The Value Investing Process: Investing in Financially Distressed and Bankrupt Securities

As we have learned from the history of the junk-bond market, investors have traditionally attached a stigma to the securities of financially distressed companies, perceiving them as highly risky and therefore imprudent. 

Financially distressed and bankrupt securities are analytically complex and often illiquid.

• The reorganization process is both tedious and highly uncertain. 
• Identifying attractive opportunities requires painstaking analysis; investors may evaluate dozens of situations to uncover a single worthwhile opportunity. 

Although the number of variables is high in any type of investing, the issues that must be considered when investing in the securities of financially distressed or bankrupt companies are greater in number and in complexity.

• In addition to comparing price to value as one would for any investment, investors in financially distressed securities must consider, among other things, the effect of financial distress on business results; the availability of cash to meet upcoming debt-service requirements; and likely restructuring alternatives, including a detailed understanding of the different classes of securities and financial claims outstanding and who owns them. 
• Similarly, investors in bankrupt securities must develop a thorough understanding of the reorganization process in general as well as the specifics of each situation being analyzed. 

Because most investors are unable to analyze these securities and unwilling to invest in them, the securities of financially distressed and bankrupt companies can provide attractive value investment opportunities. Unlike newly issued junk bonds, these securities sell considerably below par value where the risk/reward ratio can be attractive for knowledgeable and patient investors.

Areas of Opportunity for Value Investors

The theme: that attractive opportunities to purchase undervalued investments arise with some frequency in a number of areas and that these opportunities can be identified and exploited by value investors.

Areas of Opportunities for Value Investors: Investing in Spinoffs

Spinoffs often present attractive opportunities for value investors.

• A spinoff is a distribution of the shares of a subsidiary company to the shareholders of the parent company. 
• A partial spinoff involves the distribution (or, according to the definition of some analysts, the initial public offering) of less than 100 percent of the subsidiary's stock. 

Spinoffs permit parent companies to divest themselves of businesses that no longer fit their strategic plans, are faring poorly, or adversely influence investor perceptions of the parent, thereby depressing share prices. 

• When a company owns one or more businesses involved in costly litigation, having a poor reputation, experiencing volatile results, or requiring an extremely complex financial structure, its share price may also become depressed. 
• The goal in spinning off such businesses is to create parts with a combined market value greater than the present whole. 

Many parent-company shareholders receiving shares in a spinoff choose to sell quickly, often for the same reasons that the parent company divested itself of the subsidiary in the first place.

• Shareholders receiving the spinoff shares will find still other reasons to sell: they may know little or nothing about the business that was spun off and find it easier to sell than to learn; large institutional investors may deem the newly created entity too small to bother with; and index funds will sell regardless of price if the spinoff is not a member of their assigned index. 
• For reasons such as these, not to mention the fact that spinoffs frequently go unnoticed by most investors, spinoff shares are likely to initially trade at depressed prices, making them of special interest to value investors. 
• Moreover, unlike most other securities, when shares of a spinoff are being dumped on the market, it is not because the sellers know more than the buyers. In fact, it is fairly clear that they know a lot less. 

Wall Street analysts do not usually follow spinoffs, many of which are small capitalization companies with low trading volumes that cannot generate sufficient commissions to justify analysts' involvement.

• Furthermore, since a spinoff is likely to be in a different line of business from its corporate parent, analysts who follow the parent will not necessarily follow the spinoff. 
• Finally, most analysts usually have more work than they can handle and are not eager to take on additional analytical responsibilities. 

Some spinoff companies may choose not to publicize the attractiveness of their own stocks because they prefer a temporarily undervalued market price.

• This is because management often receives stock options based on initial trading prices; until these options are, in fact, granted, there is an incentive to hold the share price down. 
• Consequently a number of spinoff companies make little or no effort to have the share price reflect underlying value. 
• The management of companies with depressed share prices would usually fear a hostile takeover at a low price, however "shark-repellent," anti-takeover provisions inserted into the corporate bylaws of many spinoffs, serve to protect management from corporate predators. 

Another reason that spinoffs may be bargain priced is that there is typically a two- or three-month lag before information on them reaches computer databases. A spinoff could represent the best bargain in the world during its first days of trading, but no computer-dependent investors would know about it.

Shares of spinoffs typically do not fit within institutional constraints and consequently are quickly sold by institutional investors.

• Consider, for example, the spinoff of InterTAN, Inc., by Tandy Corporation in late 1986. InterTAN had a book value of about $15 per share, net-net working capital after all debt of roughly $11 per share, and highly profitable Canadian and Australian retailing operations. Large operating losses in Europe camouflaged this profitability and caused a small overall loss. It was clear to anyone who looked behind the aggregate losses to the separate geographic divisions that the Canadian and Australian operations alone were worth considerably more than the price of $11 per share at which InterTAN stock was trading. 

An institutional investor managing $1 billion might hold twenty-five security positions worth approximately $40 million each. Such an investor might have owned one million Tandy shares trading at $40. He or she would have received a spinoff of 200,000 InterTAN shares having a market value of $2.2 million.

• A $2.2 million position is insignificant to this investor; either the stake in InterTAN will be increased to the average position size of $40 million, or it will be sold. 
• Selling the shares is the path of least resistance, since the typical institutional investor probably knows little and cares even less about InterTAN. 
• Even if that investor wanted to, though, it is unlikely that he or she could accumulate $40 million worth of InterTAN stock, since that would amount to 45 percent of the company at prevailing market prices (and that almost certainly would violate a different constraint about ownership and control.) 

