Fructivore Investments

I was reading a book about structured finance lately, which talked about the enormous advances that have been made in leasing. It is possible, through these companies and their special purpose entities to arrange the leasing of an entire factory and its contents, for years, without recording any of it as a liability or, worse, actually spending money and putting it on the balance sheet. In fact, the latest refinement in this area is that the lessor company itself borrows the money that it uses to buy the leased property, thus allowing it to claim the tax benefits of depreciation while the bulk of the lease income can presumably be hidden offshore.

Well, the stock I have to discuss does none of those things. Microfinancial (MFI) is a finance company that deals in leasing of business equipment for fairly small amounts ($5500 on average) for the benefit of their clients who find that leasing is more effective than selling their products. So, in the above example they would be the offshore lease income receiver, although they are actually onshore.

The business has decent return on capital lately, although writeoffs have been taking their toll last year. Their P/E ratio YTD is about 12, and for 2008’s earnings it would have been 7 1/2.  The firm pays a dividend of about 7%. As the economy improves and the writeoff situation improves with it, it is likely that the firm can return to its former huge profitability, and the firm has $33 million, which is more than half of its market cap, available on its line of credit to see it through to that happy point. Furthermore, the firm has a price/book ratio of 0.63, meaning that at this price investors can purchase the leases for less than the company paid for them.

There is one more thing I have to address. I don’t like to get political, but I couldn’t let the recent decision by the Supreme Court that corporations have the freedom of speech right to spend unlimited amounts of money out of their own budgets to make campaign advertisements. This is in my view and in the views of many people the largest step, and the last step necessary, to turn the United States into a corporatocracy. Ratings agencies have used their supposed freedom of speech rights to evade responsibility for giving AAA ratings to poisoned CDOs, but this is much more sinister.

It seems to me that it is wholly anathema to freedom of speech that the more money you have, the more speech you get, and the entire line of cases that has established that corporations are entitled to the rights of citizenship has worried me. Since Obama and McCain have both blasted this decision, and it can be attacked from progressive and even Tea-bagging grounds as well, it seems to me that this is not a matter of left versus right, but a matter of left and right and bottom against the top.

It is time for a Constitutional amendment disapproving of granting corporations 14th amendment rights, and there is a more pressing and immediate need for such an amendment than any other possible amendment. I urge all concerned Americans to contact the President and their representatives in Congress (not the Supreme Court itself; they don’t care) calling for measures in response to this.

One proposal I have heard though, short of an amendment, is a rule requiring shareholder approval before any such money is spent. Although they were not clear on the details, it seems to me that this rule is virtually mandated if corporations get free speech rights; after all, corporations are the instruments of their shareholders and so if corporations are making a speech that the shareholders disagree with, then shareholders are effectively forced into making a speech that they disagree with. And if denial of free speech is a major violation of the First Amendment, forcing someone to engage in speech is an equal violation (there are cases on this point).

Accordingly, short of a Constitutional amendment (which is a good idea with or without this decision), the effect of the Court’s could be blunted, in a manner entirely consistent with freedom of speech, by requiring the unanimous approval of all shareholders before the corporation engages in this politicizing. Anything less forces the dissenting shareholders into making an involuntary speech, and that is definitely verboten.

I think I’ll write that suggestion in to Congress and the President as well.

I recently purchased Value Investing by Montier. It’s an interesting book, but it seems to focus more on behavioral finance issues and value investing philosophy than actual techniques. Now, of course, no one describes their investing style as “behavioral finance,” but to a large degree every investment philosophy depends on exploiting some mistake that most investors make so although it’s not all you need to understand to invest, it is something you need to understand. Since the techniques of value investing were invented decades ago and have not really changed much, the book’s focus is fine. It never hurts for value investors to read a well-written book that allows us to renew our smugness; we feel comforted knowing that the great titans of Wall Street are still capable of being outmatched by a little guy who’s capable of remembering that 2+2=4 (but sometimes you can buy it for 3 anyway).

Actually, as to that example, in his multi-part debunking of the efficient market hypothesis he even goes after the well-known statistic that mutual funds generally do not beat the market over long periods. First of all, he explains that mutual funds fail to beat the target index because most of the time they purchase the target index for most of their portfolio to avoid lagging behind. In fact, one bold and daring mutual fund manager was apparently forced by his company to dilute his good ideas with a premade portfolio to better replicate the index. The author’s own study revealed that over a period where good mutual funds earned 12% a year, which was the index average, if you instead considered the managers’ best ideas, as estimated by their largest positions, they managed to pull off 19% a year over the same period. So, the much touted inability of fund managers to beat the market is the fault of the fund management business, not the inability of the parties involved.

