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.

Managing Portfolio Cash Flow. Cash is the most Important determinant of Opportunity Cost

Most important determinant of opportunity cost:  Cash portion of your portfolio

If you hold cash, you are able to take advantage of opportunities during market declines.

If you are fully invested when the market declines, your portfolio will likely drop in value, depriving you of the benefits arising from the opportunity to buy in at lower levels.

This creates an opportunity cost, the necessity to forego future opportunities that arise.

If what you hold is illiquid or unmarketable, the opportunity cost increases further; the illiquidity precludes your switching to better bargains.

The most important determinant of whether investors will incur opportunity cost is whether or not part of their portfolios is held in cash.

Maintaining moderate cash balances or owning securities that periodically throw off appreciable cash is likely to reduce the number of foregone opportunities.



Managing portfolio cash flow

Investors can manage portfolio cash flow (defined as the cash flowing into a portfolio minus outflows) by giving preference to some kinds of investments over others.

Portfolio cash flow is greater for securities of shorter duration (weighted average life) than those of longer duration.

Portfolio cash flow is also enhanced by investments with catalysts for the partial or complete realization of underlying value.

Equity investments in ongoing businesses typically throw off only minimal cash through the payment of dividends.

The securities of companies in bankruptcy and liquidation, by contrast, can return considerable liquidity to a portfolio within a few years of purchase.

Risk-arbitrage investments typically have very short lives, usually turning back into cash, liquid securities, or both in a matter of weeks or months.

An added attraction of investing in risk-arbitrage situations, bankruptcies, and liquidations is that not only is one's initial investment returned to cash, one's profits are as well.



Hedging

Another way to limit opportunity cost is through hedging.

A hedge is an investment that is expected to move in a direction opposite that of another holding so as to cushion any price decline.

If the hedge becomes valuable, it can be sold, providing funds to take advantage of newly created opportunities. 

The Relevance of Temporary Price Fluctuations (unrelated to Underlying Value)

Permanent loss versus Interim Price Fluctuations

In addition to the probability of permanent loss attached to an investment, there is also the possibility of interim price fluctuations that are unrelated to underlying value. (Beta fails to distinguish between the two.)

Many investors consider price fluctuations to be a significant risk: if the price goes down, the investment is seen as risky regardless of the fundamentals.



But are temporary price fluctuations really a risk? 

Not in the way that permanent value impairments are and then only for certain investors in specific situations. 

It is, of course, not always easy for investors to distinguish temporary price volatility, related to the short-term forces of supply and demand, from price movements related to business fundamentals. The reality may only become apparent after the fact.

While investors should obviously try to avoid overpaying for investments or buying into businesses that subsequently decline in value due to deteriorating results, it is not possible to avoid random short-term market volatility. 

Indeed, investors should expect prices to fluctuate and should not invest in securities if they cannot tolerate some volatility. 




If you are buying sound value at a discount, do short-term price fluctuations matter? 

In the long run they do not matter much; value will ultimately be reflected in the price of a security.

Indeed, ironically, the long-term investment implication of price fluctuations is in the opposite direction from the near-term market impact. 

For example, short-term price declines actually enhance the returns of long-term investors.' 



Near-term price fluctuations matter to certain investors

There are, however, several eventualities in which near-term price fluctuations do matter to investors.

1.   Security holders who need to sell in a hurry are at the mercy of market prices.

• The trick of successful investors is to sell when they want to, not when they have to.
• Investors who may need to sell should not own marketable securities other than U.S. Treasury bills.

2.   Near-term security prices also matter to investors in a troubled company. 

• If a business must raise additional capital in the near term to survive, investors in its securities may have their fate determined, at least in part, by the prevailing market price of the company's stock and bonds. (This effect, known as reflexivity.)

3.  Volatility is the friend of the long term value investor.

• The third reason long-term-oriented investors are interested in short-term price fluctuations is that Mr. Market can create very attractive opportunities to buy and sell. 

Conventional Valuation Yardsticks: Dividend Yield

Dividend Yield

Why is my discussion of dividend yield so short?

• Although at one time a measure of a business's prosperity, it has become a relic: stocks should simply not be bought on the basis of their dividend yield. 

