The Importance of Trading: Since transacting at the right price is critical, trading is central to value-investment success.

There is nothing inherent in a security or business that alone makes it an attractive investment.

Investment opportunity is a function of price, which is established in the marketplace.

• Whereas some investors are company- or concept-driven, anxious to invest in a particular industry, technology, or fad without special concern for price, a value investor is purposefully driven by price. 
• A value investor does not get up in the morning knowing his or her buy and sell orders for the day; these will be determined in the context of the prevailing prices and an ongoing assessment of underlying values. 

Since transacting at the right price is critical, trading is central to value-investment success. 

• This does not mean that trading in and of itself is important; trading for its own sake is at best a distraction and at worst a costly digression from an intelligent and disciplined investment program. 
• Investors must recognize that while over the long run investing is generally a positive sum activity, on a day-to-day basis most transactions have zero sum consequences. If a buyer receives a bargain, it is because the seller sold for too low a price. If a buyer overpays for a security, the beneficiary is the seller, who received a price greater than underlying business value. 

The best investment opportunities arise when other investors act unwisely thereby creating rewards for those who act intelligently. 

• When others are willing to overpay for a security, they allow value investors to sell at premium prices or sell short at overvalued levels. 
• When others panic and sell at prices far below underlying business value, they create buying opportunities for value investors. 
• When their actions are dictated by arbitrary rules or constraints, they will overlook outstanding opportunities or perhaps inadvertently create some for others. 

Trading is the process of taking advantage of such mispricings.

Reducing Portfolio Risk

The challenge of successfully managing an investment portfolio goes beyond making a series of good individual investment decisions.

Portfolio management requires paying attention to the portfolio as a whole, taking into account 

• diversification, 
• possible hedging strategies, and 
• the management of portfolio cash flow. 

In effect, while individual investment decisions should take risk into account, portfolio management is a further means of risk reduction for investors. 



1.  Appropriate Diversification 

Even relatively safe investments entail some probability, however small, of downside risk.

• The deleterious effects of such improbable events can best be mitigated through prudent diversification. 
• The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great; as few as ten to fifteen different holdings usually suffice. 

Diversification for its own sake is not sensible. This is the index fund mentality: if you can't beat the market, be the market.

• Advocates of extreme diversification - which I think of as overdiversification - live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great. 
• My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. 
• One's very best ideas are likely to generate higher returns for a given level of risk than one's hundredth or thousandth best idea. 

Diversification is potentially a Trojan horse. 

• Junk-bond-market experts have argued vociferously that a diversified portfolio of junk bonds carries little risk. Investors who believed them substituted diversity for analysis and, what's worse, for judgment. 
• The fact is that a diverse portfolio of overpriced, subordinated securities, about each of which the investor knows relatively little, is highly risky. 
• Diversification of junk-bond holdings among several industries did not protect investors from a broad economic downturn or credit contraction. 
• Diversification, after all, is not how many different things you own, but how different the things you do own are in the risks they entail. 

2.  Hedging 

Market risk - the risk that the overall stock market could decline - cannot be reduced through diversification but can be limited by hedging. An investor's choice among many possible hedging strategies depends on the nature of his or her underlying holdings.


A diversified portfolio of large capitalization stocks, for example, could be effectively hedged through the sale of an appropriate quantity of Standard & Poor's 500 index futures. 

• This strategy would effectively eliminate both profits and losses due to broad-based stock market fluctuations. 
• If a portfolio were hedged through the sale of index futures, investment success would thereafter depend on the performance of one's holdings compared with the market as a whole. 

A portfolio of interest-rate-sensitive stocks could be hedged by selling interest rate futures or purchasing or selling appropriate interest rate options.

A gold-mining stock portfolio could be hedged against fluctuations in the price of gold by selling  gold futures.

A portfolio of import- or export-sensitive stocks could be partially hedged through appropriate transactions in the foreign exchange markets. 



It is not always smart to hedge. 