Needless to say, the great majority of Tandy's institutional shareholders simply dumped their InterTAN shares. InterTAN received no Wall Street publicity, and brokers had no particular incentive to drum up interest in the stock.

• As a result, waves of institutional selling created a temporary supply-and-demand imbalance, and numerous value investors were able to accumulate large InterTAN positions at attractive prices. 
• By 1989 the company had turned its money-losing operations around, Wall Street analysts who had once ignored the stock had suddenly fallen in love with it, and investors no longer worried about what could go wrong, focusing instead on what might go right. 
• The shares peaked that year at 62 3/4. 

Opportunities can sometimes arise not in the spinoff but in the parent-company shares.

• As an example, at the end of 1988 Burlington Northern, Inc. (BNI), which owned a major railroad and a natural resources company, spun off its investment in Burlington Resources, Inc. (BR), to shareholders. A number of unusual market forces were at work at the time that created an investment opportunity in the ongoing parent company, BNI. What happened is this: many investors held BNI primarily because of its ownership of BR, which represented about two thirds of the dollar value of the combined company. 
• A number of these investors apparently sold BNI before the spinoff was completed and bought the newly formed BR, causing BNI to decline in price relative to BR. This created an opportunity for other investors to buy BNI stock pre-spinoff and sell BR stock short in order to lock in a cost of approximately $19 per share for the newly separated railroad business. 
• Since the railroad was expected by analysts to earn $3.50 per share and pay a $1.20 annual dividend, establishing an investment in the railroad at $19 appeared to be an attractive opportunity compared with both absolute yardsticks of value and with the prices of shares in comparable companies. By 1990 the shares had approximately doubled from the 1988 level.

Areas of Opportunities for Value Investors: The Cycles of Investment Fashion - The Risk-Arbitrage Cycle

Many participants in specialized areas of investing such as bankruptcy and risk arbitrage have experienced inferior results in recent years. 

• One reason is the proliferation of investors in these areas. In a sense, there is a cycle of investment results attendant on any investment philosophy or market niche due to the relative popularity or lack of popularity of that approach at a particular time. When an area of investment such as risk arbitrage or bankruptcy investing becomes popular, more money flows to specialists in the area. The increased buying bids up prices, increasing the short-term returns of investors and to some extent creating a self-fulfilling prophecy. This attracts still more investors, bidding prices up further. While the influx of funds helps to generate strong investment results for the earliest investors, the resultant higher prices serve to reduce future returns. 
• Ultimately the good investment performance, which was generated largely by those who participated in the area before it became popular, ends and a period of mediocre or poor results ensues. As poor performance continues, those who rushed into the area become disillusioned. Clients withdraw funds as quickly as they added them a few years earlier. The redemptions force investment managers to raise cash by reducing investment positions. This selling pressure causes prices to drop, exacerbating the poor investment performance. Eventually much of the "hot money" leaves the area, allowing the smaller number of remaining investors to exploit existing opportunities as well as the newly created bargains resulting from the forced selling. The stage is set for another up-cycle. 

Risk arbitrage has undergone such a cycle during the past several years.

• In the early 1980s there were only a few dozen risk arbitrageurs, each of whom managed relatively small pools of capital. Their repeated successes received considerable publicity, and a number of new arbitrage boutiques were established. The increased competition did not immediately destroy the investment returns from risk arbitrage; the supply of such investments increased at the same time, due to a simultaneous acceleration in corporate takeover activity. 
• By the late 1980s many new participants had entered risk arbitrage. Relatively unsophisticated individual investors and corporations had become significant players. They tended to bid up prices, which resulted in narrower "spreads" between stock prices and deal values and consequently lower returns with more risk. Excess returns that previously had been available from arbitrage investing disappeared. 
• In 1990 several major takeovers fell through and merger activity slowed dramatically. Many risk arbitrageurs experienced significant losses, and substantial capital was withdrawn from the area. Arbitrage departments at several large Wall Street firms were eliminated, and numerous arbitrage boutiques went out of business. This development serves, of course, to enhance the likelihood of higher potential returns in the future for those who continue to play. 

It is important to recognize that risk-arbitrage investing is not a sudden market fad like home-shopping companies or closed end country funds.

• Over the long run this area remains attractive because it affords legitimate opportunities for investors to do well. 
• Opportunity exists in part because the complexity of the required analysis limits the number of capable participants. 
• Further, risk arbitrage investments, which offer returns that generally are unrelated to the performance of the overall market, are incompatible with the goals of relative-performance-oriented investors. 

Since the great majority of investors avoid risk-arbitrage investing, there is a significant likelihood that attractive returns will be attainable for the handful who are able and willing to persevere.

Areas of Opportunities for Value Investors: Investing in Risk Arbitrage

Risk arbitrage is a highly specialized area of value investing.

Arbitrage, as noted earlier, is a riskless transaction that generates profits from temporary pricing inefficiencies between markets. 

• Risk arbitrage, however, involves investing in far-from-riskless takeover transactions. 
• Spinoffs, liquidations, and corporate restructurings, which are sometimes referred to as long-term arbitrage, also fall into this category. 

Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments at the underlying company.

