofestimateswouldbeafirmthathas75percentoftheirpensionassetsinfixed-incomebutusesa9percentdiscountratetoestimatetheirpensionbenefitobligationliability.Lossreserves.Significantestimatesfrommanagementareutilizedincalculating
futureprobablelossesandbookingtherelatedreserve.
Thefirm’scurrentvulnerabilitiesduetocertainconcentrations.
Supplementary schedulesare another tool providingimportant disclosures forinvestingpurposes:
Estimatesofthevalueofprovedoilandgas
reservesdiscountedtopresentvalueata10percentdiscountrate(knownasSECPV10).ScheduleVofannualreportstotheSECgivingdataaboutdevelopedrealestate.Impactofchangingprices.Disclosureofsalesrevenue,operatingincome,andassets
employedformajorbusinesssegments,bygeographicareas;dataaboutexportsales.Disclosuresrelatedtofinancialinstrumentsandhedgingactivities.
Management discussionand analysis of quarterlyresults and of financialposition,liquidity,andcapitalresources are required toinclude a breakdown of
significant effects of knowntrends, events, anduncertainties (e.g., decline inmarket share). There is alsoto be a discussion ofdiscontinued operations andothernonrecurringitems.AlthoughGAAParealways
an essential tool, theimportanceof that tool in theinformation mix depends onwhat is analyzed. GAAP areprobably almost always key
in credit analysis; they arealsoalwayskey in theequityanalysis of most strict goingconcerns; theyaresometimesnot helpful in analysis of taxshelter (TS) investments; andthey are least useful inappraising companies whosevalue depends on newinventionsanddiscoveries.
SUMMARY
The purposes and uses ofaccounting in fundamentalfinance seem quite differentfrom those in conventionalapproaches. We viewfinancialaccountingasatoolto help analysts approximate(1) the performance of abusiness during a particularperiodand(2)thequalityandquantityof resourcesexistingin a company at any onemoment. Over and above
these factors, financialaccountingisalsoatoolusedto make judgments aboutmany nonfinancial (i.e., non-numeric)factorsincludingtheappraisals of managementandfindinginformationaboutmaterial documents such asleases, loan agreements,pension plans, and so on.Because GAAP imposesrelatively rigid sets of rulesand are overseen and
reviewed by independentprofessionals who renderopinions(publicaccountants),audited financial statementsare often the only numericreports available to securityanalysts that give themreliable, objectiveinformation prepared in adisciplinedsetting.GAAParenottruthorreality,butatoolanalysts use to determinetheir own versions of truth.
By contrast with GAAP,other numeric reports (e.g.,investment bankers’ opinionsandappraisers’ reports)oftenlack objectivity andindependence. There arespecial circumstances whenthe reported accountingnumbers define economicreality, legal reality, or bothas when GAAP numbers areused in the testing of loancovenants, or in regulatory
tests of capital adequacy forregulated financialinstitutions. Auditedfinancials, interim financials,and the managementdiscussion and analysis(MDA), available either incompany internet postings orSEC filings, provide acomprehensive disclosureframework that enables afundamental finance analystto understand much about
most—but far from all—businesses and the securities,both credit and equity thattheyissue._______________*ThischaptercontainsoriginalmaterialandpartsofthechapterarebasedonmaterialcontainedinChapter9ofValueInvestingbyMartinJ.Whitman(©1999byMartinJ.Whitman),Chapter8ofThe
AggressiveConservativeInvestorbyMartinJ.WhitmanandMartinShubik(©2006byMartinJ.WhitmanandMartinShubik),andideascontainedinthe19993Q,20013Q,20021Q,20022Q,20093Q,and20043Qletterstoshareholders.ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.
1Innosmallpartthisisareflectionofthepervasiveinfluenceofideasoriginatinginacademicfinancewherebusinessesareviewedaspuregoingconcerns.ForamoredetaileddiscussionofthistopicwereferthereadertoChapters2and17.2UnderIFRSindependentappraisalsofincome-producingrealestate
propertiesarerequired.Insofarastheappraisalreliesontheincomeapproachtovaluation(asallappraisalsdo)thevaluationwillalsogivereasonableestimatesofwhatfuturecashflowsarelikelytobewiththeprincipaluncertaintyusuallyrevolvingaroundpredictingfuturecapitalizationratesratherthanfutureflows.
3WediscussthepitfallsofthisapproachtoforecastingearningsinChapter6onnetassetvalue.4ThedistinctionsbetweenthepuregoingconcernandresourceconversionattributesofabusinessarediscussedinChapter2.5TheissueofequilibriumpricingisdiscussedinChapter17.6Seeanexampleofhowa
fundamentalfinanceinvestordefinesnetcurrentassetsverydifferentlyfromhowitispresentedontheclassifiedGAAPbalancesheetinthesectioninChapter6titled“NetNetsRedefined.”7WethoroughlydiscusstheissueofemployeestockoptionaccountinginChapter3onsubstantiveconsolidation.
8WecovertheappraisalofmanagementsinChapter11.9TheanalysisoftheprivateequityLBOofHertzGlobalHoldingsisdiscussedinChapter25.
CHAPTER20
CompanyDisclosuresandInformation:FollowingthePaperTrailin
theUnitedStates*
NarrativeDisclosuresintheUnitedStatesTheDocumentsandHowtoRead
ThemWhatthePaperTrailDoesfortheOutsideInvestorWhatthePaperTrailDoesn’tDoHowGoodIsthePaperTrail?Summary
Narrativedisclosuresareusedin fundamental finance astools for gainingunderstandingofabusiness—its operations, values,problems, potentials, andlong-term managementdirection. Except foroccasional forays into riskarbitrage, the investorfollowing a fundamentalfinance approach does not
attempt to predict near-termprices for securities traded inoutside passive minorityinvestor(OPMI)markets.The principal purpose for
using narrative disclosures inmuch of Graham and Dodd,in modern capital theory(MCT), in broker-dealerresearch departments, andamong conventional moneymanagers is as a tool aidinganalysts in predictingmarket
prices for common stockstrading in OPMI markets intheperiodjustahead.Certainof these market participantsuse narrative disclosures asan aid in understanding abusiness. The primaryobjective of these marketparticipants, however,remains to predict OPMImarket prices over the neartermratherthantounderstandabusiness.
Given these differences inpurposes, it is not surprisingthat corporate disclosures areused quite differently infundamental finance fromhowtheyareusedelsewhere.In fundamental finance noone type of disclosure is ofoverriding importance. Theentire mix of informationcounts. The information thatismost importantvariesonacase-by-case basis, so
timeliness of disclosures isnot a matter of materialconsequence, although italways is for otherdisciplines, relativecompletenessofdisclosuresisalways a matter of materialconsequence.
NARRATIVEDISCLOSURES
INTHEUNITEDSTATES
In the United States, asnowhere else in the world,written disclosures arecomprehensive and reliable.As amatter of fact, the verycomprehensiveness andreliabilityofthesedisclosuresmake them essentialworkingtoolsforalltypesofcreditorsand investors, from
commercial-bank lendingofficers to individualcommonstock investors.Thekeydisclosuredocuments forcreditorsof,and investors in,public companies are thoseissued pursuant to rules andregulations promulgated bythe Securities and ExchangeCommission.1
These frequently crucialdocuments discloseinformation in two forms—
financial statements andnarratives. Our primaryinterest in this chapter is innarrative disclosures. As faras mailings and websitepostings to securities holdersandfilingswiththeSecuritiesand Exchange Commission(SEC) are concerned, thereare three general types ofdisclosures that are highlyimportant for investorsfollowing a fundamental
financeapproach.
FreewheelingDisclosuresfrom
WhichManagementOpinionsand
ManagementStylesBecomeEvident
Thesedocumentsinclude:1. The letter from thechief executive officer
(CEO) in the annualreport to stockholders(ARS)2. Product and activitydescriptionsintheARS3.Pressreleases4. Conference calls withthe investmentcommunity5. Addresses to securityanalysts’societies6.Narratives inquarterly
reports7. ManagementDiscussion and Analysisof Financial ConditionandResultsofOperations(MDA) contained in allfilings of Forms 10-Kand10-QThe limits on what can be
statedonafreewheelingbasisby a management whosecomments are reviewed bysecurities’counsel,asmostof
them are, loosely follow thestrictures on free speech thatare imposed by Regulation10b-5 of the amendedSecurities Exchange Act of1934. The scope ofpermissible insiderdisclosures has beenexpandedby theSafeHarborAct (under the PrivateSecurities Litigation ReformAct of 1995) so that now,subject to hedge clauses,
managements are freer tomake forecasts. Regulation10b-5, however, remains adominant consideration. Therelevant portion of 10b-5states,Itshallbeunlawfulforanyperson . . . to make anyuntrue statement of amaterial fact or to omit tostate a material factnecessaryinordertomakethe statements made, in
light of the circumstancesunder which they weremade, not misleading . . .in connection with thepurchase or sale of anysecurity.Often,CEOlettersinARSs
and quarterly reports allowmanagementtotakecreditforwhat goes right whileblaming uncontrollablecircumstances for what goeswrong.
StereotypicalFilingswiththeSEC
Principal documents of thepapertrailinclude:2
Form10-KistheofficialannualbusinessandfinancialreportthatmustbefiledbymostcompanieswiththeSEC.Form10-Qisthequarterlyfinancialreportfiledbymostcompanies
withtheSECthatincludesdisclosureofcertainmaterialandextraordinaryeventsthatoccurredduringthereportedthree-monthperiod.Form8-KisareporttotheSEC,withinfourbusinessdaysoftheoccurrenceofareportableevent,ofunscheduledmaterial
eventsorcorporatechanges,forexample:
Amendmentstoarticlesofincorporationorbylaws;changeinfiscalyearcostsassociatedwithexitordisposalactivitiesCreationofadirectfinancialobligationoranobligationunderan
off-balance-sheetarrangementofaregistrantDepartureofdirectorsorofficers;electionofdirectors;appointmentofofficersEntryintoamaterialdefinitiveagreementFairdisclosure—regulationFDFinancialstatementsandexhibits
ResultsofoperationsandfinancialconditionSubmissionofmatterstoavoteofsecurityholdersOtherevents
Annualreportstostockholdersarethemostimportantwaymostpubliccorporationscommunicatedirectlywithstockholders.
Quarterlyreportstostockholdersarestatementsmanycompaniesprovideeverythreemonthsdirectlytotheirstockholders.Annualmeetingproxystatementsaredocumentsmailedtostockholderssolicitingtheirvotesforelectionofdirectorsandothermatters,suchastheappointmentof
independentauditors.Ifacompanydoesnotsolicitproxies,informationthatwouldotherwisehavebeendisclosedinproxystatementsisdisclosedinPartIIofForm10-K.Mergerproxystatementsareissuedwhenstockholdersaretovoteonaresourceconversionmatter—forexample,merger,consolidation,
andsaleofassetsorliquidation.Ifnewsecuritiesaretobeissuedaspartoftheresourceconversionevent,themergerproxystatementalsoservesasaprospectusforthenewissueofsecurities,andisregisteredasanS-4Registration.Prospectusesarepartofregistrationstatements
andareissuedwhensecuritiesaretobeofferedpublicly,eitherforcashorinanexchange-of-securitiestransactionwherenostockholdervoteissought.PrincipalregistrationformsaretheS-1(ageneralizedform)andtheS-7,ashortformusedbyseasonedcompanieswith
relativelyhealthyoperatinghistories.Preliminaryprospectusesareknownasredherrings.Cashtenderoffercircularsaresent,orotherwisemadeavailable,tostockholderswhenapubliclyannouncedofferismadetobuysharesforcashfromthegenerallistof
stockholders.These disclosures are
prepared by attorneys whooften follow slavishly theforms embodied in SECRegulations S-K.A commonmind-set in preparing thesedisclosures is that thequantity and quality ofdisclosures should be suchthatlawsuitsareavoided.TheuseofSECdisclosures
isthekeytoourfundamental
finance approach. Indeed,there seems to be an almostsymbiotic relationshipbetween SEC-prescribeddisclosures and our approachin that the SEC seems tomake special efforts toprovide the types ofinformation that are mostimportanttous.Thepresenceorabsenceof
encumbrances is almostalways spelled out in SEC
documents to those whocarefully read financialstatements (includingfootnotes), especially auditedfinancial statements. SECdisclosures also permitinsights into managementcharacter at least insofar astheir relationships withsecurity holders areconcerned. Informationaboutthese matters is containedeitherinproxystatementsfor
annual meetings, or whenproxies are not solicited, inPart II of Form 10-K, thecompany’sannualreportfiledwith the SEC. The proxystatement and Part II of the10-K contain descriptions ofmanagement remuneration,certain transactions withinsiders, and in proxystatementswhere shareholdervotes are solicited, proposalsdesigned to insulate
management in office. Also,financial statements, Form10-KandPartIIofForm10-Q (the quarterly report filedwith the SEC) containdisclosures on litigation. Allthese items give evidence toanalysts about managementattitudes and managementcharacter.Neitheracademics,whether
economists or financeprofessors, nor securities
traders seem to appreciatejust how useful thesedocuments are. This failurecan perhaps be explained bythe fact that most of thecritics have had virtually noexperience in preparing thedocuments required by theSEC. Document preparationhas been left largely toinvestment bankers,practicing lawyers,accountants, andmembers of
corporate managements.Although firsthandexperience as a documentpreparer is not essential tounderstanding the uses andlimitations of the paper trail,aninvestor(orcritic)oughttocomprehend how thepreparersgoaboutcomposingthe materials that they mustfile with the SEC or mail tosecuritiesholders.Thefirstthingtoremember
is that there are few liarsamong document preparers.Virtually no professionalaccountant, lawyer,investment banker, or,especially, independentauditor wants even to besuspected of misleadinginvestors,muchlessoffraud.The professionals whom weknow and work with do notwish to risk their livelihoodsandreputationsforthebenefit
of third parties, such asmanagements and largestockholders.3 As a generalrule, the information gleanedfromthepapertrailistruthfuland reliable in statingwhateveritpurportstostate.This is not to say that all
thesedocumentsarecompleteand accurate. There isshortcutting,butmuchofitisinadvertent. It is sometimesdifficult for competent and
honestdocumentpreparers tomake appropriate judgmentsas to what are materialdisclosures. However, in ourexperience, importantnondisclosures do not occurfrequently.Someshortcuttingisundoubtedlydeliberate,buttheoutrightfraudsorpossiblefrauds—Equity Funding,Stirling Homex, NationalStudent Marketing, Westec,Enron, and WorldCom—
seemfewandfarbetween.Second,aswehavealready
pointed out, in preparingdocuments, there are twowell-establishedrules:
1. Follow the requiredform so that specificregulations are compliedwith.2. Don’t run afoul ofantifraud provisions ofthesecuritieslaws.These antifraud provisions
make it unlawful inconnectionwith the purchaseorsaleofanysecurityforanyperson, directly or indirectly,“to make any untruestatementofamaterialfactortoomittostateamaterialfactnecessary in order to makethe statementsmade, in lightof the circumstances underwhich they were made, notmisleading.”4 The typicalpreparer of documents,
therefore, is going to try todisclose, as truthfully aspossible,everythinghethinksis factually relevant. He willdo this toavoid trouble,bothfrom government regulatorsand from private securitiesholderswhose attorneysmaybringclass-actionsuits,eitherderivatively or directly, toredresstheirgrievances.Understanding this is a
large part of understanding
why the paper trail is souseful. In most commercialand economic transactions,anysensibleparticipanthastoworry about the truthfulnessof the other parties to thetransactions. This is rarely aconsiderationforfollowersofthe paper trail, who rely onwrittendisclosures. It is as ifthe person contemplating thepurchase of a used car couldknow that the salesman who
says “This auto was onlydrivenonSundaysby a littleold lady going to church” istellingthetruth.Beingabletorely on the truthfulness ofdisclosures about publiclyheld corporations is ofenormoushelptoanycreditoror investor in coming tofinancialjudgments.
SourcesofReadily
AvailableandUsefulDisclosuresinAdditiontoFreewheeling
Disclosures,SECFilings,andSecurityHolders’MailingsorWebsitePostings
These sources include thefollowing:
1. Court records, inconnection with bothlitigation andChapter 11reorganizationproceedings2. Filings with otherregulatoryagencies3. Competitor SECfilings and stockholdermailings4. Trade associationreports
5. The Wall StreetJournal6. Other financialnewspapers andmagazines7. Online summaryservices such asBloomberg, Capital IQ,FactSet,Reuters,etc.8. Bankruptcy Reporter,DailyBankruptcyReview9. Industry publications
such as Ward’sAutomotive Reports,Women’s Wear Daily,Clarksons ShippingIntelligenceNetwork,etc.
THEDOCUMENTSANDHOWTOREADTHEM
Inordertotakefulladvantageof disclosure, the readerought to have anunderstanding of what iscontained in principaldisclosure documents. Thefirstandmostimportantthingtodoistoreadthem.Almostanyone, after carefullyreading, say, five 10-Ks andfourmergerproxystatements,will have good insight intohow their contents can help
him in an investmentprogram.Second, the reader should
obtain copies of the formsand the general regulationsfor the preparation of forms.Reading such materials willgive good insight into whatpreparers go through toproduce the various keydocuments. Investorspursuinganin-depthstudyoftheseformscanobtaincopies
of them as well as generalinstructions and guides fortheir preparation from theSECwebsite.5
ThereareotherSECfilingsthat are occasionallyimportant, but these arebeyondthescopeofthisbriefchapter. These includeoffering circulars underRegulation A and filings byinsiders concerning theirshareholdingsandchanges in
holdings(Forms3and4);andForm 144, filed by holdersdesiring to sell restrictedstock under Rule 144. Form13F, filed quarterly byinstitutional investmentmanagers exercisingdiscretion over accountsholding more than$100,000,000 of marketableequity securities, describesthe securities held in thoseportfolios.6Noticesofvarious
filings can be found in theSEC News Digest, a dailysummary of SEC activities,7including rules and relatedmatters, announcements,registrations, and filings inconnectionwith tenderoffersand 5 percent ownership; theSEC Docket, a weeklycompilationofthefulltextofSECreleases;andtheOfficialSummary, a monthlysummary of securities
transactions and holdingsreported by insiders, takenfromForms3and4asfiled.Most documents—for
example, annual reports,annual meeting proxystatements, prospectuses, andcash tender offers—arepublicly distributed. Theinvestor who wants to studyany of these can easily findthem and download them forfree from the Company’s
website or from the SECwebsite:www.sec.gov.
WHATTHEPAPERTRAILDOESFORTHE
OUTSIDEINVESTOR
Onceall this informationhas
been gathered, how useful isit?Howlimited?Thoughitisnotparticularlyusefulforthetrader who seeks immediatemarketperformance,wethinkit is extremely useful for allother investors,whether theybe control buyers, distressinvestors, or passivists, whohaveamodicumoftraininginwhat to look for. The papertrail is especially useful inallowing those using the
fundamental financeapproach to arrive at verymeaningful judgments mostofthetime.Thisdoesnotmeanthatthe
paper trail is perfect.Certainly it will not tell thecreditor or investoreverythinghewantstoknow.Even so, unless the outsiderhas some special know-howor know-who, we think it issogoodthathewoulddowell
to restrict his investments tosecurities covered by thepaper trail. In fact, when weadviseEuropeanclientsaboutU.S. investments, wefrequently recommendsecurities to them, ratherthan, say, real estate,precisely because the papertrail exists, and thedisclosures it provides meanthatother thingsbeingequal,an investment will involve a
lesser element of disclosureriskthanoneinanynon-SECfilingenterprise.For the followers of the
fundamental financeapproach, the paper trail isexcellent,aswenotedabove,forpointing to junior tranchesecurities that because ofpoor financial position orinsider avarice areunattractive at anyprice.Butit is also highly useful in a
more positive sense: Aninvestor can obtain quitereliable assurances that acompany’s financial positionisstrongandthatinsidersarenotoverreaching,orbasedonpast performance, are likelytooverreachinthefuture.Ineffect,muchoftheentire
SEC narrative disclosureprocess and many of thedisclosures of financialaccounting are directed
toward informing investorsabout corporate obligations.Stockholder annual reports,10-Ks, 10-Qs, 8-Ks, andwhere issued, otherdocumentswillgiveinvestorsstrong clues to theencumbrances attached to abusiness entity. Particularlyimportant in this regard areaudited financial statements,including the auditor’scertificationandthefootnotes
tothefinancials.Descriptionsof on-balance-sheet debt andfootnote descriptions ofencumbrances, includingbalance sheet items, pensionplan obligations, andcontingent liabilities, tend tobe carefully and accuratelydone.8Indeed,itappearstousthat the footnotes to auditedfinancial statements providean excellent road map toanalysts seeking toundertake
a “due diligence”investigation, where theanalystseeksbothpublicandnonpublicinformation.Auditors’ certificates are
particularly important asattestations thathavebecomeincreasinglycarefullywordedin recent years. Suchattestationsareeitherclean—presented withoutqualification—or subject tocertain conditions.
Additionally, there are whatin effect are nonattestations,namely adverse opinions ordisclaimers of opinions.Clean opinions, as distinctfrom certain but not allsubject-to opinions, adverseopinions or disclaimers ofopinions, are important ingiving comfort to investorsfollowing the fundamentalfinance approach; suchinvestors are unlikely to be
interested ina juniorsecurityon the basis of an opinionsubject to a seriousqualification(suchas“subjectto theability tocontinueasagoing concern”), or on thebasisofanadverseopinionorofadisclaimerofopinion.The encumbrances that are
missedbythepapertrailtendto be those that sometimeseventheinsidersareunawareof.Oneexampleisabusiness
that enjoys a strong financialposition only because it failstomake needed expendituresto modernize, expand, orreplace outdated facilities. Insuchcases, a strong financialposition isdeceptive, and thestrongbalancesheetwilltendto be dissipated in futureyears as the business sufferslarge operating losses,embarksonmassivecatch-upcapitalexpenditureprograms,
or both. (This is preciselywhathappened in thecementindustryinthelate1950sandearly 1960s.) Nonetheless, ithas been our experience thatmost of the time, the papertraildoesdiscloseenough,sothattheinvestor’sestimateofwhat the total encumbranceswillprovetobearerelativelyaccurate.Thepapertrailisalsofairly
good in giving clues about
insider overreaching. Proxystatements for annualmeetings at which directorsare elected containdisclosures aboutmanagement remuneration,9about borrowings by insidersfromthecompany,andaboutcertaintransactions—dealingsand participations betweenthecompanyand its insiders.In addition, the long-termrecord of management is
revealed,andthisishelpfultoanalysts who tend to believethat behavior patternsprobably do not changemuch,ifatall.
EXAMPLESince the management ofRapid AmericanCorporation forced outminority shareholders ofSchenleyIndustriesin1971at what we believed, fromexamining the 1971 proxy
material, was a grosslyunfair price, we concludedthatwewouldrathernotbean outside investor orcreditor in any companycontrolled by the RapidAmerican management,albeit there was nothingillegal about the SchenleyIndustriesforce-out.
True, much past insideroverreaching may escapedisclosure in the documentsof the paper trail. Certainly
the documents as they existtoday leave few cluesconcerning such matters asthe prevalence ofwidespreadnepotism at levels belowparent-company officers anddirectors.Yet,thereappeartobe sufficientdata, so that theoutside investor can makereasonable judgments aboutthe character of the insiders,at least insofar as it affectsactual or proposed
investments.Aninvestormaydecidethat
asecuritymeetingthecriteriaof a fundamental financeapproachisattractivebecauseof additional considerations.Thepaper trailwill helphimuncover these otherattractions,perhapsprovidinghints that future earningsmight increase dramatically;thatlargecashdistributionstostockholdersarelikely;thata
company is a takeovercandidate; that it is likely tobe liquidated or recapitalizedinwhole or in part; or that asecurity is pricedinexpensively comparedwithothercompanies,basedonitshistory.Thepaper trail canprovide
information that is crucial toassessing each of thesefactors. The knowledgegained from it about a
company’s business andoperations provides areasonable basis for makingjudgments about futureearnings, cash returns, andrisk. Information about whoowns the company’s stock,who is acquiring it andwhatresources the company hasmaytellwhetherornotitisalikely candidate for atakeover, or for a liquidationorrecapitalization.
As we stated before, thepapertrailenablesaninvestorusingthefundamentalfinanceapproach to pinpoint thosesecuritiesthatareunattractiveat any price. The statementthateverythinghasapriceatwhich it is a bargain is, as apractical matter, simply nottrue when it comes toinvestment. Junior securities—especially those that arepure residuals, such as
common stocks andwarrants—maybe in such a hopelessposition that they are likelynever to have a value highenoughtocompensateforthecostsofownership.Thismayhappen in one of twosituations. The first is wherethe financial position of thecompany is so bad thatwhether the company is inbankruptcy or not, the entirebusinesshas tobelong to the
creditors.The second situation in
which equity securitiesshould be avoided at anyprice is that of a goingconcern with an entrenchedmanagement whose primeobjective is to milk thecompany for personalbenefitsat theexpenseof thesecurity holders. By far thebest way to pinpoint such asituation is to follow the
papertrail.
WHATTHEPAPERTRAILDOESN’TDO
The principal shortcoming ofthepapertrailstemsfromthefact that it is designed andused to provide materialdisclosures of hard
information. Softinformation,suchascompanyforecasts, company budgets,and valuation appraisals ofassets—for example,appraisals of the value ofincome producing real estate—arenot disclosed.10 This isprincipallybecausemuchsoftinformationisatoolforstockmarketmanipulation.The SEC, however, has
expandedthepromulgationof
soft information throughnewrules and regulations. Abreakthroughinrequiringsoftinformation probablyoccurred in 1976 when theSEC, for the first time,required companies withinventories and grossproperty, plant, andequipment aggregating morethan $100 million andcomprising more than 10percent of total assets to
provide supplementary datain the 10-K about estimatedreplacement costs(Accounting Series Release190, datedMarch 23, 1976).In 1978, the SEC proposedguides that permitted andencouraged projections offinancial information bycompanies. These forecastswere to bemade voluntarily,and forecasters were to begiven a safe harbor, that is,
they generally would not beheld liable under the federalsecuritieslawsforreasonablybasedprojectionsthatdidnotwork out (Exchange ActReleases 15305 and 15306,dated November 7, 1978).Also, in Accounting SeriesRelease 253, dated August31, 1978, the SEC adoptedrequirements forsupplemental disclosures forfiscal years ending after
December 25, 1979, of thevaluation (and changes invaluation during the year) ofcertaincompanies’provedoiland gas reserves; this is amethod of accounting theSECcallsreserverecognitionaccounting,orRRA.Sometimes this soft
information may be vital tounderstanding a business,either as a resourceconversion enterprise or as a
goingconcern.
EXAMPLEIn early 1976 TishmanRealty announcedliquidation plans. Withoutknowing the prices atwhich Tishman’s realproperties could be sold,therewasnorealisticbasisfor judging the merits ofTishman as an investment;and without real estateappraisalsof the individualproperties,itwasextremely
difficult to approximatetheseprices.
EXAMPLEAnotherexampleisDuplanCorporation,whichinearly1976founditselfinseriousfinancial trouble, its veryviability threatened unlessit could become profitablein six months to a year.Here, managementforecasts andbudgetswerecrucial to anyonecontemplatingbecominganinvestor in or creditor ofDuplan.
Therearemanyotherkindsof information besidesmanagement forecasts,budgets, and asset appraisalsthat the paper trail fails todisclose. For example, thereare no disclosures of mergerand acquisition discussionsthat never reach a definitivestate. There rarely will beinformation aboutcomparative cost analysis,comparativesecuritypricesor
comparative marketpenetrations within anindustry.Ordinarily,outsidersdonotknowwhatacompanyought to spend on plantequipment or inventory inorder to remain competitive.Thepapertrailrarelyincludesdisclosuresofdetailedspecialstudies in areas such asmarketing or engineering.Norwilltherebeinformationabout long-festering internal
disputesamongmanagement.Occasionally, even obviouslymaterial hard informationmaybelacking.
EXAMPLECompanies may provideonly consolidated financialstatements in situationswhere such statementswould be less informativethan consolidating orcompany-only statements.(In consolidating or
company-only statements,information about theparent company andindividual subsidiaries isdisclosed, whereas suchinformation is not shownseparately in consolidatedstatements.)
There may even besituations that the paper trailmissesentirely.
EXAMPLEAn example would be avery small acquisition thatdoes not require astockholder vote. If such avote were required, proxystatementswouldbemailedto shareholders. Without aproxy or 8-K filing, thefinancial statements anddescriptions of thecompanies being acquiredwould not be available atallfromSECfilings.
It is important to note, ofcourse, that the lack of softinformationonthepapertrailis a much less seriousshortcomingforthelong-terminvestor than it is for thetrader.For the trader, anear-term earnings forecast ordividend action may be theonly disclosure of interest.The long-term investor,especially the investorwhoseanalysis rests on the
fundamental financeapproach, is resourceconscious; the hardinformation disclosed by thepaper trail is of greatimportancetohiminvirtuallyall his evaluations.Furthermore,forthisinvestoranapparentlowpricerelativeto an estimate of theresources in the business cancompensate for the risksinherent in knowing less
about a company thanwouldbeoptimal.This safetyvalvedoes not exist for the traderwho is seeking the bestpossible near-term marketperformance.
HOWGOODISTHEPAPERTRAIL?
TheSECpaper trailprovidesthe investor with astereotyped format. Thedisadvantage of thestereotypedformat,ofcourse,is that following a formfrequently results ininadequate descriptions ofreality and inadequateweighting of what isimportant. The principaladvantage is that the readercan be assured that the
professional preparers arestriving to see that thedocuments do not omitmaterial statements and donot contain material mis-statements. In addition, theinvestorwhousesstereotypeddocuments becomes a verypracticed reader and canobtain vast quantities ofinformation merely byskimming,becauseheknowswhattolookforandwhereto
lookforit.Onbalance,ourappraisalis
that most of the time thepaper trail is excellent. Wehave reached this conclusionin large part on the basis ofour experience in conductingin-depth analyses forcompanies that retain us. Inthese situations, thecompanies provide all thedata we want and do studiesto generate any necessary
data that is otherwiseunavailable. Invariably, thesein-depth analyses have beenmaterially easier to do andmore meaningful for userswhen we have had SECdocuments available as asource of information and asa check against otherinformation received.Wearesure this holds true also forvirtually all other analystsdoing comparable studies.
This points up, incidentally,one of the more importantsocial and economic benefitsto theUnitedStates from thepapertrail:Ithasupliftedthestandardsofanalysis,makingit infinitely easier to conductmeaningful analyses for allsorts of appraisers, fromcommercial-bank lenders togovernment officials, whomay not be interested insecurities markets per se or
common stock investing atall.Ofcourse,thepapertrailis
always going to be moreuseful for some kinds ofcompanies than for others.Forexample,forlarge,stable,dividend-paying companies,such as Graham and Dodd’stheoretical list of the onehundred highest-qualityissuers, the paper trailprobably imparts more
information to outsideinvestors than they care toknow. On the other hand, inareaswhereGAAParenotanoverlyusefultool—suchasinthe analysis of extractiveindustries, real estatedevelopment companies, andemerging issuers—thenonaccounting disclosures ofthe paper trail are not goingtobetoousefuleither.Forthewhole range of companies in
between, however, the papertrailisagodsend.Anyone who follows the
paper trail must, of course,appreciate what it cannot dofor him. First and foremost,much of the world isunknown and unpredictable.Thus, forecastingwillalwaysbe an art. Second, the papertrail is probably not ofmuchhelp in gaining insight intoimmediate timing and
immediateperformanceinthestock market. Obviously,thereisnowaythepapertrailis going to disclose intimatesecrets of activists and theirplans, which are frequentlyformulated no place else butin their minds. Nor does itprovide anyone with know-who,eventhoughitdoestendto give the background thatmakesiteasiertoobtain.The paper trail does not
provide full disclosure, andnever can. Like any otheranalytical tool, it has itslimitations. But for theinvestorwho concentrates onour approach, the paper trailis going to be the essentialstartingpoint forhisanalysisalmost all of the time. Insomeinstances,thepapertrailisallheorshewilleverneed.
SUMMARYNarrativedisclosuresareusedin fundamental finance astools for gainingunderstandingofabusiness—its operations, values,problems, potentials, andlong-term managementdirection. In the UnitedStates,asnowhereelseintheworld,writtendisclosuresarecomprehensive and reliable.
The key disclosuredocuments for creditors of,and investors in, publiccompanies are those issuedpursuant to rules andregulations promulgated bythe Securities and ExchangeCommission (SEC). Thereare three broad types ofdisclosures used in duediligence investigations: (1)freewheeling disclosuresfrom which management
opinions and managementstyles become evident; (2)stereotypical filings with theSEC;and(3)othersourcesofinformation. We provide adetailed description of thethree categories. For thefollowers of the fundamentalfinance approach, the papertrail is excellent. In effect,much of the entire SECnarrative disclosure processand many of the disclosures
of financial accounting aredirected toward informinginvestors about corporateobligations. The principalshortcomingofthepapertrailstems from the fact that it isdesignedandused toprovidematerial disclosures of hardinformation, which turns outto not be very useful inanalyzingtheentitiesengagedinexploration,discovery,andnew inventions. On balance,
our appraisal is that most ofthe time the paper trail isexcellent._______________*ThischaptercontainsoriginalmaterialandpartsofthechapterarebasedonmaterialcontainedinChapter10ofValueInvestingbyMartinJ.Whitman(©1999byMartinJ.Whitman),Chapter6ofTheAggressive
ConservativeInvestorbyMartinJ.WhitmanandMartinShubik(©2006byMartinJ.WhitmanandMartinShubik),andideascontainedinthe20064Qlettertoshareholders.ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1AlthoughSECdisclosuresarecrucialformostanalysesofpubliccompanies,they
arefarfromtheonlydisclosuredocumentsthatmaybeimportantinagivensituation.Theothers,however,arebeyondthescopeofabook.Chapters32,33and34ofVolumeIIoftheFinancialAnalyst’sHandbook,ed.SumnerN.Levine(Homewood,IL:DowJones-Irwin,1975),852areexcellentoverviewsofthetypesofpublicnon-
SECdisclosuresthataregenerallyavailable.Chapter32,byDorothyHennesseySussman,isentitled“InformationSources—AnOverview.”Chapter33,bySylviaMechanic,isentitled“KeyReferenceSources.”Chapter34,“AGuidetoIndustryPublications,”isareprintofabrochureoriginallyissuedbytheNewYorkSocietyofSecurity
Analysts.2Foracomprehensivedescriptionofeachoftheseformsandtheinstructionsonhowfillthemseehttp://www.sec.gov/about/forms/secforms.htm3WeareconvincedthisremainstruedespitewhatweconsidertobetheSupremeCourt’sunfortunatelanguageinregardtoSection10b-5inErnstandErnstv.
Hochfelder425U.S.185(1976).Thevastmajorityoffinancialprofessionalsappeartoustobehonestandethicalbecausetheywanttobe,notbecausetheyhavetobe.410b-5ispartoftheSecuritiesExchangeActof1934asamended.Prospectuspreparersoperateundersimilarandadditionalstricturesgrowingoutof
Section17oftheSecuritiesActof1933asamended.Inaddition,therearesimilarstricturesexistingunderotherpartsoftheSecuritiesExchangeActof1934asamended.But10b-5isthecatchalloftheantifraudregulations,coveringsituationsnototherwiseenumeratedspecifically.5
www.sec.gov/about/forms/secforms.htm
6Foracomprehensivelistofformsandtheirdescriptionsgoto:www.sec.gov/about/forms/secforms.htm7
www.sec.gov/news/digest.shtml8Thoughperhapsnotpartofanyglossary,on-balance-sheetitemscommonlyreferstoassetsorliabilitiesstateddirectlyonabalancesheet,whereasoff-balance-sheetdisclosuresusuallyrefersto
informationaboutassetsorliabilitiesdisclosedinfootnotestofinancialstatements.9Themanagementremunerationsectionofaproxystatement(orPartIIofaForm10-K)willcontaininformationnotonlyaboutsalaries,butalsoaboutallothertypesofremuneration,suchasstockoptions,stock-appreciation
rights,pensionplanbenefits,bonuses,profit-sharingplans,andemploymentcontracts.TheSECalsorequiresthatinformationaboutmanagementperquisites,suchascompanyhuntinglodgesortheuseofcompanyplanesforprivatepurposes,bedisclosed.10ThisistrueunderGAAPbutnotunderIFRSusedby
allnon-U.S.companiesowningincome-producingrealestate.SuchassetsunderIFRSarecarriedatappraisalvalueunlikeGAAPwhereincome-producingrealestateiscarriedatdepreciatedcostlessimpairments.
CHAPTER21
BuyingSecuritiesin
Bulk*
Methodsfor
AcquisitionofCommonStocksAcquisitionofVotingEquitiesthroughExchangesofSecuritiesAcquisitionofControlwithoutAcquiring
SecuritiesbyUsingtheProxyMachinerySummary
An active investor seekingcontrolorelementsofcontrolover a publicly tradedcommercial entity throughsecurities acquisition canfollow several different
courses of action. From asecurity holder’s point ofview, all acquisitions ofsecuritiesareeithervoluntaryor mandatory. Voluntaryrefers to situations in whicheach individual securityholdercanmakeuphisorherown mind as to whether totake certain actions.Mandatory refers to votingsituations in which allsecurityholdersare forced to
participate in some actiononce the requisite number ofsecurity holders of that classvote in favor of the action.Each of the methods underwhich control and quasi-control people acquiresecuritieshas advantages anddisadvantages. This chapterdiscusses the advantages anddisadvantagesofeachmethodin light of the followingfactors:
PricingissuesSecuritieslawissuesIncometaxissuesOtherregulationsAvailability-of-informationissuesAbility-to-financeissuesFinancialcommitmentissuesDoabilityissuesSocialissuesSpeedRatesofreturn
The methods reviewedbelow are not mutuallyexclusive. For example, inseekingcontrolofacompany,an activist limited by otherregulations(e.g., theneedforHart-Scott-Rodino filings ifmore than $15 million isexpended on common stockpurchase) might still gain atoeholdpositionbyacquiringtarget company commonstock for cash in the open
market, then follow up bycommencing a cash tenderoffer or by soliciting proxiesseekingtoelectanewslateofdirectors. Cash tender offersfrequently are preludes tomop-upmergers.
