Sorry for the lack of posts recently, we took a small vacation and went camping at Deep Creek Lake in Western Maryland. I read a few emails while away, but generally stayed away from technology which was nice. We spent a lot of time hiking and playing at the beach, I also had the chance to read a book How to Make Money with Junk Bonds by Robert Levine. This post isn't a book review, it's more a collection of thoughts and takeaways I had while reading the book.
The book itself is short and easy to read. I purchased my copy used off Amazon for $3.70 or so, which was worth it for the insights I had.
I never fully understood junk bond investing before reading the book, but I had always felt that there was a similarity between investing in junk bonds and investing in net-nets and deeply undervalued companies. I should point out that deeply undervalued, or deep value is a euphemism for distressed, unloved dead money investments.
A junk bond is a bond with a low rating, usually defined as a bond rated BB or below. Bonds are rated by credit rating agencies based on a number of factors. The idea in the book is to buy bonds of a low rating when they should really deserve a higher rating. An example of this would be to buy a B rated bond from a company that is actually a BB credit. If the analysis is correct eventually the bond will be upgraded and the price will rise accordingly. To put this into equity terms, the company's intrinsic value is BB (a higher rating) yet it's trading for less (the B rating).
Bonds are unlike equity investments in that there is a chart of standardized valuation guide. A company that meets certain qualifications is graded on a standard scale against other companies using the same metrics. This means that it's fairly easy to determine if a bond is trading below intrinsic value, an advantage for bond investors that equity investors don't have.
The parallels between junk bond investing and deep value investing are many. Beyond finally understanding what a value investing approach with junk bonds would look like, I had two takeaways from the book.
The first takeaway is the reinforcement that downside risk is extremely important. In the junk bond world a bond that defaults can fall 50% or more, while a mis-priced bond investment that works well could return 10%. That means that one default requires five successful investments to just break even.
There is a reason most companies trade at absurd valuation levels, there is always some problem, known or unknown. A company with a strong balance sheet, and considerable growing earnings isn't going to trade below NCAV or even book value. Stocks don't trade for low valuations because they're ignored either. A stock might appear small and have no interest, but the lack of interest is usually due to a lack of liquidity. A very small and undervalued stock with ample liquidity will be discovered quickly. All of this is to say that low priced stocks usually have a risk, sometimes a liquidity risk, other times a financial or business risk. These are real risks, and not every investment works out like the investor desires. Often risks that appear small become large quickly and can become losses.
When investing in distressed companies, or illiquid companies I am always looking at what my maximum loss could be. A net-net that's burning cash, or worse burning cash with debt could end up bankrupt and I could lose 100% of my investment. Net-nets that are well run and are profitable have a much smaller risk of total loss, yet I still need to be aware of what is possible. I aim to limit my losses on any particular investment. Even though I'm investing in the equity of companies, my style of investing isn't aiming for stocks that triple or quadruple. I'm more or less batting for singles and doubles, gains of 50-100%. A consistent approach to avoiding losses makes gains of 50-100% all the more powerful for the portfolio.
The second take away from the book was that risk can manifest itself in ways other than financial risk. Levine discusses three types of risks in junk bonds, business risk, financial risk, and liquidity risk. Financial risk is the most common risk we think about, it's the risk that a company levers itself up and can't handle the interest payments the debt incurs. A company with a great business model can end up in bankruptcy due to financial risk. My favorite example of this is local restaurants, something I'm sure is worldwide and most readers can relate to. Have you ever gone to a new restaurant in town that has a wait no matter when you go, has great food and a great reputation, then all of the sudden goes out of business? Everyone asks "how could it happen?" My answer is the same every time, too much debt, or expenses out of control.
Business risk and liquidity risk are just as real as financial risk, but often harder to detect. Business risk is related to the company's business model itself. Levine uses the example of phone books when he talks about business risk. No one under the age of 75 is using phone books anymore, and the decline clearly manifest itself in the results of phone book companies. Sales and earnings declined quickly pushing them into trouble.
For investors picking through deep value stocks I think business risk is the most pertinent risk. Some deep value companies are experiencing declining earnings, is that acceptable? Maybe they have assets that they plan to monetize that compensates for the declining business. It's also possible that a declining business could imperil the value of the company's assets as well.
In a perfect world I'd love to buy companies that are profitable with large asset undervaluations, these companies are rare, and when they exist they almost always encompass the third risk, liquidity risk. There is a reason a well run business can trade at a very cheap valuation, the reason is usually there is a small float, and the shares almost never trade. These companies are too small for institutional investors, and small fund can have trouble building a significant concentrated stake. These stocks are shunned by almost all investors except for a crazy few like myself. I regularly get emails saying I'm foolish for not concentrating myself in my best investments, but diversification is the investors friend if they wish to mitigate liquidity risk. If I put 25% of my portfolio into a very illiquid stock I could have problems when I need to sell 50% of my stake. If I put 1% of my portfolio into 25 illiquid companies with similar investment profiles I have a better chance of raising the cash I need. Additionally I don't concentrate my portfolio in just illiquid stocks, I maintain a number of listed holdings that I could sell easily if I needed. I have a range of liquidity in my portfolio, in that sense I diversify my holdings based on liquidity level.
I have written previously about how to think about investments as a bond investor. I think using a junk bond investor perspective is more fitting. Evaluate risks, work to eliminate them, and don't hesitate to take a gain when one comes. The last takeaway I had from the book is very fitting for deep value investors, make sure you're compensated for the risk you're taking. The book talks about the worst bond investments being ones where the yield isn't high enough to compensate for risks that are present. At times no yield can compensate for the risk, that's when it's time to pass. The worst investments are ones where an investor pays a B price for something that's CCC in quality.
If anyone is looking for a short, easy to read book on junk bonds that has a lot of cross over to value investing I'd recommend the book. I'd make one further recommendation, don't pay the list price, like any good investor buy cheap (used, or reseller).
Disclosure: If you buy the book through the link I provided I will receive a small Amazon.com commission.