• The principal determinant of investors' return is the spread between the price paid by the investor and the amount to be received if the transaction is successfully completed. 
• The downside risk if the transaction fails to be completed is usually that the security will return to its previous trading level, which is typically well below the takeover price. 

The quick pace and high stakes of takeover investing have attracted many individual investors and speculators as well as professional risk arbitrageurs. 

• It is my view that those arbitrageurs with the largest portfolios possess an advantage that smaller investors cannot easily overcome. 
• Due to the size of their holdings, the largest arbitrageurs can afford to employ the best lawyers, consultants, and other advisors to acquire information with a breadth, depth, and timeliness unavailable to other investors. 
• As we have learned from recent criminal indictments, some have even enjoyed access to inside information, although their informational edge was great even without circumventing the law. 

The informational advantage of the largest risk arbitrageurs is not so compelling in situations such as long-term liquidations, spinoffs, and large friendly tender offers.

• In the largest friendly corporate takeovers, for example, the professional risk arbitrage community depletes its purchasing power relatively quickly, leaving an unusually attractive spread for other investors. 
• A careful and selective smaller investor may be able to profitably exploit such an opportunity. 

At times of high investor uncertainty, risk-arbitrage-related securities may become unusually attractive. 



Example:

The December 1987 takeover of Becor Western Inc. by B-E Holdings, Inc., fit this description.

• In June 1987 Becor sold its aerospace business for $109.3 million cash. This left the company with $185 million in cash (over $11 per share) and only $30 million in debt. The company also operated an unprofitable but asset-rich mining machinery business under the Bucyrus-Erie name. The offer by B-E Holdings to buy Becor Western was the last in a series of offers by several suitors. The terms of this proposed merger called for Becor holders to receive either $17 per share in cash or a package of the following: $3 principal amount of 12.5 percent one-year senior notes in B-EHoldings; $10 principal amount of 12.5 percent fifteen-year senior debentures in B-EHoldings; 0.2 shares preferred stock in B-E Holdings, liquidation preference $25; and 0.6 warrants to buy common stock in B-E Holdings at $.01 per share. A maximum of 57.5 percent of Becor shares were eligible to receive the cash consideration. Assuming that all stockholders elected to receive cash for as many shares as possible, each would receive per share of Becor owned: $9.775 cash $1.275 principal amount one-year notes $4.25 principal amount fifteen-year debentures .085 shares preferred stock .255 warrants The cash option was almost certain to be worth more than the package of securities. Thus the total value of the consideration to holders who elected cash was greater than for those who did not. Nevertheless, a small proportion of Becor holders failed to choose the cash alternative, increasing the value to be received by the vast majority of holders who did. 

What made Becor particularly attractive to investors was that in the aftermath of the 1987 stock market crash, the shares fell in price to below $10. 

• Investors could thus purchase Becor stock for less than the underlying cash on the company's books, and for an amount approximately equal to the cash that would be distributed upon consummation of the merger, which was expected either in December 1987 or January 1988. 
• The shares were a real bargain at $10, whether or not the merger occurred. The total value of the merger consideration was certainly greater than the $10 stock price-the cash component alone was nearly $10. Moreover, there was nearly enough cash on the books of B-E Holdings pro forma for the merger to retire the one-year notes. These appeared to be worth close to par value. Based on the market price of comparable securities, the fifteen-year debentures seemed likely to trade at a minimum of 50 percent of face value and perhaps significantly higher. The preferred stock was more difficult to evaluate, but 25 percent of its liquidation preference seemed conservative compared with other preferred issues. The warrants were virtually impossible to value. Even assuming they would trade at negligible prices, however, the total value of the merger consideration appeared to be at least $14 per share.
• Better still, the downside risk to investors was minimal. The book value of Becor was $12 per share, nearly all of it in cash. There were several sizable holders of Becor stock, a fact that increased the likelihood that underlying value would be realized in some fashion. Even if the merger were rejected by shareholders, a corporate liquidation appeared likely to yield similar value. 
• At prices of $12 or below, investors faced little downside risk and the prospect of an appreciable and prompt return. As it turned out, the merger consideration was worth about $14.25 at market prices. 
• Becor shares had declined in the wake of a broad market rout to a level below underlying value, creating an opportunity for value investors.

Areas of Opportunity for Value Investors: Investing in Rights Offerings

Rights offerings are more esoteric than many other investments and for this reason may occasionally be of interest to value investors.

Some rights offerings present attractive bargains, but many are fully priced or even overpriced. 

Investors may find this an interesting area to examine but as usual must do their homework.

Unlike a typical underwritten share offering, where buying by new investors dilutes the percentage interest of current shareholders, in a rights offering shareholders are given the opportunity to preserve their proportional interest in the issuer by subscribing for additional shares. Those who subscribe retain the same percentage interest in the business but have more of their money at stake. Investors who fail to exercise their rights often leave money on the table, creating an opportunity for alert value investors.