METHODSFORACQUISITIONOFCOMMON
STOCKSThere are four methods ofacquiring common stock (orothersecurities)forcash:
1.Intheopenmarket2.Inprivatetransactions3.Intenderoffers4. By use of proxymachinery (mergers,reversesplits,consents)The first three are
voluntary; the fourth is
mandatory.
CashPurchasesintheOpenMarket
Pricingissues:Acquisitionispossibleatoutsidepassiveminorityinvestor(OPMI)prices,whichtendtobefarmoreirrationalandfrequentlyfarlowerthancanbeobtainedinnegotiated
transactions.Securitieslawissues:Nodisclosureisrequireduntilthe5percentownershipthresholdisreached;nouseofinsideinformationispermitted.TheSecuritiesandExchangeCommission(SEC),though,isexceedinglytoughonanythingthatsmacksofmanipulationofOPMI
markets.ThemostimportantmandateoftheSEC,aheadofprovidingdisclosureandoversightoffiduciariesandquasi-fiduciaries,isprotectingtheintegrityofOPMImarketplaces.Incometaxissues:Thesearenotaconsideration.Otherregulations:Hart-Scott-Rodinoapplies
wheninvestingover$15million.Availability-of-informationissues:Theseareprettymuchrestrictedtopublicinformation.Financialcommitmentissues:Buyaslittleorasmuchasdesired.Marginrulesmayrestricttheabilitytoborrow.Doabilityissues:Togain
control,investorsprobablyneedtoacquirecommonstockbyanother—perhapssupplementary—method.(Itmaysometimesbepossible,however,to“Tisch”acompany,asinthetakeoverofcontrolofCBSCorporationbyLaurenceTischsolelybypurchasesofcommonstockintheOPMI
market.)Also,owningcheapstockacquiredasatoeholdinOPMImarketmayaffordverygoodreturnsforhavingputacompanyintoplayeveniftheacquirerneverattainsanyelementofcontrol.Ontheotherhand,ifpricesriseinanOPMImarket,futurepricestoacquirecontrolbyothermethodstendto
becomemoreexpensivethantheyotherwisewouldhavebeen.Socialissues:Nosocialissuesareinvolved.Speed:Iftheobjectistoobtainelementsofcontrol,thetiminginvolvedislikelytobelongandindeterminate.Ratesofreturn:Theratesofreturnareusuallyplainvanilla.
CashPurchasesinPrivateTransactionsPricingissues:Pricesreachedinnegotiatedtransactionsareoftenfarmorerational,fromacontrolpointofview,thanpricesinOPMImarkets.(Fromtimetotime,however,thereareanxiousorevendesperatesellers—for
example,thesaleofTejonRanchcommonstockbytheTimesMirrorCompanyata25percentdiscountfromOPMImarketpricein1997.)Securitieslawissues:Disclosureissuesdependonprivacy.UnderSection10(b)oftheSecuritiesExchangeAct,Rule10b-5isalwaysa
factorintermsofimpliedremedies:whendocourtsdecidethatprivatetransactions,marketsweepsofOPMImarkets,oracombinationofthetwoaremeremasqueradesforcashtenderoffers?Also,doestheacquirerobtainrestrictedcommonorsecuritiesfreelytradableinOPMImarkets?
Incometaxissues:Purchasesofcommonstocksforcasharealmostalwaysstraightforwardtaxablecapitaltransactionsforthesellers.Availability-of-informationissues:Privacygoverns;thebuyercanseektoknowwhatthesellerknows.Ability-to-finance
issues:Thereisthepossibilityofsellerfinance;marginrulesmaybeafactorwhenthereisnochangeofcontrol.Financialcommitmentissues:Whatissuestherearedependonthesizeoftheblockbeingacquiredprivately.Dealexpensemayormaynotbeminimal.
Doabilityissues:Tyinguplargeblockstendstomakeobtainingcontroleasier,whetherthesourceofcontrolisfriendly,neutral,orhostile.Socialissues:Sometimesaspartofapurchase,thereareagreementsaboutboardrepresentationandprotectionofincumbent
management.Speed:Purchasecanbeprettyfast—daystoweeks.Ratesofreturn:Theratesofreturnareusuallyplainvanilla.
CashTenderOffersPricingissues:ApremiumaboveOPMImarketpricemustbe
offered.Thebasicrulesareasfollows:Immediatelyafterthecommencementofatenderoffer,thebiddermustfileatenderofferstatementwiththeSECandtheissueridentifyingthebidderandsettingforththesourceoffunds,thebidder’spurposeinmakingthetender(freeadvertising?),the
ownershipofothersecuritiesoftheissuer,andappropriatefinancialstatementsforthosebiddersthatarenotnaturalpeopleifthebiddersarematerialtoadecisionbysecurityholdersofthetarget.Thetenderofferhastobeopenatleast20days—10daysafteranincreaseinprice.Nobodyofany
consequenceintheOPMImarkettendersuntiljustbeforeatenderofferistoexpire.Ifthetenderisforlessthanalltheshares,pro-ratasharesmustbeaccepted.Theannouncementismadepromptlyandpaymentismadewithin10daysorsoafteracceptanceofsharestendered.Ifatenderoffer
isextended,theremustbeanannouncementoftheapproximatenumbersofsharestendered.Securitieslawissues:Withthismethod,securitieslawissuesareconsiderablymoreonerousthanopen-marketandprivatepurchasesbutconsiderablylessonerousthanusingproxy
machineryorissuingnewsecurities,whichvirtuallyalwaysrequiresregistrationunderthehighlyonerousSecuritiesActof1933asamended.PortionsoftheSecuritiesExchangeActof1934,alsoknownastheWilliamsAct,primarilygovernhere.Inhostiletakeovers,statecourtlitigation,especiallyin
Delaware,maytakecenterstage.Eveninafriendlytakeover,thereislikelytheneedtocontendwiththeplaintiffs’barrepresentingOPMIsinbothfederalandstatecourts.Thesesuitsareusuallyeasytosettle,asfeeawardsprimarilydriveplaintiffs’counsel.Incometaxissues:
Theseare,asforotherpurchases,forcash.Availability-of-informationissues:Inhostiletakeovers,onlypublicinformationisavailable;infriendlytakeovers,thereisaprioropportunitytoconductdue-diligenceresearch.Ability-to-financeissues:Conventionalfinancemaybereadily
available,startingwithsecuredlendersandworkingsouth.Sinceabiddercanneverobtain100percentacceptanceforatenderoffer,however,financingopportunitiesmaybelimitedunlessthebidderannouncesplansforamop-upmergerthatwouldresultin100percentownershipofthe
equity.Ittendstobefareasiertofinanceafriendlytakeoverthanahostileone.Financialcommitmentissues:Thereisalmostalwaysamultimillion-dollarcommitmenttopurchaseshares.Administrativeexpenses,includinglawyers’fees,printingcosts,informationagentfees,
dealer-manager/investmentbankerfees,corporatetrusteefees,andtransferservicefees,arealsolarge.Doabilityissues:ThekeytodoabilityistoofferapricepremiumaboveOPMImarketprice.Duringthependencyofacashtenderoffer,sharesare
likelytogravitateintothehandsofriskarbitrageurs,whotowardtheconclusionofthetender-offerperiodwillmakemarketdecisions(basedonthecurrentpremiumsoverOPMImarketprices)ratherthaninvestmentdecisions(basedonperceptionsoffundamentalvalues).Inhostiletakeovers,there
arealwaysuncertaintiesaboutdoability.Thereisahugeadvantage(orsometimesdisadvantage)oversolicitingproxiesorexchangingsecurities,inthattenderoffersaremuchquicker.Socialissues:Ifthedealisfriendlyorthebidderwantstomakeahostileorneutraltakeover,itisfrequentlynecessaryto
givetermsthatrewardincumbentmanagementsorothercontrolpeoplewithclout.Speed:Makingacashtenderofferisinfinitelyfasterthanusingproxymachineryorissuingsecurities.IssuingsecuritiesrequiresregistrationundertheSecuritiesActof1933.Inusingtheproxy
machinery,thereisanadditionaldelayof,say,20to60daysaftereffectivenessofaproxystatmentoraregistrationstatementsothatshareholdermeetingscanbeheld.Ratesofreturn:Ifthecashtenderofferissuccessful,thepresentvalueofcontrolbecomesimportant.
Althoughcashtenderoffersare classified here asvoluntary (each shareholdermakes up his or her ownmind whether to tender), acash tender offer becomesmandatory (i.e., coercive)when the offeror can presenta meaningful threat that ifenough shares are tendered,the company will deregisterwith the SEC and there willno longerbe apublicmarket
for the shares. This canhappenwhen there are fewerthan 300 shareholders ofrecord.
CashMergersthroughtheUseofProxy
MachineryPricingissues:Cashmergersthroughtheproxymachineryalmostalwaysofferapremium
overOPMImarketprice,butthereisnowherenearthesamepressureasinacashtender,becauseallthatisneededhereistherequisitevoteofstockholders(e.g.,anywherefrom50percentofthosevotingtotwothirdsofoutstandingholdersoncea50percentquorumvotes)tobind100percentofthe
commonstocktothetransaction.Outsidepassiveminorityinvestorsarealotmoreattentivetosalesituationsatpremiumsovermarketthantheyaretovotingsituations.Thepricepaidwillbereviewedinstatecourt,especiallyinDelaware,wheresometimestherecanbearequirementfor
“entirefairness.”Thecourtwillbeheavilyinfluenced,however,byOPMImarketpricesindeterminingentirefairness.Insiderscontroltiming;theyarefreetopickdepressedOPMImarketsasthetimeforcashmergers.Securitieslawissues:Itismuchmoredifficulttocomplywiththe
provisionsoftheSecuritiesExchangeActinsolicitingmergerproxiesthanitisinacashtenderoffer.Thelegalliabilitieshere,however,arefarlessonerousthanwhencommonstocksareacquiredforsecuritiesratherthanforcash.Issuingsecuritiespubliclygivesriseto
stricturesexistingundertheSecuritiesActof1933.TheSECclearsproxymaterialsbeforetheyaremailed.Lawsuitsbytheplaintiffs’bar,bothstateandfederal,areautomaticinmergertransactions,whetherforcashorforsecurities.(Doinsidersinmergertransactionssometimesholdbacksome
considerationinitiallysothattheyhavereserveammunitiontosettlestockholdersuits?)Inforce-outmergers,stateblue-skylaws,astheyexistinCaliforniaandWisconsin,forexample,canbeaproblem.Inpartbecauseoftime-consumingdelays,ittendstobemoredifficulttousethecash-merger
techniqueinhostiletakeoversthantouseacash-tenderoffertobefollowedbyamop-upmerger.Incometaxissues:Theseareasforothercashdeals.Aftertheinvestorowns100percentoftarget,however,itiseasiertodosubsequenttaxplanningonbehalfofthe
survivingcompanies.Availability-of-informationissues:Controlpeoplecandodue-diligenceresearch.DisclosuretoOPMIs,includingmakingadmissionsagainstinterest(e.g.,providingrosyforecasts),becomescruciallyimportant.Ability-to-financeissues:Generally,itis
moreeasytofinanceherethanwithanyothercashpurchaseofcommonstocks.Financialcommitmentissues:Usually,theseinvolvemegabucksbothfortheinvestmentandfordealexpenses.Doabilityissues:Cashmergersareverydoableiftheinvestorcontrolstheproxymachinery,but
seesecuritieslawissuesabove.Socialissues:Itisprobablynecessarytomakeadealwiththeincumbentmanagementandothercontrolgroupswithclout.Speed:Cashmergersaremuchslowerthancashtenderoffers.Ratesofreturn:Thesecanbehuge,including
premiumsforcontrol.Inthecaseoftheuseofproxymachineryforahostiletakeover,theexpendituresincurredareprobablybetteranalyzedasaninvestmentratherthanasanexpense.Iftheinvestordoesfairlywellinahostileproxysolicitation—eveniftheinvestorloses—incumbentsmostlywill
paygood-sizeamountstogetridofthehostilesolicitor.Ifthehostilesolicitorwins,thereisnodoubtthathe,she,oritwillbereimbursedforexpenditures.
ACQUISITIONOFVOTINGEQUITIES
THROUGHEXCHANGES
OFSECURITIESThere are two methods ofacquiring voting equities—common and preferred—byway of exchanges ofsecurities:
1.Thevoluntarymethod,in which eachshareholdermakesuphis,
her, or its own mindabout whether toexchange.2. The mandatorymethod, in which theproxy machinery is usedand in which, except forthose who might perfectrights of appraisal, eachshareholder has toparticipate in theproposed exchangeprovided the requisite
vote of shareholders isobtained even thosewhoperfect rights to dissentceasetobeshareholders.
VoluntaryPricingissues:ItisnecessarytoofferapremiumovertheOPMImarketpriceintermsoftheconsiderationtobereceived,whetherthat
considerationiscash,debt,preferredstock,commonstockofsomeissuerotherthanthetarget,orcombinationsthereof.Securitieslawissues:ItisnecessarytoregisterundertherelativelyonerousSecuritiesActof1933(exceptforaSection3(a)9exemption,whichinvolvesdifferent
securitiesofthesameissuerwhennosalescompensationisinvolved).VoluntaryexchangessometimestakealongtimetocleartheSEC,theyareexpensive,andtheirpotentialliabilitiesarelarge.Thesameproblemswithstatelawsuitsandplaintiffs’barexistasforcash
tenderoffersandcashmergers.Incometaxissues:Thereareopportunitiesfortaxplanning.Forexample,theexchangeofvotingsecuritiesforvotingsecuritiesmightqualifyforatax-deferredreorganizationunderSection368(b)oftheSecuritiesActof1933,andanexchangeof
votingcommonstockfornetassetsmightqualifyasaSection368(c)reorganization.Availability-of-informationissues:TheamountofinformationneededforSecuritiesActof1933registrationssometimesmakesvoluntaryexchangesadifficulttooltouseinhostiletakeovers.
Sometimesvoluntaryexchangescanbeused,however,whentheinvestoriscompetingagainstafriendlyexchangeoffer,becausethenthehostilebiddercanclonethefriendlybidder’sregistrationpapersindescribingthetarget.Ability-to-financeissues:Exchanging
securitiesmeansthattheinitiatorisgettingtargetcompanies’shareholderstofinance,atleastinpart,thebidforcontrol(e.g.,theWorldcombidforMCIin1997).Financialcommitmentissues:Usually,megabucksareinvolvedforbothinvestmentanddealexpenses.Doabilityissues:
Voluntaryexchangesareokayforfriendlytakeovers,buttheyusuallyareharderthanbuyingforcash.Socialissues:Thesetendtobehuge,especiallywhentheinvestorwantsafriendlytakeoverandiswillingtomakeadealwiththeincumbents.Speed:Voluntaryexchangesareoften
slow,althoughtheSEChasbeenspeedinguptheclearanceofregistrationstatements.Ifclearanceisrequiredfromotherregulators(e.g.,theFederalCommunicationsCommission[FCC]ortheFederalTradeCommission[FTC]),theprocesscanbelong.Ratesofreturn:Thesecanbeoffthecharts,
especiallyagainstthebackgroundthatcompanyAwilltradetwoofits$60millionoffunnymoneycommonstocksorjunkbondsfor$100millionofcompanyB’ssolidunderlyingvalue,givingOPMIsa20percentpremiumovermarket.
Mandatory
Pricingissues:Thesearemuchlikethoseforcashmerger,exceptthatitisharderfortheOPMImarkettoappraisethevalueofasecuritiespackageratherthancash.ItisprobablethatpremiumsoverOPMImarketpricesofferedinexchangesarelargerthanforcashtransactions,otherthingsbeingequal.
Thismaybeespeciallytrueinvoluntaryexchanges.Securitieslawissues:Thesearemuchlikethoseforcashmergers,except—andthisisabigexception—thattheissuerhastocomplywiththeSecuritiesActof1933(seetheWorldcomS-4redherring).TheS-4isacombinationproxy
statementforvotingpurposesandaprospectusregisteringsecuritiesthatarebeingofferedpublicly.Incometaxissues:ThereismorecertaintyregardingtheuseofSection368undertheInternalRevenueServicecodetoeffectatax-deferredreorganizationthanisthecasefor
voluntaries.ASection368(a)reorganizationencompassesamergertransaction.Acquirersknowtheyhave100percentequityownershipattheconclusionofproxysolicitation.Availability-of-informationissues:Theseareasforavoluntaryexchange.Ability-to-finance
issues:Ifseniordebtisrequiredfromthird-partylenders,itiseasiertoobtainherethanforavoluntaryexchange,inwhichtheinvestorcanneverget100percentacceptance.Financialcommitmentissues:Mandatoryexchangesusuallyinvolvemegabucks,bothinvestmentanddeal
expenses.Doabilityissues:Thesearejustlikethoseforcashmergersandvoluntaryexchanges.Mandatoryexchangestendtobehardtouseforhostiletakeovers.Socialissues:Thesearelikelytobehighlyimportant.Speed:Mandatoryexchangesareasslowas
voluntaryexchangesofsecurities,andadditionaltimeisrequiredforastockholdermeetingafterdefinitivematerialsareissued—perhapsanother20to60days.Ratesofreturn:Thesearesimilartotheratesforvoluntaryexchanges,exceptheretheremaybelesspricesensitivityonpartoftheOPMImarket,
andasisstatedabove,ittendstobeeasiertogetseniorfinancingbecauseacquirerwillbea100percentholderofacquirecommonstock.Boththesefactorsoughttoimprovereturnsoverapurevoluntaryexchange.
ACQUISITION
OFCONTROLWITHOUTACQUIRING
SECURITIESBYUSINGTHEPROXY
MACHINERYWith the advent of the shark
repellent, hostile contests forcorporate control almostinvariably end up in a proxyfight; that is, the use of theproxy machinery to get therequisite voting majorities toexercise control or elementsof control. The advantagesand disadvantages of theproxy machinery can beexaminedinlightofthesamefactors used in theexamination of security
purchases.Pricingissues:Thesearenotrelevant,butanoutsiderneedsanissueorissuestoobtainvotes.TheissueusuallyhastobethepromiseofimprovedfutureOPMImarketprices.Securitieslawissues:Theseareaproblem.TheinvestorneedsSECclearanceandhasto
defendagainstlawsuitsbyincumbentsincontrol.Incumbentshavecontrolofboththeproxymachineryandthecorporatetreasury.Incometaxissues:Areproxycontestexpensesalwaysdeductibleforoutsiders?Availability-of-informationissues:Thesearenotrelevant.
Ability-to-financeissuesandfinancial-commitmentissues:Securitiesarenotacquired.Thecostofhostileproxysolicitationusuallyrunswellintosevenfiguresforlegalfees,printingcosts(actualsolicitationandfightletters),proxysolicitorfees,publicrelations(PR)costs,
advertisingcosts,andthecostofcourtinglargeshareholders(e.g.,Worldcommaterials).Iftheattemptattheacquisitionofcontrolgoeswell,costsarelikelytoberecoverablebecauseevenifthehostilesolicitordoesnotwin,theincumbentsarelikelytopaytogetridofhimorher.Thesituationmaybe
different,however,iftheoutsidesolicitorisastrategicplayerintheindustryratherthanoneengagedonlyinafinancialtransaction.Nonetheless,intermsofdealexpense,thecompanyfinancesalloftheincumbents’expendituresandnoneoftheoutsider’sexpenditures.
Doabilityissues:Suchacquisitionsarealmostalwayshighlyuncertain.Socialissues:Theseareusuallyextremelyimportant,exceptwhentheraidercanwinwithoutthenecessityofmakinganydealwiththeincumbents.Speed:Thetransactionspeedvaries.Inmostinstances,outsiders
cannotcallaspecialmeetingofshareholders;theyhavetodotheirthingatanannualmeeting.Suchmeetingsaresupposedtobeanannualoccurrenceforlistedcompanies,butsometimestheycanbepostponedalmostindefinitely.Ratesofreturn:Thisisanactivitywithavery
highpotentialreturn.
SUMMARYActive investors seekingcontrolorelementsofcontrolover a publicly tradedcommercialentitythroughtheacquisition of securities canfollow several differentcourses of action to achievethat goal. All acquisitions ofsecuritiesareeithervoluntary
or mandatory. Voluntaryrefers to situations in whicheach individual securityholdercanmakeuphisorherown mind as to whether totake certain actions.Mandatory refers to votingsituations in which allsecurityholdersare forced toparticipate in some actiononce the requisite number ofsecurity holders of that classvote in favor of the action.
This chapter discusses theadvantagesanddisadvantagesof each method in light offactorssuchaspricingissues,securities law issues, incometax issues, other regulations,availability-of-informationissues, ability-to-financeissues, financial commitmentissues,doabilityissues,socialissues, speed, and rates ofreturn._______________
*ThischapterisbasedonChapter13ofValueInvestingbyMartinJ.Whitman(©1999byMartinJ.Whitman).ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.
PartFour
UnderstandingResourceConversion
CHAPTER22
AShortPrimeronResourceConversion*
Long-Term
ArbitragebetweenOPMIPricesandControlValuesMoreAggressiveEmploymentofExistingAssetsMergerandAcquisitionActivity
CorporateContestsforControlGoingPrivateandLeveragedBuyoutsSummary
Ifadealmakerwereto thinkabout theories of efficient
markets, he would concludethat if there were efficientmarketsatall,therewouldbetwo efficient markets—onemeasuringthepricesatwhichoutsiders trade commonstocks in the open market,and the other reflecting thevalueofbusinesses.Prices,orvalues, inonemarketusuallywouldbeunrelated to prices,or values, in the other. Putsimply, the dealmakerwould
conclude that prices paid forcommon stocks forinvestment purposes aredifferent frompricespaidforcontrol of businesses.Frequently, the value ofcontrol of businesses wouldbebelow themarketpriceofcommon stocks. In thatinstance, the activist wouldseek to sell common stockowned personally, and/orhave the controlled company
issue new common stock.Newcommonstockwouldbeissuable through the sale tothe public, for cash, of newissues,orthroughissuingnewsecurities in merger andacquisition transactions.These types of activities aredescribedindetailinthelaterchapterswherewediscusstheSchaefer Corporation andLeasco Data Processingtransactions, which are
representative of what mostof thenew-issueboomof thelate1960swasallabout.On theother hand, insiders
frequently will conclude thatthemarketpricesofcommonstocks are materially belowthe values of the businessesthese common stocksrepresent. In that event,insiders, promoters, orcompaniesthemselvesseektoacquire common stocks at
prices that represent somedifferential between thevalues being ascribed tononcontrol shares in theoutside passive minorityinvestor (OPMI) market andthe value of the enterprises.We cover examples ofcommon stocks selling wellbelow intrinsic value orcontrol value inmid 2012 inthesectionofChapter6titled“OPMI Investing in
Companies with GrowingNAVs.”
LONG-TERMARBITRAGEBETWEEN
OPMIPRICESANDCONTROL
VALUES
The two disparate marketsdescribed above exist for thesame commodity—commonstocks. That valuationsordinarily shouldbedifferentbetween these two marketsseems obvious. After all,when valuing wholebusinesses the standards ofanalysis and the decisionconsiderations tend to bedifferentfromwhentryingtopredict market prices for
common stock. Businessbuyers frequently use, as anessential part of judging theattractivenessofanissuer,thesame elements we havedescribed elsewhere in thisbook,whicharealsousedbyOPMIs following thefundamental financeapproach (Chapters 8 and15):Theconditionsforanissuer
to be attractive to a
fundamentalistbuyerinclude:1.Qualityoftheissuer
a.Strong financialposition, that is, anabilityforthebusinessto obtain credit onattractiveterms:
i.Relative absenceofliabilities
1. On-balance-sheet2. Off-
balance-sheet3.Outthereintheworld
ii.Valuable assets(cash or nearcash)iii.Freecashflowsfromoperations
b.Reasonably wellmanaged and byhonest people eitherpresent or potential
after a change ofmanagementc.Understandablebusiness, whichalways meanscomprehensivedisclosures andaudited financialstatements
2. Terms of variousissues in the company’scapitalization as well aslegal status of the
corporation based onstateofincorporationandan examination of, interalia, the articles ofincorporation andbylaws.3.Priceoftheissue
a.Common stock sellsin OPMI markets atreasonable discountsfrom its worth to acontrol buyer (say adiscountof20percent
ormore)In contrast, the
conventional fundamentalistor stock trader usuallyemphasizes the near-termoutlook, which in turninvolves judgments abouttechnical positions andearnings per share aswell asprice-earnings (P/E) ratios,which are heavily influencedby the particular company’sindustry identification. Top-
down forecasts, such as forinterest rates or grossdomestic product (GDP) arealmostalwaysveryimportantinconventionalanalysis.The market for companies
and control of them appearsto be, on its own terms, ahighly active one, especiallyduringperiodswhen:
Fundsareavailableforborrowing,and/orResourceconversion–
consciousinsiderscontrolcompanieswhosecommonstocksaresellingathighenoughpricessothatsomethingistobegainedbyissuingthosesharesinmergerandacquisitionactivities.Ifabrokerorfinderbelieveshehasadoabledealintermsofcontrol,hehasnotroublefindingpotentialbuyerstolook
atthecompanyheproposestooffer.Hedgefundsponsorscanfinanceleveragedbuyouts(LBOs).
Thus, there is a long-termarbitrage that takes placebecause of the disparitiesbetween prices in OPMImarkets and control values.But this arbitrage is far fromaperfectone,inpartbecausepeople in control of
companies whose stockmarket prices are depressedare sometimes not resourceconversion–consciousormaynotwanttotakeadvantageofthe low stock market pricesby having the companyacquire publicly held shares,having the insiders acquirethe shares, or having a thirdpartyacquiresharesbydirectpurchase, merger, oracquisition.
EXAMPLEFor example, back in theearly 1970s, BakerFentress, a registeredclosedendinvestmenttrust,wassellingataround44;itsunencumbered asset value,easilymeasurable,was notlessthan$63pershare;andeven after allowing forcapital gains taxes andliquidation expenses,minimum net asset valuewouldbewell inexcessof$50per share.As amatter
of fact, because certaincontrolled affiliatesappeared to have valuessubstantially in excess ofthe market prices used todetermineBakerFentress’snetassetvalue,itwasafairguess that a realisticliquidating value for theBaker Fentress commonstock could approach $80pershare.Through stock ownership,the Baker Fentressmanagement and control
group appeared, at least totheoutsider,tobefirmlyincontrol, and there seemedto be little to indicate thatthere was any significantinterest of management intaking those corporateactionsthatwouldresultinthe market price of theBakerFentressstockrisingso that it more nearlyapproached BakerFentress’s value asdetermined under afundamental financeapproach.
BakerFentressappeared tobe an attractive investmentusing our approach,because the stockholderwould benefit from havingcompetent investmentmanagement working toenhance, for the benefit ofthe stockholder, a goodgrade, unencumbered assetvalue that the stockholderacquired at a substantialdiscount froma reasonablemeasureofnetassetvalue.Yet, it was easy tounderstand why the Baker
Fentress common stockmight have lacked appealfor the activist and theaggressive outsider. BakerFentress did not appear tobeadoabledeal.Therewaslittle, if any, evidence thatany resource conversionactivities would occur forthe benefit of BakerFentress security holders.The same seems true in2012formanyissuers,suchas Brookfield AssetManagement, CapitalSouthwest, Cheung Kong
Holdings,HendersonLand,Investor A/B, andWheelock & Companyamongothers.Many OPMIs emphasizingthe fundamental financeapproach ought to be ableto achieve more thansatisfactory long-terminvestment results, even ifthey do not consider theprospects for resourceconversion part of theirinvestmentapproach.Theseresults seemed attainable
by acquiring BakerFentresscommonstockandsimilarequitysecurities.
Equity investments insound businesses (quality oftheissuer)boughtatwhatareperceived to be low prices(price of the issue) based onlong-term business standardsof valuation can bring theinvestornotonlycomfortbutabove-average returns.Comfort is created because
the investor is minimizinginvestmentrisk:
Theinvestorisinaconservativepositionsincehehaspurchasedahigh-qualityissuer,andhasdonesoatsignificantdiscountsfromreadilyascertainablenetassetvalue(NAV).Bydefinition,thebusinessesinwhichheisinvestinghavebeenrun
conservatively.Above-average return over
the long term ought to beachievable,too,because:
Ifthepurchasepriceforstockislowrelativetothevalueofthenetassetsbeingacquired(significantdiscountsfromreadilyascertainableNAV),prospectsoughttobereasonablygoodfor
appreciation.Intheabsenceofreadilyidentifiablecatalyststhatmaytriggeraresourceconversionevent,anaddedmarginofsafetyandassuranceofadequatereturnarereasonableprobabilitiesofgrowthinNAVovertime.
Afterall, ifon thisbasis, acompany earns an average
return on the value of assetsemployed in a business,investors whose stockpurchase prices represent asubstantialdiscountfromthatassetvaluewill enjoyabove-averagereturns,basedonthatinvestor’s cost for his stock.Reasonable growth in NAVgoingforwardwillonlymakethatreturnevenlarger.Thisisdiscussed in some detail inChapter6onnetassetvalue.
EXAMPLEAs we have alreadydescribedinChapters1and6,itisfeasibleinmid-2012asa total return investor tobuyintobluechipcommonstocks that have thefollowing characteristicsand that in our opinion,probably haven’t been asattractively priced in mid-2012sincethemid-1970s:
Super-strongfinancialposition(qualityof
issuer).CommonstockpricedatanattractivediscountfromNAVof20percentormore(WheelockandCompanyatadiscountofabout50percent)(priceoftheissue).FullcomprehensivedisclosuresinEnglishwithauditsbytheBigFour(thoroughanalysis,basedonbothqualitativeandquantitativegrounds).Tradinginmarkets
whereprotectionsforOPMIsarestrong.ProspectsseemgoodthatoverthenextthreetoeightyearsNAVwillgrowbynotlessthan10percentcompoundedannuallyafteraddingbackdividends.Ifsuchgrowthisachieved,theinvestmentsseemverylikelytobeprofitablebecauseifnot,thediscountsfromNAVwouldhavewidenedtounconscionablelevels.
WediscusstheissueofgrowthinNAVinChapters6and12.
However,suchanapproachis unsatisfactory foractivists and moreaggressive outsiders. Theyneeddoabledealsinwhichthe probabilities are thatresource conversion eventswill take place (so thatsomeone will pay themsubstantialpremiumsabovemarket for theirstockholdings),orinwhich
netassetsinabusinesswillbe employed moreaggressively in the futurethan in the past, either bythepresentcontrolgrouporanewgroup.
Trying tospotdoabledealsbefore they are announced issomething we describe asprearbitrage or predealactivities. After deals arerumored or announced,market activity tends to be
dominated by professionalarbitrageurs,acoterieofWallStreetpeoplewho,asagroup,areextremelycompetent,wellfinanced traders, who enjoylowtransactioncostsandwhoalso tend to be astute injudgingwhenandhowdoabledeals that have beenannounced will beconsummated.Duringperiodswhen professional arbitrageactivities are under way, it
frequently is difficult fornonprofessionalarbitragerstocompete.Incontrast,webelievethere
oftenareimportant,relativelynoncompetitive opportunitiesfor OPMIs in prearbitrageactivitiesand inpostarbitrageperiods.Uncovering prearbitrage
doabledeals, insofaras thosedeals involve mergers andacquisitions or tender offers,
not only creates investmentopportunities,butalsocreatesfinders’ and brokers’ feeopportunities. As is detailedintheLeascocaseinChapter26, in the vast majority ofinstances the ability to spotdoable deals entails using acombination of thefundamental financeapproach and personalrelationships,orknow-who.Itseems to us that very few
deals are even contemplatedthat are not going to benegotiated transactions, andnegotiations, by definition,always involveknow-who.Anotable exception is assetsales under Section 363 ofChapter11 of the bankruptcystatute, where an auction isrequired.However,evenwithoutany
know-who, investors usingfundamental finance
standards may haveopportunities for uncoveringdoable deals merely by thestudy of publicly availabledocuments describingsituations in companieswhose securities appearattractive, even though it hasbeen our experience thatwithout know-who,predictingjustwhatsituationswillprovetobedoableentailsasmuchluckasskill.
Doableresourceconversionactivities that might bespottedinclude:
1. More aggressiveemployment of existingassets2.Mergerandacquisitionactivities3. Corporate contests forcontrol4. Going private,includingLBOs
Examples of situationswhere doable deals couldhave been spotted on aprearbitrage basis or adetailed description of thenecessary conditions for adoable deal are presentednext.
MOREAGGRESSIVE
EMPLOYMENTOFEXISTING
ASSETSIn 1974 and 1975, a groupheaded by FrederickKlingenstein of Wertheimand Company acquiredcontrol of Barber OilCompany, listed on the NewYork Stock Exchange. TheKlingenstein group paid an
averagepriceofabout$25fortheir position in Barber Oil,an investment companyregistered under theInvestment Company Act of1940, whose net asset valuewas stated to beapproximately $40 per share.Asabusiness,BarberOilwasunencumbered, and itconsistedessentiallyofapoolof capital amounting toapproximately $100 million,
partofwhichwasinvestedinmarketable securities ofmajoroilandgascompanies,partofwhichwasininterestsinoil andgasproperties, andpart of which was in oiltankers. After theKlingensteins acquiredcontrol, the price of BarberOil declined for a protractedperiod. The shares wereavailable at prices rangingfromapproximately17to21.
In 1976, Barber Oilannounced that itwouldseekto be deregistered as aninvestment companyand thathenceforth it would employits resources to aggressivelyexpand in the energybusiness, using itsunencumberedequitybaseof$100 million as thefoundation for an acquisitionprogram that would befinancedbyincurringdebt.In
short order, additional oilproperties were acquired aswellasalargecoalcompany,Paramount Coal. In early1978,BarberOilwas tradingaround$27pershare.
MERGERANDACQUISITIONACTIVITY
Sinceitsfoundingintheearly1920s,AmeradaPetroleum,adebt-free company, had builtuponeofthelargestreservesof oil and gas in the UnitedStates,andby1968AmeradaalsohadimportantinterestsinLibya.Thecompanyengagedonly in oil and gasexploration and productionhaving no downstreamcapabilities(thatis,itdidnottransport, refine, or market
petroleum products).Amerada also had asubstantial cash surplus. In1968, the Hess Oil andChemical Companypurchased fromTheBank ofEngland a 9 percent interestinAmerada at a price of 80.Up until that time, theAmerada stock had neversold as high as 80.Within ayear of the Hess Oil andChemical purchase of
Amerada,thechairmanoftheboard of Amerada, Mr.Jacobsen, died. Leon Hess,the head of Hess Oil andChemical, obtained a seat onthe Amerada board. Shortlythereafter a merger wasproposed under which theAmeradastockworkedoutata market value of not lessthan $125. After Hess hadacquiredits9percentinterestandbeforeMr.Hessobtained
board representation, theAmerada shares still couldhave been acquired for lessthan80.
CORPORATECONTESTSFOR
CONTROL
The1970sthrough
2012Back in the late 1970s and1980s contests for controltook the form of cash tenderoffers,afar lesscumbersometakeover mechanism thanengaginginproxycontestsoroffering to acquire targetcompanies’ common stocksinexchangefortheacquiringcompanies’ securities.Corporations that were
candidates for contestedtakeoverswerethosewiththefollowingconditions:
Thecompanieswereincorporatedanddomiciledinstateswheretherearenostrongantitakeoverstatutes.Shareownershipwaswidespreadortherewereblocksthatmightbetiedupviaprivatetransactions.
Therewasapossiblelowwillofthemanagementtoresistatakeoverattempt;therewasageneralabsenceofimpedimentstothetakeover,suchasacompany’sbeinginaregulatedindustry(say,insurance,commercialbanking,oraviation).Theredidnotappeartobeantitrustproblems.
Theredidnotappeartobeimportantpeopleorinstitutions,suchascustomers,employees,orsuppliers,whocouldharmthetakeovertargetbyterminatingrelationshipswiththecompany.
Oneexampleofacontestedtender offer was theNovember 1975 cash tenderby Babcock International, a
subsidiary of Babcock andWilcox, for all the shares ofthe American Chain andCableCompanyat27netpershare, in cash. Prior to thetender offer, the shares hadtraded in 1975 in a rangebetween14and20.AmericanChain was a New Yorkcorporation, its managementheld little stock, and it wasnot in a regulated industry.Initially,AmericanChainand
Cable resisted the offer, butwhen Babcock raised theprice to 32 inDecember, thenew offer was approved bythe American Chain andCable management, severalmembers of which obtainedemploymentcontracts.There were scores of
contested cash takeovers inthe period between 1975 and1978, including those for thecommon stocks of Allied
Thermal, Husky Oil, Apco,OtisElevator,ESB,AztecOilandGas,SeaWorld,Babcockand Wilcox, Marcor, RoyalIndustries, and CarrierCorporation.1 In 2012, itseemed most hostiletakeovers were initiated bydistressed investors whoacquired credits in troubledcompanies and then in aChapter 11 reorganizationreceived common stock for
their credits aspartof aplanofreorganization.2Thisistheway Brookfield AssetManagementobtainedcontrolofGeneralGrowthPropertiesin 2011; how John Paulsonobtained control of certainresorthotels;andhowCavcoIndustries inpartnershipwithThird Avenue Value Fundobtained control of PalmHarborHomesin2011.
