Sunday, 15 January 2017

Value Investor's Opportunities in Distressed Securities

Some of the risks and opportunities associated with investing in distressed securities. 
While regular value investing involves dealing with a wide number of unknowns, distressed securities represent particularly complex situations. 

 Because most investors are unwilling to put in the time and effort involved with analysing such securities; for some, the opportunities are plentiful in this realm.

Three Reasons for financial distress

There are three reasons a company might run into financial distress: 
  • operating issues, 
  • legal issues, and/or 
  • financial issues. 



Responses to financial distress and the implications to the investment

Issuers can respond to such situations in one of three ways: 
  • continue to pay obligations, 
  • attempt to convert obligations into less stringent obligations (e.g. get debt holders to accept preferred stock), or 
  • default and declare bankruptcy. 


Investors must understand the implications to their investments as the above scenarios play out. 

Investors must also: 
  • understand how other stakeholders will react to such situations, and 
  • understand the power that various stakeholders have (for example, one third of a stakeholder groups constitutes a blocking group, and can use this to further that stakeholder group's interests).


Investing Opportunities in Bankruptcies

While bankruptcies are often complex and difficult to analyse.

Investors who know what they are doing usually have tremendous opportunities for returns with very little risk. 

At the same time, someone who doesn't know what he's doing risks losing his entire investment.

The process of analysing financially distressed securities starts at the balance sheet. 
  • Assets should be valued so that the size of the pie can be estimated. 
  • Obligations should then be subtracted from this amount. 
  • This task is much more difficult than it appears, however. 
  • For a distressed company, asset values are usually a moving target, and getting a handle on their value can be difficult. 
  • Furthermore, off-balance sheet liabilities must also be considered.

In bankruptcies, mis-pricing can occur which allow the enterprising value investors the opportunity for excellent returns.



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Value Investing Opportunities in the Banking Sector

Opportunities available for value investors in the banking sector. 

In the mid-1980s to early 1990s, many banks were selling for less than book value. 

During the recession of the early 90s, many banks had to be bailed out by the government due to some of the high-risk loans they had offered and due to the general downturn in the US real-estate market...remind you of today?

Apart from the top 10 to 20 largest banks, Wall Street analysts did not follow thrifts.

As a result, small and mid-sized shops were trading at inefficient prices, allowing value investors to purchase some companies at a large discount.



Some elements of valuing banks. 

Many banks are "un-analysable", for example if they deal in junk-bonds or complex mortgage securities or other exotic lending instruments.

Conservatism is of the utmost importance when valuing companies in this industry, due to the fact that they are highly leveraged and thus already contain a certain amount of risk.

Book value is a good start for valuing a bank, but is usually a conservative estimate of what it is worth.

  • Book value should be adjusted upward for understated assets such as appreciated investment securities, below-market leases, real estate carried below cost and a stable customer/deposit base. 
  • Investors must also be on the lookout for items that should be used to adjust book value downward, such as intangible assets, bad loans and poor investments that are carried at cost.


There are no sure things in this banking industry. 

These factors play large roles in determining whether an investment will have a good outcome:

  • asset quality, 
  • management discretion, and 
  • interest rate volatility 

All investors can do is pick low-risk individual banks with the best prices to their fundamentals and hope for the best.





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Look at FUNDAMENTALS and POTENTIAL CATALYSTS when making investment decisions

Look at Fundamentals

 Value investors who paid attention to fundamentals (e.g. strong businesses masked by unprofitable divisions, or companies trading at discounts to cash etc.) reaped enormous profits.




Look for potential catalysts

Investors should look for potential catalysts when making investment decisions.   Catalysts are events that cause a stock's value to be recognised, thus resulting in immediate returns to investors who purchased at a discount. 
  • A liquidation is an example of a catalyst, and there are some companies where such events have returned generous - and quick - positive results for investors (e.g. during bankruptcy events, where securities generally trade at a discount to their recoverable values).
  • Share buybacks and asset sales also represent partial catalysts, as they can cause a stock to inch closer to its underlying value.  More importantly, such events signal that management is interested in returning value to shareholders, which bodes well for the future.
Some areas where value investors can indeed find value include: 
  • liquidations, 
  • complex securities (i.e. securities institutions can't purchase because they don't fit set categories), 
  • rights offerings (often offering prices lower than current market value), 
  • spinoffs (as they are usually sold by holders of the parents, thus depressing prices immediately) and 
  • risk arbitrage (depending on the market's mood, as sometimes the market's exuberance can erode returns).




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Where to look for Investment Opportunities

Where to find Investment Opportunities

 Sometimes, there are so many value investments available that the only constraint on the investor is a lack of funds. 

 Most times, however, investors find it difficult to find value investment opportunities. Investors can spend a lot of time reading through financial reports, research reports, and other financial news and end up finding nothing but fairly valued opportunities. 

 Therefore, it is important that the investor look in the right places.


A few of the places for finding investment opportunities include 
  • the new-low lists, 
  • the largest percentage-decliners lists which are published by major news sources, and also,
  • companies whose dividends have been cut or eliminated can also be unduly punished by the market, leaving investment opportunities. 

Of course, just because a stock shows up on one of these lists does not make it a buy; one still has to go through the valuation process in order to determine whether it trades at a discount to its fair value.



Is the management buying or selling the company's stock?

Investors should look at what management is doing with respect to the company's stock. 

Nobody knows the business as well as management does, and so if management is buying that is often a good sign for the stock.



Why? Why?  Why has a stock been performing poorly?

Investors are also encouraged to consider why a stock has been performing poorly (and therefore may make for a good investment). 

If an investor can pinpoint this reason, he can be more comfortable that he may have found value. 

If this reason cannot be found, it is possible that the investor is missing some information which the market knows (important lawsuit pending, competitor coming out with similar product etc.).