John Nash, founder of game theory

He also describes a nifty game that was played at a conference he attended. All the parties guess a number from 0 to 100, and the winner is the one who guesses the number that is 2/3 of the average of the guesses. He describes first that since the winning answer can never be above 67, and that only applies if everyone else guesses 100, he was kind of surprised that there were answers above 67.

There was a small cluster of answers at 50, which he calls “0-level thinking.” So, an answer around 33 would be “1-level thinking” because it assumes that the average guess would be 50, and so 22 I guess would be “2-level thinking.” There was a large cluster of answers around 0 and 1 (perhaps owing to some confusion about whether 0 was a legal answer), and the author noted “these would be the game theorists and the quants.” He is correct that the answer of 0 is “n-level thinking” where n is a decently large number, because if everyone thinks the situation out and pursues optimum strategy 0 is the correct answer. But the actual answer was 17 because the average was 26 (and he concludes that the average professional investor employs 1.6 level thinking, since 50 * (2/3)^1.6 is 26).

But I want to focus on the people who voted higher than 67. He thought it was owing to some confusion about how the game worked, but I think it was just some people who wanted to annoy the game theorists and their fancy book-larnin’. Since only 3 people got the right answer (out of 1000 players and with only 68 “real” answers available, so they actually did worse than a random guess), it is possible that people played to enjoy the game rather than to win. My friend Mike adopts a similar approach to the game of Fluxx; instead of playing to win he tries to play so that the game will last forever, which is not difficult. I think that the people who voted above 67 were just trying to block the game theorists and their optimum strategizing.

I know I would.

I have spoken highly in the past of a stock selling for less than its net working capital with the additional criterion that the firm be profitable. On top of the attractiveness of the stock recovering at least to its asset value, the net working capital level serves as a price floor, thus reducing the risk of holding the company. As a result, the investor should be theoretically able to lower their required return on capital to go with the reduced risk, since a risk-free investment that can beat the risk-free rate is in a theoretical sense just as good as an ordinary equity investment that beats the ordinary return on equity.

Of course, I am skeptical of theoretical finance, but value investors agree that the way to make money from investing is simply to avoid losing it. And as a result, if the stock is already trading at or near its price floor and is profitable, the stock is at least a candidate for purchase. However it is normally a run of losses that depresses investor sentiment to the point where the stock is pushed towards or below its net working capital in the first place, so instead of currently profitable, potentially profitable would be a better test (of course, Key Tronic was always profitable, but it takes more than one stock to fill in a portfolio). When the company does return to profitability, the price should appreciate to bring return on assets in line with asset prices.

For example, Coast Distribution Systems (CRV) is a wholesaler of replacement parts for recreational vehicles and boats, and naturally with the slowing economy interest in boating and recreation has gone down. On the one hand, boats and recreational vehicles are expensive and it is more likely that owners keep their existing vehicles going longer, but on the other hand they might be abandoning this expensive hobby entirely, and even if they did not sales of new boats and RVs are going to be depressed, which will affect the market for parts for some time.

However, CRV has adapted to this situation by dramatically cutting their operating expenses, from around $27 million a year in previous years to $20.1 million in the last four quarters, and a mere $4.7 million in the last quarter reported. Of course, there is a limit to how far costs can be cut, but the firm has been profitable for the last two quarters as a result, despite sales dropping by nearly half since 2006. So, if the firm does find its feet again on its present operating scale, as it appears to be doing, there should be no little further erosion of the stockholder’s equity.

And the equity itself, according to the balance sheet, is $30.6 million against a current market cap of $17.4 million. Furthermore, the current assets, cash, receivables, and inventory, count for all but $5 million of this amount, so even if there is some erosion of current asset values the stock is selling for below the stock’s theoretical minimum value, so there is ample room for appreciation.

So, again, stocks with a built-in asset value floor that is higher than the current stock price are a good idea if they are now, or can be expected to be profitable under reasonable, not particularly optimistic assumptions.

A great deal of value investing is the process of elimination. Warren Buffett, when asked how he finds undervalued stocks, simply replied “Start with the A’s.” But in most markets only a small fraction of securities count as underpriced on an absolute basis, so value investing requires wading through an endless sea of crap in search of the delicious low-hanging fruit (yes, in this example fruit comes from the sea). Given my affinity for this mode of investing, how could I not like Ross Stores (ROST)?