TheEmergenceoftheSharkRepellent
Today, obtaining controlthrough an outright tenderoffer is a relative rarity,however, given the almostuniversal presence of sharkrepellents, which insulateexisting management inoffice.It is claimed, almost
universally, that shark
repellents are put intocorporatechartersandbylawstoprotectOPMIshareholdersfrom raiders who, in theabsence of such repellents,would obtain control ofcompanies on the cheap.Theserepellentsinclude:
PoisonpillsBlank-checkpreferredstocksDueonchange-of-controlcovenantsinloan
agreementsStaggeredelectionsformembersofboardsofdirectorsRestrictionsontheabilityofoutsiderstoconvenestockholders’meetingsSupermajorityvotingprovisionsinwhichchangesofcontrolmaybeinvolvedCertainfair-priceprovisions
There is considerablemeritto the observation that whenan otherwise unwelcomeacquirer has to negotiate atarm’s length with anincumbent management anditsboardofdirectors,pricingfor OPMI shareholders willbe better than if all theacquirer had to do to obtaincontrol was to buy directlyfromOPMIsenoughcommonstock, either at the OPMI
market price or at somepremium over OPMI marketprice. This is far from thewholestory,though.The fact seems to be that
when acquirers have tonegotiate with managements,managements are likely totake some part of thepremium paid for control forthemselves,ratherthangivingit wholly to shareholders. Ifan otherwise unwelcome
acquirercanobtaincontrolbygoing directly toshareholders, he or she neednot make special deals withmanagement. If that acquirernegotiates with management,management is unlikely towork exclusively in the bestinterests of shareholders tothe exclusion of seekingmanagement’s own rewards.Thisisjustpartandparcelofa financial world
characterizedbycommunitiesof interest and conflicts ofinterest.Furthermore shark
repellentsshouldbelookedatfrom the point of view ofacquirers who might beunwelcome to an incumbentmanagement.When potentialacquirers see such repellents,they can assume thatgarnering control is likely tonot only bemore costly than
would otherwise be the casebut also—and perhaps moreimportantly—that it is likelyto be uncertain, perhaps notdoableatall.Manywould-beacquirers conclude thatattempting this takeover isnot worthwhile. Theexistence of shark repellents,in an efficient world, has tomean that there are fewerchangesofcontrolthatwouldresult in OPMIs receiving
premiums over market thanwouldotherwisebethecase.Intuitively, it would seem
that the OPMI community isprobably hurt more byrepellents than it is helped.Given that OPMI marketprices tend to be irrationalcomparedwithafundamentalfinanceapproach,however,itcanbesafelysaid thatOPMIprices do not reflectmanagements’abilitiestorun
businesses.Putsimply,OPMIpricesdonotserveasagoodtest distinguishing betweencompetentmanagementswhodeserve to be insulated inofficeandpoormanagementswho ought to be removedfromoffice.From a national interest or
nationalproductivitypointofview, there appears to beample justification forrepellents despite
disadvantages to OPMIsbecausethecountrywouldbea lot less productive ifmanagements in general hadto run companies byconcentrating on the dailystock ticker and reportedquarterly earnings per share.Although shark repellentsseem justified from anational-interest point ofview, many repellents,including poison pills and
Pennsylvania corporate law,seem to constitute overkill.The Pennsylvaniaantitakeover statutes, forPennsylvania corporationsopting to take advantage ofPennsylvania law, in effectseem to bulletproofincumbentsinoffice.Revlon rules exist in
Delaware, the leading statefor the incorporation ofcompanies whose common
stocksaretradedpublicly.Putsimply, these rules state thatif control of a company is tochange—whether hostile orfriendly—the role of a boardof directors changes. Theboardbecomesanauctioneer,anditsdutiesaretoobtainthebest price, and other terms,that can be obtained forstockholders.Thesametrade-off seems to exist underRevlon rules as exist under
shark repellents from anOPMI point of view. Revlonrules probably result in therebeing better pricing thanwould otherwise be the caseand probably also mean thatthere will be fewer deals atpremiumsoverOPMImarketprices than would otherwisebethecase.
GOING
PRIVATEANDLEVERAGEDBUYOUTS
TaxShelter(TS),OtherPeople’sMoney
(OPM),andSomethingofftheTop
(SOTT)
People and companies rarelyact unless they expect aresulting benefit, either forthemselvesor forotherswithwhom theyhave identitiesofinterest. In making suchdecisions, the actors aim totake advantage of certainfactors that seem to bepresent in many resourceconversion activities. Thereare three such factors, andgoingprivate transactionsare
aresourceconversionactivitywhere different participantstake advantage of thesefactors.Thefirstfactor,andtheone
that probably has the singlemost pervasive influence onour economy, is taxconsiderations.Actorsseektomaximize profits byminimizing their taxliabilities. In its ultimateform, tax shelter (TS)
exempts the taxpayer fromtaxaltogether;butitmayalsoinvolve structuring atransactioninspecialwayssoas to achieve a preferentialtaxrateontheprofitsrealizedor to allow the taxpayer tocontrol the timing of the taxliability.A second factor is other
people’s money (OPM,pronounced OPIUM). OPMcan take many forms. The
most familiar of these is, ofcourse, the conventionalborrower-lender relationship,where a person pays fees forthe privilege of usingsomeone else’s money. Theuser of OPMmay, however,obtain his money withoutdirect payment of fees. Forexample, commercial banksobtain demand depositswithout paying interest onthem; insurance companies
obtain prepayment ofpremiumsonthepoliciestheyissue.TheusersofOPMmayeven obtain profits from theveryprovidersoffunds.LBOsponsors normally take aninvestment-banking fee forarranging the LBOtransaction. After the deal isclosed, the sponsor usuallytakes a regular managementfee. In leading private equityfunds, these fees generally
belongtothegeneralpartners(GPs)andarenotsharedwiththe investorswhoare limitedpartners(LPs).Thisissoalsoin the case of insurancecompanies that make moneynotonlybyinvestingthecashcreatedby theprepaymentofpremiums, but also from theoperations of the insurancebusiness itself for which thepremiumsarepaid.Finally, many people
involved with corporationstry to obtain other benefitsout of the association forthemselves or for thecorporation. This is the thirdfactor,andwecharacterizeallsuch benefits as somethingoff the top (SOTT), whichmeans different things todifferent users of it. Forexample, to a company,SOTT may mean diversifiedincome, freedom from
regulation,andpoliticalclout.Toapublic company, itmayalso mean control of theregistration process, togetherwith an ability to sell equitysecurities at an ultrahighprice, so that newproductiveassets can be obtained on anadvantageous basis via eitherapublicofferingoramergerand acquisition program. Tomanagement, SOTT meansnot only salaries, bonuses,
stock options, expenseaccounts, and perquisitessuch as prestige and bigoffices, but also power andoperatingcontrol. Inapubliccompany, this includescontrol of the registrationprocessandproxymachinery.Finally, not being an insidercan occasionally even serveas a form of something offthe top to those outsidesecurities holders who
eschew any of theresponsibilities that go withbeing an insider, and whowant nothing more thanabsolute passivity, liquidity,andmarketability.
TheExampleTake a simplifiedhypothetical example of agoing-private transaction toillustrate these factors.3 XYZ
is an ordinary non-growthpublic company with 1million shares of XYZcommon stock outstanding.XYZ is debt free. Thecommon stock sells around9½ in the outside passiveminority investor (OPMI)market, giving the commonstock an aggregate marketvalueofaround$9.5million.Going forward for thenext
five years, XYZ is to have
annual operating income ofaround $2 million includinginterest income of 6 percenton surplus cash held (i.e.,cash holdings in excess of$500,000). During this five-year period, the aggregateamount of receivablesoutstanding and inventorywill remain constant at $2million. Current liabilitiesremain constant at $600,000.Cash necessary for the
operation of the business isassumed to be constant at$500,000. The value of theproperty, plant, andequipment(PPE)accountwillremainconstantat$6million,as capital expenditures forPPE will exactly equalchargestakenfordepreciationandamortizationofPPE.Prior to any financial
engineering,theXYZbalancesheet and income account
wereasshowninTables22.1and22.2,respectively.Table22.1SummaryBalanceSheetforXYZ
Table22.2SummaryofIncomeAccountforXYZVariable Value
(000)Revenues $7,000OperatingIncome,including $2,000
interestincomeIncomeTaxesat35% $700NetIncome $1,300EarnperSharefor1,000shares
$1.30
MarketValueofEquityatseventimesearnings
$9,100
ReturnonEquity 15.48%
Then Promoter Group, viaNewco, a newly formedcorporateshell,acquires, inanewly formed wholly ownedsubsidiaryofNewco,allXYZ
assets,subjecttoallofXYZ’sliabilities. The acquisition ofthesenetassetsisforcash,atsix times operating earnings,or $12 million, equal to analmost 32 percent premiumover the prevailing price of$9.1 million for XYZ equityintheOPMImarket.Feesandexpenses of the transactionare$500,000.Newco obtains the $12.5
million cash needed to close
theXYZ transaction,withoutrecourse to Promoter Group,asshowninTable22.3.Table22.4showsNewco’sopeningbalancesheet.Table22.3FinancingforPurchaseofXYZNetAssetsSource Value
(000)XYZSurplusCash $500FundsBorrowedfromBanksat5%(fivetimesoperatingincome,securedbyvariousassetssuchasreceivables
$10,000
andproperty,plantandequipment)InvestmentofCashbyPromoterGrouplimitedpartnership
$2,000
TotalSources $12,500
Table22.4ApproximateNewcoOpeningBalanceSheet(Consolidated)
Newco’s approximate,condensed income accounts,
cash flow statements, andbalancesheetsforeachofthenext five years are as shownin Table 22.5, assuming thesecured borrowings areamortized at a rate of $500peryear.Table22.5NewcoForecastedFinancialStatements(postLBO)($2,000CommonStockInvestment)
Table 22.6 is a clone ofTable 22.5, except that theequityinvestmentintoNewcois $1,000 rather than $2,000.The $1,000 cash needed toclose is obtained by havingNewco sell, for $1,000 cash,a new parent company issueof$1,000principalamountofnonamortizing 10-year, 8percent subordinateddebentures.Thesejunkbondsare a form of mezzanine
finance.Table22.6NewcoForecastedFinancialStatements(postLBO)($1,000CommonStockInvestment)
Assume in Table 22.5 thatat the end of five years,Newco goes public at eighttimes earnings, using theproceeds from the publicoffering (say $2,000) to paydownsecuredborrowings.Ateight times earnings, old
equity would have an OPMImarket value of $8,864,resulting in a compoundannualreturnof34.7percent.Isthisacomparisonofapplesand oranges here—$2,000cashin2012versus$8,864inrestricted common stock in2017? Would it not still beapples and oranges if all theNewco common stockbecame freely tradable in2017?
Assume in Table 22.6 thatat the end of five years,Newcogoespublic,aspertheprecedingparagraph.Ateighttimes earnings, old equitywouldhaveanOPMImarketvalueof$8,392,resultinginacompound annual return of53.03 percent. Assume inTables 22.5 and 22.6 thatwith the secured lender’spermission, Newco was ableto dividend out $1,000 of
surplus cash before goingpublic. Returns of 34.7percent and 53.03 percentwould be increasedmaterially.In therealworld,Promoter
Group, as the promoter,wouldhavereceivedmuchinthe way of additionalcompensation from the XYZdeal:
Partofthat$500initialexpenseincurredin
connectionwiththeacquisitionofXYZwouldhavebeenaninvestment-bankingfeepaidtoPromoterGroup.Theactualpromotersofthedeal,asgeneralpartners(GPs)ofPromoterGroup,mayormaynothavesharedthatinvestment-bankingfeewiththelimitedpartners(LPs).
NewcoprobablypaidahomeofficechargetoPromoterGroup—say,$100peryear.ThetypicalrelationshipbetweenPromoterGroup’sGPsanditsLPsisthattheGPs,whichrunhedgefunds,getamanagementfeeofbetween1and2percentperannumofassetsmanaged,plus20percent
oftheprofits,sometimesaftertheLPsgetaminimumreturn,say7or8percentperannum.TheGPsareunlikelytohaveinvestedanyoftheirownfundsintoPromoterGroup;100percentofthefundingwouldhavebeenprovidedbytheLPs.Insteadofa32percentpremium’sbeingpaidto
OPMIinvestors(assumingthatoldXYZwasliquidatedorthatNewcohadpurchasedXYZcommonstocksratherthanXYZnetassets),perhapsonlya20percentpremiumwaspaid,withthemissing12percentgoingtoXYZmanagementandcontrolpeopleasbonusesandparachutes.
Why did the XYZ controlgroup need to sell toPromoterGroup?Thecontrolgroup could haveaccomplished a similartransaction itself in a strictgoing-private, in which casenot only would it haveextracted cash from XYZ,taxable on a capital-gainsbasis, but it would also haveremained in complete controlofXYZ.
Alternatively, importantpeople at XYZ could havehad interests in PromoterGroup or Newco commonstock. There is no need forPromoter Group to own 100percent of Newco common.Indeed, PG might haveactively sought XYZmanagement ownership of aminority interest in Newcocommon.One of the big advantages
Promoter Group has as thecontrollingentityofNewcoiscomplete control of timing.Promoter Group chooseswhen to go public. Supposethe initial public offering(IPO) market heated up in2014. Why not take Newcopublic then at, say, 12 to 15times earnings, especiallysince at that time publiclytraded comparables might besellingintheOPMImarketat
16 to 20 times earnings?Thereare lotsof institutionalpressures to have buoyantIPOmarkets:
AlargenumberofPromoterGroup–typeentitiesareeitherassociatedwithmajorunderwriters(GoldmanSachs,MerrillLynch,andMorganStanley)orhavecloserelationshipswiththem.
Securitiessalespeopleloveandneedunderwritingsbecauseof(1)largegrossspreads,asubstantialportionofwhichispaidtosalespeople,and(2)exclusiveproducts(Newco,nowrenamedXYZ,commonstockasanIPO),designedtosellatpremiumsinimmediateaftermarkets
andusuallyunavailabletodiscountbrokers.Ingoingpublic,useofproceedsbecomesaveryimportantconsideration.InNewco’ssituation,cashproceedsfromanIPOcouldhavegoneinthreegeneraldirections:theexpansionofoperations(i.e.,investmentinnewassets),thepayingdown
ofseniorborrowings,orpaymentsonjuniorsecurities,subordinates,orcommonstock.(IfpresentlyoutstandingcommonstockissoldintheIPO,thisiscalledasecondary.)
Assume that Newco hadsubstantial amounts of netloss carryforwards to shelterXYZ earnings before incometaxes and that the $12,500
acquisitionofXYZnetassetsfor cash left intact, forincome-tax purposes,Newco’s continuity ofownership and continuity ofbusiness. Cash flowsavailablefromthetransactionwould, of course, beincreased materially. Sowould Generally AcceptedAccounting Principles(GAAP) book value as perGAAP rules as promulgated
in Financial AccountingStandardsBoard(FASB)109.Under FASB 109, Newcowould have capitalized as anasset the present value ofestimated cash to begenerated via use of the netoperating loss tax carryforward.Aspartofcontroloftiming,
suppose Newco goes publicby way of an IPO andprospers, but the aftermarket
is very poor, so that theOPMI market price is fourtimes earnings. PromoterGrouptakesNewcoprivateatsix times earnings;stockholder suit is broughtand settled on the basis of a$50,000 fee to class-actionattorneys,and thestockpriceis increased by 25 cents pershare.NoNewcostockholderperfects rights to a statutoryappraisal.
SupposeNewco falters andis unable to service debt tosecured lenders, the tradecreditors,orthesubordinates.Either in court (Chapter 11reorganization) or out ofcourt (a voluntaryrestructuring), PromoterGroup, as control people andas a debtor in possession(DIP),willhaveatremendousamount of control over thereorganizationprocesses.
Suppose Promoter Groupwanted to acquire control ofXYZ in ahostile takeover. Itwouldhavethebenefitofnotnecessarily having tomake adeal with XYZ managementorcontrolgroups.Ifitowneda minority position in XYZcommon stock, PromoterGroup could serve as thecatalyst that would put XYZinplay.Therewouldbemanydisadvantages to a hostile
takeover,includingquitehighadministrative expenses,whether Promoter Groupseeks to acquire XYZcommon stock, presumablyfor cash, or solicits proxiesfor control.There are alwayslots of uncertainties inengaginginhostiletakeovers,and Promoter Group wouldbe estopped from doing due-diligenceresearchawayfrompublicrecords.
Suppose Newco were apublic company selling at 25timesearningsandwanted toacquire XYZ in a mergertransaction, exchanging anewissueofNewcocommonstock for all of the 1,000sharesofXYZcommonstockoutstanding.Newcocurrentlyhas 1,000 Newco commonshares outstanding and hasnet income of $1,000 andtherefore an OPMI market
capitalization of $25,000, or$25 per share. It acquiresXYZfor$15marketvalueofa new issue of Newcocommonstock.Thisequalsapremiumofabout56percentover theXYZcommonstockOPMI trading price. Itrequires the issuance of 600shares of Newco commonstock. As a result of thetransaction, Newco’s netincome will be increased
from$1.00pershareto$1.38per share, as shown inTable22.7.Table22.7HowNEWCO'sNetIncomeIncreasesinaMergerVariable Value
(000)NewcoNetIncome $1,000XYZNetIncome $1,200
CombinedNetIncome $2,200EarningsperShare(1,600shares)
$1.38
SUMMARYThereisalong-termarbitragebetween OPMI prices andcontrol values. Disparitiesbetween prices in OPMImarkets and control valuesgive rise to resourceconversion opportunities thatwe illustrate in this chapter.We also discuss howOPMIscan take advantage ofrelatively noncompetitive
prearbitrage or postarbitragesituations. People andcompanies rarely act unlessthey expect a resultingbenefit, either for themselvesorforotherswhomtheyhaveidentities of interest. Inmaking such decisions, theactors aim to take advantageofcertainfactorsthatseemtobe present in many resourceconversionactivities.The tale ofXYZCompany
containsexamplesnotoffreelunches,but rather simplifiedexamples of how activistsengaged in financialengineering try to get otherpeople to pay for theirlunches. Getting someoneelse to pay for your lunchcan, in themost general sortof way, fit into one or moreof three categories that weintroducedatthebeginningofthissection:
1. Something off the top(SOTT): whetherpromoter’scompensation,managements’compensation,underwriting grossspreads, salespeople’sparticipations, or free orcheapstockoroptions.2. Other people’s money(OPM): which is accessto attractive outside
capital,whetherequityordebt, and access toattractive creditenhancements, whetherfor companies or otherparticipants.3. Tax shelter (TS) forcompanies and allparticipantswithclout.
_______________*Thischaptercontainsoriginalmaterial,andpartsofthechapterarebasedon
materialcontainedinChapter12ofValueInvestingbyMartinJ.Whitman(©1999byMartinJ.Whitman)andChapter17ofTheAggressiveConservativeInvestorbyMartinJ.WhitmanandMartinShubik(©2006byMartinJ.WhitmanandMartinShubik).Thismaterialisreproducedwithpermission
ofJohnWiley&Sons,Inc.1ThereaderisreferredtoChapter21,“BuyingSecuritiesinBulk,”wherewediscussmanyoftheissuesrelatingtothedifferentmethodsofpurchaseofsecurities.2FordetailedexamplesofchangesofcontrolthroughtheacquisitionofthecreditsoftroubledcompaniesthereaderisreferredtoMartin
J.WhitmanandFernandoDiz,DistressInvesting:PrinciplesandTechnique(Hoboken,NJ:JohnWiley&Sons,2009).3InChapter25wediscussTheHertzCorporation’sgoing-privatetransactionindetail.
CHAPTER23
RestructuringTroubledCompanies*
TheFiveBasic
TruthsofDistressInvestingRehabilitationofTroubledEntitiesSummary
Distress investing isdifferentfrom what most academictheorists and common stockinvestorsareusedto.Distress
investing involves being aspecial sort of creditor. Incontrast, modern capitaltheory (MCT), the principalacademic discipline, looks atinvesting from the point ofview of either the outsidepassive minority investor(OPMI)incommonstocksorthe common stockholderconsolidated with thecompany itself.1 Bothapproaches clearly are
irrelevant for distressinvesting,thoughmanyMCTconcepts are very helpful—for example, an expandedview of the concept of netpresentvalue(NPV).Most so-called common
stock “investing” involvestrying to predict near-termmarket prices in mostsituations even where therearenoreasonablydeterminateworkouts. Weight to market
is minimal in distressinvesting. Most creditanalysis revolves aroundtrying to predict whethertherewillbeamoneydefault.In distress investing weassume that there is someprobabilitythattherewillbeamoney default. Distressinvestment analysis bottomsonfiguringoutwhathappensnext, that is, after a moneydefault occurs. Some senior
creditors will be reinstated,and perhaps never evenmissacontracted-forcashpaymentfor interest, principal, orpremium;somecreditorswillparticipateinareorganizationandreceiveanewpackageofsecurities (and maybe evensome cash) in satisfaction oftheirclaims;andsome juniorcreditors and stockholderswill be wiped out, receivingno value in the
reorganization. Sometimes acompany will be liquidatedpursuant to Chapter 7 or aChapter 11 liquidation plan.Proceeds from a liquidationwill be distributed toclaimants and parties ininterest in accordance withthe rule of absolute priority;that is,aseniorclass is toberepaidinfullbeforeanythingis paid to a junior class. Indistressinvesting,Chapter11
isnotanending;rather,itisabeginning.
THEFIVEBASICTRUTHSOFDISTRESSINVESTING
There are five basic truthsthatanybodywishingtobeaninvestor in distressed
situations cannot afford toignore.Thesetruthsrepresentthe guiding principles thatguide all reorganizations,whethertheytakeplaceoutofcourt or in a court ofcompetent jurisdiction,usuallyabankruptcycourt.
Truth1:NoOneCanTakeAwaya
CorporateCreditor’s
RighttoaMoneyPaymentOutsideofChapter11orChapter7UnlessIndividualCreditorConsents
Outside of a courtproceeding, usually Chapter11, no one can take away acreditor’s right to a moneypayment for interest,principal, or premium unless
that individual creditor soconsents. Ignorance of thisbasic rule seemed evident inthe airline bailout in the fallof 2001,which, amongotherthings,wasapprovedbya96-to-1 vote in the U.S. Senate.Cash payments of $5 billionweremade to the airlines, ofwhich well over $2 billionwasusedinthesubsequent12months to pay cash interestonalreadyoutstandingairline
indebtedness. None of thefunds dedicated to interestpayments were used toenhance the efficiency orsecurityof airlineoperations.Put otherwise, the bailoutseemed to be a bailout ofairlinecreditors ingreatpart,rather than a bailout of theairlines.What does it mean for a
distressinvestor?If a company is going to
avoid Chapter 11, creditinstrumentswithashort termto maturity give the distressinvestorde facto seniority. Ifa company is to be grantedChapter11relief,seniorityofcredit instruments will lie intheir covenants andintercreditor agreements, andmaturity dates for unsecuredlenders become irrelevant.The authors took advantageof the right to money
payments by acquiringGeneral Motors AcceptanceCorporation (GMAC) seniorunsecured notes in lateOctober 2008. The relevantdatawere:
GMAC 7¾ seniorunsecured notes,maturing1/19/2010Amount issued:$2,500,000,000Currentprice:$62.00Yieldtomaturity(YTM):
53.42%Current yield (CY):12.50%Denied access to capital
marketstorefinancematuringobligations, the GMACbusiness was effectively inrunoff in October 2008.GMAC had three types ofassets that could beconvertible to cash to meetmaturingobligations:
1.Receivablesandleases
2.A100percent interestin a profitable propertyand casualty (P&C)insurance company thatearned $400 million to$600millionperyearandwas probably worth asizable premium overbookvalue3. A one third stockinterest in GMAC Bank,much of whose assetsmight be in residential
mortgagesThe three questions that adistress investor is likely toaskare:
1. Will the 7¾ notesremainperformingloans?2. Will the 7¾ notesparticipate in a Chapter11reorganization?3. Will there be avoluntary exchange offerfor the 7¾ notes run byCerberus L.P., the
principal owner of 51percent of GMACcommonstock?Whether or not the 7¾
notes would remain aperforming loan seemed todependalotonwhatthelossexperience would be on therunoff of the receivables andlease portfolios. The authorsdid not know, but guessedtherewas a 70 percent to 75percent probability that the
runoff would be profitableenough to keep the 7¾notesa performing loan throughmaturity.Ifthishappened,thekeyperformancemeasure forthedistressinvestorwouldbeyield to maturity (YTM) of53.42percent.If the 7¾ notes were to
participate in a Chapter 11reorganization—a 25 percentto30percentprobability,say—the investor would receive
upon reorganization a newpackage of securities,probably including commonstock, in what ought tobecome a conservativelyfinanced finance company.Here the distress investormeasures his return by thedollar price paid for the 7¾notes and the workout valueof the securities to bereceived in a reorganizationover an estimated period of
time.Cerberus could try a
voluntary exchange offer forvarious GMAC seniorunsecured notes, includingthe 7¾s. The exchange offerwould probably propose thatthe7¾sacceptanewpackageof securities with stretched-outmaturitydatesthatwouldhave an expected marketvalue of, say, $80 to $85.There was no way that such
an exchange offer would beaccepted by most holders ofthe 7¾s unless the holderscouldhavebeenshownsomemeaningful downside if theydid not exchange. The onedownsidethatwecouldthinkof that might haveencouraged acceptances wasthat ifan insufficientnumberof 7¾s were tendered,GMACcouldfileforChapter11 relief. Such a scenario
seemed very unlikely.Cerberus, a GMACstockholder,wasnotgoingtowant to commit suicide, oreven take a suicide risk,knowing what could happentoGMACcommonstockinaChapter 11 reorganization.GMACdidinfacttrysuchanexchange offer, whichpredictablyfailed.In the end, GMAC
succeeded getting a capital
infusion from the TroubledAssetReliefProgram(TARP)and became a bank holdingcompany, which gave itaccess to capital from theFederal Reserve. The resultwas that the notes becamecredit enhanced and quicklytraded at a YTM of 12percent.This requirement to pay
cash in the absence ofChapter 11 relief will be the
caseaslongasthatcreditorisa beneficiary of either U.S.securities law or the termscontainedinvirtuallyallbondindentures and loanagreements. These rights tomoney payments for mostpublicly traded debtinstruments exist because oftheprovisionsofSection316of theTrust IndentureActof1939(TIA),theprovisionsofthe typical indenture issued
forpubliclytradedbonds,andtheprovisionsof typical loanagreements protectinginstitutional lenders such ascommercial banks. Section316(b)statesinrelevantpart:Notwithstanding any otherprovision of the indenturetobequalified,therightofanyholderofanyindenturesecuritytoreceivepaymentof the principal of andinterest on such indenture
security, on or after therespective due datesexpressedinsuchindenturesecurity,or to institutesuitfor theenforcementofanysuch payment on or aftersuchrespectivedates,shallnotbeimpairedoreffectedwithouttheconsentofsuchholder.The TIA contains two
exceptions to this right topayment,bothofwhichseem
minor.The first exception is
contained in Section 316(a)(2):The indenture to bequalified may containprovisions authorizingholders (except thoseknown to the indenturetrusteetobethedebtissueror insiders of the debtissuer) of not less than 75percentinprincipalamount
of the indenture securitiesor if expressly specified insuch indenture, of anyseries of securities at thetimeoutstandingtoconsentonbehalfof theholdersofall such indenturesecurities to thepostponement of anyinterest payment for aperiod not exceeding threeyearsfromitsduedate.The second exception is
contained in the latterpartofSection316(b)oftheTIA:[S]uch indenture maycontain provisions limitingordenyingtherightofanysuchholdertoinstituteanysuch suit, if and to theextentthattheinstitutionorprosecution thereof or theentry of judgment thereinwould, under applicablelaw,resultinthesurrender,impairment,waiver,orloss
of the lien of suchindenture upon anyproperty subject to suchlien.A corporate issuer is
required to comply with theTIA if $10,000,000 or moreprincipal amount of debtinstrumentsistobemarketedpublicly by the issuer over a36-month time span (Section304(a)(9)). The TIAprotection in the United
States against depriving acreditor of rights to interestand principal payments doesnotnecessarilyapplyinotherjurisdictions,suchasCanada.The indenture for Home
Products International, Inc.,95/8 percent seniorsubordinated notes, is typicalfor credit instrumentscomplying with the TIA.Relevant language in theHome Products indenture
follows:Section 9.2. Amendmentswith consent of Holders:The Company, theSubsidiary Guarantors andtheTrusteemayamendthisIndenture or the Securitieswithout notice to anySecurity holder but withthe written consent of theHolders of at least amajority in principalamount of the Securities.
However, without theconsent of each Securityholder affected, anamendmentmaynot:(1) reduce the amount ofSecurities whose Holdersmust consent to anamendment;(2) reduce the rate orextend the time forpayment of interest of anySecurity;
(3) reduce the principal ofor extend the StatedMaturityofanySecurity;(4) reduce the premiumpayable upon theredemption or repurchaseof any Security or changethe time at which anySecurityshallberedeemedor repurchased inaccordance with thisIndenture;
(5) make any Securitypayable in money otherthan that stated in theSecurity;(6) impair the right of anyHolder to receive paymentofprincipalofand interestonsuchHolder’sSecuritieson and after the due datesthereforeortoinstitutesuitfor theenforcementofanypaymentonorwithrespecttosuchHolder’sSecurities;
(7)makeanychangetotheamendment provisionswhich require eachHolder’s consent or to thewaiverprovisions.Typical language contained
in a loan agreement for debtsyndicated amongcommercial banks iscontained in a 1996–1997“Credit Agreement amongSafeliteGlassCorp.,VariousLending Institutions and the
Chase Manhattan Bank asAdministrative Agent” andfollows in “Section 12.12AmendmentorWaiver;etc.”:(a)Neither thisAgreementnor any other CreditDocument nor any termshereof or thereof may bechanged, waived,discharged or terminatedunless such change,waiver, discharge ortermination is in writing
signed by the respectiveCreditPartiesparty theretoand the Required Banks,provided that no suchchange, waiver, dischargeor termination shall,withouttheconsentofeachBank (other than aDefaulting Bank) withObligations being directlyaffectedtherebyinthecaseof the followingclause (i),(i) extend the final
scheduled maturity of anyLoanorNoteorextendthestated maturity of anyLetterofCreditbeyondtheRevolving Loan MaturityDate, or reduce the rate orextendthetimeofpaymentof interestorFees thereon,or reduce the principalamount thereof, or amend,modify or waive anyprovision of this Section12.12.
This inability in the UnitedStatesforanyoneoutsideofacourtproceedingtotakeawaya creditor’s right to amoneypaymentunlesstheindividualcreditorconsentsisextremelyimportant both to corporatemanagements and tocreditors.
Truth2:Chapter11RulesInfluenceAll
TroubledCompanyReorganizations
In the reorganization of anypublicly traded issuer,whether that reorganizationtakesplaceoutofcourtor inChapter 11, the rulesgoverning a Chapter 11reorganization will influenceheavily the actualreorganizationthateventuallytakes place. These rules
include the rule of absolutepriority and the period ofexclusivity during which thedebtor is the only party whocan propose a plan ofreorganization(POR).If a financially troubled
company, especially a largecompanywithpubliclytradedsecurities, is required torecapitalize,itwillhavethreechoices:
1.Voluntaryexchanges.
The company may seekto exchange new andmore liberalizedsecurities for theoutstanding securities. Inconnection with thesevoluntary exchangeoffers, the companyfrequently will seekconsents from eachcreditor or securityholdertodeleteoramendrestrictive covenants in
the indentures oragreements under whichthe instruments wereissued. Exchange offersand consent solicitationsrarelyworksatisfactorily.Exchange offersfrequently fail becausethey are premised on theoften-fallaciousassumption that creditorswillacceptan instrumentwith more immediate
marketvalue(asopposedto inherent or potentialvalue) in exchange foroutstanding debtsecurities that have acurrently depressedmarket value (see earlierGMAC example). Theonefactorthatfrequentlyinducescreditorstoagreetovoluntaryexchangesistoshowthecreditorsthatthere is a significant
downsideriskforthemiftheydonotparticipate inthe offer. This can oftenbemadetobethecaseifexchanged debtinstruments are grantedseniority overnonexchanging debtinstruments. Even if anoriginal bond indentureprohibits the issuance ofsenior debt, thatprovision can be
abrogated by the consentoftherequisiteamountofbonds: in the case ofHome ProductsInternational,“thewrittenconsentoftheHoldersofat least a majority inprincipal amount of theSecurities” (Section 9.2of the indenture).Agreeingtotheexchangeoffer can constitute awrittenconsent.
2. ConventionalChapter 11. Thecompanymay first file abankruptcypetitionunderthe Bankruptcy AbusePreventionandConsumerProtection Act of 2005(Chapter 11, Title 11 ofthe U.S. Code) and thenattempttorecapitalizebysoliciting acceptances ofa plan of reorganization.This conventional
approach to bankruptcyinmost situations entailsconsiderable risk anduncertainty for thecompany and itsmanagement. In aChapter 11 bankruptcy,each of the company’screditors and sometimesitsstockholdersisapartyto the proceeding withstanding to object to anyand all transactions
outside the ordinarycourseofbusiness.Thesecreditors andstockholders arerepresented by officialcommittees havingsignificant voice in theadministration of thebankruptcy and aregenerally wellrepresentedbyactiveandaggressive attorneys,accountants, and
investment bankers. TheBankruptcy Codeprovides that there beappointed an officialCommittee of UnsecuredCreditors. However,additional committeesrepresenting otherconstituencies are oftenappointed also. Each ofthese parties in interestwill likely press its ownagenda. In addition, the
company will end upfunding hugeadministrative expensesbecause it will berequired to pay the feesandexpensesofnotonlyits own attorneys,accountants, andinvestment bankers, butalso the attorneys,accountants, investmentbankers,andotheragentsforvariousclaimantsand
parties in interest. Thistends to be the casewhether thereorganization takesplaceinChapter11orviavoluntary out-of-courtexchanges.3. Prepackaged ofprenegotiated filings.Pursuant to Section1126(b) of thebankruptcy code, thecompany may solicit
requisite consents to itsbankruptcyreorganization planbefore filing for Chapter11 relief. Suchsolicitations commencedpriortofilingforChapter11 relief may nowcontinue past the filingdate based on the 2005Bankruptcy AbusePreventionandConsumerProtection Act
(BAPCPA). If suchconsentsareobtained,thecompany then will filefor Chapter 11 for thelimitedpurposeofgettingtheplanofreorganizationconfirmed by abankruptcy court.Obtaining consents priortofilingforaChapter11relief dramaticallyreduces the uncertainty,risk, and expense
involved when acompany attempts torecapitalize. Prepackagedbankruptcyreorganizationistheidealmethod for recapitalizingcertain types of publiccompanies. Goodcandidates are thosetroubled companies withrelatively stable andpredictable sources ofoperating income from
corebusinessesandthosewith fairly simplecapitalizations involvingconventional debt andonly small amounts ofcontingentliabilities.Whetherthecompanybeing
recapitalized is healthy orfinancially troubled, thetechniques used torecapitalize have to be eithervoluntary or mandatory.Voluntarytechniques(suchas
exchange offers) are thosewhere each security holderwill make an independentdecision whether to accepttheofferedrecapitalization.Ifthe security holder does notelect to accept the voluntaryoffer,therewillbenochangeto theentitlements to interestand principal in accordancewith the terms of his or herinstrument. Mandatorytechniques(suchasfreeze-out
mergersinthecaseofhealthycompanies, and Chapter 11bankruptcies in the case offinancially troubledcompanies) involve acompulsory change to theinstruments of dissentingsecurity holders if therequired threshold ofacceptances is received.Mandatory techniques almostalways entail use of thevoting process and proxy
machinery, which machineryis almost always within theabsolute control ofmanagement when a healthycompany is involved, but israrely within the absolutecontrol ofmanagementwhena troubled company isinvolved.Reorganization of a
troubled company, whetherthrough the voluntaryexchange of securities or
through relief under Chapter11, involves, in the finalanalysis, recapitalizing acompany. Successfulrecapitalizations invariablyinvolvereducing,delaying,oreliminating contractualrequirements that thecompany make cash interestor principal payments.Healthy companies alsoreorganize (i.e., recapitalize),even though such
reorganizations/recapitalizationsalmost always involveincreasing as opposed toreducing the company’sobligations to make cashpayments to creditors.Recapitalizations of healthycompanies go under suchnames as leveraged buyout,managementbuyout,cash-outmerger, purchase, and goingprivate.
Truth3:SubstantiveCharacteristicsof
SecuritiesJohn Burr Williams, aneminent economist, wrote in1938, “Investment value isthe present worth of thefuturedividendsinthecaseofa common stock, or of thefuturecouponsorprincipalinthecaseofabond.”Williamshad it wrong in terms of
analyzing distressedsituations. Here, investmentvalueisthepresentworthofafuture cash bailout,whateverthe source of that cashbailout.A security gives a holder
eitherrightstocashpaymentsby a company or ownershiprights in that company,present or potential. If thepromise of cash pay asscheduled is legally
enforceable, the security is adebt obligation or creditinstrument. If the promise ofcashpayasscheduledisnotalegally enforceable rightexcept in very limitedcircumstances (e.g., neitherthe declaration of a commonstockdividendorrepurchasesofoutstandingcommonstockcan be made unless cashpayments are first paid to asecurity with seniority over
the common stock), thesecurity is a preferred stock.If the security combines thepromise of cash pay withownership rights—present orpotential—the security is ahybrid, either a convertibledebtor convertiblepreferred,oraunitconsistingofacreditinstrument or preferred stockand detachable ornondetachable warrants orcommon stock. A security
with ownership rights but nocontractual or legal rights toreceivecashpayisacommonstock.Aswasdiscussedalreadyin
Chapter 4, for a security tohavevalue,ithastohavethepromise of delivering a cashbailout to a holder. Cashbailouts come from threedisparatesources:
1. Payments by thecompany, whether for
interest, principal,premium, dividends, orsharerepurchases.2. Potential sale to somesort of amarket, not justan outside passiveminorityinvestor(OPMI)—a market such as theNew York StockExchange, but also othermarkets,suchastakeovermarkets.3.Controlorelementsof
control of the company.Common stocks withouteconomic value cansometimes have agovernancevalue.A common stock that does
not pay a dividendhas valuetoaholderonlyifitprovideseither a market-out orelementsofcontrol (also,butrarely,nuisancevalue).Manyif not most recipients ofcommon stocks upon the
consummation of a plan ofreorganization (POR) arepassive rather than controlinvestors. For example,commercial banks andinsurance companies bydefinition are noncontrolinvestors. Frequently, theyare required to take commonstock in a POR, as was thecase in the 1985reorganization of AngloEnergy when they received
75percent of the newAnglocommon stock.Rule 1145ofthe bankruptcy code at thattime prevented personsgetting 5 percent or more ofthe common stock to beoutstanding from sellingthosesharesinpublicmarketsunless they were held, fullypaid,foroneyear,afterwhichcommon shares could bedribbled out weekly at thegreater of 15 percent of the
daily volume or 1 percent ofthe outstanding issue.Regulators and otherspromulgate Rule 1145 andothers likeit(SECRule144)because they fear share pricedeclines in common stockmarketsifblocksofcommonstock are dumped. This fearfactor seems much worse inJapan than in the UnitedStates, where large amountsof cross-holdings, especially
common stocks held bycommercial banks, arefrequently restricted frombeing sold in the openmarket. This seemsmistakenpolicy. It is much moreimportant to have PORsbecome feasible by givingnoncontrol shareholders easymarket-outs so that theybecome willing recipients ofcommonstocksinPORsthanitistoprovidepricesupports
for OPMI stock markets,which are bound to pricesecurities capriciously in anyevent.A disconcerting
development revolves aroundbankruptcy court rulings thatprohibit sales by creditorswho are likely to receivecommon stocks in areorganization in order topermitcompanies topreservethe value of net operating
losses that would becompromised if, forpurposesofSection382oftheInternalRevenueCode, therewere tobe a change of ownership.One example is the 1994Phar-Mor Chapter 11 caseheardintheNorthernDistrictof Ohio. For noncontrolshareholders owning non-cash-pay securities, thosesecurities have little or novalue unless the security
holder is provided with amarket-out sooner or later,preferablysooner.Control securities are a
different commodity frompassive securities from aneconomicpointofvieweventhough they areindistinguishable in legalform. As an example, asecurity with no apparentvalue to a holderwouldbe anonmarketable, non-
dividend-paying, minority-interest commonstockwherethe holder has no nuisancepotential. A similar situationwherethereisapparentvalueto a holder is that of asecurity that is a deeplyunderwater common stockwheretheholderisthedebtorin possession (DIP) enjoyingtheperiodof exclusivity in aChapter 11 case—agovernancevalueevenwhere
thereisnoeconomicvalue.