• Rights offerings can effectively compel current shareholders to put up more money in order to avoid considerable dilution of their investments. By way of example, assume XYZ is a closed end mutual fund with one million shares outstanding, which trade at a price equal to the fund's net asset value of $25. Further assume that XYZ, seeking to raise an additional $15 million to take advantage of market opportunities, issues every holder a nontransferable right to buy another XYZ share for $15. If all holders subscribe, then immediately after the rights offering XYZ will have two million shares outstanding and $40 million of total assets, or $20 per share. If holders of 50,000 shares do not exercise their rights, while holders of 950,000 shares do, the 1,950,000 shares outstanding after the rights offering will have a net asset value of $20.13. The investors who subscribed will have an average cost of $20 per share, while those who did not will have an average cost of $25. Since nonsubscribers will suffer an immediate loss of almost 20 percent of their underlying value, all holders have a powerful incentive to subscribe. Some rights offerings give holders the opportunity to oversubscribe beyond their own proportional interest for shares that others do not buy. In the case of XYZ, investors who chose to oversubscribe for the 50,000 shares left unsold at the original offering could have made a quick $250,000 buying those shares at $15 and promptly selling them at the pro forma net asset value of $20. 
• Companies occasionally employ a rights offering to effectuate the initial public offering of shares in a subsidiary.  In 1984, for example, Consolidated Oil and Gas, Inc., utilized a rights offering to bring its Princeville Development Corporation subsidiary public. Consolidated was an overleveraged energy company that owned some attractive Hawaiian real estate properties, which were held by its Princeville subsidiary. To separate the Hawaiian properties from the rest of the business while preserving the value of those properties in shareholders' hands, Consolidated conducted a rights offering. Under its terms shareholders of Consolidated were offered the right to purchase one share of Princeville for each share of Consolidated they owned. The initial offering price, $3.25 per share, was arbitrary, according to the prospectus, and considerably below Consolidated's cost basis in Princeville. When the rights started to trade, little information had been released by Consolidated Oil and Gas concerning Princeville. The prospectus was apparently not yet publicly available. In the absence of publicly available information, some rights traded for as little as 1/32 and 1/64 of a dollar per right. Alert investors willing to make an educated guess were able to earn an enormous profit on this obscure rights offering; upon completion of the offering, the market price of Princeville quickly rose above $5 per share. Rights that traded as low as 11/2 cents rose in price to nearly $2 only a few weeks later

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. 

Areas of Opportunity for Value Investors: Investing in Corporate Liquidations

Some troubled companies, lacking viable alternatives, voluntarily liquidate in order to preempt a total wipeout of shareholders' investments. 

Other, more interesting corporate liquidations are motivated by

• tax considerations, 
• persistent stock market undervaluation, or 
• the desire to escape the grasp of a corporate raider. 

A company involved in only one profitable line of business would typically prefer selling out to liquidating because possible double taxation (taxes both at the corporate and shareholder level) would be avoided.

A company operating in diverse business lines, however, might find a liquidation or breakup to be the value-maximizing alternative, particularly if the liquidation process triggers a loss that results in a tax refund. 

Some of the most attractive corporate liquidations in the past decade have involved the breakup of conglomerates and investment companies. 


Most equity investors prefer (or are effectively required) to hold shares in ongoing businesses. Companies in liquidation are the antithesis of the type of investment they want to make.

• Even some risk arbitrageurs (who have been known to buy just about anything) avoid investing in liquidations, believing the process to be too uncertain or protracted. 
• Indeed, investing in liquidations is sometimes disparagingly referred to as cigarbutt investing, whereby an investor picks up someone else's discard with a few puffs left on it and smokes it. 

Needless to say, because other investors disparage and avoid them, corporate liquidations may be particularly attractive opportunities for value investors.

Areas of Opportunity for Value Investors: Catalysts

Owning securities with catalysts for value realization 


The attraction of some value investments is simple and straightforward: ongoing, profitable, and growing businesses with share prices considerably below conservatively appraised underlying value. 

• Ordinarily, however, the simpler the analysis and steeper the discount, the more obvious the bargain becomes to other investors. 
• The securities of high-return businesses therefore reach compelling levels of undervaluation only infrequently. 

Usually investors have to work harder and dig deeper to find undervalued opportunities, either by ferreting out hidden value or by comprehending a complex situation. 

Once a security is purchased at a discount from underlying value, shareholders can benefit immediately

• if the stock price rises to better reflect underlying value or 
• if an event occurs that causes that value to be realized by shareholders. 

Such an event eliminates investors' dependence on market forces for investment profits.

• By precipitating the realization of underlying value, moreover, such an event considerably enhances investors' margin of safety. 

I refer to such events as catalysts. 

• Some catalysts for the realization of underlying value exist at the discretion of a company's management and board of directors. The decision to sell out or liquidate, for example, is made internally. 
• Other catalysts are external and often relate to the voting control of a company's stock. Control of the majority of a company's stock typically allows the holder to elect the majority of the board of directors.  Thus accumulation of stock leading to voting control, or simply management's fear that this might happen, could lead to steps being taken by a company that cause its share price to more fully reflect underlying value. 

Catalysts vary in their potency. 

• The orderly sale or liquidation of a business leads to total value realization. 
• Corporate spinoffs, share buybacks, recapitalizations, and major asset sales usually bring about only partial value realization. 
• The emergence of a company from bankruptcy serves as a catalyst for creditors.  Holders of senior debt securities, for example, typically receive cash, debt instruments, and/or equity securities in the reorganized entity in satisfaction of their claims. The total market value of these distributions is likely to be higher than the market value of the bankrupt debt; securities in the reorganized company will typically be more liquid and avoid most of the stigma and uncertainty of bankruptcy and thus trade at higher multiples.  Moreover, committees of creditors will have participated in determining the capital structure of the reorganized firm, seeking to create a structure that maximizes market value. 