Ross Stores is a discount retailer that sells clothing and home accessories, and gathers much of its apparel through sniping manufacturer overruns and cancelled orders, much as investors would do if they want something on sale. This strategy can acquire some highly desirable and serviceable clothing, but much of Ross’s purchases are not in demand for a good reason (lime green pants, anyone?). How could a value investor not like this business model? For people who like the thrill of the hunt aspect of shopping it creates a fine shopping experience.

As you may imagine, Ross has been doing very well at luring customers during a recession. They are on pace to earn $400 million this year, when normally they earn somewhere in the $300 million range. This ability to do well in a recession reminds me of Rayonier or Compass Minerals. I discussed Rayonier as an inflation hedge, with the advantage over gold and TIPS that they can produce a decent return even without inflation. Upon reflection, I believe that Compass Minerals offers the same advantage from its salt and fertilizer. Road salt is a widely used de-icer and is vital in regions that are not so environmentally concerned as to adopt calcium or magnesium chloride, and fertilizer is similarly impossible to do without, so I am convinced that Compass Minerals is also good for an inflationary situation.

Ross is not a hedge against inflation, but the fact that its sales increase when the economy weakens and sales everywhere else tend to decrease, makes it a useful hedge against an economic downturn. Even after this growth, Ross trades at a P/E ratio of 13.6, which has actually been trending down of late. Thus, it does not really produce outsize returns, but its robustness in a recession is attractive. I normally prefer an earnings multiplier of about 10, because I try to avoid overpaying for growth, which often translates to “I try to avoid paying for growth,” and if I can usually find 10 anyway, why depart from it? In fact, if we go by Ross’s more typical historical earnings, at current prices Ross would have a P/E ratio of 18. However, I do feel that Ross is entitled to some premium from its ability to hedge against a downturn, and since they have been opening new stores all the while, at least some of the expansion of sales is here to stay, and not just the temporary influence of thrift.

I should mention, though, that Ross uses share buybacks instead of raising its dividend, and I  wish they would declare a dividend and be done with it, since it suggests a greater degree of stability and permits all shareholders to benefit immediately from positive cash flows. Certainly a share buyback concentrates the effect of future earnings, but existing earnings have to count for something too.

So, I am convinced that Ross is one of those great companies at a good price that Warren Buffett talks about, but, like Graham, I have always been suspicious of the view that if you get a good quality stock the price will take care of itself (I’ve always thought the reverse was more accurate), and at any rate, the time to hedge against a recession is over; one’s already here. Nonetheless, this king of discount stores comes with a built-in put option on the rest of the economy and should be entitled to a premium for it. And despite what the regulators would have you believe, this is not the last recession we’re ever going to have.

The trouble with getting in on the ground floor of a new technology is that you never know how tall the building is going to be. Too many investors confuse technological brilliance with competitiveness, and a typical example of that is Rentech Inc.

On the whole I’ve never been too excited about technology for its own sake, and when I read a company profile that talks about improving chip interface architecture my eyes start to glaze over, which I think is a reasonable defense mechanism for an investor because there is a difference between knowing what a company literally does and knowing why they’re good at it (and more importantly whether their competitors might not become better at it). However, I was all excited about RYN and its black liquor processing, so it occurs to me that I like technology just fine, but not computers.

Rentech has a patented and proprietary method for turning synthetic gas (a mixture of carbon monoxide and hydrogen) into hydrocarbons usable for fuel, and synthetic gas apparently can be manufactured from ordinary waste. From the company’s overview in their SEC filings, they seem to make much ado of the fact that synthetic gas comes from urban and rural garbage, sugar cane refuse and other biomass, which gives them green credentials and also qualifies them for a grant from the Department of Energy  (unlike USEC which refines uranium using proven technology that actually is competitive and only wanted a loan guarantee but that is another story…). However, according to that same filing they have found that fossil fuels such as coal or petroleum refuse is more technologically complicated but seems to work better.

They have constructed a demonstration plant, and have made several attempts to demonstrate commercial viability, without success. Their primary source of funding has been issuing their own stock at a discount to whoever will buy it, which is not good for the shareholders but since the firm is not stable enough to sustain debt financing, there isn’t much else they can do. It explains why a company with a market cap of $300 million is selling at less than $2 a share right now. I don’t normally pay too much attention to a company’s price per share, but that is certainly anomalous. This year, they acquired, presumably using the proceeds of new issuance, an equity interest in a company that makes their feedstock out of cellulose, and acquired another that creates feedstock out of biomass, but it is not clear to me whether their main issue in commercialization is a sufficiently cheap source of feedstock or inefficiency in their own refining process.

