Fructivore Investments

A great deal of analysis is devoted to ferreting out a company’s true earnings. It may be necessary, for example, to adjust asset impairment costs if the reality is not that the assets suddenly became impaired but that the company overpaid for them to begin with. Benjamin Graham’s Security Analysis devoted a significant number of chapters to recasting financial reports in a way that is more useful to analysts.

One common item to consider is the excess of depreciation charges over capital spending, if any. Depreciation, although it is charged against earnings, does not entail any cash expenditure. Therefore, excess depreciation constitutes additional earnings to the equity holder.

However, in order to count the excess depreciation as free cash flow, investors must assure themselves that the company is not shortchanging its capital expenditures, which will result in diminished earning capacity. During the junk bond era, many analysts used EBITDA, earnings before interest, taxes, and depreciation, to determine just how much debt a company could carry, but unless the company requires no additional capital expenditures (unlikely), it is simply liquidating itself in slow motion. The correct measure is earnings before interest, taxes, and the net of depreciation and amortization over anticipated necessary capital expenditures, but EBITNDAOANCE is harder to pronounce.

To illustrate this situation, in 2008 Qwest Communications took a charge of $2.354 billion for depreciation but made only $1.777 billion in capital expenditures. This excess has persisted over several years back, and is suggestive of a business with a high initial startup cost and a lesser capital maintenance requirement, and in Qwest’s case it causes the PE ratio to drop from 10 to 5 and a half. However, as stated above Qwest may be slowly ratcheting down the scale of its business, and indeed its operating earnings and its number of subscribers have declined in the last few years, although since less than half of its earnings come from its mass market services the gross number of subscribers may not be dispositive. At any rate, when a company can legitimately squeeze extra cash flow out of its depreciation, its owner has a claim to more income than the reported earnings alone indicate.

Of course, the previous post is common knowledge. By way of example, and to illustrate a strategy that commonly arises from market misconception (I’m glad to say I thought of before I read an excellent out-of-print book, Margin of Safety by value investor Seth Klarman) is to buy the junk bonds of a company and short its stock. This opportunity arises from a confusion in the public’s mind about who actually owns the company–not in the legal sense, but in the sense of who receives the economic benefit of owning it. Normally, buying the bonds and shorting the stock is a losing bet because bond buyers generally insist that debt service payments be covered several times by the issuer’s income and the bonds do not participate in any expansion of the company. However, when a company’s earnings are barely sufficient, or insufficient, to cover debt service, hardly anything flows through to the equity owners. Thus, the bondholders have all the benefit of owning the company, and the stock becomes an afterthought, a thing that only exists because someone has to hold it.

Of course, it is necessary that these facts have not crystallized in the minds of the investing public. When the stock has already dried up to nothing, or the sub-1$ graveyard area, shorting it will not provide much of a hedge. In fact, very low-priced stock behaves more like a call option on the company’s future. So, in the unlikely event that the company recovers, the bonds will certainly regain some of their price, but the recovery will be dwarfed by a massive loss in the short position. But if the stock has room to fall, then it can serve as a useful hedge. Any losses taken on the bonds will be offset by gains on the short position. On the other hand, if the company should strengthen its position, then to a degree the bonds should benefit before the stock does, at which point the position can be closed. Even in the likely event of default, the insolvency proceedings will more than likely make the stock worthless, or at least severely diluted. The bonds, which will have paid a nice high interest rate until the default occurs, may or may not decline to zero. And in bankruptcy, the bondholders usually emerge as the new owners of the reorganized company, thus enshrining in law the economic reality of the situation.

Bon-ton Department Stores offers an example of this sort of arrangement. In 2006 the company engaged in what was in retrospect a dramatically ill-timed expansion fueled by leverage. In 2007 they barely earned enough to cover their interest, and in 2008 they didn’t earn enough. In mid-2008 the bonds stood at around 64 with a current yield of 16% and the stock was around $5 a share and, inexplicably, paying 20 cents a share in dividends, or 4%. During the market panic, the bonds declined to the teens in March and the stock dropped to 75 cents. As of today, May 28, 2009, the stock is around $4 and still inexplicably paying dividends, and the bonds are at 46. The company is projecting losses in 2009 as well; in fact, the losses are projected to be between $3.40 to $4.30 a share, about the share price of the stock. Adding back in 2008’s interest payments (not all of which is attributable to the bonds, of course) produces $.81 to $1.71 in profits. So it should be pretty clear who really owns Bon-Ton, and pretty unclear why the stock is trading at above graveyard prices. Management claims to be belatedly enacting a program of cutting costs and improving margins, but even if their projections are accurate, the improved situation will inure to the benefit of the bondholders, and their prices should recover before the stock explodes.

I hope you found this informative. Thank you for reading and good luck.

Disclaimer: This blog and website are for informational, educational and discussion purposes only. Although the author has made reasonable efforts to produce accurate information, the accuracy of this information is not guaranteed. Author disclaims all obligation to update information. No fiduciary or attorney-client relationship is created between the reader and author. No reader should act in reliance on anything discussed in this blog without prior consultation with a licensed professional. All investors should do their own research; it’s the fun part anyway.

Why fructivore? Fructivore means fruit-eater,and when investing the wisest approach is to pick the low-hanging fruit. In other words, go for the easy money, the instruments that are on sale, and leave the rest on the table. Of course, that is the goal of any risk-averse investor, but a goal does not equate to a method. The method is to make sure that you get your money’s worth in an investment, which necessarily means getting more than your money’s worth because you are exposed to an uncertain future.

The future vexes and gives hope to all investors; many investors, properly called speculators, attempt to see into the future and get in on the ground floor of the next big thing, forgetting how small the last big thing usually wound up being. Quite simply, it is impossible to see into the future. It is less difficult, and at least possible, to see into all possible futures and have a plan for each one. Accordingly, it is wisest to insulate oneself from the future by the margin of safety that a value investor insists on. Many investors understand and embrace this view, and so many others say “No thanks, I’ll stick with the crystal ball approach.” At any rate, a mismatch between quoted price and underlying value is the goal.