• When the available return is sufficient, for example, investors should be willing to incur risk and remain unhedged. 
• Hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment. 
• When the cost is reasonable, however, a hedging strategy may allow investors to take advantage of an opportunity that otherwise would be excessively risky. 
• In the best of all worlds, an investment that has valuable hedging properties may also be an attractive investment on its own merits. 

By way of example, from mid-1988 to early 1990 the Japanese stock market rose repeatedly to record high levels. The market's valuation appeared excessive by U.S. valuation criteria, but in Japan the view that the stock market was indirectly controlled by the government and would not necessarily be constrained by underlying fundamentals was widely held.

• Japanese financial institutions, which had become accustomed to receiving large and growing annual inflows of funds for investment, were so confident that the market would continue to rise that they were willing to sell Japanese stock market puts (options to sell) at very low prices. 
• To them sale of the puts generated immediate income; since in their view the market was almost certainly headed higher, the puts they sold would expire worthless. 
• If the market should temporarily dip, they were confident that the shares being put back to them would easily be paid for out of the massive cash inflows they had come to expect. 

Wall Street brokerage firms acted as intermediaries, originating these put options in Japan and selling them in private transactions to U.S. investors.' These inexpensive puts were in theory an attractive, if imprecise, hedge for any stock portfolio.

• Since the Japanese stock market was considerably overvalued compared with the U.S. market, investors in U.S. equities could hedge the risk of a decline in their domestic holdings through the purchase of Japanese stock market puts. 
• These puts were much less expensive than puts on the U.S. market, while offering considerably more upside potential if the Japanese market declined to historic valuation levels. 

As it turned out, by mid-1990 the Japanese stock market had plunged 40 percent in value from the levels it had reached only a few months earlier.

• Holders of Japanese stock market put options, depending on the specific terms of their contracts, earned many times their original investment. 
• Ironically, these Japanese puts did not prove to be a necessary hedge; the Japanese stock market decline was not accompanied by a material drop in U.S. share prices. 
• These puts were simply a good investment that might have served as a hedge under other circumstances.

The Importance of Liquidity in Managing an Investment Portfolio

Since no investor is infallible and no investment is perfect, there is considerable merit in being able to change one's mind.

• If an investor purchases a liquid stock such as IBM because he thinks that a new product will be successful or because he expects the next quarter's results to be strong, he can change his mind by selling the stock at any time before the anticipated event, probably with minor financial consequences. 
• An investor who buys a nontransferable limited partnership interest or stock in a nonpublic company, by contrast, is unable to change his mind at any price; he is effectively locked in. 
• When investors do not demand compensation for bearing illiquidity, they almost always come to regret it. 

Most of the time liquidity is not of great importance in managing a long-term-oriented investment portfolio. 

• Few investors require a completely liquid portfolio that could be turned rapidly into cash. 
• However, unexpected liquidity needs do occur. 
• Because the opportunity cost of illiquidity is high, no investment portfolio should be completely illiquid either. 
• Most portfolios should maintain a balance, opting for greater illiquidity when the market compensates investors well for bearing it. 

A mitigating factor in the trade-off between return and liquidity is duration. 

• While you must always be well paid to sacrifice liquidity, the required compensation depends on how long you will be illiquid. 
• Ten or twenty years of illiquidity is far riskier than one or two months; in effect, the short duration of an investment itself serves as a source of liquidity. 
• Investors making venture-capital investments, for example, must be exceptionally well compensated to offset the high probability of loss, the large proportion of the investment that is at risk (losses are often complete wipeouts), and the illiquidity experienced for the duration of the investment. 
• The cost of illiquidity is very high in such situations, rendering venture capitalists virtually unable to change their minds and making it difficult for them to cash in even when the businesses they invested in are successful. 

Liquidity can be illusory.

• As Louis Lowenstein has stated, "In the stock market, there is liquidity for the individual but not for the whole community. 
• ''''The distributable profits of a company are the only rewards for the community."! 
• In other words, while anyone investor can achieve liquidity by selling to another investor, all investors taken together can only be made liquid by generally unpredictable external events such as takeover bids and corporate-share repurchases. 
• Except for such extraordinary transactions, there must be a buyer for every seller of a security. 