Truth4:RestructuringsAreCostlyforCreditors
The creditors of a distressedcompany are going to beripped off by investmentbankers, lawyers, andmanagements, whether thereorganization or liquidationprocess takes place out of
court or in Chapter 11 orChapter 7. Unlike commonstock investing for control,whenacompanyisdistressedit is likely to pick up all theprofessional expenses forattorneys, accountants,investment bankers, andappraisers incurred bydominant creditors, whetherthecompanyisreorganizedinChapter11oroutofcourtorit is liquidated under either
Chapter11orChapter7.Academic finance is way
off base in attempting tomeasure the direct andindirect costs for a troubledcompany for professionals,particularly attorneys andinvestment bankers—the so-calleddirectcostsofdistress.In lead articles, including“Bankruptcy Resolution” byLawrence A.Weiss (Journalof Financial Economics 27,
1990), it has been estimatedthat in Chapter 11reorganizations direct costsaverage 3.1 percent of thebook value of debt plus themarket value of equity, withbook value measured as ofthe end of the fiscal yearbeforeafilingforChapter11relief.Twothingsareterriblywrong with this approach.First,asapercentageofassetvalue, asset value has to be
measured, not as of the datebefore filing, but as of thedate of confirmation of aPOR.Suchassetvaluewouldbeeitherreorganizationvalueormarketprices immediatelyafter confirmation. Moreimportant, though, is thefailureofacademicstorealizethat these professional feesand expenses areadministrative expenses,always paid in cash and
always the beneficiary of asuper-priority giving themprecedence over prepetitiondebt. Thus, it is mostmeaningful to examineprofessional fees as apercentage of the cash in thedistressed company at thetimeofreorganization.Professional costs are
highly burdensome in thereorganization of troubledissuers either in court or out
ofcourt.Thedebtornormallypicks up the professionalexpenses of each creditorconstituency, except theU.S.government. Those claimingthese costs are notburdensome know notwhereof they speak. Theexpenses are so large that ithasbecomeuneconomictobeinvolved in smallChapter11cases unless they are donepursuanttoaprepackaged(or
equivalent)plan.In trying to measure the
indirect costs of Chapter 11,itisimportanttoaddbackitsfourbenefits:
1.Norequirementtopayinterest to unsecuredcreditors during thependency of a case, andprobably not as part of aPOR2. The debtor better ableto take advantage of
benefits under the U.S.taxcodeifreorganizedinChapter 11 rather thanoutofcourt3. The automatic stayduring thependencyofacase4. The availability ofpost-petition DIPfinancing, because post-petition lenders obtainsuper-priority as anadministrativeexpense
Truth5:CreditorsHaveOnlyContractual
RightsA creditor has onlycontractual rights, notresidual rights. Residualrightsbelong toowners (e.g.,a duty of directors for fairdealing in relationships withowners). The law is wellsettledforsolventcompanies.Thebeneficiariesofdutiesof
care and fair dealings byboards of directors and othercontrol persons flow directlyto the owners of firms.Lenders to solvent firms areentitled only to those rightsthat are spelled out in loanagreements and bondindentures,plus severalotherrights provided by law.Specifically, lenders obtainprotection under statutesgoverning fraudulent
conveyance and fraudulenttransfers. But the lender to asolvent corporation has noresidualrights(e.g.,tobethebeneficiariesofdutiesofcareandfairdealingbythepeoplerunning companies). Thesebenefits belong to thebusiness itself andspecifically to businessowners.When a corporation enters
into a zone of insolvency,
mostcommentatorsagreethattheretendstooccurashiftinthe duties of boards ofdirectors from protecting theinterests of owners toprotecting the interests ofcreditors. This is somewhatvaguesincethereisdifficultyin defining exactly what azone of insolvency is.Whenactually insolvent, the roleofthe board of directors shiftsfrom protecting the interests
of owners to protecting theinterestsofcreditors.
REHABILITATIONOFTROUBLED
ENTITIESThere are three ways ofrescuing troubled companiesso that thesecompanieshaveodds in their favor that they
can be made feasible goingforward.
1. Reorganize—that is,recapitalize:
a.Voluntary exchangeoffersb.Smallreorganizationcasesc.Large reorganizationcasesd.Prepackaged,prenegotiatedcases
2. Liquidate—that is,convert assets to otheruses and/or otherownership and/or othercontrol:
a.Section363sales3.Makecapitalinfusionsintothebusinessentity
ReorganizationsWhether the company beingrecapitalized is healthy or
financially troubled, thetechniques used torecapitalize have to be eithervoluntary or mandatory.Voluntarytechniques(suchasexchange offers) are those inwhich each security holderwill make an independentdecision whether to accepttheofferedrecapitalization.Ifthe security holder does notelect to accept the voluntaryoffer,therewillbenochange
to the entitlements to cashinterest and cash principal inaccordancewith the terms oftheholder’scredit instrumenteveniftherequiredthresholdof acceptances ismet so thatother terms of a creditinstrument are altered.Mandatory techniques almostalways entail use of thevoting process and proxymachinery, which is almostalways within the absolute
control ofmanagementwhena healthy company isinvolvedbutisrarelysowhena troubled company isinvolved.
VoluntaryExchangesVoluntary methods for therecapitalization of troubledcompanies are attemptedprior to a Chapter 11 filing.These voluntary methodsusually involve offers to
current holders to trade theirexisting securities or debtinstruments for newinstruments, usually with alower principal amount(typically set at a smallpremium over the currentmarket)andwithlessonerouscash service requirements.Those making exchangeoffers often seek forbearanceon defaulted cash service tocreditors, hoping that no
creditor group forecloses oncollateral, accelerates thedebt, or files an involuntaryChapter 11 or Chapter 7petitionunder thebankruptcycode. Occasionally, there areofferstobuyoutcreditorsforcash, with the considerationrepresenting a substantialdiscount from the face valueoftheclaimbutatapremiumover the then current marketvalue.Forexample,thePetro
Lewis Corporation and FirstCity Bancshares transactionsinvolvedcashofferstopublicbondholders.The biggest problem with
exchange offers is thevoluntary aspect of theoffer.No creditor can ever beforced to give up rights tocash interest or principalpayments outside of aChapter 11 case or a similarstate proceeding. There is a
large and growing list ofcompanies that haveexperienced difficult andlengthy exchange offers orwere totally unsuccessful ineffecting recapitalizationsthrough voluntary exchangeoffers.The second-biggest
problemwithexchangeoffersis they require that aregistration statement andprospectus be filed with the
Securities and ExchangeCommission(SEC)under therelatively onerous SecuritiesActof1933.Such filingsareoften expensive andsometimestimeconsuming.It is frequently difficult to
induce voluntary exchangeswhenthedebtinstrumentsarepublicly traded and themarket prices of these creditinstruments are substantiallydiscounted from their
principalamount.Putsimply,whenthereisa
voluntaryexchange,creditorsknow two things: (1) theycannot be forced to give uptheir contractual rights tomoney payments and (2) ifthey refuse to tender theirsecurity and then becomeholdouts,thechancesarethatthe market value of thenontendered security willincrease dramatically if other
creditorsacceptthevoluntaryexchange offer and thetroubled company elects toconsummate the exchange,providedthatthetermsoftheexchange offer do not resultin considerable downsidedangersforanon-exchangingcreditor. This is true becausewithout the downside threat,thecreditworthinessofanon-exchanged instrumentwillbeimproved after the voluntary
exchange is completed andthe company’s debt-servicerequirements are materiallylessened.Asa result,holdersofpublicbondsareadifferentbreedofanimal fromholdersofpublicstockwhenitcomestovoluntaryexchanges.Offerthe latter a premium overmarket, and they maystampedetoexchange.Thisisnot so for creditors if theissuer cannot show the
creditors meaningful risks ifthey do not exchange. It isalso true that many of theholders of large positions inthe debt of troubledcompanies are secondarymarketpurchasersandnottheoriginal purchasers of thedebt.Professionalinvestorsintroubled securities are muchless likely to rush to acceptvoluntary exchange offersthan are bondholders who
acquired debt securities inorder to collect interestincome.Issuers invariably attempt
to coerce creditors in avoluntary exchange byseeking nonmonetaryconsents or amendments tothe indentures or agreementsunder which the outstandingdebtinstrumentswereissued.These amendments orconsents usually are
structured so that non-exchanging creditors willhave their collateral invadedor their seniority reduced ifthe exchange offer succeeds.Exchange offers werestructured this way by theadvisors to Public ServiceCompanyofNewHampshirepriortothatcompany’sfilingfor Chapter 11 relief. Thisattempt failed becausesophisticated investors
acquired a sufficient dollaramount of credit instrumentsso that the requiredamendmentstotheindenturesto permit the company toinvade collateral or reducesenioritycouldnotsucceed.
SeekingReliefunderaConventionalChapter11FilingAChapter11recapitalization
has a distinct advantage overa voluntary recapitalizationbecause of the mandatorynatureof the recapitalization.In a Chapter 11, thereorganization isimplemented and becomesbinding on all claimantspursuant to a bankruptcycourt order of confirmation.Acourt isentitledtoconfirma plan of reorganization iftwo thirds in amount and a
majorityinnumberofholdersof each separate class ofclaimants who voted on theplan (e.g., holders of secureddebt and unsecured debt)elect toapprove theplanandtwo thirds of the amountvoted by party-in-interestholders (e.g., holders ofpreferredandcommonstock)elect to approve the plan. Inaddition, if some classes ofclaimantsandinterestholders
approve the plan and otherclasses reject it, thebankruptcy court mayconfirm the plan over thoserejectionsviaacram-downifthe court determines that theplan does not discriminateunfairly, that it is fair andequitable to each class, andthat the rejecting classeswillreceive more under the planof reorganization than theywould if the company were
liquidated. There can be nocram-down of a rejectingclass, however, if (1) therejectingclasswillobtainlessthan the full value of itsclaims and (2) amore juniorclasswillreceiveanyvalueatall under the plan ofreorganization.Notwithstanding the merits
ofaChapter11bankruptcyasatooltorestructureatroubledcompany, most troubled
issuers and investment bankshave considerable reluctanceto use Chapter 11. Thereluctance is premised onfactors such as perceivedstigma, large administrativeexpenses, and loss ofmanagement control.Although the stigma issueandtheexpenseissue(atleastversus voluntary exchanges)seem to have little basis infact, control issues are very
real considerations inuncontrolled Chapter 11bankruptcies.With respect to the stigma
issue, there appears to belittle difference for largetroubledcompanieswhetherareorganization takes placewithin or without a Chapter11. Troubled companies arestigmatized (if at all) whentheyarenotabletodischargedebts on a timely basis, and
that stigma will last only solongas the troubledfinancialconditionexists.Whether therecapitalizationtakesplaceinChapter 11 is a detail that isbeside the point because thestigma, ifany,alreadyexists.Isthereanycompanythathasbeen successfullyrecapitalized—by way ofeither a bankruptcy or anexchange offer—and thensuffered a continuing loss of
goodwill? Today, people donot seem to perceiveChrysler, General Motors,CIT, and numerous smallerrecapitalized companies asbeingstigmatized.Ironically, an uncontrolled
bankruptcy is often anexpensive proposition for thedebtor company. With courtapproval, the troubledcompany in Chapter 11 paysnot only the fees and
expenses of a whole host ofprofessionals—attorneys,investment bankers,accountants, and sundryexperts—who represent thecompany, but also the feesand expenses of variousofficialcreditors’committees,official equity committees,and such court-appointedofficials as examiners. Inaddition, the debtor may beliable for the fees and
expenses of otherswho havemade “substantialcontributions” to thereorganization of thecompany inChapter11.Thisheavyexpensefactorisoffsetto some extent by theexistence of the automaticstayinbankruptcythatallowsthe company to forgo cashservice on prebankruptcyunsecured claims and certainsecured obligations. The
sametypeofheavyexpenses,however, exist for out-of-court voluntary exchanges,usually without the fullbenefitofanautomaticstay.There is littledoubt thatan
uncontrolledChapter 11 caseusually poses large threats tocontinued control of abusiness enterprise by itscurrent management andstockholders. The loss-of-control issue, however, must
be viewed in context. Evenwithout seeking Chapter 11relief, troubled companiesmost often are required, inconnection with exchangeoffers and other voluntaryattempts to recapitalize, tocede large blocks of controlto creditors and others. Priorto a money default, mosttroubled companies have toact as supplicants in order toobtain relief from bank
lenders, tradesuppliers, laborunions,governmentagencies,andsoon.AfteraChapter11filing, though, it is commonfor lending institutions andtrade creditors to be quiteagreeable to providing post-petitionfinancingtoadebtor.Nonetheless,onceacompanyhasfiledforChapter11,thereis usually an additional andmaterial loss of controlduring the pendency of the
Chapter 11. The debtorcompany generally lays bareits business and financialsoul; the company cannottake any actions outside itsordinary course of businesswithout requisite noticefollowed by a hearing andapproval by the bankruptcycourt; the company mustshare business and strategicplans with claimants andmajor parties-in-interest; and
thecompanysubjectsitselftomassive reporting, discovery,and testimony under oath. Inan uncontrolled Chapter 11,the odds are that claimantsandparties-in-interestwillbeorganized andknowledgeable, and theiropposition to any proposalsby the debtor company willbe financed by the debtorcompany.In an uncontrolled
bankruptcy, there is also ariskthatatrusteeorexaminerwill be appointed to run,oversee, or investigate theaffairs of the company. Thetrustee risk is remote if thereis an absence of fraud orgrossmalfeasance.Examinershave duties that clearlyimpinge on managements’abilitytorunthebusinessandthe reorganization. Forpractical purposes, though,
the appointment of anexaminerremainsanunlikelyevent.A key element giving
managementacertainamountof control inside of Chapter11 is that the debtor isgranted theexclusiveright topropose a plan ofreorganization for up to amaximum of 18 months.During this period ofexclusivity, the debtor is
allowed an opportunity tonegotiate with claimants andparties-in-interest toformulate a plan ofreorganization. If a plan ofreorganization is formulated,the debtor has an additional60days to solicit consents toitsplanofreorganization.Theperiodofexclusivitymaynotbe extended beyond 18months, and the exclusiverighttosolicitacceptancesfor
a PORmay not be extendedbeyond 20months.Once theexclusive period isterminated, creditors can putforward their own plans thatwill likely result in aresolution of reorganizationissues in a far differentfashion from the onecontemplated bymanagement.The ultimate loss of
managementcontroloccursif
it is perceived that theChapter11caseismakingnoprogress. Any claimant orparty in interestmay seek toeither have the Chapter 11dismissed or have the caseconverted to a Chapter 7liquidation. If Chapter 11 isdismissed, theautomatic stayisliftedandcreditorsarethenentitled to move to asserttheir contractual remedies(i.e., foreclose on collateral
and accelerate payments ofdebt).Ifthecaseisconvertedto a Chapter 7, a trustee isappointed, and the companyis liquidated. Liquidationproceeds are paid out toclaimants and parties-in-interest in accordance with astrictruleofabsolutepriorityunderwhichsecuredcreditorshave first priority to theextent of their collateral andcommon stockholders come
last. For large publiccompanies,however, thevastmajority of Chapter 11 caseshave resulted in plans ofreorganization rather than adismissal or a conversion ofthecase.The ability to control the
timing of events is a keyelement of managementcontrol. Timing is a difficultthing to predict in acontrolled Chapter 11 and
impossibleinanuncontrolledcase.Plansofreorganizationalso
include corporate governanceprovisions as well aseconomicprovisions.InmostChapter 11 cases, thecorporate governanceprovisions adopted entrenchexisting management inoffice.A conventional Chapter 11
has a number of tremendous
advantages over a voluntaryexchange. First, troubledcompanies are almost alwaystroubled because they sufferfromacashshortage.Onceacompany files a petition forChapter 11 relief, it canreceivepost-petitionordebtorinpossession(DIP)financingfromfinancialinstitutionsandtrade creditors,which carriesa super priority and will berepaid before prepetition
debts. Thus, a company inChapter 11 has access tofinancing that is usuallyunavailable to companiesseeking to reorganize out ofcourt.TheautomaticstaythatgoesintoeffectwhenChapter11 relief is put in placeinsulates managements fromcontinuous hounding byunpaid creditors, a commoncondition existing prior toany Chapter 11 filing.
Furthermore, when acompany emerges fromChapter11,itisgivenafreshstart. Most claims against acompany are resolved in theplan of reorganization, andmost other claims notresolved are barred. Bycontrast, without court relief,a company is still stuckwithall its old liabilities, knownandunknown,contingentandfixed, in the financials or
undisclosed anywhere.Hidden liabilities tend to bemore of a real problem inanalyzingtroubledcompaniesthan is the case for healthyissuers.
PrepackagedorPreplannedBankruptcyReorganizationsKnowledgeable people in
reorganizations go to greatlengths to keep thereorganization process fromgettingoutofcontrol.Thisisnotaneasy thing todowhendealing with troubledcompanies, whether suchcompanies seek torecapitalize voluntarily orseekChapter11relief.TheeventsinvolvingPublic
Service Company of NewHampshire are a good
example of a needlesslyuncontrolled bankruptcy. Atthe time of filing, PublicService had annual operatingincome before interest andtaxes (EBIT) of around $130millionthatwasderivedfromstableoperationsunrelated toits interest in the deeplytroubled Seabrook nuclearfacility. Clearly, PublicService was easilyreorganizable, whether EBIT
was $100 million, $200million, or something inbetween, because a companycan easily reorganize on thebasis of existing earningswithout extinguishing anysecurity holders’ ownership(existing holders of commonstock would have had theirpercentage ownershipreduced from 100 percent toaround 2 to 5 percent of thereorganized entity). On
January 28, 1988, however(and perhaps predictably),Public Service filed forbankruptcyreliefwithoutfirstattempting a prepack. Thefiling was precipitated by anadverse finding by the NewHampshireSupremeCourt inaratecase.Thefilingresultedin an uncontrolled Chapter11,andthescenariosoutlinedabove for a hotly contestedChapter 11 reorganization
were played out. In ananalysis of Public Service,given its rate base,reorganization values oughttohaverangedbetween$800millionand$1.2billionintheabsenceofanyrateincreases.Since Public Service hadoutstandingonly$741millionof mortgage debt, it seemedobvious that all mortgageloans would bemadewhole,receiving in present value
cash, new securities, or bothcashandsecuritiesthatwouldhave a reorganization valueequal to mortgage principalplus back interest. Themortgage bonds could havebeen purchased prior to andjustaftertheChapter11filinginthelow70s.TheresultforPublic Service after a three-year case was areorganization value of inexcess of $2 billion, which
contrastedwith theperceivedmaximum $1.2 billion valuepriortofiling.TheincreaseinvaluecameaboutbecausetheNew Hampshire PublicUtilitiesCommissionallowedPublicServicetobenefitfrommassive rate increases. Putotherwise, the NewHampshire ratepayers weresubjectedtocost increasessothatunsecuredcreditorscouldbemadewholeandholdersof
PublicServicecommonstockcould participate in thereorganization in ameaningfulway.Had Public Service been
willingtoconsideraprepack,it might well have been ableto reorganize within sixmonths, with each class ofsecurity holders treated in amanner that complied withbankruptcy coderequirements that the plan of
reorganization must be fairandequitabletoallparties.Inaddition,theplancouldeasilyhave been determined to befeasible (also as required bythebankruptcycode)becausean agreement on retail ratescouldhavebeenreachedwiththe New Hampshire PublicUtilities ServiceCommissionin a less confrontationalatmosphere than that whichhad existed prior to the
Chapter11filing.A prepackaged bankruptcy
reorganizationisprovidedforin Section 1126(b) of thebankruptcy code, whichstates,inpart:Forpurposesof subsection(c) and (d) of this section[(c) and (d) describe therequisitevotestoapproveaplan], a holder of a claimor interest that hasaccepted or rejected the
plan before thecommencementofthecaseunderthistitleisdeemedtohave accepted or rejectedsuchplan,as thecasemaybe,if—(1) the solicitation of suchacceptanceorrejectionwasin compliance with anyapplicable non-bankruptcylaw, rule or regulationgoverning the adequacy ofdisclosure in connection
withsuchsolicitation....In other words, a troubled
companywhosesecuritiesarepublicly traded can use theproxy rules under Section 14oftheamendedSecuritiesandExchange Act of 1934 tosolicit consents of itscreditors and equity holdersto a Chapter 11 plan ofreorganization before thatcompany ever files forChapter 11 relief. Again, in
anuncontrolledChapter11,atroubledcompany is requiredto give seats at thenegotiating and litigatingtable to all claimants andsometimes to parties-in-interest. In a prepack, thesolicitation of acceptances ofa plan of reorganization isconducted before creditorsand equity holders areorganized with officialcommittees and aggressive
attorneys and investmentbankers, resulting in a muchhigherdegreeofmanagementcontrol. In essence, much oftheinfrastructureandmassivecostofabankruptcycurrentlyprovided for by thebankruptcy code can beavoided with a prepack. Inaddition,partofthebeautyofa prepack is that the processdeprives public bondholdersof any incentive to hold out,
becausethisisnotavoluntaryrecapitalizationtechnique.Aswasalreadypointedout
in Chapter 22 of this book,the control of the proxymachinery of a publiccompany is virtually alwayswithin the power ofmanagement. In a prepack,themanagementofatroubledcompany controls the timingof the solicitation and thecontent of the solicitation
materials. Clearly,management of a troubledcompany will find it muchharder to obtain theprebankruptcyconsentstotheplan of reorganization than,for example, to obtainshareholderconsenttoelectaslate of directors. Theprebankruptcy consentsshould be much easier toobtain, however, than thosesame consents after the
various creditor groups areorganized inside Chapter 11.Finally, if the prebankruptcysolicitation fails, the troubledcompany will always havethe option to pursue aconventional Chapter 11. Insuch an event, the companywill have the addedmomentum that will beprovided by its attemptedprepack.
Section363SalesA 363 sale is the sale ofassets by a company inbankruptcy in accordancewith Section 363 of theFederal Bankruptcy Code.The process starts with astalking horse bidder thatenters into a purchaseagreementfortheassets.Thisprovides a floor bid andserves as a basis for
conducting an auction. Asrecognition of the expenseand risk associated withentering into this agreement,the stalking horse bidder isentitledtoabreak-upfeeandexpensereimbursementifitisnot the successful bidder. Inconjunction with courtapprovalofthestalkinghorsebid, dates are set for a biddeadline, auction, and courthearing to approve the
winning bid. If other bidderssubmit qualified bids by thebid deadline, they arepermittedtoparticipateintheauction, which typically isconducted by the law firmrepresenting the debtor.Following the auction, boththe winning bid and analternate bid are approved inabankruptcycourthearing.
EXAMPLE
Third Avenue Value Fundpurchased $100 million(face) of Nortel Seniorunsecured debt at anaveragepriceof17percentof claim following itsbankruptcy filings inJanuary 2009. The co-portfolio manager of theFund, Ian Lapey, attendedthe auction of a portion ofNortel’s Carrier Networksbusiness(itsCodeDivisionMultiple Access and LongTerm Evolution assets) on
July24,2009,at theofficeof Cleary Gottlieb Steenand Hamilton LLP(Nortel’s bankruptcycounsel). Nokia Siemenswas the stalking horsebidder, a position that itearned by entering into apurchase agreement onJune19th tobuytheassetsfor $650 million. Thedebtors(Nortel)determinedthat this agreementrepresented the bestopportunity to maximizevalue for the assets and
serve as a basis forconducting an auction. OnJune 29th and June 30th,respectively, the CanadianandU.S.bankruptcycourtsapproved BiddingProcedures, including abreak-up fee of $19.5million and expensereimbursement of $3million if Nokia Siemenswas not the successfulbidder, and a July 21stdeadline for competingbids. Additionally, aminimum overbid of $5
million was established.Two additional parties,MPAM Wireless, Inc. (anaffiliate of MatlinPatterson, a Nortel bondholder) and Ericssonsubmitted qualified bidspriortothedeadline.Thesebids were required toexceed the stalking horsebid by the sum of thebreak-up fee, expensereimbursement, andminimum overbid. Theauction on July 24thconsisted of seven rounds
of bidding with no bidsreceived in the last round.Ericsson’s sixth round bidof $1.13 billion was theSuccessful Bid, and NokiaSiemens’$1.03billionfifthround was the AlternateBid. Ericsson’s bidrepresented a 70 percentimprovement compared tothestalkinghorsebid,evenadjustedforthepaymentofthe break-up fee andexpenses.
Section 363 sales can be
preferable to corporateacquisitions for both buyersand sellers. Buyers benefitfrom asset purchases that arefreeandclearofallliabilitiesother than those that areexpressly assumed (such aswarranties). This simplifiesthe diligence process andenables buyers to avoiddifficult-to-quantify liabilitiessuch as retirement benefitsand prepetition litigation.
Additionally, valuations in363 auctions are typicallyattractive,basedprimarilyonasset value supported bytangible assets, such as realestate, receivables, andinventory, as opposed togoingconcernvalue.Sellers benefit from a fair
auction process in whichpricewill usuallybe the solefactor in determining thewinning bidder. This
typically is not the case incorporate deals whenmanagement often drives theprocesstotheirbenefit.
EXAMPLEInstinet’s management anda private equity investorpurchased the company’sagency brokerage businessfor$207million,adiscountof $100million fromwhatthe Third Avenue ValueFund offered, and sold thebusiness one year later toNomurafor$1.2billion.
CompaniessuchasGMandChrysler that were burning
significant cash fromoperationsbeforedebtservice(not the casewith FleetwoodorNortel)maynotexperiencea fair auction process,particularly if existingcreditors are unwilling tofund additional losses. Inthese situations, the field ofbidders is limited (only theU.S.Government in the caseof GM and Chrysler) andliquidation can be the only
alternativetoafiresale.
CapitalInfusionsMakingcapital infusions intotroubled issuers was awonderful business in 2008–2009. Those making capitalinfusions can almost writetheir own tickets. And it ismuch more productive fortroubled companies to haveinvestors, private or
governmental, buy newsecurities directly from thecompany rather than fromexistingshareholders.A few examples of capital
infusionsareasfollows:JPMorganChaseacquiredBearStearnsbyissuingcommonstockanddeliveringtoBearStearnscreditworthiness.WellsFargoacquiredWachoviaBankatahuge
discountfromnetassetvalues.ThefederalgovernmentacquiredcontrollinginterestsinFannieMae,FreddieMac,andAIGbyreceivinginexchangeforcashinfusionsunitsofpreferredstockandwarrantstoacquiremajorityinterestsinthetroubledcompanies.BerkshireHathaway,in
returnforcashinfusions,receivedunitsofpreferredstockandcommonstockissuedbyGoldmanSachsandGeneralElectric.TheU.S.governmentinvested$700billionintotroubledfinancialinstitutionsthroughtheTroubledAssetReliefProgram(TARP),presumablyby
purchasingunitsconsistingofperpetualpreferredstocksandwarrantstobuycommonstock.Theperpetualpreferredstockspaiddividendsof5percent(9percentafterfiveyears),werecallable,weretransferable,andhadlimitedvotingrights.Theperpetualpreferreds,inotherwords,wereplain
vanilla.Thewarrantstopurchasecommonstockpermittedtheowner(s)ofthewarrantstopurchaseanumberofcommonshareswithanaggregatepriceequalto15percentoftheamountofinvestmentintheperpetualpreferredstock.Thewarrantswereexercisableatapriceequaltotheaverage
tradingpriceforthe20-dayperiodpriortotheinitialissueoftheperpetualpreferredstock.2
All of these capitalinfusions with equitycomponentsresultedinhighlydilutive results for existingstockholders unless suchinfusionsweremadepursuantto rightsofferings toexistingshareholders.Rightsofferings
are relatively rare. Whereundertaken, existingshareholders are giventransferable rights permittingthem to subscribe to thenewissue on a pro-rata basis,usually with anoversubscription privilege.Rightsofferingsarenormallyopen for a 21-day period.Existing stockholders dobenefit fromcapital infusionsevenwhentheyaresubjectto
massivedilution,whichistheusual case where there is noright offering, because thecompanies in which theyhave invested are creditenhanced, usually verymateriallycreditenhanced.
SUMMARYDistress investing involvesbeing a special sort ofcreditor.Most credit analysis
revolves around trying topredictwhether therewill bea money default. In distressinvesting we assume that amoney default is likely tooccur. Distress investmentanalysis bottoms on figuringout what happens next; thatis, after a money defaultoccurs. We explain the fivebasic truths that guide allreorganizations of troubledissuers.There are threeways
of rescuing troubledcompanies so that thesecompanieshaveodds in theirfavor that they can be madefeasiblegoingforward.Thesemethodsare:(1)reorganize—that is, recapitalize, througheither voluntary exchanges,standard reorganizations, andprenegotiated cases; (2)liquidate—that is, convertassets to other uses and/orother ownership and/or other
control; and (3)make capitalinfusions into the businessentity._______________*ThischaptercontainsoriginalmaterialandpartsofthechapterarebasedonmaterialcontainedinChapter6ofDistressInvestingPrinciplesandTechniquebyMartinJ.WhitmanandFernandoDiz(©2009byMartinJ.
WhitmanandFernandoDiz).ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1WehavediscussedtheissuesofsubstantiveconsolidationinChapter3,definedtheconceptoftheOPMIinChapter1,andthoroughlycontrastedourinvestingapproachtoacademicfinanceinChapter17.
2WediscusstheroleofgovernmentinreorganizationsinChapter24ofthisbook.
CHAPTER24
TheRoleofGovernmentinReorganizations*
Bailoutsor
CapitalInfusions?TooBigtoFailIsaPhonyConceptTheGovernmentandPrivateSectorAreinPartnershipWhetherTheyLikeItorNotWallStreet
ProfessionalsandCorporateExecutivesAreAllintheBusinessofCreatingMoralHazardsTaxpayerBailoutsAreaPhonyConcept
ARevolutioninCorporateReorganizationsandLiquidationsMayHaveOccurredin2009withtheChapter11ReorganizationsofGeneral
Motors,Chrysler,andCITCorporationStrictRegulationofFinancialInstitutionsIsAbsolutelyNecessarySummary
As we have already pointedout in the previous chapter,there are three ways ofrescuing troubled companiesso that thesecompanieshaveodds in their favor that theycan be made feasible goingforward.
1. Reorganize—that is,recapitalize2. Liquidate—that is,convert assets to other
uses and/or otherownership and/or othercontrol3.MakecapitalinfusionsintothebusinessentitySometimescapitalinfusions
are made by the privatesector. Sometimesgovernments have to makethe capital infusions becauseno funds are available fromtheprivatesector.Thisoccursat the all-too-frequent times
when private markets freezeupbecausethesemarkets,forthese purposes, arenotoriously capricious andgrossly inefficient. All sortsofbusinesses,especiallymostfinancial institutions, needcontinuous access to capitalmarkets.Capitalinfusionsaretheir lifeblood. Sometimesthe infusions have to besuppliedbygovernments.
BAILOUTSORCAPITAL
INFUSIONS?To economists, capitalinfusionsbygovernmentsareknown pejoratively asbailouts. It isn’t necessarilyso. It certainly isn’t so if thegovernment earns areasonable profit from thecapital infusion and/or
otherwise obtains productiveconcessions from the entitiesthat receive the capitalinfusion. To distinguishbetween a bailout and acapital infusion, a bailoutexists where a capitalinfusion is made into aneconomic entity with noprospect of any returnwhatsoever. If a return isexpected, howevermeasured,itisacapitalinfusion.
In many recent cases—Lehman Brothers, AIG,Citigroup, Fannie Mae,FreddieMac—it would havebeen extremely difficult, ifnot impossible, to eitherreorganize or partiallyliquidate each company inorder to rehabilitate it. Thiswas the case whether therehabilitation would havetakenplacethroughvoluntaryexchanges or by seeking
court protection, usuallyunder Chapter 11. First,voluntary exchangesfrequently don’t work since,as we have already pointedoutinthepreviouschapter,intheUnited States no creditorcanbecompelledtogiveuparight to a money paymentunless the individual creditorso consents, or a court ofcompetent jurisdiction, aChapter11Court,imposesan
automatic stay on payments.SeekingChapter11relief (orits rough equivalent from aState Insurance Department),might not contribute to aneffective rehabilitation sincemany assets of troubledissuers, such as derivatives,don’t deliver to the troubledissuer the benefits of theautomatic stay. Thus, as ifalmost by default, thepreferred method for
rehabilitating troubledfinancialinstitutionsin2008–2009 was making capitalinfusions by the governmentandgovernmentagencies.Thebasicproblemwiththe
various government stimuluspackages certainly hasnothing to do with thetaxpayer bailouts or whetheror not the returns to thegovernment agencies fromprovidingthefinancingresult
in an accounting profit.Rather, the problems revolvearoundquid pro quos. Therewasanapparentfailureofthegovernment to negotiateterms for the capitalinfusions, which might havecompelled various financialinstitutions in return for thegovernment’s capitalinfusions, to undertakeactions, which would havebeen beneficial to the
economy even though theyentailed realizing losses forthefinancialinstitutions.
EXAMPLEOne quid pro quo couldhave been the requiredrestructuring of largeamounts of underwaterresidential mortgages heldas assets by the financialinstitution receiving thecapital infusion. Anotherquid pro quo might have
revolved aroundcounterparty risk inherentin derivatives, such asGoldman Sachs, under thethreat of AIG insurancesubsidiaries entering state-supervisedconservatorship,might have been coercedinto compromising itsclaimsasapolicyholderofcreditdefaultswaps.Admittedly such strong-arm tactics probably werepolitically unfeasible.However, we bet that if it
wereprivate,profit-seekingentities negotiating theterms for capital infusionsinto troubled companies,lots of strong-armcompulsion would haveexisted. Quid pro quoswouldhaveoccurred.
TOOBIGTOFAILISAPHONY
CONCEPTBank holding companies andcommercial banks are twodifferent financialinstitutions. Bank HoldingCompanies own the commonstocks of commercial banks,frequentlythecommonstocksof other eligible businessesand perhaps other assets.Bank holding companies arefinanced conventionally—
perhapswithseverallayersofdebt, mostly publicly heldpreferred stocks and publiclyownedcommonstock.Commercial banks are
primarily financed bydeposits plus, to a muchsmaller extent, loans fromU.S.governmentagencies.Failure of a financial
institution occurs when theholding company’s commonstockholdersarewipedout,or
almostcompletelywipedout,whether that holdingcompany is a bank holdingcompany, an insuranceholding company, a broker-dealer holding company oranother type of holdingcompany. Thus, in 2008 and2009 many giant financialinstitutions did, in fact, fail.Such failures included AIG,Citigroup, Lehman Brothers,Fannie Mae, Freddie Mac,
Bear Stearns, GMAC, andCountrywide Financial. Withthe possible exception ofLehman Brothers, all of theabove-named failedcompanies are still inbusiness.Those inexperienced in
rehabilitating companiesdon’treallymeanTooBigtoFail.Theymean:TooBigtoBeReorganizedor Liquidated in an
Uncontrolled, ContestedProceeding Whether Out-of-CourtorinChapter11.The solution to preventing
Lehman-type debacles seemstobenottorestrictthesizeoffinancial institutions, butrather to set in placemechanisms wherebyfinancial institutions—largeand small—can bereorganized, if troubled, viaprepackaged, prenegotiated
plans of reorganizations(POR) where relevantgovernmentregulatorshaveastrong influence on what thePOR will be. Thereorganization of GeneralMotors, Chrysler, and CIT,all accomplished after lessthan 60 days in court, mayhave set a very goodprecedent for where majorU.S. reorganizationsought togo.
In other countries, theexistence of giant financialinstitutions doesn’t seem tocause a problem. Canadianfinance seems to functionextremelywell,dominatedbyfive super-large commercialbankholdingcompanies.Most financial institutions
need relatively continuousaccess to capital markets torefinance short-termindebtedness of all sorts. As
such, even well managedcompanies can be in troublewhen markets freeze up astheydidin2008.Mechanismsought to be in place toprovide capital, and/orexpeditiously reorganizethese companies, which arereasonablywellmanaged butlackaccesstocapitalmarkets.Badly managed companiesought to be permitted to besick—that is, go out of
business either throughliquidation or thereorganization process. Thisis the case regardless of thesize of the enterprise. Thethingthatoughttobeavoidedin the United States at anyrate is uncontrolledreorganizations andliquidations; these areinordinately expensive andinordinately unpredictable.Very little will be
accomplished, we fear,withoutintelligentcourts,andintelligent, powerfulregulators.