Curiously, though, the company also owns a profitable segment: they use natural gas to produce nitrogen fertilizer. This Cinderella of a subsidiary supplies the operating needs of the company and also occasionally allows them to turn a profit (like last quarter, although it was the seasonal peak for demand of ammonia fertilizer). In fact, in 2008 if you neglect R & D expenditures, they turned a profit. According to Damodaran, research and development should be treated as a capital expenditure, rather than a flat expense, because it is not all money thrown away. In 2009 to date, Rentech have ratcheted down their R & D, but it seems to me that by acquiring these two new synthetic gas producers they have simply bought their research instead of doing it in-house.

So, this makes me wonder if we should turn it around; instead of a fuel refiner with a fertilizer segment slaving away to keep the firm afloat, perhaps we should look at Rentech as a fertilizer company with a parasitic fuel refinery. The refinery itself contributed $50 million year to date to operating earnings so far in 2009 (even after their supply contracts required them to pay an above-market price for natural gas, which the firm recorded as a loss), and $33 million last year. After $8 million year to date in interest, that leaves $42 million in pretax earnings, which would normally translate to $28 million in post-tax earnings but the firm is stuffed full of net operating loss carryforwards. With the firm’s market cap of only $330 million, that’s a P/E ratio of less than 8, which is good, right?

No. Unfortunately a parasite cannot be ignored, and given last year’s performance the nitrogen segment’s profits might be unsustainably good this year. I have been thinking of “real options” analysis, which is an attempt by finance professors to discover the next new thing, applying option valuation techniques to a company’s choices in its business plan. It may be said that we hold a profitable fertilizer company and hold an option on the future profitability of its refinery, but given the $60 million in R & D last year, and the $16.5 million plus acquisitions this year, it seems like this option has a high premium and seems constantly to be expiring and needing to be re-bought. And, of course, “we” the investor do not hold the option; the company management does and they seem to be very attached to it.  And, of course, there is their ongoing equity issuance, which dilutes ownership of the entire company, not just the refinery side.

Of course, if this refinery pays off the company should do very well by it, but I don’t know at what price per barrel of oil they will become competitive or whether that price has gone down or up in the last few years. If I had that information (perhaps the company could do something useful and commission a study that would actually figure this out), I would feel better if the price were something I could see happening in the near future.

But as things stand, I think a wise fructivore should take a pass. Buying into exciting new technology cheaply is always enticing, but better to wait for the technology to pass the “new” phase and into the “workable” phase.

Since I last proposed Callon Petroleum bonds, and following my success with the Bon-Ton junk bonds, I’ve been considering focusing more attention on this part of the market. Junk bonds, of course, offer massive yields, higher than nearly all dividend-paying stocks and certainly higher than normal bonds; however, defaults are a constant worry and the possibility of bankruptcy adds an exciting new aspect to investing. Moyers, in his Distressed Debt Analysis, warns that the small investor faces structural disadvantages as well, since bonds tend to trade blocks of hundreds of thousands of dollars at a time so the small investor has to pay a horrible spread. I suppose one correct call with Bon-Ton does not a guru make, but the more inefficient a market is, and particularly after the horrific price declines during that golden moment when the original purchasers realize for the first time that they’re holding junk, the more opportunities are available.

At any rate, consider Quiksilver, which makes clothes. Like so many companies, they have profitable operations but no actual profits because they are a friend of debt. But debt is not returning the favor. Of course, the acceptable debt level for a firm varies; the debt level that a utility would find quite bearable would strangle a manufacturer, for example, but when operating income is consumed entirely by interest payments and the shareholders get hardly anything, there is too much debt to make the equity look attractive. Of course, the academic financiers have argued that in an environment with income taxes and no defaults the optimum capital structure is 100% debt, and this discovery was apparently viewed as some sort of grand discovery on par with splitting the atom, although in terms of usefulness they may as well have told us what the optimum capital structure would be if the CEO were a unicorn (although this principle might explain why AIG is trading at a price above zero).

Getting back to Quiksilver, based on their current results virtually all their earnings are eaten up by interest and I am not convinced this situation is purely temporary, so obviously the equity of the firm cannot have any realistic margin of safety. However, the same was true of Bon-Ton stores. However, there is one worrisome aspect of Quiksilver versus Bon-Ton stores and that is on the balance sheet. Specifically, both of them have a senior secured bank line of credit that ranks ahead of its bonds. Although Ben Graham writes in Security Analysis that a bond investor is protected by the quality of the company rather than security interests and assets pledged, he was talking about investment grade bonds. Here, asset backing is probably worth a little attention in case something happens like being forced into bankruptcy.