In times of general market stability the liquidity of a security or class of securities can appear high. In truth liquidity is closely correlated with investment fashion. 

• During a market panic the liquidity that seemed miles wide in the course of an upswing may turn out only to have been inches deep. 
• Some securities that traded in high volume when they were in favor may hardly trade at all when they go out of vogue. 

When your portfolio is completely in cash, there is no risk of loss. There is also, however, no possibility of earning a high return. 

• The tension between earning a high return, on the one hand, and avoiding risk, on the other, can run high. 
• The appropriate balance between illiquidity and liquidity, between seeking return and limiting risk, is never easy to determine. 

Investing is in some ways an endless process of managing liquidity. 

• Typically an investor begins with liquidity, that is, with cash that he or she is looking to put to work. 
• This initial liquidity is converted into less liquid investments in order to earn an incremental return. 
• As investments come to fruition, liquidity is restored. Then the process begins anew. 

This portfolio liquidity cycle serves two important purposes. 

• First, portfolio cash flow - the cash flowing into a portfolio - can reduce an investor's opportunity costs. 
• Second, the periodic liquidation of parts of a portfolio has a cathartic effect. 
• For the many investors who prefer to remain fully invested at all times, it is easy to become complacent, sinking or swimming with current holdings. 
• "Dead wood" can accumulate and be neglected while losses build. 
• By contrast, when the securities in a portfolio frequently tum into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available.

Portfolio Management and Trading

Investing would be complete without a discussion of trading and portfolio management.



Trading

Trading - the process of buying and selling securities - can have a significant impact on one's investment results.  Good trading decisions can

• sometimes add to an investment's profitability and 
• other times can mean the difference between executing a transaction and failing to do so. 

Portfolio Management

Portfolio management encompasses

• trading activity 
• as well as the regular review of one's holdings. 

In addition, an investor's portfolio management responsibilities include

• maintaining appropriate diversification, 
• making hedging decisions, and 
• managing portfolio cash flow and liquidity. 

All investors must come to terms with the relentless continuity of the investment process. 

Although specific investments have a beginning and an end, portfolio management goes on forever. 




Investors in marketable securities will not have predictable annual results

Unlike many areas of endeavor, there is no near-annuity of profitable business, no backlog of upcoming investment returns. 

Heinz ketchup will have a reasonably predictable volume of sales year in and year out. In a sense, its profits of tomorrow were partially earned yesterday when its franchise was established.

Investors in marketable securities will not have predictable annual results, however, even if they possess shares representing fractional ownership of the same company. 

Moreover, attractive returns earned by Heinz may not correlate with the returns achieved by investors in Heinz; the price paid for the stock, and not just business results, determines their return.

JOHN MAYNARD KEYNES: COURAGE IS THE KEY TO INVESTING

Posted by jasonzweig on Oct 17, 2016 in Articles & Advice, Blog, Columns, Featured, Radio & Podcasts |

Image Credit: “Maynard Keynes,” Duncan Grant (1917-18), The Charleston Trust

 

By Jason Zweig |  Oct. 14, 2016 11:21 am ET

The next time the stock market crashes, we will all step forward and buy stocks boldly — at least in our imaginations.

But buying stocks when the market collapses is far harder to do than to imagine. New research looks at how the great economist  — and equally great investor — John Maynard Keynes waded into the wake of the Great Crash of 1929, when U.S. stocks fell by more than 80% from peak to trough. His experience should teach all investors the importance of preparation, courage and patience.

Between the early 1920s and his death in 1946, Keynes wrote several books, revolutionized economic policy and helped devise the modern global monetary system. In his spare time, he managed the endowment of King’s College at the University of Cambridge. From 1922 through 1946, Keynes’ stock portfolio outperformed the U.K. stock market by an average of nearly six percentage points annually — over a period covering the worst market crash, the worst economic depression and the worst war in modern history.