THEGOVERNMENTANDPRIVATESECTORARE
INPARTNERSHIPWHETHER
THEYLIKEITORNOT
The real environment thatexists is that the governmentis part of the problem andpart of the solution. Theprivate sector is also part of
theproblemand thesolution.If you don’t believe that theprivate sector is part of theproblem,lookattheultrapoorperformance of various partsof the private sector in thelast thirtyyears rangingfromthe 2008–2009 fiasco inresidentialhousingandgoingthrough the myriad of failedcompanies in automobilemanufacturing, textiles,shoes,TVsetmanufacturing,
steel, motion pictureexhibition, real estate, andretailing,amongothers.It is important for the
government to providemeaningful incentives to theprivatesector,and,ingeneral,the government should earnreasonable returns forproviding such incentives.There are myriadrelationships between theprivate sector and the
government. There are threeareas, though, where theprivatesectorreactsinstantly,massively, and efficiently togovernment policies. It is asif government policies, inreality, direct the invisiblehandsthatAdamSmithwroteabout in 1776. These threeareas are tax policy, creditgranting, and creditenhancement.In terms of tax policy,
much more important thanthetaxratearetaxprovisionsthat give the private sectorincentives to undertakeactivitiesthatmightbehighlyproductive. For example,there seems to be a cryingneed for the private sector(rather than the government)to be making equityinvestments in financiallytroubled companies.Corporations such as AIG,
General Motors, Chrysler,and Citigroup, all havehidden assets, in the form ofbillions of dollars of unusedtax loss carryforwards. ItwouldbehighlyproductiveifSection 382 of the InternalRevenue Code (IRC) wererepealed or amended toeliminate the change ofownership rules in order toensure that these tax losscarryforwards would be
available to offset futureincome taxes that wouldotherwisebepayablebysuchcompanies. Under Section382, the issuance of asignificant amount of newstock by a troubled companycould result in a change ofownership, which coulddramatically reduce theability of the issuingcompany to use its tax losscarryforwards.Thechangeof
ownership rules deterfinancially troubledcompanies from issuingsignificant equity, whichcould provide much neededcapital for use in expandingtheirexistingbusinessesorinacquiringnewandpotentiallyhighly profitable businesses.Underpresentlaw,itisprettymuch impossible for atroubled company to issuesignificant amounts of new
shares of its common stockwithoutsacrificing theabilityto use its net operating losscarryforwards.Tax loss carryforwards
become a tremendouslyvaluable asset for troubledcompaniesinsofaras:
Futurelossesarestemmedoreliminated.Newsourcesofincomecanbeshelteredfromtaxation.
Therepealoftheownershipchange rules wouldencourage the country’sleading entrepreneurs,investors, and investmentbankers to make massiveequity infusions into troubledcompanies. Furthermore,equity capitalwould improvetheissuers’balancesheet,butfear of triggering anownership change drivescompanies to borrow, which
overextendsthem.The virtual ban on the
trafficking in tax losses is arelatively new phenomenon.The current version ofSection382waspromulgatedas part of the Income TaxReform Act of 1986. In ouropinion, it is likely thatincreasesinproductivityfromthe repeal of Section 382wouldfaroutweighthelossesof tax revenue for the
government.
WALLSTREETPROFESSIONALS
ANDCORPORATEEXECUTIVESAREALLIN
THEBUSINESSOFCREATING
MORALHAZARDS
The environment for moralhazard exists where anactivist can create a situationvis-à-vis a passivist, so thatthe activist can believe“Heads IWin; Tails I Don’t
Lose or I Don’t Lose TooMuch.”That’swhatcorporateexecutives do vis-à-vis theirstockholders. That’s whatWall Street professionals doas underwriters, salesman,investment bankers, hedgefund general partners,leverage buyout generalpartners and mutual fundmanagers.Economistsseemtobelieve
that much of the problem in
commercial banking revolvesaround moral hazard—banksfinanced largely withgovernment insured depositscould take special risks inlending because if the loansturned bad, the governmentwouldbailoutthedepositors.Virtually all thesecommercial banks were, andare, wholly ownedsubsidiaries of holdingcompanies. Insofar as the
banks took excessive risk,holding company securityholders were compromised,or in many cases virtuallywiped out (see CitigroupCommon). Prior to 2008–2009, bank managementcausedthebankstotakerisksforwhichtheywerenotcloseto adequately compensated.The blame for thesemanagement shortcomingsseems not to be on moral
hazard, but ratherincompetence and a follow-the-herdmentality.Wearetroubledbyallthese
moral hazard attacks. First,we’ve never met a bankexecutive who did not careverymuchabouttheinterestsof the holders of holdingcompany common stock.Second, andmore important,if moral hazard wereeliminated, we fear the
economywouldbemuchlessinnovative and productivethanitis.
TAXPAYERBAILOUTSARE
APHONYCONCEPT
In Chapter 11 proceedings,there are questions of
substantive consolidation, forinstance, should a parentcompany and its subsidiariesbe treated as one entity forreorganization or liquidationpurposes, or should they betreated as separate entities.The government is thegovernment; it is not thetaxpayersunlessonestretchesthe concept of substantiveconsolidation beyond reason.If the government provides
financingtotheprivatesectoron a basis where there arepositive returns to thegovernment or the country,there has been no bailout. Ifthe government providesfinancing to private sectorentities at a loss to thegovernment or the country,then it is the governmentproviding bailout funds, nottaxpayerswhocanbedeemedto be the equivalent of
common stockholders. In thefirst instance, the funds forthe “bailout” are provided tothegovernmentby lenders tothe government, such as theChinese much more thanaveragetaxpayers.The concept of taxpayer
bailout seems to be apejorative uttered by sincerepeoplewhodonotunderstandthat capital infusions can bean extremely useful tool, but
only one tool, useful in therehabilitation of financiallytroubledentities.
AREVOLUTIONINCORPORATEREORGANIZATIONS
AND
LIQUIDATIONSMAYHAVE
OCCURREDIN2009WITHTHECHAPTER11
REORGANIZATIONSOFGENERALMOTORS,
CHRYSLER,ANDCIT
CORPORATIONWe are the authors of,Distress Investing—Principles and Technique(John Wiley & Sons, 2009).Wefinishedwritingthebookin December 2008. At thattime, we never dreamed thatif a major corporation like
General Motors filed forChapter 11 relief thatanythingcouldbedoneintheshort term. Rather, wethought it had to be anuncontrolled proceeding fullof uncertainties, with anunpredictable outcome,lengthy and very, veryexpensivewithadministrativecosts probably running toseveral billiondollars. In ourbook we pointed out how
important it was to havecontrolled reorganizations orliquidations: prepacks,prearranged, or whatever. Atthe time, we wrote thatcontrolled reorganizationsappeared doable only forsmallcompanies.Perhaps General Motors,
Chrysler, andCIThave set anew precedent that will giverise to new legislation thatwill permit, and even
encourage, all sorts oftroubled issuers to reorganizeexpeditiously in a controlledmannerwhile still preservingcreditor rights. If so, suchdevelopments would behighly constructive for theU.S.economy.
STRICTREGULATION
OFFINANCIALINSTITUTIONS
ISABSOLUTELYNECESSARY
The enormous success of themutualfundindustryoverthelast twenty-five years seemsdirectly attributable toultrastrict regulation under
the InvestmentCompanyActof 1940 as amended (theAct). Because of thestrictnessoftheAct,investorswoke up to the fact that theindustry could be trusted;fund investors would get afair shake. There is noquestion that theexistenceofthe Act has stifled initiative,is very expensive, issometimes unfair and placesburdens on a fund manager,
such as ourselves, that we’drathernothave.Grantingthis,wehave no question that theexistenceoftheActhasbeenbeneficialtotheIndustry.In seeking strict regulation
for other financialinstitutions, legislation mightwell look at the Act as atemplate for regulation,adapting theprinciplesof theActtotheregulationsofotherfinancial institutions all of
whom are vastly differentfrom mutual funds and needvastly different regulations.Comprehensive regulationshould cover the variousareas covered by the Act:asset composition; howfinanced; how operations areconducted; executivecompensation; corporategovernance; disclosurerequirements;andincometaxissues.
SUMMARYMakingcapital infusions intotroubled companies is one ofthethreemethodsavailabletorescue these entities so thattheyhaveodds in their favorthattheycanbemadefeasiblegoing forward. Sometimescapital infusionsaremadebytheprivatesector.Sometimesgovernments have to makethe capital infusions because
no funds are available fromtheprivatesector.Thisoccursat the all-too-frequent timeswhen private markets freezeupbecausethesemarkets,forthese purposes, arenotoriously capricious andgrossly inefficient. All sortsofbusinesses,especiallymostfinancial institutions, needcontinuous access to capitalmarkets.Capitalinfusionsaretheir lifeblood. Sometimes
the infusions have to besupplied by governments.The concepts of taxpayerbailoutsandtoobigtofailarephony concepts, and weexplainwhy.Thegovernmentand the private sector are inpartnershipwhether they likeit or not. A revolution incorporate reorganizationsoccurred with thereorganizations of GM andChrysler.It iscleartousthat
strict regulation of financialinstitutionsisnecessary._______________*Thischaptercontainsoriginalcontentandpartsofthechapterarebasedonideascontainedinthe20054Qlettertoshareholders.
PartFive
ActiveInvestorsBuy
andSellCommon
Stocksonan
AdvantageousBasis
CHAPTER25
TheEconomicsofPrivateEquity
LeveragedBuyouts
The2005AcquisitionofHertzGlobalHoldingsandSubsequentEventsasaPrimeExampleSuper-AttractiveAccesstoCapitalMarkets
CashPaymentstoSponsorsandSponsor-ControlledFundsSponsors’ControlofHertzSponsorsAttunedtotheNeedsofBankersandtheWallStreet
UnderwritingCommunityQuestionsaboutLBOsSummary
This chapter discusses the2005leveragedbuyout(LBO)ofthecommonstockofHertzGlobal Holdings at a
relatively high price earnings(P/E) ratio and a substantialpremium above book value.Despite mediocre operatingresults subsequent to theLBO, the Hertz GlobalHoldingstransactionseemstohavebeenquite remunerativefor the LBO sponsors andtheir investors. In our viewthis success is attributablemostly to the fact that timeand again the sponsors
enabled holders of HertzGlobal Holdings commonstock to obtain super-attractive access to capitalmarkets. Also sponsors andinvestors received two largedividendswherethefundsforpaying one of the dividendscamefromaloanwithliberalcovenants, and for the other,from the proceeds of anunderwritten common stockofferingtothepublic.
THE2005ACQUISITIONOFHERTZGLOBALHOLDINGS
ANDSUBSEQUENTEVENTSASA
PRIMEEXAMPLE
The essential element of anyLBO is the purchase of 100percent of the outstandingcommon stock of the targetcompany, almost always forcash, thereby eliminating theinterests in the company ofthe selling stockholder(s). InDecember 2005 Ford MotorCompany, the sole
stockholder of a companysince renamed Hertz GlobalHoldings (Hertz), sold itsentireinterest inthecommonstock of Hertz forapproximately$2,295,000,000 cash. Theprivate equity grouppurchasingHertzconsistedofa consortium, or club, puttogether by three sponsors(sponsors): Clayton Dubilierand Rice (CDR); Carlyle
Group (Carlyle); and MLGlobal Private Equity Fund(MerrillLynch).From the point of view of
the sponsors, and thesponsors’investors,theHertzbuyout has proved to behighly successful despite thefact that from 2006 throughJune30,2012,Hertzhasbeena quite mediocre operationreporting losses underGenerally Accepted
Accounting Principles(GAAP) in three of the sixyears from 2006 through2011.From2006 todate, thesponsors on behalf ofthemselves and theinvestmentfundsmanagedbythem have extracted$4,973,500,000incasheitherfrom Hertz or from sales ofHertz common stock inpublic offerings. At the timeofthiswriting,theinvestment
funds still hold 110,009,479sharesofHertzcommonwitha market value of almost$1,800,000,000.
SUPER-ATTRACTIVEACCESSTOCAPITAL
MARKETSClearly, the principalcontributing factor to thesuccess of the sponsors andtheir investors has been thesponsor’s enormous abilityand enormous credibility inaccessing capital markets ona super-attractive basis. Thishas enabled Hertz time andagaintofinancecashpayoutsto investment fundsmanaged
by the sponsors. This abilityto access capital markets onan attractive basis seemspervasive in the LBOindustry for not only CDR,Carlyle, and Merrill Lynch,butalsoforanumberofothersponsors.The goal of the Hertz
sponsorsseemstwo-pronged:Firstmaximizesponsors’andtheircontrolledinvestmentfundsnet
presentvalues(NPV)byextractingfromHertzandthepublicmarketsforthebenefitofthesponsorsandinvestmentfundsasmuchcashaspossibleassoonaspossible.Second,keepcontrolofHertzandextractlargeamountsoffeesandemolumentsfromHertz,probablylargelyor
completelyforthebenefitofthesponsorsandtheirappointedHertzdirectors.
Table 25.1 summarizes theHertzincomeaccountsfortheperiods from calendar 2006throughJune30,2012.Table25.1HertzGlobalHoldingsIncomeStatement(000)
In marketing a$1,950,000,000 unsecuredloan in 2012, Hertz mostly
ignored GAAP incomeattributable to commonstockholders, but insteadfocusedoncorporateearningsbefore interest, income taxes,depreciation, andamortization (EBITDA).EBITDA do not seem to befigures with much economicsignificance for potentialunsecured creditors, simplybecause in Hertz’s case thebulk of depreciation charges
do not appear to be noncashcharges. Rather Hertz isrequired to replace itsrevenue-generatingequipment continuously; carsbecome obsolete withinrelatively short time periodsandindustrialequipmentageswith use. Table 25.2 showsthat depreciation of revenueearnings equipment plusproceedsfromthedisposalofrevenue equipment barely
exceeded revenue earningsequipment expenditures forthe six years and sixmonthsended June 30, 2012. Theexcess of depreciation ofrevenue earnings Equipmentplusproceedsfromthesaleofsuch equipment exceededcapital expenditures by only$1billionover thesix-and-a-half-yearperiod.Table25.2SelectedConsolidatedCashFlows,HertzGlobal
Holdings,Inc.
In contrast, Hertz focusesoncorporateEBITDAforthesix years and six months inmarketing unsecured debt in2012asshowninTable25.3.Table25.3EBITDAforHertzGlobalHoldings,Inc.(000)
Despite these mediocreoperating results, Hertz wasable to borrow$1,950,000,000 to fund the$2,200,000,000acquisitionofDollar Thrifty Group (DTG)which closed on November16, 2012. Such borrowing ison an unsecured basis wherea one-year bridge loan mayconvert into an unsecuredeight-year bullet (i.e.,nonamortizing) loan. In our
view,theSponsorsandHertzmanagement deserve greatplaudits for their ability toconsummate such afinancing, even at interestrates, which could reach 57/8percentplus fees.Thisseemstobeanexcellentexampleofthe sponsors’ credibility andtalent for accessing capitalmarkets on a super-attractivebasis.Ifwewerethelenders,and given Hertz’s record in
thelastsixandonehalfyears,there is no question that wewould lend for the DTGtransactionatapriceneartheprincipal amount only if webelieved we were adequatelysecured.The ability to market
unsecureddebtreflectssuper-attractive access to capitalmarkets. While theacquisition of DTG maymake Hertz’s future much
brighter than would be thecasewhere the analyst reliedheavily on Hertz’s operatingrecord from 2006 to 2012,thisoughtnottobemuchofaconsideration for unsecuredcreditors acquiring debtinstruments priced at or nearthe principal amount, whichinthiscaseisequaltothecallprice. The unsecured creditinstrument has no materialpriceupsidepotential,andthe
holder has to be convincedtheloanwillbeaperformingloan. In that environment apotential creditor would notrely on outlooks based on abase case analysis or anoptimistic analysis. Ratherthe creditor should reach hisconclusions based on areasonable worst-caseanalysis. Given Hertz’s six-and-one-half year record, itseems quite risky to pay the
principal amount to becomean unsecured creditor ofHertz based on anyreasonable worst-caseanalysis.Indeed,itappearsasif there might have been aquestionaboutHertz’sabilityto remain solvent after theeconomicmeltdownoccurredin late 2008 and early 2009.Anunsecuredcreditorusingareasonable worst-caseanalysis probably would
conclude that economicconditions could at someindeterminate time in thefuture again approximate the2008–2009 economicmeltdown in either NorthAmericaorEuropeorboth.
CASHPAYMENTSTOSPONSORS
ANDSPONSOR-CONTROLLED
FUNDSThe ultraskillful use by thesponsorsofcapitalmarketsisdemonstrated in Table 25.4,which summarizes cashpayments to sponsors andsponsors-controlledinvestment funds from 2006throughDecember2012.
Table25.4CashPaymentstoSponsorsandControlledInvestmentFunds(000)
The $1,000,000,000 loanprovides strong evidence ofthesponsors’abilitytoaccess
credit markets on super-attractive terms. The lenderswere a blue chip group offinancial institutions and theterms—especially thepossible deferral of cashinterest payments—wasquiteattractive for Hertz. Suchborrowing capacity does notseem achievable by almostanyindividualoutsidepassiveminority investor (OPMI) orgroupofOPMIs.
After extracting nearly $5billion from Hertz and thepublic market, investmentfunds associated with CDR,Carlyle, and Merrill Lynchstill owned about 26 percentof the outstanding commonstock capitalization. At aprice of 16.24 at the time ofthiswriting, themarketvalueof the Hertz shares held bythe investment funds wasover$1.8billion.
We have not seen any ofthe private placementmemorandums(PPMs)of thevarious investment funds.Thereforewedonotknowtheterms of the relationshipsbetween the sponsors (i.e.,general partners [GPs]), andthe investors (i.e., limitedpartners or LPs or OPMIs).However, even assuming ahighlevelofcompensationtothe GPs—say a 2 percent
management fee plus a 20percent profit carry plus allfees paid by Hertz going totheGP,Hertz seems to havebeen a super-attractive dealfor the LPs. This super-attractiveness does not seemto trace to any achievementsby Hertz as an operation inthe last six and a half years.Ratheritseemsattributabletothe talents evidenced by theGPs in accessing capital
markets. This skill is notexclusivetoCDR,Carlyle,orMerrill Lynch. We think itexists for among others,Brookfield AssetManagement PrivatePartnerships, Vestar, andLeonardGreen.
SPONSORSCONTROLOF
HERTZThe sponsors are in firmcontrol ofHertz even thoughamajorityof theHertzboardof directors have been“independent directors” sinceAugust 2011. CDR has twoseats on the board, one ofwhom is chairman, andCarlyle and Merrill Lyncheachhaveoneseat.Directorsnow receive annual retainers
of $210,000 of which$85,000 is paid in cash and$125,000 in equity.Additional cashcompensation of $25,000 ispaid to the chairman of theaudit committee and othermembers of the auditcommittee receive $10,000.For service on thecompensation, nominationand governance committeethe chairman received
$15,000 and other members$10,000. In addition afterservingfor5years,adirectorreceives, amongother things,freeworldwiderentals for15yearsthereafter.Other benefits accruing to
the sponsors and investmentfunds include demand rightsof registration for the sale ofHertz common stock andindemnification agreements.The reputation of the
sponsors is probably aprincipal reason why Hertzcommon enjoys such a goodaftermarketontheNewYorkStock Exchange most of thetime despite the mediocreperformance of the Hertzbusiness since 2006. Thereallypoorpriceperformanceof Hertz common occurredduring the 2008–2009economic meltdown.Otherwise Hertz common
seems to be selling most ofthe time at very high P/Eratios and large premiumsover book value. Table 25.5summarizes the price historyofHertzcommon.Table25.5HertzGlobalHoldingsCommonStockPriceYearEnded12/31 High Low2006 $17.48 $14.552007 $27.20 $14.812008 $15.85 $1.552009 $12.55 $1.97
2010 $15.60 $8.362011 $17.64 $7.802012 $16.50 $10.62
SPONSORSATTUNEDTOTHENEEDSOFBANKERSANDTHEWALL
STREETUNDERWRITINGCOMMUNITY
It seems to us that thesponsors are sensitive to theneedsofbankersandtheWallStreet underwritingcommunity. In particular thegross spreads paid tounderwriters seemreasonable, and as far as we
knowthesponsorstrytopricepublic offerings so thataftermarket prices will bebuoyant, better than theunderwritingprice.This is incontrast with seeminglyunsophisticated issuers, suchas Facebook, Inc. whonegotiatedforminimumgrossspreads and tried to priceissues at peak prices whileselling as many shares as isfeasible in an IPO. A
comparison of gross spreadsisshowninTable25.6.Table25.6UnderwritingGrossSpreadsIssuerandDate GrossSpreadHertz11/06 4.25%
Hertz6/07 3.50%Hertz5/09 4.14%Facebook5/12 1.10%
The aggregate size for theFacebook offering was fargreater than any Hertz
offeringsothat theaggregatedollars of gross spread forFacebook of some $176million dwarfed thecomparable number forHertz.YetitseemslikelythatFacebook was a lot lesssensitive to the needs anddesires of the underwritingcommunity than were theHertzSponsors.
QUESTIONSABOUTLBOS
Finally, there are threequestions that arise inexamining LBOs that followthe Hertz pattern, as webelievemostofthemdo:
1. Do LBOs help thetargetcompany?2. Do LBOs help thegeneraleconomy?
3. Are LBOs attractiveinvestments for OPMIswho become limitedpartners?Given LBO sponsors’
predilection towardmaximizing net presentvalues for themselves andtheirLPsitwouldappearasifthe LBO phenomenoncontributes little, or nothing,to either growing a targetcompany or making it more
creditworthy.Infact,muchofwhat the sponsors demandcanbenegativefor thetargetcompany. This is sometimesameliorated.WhenHertzwasin deep trouble in 2009, acapitalinfusionintheformofcommon stock by theinvestment funds and thepublicmayhavebeencrucialin having Hertz avoid apainful restructuring, perhapsinChapter11.
From a financial point ofview it is hard to see howLBOs aid the economy. Forstarters it is axiomatic thathaving a target pay cash todeparting stockholders,makes a target company lesscreditworthy than wouldotherwise be the case.Perhaps,ifsponsorscanmakecompanies more efficientoperations than they wouldotherwisebe,acaseforLBOs
aiding the overall economywould exist. However, wehave not seen evidence thatLBOsponsorsareparticularlyadept at improvingoperations.TodateHertzhasbeen a mediocre operation.LBOsponsorscanhelptargetcompanies by giving themsuperior access to all capitalmarkets—bothcreditmarketsandequitymarkets.However,with the focusonnetpresent
value;thatis,gettingcashoutof the target, all too oftensponsors preempt access tocapital markets forthemselvesandtheirinvestorsrather than for the targetcompany. This seemed tohavebeenthecaseforHertz,exceptin2009.Given such super access to
capital markets, there is noquestion in our minds thatbecomingalimitedpartnerin
investment funds run byCDR, Carlyle, or MerrillLynch is an attractive optionfor OPMIs. The history ofinvestor returns while thesponsors controlled Hertz isample evidence of this.BecauseLBOsweakencreditworthiness ab initio andmaybe during the life of theLBOownership,therisksofatarget company failure seemto be much above average.
However,we think anOPMIwould probably fare quitewell could he, she or itbecome a limited partnerfinancing, say, four or fiveHertz-liketransactions.
SUMMARYDespite mediocre operatingresults subsequent to theLBO, the Hertz GlobalHoldings Transaction seems
to have been quiteremunerative for the LBOsponsors and their investors.In our view, this success isattributablemostlytothefactthat time and again thesponsors enabled holders ofHertz Global Holdingscommon stock to obtainsuper-attractive access tocapitalmarkets.Forexample,sponsors and investorsreceived two large dividends
where the funds for payingone of the dividends camefrom a loan with liberalcovenants, and for the other,from the proceeds of anunderwritten common stockoffering to the public.Sponsors have proven to bevery skillful resourceconverters who appear to beverysensitivetotheneedsofbankers and the Wall Streetunderwritingcommunity.We
briefly discuss LBOs fromthe points of views ofinvestors, the company andtheeconomy.
CHAPTER26
TheUseofCreative
FinanceinaCorporateTakeover*
TheCaseThePostscriptInvestmentLessonsTheAppraisalofManagementSpottingDoableDealsSummary
If you are involved incorporate takeovers ormergers and acquisitions,commonly your mostimportant problems do notrevolve around whether aproposed acquisition isattractiveonitsownfinancialmerits.Rather,themoreusualproblems revolve aroundwhether or not a deal isdoable: Can you actually
obtaincontrolorconsummatea merger or other corporatereorganization at a cost thatkeeps the bargain a bargain?From a control buyer’s pointof view, it always is mucheasier to ferret outcorporationswhosestocksareselling at bargain prices thanit is to get control of thesecorporations.
THECASEThe subject covered in thischapter is how Leasco DataProcessing Company—betterknown as Leasco and laternamedTheRelianceGroup—in the summer and fall of1968 financed the purchasefor cash of the large-blockholdingsofcommonstockofthe Reliance InsuranceCompany. The purchase of
the Reliance blocks was thekeytomakingthetakeoverofReliance by Leasco doable.And to make the Reliancedeal doable, Leasco waswilling,evenanxious,togiveinvestors who would put upthe $57.5 million needed anoutstandingly attractivebargain.There never was any
seriousquestionthatReliancewould be a uniquely good
acquisition for Leasco,providedLeascocouldobtaincontrolofReliancebyissuingLeasco equity securities inthe form of Leascosubordinated debentures,preferred stocks, commonstock or warrants, orcombinationsthereof.In the late 1960s, old-line,
conservatively managed fireand casualty insurancecompanies were genuinely
attractive acquisitions forconglomerateurs. Not onlydid Leasco acquire Reliance(after being moderatelyhinderedbycompetitionfromData Processing FinancialandGeneralCorporation),butalso, inter alia, HomeInsurance was acquired byCity Investing, GreatAmerican Insurance byNational GeneralCorporation, and Hartford
Fire by InternationalTelephone. Insurancecompany stocks tended to bedepressed because thecompanies were sufferingunderwritinglossesfromtheirpure insurance operations,and the stock marketemphasized earnings fromoperations rather than otherelements thatmade insurancecompanies valuable, namely,thesteadily increasingprofits
from dividends and intereston their investmentportfolios,andthehugepoolsof liquidity built up throughtheir holdings of marketablebonds and stocks. Mostimportant, itseemedlikelytothe acquirers that a goodportion of this liquidity(called redundant capital orsurplus-surplus) could beremoved from the insurancecompanies and used by their
newparents.Over and above the
possible use of surplus-surplus, insurers such asReliance and Hartford Firewereattractivetoacquisition-minded companies, such asLeasco and ITT, for twoadditionalreasons.First,therewas the opportunity tomanage earnings to bereported to stockholders inthe future, but only if the
acquisition could beaccounted for in reports tostockholders through the useof pooling of interestsaccounting rulesas they thenexisted(priortoNovember1,1970) rather than throughpurchase accounting. Theinsurance companies hadinvested a portion of theirassets in common stockportfolios that by the late1960shadenjoyedsubstantial
market appreciation. If theinsurancecompaniescouldbeacquiredunderapooling, theacquiring companies wouldcarry the insurancecompanies’portfoliosintheirown books at the insurancecompanies’ original costs. Ina purchase accountingsituation, on the other hand,the acquirers would have towrite the insurers’ portfoliosup to the portfolios’ market
valuesand,inaddition,wouldprobablyhavetoreflectasanintangibleasset theexcessofthe acquirer’s purchase priceover the market value of theinsurers’ assets. (Theacquirers’ purchase pricewould be measured by themarketvalueofthesecuritiesissued by the acquirer toconsummatethetakeover.)Of course, if pooling
occurred, the acquirer could
virtuallyassureitselfofbeingable tocreate futureearningsin reporting to stockholders,because in order to createsuch instant earnings, all thatLeascoorITTwouldhavetodowouldbetoselloff(ortoinduce their insurancesubsidiaries to sell off)commonstocksforwhichthecost basis was well belowmarket. The differencebetween proceeds of
securities sales and the costbasis for thesecuritieswouldequal earnings that could bereportedtostockholders.At the time it was
endeavoring to acquireReliance, Leasco knewthrough Reliance’sconsolidated balance sheetthatasofDecember31,1967,the insurer’s common stockportfoliohadacarryingvalueof $110.8 million, compared
with a market value of $215million. By the summer of1968,themarketvalueofthatportfolio had appreciated. Ifpoolingwereused,Leasco,inits consolidated statement tobe issued after the Reliancetakeover, would carry theReliance portfolio at $110.8million. Even assuming thatall warrants were exercised(which would bring a lot ofnew cash into Leasco) and
that all convertible securitieswere converted, Leascowould still have fewer than10 million common sharesoutstanding.So, at theworst,there was a maximumpotential for the creation byLeascoofover$10pershareof instant pretax earnings,provided it could poolReliance. The ability to poolReliancewouldgiveLeascoareservoir of future earnings
that it might be able to callupon and that, after 25percent capital gains taxes,wouldstillbeinexcessof$7pershare.Thiswasviewedasquite a potential windfall byLeasco,whichuptothattimehad never in any one yearearnedasmuchas$1asharesince it started business in1961 (although Leasco stockwas, in July 1968, sellingbetween65and70).
Leasco,though,itshouldbenoted, would not havecomplete influence over thecreation of instant earnings,since by contract the assetsthat remained in Reliancewere to be under the controlof the old Reliancemanagement; however,insofar as Leasco would beable to extract assets fromReliance, it would have fullcontrol over the creation of
instant earnings by sellinglow-cost stock out of itsportfolio.An additional area of
attraction in acquiringcompanies such as Relianceand Hartford Fire was thattheygavetheacquirersentréeinto the financial servicesindustry.Inparticular,LeascothoughtthattheacquisitionofReliance, with its hugeresources and widespread
sales force coupled withLeasco management, couldprovide the foundation forbuilding a financial empirethat might encompass notonly leasing and insurance,butalsoareassuchasmutualfunds and commercialbanking.As amatter of fact,within three months of itsacquisition of Reliance,Leasco turned its attention toacquiringcontrolofChemical
New York, the parentcompany of Chemical Bankand Trust Company, thenation’s fifth-largestcommercial bankinginstitution. The stab atChemical by Leascowas notonly abortive, but also illadvised.Itapparentlyresultedin the withdrawal of WallStreet sponsorship fromLeasco,1andat theminimumcontributed to Leasco’s
inability to consummate apublic underwriting in 1969or 1970, which has much todo with the outcome of thestorythatisthesubjectofthiscase.Early in 1968, Leasco
became convinced thatReliancewouldbeadesirableacquisition. Leasco was asmall computer leasingcompany founded in 1961and run by Saul Steinberg,
who at that time had not yetreached age 30. For the yearending September 30, 1967,Leasco’s total income wasreportedat$14.4million,anditsnetincomewasreportedat$1.8millionbefore taxesand$1.4 million after taxes.Stated net worth was about$16 million. The Leascoequity in mid-1968, though,was valued in the stockmarket at around $120
million. Reliance, on theotherhand,hadnetpremiumsearned of around $300million in 1967; its netincome was almost $20million, and its stated networth was $230 million.Before Leasco becameinterested,thevaluethestockmarket placed on Reliance’sequity rarely exceeded $190million. By any reasonablenon-stock-market statistical
measure, Reliance was 10times the company Leascowas. But by the one mostimportant stock marketmeasure—stock price—Reliancewasonlyaboutone-and-one-half times thecompanyLeascowas; and inaddition, Leasco was on themove up, whereas Relianceseemedtobegoingnowhere.Leascobecameinterestedin
Reliance after it had been
solicited by the then NewYork Stock Exchangemember firm of Carter,Berlind and Weill through areport written by a securityanalyst, Edward Netter, whospecialized in insurancestocks. For their services,Carter, Berlind and Weillreceived a fee of $750,000after the takeover wasconcluded successfully.Initially, through early April
1968Leascopurchasedintheopen market 132,000 of the5.5 million Reliance sharesoutstanding, at about$33pershare.In the spring of 1968, the
Leascomanagement,togetherwith partners of Leasco’sinvestment banker, White,Weld, approached theReliance management aboutLeasco’s acquiring Reliance.Leasco was rebuffed, and
Reliance management wasprobablypreparedtocontinueto oppose Leasco no matterwhat proposals for aLeasco-Reliance combinationLeascomight make. Relianceoppositionwouldmakeadealmanifestly less doable byLeasco, and less valuableeven if it were doable. IfLeascocouldobtainReliancemanagement cooperation (orfailing that, an absence of
Reliance managementopposition), it wouldmake atransactionmore feasible andmorevaluable forLeasco forthefollowingreasons:
1. Cooperation, or theabsence of opposition,would likelyshort-circuitany others who mightwant tobid forReliance,such as Data ProcessingFinancialandGeneral.2. Stockholder
solicitation would bemade immensely easier,becauseLeascootherwiseprobablycouldnotobtainastockholderlistorhaveReliance mail anexchange offer on itsbehalf.Withoutaccesstoastockholderlist,Leascowould be able to solicitReliance shareholdersonly through newspaperadvertisements or
through a proxy contest,which of itself wouldresult in all sorts of newtiming, legal, andadministrativeproblems.3.Relianceobstructioninthe courts and withregulatory agencies—theSecurities and ExchangeCommission and thePennsylvania InsuranceCommission—would beeliminated if
managementwereatleastneutral.4. With friendlymanagement, a smallerconsideration could beoffered to Reliancestockholders. WhenLeasco thought Reliancewouldoppose,itpreparedto offer Relianceshareholdersapackageofsecurities consisting ofsubordinated debentures
and warrants, which fortax purposes would beconstrued to be aninstallment sale, makingit almost the equivalentof a tax-free transactiontoReliance shareholders.After Reliancemanagement oppositionwaseliminated,preferredstockwas substituted forthe debentures. This notonly resulted in the
exchange offer’sbecomingfullytaxabletothe Relianceshareholders, but it alsocreated the environmentunder which Leascomight be able to accountfor the Relianceacquisition as a poolingofinterests.5. The removal ofuncertainty caused bymanagement opposition
made itmanifestly easierto assure Leasco thatenough Reliance shareswould be tendered forcontrol (50 percent)and/or for accountingpurposes (95percent), sothat Leasco couldaccount for thetransaction as a poolingof interests. Withmanagement opposition,it would be difficult to
get Wall Street’sarbitrage communityinterested in thetransaction; onceinterested, they wouldpurchase Reliance sharestotender,makingaprofitnotonlyonthespreadinprice between Reliancesecurities purchased andLeasco securities soldshort, but also on thesoliciting dealer fee of
$.90 per share, whichwould be paid them foreach Reliance sharetendered to Leasco. Ifarbitrageursthoughttherewere reasonableprospects that theexchangeofferwouldnotsucceed, they wouldforgo purchasingReliance. Contrariwise,confidence in its successwould produce the
purchasers of Relianceshares to be tendered,resulting in just the typeof bandwagon effect thatwould be helpful ingetting stock tendered toLeasco.Leascocouldsee,however,
that the active Reliancemanagement might bevulnerable. Its shareholdingsinitsowncompanyamountedto only about 43,000 shares.
There were in existenceblocks ofReliance stock, theequivalent of almost 800,000shares (or 14 percent) of theoutstanding stock, whichwereheldby14stockholdersofrecord,whohadexchangedshares in small insurancecompanies they owned forReliance stock,principally in1963 and 1965. Thebeneficial owners of theseshareswereCorroon&Black
Corp., and in Chicago, thefamily of Alfred MacArthur,who was deceased. TheCorroon interests and theMacArthur interestseachhadone representative out of the17 seats on the Relianceboard.Theywere not part ofthe day-to-day management.Control of these shares byLeascomightbetheleverthatwouldavertactiveoppositionbytheReliancemanagement.
Leasco, though, could notbe sure that even if itobtained control of this 14percent block, it would beable to induce the Reliancemanagement not to oppose atender. First, virtually alltheseshareswereintheformofRelianceClassAcommon,and the A stock had verylimited rights of conversioninto Reliance common;indeed, someof theAshares
issued would not becomeconvertible until 1979. Eachshare of Class A commonwasequivalentinallrespectsto ten shares of common,except that the A had onlyonevotepershareratherthanten. Thus, although the Ashares represented a 14percent economic interest inthe Reliance equity, theyrepresentedonlya1.4percentvoting interest; it might take
years before that 1.4 percentvoting interest could bechanged into a percentagethat would be of control usefor Leasco. Furthermore,evenifLeascoweretoobtaina majority of Reliance’svoting power, it could stilltake years to obtain amajority of the Relianceboard of directors. Reliancehadasystemofclasselectionunder which directors were
electedforstaggeredtermsoffour years; in addition, therewascumulativevoting.Thus,assuming 4 of 16 directorsstood for election each year,if Leasco had a majority ofReliance’s stock, it might beable to elect only threedirectorsayear:itwouldtakeLeascothreeyearsafterithadamajorityofReliance’sstockto elect a majority of theboardofdirectors.
Against this background,Leasco’s strategy was toattempt to tie down this 14percentblock, so thatLeascocouldcalluponitintheeventitobtainedamajorityinterestin Reliance. If Leasco werearmed with the potentialownership of a 14 percentequity interest inReliance, itfelt it might be able tobargain with the Reliancemanagement,sothatitwould
no longer oppose a tender,and indeed, with luck mightevenfavorit.The A holders made it
knowninJuly1968that theymightbewillingtocommittosell their shares to Leasco,buttheywantedtwothings—cash,notLeascopaper,andapremium above the thenmarketforReliancecommon.Leasco accommodated them,entering into an agreement
with the Corroon & Blackand the MacArthur interestson July 23, 1968, at whichtime Reliance common wasselling at 69. The essentialelements of the July 23agreementwereasfollows:
1.IfLeascoacceptedanyReliancesharesunderthetender offer it proposedto make, Leasco wouldbe required to buy allthese Corroon and
MacArthur shareholdingsfor$72pershareincash.If Leasco did not acceptany Reliance sharesunder the tender offer, itwould not be required topurchase any of theseshares.2. Payment of the $72wastobemadeeitherbyLeasco directly or byarranging that theseselling shareholders
tender their Relianceshares for Leascosecurities, which wouldthenbe immediatelysoldto certain designatedbuyerstoyieldthesellers$72pershare incashfortheir Reliance holdings.This latter provisionbecame operative, andthe $72 purchasers inSeptember were a groupofinstitutionalinvestors.
By virtue of the July 23agreement, Leasco had tieddown this 14 percent interestwithout any cash outlay. Itwould only be committed topurchase them if Leascoobtained a majority of theReliance shares, because ofthe terms of the tender offerthat Leasco need not acquireanyReliancesharesunless50percent of the outstandingstock was tendered.
