Sunday, December 9, 2012

Thinking like a bond investor

"It would be a sounder procedure to start with minimum standards of safety, which all bonds must be required to meet in order to be eligible for further consideration.  Issues failing to meet these minimum requirements should be automatically disqualified as straight investments, regardless of high yield, attractive prospects, or other grounds for partiality.  Having thus delimited the field of eligible investments, the buyer may then apply such further selective processes as he deems appropriate.  He may desire elements of safety far beyond the accepted minima, in which case he must ordinarily make some sacrifice of yield.  He may also indulge his preferences as to the nature of the business and the character of the management.  But, essentially, bond selection should consist of working upward from definite minimum standards rather than working downward in haphazard fashion from some ideal but unacceptable level of maximum security." - Benjamin Graham, Security Analysis 1951.

I have been thinking a lot recently about stocks as bonds, and looking at a stock the same way a bond buyer would.  For whatever reason the investment world is divided into stock investors and bond investors.  The division seems strange to me because both parties are investing in securities issued by the same companies.  Bond investors are usually worried about principal protection, and yield secondarily.  Equity investors are worried about what yield they can obtain for a security, and sometimes concerned about potential for losses, if at all.

I number of investors have stated to me that they don't know where to look for stocks.  With 60,000 stocks worldwide it's no surprise.  It's much easier to start with a narrow focus and work outwards from there.  In the quote at the top of this post Graham talks about finding a minimum set of acceptable parameters for an investment and using those as a starting point.  A lot of readers believe I only own net-nets.  I write about a lot of net-nets, but my portfolio has a nice mix of stocks, not all net-nets, not even a majority.  My minimum standard of acceptability is a net-net, followed by a low P/B stock, low P/E, EV/EBIT stock, and finally a franchise company.

For me finding a franchise company selling cheap, without serious issues, is the holy grail of investing. All I need to do (theoretically) is buy, and in 15 years I'll have 4x or 5x my money as the business compounds my investment year after year.  A lot of investors start by looking for these franchise companies and then when they don't find any start to move down the chain of potential investments.  Eventually they might end up slumming it and buying a company trading for less than book value, or (gasp) less than NCAV.

The valuation of a franchise company might rest on dozens of variables.  If any one of the variables is misjudged it's possible that the investment thesis could be thrown off, or the result isn't one an investor initially expected.  The opposite is true for a net-net.  There is really only one variable for a net-net, is the company going out of business?  If a net-net isn't facing a situation where they'll cease to exist soon then their valuation is unreasonable.  No going concern should be worth less than their current assets minus all liabilities.

The math starts to get more complicated as one travels upwards from the minimum criteria for investment.  "Is this business worth book value?", "Are earning sustainable?", "What happens if the management team leaves?", "Am I projecting a reasonable growth rate?"

At the beginning of this post I mentioned that I'd been thinking about stocks as fixed income investments.  Part of that thinking relates to making sure my principle is safe when I invest in a given stock.  Buying a net-net is similar to buying a bond below par.  If I buy a bond at $.65 (par $1) and the company is only able to pay $.85 I still have a gain on my investment.  When looking at a deeply discounted bond I am concerned about the collateral, what's the quality of it, can the company use it to borrow against, or sell for a reasonable value?  I'm worried about the seniority of my investment as well.  If I'm behind a number of other claims it doesn't matter that I'm buying at $.65, I might only get $.45 back after everyone else is paid.  But most importantly I'm worried about interest coverage.

Bond investors are content as long as their interest is covered by operating earnings.  If the company is able to generate sufficient operating earnings in a period of distress they will receive interest due to them.  If the bond is backed by high quality collateral and has seniority then interest coverage rules the day.

As equity investors I don't think we spend enough time looking at coverage ratios.  If a company has debt I know most investors make sure the interest is adequately covered, but beyond that there isn't much research.  I've been toying with the idea recently of stress testing net-nets and companies I'm interested in.  What I mean is not only looking at how many times the company can cover their debt with operating earnings, but how many times a company can cover operating expenses, and how much of a revenue drop is necessary before the company falls into the red.

I recently profiled Mexican Restaurants, and one of the reasons I haven't invested yet is because I'm worried about this stress test.  Mexican Restaurants has their lease expense covered 3x by sales minus labor/sg&a/cogs.  The company has lease expenses of $5m in 2012, and only $800k in the bank.  If sales dropped off 25% they would have trouble paying for their locations, this is a major concern.  At the opposite end of the spectrum a cash-box I own, Goodheart-Willcox could last almost two years with zero revenue before they would have problems paying employees and printing textbooks.  The company has almost two years of cost of goods sold and SG&A expenses in the bank.

An extreme case of this is some Japanese net-nets which could operate for a number of years without ever selling an item.  The more applicable example would be looking at how far sales need to fall before the company starts to lose money and has trouble paying their bills.  After determining this value the next step is to look in the recent or even the distant past and see if sales have ever dropped by that amount.  If they have a moment of deep introspection will be required.  If sales dropped by 35% in the past, and 32% pushes the company into the red, what does that mean for an investor?  How long can the company survive losing money?

My goal is to not lose money when I invest.  I fail at achieving this goal, but I can work hard to minimize it.  I think looking at worst case scenarios, and viewing stocks as bonds can help mitigate a loss situation.  Any company is vulnerable to a random exogenous event, but losing money in a situation that was predictable ahead of time is unacceptable.

I recently walked through this method with a long time holding of mine.  I realized that the the upside was limited due to the fact the company already had a monopoly in many markets.  Yet the downside was potentially large because regulators had suddenly taken an interest in the company, and wanted the company to pay for the monopolistic "sins".  I ended up selling off a large portion of my position, the risk was asymmetric on the downside.

As investors we need to be mindful of our principle, always watching and ensuring we don't lose principle.  If we buy enough equities or bonds below par the returns will work themselves out.

Talk to Nate

2 comments:

  1. Nate,

    This comment isn't about the bond post.

    I read your writeup on SHFK (I own some as well) and thought you might be interested in this data point.

    http://www.bizquest.com/buy-a-business-for-sale/large-steel-fabrication-company-sold/998636.html

    ReplyDelete