Keynes didn’t look like a great investor all the time. As what we today call a value investor, focused on buying stocks at bargain prices, he got left behind in the torrid bull market of the 1920s. Keynes didn’t see the Great Depression coming; he went into the Crash of 1929 with roughly 90% of the college’s funds in stocks even though, at the time, most other endowments overwhelmingly preferred bonds.

By late 1929 Keynes had cumulatively underperformed the British stock market by 40 percentage points over the preceding five years.

But he was already turning his performance around.

In a new research paper in Business History Review, an academic journal, finance professor David Chambers of Cambridge’s Judge Business School and economist Ali Kabiri of the University of Buckingham analyze how Keynes mustered the courage to invest heavily in U.S. stocks devastated by the crash and the ensuing depression.

Keynes had almost entirely ignored U.S. stocks in the college’s endowment until September 1930. What a time to get interested! The U.S. stock market had fallen 38.4% over the preceding 12 months. But Keynes was so excited by the bargains he saw opening up in the U.S. that he worked with a small New York brokerage, Case Pomeroy & Co., to research the market and his own stock ideas. In 1931, when U.S. stocks fell a bloodcurdling 47.1%, and again in 1934, when they dropped another 5.9%, Keynes traveled to the U.S., spending much of his time meeting people on Wall Street, in government and in business who could help him research his investment ideas.

He bought U.S. stocks throughout the depression. When they fell another 38.6% in 1937, Keynes, undaunted, bought still more. By 1939, he had put half his main portfolio for the college in U.S. companies, favoring high-dividend-paying preferred stocks, investment trusts (diversified stock portfolios similar to today’s mutual funds) and, later on, public utilities. He focused on a small number of stocks trading at low multiples of their value as businesses, often hanging on for eight years or more until their stock prices finally rose to reflect those asset values.

Chapter 12 of Keynes’ book “The General Theory of Employment, Interest and Money,” which he wrote 80 years ago, remains one of the most concentrated bursts of brilliance anyone has ever brought to bear on investing. His words still ring with the resolve it must have taken to buy when blood was running in the streets:

“The spectacle of modern investment markets has sometimes moved me towards the conclusion that to make the purchase of an investment permanent and indissoluble, like marriage, except by reason of death or other grave cause, might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only.”

Keynes understood, as did his contemporary, the American value investor Benjamin Graham, that bear markets are so unpredictable that reliably sidestepping them is nearly impossible — and that the pain of losing money is nearly unbearable.

Still, Keynes knew, barging into bear markets to buy, rather than trying to sidestep them, is the way to prevail. Since, over the long run, stocks tend to go up more than they go down, one of the greatest advantages an investor can have is the gumption to buy stocks aggressively in falling markets.

That requires both cash and courage.

With stocks still not far from their record highs today, sitting on some cash is a better idea than ever.

And — unless you’re in or near retirement, in which case you should probably be scaling back on stocks already — steel your courage. Write a binding contract with yourself, witnessed by a friend or family member, committing you to buy more stocks when they fall 25%, 50% or more. Years from now, you’ll be glad you did.

Source: The Wall Street Journal

http://blogs.wsj.com/moneybeat/2016/10/14/john-maynard-keynes-courage-is-the-key-to-investing/

Your financial well-being is definitely not something to trifle with.

Once you choose to venture beyond U.S. Treasury bills, whatever you do with your money carries some risk.

Don't think you can avoid making a choice; inertia is also a decision.

It took a long time to accumulate whatever wealth you have; your financial well-being is definitely not something to trifle with. 

For this reason, I recommend that you adopt a value-investment philosophy and

• either find an investment professional with a record of value-investment success 
• or commit the requisite time and attention to investing on your own.

Investing in Financially Distressed and Bankrupt Securities: Issuer Responses to Financial Distress

There are three principal alternatives for an issuer of debt securities that encounters financial distress:

• continue to pay principal and interest when due, 
• offer to exchange new securities for securities currently outstanding, or 
• default and file for bankruptcy. 