Furthermore, under the Julyagreement Leasco in effectobtained an option either touse its own cash andborrowingsaggregating$57.5million for the purchase ofthesesharesortosubstituteathird party or parties thatwould purchase Leascosecurities from the Corroonand MacArthur interests forthesame$57.5million.Under the terms of the
exchange tender offer, theLeascosecuritiestobeissuedfor amaximum of 5,582,540Reliancesharesweretobeasfollows: For each Reliancecommonshare,LeascowastoexchangeoneshareofLeascoSeriesBconvertiblepreferredstock,convertibleintoLeascocommonat$90per share (orinto .6111 Leasco common),and one half of a Leascowarrant, twoofwhichwould
entitletheholder,foraperiodof10years, tobuyoneshareofLeascocommonat$87pershare.WiththeJuly23agreement
a fait accompli, Leasco nowreentered negotiations withthe Reliance management.These negotiations, unlikeearlier efforts, weresuccessful: Reliancemanagement agreed to beneutralinconnectionwiththe
forthcomingtenderoffer,andto(or inanyevent,did)mailtheLeasco tenderoffer toallReliance shareholders. Thesubstance of the Leasco-Reliance pact was embodiedin an August 1, 1968,agreement, the principalterms of which were asfollows:
1. Reliance managementwould not opposeLeasco’s removing the
surplus-surplus fromReliance, an amount thatLeasco estimated wasabout$125million.2. For fiveyears,Leascowas to elect only onethird plus one of theReliance board ofdirectors.3. Reliance was to takeno action outside theordinary course ofbusiness without the
affirmative vote of atleast two thirds of itsdirectors.4. A. Addison (Bill)Roberts was to continueaschiefexecutiveofficerand a director ofReliance.Parallel to this,Mr.Robertsalsoobtaineda long-term employmentcontract at a substantialpay increase. The long-term contract for Bill
Roberts probablyprotected Leasco at leastasmuchasitdidRoberts,becausehewasviewedasan exceptionally ableoperating insuranceexecutive.With management
opposition removed, Leascowas ready tomake its tenderoffertoexchangethepackageof Leasco preferred andwarrants for Reliance
common.TheofferwasmadeonMonday,August19,1968.The previous Friday, Leascocommon had closed at87.625; thus, if the preferredstocktobeissuedonashare-for-share basis for Reliancecommon was valued at itsconversion parity (.6111common), it would have amarket value of $53.55 pershare. In addition, warrantsexactly the same as Leasco
wasproposing to issue in theexchange were alreadytrading over-the-counter atabout $43 per warrant. Themarket value of the Leascopackage, consisting of onepreferred and one-halfwarrant,wastherefore$75.05(or $53.55 plus half of 43).RelianceclosedonAugust16at66.5;RelianceshareholderswereinducedtotenderfortheLeasco package because of
the almost nine-point spreadbetween the market price ofthe Leasco package and themarket price of Reliancecommon.TheLeasco exchange offer
wasarip-roaringsuccess,andby the second week ofSeptember itbecameobviousthat Leasco not only wouldobtain control of Reliance,butalsowouldobtainover95percentoftheReliancestock,
in which event Leasco’sindependentauditors,ToucheRoss and Co., would permittheRelianceacquisitiontobeaccounted for as a fullpoolingof interests,providedother necessary conditionsweremet.NowLeascowasfacedwith
theproblemofpayingforthesharestobepurchasedat$72cash from the Corroon andBlack and the MacArthur
interests in accordance withthe terms of the July 23agreement.Leascobelieveditcouldpayforthesharesfromits own treasury, because itnowhad$46million,mostofwhichhadbeenraisedalmostconcurrently through the saleof Eurobonds by a newLeasco subsidiary, LeascoWorld Trade. However,Leasco clearly preferred tohave the $57.5 million paid
by third parties for tworeasons. First, Leascobelieved that if it reinvesteditsownfundsintoproductiveactivities rather than in therepurchase of its ownsecurities, it would growmuch faster. Second, insofaras Leasco itself repurchasedthis 14 percent interest, itwouldbeunabletofullypoolReliance’s accounting data,but would instead be stuck
withanowextinctaccountinghybrid—part pooling, partpurchase. Full poolingmeantmore benefits for futureearnings than part pooling,partpurchase.Leasco turned to White,
Weld to structure a packagethat third parties would buy.By the second week ofSeptember, the Leascopackage had a stock marketvalueof around80 to 83per
unit. However, for theamount of units involved(799,050),itwastoomuchtoexpectthethirdpartiestopaythe Corroon and MacArthurgroups $72 per unit in cashvirtually simultaneously withthese groups’ havingexchanged their Relianceshares for the Leascopackage.Nothirdpartybuyerwould be able to sell thatamount of Leasco equity in
theopenmarketat80to83inthe absence of a registrationstatement with the Securitiesand Exchange Commission.Offering about 800,000 ofLeasco units at this time bywhat the market mightinterpret as being quasi-insiders might also depressthe market from its 80–83level.Against this background,
White, Weld and Lehman
Brothers, which were nowacting jointly as Leasco’smain investment bankers,structured a deal that wouldbe inordinately attractive totheir institutional clients. Ineffect, Leasco would use itscredit to guarantee that, atworst,apurchaseroftheunitsfor $72 could at the end ofone year obtain his moneyback plus a return of 15.6percent,mostofwhichwould
be taxable as a capital gain.At best, the purchaserwouldobtain for his units $72, plus$.75 for eachmonth the unitwasheld,plusaparticipationin the profits to be realizedover $72, and plus $.75 permonth in the event the unitswere sold pursuant to aplanned public underwritingof these preferred shares andwarrants. The investors weretoobtainonehalfof thegain
from the underwriting, asmeasured by the differencebetween90and72,plus$.75per month. Leasco was topocket theother half. Insofaras the units were publiclysoldatapriceinexcessof90,the investors were to haveone quarter of that gain andLeascothreequarters.Withabuoyant market for Leasco,theseinvestorsmightevenbeable to obtain a return of 55
percent ormore on a no-riskorlow-risk-investment.2
This dealwas embodied ina three-party contract, theexchange and purchaseagreement (E&P),whichwasdated September 17, 1968,and which was closed onSeptember 19, the day theLeasco package attained amarket value of 88.625. Thepertinent terms of the E&Pwereasfollows:
1. There were threeparties to the E&P,namely, the sellingstockholders, thepurchasing investors,andLeasco.2. Sellers were to tendertheir Reliance shares inexchange for the Leascopackage, and thepurchasers were toacquire the Leascopackage from the sellers
at$72cashperunit.3. For the next year, thepurchasers were to beguaranteed by Leascoproceedsof not less than$72 per share, plus $.75foreachmonthorportionthereof that the Leascopackagewas held by thepurchasers.This$72plus$.75 was known as “theguaranteedprice.”4.Thepurchaserswereto
be given one half of thedifference between $90and the guaranteed priceintheeventthattheunitswere sold, and alsowereto obtain one quarter ofthe guaranteed price inexcessof$90.5.Leascowas toarrangeat its own expense (if itcould) that these unitswould be registeredwiththe Securities and
Exchange Commission,sothattheycouldbesoldpublicly, preferablythrough an underwrittenpublicoffering.It is interesting to seewho
theinstitutionalinvestorswhopurchased this package were(see Table 26.1), since theyappearedtobeamoreorlesstypicalcross-sectionoftrusts,pension plans, mutual funds,andinsurancecompanies.
Table26.1CompositionofInstitutionalInvestorsandTheirSubscriptionPercentagesInstitution %of
799,050UnitsSubscribed
IntheirCapacityas
ContinentalIllinoisNational
28% Invariousfiduciarycapacities
ChaseManhattanBank
26% Variousemployeebenefittrusts
Commonwealth 9% Fund
CapitalFund,Inc.TechnologyFund,Inc.
5% Fund
U.S.TrustCo.,astrusteeand/or
5% Agent
YaleUniversity 5%ConnecticutGeneralLife
3% Insurancecompany
BankhausBurkhardt
2%
StateFarmMutualAutomobile
2% Insurancecompany
Banquede 2%
FinancementBanqueLambertS.C.S.
2%
N.M.Rothschild&Sons
2%
EmployersMutualLiability
2% Insurancecompany
ExchequerAssociates
2%
OldKentBank,trustee
2%
L.D.P.Associates
2%
StateFarmLife <1%
InsuranceCo.StateFarmFire&Casualty
<1%
GeneralAmericanLife
<1%
FirstNationalBankofChicago,
<1% Agent
TOTAL 100%
First and foremost, thetransaction provided theinvestorsaveryhighreturnof15.6 percent, at a timewhenLeasco was borrowing from
banks at 6.5 percent to 7.5percent. The investment,therefore, had considerablesafety because of the Leascoguaranty. The return of 15.6percentwouldbeobtainedasfollows if the investors heldthe Leasco package for thefullyear:Dividendof$2.20onconvertiblepreferred
$2.20
$0.75permonthfor12months
$9.00
Cashreturn $11.20
Rateofreturnon$72purchaseprice
15.60%
Most of the return hadbetter tax-sheltercharacteristics than it wouldhave had if it had beentaxable to the investors asinterest income. The $9 inparticular was taxable atcapital gains rates. This tax-sheltered return to theinvestor would not per seresult in diminished tax
payments to InternalRevenue,becauseLeascowasnotabletodeductfromitstaxreturn preferred dividends orany payments of theguaranteed price, as itwouldinterestpayments.However,15.6percentwas
only the minimum return tothe investors.Remember thatat the time that the E&Pclosed, the Leasco packagehad a market value of 885/8.
Suppose that in about sixmonths there could be apublicofferingoftheunitsat85 net; the investor wouldthen receive a return at anannual rate of 27.4 percent,all with having undertakenonly very minimal risk. The27.4 percent returnwould becomputedasfollows:6months’dividendof$2.20onconvertiblepreferred
$1.10
$0.75permonthfor6months $4.50
½ofthedifferencebetween85andtheguaranteedpriceof$72plus$4.50
$4.25
Totalcashreturn $9.856months’rateofreturnbasedon$72purchaseprice
13.70%
6months’annualizedrateofreturn
27.40%
Even the 27.4 percentreturn must have seemedmodest during this period,because Leasco was adynamic market performer;
one could just as soon havepostulated a public offeringfortheLeascopackageat95,105,or115,ratherthanat85.From Leasco’s point of
view, if the public offeringhad been consummated in,say, six months at then-prevailing market prices,Leasco would not only havepurchased the key blocknecessary for it to obtaincontrol of Reliance with
virtually no cash outlay, itwouldalsohavemademoneyon the deal. Depending onwhether thepriceof apublicofferingsixmonths laterwas85, 95, or 105 net, cashinflows to Leasco per unitfrom the operation of theE&P would have been asfollows:
If there had been a publicoffering as contemplated,both Leasco and theinstitutional investors wouldhave profited enormously. Itwasnot thatbothweregoingtogetfreelunches,butratherthat the stock market public
thatwaswilling to pay extrapremium prices for Leascoequitieswassupposedtotreatboth the institutionalinvestors and Leasco tolunch.Although the institutional
investors had a highlyattractive deal whether theshares they held were to besoldtothepublicatpremiumprices or whether theinstitutionalinvestorswereto
receive only the guaranteedprice, the transaction, likealltransactions, had some risksand uncertainties. Many ofthese investors probablyrealized that Leasco was notthe best credit risk in theworld; all realized that underthe securities laws, theywould become statutoryunderwriters if there was tobe a public offering of theirunits, in which case there
would be some exposure topotentiallegalliabilities.Asamatter of fact, a stockholderderivativeactionwasbroughtby a Leasco shareholderagainst the institutionalinvestors, claiming thatLeasco was harmed becausetheE&PconstitutedaloantoLeascoatexorbitantratesandwas in violation of marginregulations.3Nonetheless, theinstitutional investors did
makeahighlyattractivedeal,probably as close to a freelunch as anyone in thefinancial community evergets.Leasco would have done
brilliantly had a publicofferingabovetheguaranteedprice ever taken place. Notonly would the July 23agreement coupled with theE&Phave enabledLeasco tocreate an environment under
which it could get control ofReliancerelativelyeasily,butit would also have enabledLeasco toshare in theprofitscreatedby thesaleofLeascostockthathadbeenissuedforRelianceshares.
THEPOSTSCRIPT
Unlike the institutional
investors, Leasco hadmeaningful exposure; if apublic underwriting was notaccomplished by September1969,Leascowouldhavehadto pay the guaranteed pricewith its own funds. Butsubsequent events showedthat this was not the worstfate that couldbefallLeasco;a fair argument could bemade that had not Leascoacquired Reliance, Leasco
after September 1969 mighthavebeeninsolvent,orinanyevent, in quite serioustrouble. All Leasco’soperations other thanReliance proved to beoperating disappointmentsand cash drains. In early1974, Leasco was renamedTheRelianceGroup.Leasco was unable to
accomplish a public offeringof the units in 1969.We are
not certainof the reasons forthis,but itseemsafairguessthatLeasco’sabortiveattemptto acquire control ofChemicalBankinearly1969was a contributing factor. Itshould be noted, too, thatduringearly1969 themarketprices of virtually allcomputer-leasing stocksweakened. The Wall Streetcommunity rapidly withdrewsupport from Leasco, and its
investment bankers producedvarious stated reasons for nolonger underwriting Leascosecurities.By July 1969, Leasco was
attempting to extend theterms of the E&P untilOctober 1970. Many of theoriginal institutionalinvestors, holding about 25percent of the units, refusedto go along. Leasco foundotherinstitutionalinvestorsto
taketheirplacebypayingtheoriginal investors theguaranteedpriceof$81($72,plus $.75 for each of twelvemonths). In order to inducetheotheroriginalinstitutionalinvestors and the newinstitutional investors to, ineffect, extend the E&P,Leasco offered the originalE&P termsplus a bonus thatwastodependonstockpricesand was to be anywhere
between $1 per unit and $3perunit;itendedupbeing$1perunit.However,thesecondE&P probably was not asattractive as the first year’sE&P;unlikeSeptember1968,September 1969 was not atime in which most peoplewere caught up in euphoricoptimism about howwonderful a stock marketperformer Leasco was likelyto be in the next year. On
October 1, 1970, Leasco hadto make good on itsguarantee, at which time itrepurchasedall799,050unitsattheguaranteedpriceforanaggregatecashoutlayofover$72million.By1970,thisputquite a crimp in Leasco’sfinances.
INVESTMENT
LESSONSIn our view, the transactionsdescribed here are examplesof the types of creativefinance that can be used toaccomplish corporateobjectives, andofhowastuteinvestors can be primebeneficiariesoftheproductofsomeone else’s creativefinance. The essentialingredient that created the
environment that permittedthe institutional investors tocome close to getting a freelunch was the stock marketappraisal of Leasco. As longasthepublicmightbewillingto pay ultrahigh prices forLeasco equities, Leasco wasmore thanwilling togive theinstitutional investors thebenefit of a bargain, just solong as it helped Leascoobtainitsobjectives.Leasco’s
objectives were to obtaincontrol of Reliance by paperonly,notcash;toaccountforthe Reliance acquisition as apooling;andtonotcommittopurchase a large block ofReliance stock unless thatblock was part of a controlblock. The institutionalinvestors aided Leasco inthosegoals.It is probable that the type
of opportunity that was
offered here to theinstitutional investors wouldneverbeavailable tooutside,passive investorswho lackedknow-who. Yet, we feel thecase is instructive for all ourreadersbecause:
1. It serves as a goodexample of the types ofthings many intelligentpeople are involvedwithinthefinanceindustry.2. It gives the reader an
insight into a financialinstrumentwithwhichhemay not be familiar,namely,theguaranty.The Leasco-type guaranty
is something commonly usedinprivatetransactions,inpartbecause it results in capitalgains treatment for thebuyers’ profit and an off-balance sheet liability for theissueroftheguaranty.Infact,the types of arrangement
found in the E&P is knownby many as a put-callagreement.Putmeansthattheholder of a security canrequire someone else, undercertain conditions, torepurchasethatsecurity:Thatis, the institutional investorscould force Leasco orLeasco’s nominee to paythem the guaranteed price attheendofayear.Callmeansthat the holder can be
required by someone else tosell the security he holds:That is, Leasco could, as apractical matter, haverequired the institutionalinvestors to sell theirholdings, as long as theinstitutional investors got atleast the guaranteed priceplus a market appreciationparticipation,ifany.4
Whether or not a deal ispotentially doable is an
important marketconsideration. Reliance stockwas undoubtedly a verysound, fundamental value inlate 1967 and early 1968when it was selling in themid-30s. If the company hadbeeninvulnerabletotakeoverand wholly uninterested inmerger, it is fair to say theremight have been moderateappreciation as earningsimproved and as the market
gave increased recognition tothe business’s exceptionallygood quality. But it is veryhardtopostulatethatwithoutLeasco, or someone likeLeasco, in the picture themarket values attributable toReliance common wouldhave been in the 80s in thefall of 1968 and over 100 inlate 1968 and early 1969.Leasco would not have beenin the picture if it was
obviousthatReliancewasnotadoabledeal.The Leasco-Reliance
transactions raise three veryinteresting questions, goodanswers to which arecertainly a (if not the) royalroadtoinvestmentriches.
1. How do you appraisemanagements such asLeasco’s?2. How do you spotdoable deals such as
Reliance’s beforesomeoneelsedoes?3.Howdoyouget to bean institutional investorwho is shown highlyattractive privatefinancings such as theE&P?
THEAPPRAISALOF
MANAGEMENTThe Leasco managementshowed a high, even rare,degree of ability in firstrecognizing the values ofReliance to Leasco, and inthen engineering thetakeover.Manyconglomeratemanagementsin1968,ontheother hand, demonstrated noabilities other than a knackfor promoting the prices of
the stocks of the companiesthey controlled. These otherswere just good at go-go.NotsowithLeasco.TheReliancetakeover represents strongevidence that Saul Steinbergand his associates wereintelligent, resourcefulbusinessmenwho understoodnot only how to avoid therisksofcommittingcash toadealthatmightnotbedoable,but also what their company
needed in the way of anacquisitionandhowtogetit.Yet, within a few months
Leasco came a cropper, andthe company was unable toclose out the Reliancetransaction by sellingsecurities to thepublic ratherthan by using Leasco’scorporate cash. It is possiblethat Leasco’s inability toclosetheReliancetransactionvia a public offering of the
securitiesheldbyinstitutionalinvestors was absolutelybeyond its control. Marketprices did sag in 1969. It ispossible, too, that theLeascomanagement itself was amajor contributor to thecompany’s inability toobtainapublicoffering:theabortivestab at acquiring ChemicalBank in February 1969 usedupmuchof thegoodwill andhigh regard Leasco had built
up in the financialcommunity. WhereasengineeringtheacquisitionofReliance was evidence ofmanagement brilliance,coveting Chemical wasevidence of managementinsensitivity and stupidity,and yet both were the samemanagement.Which type of dealmaker
wastheLeascomanagement?Brilliant, or insensitive and
stupid? In our view, it wasboth.Itaccomplishedamajorfinancial tour de force in1968, but came a cropper in1969. Brilliant managementin one context is notnecessarily brilliantmanagementinanother;thosewho are good dealmakers atone time may be bad inanother period. A talent forobtaining operationalefficiency, for example, may
obscure a predilection formisunderstandingsophisticated finance. In1968, there were good stockmarket reasons for equatinggood management withaggressive management; in1975, 2007, and 2008 therewere good stock marketreasons for equating goodmanagement withnonaggressive management(those whose policies kept
their companies liquid). It isnot necessarily contradictorythat the same Leasco peoplewho were such brilliant dealmakers in 1968 weresomewhat less than brilliantafter 1969; it is possible thatthe same boldness thatcontributed to theircompany’s positiveaccomplishmentsin1968alsocontributed to Leasco’sfailuresafter1968.
Because it is sodifficult toappraisemanagements,wedonot believe that outsideinvestors should, as a rule,paypremiumprices to investin the stocks of companieswith superior managements.There usually are availablemany common stocks ofgood-grade companieswheremanagement is superior andwhere the price of the stockdoes not reflect that
superiority.On the other side of the
coin, we think all investorsshouldavoidthesecuritiesofcompanies deemed to havebad managements, regardlessof the price of the equitysecurity. This is an essentialelement of the fundamentalfinance approach. Badmanagements are, in ourview,easiertospotthangoodmanagements. Bad managers
are marked by self-dealingand/or ineptness in virtuallyall areas except one—protecting their ownpositions. Bad management,it should be noted, does notspecifically refer tomanagements that do notcontributetotheircompanies’having favorable stockmarket prices. Reliance hadgoodmanagement before theLeasco takeover, because
theywereskilledinoperatinga large insurance business asagoingconcern.As amatterof fact, one of the factors tolook for in spotting doabledeals is companies that arewellmanaged, at least in thecustodial, going concernsense. It is an untrue andmisleading myth thatcompanies seekingacquisitions—for example,Leasco—look for companies
with bad managements. Theopposite is true. Leascowould not have beeninterested in Reliance if theydidnotbelieveitwasawell-run going concern. To havebeen interested otherwisewhen Leasco had nooperating experience in theinsurance industry wouldhavebeenreallystupid.
SPOTTINGDOABLEDEALS
There is a school of thoughtthat contends that the mostdoable deals are thosewhereshares are widely held andactively traded, and wheredirectors and managementown very little stock. Thiscertainlywasnotthecasefor
Leasco-Reliance,where therewere blocks that accountedfor14percentofthecommonstock issue; if those blockscould be tied up, Reliancewould become (as it did)quite doable, and if it couldnot, the prospects forobtainingcontrolwouldhavebeen quite discouraging.Thus, there are no hard andfast rules by which anoutsider without any inside
contacts can tell whether aspecific situation can orcannot be a doable deal.Rather, frequently in acorporation there is a personor a few people who candeliver control, either byactive cooperation or by afailure to oppose a takeover.Among potential acquirers,therearethosewhowouldtryto accomplish an acquisitionin a contested takeover and
those who would nevercontestforcontrol,regardlessof how attractive the targetcompany isorhowmuch theacquirer needs to get controlof the target. You usuallycannot know who would dowhat without informationfrom the people whowill beactive doers. In other words,youneedknow-who.This inability of outsiders
lacking know-who to spot
doable deals brings outanother point for theseinvestors. Itprobablypays todiversify5 such a portfolio ofsecurities. Reliance was anexcellent value in 1968, butwithout takeover activity itmight have been a mediocreperformer. We do not knowof any a priori way foroutsiders to spot suchtakeover interest where thereisa lackofknow-who,but it
is our feeling that aportfolioof five Reliances bought atany time would probablyworkoutwell,notbecauseallofthemwouldbetakenover,butbecauseoneortwomight.Althoughitmaybewiseto
diversify where an investorlacks know-who, there is nological course but toconcentrateinareaswheretheinvestor has know-who. Wedonotmeanthisinthehottip
sense. Rather, as ahypothetical example, it islogical that Reliance, sellingat around 40, would havebeen a good stock toconcentrateinforaninvestorwhowastoldbyamemberofthe Corroon family that,while no transaction waspending andwhile hewasn’tsure,hewouldbe inclined tosell if someone would offerover $50 per common share
for all their Relianceholdings.
SUMMARYThe 1969 Acquisition ofReliance InsuranceCompanyby Leasco Data ProcessingCompany is a good exampleof a small business, almost astart-up, obtaining control ofamajorpropertyandcasualtyinsurance company without
having to invest anymaterialamountofcashunlesscontrolwasactuallyobtained. In thiscaseweexaminethemethodsby which Leasco DataProcessing Companyfinanced the purchase forcash of the blocks of sharesof Reliance InsuranceCompany, which Leascobelieved it needed to acquireif it was to obtain control ofReliance. The case is of
interestinpartbecauseoftheextremely attractiveconsideration that was givento providers of cash so thatthey obtained (a) a safe,above-average return on atax-privilegedbasisaswellas(b) an opportunity toparticipateinpotentialmarketappreciation. This was theepitomeofaninvestmentthatcould be deemed to beattractive using the safe and
cheap approach. Yet, thetransaction was also highlyattractive for others,especially Leasco, because itenabledLeasco to tie up keyblocks of common stockwithoutriskingcash,unlessitwas to obtain control ofReliance, and also to usepooling of interestsaccounting treatment in thefuture, with consequentbeneficialeffectsonLeasco’s
reported earnings to itsstockholders.(Theabilityofacompany to use pooling ofinterests accounting inconnection with anacquisition transaction nolongerexists)._______________*ThischapterisanupdatedreproductionofAppendixIIinTheAggressiveConservativeInvestorbyMartinJ.Whitmanand
MartinShubik(©2006byMartinJ.WhitmanandMartinShubik).ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1AnexcellentaccountoftheLeascoattempttotakeoverChemicalappearsinJohnBrooks’sTheGo-GoYears:TheDramaandCrashingFinaleofWallStreet’sBullish60s(Wiley
InvestmentClassics,1973,1999).2Theoretically,thereturnonequitycouldhavebeeninfinite,assumingthatthepurchasersecuringhispurchasewithLeasco’screditborrowedallofthepurchaseprice.Thepurchaserwouldpayovertheoneyear,say,7percentinterest,whichwouldcomparewithhis
guaranteedminimumreturnof15.6percent.However,thetypeofinvestorswhoboughtthedealwasinstitutions,whichtypicallyinvesttheirownfundsandforwhichthe15.6percentto50percentreturnismoreappropriate.3Thesuitdidnotresultinanymaterialliabilitytotheinstitutionalinvestors.4Infact,theleverin
Leasco’scallwasthatiftheinstitutionalinvestorschosenottoheedthecall,Leasco’sguarantee,orput,wouldnolongerbeoperative.5WecovertheissueofdiversificationinmoredetailinChapter13.
CHAPTER27
TheUseofCreativeFinancetoBenefit
Controlling
Stockholders*
TheProblemsFacedintheSchaeferCorporationDealTheBackgroundoftheDealDiscount
PurchasesofRestrictedCorporateStockCorporation’sAcquisitionofBrewingProblemsandWealthCreationPotentialsforthePartiesinInterest
Summary
It is likelythatmorefortuneswithin the financialcommunity are obtainedthroughthediscountpurchaseof securities in negotiatedtransactions than throughbrilliant analysis resulting inthepurchaseatmarketpricesof securities that willappreciate dramatically. A
discount purchase is one inwhich a stockholder obtainssecurities at a price belowthatwhichprevailsoristobecreatedinapublicmarket.Only a small minority of
the Wall Street successstoriescomeoutofanoutsideinvestor’sactingona feelingabout the growth of aparticular industry, such asfeelingin1955that“copyingis going to be a great
business; ergo, I shall buyand holdXerox.”Rather, themore common method ofamassing wealth in thefinancial community is to beinvolved in a deal thatenables you to buy commonstock at, say, $.42 or $1 pershare, for which the publichaspaidorwillpay,say,$26per share.A largenumberofdeals resulting in suchdiscountpurchaseshavebeen
put together, including, toname a few, Eastman Dillonpromoting WestcoastTransmission, AmericanSecuritiespromotingWesternUnion International,Ladenburg Thalmannpromoting GuerdonIndustries, and LehmanBrothers promotingMonterrey Oil. Discountpurchasesarenotconfinedtoinvestment bankers and
brokers; other deals haveincluded Albermarle Paperpurchasing EthylCorporation, MalcolmMcLean acquiring certainshipping interests, andNorthwest IndustriesacquiringVelsicolChemical.Inthischapter,wedescribe
one set of discount-purchasetransactions in detail; theseculminated in the November1968publicofferingoftheF.
& M. Schaefer Corporation,parent company of theproducer and marketer ofSchaeferbeer.The reason for picking
Schaefer as a case study isthat it is one of the morecomplex transactions, so thatmanyofthekeyelementsthatgo into a discount-purchasetransaction are covered. Itshould be noted, however,thatanimportantelementnot
covered in the Schaefertransaction is the use of tax-loss carrybacks and tax-losscarryforwards.There are a number of
valuablelessonstolearnfromthe Schaefer case study. Thefirst concerns the mechanicsofsuchtransactions.Itisalsoimportant to have someappreciation of what goesinto Schaefer-typetransactions in order to
understand Wall Street.Another equally importantlesson has to do withunderstanding the problemsand goals of the variouspartiestothetransactions.The transactions are
examined from the points ofview of eight differentconstituencies:
1. The sellingstockholders2. The company’s
operatingexecutives3. The commercial bankthat provided short-termfinancing4. The promoters of thetransactions5. The underwriters whomarketed the initial issuetothepublic6. The institutionallenders (basically lifeinsurance companies)
that provided thebulkofthelong-termfinancing7.Thepublicinvestors8.Thenewbusiness thatemerged as a publiclyowned, rather than acloselyheld,enterpriseLike all things on Wall
Street, everything in thistransaction, includingdiscount purchasing, had itsproblems. In some contexts,the public shareholder who
was able to obtain stock at$26intheinitialofferinghadfewer problems and a moreattractive holding than someof the other parties whopurchased stock at $1 persharetwomonthsearlier.
THEPROBLEMS
FACEDINTHE
SCHAEFERCORPORATION
DEALThe mechanical problemsfaced in this complex dealincludedthefollowing:
Taxproblems,especiallyforthesellersandthepurchasersofdiscountsecuritiesAccountingproblemsfor
thepubliccompanyCommercial-bankborrowingsPrivate-placementborrowingsfrominstitutionallenders,suchaslifeinsurancecompaniesWarrantsConvertiblesecuritiesSeniorloansversussubordinatedloansCorporatetaxshelter
(TS)PublicunderwritingRightsofregistrationRule144CashreturnsversusnocashreturnsQualifiedstockoptionsSignificanceoffinancialpositionsindealmakingSignificanceofreportedearningsforapubliccompanyNASDRulesofFair
PracticeAll the information used
here was obtained frompubliclyavailabledocuments,mostlyfromSECfiles.Therewere no interviews orconversations with anyoneassociated with thetransactions. There is noquestionthatiffieldworkhadbeen done, our work wouldbe more complete. It is alsopossible that with the
personal explanationof thoseinvolved in the transactions,certainofourconceptswouldbe changed. This goes withour thesis that in securityanalysis, studying documentsis no substitute for fieldworkandviceversa.However, thepointofforgoingfieldworkisto demonstrate that vastamounts of informationfrequently are available, sothat quite meaningful
conclusions often can beobtained by trained analystsrelying solely on publiclyavailabledocuments.
THEBACKGROUNDOFTHEDEAL
On June 10, 1968, the F. &M. Schaefer Corporation
(hereaftercalledCorporation)was incorporated in NewYork State. Corporation’spurposewastwofold:
1. To acquire all thecapital stock of the F.&M. Schaefer BrewingCompany (hereaftercalled Brewing), also aNewYorkcorporation2. To go public via anunderwritten publicoffering
Bothof these eventsdid infact occur less than sixmonths after incorporation.The market for newunderwritings was favorablein June1968.Marketplayerswere seekinga repriseof the1961–1962 new issue spree,in which they had boughtissues at the initial offeringprice and realized a profitwhen the shares sold atimmediate premiums. They
werelookingforsecuritiesofcompanies in growthindustries, especially thosethatwereoutperforming theirown industries in terms ofsteadily increasing sales,market penetration andprofits.Thebrewing industrywas viewed by many aspoised for relatively rapidgrowth, because the progenyof the post–World War IIbaby boom were reaching
beer-drinking age andbecausehigherprofitpackagesales, especially cans, weretaking over from draft beer,which was generally abrewer’slowest-profitmarginproduct.Brewing,whichhadbeenin
thebeerbusiness since1842,was a strong, prosperous,family-ownedbusinessinmidto late 1968. It had Schaeferbeer plants in Albany,
Brooklyn, and Baltimore.Sales of Schaefer beer,marketed in the northeasternUnited States, had increasedsteadily from 2.8 millionbarrelsin1958to4.7millionbarrels in 1967, and in 1968barrel sales were runningsome 7 percent ahead of1967. Market penetration,too, had been on the rise.Beer sales in barrelsincreased from an estimated
3.3 percent of the industrytotal in 1958 to about 4.4percent in 1967. Brewingseemedboundtoatleastholdits market share in 1968,based on results for the firstninemonthsofthatyear.Brewing had been quite
profitable and was growingrapidly. Net sales hadincreased steadily from $151million in calendar 1963 to$181millionin1967.Income
before extraordinary creditswas $2,546,000 in 1963 andhadincreasedyearbyyearto$5,127,000 in1967,althoughoperating profits had dippedmodestly in 1964 because ofa $1,349,000 pretax expenseincurred in connection withpromotions by the companyat the New York World’sFair. As is true of manyprivatecompanies,Brewing’sprofit figures seem to have
been conservatively stated,1and were reported, after taxaccruals, at the approximatemaximumincometaxrates.Moreover, the company
was well financed. TheBrewing balance sheet thatwould have been availablebeforeJune10,1968,wasnotpublic information, but theJuly31,1968,auditstatementshowedthatthecompanywasquite comfortable. Cash and
equivalent was $10,405,000,andcurrent assets aggregated$40,468,000. Currentliabilities were $19,970,000,leaving working capital of$20,498,000. The only otherliabilitieswere$3,029,000ofemployee benefits and$15,210,000 of long-termdebt, $15 million of whichwas in the form of 5.17percent notes held by thePrudential Insurance
Company of America. Thesenotes matured serially to1983,butannualamortizationduring the next six yearswould be only a modest$500,000 for1968and1969,and$825,000for1970,1971,1972,and1973.Tangible asset value was
stated at $53,149,000,probably a conservativefigure. Property, plant, andequipment—whichincludeda
maltingplantinBuffalo,NewYork, and six distributingcenters, as well as the threebreweries—was carried at anet value of $44,877,000,after deducting accumulateddepreciation of $38,841,000.This $44,877,000 amountedto only $8.56 per barrel ofcapacity,basedonBrewing’s1967 capacity of 5,240,000barrels. In light of the factthat replacement costs were
runningaboutthreetimesthisper barrel of capacity,2Brewing’s property, plant,and equipment seem to havebeen worth at least theamounts forwhich theywerecarriedonthebooks.
DISCOUNTPURCHASESOFRESTRICTED
CORPORATESTOCK
AweekafterCorporationwasorganized, R. W. Pressprichand Company purchased160,000 newly issued sharesof Corporation common for$66,667, or $.42 per share.This was the first discountpurchase.Pressprich, located at 80
PineStreetinNewYorkCity,was a medium-sized NewYork Stock Exchangememberfirm,whichformanyyears had been highlyregarded in the financialcommunity.Pressprichwasaprincipal, if not the principalarchitect of the Corporation-Brewing transaction andsubsequent public offering,and also arranged thefinancing that gave
Corporation the wherewithalto effect the purchase.Pressprich had agreed not toresell these 160,000 sharesbefore March 15, 1971,without firstoffering themtoCorporationat$.42pershare.OnSeptember20,1968,the
day Corporation signed apurchase agreement for theacquisition of all ofBrewing’s capital stock, anadditional 170,000 shares of
newly issued Corporationcommon stock were sold at$1 per share. The purchasersof these shares includedmembers of the Schaeferfamily, members of theBrewing executivemanagement committee, anda group of institutionalinvestors who were to lendCorporation funds for theacquisitionofBrewing.Thus,all of them were providing
other benefits forCorporation,either at presentor prospectively. Thepurchasers, their relationshipto Corporation, and thespecial terms of theirpurchasesareshowninTable27.1.Table27.1Purchasersof170,000CorporationCommon@$1perShare
As noted, all of the sharesissued in these two discount
purchase transactions, exceptthe150,000purchasedbytheinstitutional investors, weresold subject to contractualrestrictions on public resale.The shares could be soldprivately to anothersophisticated holder whowould agree to be bound bythe restrictions on resaleagreed to by the discountpurchasers. Such a resalewould be unlikely, however,
andevenifaccomplished,theprice realized would be asubstantialdiscount(probably25 percent to 60 percent)fromthecurrentmarketprice.Apart from these
contractual restrictions onresale, the 330,000 sharesinvolved were restricted forSecurities and ExchangeCommission purposes.Accordingly, public resalewaslimitedbylaw.Underthe
rulesandregulationsineffectin 1968, these shares couldhave been sold publicly onlythrough a registered offeringvia a registration statementfiled with the Securities andExchange Commission,unless the Commission wastoissueanoactionletteroraholder was able to obtain alegal opinion that there hadbeen a “change ofcircumstances.”Asapractical
matter, thechancesofanyofthesepurchasers’gettinganoaction letter or change ofcircumstances opinion wereslimatbest.Thus, at the time of the
discount purchases, the onlywayforthepurchaserstoselltheir Corporation equitysecurities publicly was byregistrationwith the SEC fora new public offering inwhich their shares would be
sold.As a result, registrationrights—an agreement byCorporation to register withthe SEC for the distributionof restricted shares—werecrucial, at least to thosediscountpurchaserswhowerenotinapositionofcontrolinCorporation. Both theinstitutional investors andPressprich negotiated fairlystrong registration rights,which are discussed at some
lengthlaterinthischapter.SinceApril1972,Rule144
had provided holders ofrestricted stock purchasedpreviously anothermechanism for reselling theirshares. Basically, under thisrule such a holder who hadheld shares outright for twoyears might sell them inregular market transactionson the New York StockExchange. Back then, Rule
144 provided that the salescould occur only once everythree months, however, andthe number of shares thatmight be soldwas limited tothegreaterof1percentoftheoutstanding stock of thecompany, or the weeklyaverage traded for the fourweekspreceding thefilingofaForm144withtheSEC.Inthis case, 1 percent ofCorporation’s common stock
at the time it went publicwould have been 18,000shares.3
CORPORATION’SACQUISITIONOFBREWING
ThePurchaseAgreement
On September 20, 1968,Corporation signed anagreementunderwhichitwasto acquire all of Brewing’soutstanding capital stock for$106 million in cash andnotes.Thisstockconsistedoftwo issues. The Class AparticipatingsecondpreferredstockwasownedbyArjayess,a corporation wholly ownedby Rudolph J. Schaefer. TheClass B stock was held by
four trusts setup in1944 forthe benefit of variousmembers of the Schaeferfamily.Under the terms of the
purchase agreement,Corporation was to acquirethe Class A stock for a cashpayment of $6 million. Theremaining$100millionofthepurchase price, paid to theholders of theClassB stock,was in the form of a cash
payment of $10 million andvarious notes, detailed inTable27.2.Table27.2ConsiderationGiventoSellersofBrewing’sCapitalStock
The purchase wascontingent uponCorporation’s receiving netproceeds of at least $35millionfromapublicoffering
of its common stock. Theactual purchase was to takeplace simultaneously withCorporation’sreceiptoftheseproceeds, but not later thanDecember 31, 1968. In fact,theclosing tookplaceduringthefirstweekofDecember.Brewing’s officers and
employeeswere to remain intheir positions after theacquisition, at the same orimproved rates of
compensation.