Too often struggling companies sport high dividend yields, not because the dividends have been increased, but because the share prices have fallen. 

• Fearing that the stock price will drop further if the dividend is cut, managements maintain the payout, weakening the company even more. 
• Investors buying such stocks for their ostensibly high yields may not be receiving good value.  On the contrary, they may be the victims of a pathetic manipulation. 
• The high dividend paid by such companies is not a return on invested capital but rather a return of capital that represents the liquidation of the underlying business. 
• This manipulation was widely used by money-center banks through most of the 1980s and had the (desired) effect of propping up their share prices.

Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield
Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

Conventional Valuation Yardsticks: Book Value

Book Value

What something cost in the past is not necessarily a good measure of its value today.  Book value is the historical accounting of shareholders' equity, the residual after liabilities are subtracted from assets.

Sometimes historical book value (carrying value) provides an accurate measure of current value, but often it is way off the mark.

• Current assets, such as receivables and inventories, for example, are usually worth close to carrying value, although certain types of inventory are subject to rapid obsolescence. 
• Plant and equipment, however, may be outmoded or obsolete and therefore worth considerably less than carrying value. 
• Alternatively, a company with fully depreciated plant and equipment or a history of write-offs may have carrying value considerably below real economic value. 
• Inflation, technological change, and regulation, among other factors, can affect the value of assets in ways that historical cost accounting cannot capture. 
• Real estate purchased decades ago, for example, and carried on a company's books at historical cost may be worth considerably more. 
• The cost of building a new oil refinery today may be made prohibitively expensive by environmental legislation, endowing older facilities with a scarcity value. 
• Aging integrated steel facilities, by contrast, may be technologically outmoded compared with newly built mini-mills. As a result, their book value may be significantly overstated. 

Reported book value can also be affected by management actions.

• Write-offs of money-losing operations are somewhat arbitrary yet can have a large impact on reported book value. 
• Share issuance and repurchases can also affect book value. 
• Many companies in the 1980s, for example, performed recapitalizations, whereby money was borrowed and distributed to shareholders as an extraordinary dividend. This served to greatly reduce the book value of these companies, sometimes below zero. 
• Even the choice of accounting method for mergers-purchase or pooling of interests - can affect reported book value.

To be useful, an analytical tool must be consistent in its valuations. Yet, as a result of accounting rules and discretionary management actions, two companies with identical tangible assets and liabilities could have very different reported book values.

• This renders book value not terribly useful as a valuation yardstick. 

As with earnings, book value provides limited information to investors and should only be considered as one component of a more thorough and complete analysis.

Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield

Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.

Conventional Valuation Yardsticks: Earnings and Earnings Growth

Earnings and Earnings Growth

Earnings per share has historically been the valuation yardstick most commonly used by investors.

Unfortunately, as we shall see, it is an imprecise measure, subject to manipulation and accounting vagaries.

It does not attempt to measure the cash generated or used by a business.

And as with any prediction of the future, earnings are nearly impossible to forecast.


Massaging earnings by managements

Corporate managements are generally aware that many investors focus on growth in reported earnings, and a number of them gently massage reported earnings to create a consistent upward trend.

A few particularly unscrupulous managements play accounting games to turn

• deteriorating results into improving ones, 
• losses into profits, and 
• small profits into large ones.

Earnings can mislead as to the real profit.

Even without manipulation, analysis of reported earnings can mislead investors as to the real profitability of a business.

Generally accepted accounting practices (GAAP) may require actions that do not reflect business reality.

• By way of example, amortization of goodwill, a noncash charge required under GAAP, can artificially depress reported earnings; an analysis of cash flow would better capture the true economics of a business. 
• By contrast, nonrecurring gains can boost earnings to unsustainable levels, and should be ignored by investors." 

Most important, whether investors use earnings or cash flow in their valuation analysis, it is important to remember that the numbers are not an end in themselves. Rather they are a means to understanding what is really happening in a company.




Conventional Valuation Yardsticks: Earnings, Book Value, and Dividend Yield

Both earnings and book value have a place in securities analysis but must be used with caution and as part of a more comprehensive valuation effort.