Value investors are always on the lookout for catalysts. 

• While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst is an important means of generating profits. 
• Furthermore, the presence of a catalyst serves to reduce risk. If the gap between price and underlying value is likely to be closed quickly, the probability of losing money due to market fluctuations or adverse business developments is reduced. 
• In the absence of a catalyst, however, underlying value could erode; conversely, the gap between price and value could widen with the vagaries of the market. 

Owning securities with catalysts for value realization is therefore an important way for investors to reduce the risk within their portfolios, augmenting the margin of safety achieved by investing at a discount from underlying value.  


Catalysts that bring about total value realization are, of course, optimal.  Nevertheless, catalysts for partial value realization serve two important purposes.

• First, they do help to realize underlying value, sometimes by placing it directly into the hands of shareholders such as through a recapitalization or spinoff and other times by reducing the discount between price and underlying value, such as through a share buyback. 
• Second, a company that takes action resulting in the partial realization of underlying value for shareholders serves notice that management is shareholder oriented and may pursue additional value-realization strategies in the future. 
• Over the years, for example, investors in Teledyne have repeatedly benefitted from timely share repurchases and spinoffs.

Investment Research Process

Investment research is the process of reducing large piles of information to manageable ones, distilling the investment wheat from the chaff.

There is, needless to say, a lot of chaff and very little wheat.

The research process itself, like the factory of a manufacturing company, produces no profits.

The profits materialize later, often much later, when the undervaluation identified during the research process is first translated into portfolio decisions and then eventually recognized by the market.

In fact, often there is no immediate buying opportunity; today's research may be advance preparation for tomorrow's opportunities.

In any event, just as a superior sales force cannot succeed if the factory does not produce quality goods, an investment program will not long succeed if high-quality research is not performed on a continuing basis. 

Investment Research and Inside Information

The investment research process is complicated by the blurred line between publicly available and inside, or privileged, information. Although trading based on inside information is illegal, the term has never been clearly defined.

As investors seek to analyze investments and value securities, they bump into the unresolved question of how far they may reasonably go in the pursuit of information.

• For example, can an investor presume that information provided by a corporate executive is public knowledge (assuming, of course, that suitcases of money do not change hands)? 
• Similarly, is information that emanates from a stockbroker in the public domain? 
• How about information from investment bankers? 
• If not the latter, then why do investors risk talking to them, and why are the investment bankers willing to speak? 
• How far may investors go in conducting fundamental research? 
• How deep may they dig? May they hire private investigators, and may those investigators comb through a company's garbage? What, if any, are the limits? 
• Do different rules apply to equities than to other securities?  

The troubled debt market, for example, is event driven.  Takeovers, exchange offers, and open-market bond repurchases are fairly routine.

• What is public knowledge, and what is not? 
• If you sell bonds back to a company, which then retires them, is knowledge of that trade inside information? 
• Does it matter how many bonds were sold or when the trade occurred? 
• If this constitutes inside information, in what way does it restrict you? 
• If you are a large bondholder and the issuer contacts you to discuss an exchange offer, in what way can that be construed as inside information? 

When does inside information become sufficiently old to no longer be protected?

• When do internal financial projections become outdated? 
• When do aborted merger plans cease to be secret? 

There are no firm answers to these questions.

• Investors must bend over backward to stay within the law, of course, but it would be far easier if the law were more clearly enunciated. 
• Since it is not, law abiding investors must err on the side of ignorance, investing with less information than those who are not so ethical. 
• When investors are unsure whether they have crossed the line, they would be well advised to ask their sources and perhaps their attorneys as well before making any trades.

Insider Buying and Management Stock Options Can Signal Opportunity

In their search for complete information on businesses, investors often overlook one very important clue. In most instances no one understands a business and its prospects better than the management. Therefore investors should be encouraged when corporate insiders invest their own money alongside that of shareholders by purchasing stock in the open market.

It is often said on Wall Street that there are many reasons why an insider might sell a stock (need for cash to pay taxes, expenses, etc.), but there is only one reason for buying. 

Investors can track insider buying and selling in any of several specialized publications, such as Vickers Stock Research.

The motivation of corporate management can be a very important force in determining the outcome of an investment. 

• Some companies provide incentives for their managements with stock-option plans and related vehicles.  Usually these plans give management the specific incentive to do what they can to boost the company's share price. 
• While management does not control a company's stock price, it can greatly influence the gap between share price and underlying value and over time can have a significant influence on value itself. 
• If the management of a company were compensated based on revenues, total assets, or even net income, it might ignore share price while focusing on those indicators of corporate performance.
• If, however, management were provided incentives to maximize share price, it would focus its attention differently. 

For example, the management of a company whose stock sold at $25 with an underlying value of $50 could almost certainly boost the market price by announcing a spinoff, recapitalization, or asset sale, with the result of narrowing the gap between share price and underlying value. The repurchase of shares on the open market at $25 would likely give a boost to the share price as well as causing the underlying value of remaining shares to increase above $50.

Obviously investors need to be alert to the motivations of managements at the companies in which they invest.

How Much Research and Analysis Are Sufficient?

Some investors insist on trying to obtain perfect knowledge about their impending investments, researching companies until they think they know everything there is to know about them. They study the industry and the competition, contact former employees, industry consultants, and analysts, and become personally acquainted with top management. They analyze financial statements for the past decade and stock price trends for even longer.