FinancingtheAcquisition
Corporation needed about$121.8million to accomplishthis acquisition;$106millionof this, of course, was thepurchase price to be paid toBrewing’s sellingstockholders. In addition,Corporation needed $15
million to prepay the 5.17percent Brewing notes thatwere held by PrudentialInsurance, and $800,000 topay expenses incurred inconnection with arrangingthisdeal.Twopartiessharedthebulk
ofthe$800,000expenseitem.The first was the eminentNew York City law firm ofWhite andCase,whose legalfees were around $350,000.
White and Case hadrepresentedtheSchaefersandBrewingforalongtime.Onepartner, Glover Johnson, hadbeenaconsultanttoBrewing,ona retainer, since1955andwas a director of thatcompany. He was also asuccessor trustee of the fourSchaefer trusts, forwhich hewas to receive an annual feeof 2 percent of trust incomeafter 1968. The firm became
counsel for Corporation, andMr. Johnson and his partner,John C. Reed, becamedirectorsofCorporation.4
In addition to White andCase’s legal fees, Pressprichreceived a fee of $425,000,primarily for its work inconnection with theplacement of Corporation’slong-term notes. This$425,000 fee was separatefrom Pressprich’s discount
purchaseof160,000sharesofCorporation stock. The bulkof the fee, of course, wasconditionedongoingpublic.After its organization,
Corporation obtained$236,667 in cash from theproceeds of its sales ofcommon stock at a discount.It had also conditioned theacquisitionofBrewingonthereceiptof$35millionfromitspublic offering,whichwould
be available to it. Under theterms of the purchaseagreement, Corporation hadarranged to borrow $20million from the Schaeferfamily trusts, to whom $20millionofjuniorsubordinateddebenturesweretobeissued.These funds, aggregating alittle over $55 million,together with the $6 millionsurplus cash that Brewinghad, still left it considerably
short of its $121.8 milliongoal, however. To fill thegap, Corporation arranged toborrow $65million from theseven institutional investorsthat had participated in thesecond discount purchase.Thus, Corporation’s sourcesoffundsandsecuritiesissuedor issuable would be asshowninTable27.3.Table27.3SourcesofFundsandSecuritiesintheTransaction
Thiswasnot thepicture asof the time of the publicoffering, however. Theinstitutional investors wouldnot lend any funds before
January 15, 1969, and theirinvestment was to be phasedinover18months,accordingtothefollowingschedule:Date AmounttoBeInvestedat
ThisDate1/15/69 $31,845,3577/15/69 $8,222,500
1/15/70 $13,510,7147/15/70 $11,421,429
$65,000,000
Thereasonfor thisphasingis not clear, especially since
Corporationwas obligated topay the entire $106 millionpurchasepricetotheBrewingshareholders by July 15,1969.Itmayhavebeenduetothe investment schedulingrequirements of individuallenders, all of which haveschedulesofcashinflowsandoutflows, or it may haveinvolved things peculiar tothese transactions. In anyevent, the arrangement left
Corporationwithatemporaryshortfall,whichitcoveredbyarranging a short-term loanfromFirstNationalCityBankof New York at the primerate.5
Corporation’sDebtSecuritiesDescribed
The financing schemeoutlined above called for theissuanceof$85millionworth
of debt by Corporation. Alittleover$36millionof thiswas in the form of 7.75percent,20-yearseniornotes.The balance was insubordinatednotesofvaryingterms,allofwhichhadequityprivileges.The $20 million of 4
percent, 30-year notes issuedto the Schaefer trusts carriedconversion rights. BeginningJanuary 15, 1971, they were
convertible into Corporationcommonatapriceof$40pershare. This conversion pricecould be reduced on January15,1972,totheaveragepriceofthestockontheNewYorkStock Exchange for the 60trading days prior to January15, 1972, but in no eventcould it fall below the initialoffering price at whichCorporation went public($26). Thus, if for the
60 trading days beforeJanuary15,1972,theaverageprice for Corporationcommon stock was $40 orbetter, the 4 percent noteswould be convertible into500,000 common; if theaverage pricewas $35, the 4percent notes would beconvertible into 571,429Corporation common; and ifthe averagepricewas$26orless, the 4 percent notes
would be convertible into769,231common.The 5.75 percent, 20-year
subordinated notes issued tothe institutional investorswere structured somewhatdifferently. Approximately$1.2 million of the$27,857,143 issue wasconvertible into Corporationcommon at prices rangingfrom $10 to $6.50 per share(onequarteroftherespective
maximum and minimumconversion prices for the 4percent notes), based on thesame timetable and the samesixty-day average priceformulausedforthe4percentnotes.The remainder of the issue
was not convertible. Instead,theseveninstitutionsreceivedwarrants, exercisablebeginning January 15, 1971,to purchase 84,866
Corporation common at $10pershare.Liketheconversionrights, the warrants could beadjustedonJanuary15,1972,depending on the 60-dayaverage New York StockExchange price of the stock,into warrants to purchase asmuchas130,563Corporationcommon at $6.50 per share.These warrants weredetachable from the 5.75percent notes, and were
transferable upon compliancewith SEC registrationrequirements. Theinstitutional holders hadregistration rights inconnection with both thewarrants and the commonstock, issuable uponconversionofthenotes.Theequityprivilegesofall
of these subordinatedsecurities were protected byantidilutionprovisionssimilar
to those usually found inpublicly held convertiblesecurities and warrants. Forexample, in the event of atwo-for-one stock split, theconversion price would bereducedby50percent,sothatthe holder of the notes orwarrants would receive thesame proportionate equityshare on conversion orexercise as it would havebeforethesplit.Assuming,as
actually happened, that in1972 the conversion andwarrant prices were reducedtotheminimumallowed,thenin the event of such a split,the4percentnoteswouldbeconvertible at $13, and the5.75percentnotesorwarrantsat$3.25.While the antidilution
protections accorded thesesubordinated notes are fairlystandard,otherfeaturesofthe
subordinated notes are quitedifferent from thosecommonly associated withpubliclyheldseniorsecuritieswith equity privileges.Particularly noteworthy inthis regardare theprovisionsfor mandatory and voluntaryredemption, and the variousprotective provisions grantedtheholdersofthesenotes.
Mandatory
RedemptionProvisions
Theconventionalpublicissueof senior securities withequity privileges has onlyvery small amortization, orsinking fund, provisions thatoperate in the early yearsafterissuance.Forexample,atypical 20-year publiclyowned subordinateddebenture might have a
sinking fund provision thatbecomes operative after 10years and provides thereafterfor annual redemptions of 3percentoftheissueatpar.A relatively small sinking
fund provision does, ofcourse, operate to thebenefitof the public holder of aconvertible note. Rapidpayback of debt to such aninvestor would diminish thevalue of his conversion
privilege by “forcingconversion” whenever themarket price exceeds theconversion price at the timeofredemption.Thisphenomenonofforced
conversion is best explainedby a concrete example.Assume that Corporationcalls for redemption $1million of debenturesconvertibleat$6.50atatimewhen its stock is selling for
$8ashare.Theholderof thedebentures can redeem themat par, realizing $1 million.But his conversion privilegeentitles him to receive153,846 shares of commonstock. Ifhe sells these sharesshort at $8 when theredemption is announced,converting the debentures tomake delivery against theshort sale, he will realize$1,230,769 before
commissions and othertradingcostsoftheshortsale.The economic benefit of thislatter strategy—in this case,$230,769—is what forcesconversion. Such forcedconversion will, of course,occurwhethertheredemptionof the convertible notes ispursuant to a mandatorysinkingfundprovisionortoavoluntary (by Corporation)call.
In the context of this deal,the interests of the Schaeferfamily trusts in terms ofsinking fund provisionswereessentiallythesameasthatofa public holder of aconvertible note.Accordingly, the mandatoryredemption provisionsgoverningthe4percentnoteswere similar to those for atypical public issue: Thesinking fund was not to
become operative untilJanuary 15, 1979, about 10years after issuance;thereafter, annualredemptions at par wouldamount to $500,000, or 2.5percent of the original issue,until the debt held by theinstitutional investors was tobe retired in 1989; annualredemptions would thendouble for the last 10 years,leaving a $6 million
unamortizedbalance,payableatmaturity.The interest of the
institutional investorsinvolved in this deal wassomewhat different: a steadyand relatively rapid paybackof their loans, rather than astraight conversion privilege,was their primary goal.Accordingly,the5.75percentnotes issued to them hadsinking fund provisions
requiring annual redemptionat par of 6.25 percent of thedebt outstanding, beginningJanuary 15, 1974, five yearsor less after issuance. Indollar terms, this amounts toannual redemptions of $1.7million for 16 years. Thisredemption scheme does notdiminish the value of theinstitutional investors’ equityprivileges,becauseofthewayin which those privileges
were structured. The greatbulkofthe5.75percentnoteswere accompanied bywarrantsthat,asnotedabove,were detachable from thenotes.As to the $1.2millionof debt that was in the formof convertibles, theinstitutional investors wereprotected by a provision thatin the event of prepayment,warrants to purchase wouldbe issued in lieu of, and on
the same basis as, theconversion privileges. Thesewarrants were to expire in1989.
VoluntaryRedemptionProvisions
Typically,theissuer’srighttovoluntarily call a publiclyheld subordinated debenturewith equity privileges ispervasive. The issue is
callable in whole or in partanytimeafter issuanceatpar.Thus, the issuer is in apositiontoforceconversionifthe price at which thecommon stock is selling isabove the price at which theseniorsecurityisconvertible.6Corporation’s voluntary callprovisions were quitedifferent from those typicallyfound in connection with apublicissue.
The 5.75 percent notescarried a five-year callprotection, so thatCorporation could notvoluntarily redeem the notesuntil January 15, 1974.Afterthat, Corporation couldvoluntarily redeem$1,740,884 of notes at pareachyear.Noadditionalcallswere permitted until January15, 1979; thereafter, suchcallswerepermitted,butonly
at a premium. Theprepayment premium was105.75percentofparin1979,declining gradually to par in1988.The4percentnotescarried
an eight-year call protection.Thus, there could be novoluntary call before January15,1977.After that date, thenotes were callable at apremium—104percentofparin 1977, gradually declining
to par in 1998. In addition,Corporation was grantedrights to voluntarily call$500,000ofnotesperyearatpar beginning January 15,1979,and$1millionofnotesper year beginning January15,1988.
ProtectiveProvisionsThe usual public issue ofsubordinated debentures or
notes, or even preferredstock, tends to haveprotective provisions that arefew and generally not toomeaningful. The protectiveprovisions of the 4 percentnotes issued to the Schaeferfamily trusts were similarlyskimpy. Indeed, if anything,these notes were less wellprotected than the typicalpublic issue, since theywerefullysubordinatednotonlyto
the senior notes, but also tothe subordinated notes heldbytheinstitutionalinvestors.The notes held by the
institutional investors, bycontrast, contained protectiveprovisions that were farstronger than those found inany publicly tradedsubordinated debenture ofwhich we are aware. Theseincluded both negativecovenants (things
Corporation was prohibitedfrom doing) and positivecovenants (thingsCorporation was required todo). For example, the termsof the purchase agreementunderwhichthesenoteswereissued required Corporationto maintain a certainminimum working capital atalltimes,andlimitedamountsthat could be borrowed byCorporation and by its
subsidiaries, depending oncertain earnings and nettangible assets tests. It alsoimposedrestrictionsonrentalcharges incurred, dividendpayments, the repurchase ofshares and the voluntaryredemption of seniorsecurities. Further, theagreement containedprohibitions against sale andlease-back transactions andagainst investment in the
securities of other companiesor entities, other thansubsidiaries and the U.S.government.
OtherDistinguishingFeatures
Although, as noted, the 4percentnotescontainedfairlyinsignificant protectiveprovisions, they contained avery interesting and unusual
controlprovision.Theholderwas given the right toaccelerate payment of theentire amount in the eventthat one person acquiredbeneficially 30 percent ormoreofCorporation’svotingsecurities, or two or moreholdersacquiredvotingstockof Corporation for thepurposeofexercisingcontrol.This should have effectivelydiscouraged anyone from
seeking to oust the Schaeferfamily from control ofCorporation.One final difference
between Corporation’ssubordinates and similarpublicly held issues that isworthy of note is that theywere private placements.Although this statement mayseem to belabor the obvious,in fact the statusof thenotesas the product of purchase
agreements betweenCorporationandtheacquirersis significant in terms of theprotection afforded theholders.Apublicdebtissueisissuedunderatrustindenture,which is an agreement,conforming to the SEC-administered Trust IndentureAct of 1939, between theissuer and a large-bank-designatedtrusteeforthedebtsecurities holders. In the
event of default or breach ofthe agreement, the individualholder of a public debt issueisnotusuallyinapositiontotakeactionagainsttheissuingcompany on his own unlesshe and others represent notless than 25 percent of theoutstanding debt issue.Rather,thedebtholderhastowait for the trustee to takeaction. The trustee will takeaction only in strict
conformity with hisinterpretation of theindenture. Thus, the publicdebt security holder may belessprotected than thepubliccommon stockholder, whotends to be free to take legalactions on behalf of allstockholders or the companyitself. The institutionalinvestorsinvolvedinthisdealhave an advantage notpossessedbypublicinvestors,
in that they can themselvesmove rapidly againstCorporation in the event ofdefault or breach of thepurchaseagreement.Conversely, there may be
situations in which the veryfact that this issue is heldbyonly a handful of ownersplaces the institutionalinvestors in a less favorableposition than that enjoyedbya public investor. For
example, if the issuer wantstomodifythetermsofaloanagreement without recourseto the bankruptcy statutes, itis in a position to negotiatechanges with a few privatelenders.Theissuercannot,asapracticalmatter,dosowitha trustee for indebtedness orwith individual publicinvestors,however.Thus, theprivate investor may beforced to agree to changes
adverse to his interests inorder to avoid bankruptcy ofthe issuer, whereas fullservicemay be continued onsubordinated debenturesbecause they are publiclyheld.7
ArrangingthePublicOffering
On September 26, 1968, alittle over three months after
itsincorporation,Corporationfiled a preliminaryregistration statement withtheSEC,showinganintenttooffer 1 million shares ofcommonstockatamaximumpriceof$26pershare.Atthetime of the filing, Pressprichwas tomanage the syndicatethat would underwrite theoffering, but that firm wassoon replaced by White,Weld and Company, a
leading New York Cityinvestmentbankingfirmpriorto its merger in 1978 intoMerrill, Lynch, Pierce,Fenner and Smith. AlthoughWhite,Welddidnot actuallyexecute a written agreementwithCorporationorwithanyof the proposed members ofthe underwriting group untiljust before the registrationstatement became effectiveonNovember27,1968,itwas
busy putting together anunderwritinggroupduringtheincubation period in whichthe SEC was reviewing andcommentingonCorporation’sfiling.Inall,theunderwritinggroup included 128 firms—117 U.S. firms and 11European businesses. White,Weld, as manager,underwrote 218,000 of the1.5 million shares offered.The underwriting group also
includedDillonRead;HalseyStuart; Kidder, Peabody;Kuhn Loeb & Co.; LazardFreres; Paine, Webber,Jackson and Curtis; andParibas.The issue was offered for
sale at $26 per share onNovember27,1968,andwasan immediate success. ThewarningintheprospectusthatCorporation’s largedebt loadand negative tangible net
worth made the issue highlyspeculative certainly did notdepress the price, and mayevenhavebeenthereasontheissue went to a premium. Inany case, the stock closed at31 bid on the date of theissue.8
Of the $39 million grossproceedsfromtheoffering,6percent (amounting to $1.56per share), was retained asunderwriting discount;9
$1,065,000 of this(amountingto$.71pershare)went to White, Weld for itsmanagement fee and for thelegal, advertising and otherexpenses incurred inconnection with theunderwriting. The balancewas paid to certain dealers,includingtheunderwriters,asasalescommission.10
Corporation incurredexpenses of about $330,000
in connection with theunderwriting,overandabovethe underwriting discount.These includedsuch itemsaslegal fees ($100,000),accounting fees ($75,000),printingcosts($75,000),SECand blue sky (state securityregulation) fees ($30,000),liability insurance ($35,000),and transfer agent fees($15,000).Contemporaneously with
the public offering,Corporation granted optionsto its employees to purchase98,134 Corporation commonshares. These were grantedpursuant toaqualifiedstock-optionplancovering200,000shares of Corporationcommon, which had beenapproved on October 30,1968. These options, whichwere granted at 100 percentofmarketvalueonthedateof
grant, were good for fiveyears if the holder remainedemployedbyCorporationorasubsidiary.Upontheexerciseof the qualified option,Corporation would lend theemployee 90 percent of theexercise price at 4 percentinterest; 20 percent of theoutstandingamountwastoberepaid annually for the firstfouryears, thebalance in thefifth year. These options
enabled the holder to profiton a tax-sheltered capitalgainsbasis fromappreciationin the market value ofCorporation’sstock.
PROBLEMSANDWEALTHCREATIONPOTENTIALS
FORTHEPARTIESININTEREST
TheSellingStockholders
ThesellingstockholderswereArjayess, a corporationwholly owned byRudolph J.Schaefer, and four trusts for
members of the Schaeferfamily.There are a number of
things that motivated theSchaefers to follow thecourse of action they didrather than the alternativeopportunities that might besummarizedasfollows:
1. Brewing could havegone public by offeringits stockvia aPressprichor White, Weld and
Company or equivalentunderwriting.2. Brewing could haveremainedas itwas—asaprivate company—anduseditsborrowingpowerto incur debt, theproceeds ofwhichmightthenbedistributed to theSchaefer familystockholders.3. Brewing could havesold out to a larger
company—say, beenmerged intoorotherwiseacquired by a massmerchandiser, followingin a general way theacquisition of MillerBrewingbyPhilipMorrisin 1969, or Hamm’sBrewing by Heublein in1965.4. Brewing could havedone nothing, in whichevent cash distributions
to its shareholderswouldhave been no larger thanannual earnings ofaround $5 million peryear.The Schaefer family,
through these transactions,obtained by July 15, 1969,some$86millionincashonatax-sheltered (capital gainsrather than dividend income)basis, after which they werestill left in control of the
company.The company, too,was nowpublic,with a hugestock market value in whichthe Schaefers expected toparticipate, at least to someextent. Unlike the otherstockholders’ holdings,though, the Schaefers’security holdings wouldprovidethefourtrustswithan$800,000 annual cash return,because the four trusts held$20 million of 4 percent
convertibledebentures,ratherthancommonstockonwhichitwaslikelythatnodividendswouldbepaid.Assumingthatthe average price forCorporation’s common stockforthe60tradingdaysbeforeJanuary 15, 1972, was 40 ormore, the Schaefer familyinterests would own 19.6percent of Corporation’sequity on an all-converted,all-exercised basis.
Assuming,ontheotherhand,that the average price forCorporation’s common stockfor the sixty trading daysbeforeJanuary15,1972,was26 or less, the Schaeferfamily interests would own26.1percentofCorporation’sequity on an all-converted,all-exercised basis. In eitherevent, the Schaefer familywould control Corporation.The Schaefer family
ownership interests arecomputed as shown in Table27.4.Table27.4SchaeferFamilyOwnershipInterestsComputedunderTwoDifferentPriceScenarios
AtPriceof40orMore
AtPriceof26orLess
No.sharesoutstandingafterpublicoffering
1,830,000 1,830,000
No.shares 15,000 15,000
ownedbySchaeferfamilyinterestsofoutstanding%ownedbySchaeferfamilyinterests
0.80% 0.80%
No.sharesissuableuponconversionofdebt,exerciseofwarrantsandexerciseofqualifiedoptions
798,134 1,175,057
No.shares 500,000 769,231
issuabletoSchaeferuponconversionof4%notesNo.sharestobeoutstandingonall-converted,all-exercisedbasis
2,628,134 3,005,057
No.sharestobeheldbySchaefers
515,000 784,231
%ownedbySchaeferfamilyinterests
19.60% 26.10%
Each of the alternative
opportunities had specialdisadvantages. The Schaeferfamily interests could havecontemplated, and may wellhavestudied,merelyofferingsome of the Brewing stockheldbyArjayessandthefourtrusts in a so-calledunderwritten secondaryoffering. Such an offeringwould have resulted in thesellers’ realizing cash on acapital-gainsbasisandwould
also have left the Schaeferinterestsincontrolofapubliccompany. Furthermore, thispublic company, unlikeCorporation, would enjoyconsiderable financialstrength. However, it wouldhave been virtuallyimpossible for a secondaryunderwriting to be arrangedon such a basis that theSchaefer family interestswould be able to realize $86
million in cash. Indeed,Corporation’s $39 milliongross proceeds from itsunderwriting was relativelylargeforanissueofthistype.Not only were the Schaeferfamilyinterestsabletorealize$86 million of cash fromdoingwhat theydid,butalsotheymaywellhaveachievedamuchbetteraftermarketfortheir remaining holdings inBrewing’s parent thanwould
havebeenthecaseonstraightunderwriting.BecausecertaininfluentialWallStreetentities(Pressprich and the seveninstitutional investors) wereimportant shareholders,Corporation may well havebecome a better-sponsoredsecurity in 1969 and 1970than would otherwise havebeen the case. Corporation’sstock price rose almoststeadily after the initial
offering in November 1969,reaching a peak in February1970,whenthesharessoldata price of $59, equal to 25times1969earningsof$2.30pershare.Had Brewing remained a
privatecompany,itsabilitytoborrow from lendinginstitutions would have beenconsiderably poorer than aspart of a public vehicle.Onecrucial factor that made the
$65 million borrowing byCorporation attractive to theseven institutions was theirobtaining discount purchasesof equity interests—that is,150,000 common at $1 pershare, and rights to obtainbetween200,000and307,692common shares at between$10 and $6.50 per share,dependingonwherethestock(which was to go public at26) would be selling three
yearslater.It is possible that the
Schaefer family interestscould have receivedmaximum tax shelter byremaining private and byhaving borrowed funds flowinto Brewing. Since thefamily owned 100 percent ofBrewing, the funds mighthave been usable by themwithout any, or anyappreciable, amounts being
distributed toArjayessor thefour trusts. However, such acourse of action could raisetax problems for Brewing,namely, a Section 531problem on the unlawfulretention of surplus, eventhough this probably wouldhave been vitiated byBrewing’s plans to spend atleast$38million toconstructa new facility in easternPennsylvania. In any event,
wehavenoinformationaboutthe amount of tax shelteravailable to Arjayess on itsreceiptof$6million.Also, itisprobablethatthefourtrustshave obtained more taxshelter from returns on theirinvestments thanwould havebeen feasible if the samefunds had been invested inBrewing.Thereisnoquestionthat with the considerableplanning that went into the
transactions, they weredesigned so that thecombined tax impacts onArjayess and the four trustswereminimized.HadBrewingchosentosell
out toa largercompany, it isextremely unlikely that theSchaefer family interestscouldhave retained the sametypeofcontroloverBrewingthatbecameavailabletothemthrough the creation of
Corporation, which alonemay have discouraged thisapproach. In addition, itprobablywasdifficult tofindan acquirer with whom anagreement could be reachedthat would result in theSchaefer family interests’receiving$86million incash(either from the acquirer’streasury or from the sale ofshares received), plus ameaningful equity interest in
the common stock of theacquiring company. It ispossible, but not probable,thatanacquirerwithausabletax-loss carryforward mightpay out that much cash forBrewing(forexample,seetheNorthwest Industriesacquisition of BuckinghamCorporation in 1971). If theSchaefer interests were toreceive $86 million casheither directly from the
acquirerorthroughthesaleofcommonstockoftheacquirerreceived, the acquiringcompany in all probabilitywould have had to accountfor the Brewing acquisitionon a purchase basis ratherthan a pooling-of-interestsbasis. In addition, the saleofBrewing toa largercompanycould easily have beenstopped or made difficultbecause of antitrust
proceedings of the U.S.Department of Justice or theFederalTradeCommission.HadBrewingremainedasit
was, a private, relativelydebt-free corporation, therewould have been no large-scale cash distributions toArjayessorthefourtrusts.Inaddition, assuming therewasnointentiontoevergopublic,Brewing’s business mighthave suffered because of the
difficulty of offering keypersonnel meaningful equityinterestsintheenterprise.On balance, the transaction
that did take place did havemany advantages for theSchaefer family interests.Thisdoesnotmeanthattherewere not a considerablenumberofdisadvantages thatensued. First, the Schaeferswere now in control of ahighly leveraged public
company with new sets ofobligations to importantoutside interest groups. Theseven institutional investorsplaced restrictions onoperations and financing inaccordancewith the terms ofthe various purchaseagreements.BothCorporationand the Schaefers were nowsubject to SEC requirementsas to reporting and corporateconduct.
Also, lawyers representingminority interests would bevery ready and able to seekredressforwhattheybelievedwerewrongs to stockholders.If Brewing had remainedclosely held and if theSchaefer family interestsdesired to acquire forthemselves, say, a beerdistributor, there would havebeen no need to offer thisdistributor first to Brewing;
however, as a public entity,Corporation would find thatsuch a transaction would beextremely suspect, and quitepossiblyimpossibletodoasapracticalmatter.Furthermore, as a result of
going public, corporateobjectives changed. As aprivate company, Brewingwould strive to maximizeeconomicprofits,whereas,asa public entity, Corporation
tends to strive to maximizeimmediateaccountingprofits.Frequently, themaximizationof economic profits is indirect conflict with themaximization of immediateaccounting profits. As aprivate company, Brewingwould take as muchdepreciation as it could inorder to reduce income taxesand accounting profits, andBrewing would be more
willing to launch expensiveprograms—say, very large-scale advertising—thebenefitsofwhichmaynotbeapparentformanyyears.The Schaefer family
interestswereleftwithalargeownership interest in andcontrol of a financiallyweakened company that wasnot as well prepared tomeetcompetitive onslaughts as itmight otherwise have been.
As a matter of fact, in theearly 1970s the principalnational companies,Anheuser-Busch,Schlitz,andMiller’s, commenced raidingregional markets withprogramsconsistingofprice-cutting and other forms ofaggressive merchandising.Such programs wererelatively successful for thenationals. Corporation’saccountingearningspershare
peaked at $2.30 in 1970 anddeclined to $1.75 in 1971.Corporationsufferedadeficitof in excess of $1million in1972, and deficit operationscontinued through 1973. Thebusiness was nominallyprofitable in1974,1976,and1977, reported a massivedeficitin1975,andsufferedalargelossin1978.Although the Schaefer
family interests did create a
large market value for theirholdingsinCorporation,suchvalue was not readilyrealizable.Unlike theoutsidestockholders’ shares, sharesin Corporation held by theSchaefers were “tainted”—that is, they were not freelysalable.Asapracticalmatter,sales of large amounts ofstockbythemprobablycouldonly be accomplished byhaving another registered
secondary or by selling theshares privately at a verysubstantial discount frommarket. A registeredsecondary might beaccomplishable only via anunderwriting, the cost ofwhichmightrunfrom7to10percentofthegrossproceeds,and at that, might beaccomplishable only duringperiods when both the new-issue market was doing well
and Corporation itself wasprospering.
Brewing’sExecutiveEmployees
Two principal changesoccurred for Brewing’sexecutive employees. First,theyreceivedanewfinancialincentive in the form ofdiscount purchases ofCorporation stock, which
theoretically could bedisposed of by public sale inwhole or in part at somefuture date. Second,Brewing’s executiveemployees were nowmanaging a consolidatedenterprisethatwasheavilyindebt and publicly owned,ratherthanaprivatecompanywith excess financialresources.The discount purchases by
these executiveswere of twotypes. The first was theaggregate of 5,000 shares ofCorporation commonpurchased at $1 per share byfive members of Brewing’sexecutive managementcommitteetwomonthsbeforeBrewing went public at 26.On a gross valuation basis,this transaction resulted in awindfall of $25 per share, or$25,000 for each of the five
individuals. Such acalculation,though,wouldbemisleading.The reasonswhythe difference between a $1purchase price and a$26 market price wassomething less than $25 canbesummarizedasfollows:
1. The $1 price was acash cost, whereas the$26marketvaluewasnota value these executivescould realize in cash,
eitherbysellingthestockorbyusingitascollateralfor loans. In thissense—that is, as measured byability to realize cash—the shares could bedeemed to have a valueof $26 only if theywereregistered with the SECand if they were heldbeneficially by outsiders,not insiders. These arestrictures that could
adversely affect valueeven in the absence ofspecific contractualrestrictions.2. At the time ofpurchase, there was noassurance thatCorporation could gopublic at all, or if itcould, at what price itwould go public. Valueshould have beenadjusted to provide an
estimate for thisuncertainty.3. The $1 shares wereacquired subject tospecific contractualrestrictions. Eachexecutiveagreedtoreselltheshares toCorporationat $1 per share in theevent he left Brewingbefore January 1, 1974,except in the case ofdeath, disability, or
approved retirement.After January 1, 1974,only 20 percent of theshares became free oftheir contractualrestrictions per yearcumulatively.By having the opportunity
to purchase Corporationshares at $1 per, the fiveexecutives did receivesomething of value, althoughfor income-tax purposes this
was not construed to be adiscountorbargainpurchase.Thereasonswhythepurchasewasnotsoconstruedwasthatbased on what the tangibleswere in Corporation’sbusiness on September 20,1968 (thepurchasedate), theshares were not even worth$1.Also,othersalsopaid thesame price at that time. HadIRS considered the shares abargain purchase, these
executiveswouldhavehadtotreat the difference betweenthe fair value of the sharesreceived (26, for taxpurposes) and the $1 per-share cost as employmentcompensation to be taxed atordinary income rates. If thathad been the case, it is veryprobable some or all of theexecutives would haveconsidered the right to buyshares at $1 per share on
September 20, 1968, assomething with a negativevalue.Also, these five executives
received, in the form ofequity ownership incentive,qualifiedstockoptionsaspartof a program under whichdesignated employees,includingcertainofficers anddirectors of Brewing,received options to purchase98,134 Corporation common
at 26. The options weregranted at fair market value(26pershare)onthedatetheunderwriting agreement wassigned.Theseoptionsweretoexpire five years from thedateofgrantorearlier in theevent of termination ofemployment, disability, ordeath. In thecaseofsomeofthe options, if they were notexercisedduringthefirstfouryearsaftergrant, theexercise
price could be payable byborrowing 90 percent of therequired funds fromCorporation. Suchborrowings would bearinterest at 4 percent, and thenotes would be repayable atthe rate of 20 percent peryear. Put simply, thesequalified options permittedthe holders’ potential profit,onatax-shelteredbasis,fromappreciation in Corporation’s
stockprice,withoutanycashoutlayatallforfiveyearsandwithveryattractivefinancingtermsforthenextfiveyears.The tax shelter existed
because theoptionswere, forIRS purposes, “qualified.” Ifthe employees had receivednonqualified or nonstatutorystockoptions,thentheexcessof the fair value of thoseoptionsovertheircostwould,in the majority of cases and
unlesscarefullystructured,betaxable as employeecompensation in the year ofreceipt.Theworsttaxpostureataxpayercanfindhimselfinwould result from such anonstatutorystockoption.As the operating heads of
Brewing and its parent,Corporation, the officers anddirectors of the publiccompany now foundthemselves influenced by a
different discipline fromwhen they were officers anddirectors of a privatecompany with excessfinancial resources. Thedifferent discipline was notnecessarily better or worse,butitwasdifferent.
1. In a public company,all other things beingequal,thereisatendencytoward moreaggressivenessinstriving
for near-term results andless emphasis on long-range planning,especially if such long-range planning mightadversely affect near-term profits. Forexample, there might beless institutionaladvertising.2. In a public company,there is a tendencytoward making reported
results as good aspossible, even though itwould make actualeconomic results worsethantheyoughttobe.Forexample, theCorporation-Brewingtransaction could havebeen structured so thatdepreciation chargesagainst income wouldhave been based onCorporation’s purchase
price for Brewing, $106million, rather than onBrewing’s net assetvalue, $53 million. Thetax savings would havebeen highly significant.However,ifthathadbeendone, Corporation’sreported earnings from1969forwardwouldhavebeen substantially lower,with consequent possibleadverse effects on stock
market valuations. Forpublic companies, stockmarket consciousnessfrequently takesprecedence over taxconsciousness andunderlyingbusinessvalueconsciousness. In privatecompanies, the questionusually never arises; theprivate companywilloptfor maximum taxsavings.
3. With the public aspartners, Corporation’sand Brewing’sexecutives,aswellasthecorporation itself,became subject to awhole gamut of newdisciplines in terms ofwhat they were requiredto disclose in thewayofinformation and theliabilities to which theybecame subject, both to
government authoritiesand stockholders,becausetheywerepublic.4. Managements withpublic stock to use tendto be more conscious ofvaluesthatcanbecreatedby using the stock,especially when it isselling at a liberal price.This, for example,manifests itself incertainpublic companies having
active merger,acquisition, andrefinancingprograms.
TheCommercialBankProvidingBridge
FinancingFirst National City Bankprovided $24.9 million ofloans to Corporation withinterest at the prime rate. Inaddition, the bank received a
commitment, or standby, feeequal to an annual rate of 1/8percentoftheunusedbalance(that is, the portion of the$24.9 million not borrowed)from September 26, 1968, tothe closing or December 31,1968, whichever was earlier.Subsequently, thecommitment fee on theunusedbalancewasincreasedto¼percent.These loans, inthe form of short-term notes,
were issued inJuly1969andwere retired within one yearas the seven institutionsinvested their funds intoCorporation in the form oflong-term senior notes andsubordinated notes.Corporation did have theright toprepay thebank loanat any time, but would haveincurred a ¼ percentprepaymentpenalty if itusedfundsobtainedbyborrowings
at a lower interest cost thanFirst National City’s primerate.From the bank’s point of
view, the loan in the formofbridge financing seemedreasonably safe. First, therewas the take-out by thepermanent lenders, the seveninstitutions who werecommitted to invest furthersums on January 15, 1970,and July 15, 1970, the first
proceedsofwhichweretobeusedtorepaytheseshort-termnotes. Second, Corporationconsolidated with Brewingwas a profitable, growingbusiness with operatingearnings in excess of $1million per month, asubstantial balance-sheetcushionbehindthesenotesintheformofabout$12millionof subordinated notes,$20 million of junior
subordinated notes and astockholder’s equity(including over $50 millionof nonamortizing good will)of about $37 million. Also,Corporationwasmanagedbya highly reputable andsuccessfulgroup.Returns to the bank
exceeded merely interest attheprimerate.Theloanitselfprobably requiredcompensating balances of 10
percent to 20 percent of thenotes outstanding to be kepton deposit. First NationalCity may also have becomethebankofdeposit,aswellasthe lending bank, inconnection with otherCorporation activities, andthe transactions may haveresulted in creating trustbusiness for the bank.As faras corporate trust activitiesare concerned, FirstNational
Citydidbecometheregistrarfor Corporation common.Asfar as personal trust isconcerned, First NationalCity could conceivably haveobtained investmentmanagementand/orcustodianbusiness from the Schaeferfamilyinconnectionwiththehandlingoftheirportfolios.Although the financing of
acquisitions is attractive,banks view it as the least
productive part of theirlending activities. These arevirtually the first loans to becut out in periods whenmoney is tight or generallyunavailable,as in1966, from1969 to 1970, and again in1973 and 1974 and 2008–2009.
TheWallStreetPromoters
Pressprich, thenaprestigiousNew York Stock Exchangemember firm, appeared tohave profited handsomelyfrom the transaction underwhichCorporationpurchasedBrewing’s equity securitiessimultaneously withCorporation’s going public.Off the top, Pressprichreceivedfeesof$425,000forarranging Corporation’sfinancing; and for $.42 per
share, or a total of about$67,000, Pressprichpurchased 160,000 commonfivemonthsbeforethepublicsubscribed to freely tradablesharesofthesameissueat26per share (equal to$4,160,000 for 160,000shares). The 160,000common held by Pressprichwere, for SEC purposes,unregistered, or restricted,shares; in any event,
Pressprich had agreed withCorporation not to sell theshares to anyone beforeMarch15,1971,withoutfirstoffering the shares toCorporationat$.42pershare.Even with these restrictionson resale, the 160,000 shareacquisition seemed to havebeen quite a bargain forPressprich from any point ofview except that of theInternalRevenueService.
Less visible and lesstangible were other benefitsto Pressprich. First, the firmgained two seats onCorporation’s board ofdirectors, which probablyresulted in small fees andelements of control overimportantassets.“Control,”amany-faceted concept, couldextend, for example, tohaving Pressprich’s directorsinfluence the company in
registering shares fordistribution with the SEC,including the 160,000 sharesheld by Pressprich. In thenormal situation, however,the Pressprich directorswould be outside directors,andtheirdefactocontroloverthe affairs of Corporationwouldbemanifestlylessthanwould the inside directors’and management members’,whetherdirectorsornot.The
liabilities of the outsidedirectors, however, couldeasily be just as large asanyone else’s in the case ofjudicial or administrativefindings of wrongdoing thatharmed Corporation or itsstockholders. (This is whymany people are reluctant toserve on boards, especiallysince neither corporateindemnification provisionsnor directors’ liability
insurance can give a directorassured insulation fromliabilities. Yet, on balance,most people probably feelthere is anetbenefit to themandtotheirorganizationfromserving as outside directorson the boards of publiccorporations.)Another benefit that may
well have been available toPressprich was futurebusiness from happy clients.
