Areas of Opportunity for Value Investors: Investing in Complex Securities

I define complex securities as those with unusual contractual cash flow characteristics. Unlike bonds, which provide a constant cash stream to investors, a complex security typically distributes cash according to some contingent event, such as the future achievement of a specified level of earnings, the price of a particular commodity, or the value of specified assets. Often brought into existence as a result of mergers or reorganizations, their inherent complexity falls outside the investment parameters and scope of most investors. 

Indeed, while some complex securities are stocks or bonds, many of them are neither. As a result of their obscurity and uniqueness, complex securities may offer to value investors unusually attractive returns for a given level of risk. 

Complex securities have existed throughout modern financial history.

• In the 1930s, for example, railroad bankruptcies often resulted in the creation of income bonds, which paid interest only if the issuer attained certain levels of income. In 1958 the Missouri-Kansas-Texas Railroad Company (MKT) reorganized and issued participation certificates whose only entitlement to monetary benefit consisted of the right to have payments made into a sinking fund for their retirement. Such payments were required to be made only after accumulated earnings reached a specified level as defined in the indenture. The certificates traded for years in the illiquid pink sheet market at very low prices, partly as a result of investor neglect. In 1985 MKT was merged into the Missouri Pacific Railroad Company, and the certificates were the target of a tender offer at several times the market price prevailing earlier that year. 
• As another example of a complex security, when BankAmerica Corporation acquired Seafirst Corporation in 1983, a series of preferred stock was issued as partial consideration to Seafirst shareholders. The dividend was fixed for five years and then would fluctuate based on prevailing market conditions. The redemption price could also be reset, based on the value of certain problem loans in Seafirst's portfolio. In effect, if losses exceeded $500 million on a specified $1.2 billion pool of troubled loans, the preferred stock with a $25 original par value would likely be retired by BankAmerica at only $2 per share. Since few investors understood how to value such an atypical security, from time to time its price dropped to levels that were attractive even on a worst-case basis. 
• Another example of a complex security was the contingent value rights issued to Marion Laboratories, Inc., shareholders by Dow Chemical Company as part of the combination of Marion with Dow's Merrell Dow Pharmaceuticals, Inc., subsidiary in December 1989. Two or three years after their issuance (at Dow's option) these separately tradable rights would be redeemed for cash if Marion stock failed to reach designated levels. Specifically, the rights entitled holders to the difference on September 3D, 1991, between $45.77 and the average Marion share price between June 19 and September 18, 1991, up to a maximum of $15.77 per right. In effect, these were put options on Marion stock which had a ceiling on their value. Dow Chemical owned roughly 67 percent of Marion Merrell Dow, Inc.; the public owned the remaining 92 million shares, as well as a similar number of contingent-value rights. The highly unusual nature of these securities ensured very limited demand from institutional and individual investors and increased the likelihood that they would at times become undervalued compared with other publicly traded options. 

Not all complex securities are worthwhile investments. They may be overpriced or too difficult to evaluate. Nevertheless this area frequently is fertile ground for bargain hunting by value investors.