This diligence is admirable, but it has two shortcomings. 

• First, no matter how much research is performed, some information always remains elusive; investors have to learn to live with less than complete information. 
• Second, even if an investor could know all the facts about an investment, he or she would not necessarily profit. 

This is not to say that fundamental analysis is not useful. It certainly is.

• But information generally follows the well-known 80/20 rule: the first 80 percent of the available information is gathered in the first 20 percent of the time spent. 
• The value of in-depth fundamental analysis is subject to diminishing marginal returns. 
• Information is not always easy to obtain. Some companies actually impede its flow. Understandably, proprietary information must be kept confidential. 
• The requirement that all investors be kept on an equal footing is another reason for the limited dissemination of information; information limited to a privileged few might be construed as inside information. Restrictions on the dissemination of information can complicate investors' quest for knowledge nevertheless. 

Moreover, business information is highly perishable. 

• Economic conditions change, industries are transformed, and business results are volatile. 
• The effort to acquire current, let alone complete information is never-ending. 
• Meanwhile, other market participants are also gathering and updating information, thereby diminishing any investor's informational advantage. 

David Dreman recounts the story of an analyst so knowledgeable about Clorox that he could recite bleach shares by brand in every small town in the Southwest and tell you the production levels of Clorox's line number 2, plant number 3. But somehow, when the company began to develop massive problems, he missed the signs....' The stock fell from a high of 53 to 11." 

Although many Wall Street analysts have excellent insight into industries and individual companies, the results of investors who follow their recommendations may be less than stellar. 

• In part this is due to the pressure placed on these analysts to recommend frequently rather than wisely, but it also exemplifies the difficulty of translating information into profits. 
• Industry analysts are not well positioned to evaluate the stocks they follow in the context of competing investment alternatives. 
• Merrill Lynch's pharmaceutical analyst may know everything there is to know about Merck and Pfizer, but he or she knows virtually nothing about General Motors, Treasury bond yields, and Jones & Laughlin Steel first-mortgage bonds. 

Most investors strive fruitlessly for certainty and precision, avoiding situations in which information is difficult to obtain.

• Yet high uncertainty is frequently accompanied by low prices. 
• By the time the uncertainty is resolved, prices are likely to have risen. 
• Investors frequently benefit from making investment decisions with less than perfect knowledge and are well rewarded for bearing the risk of uncertainty. 
• The time other investors spend delving into the last unanswered detail may cost them the chance to buy in at prices so low that they offer a margin of safety despite the incomplete information.

Value Investing and Contrarian Thinking

Value investing by its very nature is contrarian. 

Out-of-favor securities may be undervalued; popular securities almost never are. 


What the herd is buying is, by definition, in favor.

• Securities in favor have already been bid up in price on the basis of optimistic expectations and are unlikely to represent good value that has been overlooked. 

If value is not likely to exist in what the herd is buying, where may it exist?

• In what they are selling, unaware of, or ignoring. 
• When the herd is selling a security, the market price may fall well beyond reason. 
• Ignored, obscure, or newly created securities may similarly be or become undervalued. 

Investors may find it difficult to act as contrarians for they can never be certain whether or when they will be proven correct. 

• Since they are acting against the crowd, contrarians are almost always initially wrong and likely for a time to suffer paper losses. 
• By contrast, members of the herd are nearly always right for a period. 
• Not only are contrarians initially wrong, they may be wrong more often and for longer periods than others because market trends can continue long past any limits warranted by underlying value. 

Holding a contrary opinion is not always useful to investors, however.

• When widely held opinions have no influence on the issue at hand, nothing is gained by swimming against the tide. 
• It is always the consensus that the sun will rise tomorrow, but this view does not influence the outcome. 

By contrast, when majority opinion does affect the outcome or the odds, contrary opinion can be put to use. 

• When the herd rushes into home health-care stocks, bidding up prices and thereby lowering available returns, the majority has altered the risk/reward ratio, allowing contrarians to bet against the crowd with the odds skewed in their favor. 
• When investors in 1983 either ignored or panned the stock of Nabisco, causing it to trade at a discount to other food companies, the risk/reward ratio became more favorable, creating a buying opportunity for contrarians.

Market Inefficiencies and Institutional Constraints

The research task does not end with the discovery of an apparent bargain. It is incumbent on investors to try to find out why the bargain has become available. 

If in 1990 you were looking for an ordinary, four-bedroom colonial home on a quarter acre in the Boston suburbs, you should have been prepared to pay at least $300,000. If you learned of one available for $150,000, your first reaction would not have been, "What a great bargain!" but, "What's wrong with it?" The same healthy skepticism applies to the stock market. A bargain should be inspected and reinspected for possible flaws. 


Irrational or indifferent selling alone may have made it cheap, but there may be more fundamental reasons for the depressed price.

• Perhaps there are contingent liabilities or pending litigation that you are unaware of. 
• Maybe a competitor is preparing to introduce a superior product. 
• When the reason for the undervaluation can be clearly identified, it becomes an even better investment because the outcome is more predictable. 

By way of example, the legal constraint that prevents some institutional investors from purchasing low priced spinoffs is one possible explanation for undervaluation. Such reasons give investors some comfort that the price is not depressed for an undisclosed fundamental business reason.