The happy clients were oftwotypes,bothofwhomhadenormous amounts ofinvestible funds (the sort ofclients that investmentbankersandstockbrokerslikePressprichlikebest).Thefirstset of clients were theshareholdersofBrewingwhoreceived$86million in cash,namely, the corporationcontrolled by RudolphSchaefer, Arjayess, and the
four trusts for the benefit ofvarious members of theSchaefer family. The secondset of happy clientswere theseven institutions thatpurchased corporation seniorand subordinated notes withequity privileges, which bythemselves seemed areasonable investment. Theseinstitutionsalsosplitamongstthemselves150,000sharesofCorporation common
purchasedfor$1pershare.Finally, the successful
completion of Corporation’spublic underwriting andsubsequent favorable marketaction for Corporation stockunquestionably enhancedPressprich’s reputation, bothwithin the financialcommunityandwithothersofmeanswhowere seeking thecreative finance that theSchaefer case had
demonstrated.Thesuccessofthe transactions, therefore,could easily result inPressprich’sgainingaccesstomuch more new investmentbankingbusinessunrelatedtotheSchaefertransactionsthanwouldhavebeenthecasehadPressprich not concludedsuccessfully the Schaeferdeal.One footnote is that
Pressprich was a member of
the National Association ofSecuritiesDealers,commonlyknown as the NASD. AllNew York Stock ExchangememberfirmsarealsoNASDmembers. The new (since1970) NASD Rules of FairPractice that relate tocorporate financing wouldhave prevented Pressprichfrom doing what it did in1968.First,Pressprichwouldhavehadtohaveheldits$.42
stock for at least six monthsandinallprobabilityoneyearbefore Corporation couldhave gone public. If it didnot, the NASD probablywould rule under currentregulations that the $.42purchasepricewasintegratedwith the $26 public offeringand resulted in Pressprichreceiving unreasonablecompensation. Also, if thetransactions were to be
undertaken now, it is quitepossible that the NASDwould rule that Pressprich’spurchase of stock would belimited to 10 percent of thepublic offering. TheCorporation public offeringwas for 1.5 million shares,which would limitPressprich’spriorpurchaseto150,000shares.In any event, Pressprich’s
discountpurchaseof160,000
shares appears to have beenperfectly legitimate in 1968andwascertainlynotthenanuncommontransactionwithintheinvestmentcommunity.
TheUnderwritersofthePublicIssueandTheirSecurities
SalesmenWhen Pressprich becameinvolved with the
Corporation-Brewingtransactions, it wascontemplated that R. W.Pressprich and Companywould manage theunderwriting of 1 millionCorporation common ataround 26, which laterincreased to 1.5 millionshares. In fact, when thepreliminary registrationstatement was filed with theSecurities and Exchange
Commission on September26, 1968, R. W. Pressprichand Company was listed asthemanagingunderwriter.We do not know the
reasonswhyWhite,WeldandCompany was substituted asmanaging underwriter forPressprich, and whyPressprichwasnotamemberof the Corporation’sunderwriting group in anycapacitywhenthe1.5million
shares were marketed onNovember 27, 1968. Theprobabilities are that theNational Association ofSecurities Dealers, under itsRulesofFairPracticeastheythen existed, frowned onPressprich or any Pressprichaffiliate participating in theCorporation underwriting,because only a few monthspreviously Pressprich hadpurchased 160,000 shares at
$.42 per share. When thepreliminary registrationstatement was filed with theSEC, the maximum filingpricewas26.TheswitchfromPressprich
toWhite,Weldbringstolightthree important points. First,in putting together complextransactions, things rarely, ifever, go smoothly, and allsorts of changes are usuallymade in midstream. Second,
itislikelythatthepartofthecompensation to Pressprichconsisting of financial feesand bargain purchases ofCorporation stock were ineconomic fact payments forarranging the publicunderwriting.Third,itwouldappearasif
White, Weld, as managingunderwriter, wasundercompensated, comparedwith what was received by
certain other insiders andquasi-insiders, namely theselling stockholders,Pressprich and the lendinginstitutions. After all, theachievement of the publicdistributionandtheraisingofover $30 million was a sinequa non. Yet, White, Weldpurchased no discount stockand received no special fees:it participated only in itsshare of the underwriting
spread, or discount, of $1.56pershare,or$2,340,000.Under the NASD Rules of
Fair Practice, as well as inconnection with certain bluesky laws, it may have beeninappropriate for theunderwriters to seekmateriallygreateramountsofcompensation. Even so, thetransaction probably was areasonably profitable onefromWhite,Weld’s point of
view. White, Weld obtainedbyfarthelargestparticipationin the underwriting, 218,000shares,or14.5percentof the1.5-million-share issue. Thenext-largest participation fora firm in the underwritinggroup was 33,000 shares,taken down by Dillon, Readand Kuhn, Loeb. The next-lowest bracket was 22,000shares, and firmsparticipatingatthislevelwere
Halsey, Stuart; Kidder,Peabody; Lazard Freres;Lehman Brothers; Paine,Webber, Jackson and Curtis;Paribas; Shields; Stone andWebsterSecurities;andG.H.Walker. Since the issue wasindemand,theseunderwritersand their sales forces wereable to realize their allottedcompensation both forperforming the underwritingfunction and as selected
dealers.Compensation to White,
Weld,otherunderwriters andmembersofthesellinggroup,most or all of whom werealsounderwriters,wasspelledout in three agreements thathadbeenpreparedpreviouslybut that were executed onNovember 26, 1968, the daythe offering was declaredeffectiveby theSECand thedaybeforetheactualoffering.
The first agreement was theUnderwriting Agreement(sometimes called thePurchaseAgreement),enteredinto between White, WeldandCorporation. The secondagreement was theAgreement AmongUnderwriters (sometimessimply called the AgreementAmong) between White,Weld as representative of allthe underwriters and each
individualfirmthatbecameapartytotheunderwriting.Thethird agreement was theSelected Dealer Agreementbetween White, Weld asrepresentative of theunderwriterandeachselecteddealer.The Underwriting
Agreement spelled out inspecifics the various termsbetween White, Weld andCorporation, including the
representations andwarranties each gave to theother, the conditions ofclosing,indemnifications,andso on. Briefly, Corporationagreed to sell to each of theunderwriters, andeachof theunderwriters agreed topurchase, the specifiednumberofCorporationsharesallotted to them (218,000 forWhite, Weld) at $24.44 pershare. Payment was to be
made to Corporation onDecember4,1968,oneweekafter the offering, but in noevent more than eightbusinessdaysafterDecember4.The Agreement Among as
well as the Selected DealerAgreementgaveWhite,Weldstrong control over how theissuewouldbemarketedandbywhom.OneofthemattersintheAgreementAmongwas
that the underwriterswere toact severally, not jointly, sothatdefaultbyonememberofthegroupwouldnotmakeallother members liable. Ineconomic terms, theAgreement Among and theSelected Dealer Agreementoutlined how the $1.56underwriting discount (thedifference between the $26public offering price and the$24.44 to be paid to
Corporation) was to be split.In tabular form, the splitwastobeasshowninTable27.5.Table27.5CompositionoftheSpreadbetweenWhatCorporationandOthersGet
The $.85 concession toselected dealers is basicallysales compensation, equal toabout a triple commissionover the standard New York
Stock Exchange commissionrates. The extra promotionalconsideration available tosalesmen, some of whommight obtain close to 50percentofthethen$.85,goesalongwaytowardexplainingwhy the financial communityhas such a vested interest inpromoting new-issue booms.It also explains why thesecurities laws are sowrittenthattheSECtriestomakeits
rules and laws onconditioningmarketssomuchstricter when underwritingsareinvolved.Handling a good-grade hot
issue such as Schaeferbrought other benefits toWhite, Weld. First, itunquestionablybroughtprofitcontributions and overheadcoverage to its underwritingdepartment. Second, itbenefitedWhite,Weld’ssales
force by giving themattractivemerchandise to sellandatratesthatallowedthemhigh compensation for aneasy sell. Third, it enhancedWhite, Weld’s ability toparticipate in underwritingsmanagedbyothers:Theoddsare that because Kuhn, Loeband Lehmanwere invited byWhite, Weld into importantpositions in Corporation’sunderwriting, Kuhn, Loeb
and Lehman would be moredesirous of inviting White,Weld into their underwritinggroups for attractive issuesthan would otherwise havebeen the case. Also, in theevent White, Weld was tofind itself in the type ofpromotional position thatPressprich was in, in thesetransactions, Pressprich orothers might be moresympathetic to managing an
underwriting of a White,Weld deal than it wouldotherwise.
TheInstitutionalLendersProviding
Long-TermFinancingThe seven financialinstitutions had two reasonsforinvesting$65millionintoCorporation’s senior notesand subordinated notes. First
and—at least in the case ofthe six insurance-companyinvestors—foremost was thethesis that these werereasonably safe long-termloans affording a cash returnintheformofinterestincomeclose to what good-gradebonds were then paying.Second,theseveninstitutionsobtained very significantequity kickers in the formofthe discount purchase of
150,000commonat$1andofwarrantstopurchasebetween84,866 and 130,563 commonat a price that could be 75percent below the marketprice three years later; theyalso gained the right toconvert $1,151,340 ofsubordinated notes intocommonstockataprice thatcouldbe75percentbelowthemarketprice threeyears later(or$6.50ashare).
It should be noted,however,thatonconservativeanalysis the total$65millioninvestment could at best becalledonlyfairlysafe.Itwasfar from risk-free, since$27,857,143(or42.9percent)of the $65 millioncommitmentwas in the formof subordinates. Thus, in theevent Corporation sufferedseriousfinancialreverses,thesubordinates could be junior
in payment not only to theseseniornotes,butalsotoothersenior notes that might beissued in the future. On anoverall basis, these issuesfailedfourofthesevensafetytestspromulgatedbyGrahamand Dodd in SecurityAnalysis (4th Edition,McGraw-Hill1962).(Grahamand Dodd advise forgoinginvesting in any seniorsecurity that ever fails one
test.) Corporation’s seniorsecurities seemed to havequalified under the followingthreetests:
1.Natureand locationofthebusiness2.Sizeoftheenterprise3.TermsoftheissueTests where these $65
million of securities werefoundwantingwere
1.Recordofsolvency,at
least insofar asCorporation wasconcerned,since itwasanew entity operatingunder a new (that is,public)discipline2. Relationship ofearnings to interestrequirements3. Relationship of thevalue of the property tofundeddebt4. Relationship of the
stock capitalization tofundeddebtInterestingly enough,
Graham and Dodd do nothave an eighth test, whichmaybethesinglemostdirecttest of senior security safety—the relationship of cashflow to debt service, or thecash flow available to meetboth interest and principalpayments.Although the institutional
investors would hardlyconsider the $65 millionloans top drawer from asafety angle, theywere goodenough.Theimportantaspectwas the equity kicker. Inappraising the equity kicker,the institutions looked atthreethings:
1. The discount frommarket at which theycouldobtainshares.2. The appraisal of the
outlook for the business,on the theory that thelong-term price of thestock would tend to berelated to theperformance of thecompany (in thisanalysis, the institutionsused many of the samevariables that were usedwhen appraising thesafetyoftheloan).3. The rights of
registration that wouldpermit the institutions todisposeoftheshares.Rights of registration were
more important to the seveninstitutions than theywere tothe other purchasers ofdiscount stock, namely, thesellingstockholders,Brewingexecutives, and Pressprich.These purchasers were allrepresented on the board andmight be in a position to
influence the company toregister the shares they heldwith the SEC. The seveninstitutions,incontrast,couldonly be assured ofregistration rights incontractualprovisions.Registration rights are
extremely valuable topurchasers of unregistereddiscountsecurities,especiallythose who acquire largeamounts of restricted
securities.Forthoseacquiringsmall blocks of restrictedsecurities, the use of theSEC’s Rule 144, in effectsince April 15, 1972, ispractical.Just how valuable
registrationrightsaredependson the various contractualrights embodied in theagreements that relate to thestockmarketsituationfortheparticular securities. The
contractual provision can bequite diverse, ranging fromvery strong to almostmeaningless. (Registrationrightsalsoencompassmattersnotdiscussedherebutthatareessentially legal, such asindemnification provisionsand agreements to supplydocumentation.)Wethinktheregistrationrightsreceivedbytheseveninstitutionallenderswere very strong. Briefly
reviewed, the principaleconomic provisions of theregistration rights to theinstitutionalinvestorswereasfollows:Effective date. Theinstitutions’ rights ofregistration becameeffective January 15,1971,orabout twoyearsafter the initialinvestment. Incidentally,Pressprich obtained
registration rights thatwere different from theinstitutions’ rights andthat became effectiveMarch15,1971.Expirationdate.None.Demand, or trigger,rights. This refers to theright of a security holderto require a company tofile a registrationstatement enabling thebeneficiaries of such
registration rights topublicly offer theirshares. The institution orinstitutions could makefour such requests;Pressprich could makeone.Piggyback rights. Thisrefers to rights to haveholders’ shares includedinaregistrationstatementfiled by the company orby other selling
stockholders. Theinstitutions andPressprich had unlimitedrights in this regard. It isadvantageous to be ableto piggyback, but itfrequently isdisadvantageous to bepiggybacked by others.For example, assumeJohn Hancock and NewYork Life used a triggerright to register 75,000
shares for sale. Leftalone, the 75,000 sharesmight be sold at or nearthe market price.However, the agreementwould give all otherholders of restrictedsecuritiestherighttojoinin, or piggyback, anyregistration. The JohnHancock and New YorkLife request to register75,000 shares could
easily result in, say,530,000 shares beingregistered and sold. Thiscould result in severelydepressing the marketprice, or as a practicalmatter, making sale ofJohnHancock’sandNewYork Life’s 75,000sharesunachievable.Number of timesregistration can berequested. In the
institution’s case, it wasfour for trigger (one forPressprich),unlimitedforpiggyback.Expenses. With minorexceptions, expenseswere to be borne byCorporation.Requirement thatregistration beunderwritten.None.Obligationofcompanytokeepregistrationeffective
afterninemonths.Yes.
ThePublicInvestorsThoseof the investingpublicwhowerefortunateenoughtoget in on a new hot issue atthetimeoftheinitialofferingpaid 26 per share forCorporation common onNovember 27, 1968.Pressprich had paid $.42 pershare five months before for
Corporation common, andothers had paid $1 per sharejust twomonths before. Andthepublicstoodinlinefortheprivilege!The Corporation common
stock bought by the publicwasnot,ineconomicfact,thesame Corporation commonpurchased by insiders andquasi-insiders. For one thing,any public shareholder wasfreetodisposeofhissharesat
any time. Indeed, any publicpurchaser who obtained hisshares on the initial offeringcould have disposed of hisstock at a profit at any timefrom the afternoon of theoffering through April 1971,aperiodofalmost30months.The purchasers of discount-priced securities, however,were prevented from sellingany stock before January1971 at the earliest. In each
instance, the purchasers ofdiscount securities weresubject to a number ofconstraints or were requiredto perform special services;the public investors, though,were purely passive andassumed no obligations.Thisis not to say that the publicreceived a highlyadvantageous positioncompared with the Schaeferfamily, Brewing executives,
Pressprich,ortheinstitutionallenders;thatwouldbesilly.Itis to say that the publicinvestors were marching, ordo march, to the beat of adifferent drummer from thepromoters’andinsiders’.Asaconsequence, by thestandards used by the publicthe $26 issue price was abargain.The public in 1968 tended
to be uninterested in things
that contributed to value iftheydidnotalsocontributetomarket performance. Thepublic stockholders acquiringCorporation common stocksought, above all, immediatestock market performance.New issues such asCorporation’s offering gavegreat promise in 1968 ofimmediate performance forthefollowingreasons:
1. Underwriters
consciously try to pricenew issues so that theywill sell at premiumsafter the offering.Normally, the strongestdeterminant of a marketprice will be industryidentificationas it relatesto earnings, especiallyearnings trends. Inpricing Corporationcommon where theearnings trend was
favorable, theunderwriters appeared tohaveattachedtoSchaefera price-earnings (P/E)ratio moderately belowthat at which otherbrewing equities withfavorable operatingtrendswereselling.2. Good marketperformance is morelikely to occur when anissue is well sponsored.
Corporation’s bankersand promoterswerewellregarded;itsunderwritinggroup was top drawer;investors in thecompany’s commonstock included veryastute names, such asJohn Hancock, InvestorsSyndicates, and NewYork Life; and the issuewas to be listed on theNew York Stock
Exchange.3. Securities salesmenlove to push new issues.A rule of thumb in 1968was that salesmen’scompensationforplacinga new issue should beaboutthreetimesthethenstandardNewYorkStockExchange commissionfor an order of similarsize.Sales forces tend totalkupnew issues, if for
noother reason than thattheyareveryinterestedinthem.This contributes tocreating instantperformance.It would have been
difficult, ifnotimpossible, tohaveBrewingorCorporationgo public via an offering ifthebusinesswasnotonewitha favorable industryidentification and a “growthstory.” In 1968, virtually all
the companies in the new-issue boom had growth-industry identifications inareas such as computers,electronics, franchises, andnursing homes. There werelittle or no sales of commonstocks of companies goingpublic for the first time inindustries such as railroads,textiles, or general-line fireandcasualtyinsurance.Yet there are things other
than positive industryidentification and growthprospects that contribute tovalue. For example, inBrewing itself one of thegreat elements of value toothersthanthepublicwasthefact thatBrewinghadunusedfinancial resources; this wasone of the bases givingCorporation the ability toborrow $65million from theseven institutions. Other
elements of value that thepublic would not normallyconsider include usable tax-loss carryforwards (or betteryet, creatable tax losses) incompanies unencumbered byother obligations, and largeasset values, whetherreflected in accountingfiguresornot.In fact, the trick in
underwriting is that if anequity security is discount-
priced based on businessstandards, it probably cannotbe underwritten. The publicthatbuysnewcommon-stockissues tends to want instantperformance, which cannotbegottenoutofan issue thatis not susceptible to beingmade popular. If an issue ispopular, it is unlikely to bediscount-priced based onbusiness standards.However,once an issue has an
identification that makes itsusceptible to popularization,the underwriter will (a)popularize it and (b) try toprice it at a discount basedsolely on stock marketstandards—that is, it will bepriced at a P/E ratiomoderately below the P/Eratio at which the stocks ofsimilar companies that arealreadypublicsell.In giving the public a
discount in new issues basedon stock market standards,the underwriter tends to bemoderate, not gross in hisrelative underpricing. Thepublic, after all, tends tobuynew-issue sizzles, not steaks,in the form of ephemerals(sponsorship, P/E ratios,growth, and so on) that theybelieve should contribute toimmediate performance.Purchases are not based on
any fundamental bedrock ofreal knowledge about thebusiness.Thus,suspicionsareeasily aroused. Too low aprice—say, offeringCorporationstockat10timesearnings when Anheuser-Busch is selling at 20 timesearnings—woulddetractfromthe salability of theCorporation common-stockissue, whereas an offering at16 times earnings probably
wouldcontributetoit.
TheNewPublicCompany
Asmentionedpreviously, theBrewing operation has beentransformed into a new onewith a different discipline—not better or worse, butdifferent.The differences areoutlinedinTable27.6.Table27.6TransformationofOld
BrewingintoaDifferentDisciplineNewCorporation Old
BrewingHeavydebtload Excess
financialresources
MoreattunedtoimmediateresultsRequirementsforpublicobligationsincludingfilingsAcommonstockusableforemployeeincentivesAcommonstockusableforacquisitionsEmphasizesAFF— Emphasis
accountingfudgefactor—reportedearnings.(EspeciallypronouncedisfailuretowriteupassetstoreflectCorporation’s$106millionpurchasepriceforBrewing’sequitysecurities.)
ontaxshelter
SUMMARYDeals are not like a chessgame, where by definition ifonesidewins,theotherloses;they are not zero sum. A
well-structured deal hassomething in it for everyone.Few readers of or writers onfinancewilleverbe involvedinthedesignandarchitectureof a deal of the dimensionsdescribed here. But anunderstanding andappreciation of its structureshould help to provide someinsights into therealitiesofaworld of finance rarely seenbutalwayspresent.
_______________*ThischapterisanupdatedreproductionofAppendixIinTheAggressiveConservativeInvestorbyMartinJ.WhitmanandMartinShubik(©2006byMartinJ.WhitmanandMartinShubik).ThismaterialisreproducedwithpermissionofJohnWiley&Sons,Inc.1Oneindicationthat
Brewing’saccountingpracticeswereconservativewasthatBrewing,whichwaschargingover$4millionperyearagainsttheincomeaccountsfordepreciation,usedthesamedepreciationmethods(the200percent,double-declining-balancemethod)forbookpurposesasitdidfortaxpurposes.NordoesthefactthatBrewingflowed
throughinvestmentcredits,whichamountedto$275,000in1967,indicateotherwise;theamountinvolvedwassmall,particularlycomparedwithdepreciationcharges.Thecompany’sfive-yearstatementshadbeenauditedbyPriceWaterhouseandCompany,andcertifiedclean.2Brewinghadplansto
constructanew1.7-million-barrelfacilityineasternPennsylvania.TheinitialphaseofthePennsylvaniaconstructionwastoprovidean850,000-barrelannualcapacityatanestimatedcostofapproximately$38million,or$44.71perbarrel,somefivetimesasmuchasthenetbookvalueofexistingplant.Evenassumingthattheremainder
oftheproposedPennsylvaniaplantcouldbebuiltforarelativelysmallsum,thetotalcostwasunlikelytobelessthan$25perbarrel,orsomethreetimesthenetbookcarryingvalueoftheexistingplant.Notwithstandinganyotherfactors,suchaslabor-savinginnovationsandotherefficienciesinnewplants,Brewing’sproperty,plant,
andequipmentdonotseemtohavebeenovervaluedonthebooks.3Parenthetically,restrictedsharesissuedafterthepassageofRule144inApril1972couldonlybesoldpubliclypursuanttothatruleorviaregistration.Noactionlettersandchange-of-circumstancesopinionsnolongerexistedinsuchcases.From1972untillate1978,
whenresalerestrictionswereliberalized,salesunderRule144couldoccuronlyonceeverysixmonths,andthenumberofsharesthatcouldbesoldwaslimitedtothelesserof1percentoftheoutstandingstockofthecompany,ortheweeklyaveragetradedforthefourweeksprecedingthefilingofaForm144.4Theothermembersof
Corporation’stwelve-manboardofdirectorswerethreeSchaeferfamilymembers,threeexecutivesofBrewing,twoexecutivesofPressprich,andtwooutsidedirectors—thechiefexecutiveofficerofUnitedAircraftandavice-chairmanoftheboardoftheFirstNationalCityBank.5CorporationalsoenteredintoanagreementwithFirst
NationalCityonNovember25,1968,underwhichthebankwouldprovideanyinterimfundsthatmightbeneededtomeetthepaymentsduethefourSchaefertrustsbyJuly15,1969.Thiswasestimatedatunder$25million.6Insomeinstances,warrantscanbeexercisedbythesurrenderofseniorsecuritiesvalued,for
purposesofexercise,atpar.Iftheseniorsecurityhasamarketvalueoflessthanpar,thenthesenior-security-warrantpackagebecomestheequivalentofaconvertiblesecurity.7Thisphenomenonreacheditspeakinrecentyearswiththedebtrestructuringofanumberoftroubledrealestateinvestmenttrusts.Incertaininstances,suchas
ChaseManhattanMortgageandRealtyTrust,seniorlenderseveninvestednewfundsintherealestateinvestmenttrusts,partofwhichwereinfactusedtocontinuetofullyservicethesubordinateddebentures.8Atyear-end,itspricewas30bid.Corporation’sstockwaslistedfortradingontheNewYorkStockExchangeonJanuary24,1969.
9Thisgrossspreadwasaboutstandardforafairlylargenew-issueofferingofanindustrialissuergoingpublic.Althoughtherehavebeennewissuesofcommonstockmarketedatasmallergrossspreadwhenacompanywasgoingpublic(mostnotablyCommunicationsSatelliteCorporation,orComsat,whosegrossspreadwas4
percentwhenitwentpublicin1965),thisisunusual.Smaller,unseasonedissuerscallforhighergrossspreads,frequentlyashighas18percent,exclusiveofotherconsiderations—suchascontinuedfinancialconsultingfees,boardrepresentation,andrightsoffirstrefusalonfuturecompanyofferings—grantedtotheunderwriter.
10Thissalescommissionof$0.85,or$85per100shares,wasconsiderablyhigherthan$0.32pershareor$32per100sharessellingat26,thestandardcommissionprevailingin1968forroundlots(usually100shares)ofoutstandingstocklistedontheNewYorkStockExchange.
GlossaryofAcronyms
AFFATPAUMBAPCPABIPSCAPMDCF
Accounting fudgefactorArbitrage pricingtheoryAssets undermanagementBankruptcyAbuse
DIPEPTE&PE&PEBITDAEMHEPSEVEVAFASBFFFINRAG&D
Prevention andConsumerProtection Act of2005BasispointsCapital assetpricingtheoryDiscounted cashflowsDebtor inpossessionEfficient portfoliotheory
GAAPGADCPGARPGDPGPIFRSIPOIRCIRS
Exchange andpurchaseagreementExploration andproductionEarnings beforeinterest, incometaxes,depreciationandamortizationEfficient markettheoryEarningspershareEnterprisevalue
Economic ValueAddedFinancialAccountingStandardsBoardFundamentalfinanceFinancial IndustryRegulatoryAuthorityGraham, Dodd,and Cottle. Refersto their book
Security Analysis:Principles andTechnique, 4thEdition (McGrawHill1962)GenerallyAcceptedAccountingPrinciplesGrowth at dirt-cheappricesGrowth atreasonableprices
Gross domesticproductGeneralpartnerInternationalFinancialReportingStandardsInitial publicofferingInternal RevenueCodeInternal RevenueService
IRRLBOLPLTMM&AMBOMCTNAVNINPVNTMOPMOPMI
Internal rate ofreturnLeveragedBuyoutLimitedpartnerLast twelvemonthsMergers andacquisitionsManagementbuyoutModern capitaltheoryNetassetvalue
PEPEGPFICPGPIIGSPITAPORPPMPRREITROAROE
NetincomeNetpresentvalueNext twelvemonthsOther people’smoneyOutside passiveminorityinvestorPrice earningsratioPrice earnings togrowthratioPassive foreign
ROIRRASBASECSOTTTARPTIATSYTM
investmentcompaniesPromotergroupPortugal, Ireland,Italy, Greece andSpainPain in the assinvestingPlan ofreorganizationPrivate placementmemorandumPublicrelations
Real estateinvestmenttrustReturnonassetsReturnonequityReturn oninvestmentReserverecognitionaccountingSmall BusinessAdministrationSecurities andExchange
CommissionSomething off thetopTroubled AssetReliefProgramTrust IndentureActof1939TaxshelterYieldtomaturity
AbouttheAuthors
MARTINJ.WHITMAN,
CFARegarded as the Dean ofValue Investing, Martin J.
Whitman has proven aneffective value investor incommon stocks and an adeptcontrol investor who has ledthe rehabilitations ofcompanies in variousindustries over the past fivedecades.After serving in the U. S.
Navy during World War IIand attending SyracuseUniversity and GraduateSchool at Princeton
University on the G.I. Bill,Mr.WhitmanjoinedtheranksofWallStreetasananalystatShearson Hammill & Co.Later, while working at thefamily office of WilliamRosenwald, son of a founderof Sears Roebuck, hedeveloped a risk aversioncommensurate with theresponsibility of managinganother family’s legacy. Hisability to find safety through
the careful study of assetsenabledhimtoventurewhereother investors would not,like the bankrupt PennCentralRailroadsecureddebtor the mortgage debt oftroubled utilities, such asGeneral Public Utilities andthe Public Service CompanyofNewHampshire.Mr. Whitman founded his
own brokerage firm in 1974and the predecessor to the
ThirdAvenueFundsin1986.He managed the flagshipThird Avenue Value Fundfrom its inception in 1990through 2012 and was ThirdAvenue’s Chief InvestmentOfficer from its foundingthrough January 2010. Hecontinues to work closelywith Third Avenue’sinvestmentteam.For over 30 years, Mr.
WhitmanwasaDistinguished
Management Fellow at theYaleSchoolofManagement.He frequently teaches atSyracuse University andColumbia University. He isalso an honorary trustee ofSyracuse University, hisundergraduate alma materand home to the WhitmanSchool of Management,which isnamed inhishonor.He is the author of TheAggressive Conservative
Investor (Wiley InvestmentClassics, 2005), ValueInvesting: A BalancedApproach (John Wiley &Sons,1999)andco-authorofDistress Investing:Principlesand Technique (John Wiley& Sons, 2009). He holds amaster’sdegreeinEconomicsfromTheNewSchooland isamagnacumlaudeSyracusegraduate. Mr. Whitman is aboard member at Tel Aviv
University’s Institute forNationalSecurityStudies.
FERNANDODIZ,PHD
Dr. Diz is the ManagingDirectorofTheOrangeValueFund, LLC, a fund whoseguiding investing philosophyis “safe and cheap.” He isalso the Martin J. Whitman
Professor of Finance and theDirector of the BallentineInvestment Institute atSyracuse University’sWhitman School ofManagement.Afterobtaininghis doctorate from CornellUniversity in 1989, Dr. Dizworked and did research inthederivativesarea,becameacommodity trading advisor,and founded M&E FinancialMarkets Research, LLC
where he managed a futuresportfoliountil themid-1990s.He has been working withMr. Whitman since he firstmet him two decades ago.WithMr.Whitman’shelp,hecreated theDistress InvestingSeminar,nowinitstenthyearof operation, and in 2006 hedeveloped the academiccontent for the two-yearundergraduate ValueInvesting program. He is the
co-author of DistressInvesting: Principles andTechnique,a book that is theoutcomeofDr.Diz’andMr.Whitman’s collaboration inco-teaching the DistressInvestingSeminars.Professor Diz’s research
has appeared in manyacademic journals as well asin industry publicationsincluding the Review ofFinancial Studies, The
Journal of Futures Markets,Managed Account Reports(MAR), Barclay ManagedFuturesReport,EnergyintheNews, Metals in the News,Futures Magazine, TheJournal of BankruptcyPractice, and others.Dr.Dizhas consulted with theIndependent Consultants toUBS andBear Stearns underthe SEC Global Settlementand with many other
companies including NewYork State Electric and Gas,El Paso Power Services,Citizens Power, Connectiv,Agway Energy, NiagaraMohawk Power Corporation,Barclay Trading Group,CaixaCatalunya,andMEFF.Professor Diz teaches
Value, Control, and DistressInvesting classes that hedeveloped with the guidanceandcounselofMr.Whitman,
and directs the ValueInvesting program atSyracuseUniversity.
IndexAActivistsAECOMTechnologyCorp.AIGAlbemarle PaperManufacturingCompanyAlcoa,Inc.Alienability
AllyBankAmbaseAmeradaPetroleumAmerican Chain and CableCompanyAmericanExpressCompanyAPB25Apple,Inc.AppliedMaterialsAssets, composition andcharacteristicsofAT&T
BBabcockInternationalBailoutsBakerFentressBankofAmericaCorporationBankruptcy, prepackaged orpreplannedBarberOilCompanyBearStearnsBensonandHedgesBerkshireHathawayBlueskystatutes
BoeingCompanyBostonCeltics,L.P.,IPOofBroadcomCorp.Broker-dealer researchdepartmentsandconventionalmoneymanagershowtheythinkproblemsfacedbyanalyses that focus onbasecaseforecastsapproach antithetical tothose used by private
businesspeople andcontrolbuyersexternalpressuresforecastingearningsconventionalanalysislack of awareness ofrelationship betweenincomeaccountnumbersand balance sheetnumbers and analyticconflictsbetweenrelatednumberslackofbalancedfocus
operatingratiosbasedonfinancial accountingstatistics, concentratingonpredicting futureearnings while ignoringexistingbalancesheetrelianceonfieldworkreliance on perceptionsofwhatothersthinktop-downanalysis
Brookfield AssetManagement
Buffett,Warren
CCapitalmarkets,accesstoCapital SouthwestCorporationCapitalstructureconservativefrom the corporateperspectiveconstituency conflictswithcorporatefeasibility
constituency stakes incorporatefeasibilitydividendpolicyequity markets,accessingresource conversion,capitalizationinretained earnings,financingwithsubstantiveconsolidation
factorsaffecting
assets, composition andcharacteristicsofcreditors, needs anddesiresofcustomandusageinvestment bankers,attorneys, andaccountants,professionaladviceofmanagements andcontrol groups, needs,desires, and proclivitiesof
OPMIs and theirrepresentatives, needsanddesiresofrating agencies, needsanddesiresofregulators, needs anddesiresof
Capital SouthwestCorporationannual per share NAV,growth rate, per sharemarket price and premium(discount)toNAV
Capitalism and Freedom(Friedman)CarlyleGroupCashdividendsroles of, in securityanalysis and portfoliomanagementandbailoutsconventionaltheoriesas a factor in marketperformanceandlegallists
placeboeffectofandportfoliomanagementsecuritiesholders,goalsof
CaterpillarInc.Cerberus,L.P.Chapter11filingCheung Kong HoldingsLimitedannual per share NAV,growth rate, per sharemarket price and premium(discount)toNAV
ChevronCorporationChryslerChapter 11 reorganizationof
CiscoSystems,Inc.CITCorporationChapter 11 reorganizationof
CitigroupCitizensUtilitiesClayton Dubilier and Rice(CDR)
Coca-ColaCompanyCommonstockmethodsforacquisitionofcash mergers throughuseofproxymachinerycash-tenderoffersopen market, cashpurchasesinprivatetransactions,cashpurchasesin
prices, influence ofreportedearningson
Company disclosures andinformationdocumentspapertrailU.S., narrative disclosuresinfreewheelingsourcesstereotypicalfilingswithSEC
Control,importanceofControlling stockholders, use
ofcreativefinancetobenefitSchaeferCorporation
Corporatefeasibilityconstituencyconflictswithconstituencystakesin
Corporate FinancialReporting in a CompetitiveEconomy(Bevis)Corporate takeover, use ofcreativefinanceinLeasco Data ProcessingCompany
Corporation Finance (Ross,Westerfield,&Jaffe)Corroon&Black“The Cost of Capital,Corporation Finance and theTheory of Investment”(Modigliani&Miller)CountrywideFinancialCorp.Creditworthinessfrom the borrowing entitypointofviewcapitalstructure
from the corporateperspectivefactorsaffecting
DDCF. See Discounted cashflowDelaware Block valuationmethodologyDiscountedcashflow(DCF)Distressinvestingfivebasictruthsof
DividendpolicyDividendscashroles of, in securityanalysis and portfoliomanagement
stockDiversificationcorporatevs.concentrationportfolio vs. securitiesconcentration
Dodd,David
viewonNAVDuplanCorporation
EE.I.duPontdeNemoursandCompanyEarningsrecord,long-termEfficient market hypothesis(EMH)EljerIndustriesSecuredBankDebtEMH. See Efficient market
hypothesisEnronEnterprisevalue(EV)EquilibriumpricingEquitymarkets,accessingErnst&Ernstv.HochfelderEurozonecrisisresolutionExxonMobilCorporation
FFacebook,Inc.FannieMae
FASB123Financial accounting, usesandlimitationsofconventionalapproachesGAAP as defining realityfor certain specificpurposesGAAP as road map fordue-diligence and lessthoroughinvestigationsreports as objectivebenchmarks
Financial InstitutionsRegulatory Authority(FINRA)FitchRatingsForestCityEnterprisesFreddieMacFriedman,MiltonFunds under management,selected companies (2011year-end)
G
GAAP. See Generallyaccepted accountingprinciplesGAAP Guide: InterpretationandApplication ofGenerallyAccepted AccountingPrinciples(Bragg)Galbraith,JohnK.G&D (Graham and Dodd).See Graham, Benjamin;Dodd,DavidGeneralElectricCompanyGeneralMotors(GM)
Chapter 11 reorganizationof
General Motors AcceptanceCorporation(GMAC)Generally acceptedaccounting principles(GAAP)as defining reality forcertainspecificpurposesas road map for due-diligenceandlessthoroughinvestigations
Georgia-PacificCorporation
GoldmanSachsGraham,Benjaminand Dodd, placed incontextfinancial accounting,usesandlimitationsofgoing concern andinvestment companyviewsofbusinessesmarket performance,importanceofmarket risk vs.
investment risk andmarginofsafetymodern capital theoryvs.OPMIdefinedOPMI perspective ofanalysisprimacy of incomeaccount andappraisalofmanagementsprimacy of incomeaccount anddiversification
primacy of incomeaccount, dividends, andcorporateusesofcashprimacy of incomeaccount and growthstocksprimacy of incomeaccount and top-downvs.bottom-upanalysisprimacy of incomeaccount and wealthcreationpromoters,
compensationofstockmarketpricessubstantiveconsolidationtrade-offs
viewonNAVGreat American HoldingCompanyTheGreatRiskShift(Hacker)GreentownChinaHoldingsGrossspreads,underwritingGrowth at dirt cheap prices
(GADCP)Growth at a reasonable price(GARP)
HHangLungPropertiesHart-Scott-RodinofilingsHayek,F.A.HellerFinancialHenderson LandDevelopmentHertzGlobalHoldings
cash payments to sponsorsand controlled investmentfundscommonstockpriceconsolidatedcashflowsEBITDAleveragedbuyoutofincomestatement
HessOilandChemicalHewlett-PackardCompanyHomeDepot,Inc.HomeInsuranceCompany
HopewellHoldings
IIBM. See InternationalBusiness MachinesCorporationIFRS. See InternationalFinancial ReportingStandardsIncomeaccount,primacyofcommon stock prices,influence of reportedearningson
long-termearningsrecordparsingwealthcreation
InstinetGroupIntelCorporationThe Intelligent Investor(Graham)International BusinessMachinesCorporation(IBM)International FinancialReportingStandards(IFRS)Investingvs.speculating
definitionsforincomeortotalreturnmethod of purchase andholdingtimehorizonoperationratherthanissuesafety of principal asavoidanceofrisktypeofsecurity
Investment Advisers Act of1940Investment Company Act of1940
Investmentriskavoidanceofmethods
componentsofminimizingspecific
InvestorA/B
JJohnson&JohnsonJPMorganChase&Co.
KKellyformulaKeyCorp.Keynes,JohnMaynardKmartKraftFoodsInc.Krugman,Paul
LLaiSunGarmentLazardFreres
Leasco Data ProcessingCompanyinstitutional investors andsubscriptionpercentages
LehmanBrothersLeveraged buyouts, privateequityacquisitionofHertzGlobalHoldingscapital markets, super-attractiveaccesstocash payments to sponsors
and sponsor-controlledfundsquestionsaboutsponsors attuned to needsof bankers andunderwritingcommunitysponsors’controlofHertz
Liquidation
MMacArthur,AlfredManagements,appraisalof
GARPvs.GADCPgrowthatdirtcheapprices(GADCP)growth at a reasonableprice(GARP)newframeworkforOPMI interests,managementsattunedtoasresourceconverters
MarginalismMarketefficiencydeterminantsof
complexityexternalforcesmarketparticipanttimehorizons
externaldisciplines,lackofcorporate monopoliesandoligopolieshedge-fundoperatorsinvestmentbankersmerchantbankersmoneymanagementotherprofessionals
promoters in tradingenvironmentssecuritiessalespeopletop corporatemanagements
externalforcesinfluencingandfairpricesintakeoversvalue investors, learningfrom
Market performance,significanceofbailouts
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