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Business value cannot be precisely determined. Make use of ranges of values.

Business value cannot be precisely determined. 

 Not only do a number of assumptions go into a business valuation, but relevant macro and micro economic factors are constantly changing, making a precise valuation impossible. 

 Although anyone with a calculator or a spreadsheet can calculate a net present value of future cash flows, the precise values calculated are only as accurate as the underlying assumptions.

Investors should instead make use of ranges of values, and in some cases, of applying a base value. 

Ben Graham wrote:
The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It needs only to establish that the value is adequate—e.g., to pro­tect a bond or to justify a stock purchase—or else that the value is considerably higher or considerably lower than the market price. For such purposes an indefinite and approximate measure of the intrinsic value may be sufficient.




There are only three ways to value a business. 

1.   The first method involves finding the net present value by discounting future cash flows. 

Problems with this method involve trying to predict future cash flows, and determining a discount rate. 

Investors should err on the side of conservatism in making assumptions for use in net present value calculations, and even then a margin of safety should be applied.


2.  The second method is Private Market Value using Multiples. 

This is a multiples approach (e.g. P/E, EV/Sales) based on what business people have paid to acquire whole companies of a similar nature. 

The problems with this method are that comparables assume businesses are all equal, which they are not. 

Furthermore, exuberance can cause business people to make silly decisions. 

Therefore, basing your price on a price based on irrationality can lead to disaster. 

This is believed to be the least useful of the three valuation methods.


3.  Finally, liquidation value as a method of valuation. 

A distinction must be made between a company undergoing a fire sale (i.e. it needs to liquidate immediately to pay debts) and one that can liquidate over time. 

Fixed assets can be difficult to value, as some thought must be given to how customised the assets are (e.g. downtown real-estate is easily sold, mining equipment may not be).





When should each method be employed? 

They can all be used simultaneously to triangulate towards a value. 

In some cases, however, one might place more confidence in one method over the others. 

For example, 
  • liquidation value would be more useful for a company with losses that trades below book value, while 
  • net present value is more useful for a company with stable cash flows.

Using the methods of valuation described, you can search for stocks that are trading at a severe discount; it is possible, their stock price more than doubled soon after.




Beware of these failures

The failures of relying on a company's earnings per share - too easily massaged.

The failure of relying on a company's book value  - not necessarily relevant to today's value.

The failure of relying on a company's dividend yield - incentives of management to make yields appear attractive at the expense of the company's future.



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Saturday, 14 January 2017

Central elements to a Value Investing Philosophy

The three central elements to a value investing philosophy:

1) A "bottom-up" strategy
2) Absolute (as opposed to relative) performance
3) A risk averse approach



Bottom-Up Investing

Most institutional investors use a top-down approach to investing. 

  • That is, they try to forecast macroeconomic conditions, and then select investments based on that forecast. 
  • This method of investing is far too prone to error, and doesn't allow for a margin of safety.
  • For example, a top-down investor must be correct about the big picture, draw the correct conclusions from that big picture prediction, correctly apply those conclusions to attractive areas of investment, correctly specify specific securities, and finally, beat other investors to the punch who have made the same predictions.
  • In addition to these challenges, top-down investors are buying based on concepts, themes and trends. 
  • As such, there is no value element to their purchase decisions, and therefore they cannot buy with a margin of safety. 

On the other hand, bottom-up investors can apply a margin of safety and face a limited number of questions, e.g. what is the business worth, what is the downside etc.



Absolute Performance

Institutional investors are judged based on their performance relative to their peers or the market. 
  • This results in a short-term investing horizon.
  • Thus, if an investment opportunity appears undervalued but the value may not be recovered in the near-term, such investors may shun such an opportunity. 

Absolute investors don't judge themselves based on their performance to the market, which results in a short-term investing horizon. 
  • Instead, they focus on investments that are undervalued, and are willing to wait for that value to come uncovered.



Risk

In the financial industry, returns are expected to correlate with risk. 
  • That is, you cannot generate higher returns without taking more risk. 
  • Downside risk and upside potential are considered to have the same probability (an implication of using beta, a measure of a stock's volatility versus the market).

Value investors think of risk very differently. 
  • Downside risk and upside potential are not necessarily the same.
  • Value investors seek to exploit this key difference by buying stocks with strong upsides and limited downsides.


Read:
Seth Klarman - Margin of Safety




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The Philosophy of Value Investing and Why It Works

What is Value Investing?

 The terms used to describe value investing don't require any accounting or finance background.

Value investing is described as paying 50 cents for a business worth $1. 

Warren Buffett's analogy using the maximum allowable weight of a bridge is used to illustrate how this margin of safety works:

"When you build a bridge, you insist it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing."




Margin of Safety (buying at a discount) is of utmost importance

What allows value investors to apply a margin of safety while most speculators and investors do not?

Again using a Buffett analogy to illustrate this:

A long-term-oriented value investor is a batter in a game where no balls or strikes are called, allowing dozens, even hundreds, of pitches to go by, including many at which other batters would swing. Value investors have infinite patience and are willing to wait until they are thrown a pitch they can handle—an undervalued investment opportunity.

Value investors do not buy businesses they do not understand, nor ones that they find risky. For example, they will avoid technology companies and commercial banks. 

Value investors will also invest where their securities are backed by tangible assets, to protect them from downside risk.

Because the future is unknown (e.g. a business worth $1 today might be worth 75 cents or $1.25 tomorrow), there is little to be gained by paying $1 for this business.

The margin of safety (buying at a discount) is therefore of utmost importance. 

Value investors gain an advantage when many:

  • do not buy with a margin of safety, 
  • remain fully invested at all times, and 
  • trade stocks like pieces of paper with little regard to the underlying asset values.






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