A potential investor in distressed securities must consider each of these three possible scenarios before committing capital.

Financially troubled companies can try to survive outside bankruptcy by resorting to

• cost cutting, 
• asset sales, or 
• an infusion of outside capital. 

Such efforts can be successful, depending on the precise cause of the debtor's woes.  Short-term palliatives, however, can contribute to the erosion of long-term business value.

Efforts to conserve cash by cutting back inventory, stretching out accounts payable, or reducing salaries, for example, can get a business through a short-term crisis, but in the long run some of these measures may hurt relationships with customers, suppliers, and employees and result in a diminution of business value. 

A second option for a company is to make an exchange offer to replace outstanding debt and, where relevant, preferred stock with new securities. The possibility of an exchange offer adds a strategic dimension to investing in financially distressed securities absent from most passive investments. An exchange offer is an attempt by a financially distressed issuer to stave off bankruptcy by offering new, less-onerous securities in exchange for some or all of those outstanding.

An exchange offer can serve as an out-of-court plan of reorganization. Sometimes an offer is made to exchange for only one security; perhaps the issuer needs only to extend an upcoming maturity. Other times most or all outstanding debt securities and, where relevant, preferred stock are offered the opportunity to exchange.

Exchange offers are difficult to complete. Typically they involve persuading debt holders (and preferred stockholders, if any) to accept less than one dollar's worth of new securities for each current dollar of claim against the debtor. The greatest difficulty in consummating an exchange offer is that, unlike stockholders, bondholders cannot be compelled to do anything. Depending on state law, a vote of 50 percent or 67 percent of the stockholders of a company is sufficient to approve a merger; the minority is compelled to go along. However, the majority of a class of bondholders cannot force the minority to accept an exchange offer. This results in a free-rider problem since the value of "holding out" is typically greater than the value of going along with a restructuring.

Suppose Company X needs to cut its debt from $100 million to $75 million and offers bondholders an opportunity to exchange their bonds, currently trading at fifty cents on the dollar, for new bonds of equal seniority valued at seventy-five. This offer may be acceptable to each holder; individually they would be willing to forego the full value of their claims in order to avoid the uncertainty and the delay of bankruptcy proceedings as well as the loss of the time-value of their money. They may be concerned, however, that if they agree to exchange while others do not, they will have sacrificed 25 percent of the value owed them when others have held out for full value. Moreover, if they make the sacrifice and others do not, the debtor may not be sufficiently benefitted and could fail anyway. In that event those who exchanged would be rendered worse off than those who did not because, by holding a lower face amount of securities, they would have a smaller claim in bankruptcy.

An exchange offer is somewhat like the Prisoner's Dilemma. In this paradigm two prisoners, held incommunicado, are asked to confess to a crime. If neither confesses, they both go free. If both confess, they incur a severe punishment but not a lethal one. If one confesses and the other holds out, however, the holdout will be executed. If they could collude, both prisoners would hold out and go free; held in isolation, each fears that the other might confess.

The Prisoner's Dilemma is directly applicable to the bondholders in an exchange offer. Each might be willing to go along if he or she could be certain that other holders would also, but since no bondholder could be certain of others' cooperation, each has a financial incentive to hold out. Exchange offers often require a very high acceptance rate in order to mitigate this problem. If all bondholders could be brought together, there might be a chance to achieve voluntary cooperation. Historically, however, bondholders have been a disparate group, not always even identifiable by the debtor and hard to bring together for negotiations.