In the case of Bon-Ton, the trade creditors (who in a bankruptcy are customarily given priority because their continued business is vital to the firm) and the secured credit together total a little more than the current assets, leaving the property, fixtures, and equipment available to cover the bonds. So, although this neglects asset shrinkage which often accompanies a bankruptcy, the fact is that $750 million in plant and equipment were available to supply a $600 million bond issue that was selling for less than $300 million when I posted the article (and actually dropped to $66 million at some point during the lifetime of the bonds).

But in the case of Quiksilver, the senior notes are also unsecured, and they also have a secured line of credit of up to 320 million in Europe, a 150 million privately placed note, also secured, and 20 million secured on a US line of credit, on which they have another 180 million available (which does give confidence in Quiksilver’s ability to ride out a further weak patch in the economy, but if they fail to do so it’s just that much more debt in line ahead of the bonds). So, about 500 million in secured debt are in line ahead of the notes, and on top of another 220 million in trade credit and some other debts, there are, say, 750 million in higher priority debts over the bonds, which eats up nearly all of their cash, receivables, and inventories. What remains is 75 million in current assets, 237 million in plant and equipment, and so the remaining 87 million in bonds is left to look to intangibles, goodwill, and “other.”

Now, intangible assets are not the same thing as nonexistent assets; they do represent capital and a source of excess returns, but the problem is that they are much harder to appraise, round up, and sell off. Of course, the $400 million in bonds is now just a hair over $300 given the bonds’ current price of 76 cents, but even without asset shrinkage there is no margin of safety in the bond purchase, unlike the $450 million in bond safety available from buying the Bon-Ton bonds at a price of under 50.

Yes, when junk bond investing, it is entirely possible to have to ride out a Chapter 11, which does itself only come after some truly buttocks-clenching drops in prices. So the reason you have to consider what piece of the firm is represented by your bonds is because there is not a trivial possibility that it will become an issue. And, of course, during the Chapter 11 itself interest on bonds is frequently suspended, especially for unsecured bonds. The reason to figure out security interests as well as priority in a Chapter 11 is because, even though secured creditors can be prevented from actually repossessing and selling their collateral, they are entitled to force the company to take steps to protect their secured property, including calls for additional payment, providing a lien on replacement assets (which is almost always done for inventory when it is sold and new inventory purchased, but they could even give a creditor with inventory as collateral an interest in the property and plant), and several other methods.

So, how did it come to pass that Bon-Ton’s bonds are backed by more assets than those of Callon Petroleum and Quiksilver? I think part of it might be the nature of the bonds. Bon-Ton’s bonds were issued in order for them to complete a large, expansionary acquisition, and the market realized the speculative nature of that expansion by giving them an interest rate of 10.125%. In other words, the bonds were junk and then became junkier. Callon’s bonds were perfectly well secured until falling oil prices and a couple of hurricanes caused them to take a huge writeoff, and even so their coupon was 9.75% representing the riskiness of the oil development in the Gulf of Mexico. Quiksilver’s bonds, though, were issued with a coupon of 6.875%, which is not indicative of junk and suggests that the company was considered a reasonably safe issuer that has suffered some deterioration over time, so their creditors were clearly not thinking about bankruptcy at all when they purchased the bonds.

So, although the massive writedowns of Quiksilver’s discontinued operations seem to have abated since the first quarter of this year, I’m not convinced that at this price the bonds represent an appropriate margin of safety, and with a current yield of 9% it’s not as if there aren’t better yields available elsewhere. But it never hurts to brush up on distressed and junk bond analysis, because sometimes in addition to getting all the earnings of a company, a skilled distressed debt investor can get a good piece of the company (which is to say, a piece of a good company) itself as a consolation prize from the Chapter 11.

Windstream has announced their fourth acquisition since they started, this time for  Iowa Telecommunications Services for 1.1 billion, consisting of 26.5 million shares of stock, $260 million in cash, and assuming $600 million of debt. The target firm has 256,000 access lines, 95,000 high speed Internet customers, and 26,000 digital TV customers, which the article mentions (perhaps with some prompting by Windstream) as the focus of Windstream’s current business plan.

However, it seems to me that this acquisition is unlike the other three purchases. In those cases, the price paid, if you indulged management’s optimism about synergies, and taking into account the excess of depreciation over capital expenditures, you still wound up with a price/free cash flow of around 10. Here, Windstream claims that about 8% of the purchase price consists of tax loss harvesting (which the Tax Code has very Byzantine rules about, but for 8% it is not the driver of the transaction so I wouldn’t be too worried).  But of the other 92%, I find that net income plus depreciation minus capital expenditures comes to an average about 50 million a year, which, given the $530 million paid for the equity is close to 10 but not quite there.