Other institutional constraints can also create opportunities for value investors.  For example, many institutional investors . become major sellers of securities involved in risk-arbitrage transactions on the grounds that their mission is to invest in ongoing businesses, not speculate on takeovers. The resultant selling pressure can depress prices, increasing the returns available to arbitrage investors.

Institutional investors are commonly unwilling to buy or hold low-priced securities. Since any company can exercise a degree of control over its share price through splitting or reverse-splitting its outstanding shares, the financial rationale for this constraint is hard to understand. Why would a company's shares be a good buy at $15 a share but not at $3 after a five-for-one stock split or vice versa?

Many attractive investment opportunities result from market inefficiencies, that is, areas of the security markets in which information is not fully disseminated or in which supply and demand are temporarily out of balance. Almost no one on Wall Street, for example, follows, let alone recommends, small companies whose shares are closely held and infrequently traded; there are at most a handful of market makers in such stocks. Depending on the number of shareholders, such companies may not even be required by the SEC to file quarterly or annual reports. Obscurity and a very thin market can cause stocks to sell at depressed levels. 

Year-end tax selling also creates market inefficiencies. The Internal Revenue Code makes it attractive for investors to realize capital losses before the end of each year.  Selling driven by the calendar rather than by investment fundamentals frequently causes stocks that declined significantly during the year to decline still further. This generates opportunities for value investors.

Where to look for opportunities: The Challenge of Finding Attractive Investments

Investment Research: The Challenge of Finding Attractive Investments 

While knowing how to value businesses is essential for investment success, the first and perhaps most important step in the investment process is knowing where to look for opportunities. 

Investors are in the business of processing information, but while studying the current financial statements of the thousands of publicly held companies, the monthly, weekly, and even daily research reports of hundreds of Wall Street analysts, and the market behavior of scores of stocks and bonds, they will spend virtually all their time reviewing fairly priced securities that are of no special interest.


Good investment ideas are rare and valuable things, which must be ferreted out assiduously.

• They do not fly in over the transom or materialize out of thin air. 
• Investors cannot assume that good ideas will come effortlessly from scanning the recommendations of Wall Street analysts, no matter how highly regarded, or from punching up computers, no matter how cleverly programmed, although both can sometimes indicate interesting places to hunt. 

Upon occasion attractive opportunities are so numerous that the only limiting factor is the availability of funds to invest; typically the number of attractive opportunities is much more limited.

• By identifying where the most attractive opportunities are likely to arise before starting one's quest for the exciting handful of specific investments, investors can spare themselves an often fruitless survey of the humdrum majority of available investments. 

Value investing encompasses a number of specialized investment niches that can be divided into three categories:

• securities selling at a discount to breakup or liquidation value, 
• rate-of-return situations, and 
• asset-conversion opportunities. 

Where to look for opportunities varies from one of these categories to the next.

• Computer-screening techniques, for example, can be helpful in identifying stocks of the first category: those selling at a discount from liquidation value. Because databases can be out of date or inaccurate, however, it is essential that investors verify that the computer output is correct. 
• Risk arbitrage and complex securities comprise a second category of attractive value investments with known exit prices and approximate time frames, which, taken together, enable investors to calculate expected rates of return at the time the investments are made. Mergers, tender offers, and other risk-arbitrage transactions are widely reported in the daily financial press-the Wall Street Journal and the business section of the New York Times-as well as in specialized newsletters and periodicals. Locating information on complex securities is more difficult, but as they often come into existence as byproducts of risk arbitrage transactions, investors who follow the latter may become aware of the former. 
• Financially distressed and bankrupt securities, corporate recapitalizations, and exchange offers all fall into the category of asset conversions, in which investors' existing holdings are exchanged for one or more new securities. Distressed and bankrupt businesses are often identified in the financial press; specialized publications and research services also provide  information on such companies and their securities. Fundamental information on troubled companies can be gleaned from published financial statements and in the case of bankruptcies, from court documents. Price quotations may only be available from dealers since many of these securities are not listed on any exchange. Corporate recapitalizations and exchange offers can usually be identified from a close reading of the daily financial press. Publicly available filings with the Securities and Exchange Commission (SEC) provide extensive detail on these extraordinary corporate transactions. 

Many undervalued securities do not fall into any of these specialized categories and are best identified through old-fashioned hard work, yet there are widely available means of improving the likelihood of finding mispriced securities.

• Looking at stocks on the Wall Street Journal's leading percentage-decline and new-low lists, for example, occasionally turns up an out-of-favor investment idea. 
• Similarly, when a company eliminates its dividend, its shares often fall to unduly depressed levels. 
• Of course, all companies of requisite size produce annual and quarterly reports, which they will send upon request. Filings of a company's annual and quarterly financial statements on Forms 10K and 10Q, respectively, are available from the SEC and often from the reporting company as well. 
• Sometimes an attractive investment niche emerges in which numerous opportunities develop over time. One such area has been the large number of thrift institutions that have converted from mutual to stock ownership. Investors should consider analyzing all companies within such a category in order to identify those that are undervalued. Specialized newsletters and industry periodicals can be excellent sources of information on such niche opportunities.

The Choice of a Discount Rate

The other component of present-value analysis, choosing a discount rate, is rarely given sufficient consideration by investors.

• A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars. 
• Investors with a strong preference for present over future consumption or with a preference for the certainty of the present to the uncertainty of the future would use a high rate for discounting their investments. 
• Other investors may be more willing to take a chance on forecasts holding true; they would apply a low discount rate, one that makes future cash flows nearly as valuable as today's. 
• There is no single correct discount rate for a set of future cash flows and no precise way to choose one. 