One way to overcome the free-rider problem is a technique known as a prepackaged bankruptcy, in which creditors agree to a plan of reorganization prior to the bankruptcy filing. Because negotiations have already been completed, a prepackaged bankruptcy is reasonably expected to be dispatched in months rather than years; the duration is not much greater than the time involved in completing an exchange offer. The advantage of a prepackaged bankruptcy over an exchange offer is that since a majority in number and two-thirds of the dollar amount of each creditor class must approve a bankruptcy plan, up to one-third of the dollar amount of a class can be compelled to go along with the other creditors, effectively eliminating the freerider problem. It seems likely that there will be increased use of the prepackaged bankruptcy in future efforts to restructure overleveraged companies in order to expedite the reorganization process, avoid the high administrative costs of a traditional Chapter 11 filing, and circumvent the free-rider problem.


If measures to keep the patient alive prove unsuccessful, the third option is to file for court protection under Chapter 11 of the federal bankruptcy code and attempt to reorganize the debtor with a more viable capital structure. This is typically a last resort, however, for there is still considerable stigma attached to bankruptcy.

Investing in Financially Distressed and Bankrupt Securities

Financially Distressed and Bankrupt Businesses 

Companies get into financial trouble for at least one of three reasons: 

• operating problems, 
• legal problems, and/or 
• financial problems. 

A serious business deterioration can cause continuing operating losses and ultimately financial distress. Unusually severe legal problems, such as those that plagued Johns Manville, Texaco, and A. H. Robins, caused tremendous financial uncertainty for these companies, leading them ultimately to seek bankruptcy court protection. Financial distress sometimes results almost entirely from the burdens of excessive debt; many of the junk-bond issuers of the 1980s shared this experience.



Financial distress is typically characterized by a shortfall of cash to meet operating needs and scheduled debt-service obligations.

• When a company runs short of cash, its near-term liabilities, such as commercial paper or bank debt, may not be refinanceable at maturity. 
• Suppliers, fearing that they may not be paid, curtail or cease shipments or demand cash on delivery, exacerbating the debtor's woes. 
• Customers dependent on an ongoing business relationship may stop buying. 
• Employees may abandon ship for more secure or less stressful jobs. 

Since the effect of financial distress on business results can vary from company to company, investors must exercise considerable caution in analyzing distressed securities.

• The operations of capital-intensive businesses are, over the long run, relatively immune from financial distress, while those that depend on public trust, like financial institutions, or on image, like retailers, may be damaged irreversibly. 
• For some businesses the decline in operating results is limited to the period of financial distress. 
• After a successful exchange offer, an injection of fresh capital, or a bankruptcy reorganization, these businesses recover to their historic levels of profitability. Others, however, remain shadows of their former selves. 

The capital structure of a business also affects the degree to which operations are impacted by financial distress.

• For debtors with most or all of their obligations at a holding company one or more levels removed from the company's primary assets, the impact of financial distress can be minimal. 
• Overleveraged holding companies, for example, can file for bankruptcy protection while their viable subsidiaries continue to operate unimpaired; Texaco entered bankruptcy while most of its subsidiaries did not file for court protection. 
• Companies that incur debt at the operating-subsidiary level may face greater dislocations. 

The popular media image of a bankrupt company is a rusting hulk of a factory viewed from beyond a padlocked gate.

• Although this is sometimes the unfortunate reality, far more often the bankrupt enterprise continues in business under court protection from its creditors. 
• Indeed, while there may be a need to rebuild damaged relationships, a company that files for bankruptcy has usually reached rock bottom and in many cases soon begins to recover. 
• As soon as new lenders can be assured of their senior creditor position, debtor-in-possession financing becomes available, providing cash to meet payroll, to restock depleted inventories, and to give confidence both to customers and suppliers. 
• Since postpetition suppliers to the debtor have a senior claim to unsecured prepetition creditors, most suppliers renew shipments. 
• As restocked inventories and increased confidence stimulate business and as deferred maintenance and delayed capital expenditures are undertaken, results may begin to improve. 
• Cash usually starts to build (for a number of reasons). 
• When necessary, new management can be attracted by the prospect of a stable and improving business situation and by the lure of low-priced stock or options in the reorganized company. 
• While Chapter 11 is not a panacea, bankruptcy can provide a sheltered opportunity for some troubled businesses to return to financial health.

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.