However, Iowa Telecom has also been a ravenous acquirer of other companies, and if we take those into account they eat up almost all the firm’s free cash flow for the last few years. It is possible that Iowa Telecom got what it paid for, but I am not entirely convinced. I would like to know if these acquisitions were motivated by necessity or strategy, since necessity places them more along the lines of a capital expenditure and therefore they would eat into free cash flow.

As for the assumption of debt, Iowa Telecom’s 600 million in debt was financed at fixed or variable rates that have recently run about 5-6%, representing an extra 31 million in cash flow to the firm. However, the lenders that made the financing provision made their deal with Iowa Telecom, not with Windstream, so rather than stepping into their shoes Windstream is going to have to refinance, and Windstream’s own interest rate, based on their latest private placement of notes, is closer to 8%. So, 387.5 million of that transaction can be financed from Iowa Telecom’s existing interest layout, but the rest of the debt, representing 17 million a year, will have to be financed elsewhere, and taking that out of the 50 million in free cash flow to equity (after taxes) leaves only about 38-39 million, for a price/free cash flow to equity of 13.8, which is worse than what Windstream had before the merger, and Windstream’s other acquisitions, provides. But at least Iowa Telecom is a public company so we can see the numbers for ourselves.

Windstream also claims that they will get $35 million a year in synergies out of the deal, and indeed they may. They were expecting a similar amount of synergy out of the Nuvox deal, which was smaller, so it could be more achievable in this case, but again, synergy is a thing that you believe in when you see it, because synergy is also the preferred method of the staff of acquisitive CEOs to make an unattractive deal look more attractive. And even when synergy does arrive when the acquisition and integration are sorted out, it may not be clear which acquisition it goes to.

So, to review, 80 million in free cash flow to firm, minus 48 million a year from the debt they take on and refinance, minus 21 million from the cash they paid (cash that could also be used to pay down debt), minus 26 million for the equity (from the dividends, but even without the dividends this is about their implied cost of equity), comes to minus 15 million, which has to be made up with “synergy.” I worry with this acquisition that Windstream’s management is more interested in building a bigger company than a better company. I would like to see them going through a trimming phase after this acquisition phase, where they sell off some of the properties or regions that are strategically unnecessary or financially weak. If not I may have to reconsider the attractiveness of the dividend given the safety of the firm. And their next acquisition really should be better than this one, for the sake of market perception.

If you have been following this blog for some time, you may recall the first move I recommended was the bonds of Bon-Ton Department Stores, which I suggested could be hedged by shorting an equivalent dollar value of the stock. At the time the bonds were at 46 and the stock was at $4. Now, the company has announced that they are not as doomed as previously thought, so the bonds have shot up lately to around 90 and the stock to almost 12. The bonds have paid their semiannual coupon since then, so they have properly speaking shot up to 95, but the follower of this move would have made $500 on the bonds and lost $800 on the short. I think that $12 for a company that is still having all of its earnings eaten up by interest is too high of a price, so these results have not diminished my enthusiasm for capital structure arbitrage (which is the formal name for this move), or for junk bond investing. Ben Graham wrote that even an unattractive form of investment, like a bond that is inadequately secured, can be attractive at an attractive price. Even though they are unlikely to appreciate past par, especially because most bonds these days are callable, they can still produce attractive returns.

However, the majority of junk bonds are junk for a reason, and they require careful screening. Consider the bonds of Callon Petroleum Co., which pay 9.75% and are trading at 60, currently yielding 16%. They fall due in December of 2010, but most of those bonds will never be redeemed, because the firm was forced to institute a tender offer because what with two hurricanes and a drop in the price of oil they were forced to discontinue a large operation in the Gulf of Mexico. Their other operations are barely able to cover their interest. The terms of the tender offer are  replacing the $1000 9.75% bonds with $750 13% bonds (thus actually saving nothing on interest), plus what works out to 37 ½ shares of stock. The new bonds fall due in 2016. The company is pleased to report that they have over 90% participation in the tender offer.

However, there is a small problem with their plan. Although the company is presently able to cover their interest, and possibly even with a few pennies left over for the shareholders, the firm’s long term strategy is in doubt. Unlike Linn Energy or Breitburn Energy, which focus on properties with a long development life, most Gulf of Mexico properties have a development life of only a few years, with most of the production heavily front-weighted. So, they have to acquire, explore, and exploit properties with considerable frequency. However, with no spare income and also no shareholders’ equity left (even with the bonds discounted and the nonrecourse debt from the discontinued operation moved off the balance sheet, they are below even), it is hard to determine what the company will use to acquire these new properties. They claim to be looking into longer-lived properties and joint ventures, and best of luck to them. Otherwise, they are potentially doomed beyond the assistance even of the Chapter 11 that they are trying to prevent with this tender offer.