The appropriate discount rate for a particular investment depends not only on an investor's preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment under consideration, and on the returns available from alternative investments.

• Investors tend to oversimplify; the way they choose a discount rate is a good example of this. 
• A great many investors routinely use 10 percent as an all-purpose discount rate regardless of the nature of the investment under consideration. 
• Ten percent is a nice round number, easy to remember and apply, but it is not always a good choice. 
• The underlying risk of an investment's future cash flows must be considered in choosing the appropriate discount rate for that investment. 
• A short-term, risk-free investment (if one exists) should be discounted at the yield available on short-term U.S. Treasury securities, which, as stated earlier, are considered a proxy for the risk-free interest rate.
• Low-grade bonds, by contrast, are discounted by the market at rates of 12 to 15 percent or more, reflecting investors' uncertainty that the contractual cash flows will be paid. 

It is essential that investors choose discount rates as conservatively as they forecast future cash flows.

• Depending on the timing and magnitude of the cash flows, even modest differences in the discount rate can have a considerable impact on the present-value calculation. 
• Business value is influenced by changes in discount rates and therefore by fluctuations in interest rates. 
• While it would be easier to determine the value of investments if interest rates and thus discount rates were constant, investors must accept the fact that they do fluctuate and take what action they can to minimize the effect of interest rate fluctuations on their portfolios. 

How can investors know the "correct" level of interest rates in choosing a discount rate?

• I believe there is no "correct" level of rates. 
• They are what the market says they are, and no one can predict where they are headed. 
• Mostly I give current, risk-free interest rates the benefit of the doubt and assume that they are correct. 
• Like many other financial-market phenomena there is some cyclicality to interest rate fluctuations. 
• High interest rates lead to changes in the economy that are precursors to lower interest rates and vice versa. 
• Knowing this does not help one make particularly accurate forecasts, however, for it is almost impossible to envision the economic cycle until after the fact. 

At Times when Interest Rates are Unusually Low

• At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. 
• Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. 
• This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive. 

Investors can apply present-value analysis in one of two ways.

• They can calculate the present-value of a business and use it to place a value on its securities. 
• Alternatively, they can calculate the present-value of the cash flows that security holders will receive: interest and principal payments in the case of bondholders and dividends and estimated future share prices in the case of stockholders. 
• Calculating the present value of contractual interest and principal payments is the best way to value a bond. 
• Analysis of the underlying business can then help to establish the probability that those cash flows will be received. 

By contrast, analyzing the cash flows of the underlying business is the best way to value a stock.

• The only cash flows that investors typically receive from a stock are dividends. 
• The dividend-discount method of valuation, which calculates the present value of a projected stream of future dividend payments, is not a useful tool for valuing equities; for most stocks, dividends constitute only a small fraction of total corporate cash flow and must be projected at least several decades into the future to give a meaningful approximation of business value. 
• Accurately predicting that far ahead is an impossibility. 
• Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. 

In theory, investors might assign different probabilities to numerous cash flow scenarios, then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers.

• In practice, given the extreme difficulty of assigning probabilities to numerous forecasts, investors make do with only a few likely scenarios. 
• They must then perform sensitivity analysis in which they evaluate the effect of different cash flow forecasts and different discount rates on present value. 
• If modest changes in assumptions cause a substantial change in net present value, investors would be prudent to exercise caution in employing this method of valuation.

Present-Value Analysis and the Difficulty of Forecasting Future Cash Flow

When future cash flows' are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation.

Unfortunately future cash flows are usually uncertain, often highly so.

Moreover, the choice of a discount rate can be somewhat arbitrary. 

These factors together typically make present value analysis an imprecise and difficult task.



The Perfect Business to Value - Annuity

A perfect business in terms of the simplicity of valuation would be an annuity; an annuity generates an annual stream of cash that either remains constant or grows at a steady rate every year. 



Real businesses, even the best ones, are unfortunately not annuities. 

Few businesses occupy impenetrable market niches and generate consistently high returns, and most are subject to intense competition. 

Small changes in either revenues or expenses cause far greater percentage changes in profits. 

The number of things that can go wrong greatly exceeds the number that can go right.

Responding to business uncertainty is the job of corporate management.

However, controlling or preventing uncertainty is generally beyond management's ability and should not be expected by investors.'

How do value investors deal with the analytical necessity to predict the unpredictable?

The only answer is conservatism. 

Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb.

Virtually everything must go right, or losses may be sustained.

Conservative forecasts can be more easily met or even exceeded. 

Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.

Three elements of a value-investment strategy: Bottom-up approach, Absolute performance orientation, and Managing risk.

The primary goal of value investors is to avoid losing money. 

Three elements of a value-investment strategy make achievement of that goal possible.

1.   A bottom-up approach, searching for low-risk bargains one at a time through fundamental analysis, is the surest way I know to avoid losing money.

2.  An absolute performance orientation is consistent with loss avoidance; a relative-performance orientation is not.

3.  Finally, paying careful attention to risk - the probability and amount of loss due to permanent value impairments - will help investors avoid losing money.



So long as generating portfolio cash inflow is not inconsistent with earning acceptable returns, investors can reduce the opportunity cost resulting from interim price declines even as they achieve their long-term investment goals.