I recently wrote a post where I discussed using a bond investor approach to evaluating equities. I've continued to think about that post since writing it, and wanted to write a follow up extending that line of thinking further. This post could really be thought of as the second half to my bond investor post.
A bond investor is buying a security issued by a company on the market. The bond investor is worried about losing money and ensuring the business has enough operating earnings to cover interest costs.
A lender is one step closer to the business than a bond investor. The bond investor is buying what the company is offering, a lender is taking a look at a given company and evaluating what to offer them. A company wants or needs capital and they're at the mercy of the lender. The bond investor is at the mercy of the company. Thinking through this subtle difference can be helpful in making investment decisions.
The best way to apply this thinking is to ask the question "would I loan this company money, how much, and where on the seniority ladder?" when looking at a potential investment. Asking questions like this can root out all sorts of seemingly tiny problems that have the potential to grow into large problems.
I like to take the lender approach when looking at net-nets if possible. Obviously net-nets have large unencumbered asset balances, so it would be relatively simple to make them a loan correct? Not exactly. A lender is worried about collateral quality and the borrower's ability to pay. The ability to pay concerns the borrower's operations. If operations are slowly melting away, the company's current assets could be at risk. It's hard without having a frame of reference to know if current assets are at risk in a poorly performing net-net. Using the lending framework makes it easier. Think through how much you'd potentially lend to a given net-net, and think about how long the company would be able to pay your rate. Next think about what might have to happen before your money is at risk. It seems like a bit of a jump for an equity investment, but it really isn't. Given a net-net that doesn't have debt, the equity is the most senior claim. The "interest" you'd receive is the earnings yield. Maybe the company isn't earning anything, would you be happy loaning a company money for no return? The loan would be similar to a zero-coupon bond, would you issue something like that to the company?
Often using the lending framework I'm able to flush out small details that make me really uncomfortable with an investment. There have been two investments recently where using this framework would have been very helpful. In the first instance I didn't think like this and I ended up with a slight loss. The loss could have been greater but I realized my mistake quickly and sold very quickly. The second, which I'll detail below was an investment where I wasn't completely comfortable and I avoided a loss.
Some readers will be familiar with Eagle Hospitality Trust. The company was a REIT that owned a series of hotels in the Midwest. The trust fell on hard times and cancelled their common stock and began to run into problems with their lender. A lot of things happened during the financial crisis, but their debt eventually ended up with the Fed who sold it to Blackstone. Operations never righted themselves and Blackstone threatened to foreclose on the properties if the trust couldn't sell them first.
The trust had some preferred shares outstanding, and writeups I'd seen online talked about how the preferreds could be worth up to $15 per share depending on the outcome of the hotel sale. This was really enticing because the shares were trading at $5 apiece. To add to the intrigue the trust is a dark company, requiring a share purchase and proof of ownership to get financial statements. When the company distributed the financials they included a disclaimer stating that the following information was confidential and shareholders weren't allowed to discuss or share it with anyone. So all online writeups were of the cloak and dagger variety. As I stated, I have the financials, my email is below, hint hint.
The thesis on Eagle was that the hotels would sell for some rich valuation and the remaining cash and receivables would end up going to the preferred shareholders. The potential reward on this investment was significant, it was exciting. I kept looking at it and thinking that I could double or triple my money in a short period of time. Then I started to look at Eagle from the lender perspective.
My first thought was why would Blackstone agree to let Eagle sell the properties and pay back their loan at a discount? Some people thought it was because Blackstone were a bunch of nice guys, and by doing so Blackstone would juice their fund's IRR. My concern was that the hotels might not be worth as much, or be as salable as initially thought. I thought about this from the perspective of would I lend Eagle any of my own money, and how much, and at what rate, and what asset would back it?
The problem is when I started to think like a lender I couldn't get comfortable that I'd be guaranteed to get my money back. The company was losing money so they wouldn't be able to pay any interest. The hotels were spoken for by Blackstone and I was left with some cash and miscellaneous items that might or might not have value. What I couldn't escape was that while there was the potential for a huge upside there was also the potential for a complete loss. Not just a 5% or 10% loss, but a 100% loss. If the hotels went to Blackstone, Eagle would be left with nothing. As a claim holder at the bottom of the chain I had a claim on nothing if the hotels didn't sell for a high value. Eagle would have been a great investment if I was in Blackstone's shoes, buying cash producing hotels at a discounted valuation.
I never got comfortable with Eagle and never increased my tracker position. I owned 10 shares at $5, so I was in for $50. This week the news came out that Eagle was unable to sell their properties and just turned them over to Blackstone. They stated they expected to deplete the rest of their cash winding down operations and expected to make no distributions. I sold my 10 shares for $.12 apiece. No need to feel bad, I can handle a $50 loss, the lessons learned were worth much more than $50.
I'm happy that I avoided a bigger loss, but it was just as likely that a positive outcome could have happened with Eagle. Alternatively I could have been sitting here with my $50 that turned into $150 wishing I mortgaged the house to invest. The truth is we never know the future, but in the face of uncertainty I want to work on what I can control, avoiding losses, instead of shooting for large gains.
Talk to Nate