As is often the case in distressed debt, the decision of whether to tender the bonds is a prisoners’ dilemma situation; if enough bondholders accept the exchange, the company will be able to redeem the non-tendered bonds without difficulty, so the holders who rejected the tender offer will make a windfall. But if not enough holders accept the tender offer, the company will be forced into bankruptcy. This is why, as Moyer wrote in Distressed Debt Investing, firms tend to require over 90% participation in any tender offer, a provision they can waive if necessary. Here, there is legitimately over 90% participation, so that hurdle is not an issue. Based on the current prices, apart from about $90 (discounted) in coupon payments due between now and the payoff date, the bondholder who rejects the offer is looking at $900 (discounted) for a price of only $510 per bond. This implies that even now there is an expected 57% chance of no recovery, assuming that 60 is also a fair price for accepting the tender.

The tender offer expires on Monday, and it is clear from the overall prospects of the firm, that it would be best to reject the tender offer and take our chances with the 2010 payoff. However, this firm does not appear to be another Bon-Ton stores, so the wise fructivore should consider a purchase very carefully.

The Greek word for marketplace is “agora,” so the word “agoraphobia” literally means “fear of the marketplace,” and Congress seems to be suffering terribly from it lately. Given what has happened over the last couple of years their reaction is unsurprising.

Indexing, long touted as the safe long-term option for the passive investor, has shown itself to be riskier than we all imagined, producing a negative 10-year return. If stocks always beat bonds over the long term, claim the authors of Dow 36000, then they are in fact less risky than stocks and thus the Dow deserves to be at 36000. If, however, they are more risky, then the index fund industry has some explaining to do.

Of course, after the dot-com collapse, the Nasdaq fell from 80% from top to bottom amid much less wailing, but I get the impression that there was a better sense of the speculativeness of those ventures, whereas the recklessness of financial institutions came as much more of a surprise. As Keynes wrote, “A speculator takes risk of which he is aware; an investor takes risks of which he is unaware.”

However, the response strikes me as excessive in some areas. Even though the the decision by the Fed to guarantee all commercial paper after the fall of Lehman Brothers was a stroke of genius (took in plenty of guaranty premiums without a single payout, not to mention saving the economy and I say that without exaggeration), we have to weigh that against Chairman Cox’s decision to outlaw short selling of financial stocks, which was a  knee-jerk reaction that demonstrated a fundamental lack of comprehension of market dynamics that one would not expect from the head of the SEC. In fact, in terms of ignorance it ranks alongside Alan Greenspan finding his “flaw.” Short sellers are a source of liquidity, and illiquidity in the face of panic selling produces a price collapse. Furthermore, shorts taking profits, which they certainly had in plenty last year, are a source of buying pressure that would mitigate the price collapse.

And what, may we ask, is so wrong with a price collapse? If the price drops and sets off a chain reaction of panic selling and margin calls, this will only push the price below even the most pessimistic fundamental estimates, at which point the sensible fructivores will start buying. It is the basis of all value investing, and we actually look forward to it. What distinguishes the commercial paper workout from the ban on short selling is that in the commercial paper arena what we were facing was a complete loss of confidence in the entire market, whereas the short selling ban was nothing more than an artless attempt to prop up prices. As an aside, I read somewhere that a CEO who blames shorts for the low share price of his company tends to give up on average 2% a month in share prices for the next year, and if the CEO blames a conspiracy of shorts, 4% a month.

So, apart from the fact that it’s the Baby Boomers’ retirement, what harm is there in coming to a sudden realization that the markets are riskier than we (most of us, anyway) all thought? Yes, too big to fail institutions are a problem and ideally should be broken up, or better still, forced to pay through the nose into an emergency liquidity fund to clean up the mess when they do fail. Beyond that, though, I don’t see what is the use of having measures designed to reduce volatility or the apparent riskiness of the market–and much of the effects of these measures will stop at appearance only. Optimizing capital structures using leverage does, it must be admitted, increase risk, but it also increases the amount of available capital in the economy, which is good for the GDP, and any mistakes normally work themselves out in bankruptcy court.

It is disturbing, though, that the regulators still embrace value at risk, which assesses the risk of loss on a financial asset by applying a stochastic process based on volatility that has been observed over a certain period, typically less than five years. Of course, the five years before 2008 were extremely boring in terms of volatility. Value at risk could perhaps be preserved if the period surrounding the collapse of Lehman Brothers was used as representative, but it would be quicker to abandon the stochastic myth, since security prices stop behaving as though they follow a stochastic process just about when panic strikes and every market participant wants them to be stochastic. In a book I read called Lecturing Birds on Flying, Pablo Triana suggests a Levy distribution, whereby events that are 6 standard deviations away from the norm may be predicted to occur every couple of decades instead of every couple of eons. I’ve never been that swayed by quantitative analysis, but if regulators are going to use a quantitative method they could at least use one that hasn’t been demonstrated not to work.

I suppose it is the embracing of the Capital Asset Pricing Model’s conflation of volatility and risk that informs much of the love of quantitative analysis. Volatility is neutral; by chance alone it can put prices in the wrong place, but exploitably and allowing for the likelihood of reversion. Risk is not neutral; it is negative and its effects tend to be more or less irrevocable, unexploitable for most people, and, of course, largely invisible. As an analogy for illustration, suppose that in a hand of Texas Hold’em, I have flopped a straight against my opponent who has flopped a set. There is about a 1/3 chance that he will improve to a full house or better. That is volatility. There is also an unknowable but nonzero chance that he will pull out a gun, rob everyone at the table, and vanish into the night. That is risk. But because it is hard to separate their effects during a the chilling moments of financial panic, Congress and the regulatory bodies feel bound to do something.

The latest proposal from the Senate Finance Committee is a plan to reorganize regulators, create provisions to split up banks that are too big to fail, and create a clearinghouse for derivatives. I agree that too big to fail should mean too big to exist, and as for the regulators, in my view whoever does the regulation is less important as long as they have teeth and the regulations are effective. However, I worry that stripping the Federal Reserve of its power over banks is just anti-Fed hysteria. My issue, however, is with the derivatives clearinghouse. The problem is that so many fancy derivatives these days are over the counter, which allows their terms to be customized. To trade via a clearinghouse, they would have to be standardized and commoditized, which might make them less useful. Furthermore, as happened with equity options and mortgage securities, these arcane instruments would be “domesticated,” and thus acquire an aura of safety and familiarity that is inconsistent with how bad of a mess they can make. Thus Congress, in an attempt to limit their impact by instituting these controls, may wind up causing them to expand, thus exacerbating the problem they intended to solve.

As some of you may recall, I called Coinstar an attractive short target some months ago, and it didn’t exactly go so well. In fact, it did go exactly as high as $38.28, when I called for the short at $25.91. Of course, that was during a massive stock market rally; one of the purposes of short selling is to reduce your exposure to broader market movements, which tends to work against you when you have short something that is highly correlated with the indexes during a rally.

However, with their recent earning announcement last Thursday/Friday, Coinstar very kindly gave up $3, dropping back to $29, and despite today’s rally they have regained none of that ground. And all this, despite beating analyst estimates for the quarter by a considerable margin. Of course, I’ve never understood the obsession with beating analyst earnings; if the company fails to beat the estimates the stock gets punished as if it’s the company’s fault rather than the stupid overoptimistic analysts’.

But as for Coinstar, it is true that they have increased their sales by $90 million since the same quarter last year, but do you happen to know by how much they increased their profits? Less than $2 million. So it is clear that we are dealing with a low profit margin firm, and now one that is facing increased competition from Blockbuster kiosks, as well as having to deal with Netflix and several antitrust suits that I don’t think they’re going to win. As I mentioned before, when Coinstar bought out its co-owners the price paid implied a value of $300 million for the entire Redbox division, and the counterparty was a sophisticated seller that had access to inside information, that probably concluded that the business was not likely to generate excess returns from any more capital put in, and based on these margins I am inclined to agree. Their other divisions have been more or less flat, so I remain unconvinced that this company is going to produce the kind of growth that will justify their still-optimistic valuation.

Accordingly, I continue to short Coinstar and suggest that the rest of you, if you do short, short this one too.

P.S. I couldn’t miss out on this little gem from the conference call. From seekingalpha.com

“We closely track consumer satisfaction by measuring our net promoter scores. As you can see on slide five, we continued to hoverer [sic] north of 80%, which puts us with such companies as Apple, Google and Amazon.com, iconic brands that have been established over a much longer time.”

http://seekingalpha.com/article/171699-coinstar-inc-q3-2009-earnings-call-transcript?source=yahoo&page=2

Yes, I suppose they are comparable to Apple, Google, and Amazon.com…in this small and almost completely irrelevant aspect.