My notes on Seth Klarman's Margin of Safety - Part 3
Unlocking Potential is a newsletter by me, Francisco H. de Mello, CEO of Qulture.Rocks (YC W18)
So, this is the last part of our tryptic series on Seth Klarman's Margin of Safety. The book gets gradually more practical.
I hope you enjoy it.
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Part Three: The Value-Investment Process
The third and final part of the book, called “The Value-Investment Process” is a more practical discussion on how to apply the value investing framework (discussed in the first two parts) on the markets. It is the most dated section of the book, because it relates a lot to the realities and opportunities of the time when the book was originally written, but offers nonetheless very interesting insights into how to profit conservatively and consistently on the markets: namely, by digging ever deeper to find opportunities, and totally refraining from investing when such opportunities do not arise.
Chapter 9: Investment Research: The Challenge of Finding Attractive Investments
Investment research is the process that starts with screening the markets for opportunities, identifying them, and then digging deeper into the fundamentals to check why bargains are bargains, and if there isn't a solid reason for stocks being on the cheap, buying them. As Seth Klarman says, "just as a superior sales force cannot succeed if the factory does not produce quality goods, an investment program will not long succeed if high-quality research is not performed on a continuing basis."
As we've seen in past chapters, value investors need to dig deep to find interesting opportunities. Digging deep into companies takes time, and time is a scarce resource. Therefore, investors need to develop screening systems in order to identify the opportunities in which to dig. Value investors focus on a few market niches, and for each of them, a different screening strategy is advised.
"Value investing encompasses a number of specialized investment niches that can be divided into three categories: securities selling at a discount to break up or liquidation value, rate-of-return situations, and asset-conversion opportunities. Where to look for opportunities varies from one of these categories to the next.
“Computer-screening techniques, for example, can be helpful in identifying stocks of the first category: those selling at a discount from liquidation value. Because databases can be out of date or inaccurate, however, it is essential that investors verify that the computer output is correct.
“Risk arbitrage and complex securities comprise the second category of attractive value investments with known exit prices and approximate time frames, which, taken together, enable investors to calculate expected rates of return at the time the investments are made. Mergers, tender offers, and other risk-arbitrage transactions are widely reported in the daily financial press — the Wall Street Journal and the business section of the New York Times — as well as in specialized newsletters and periodicals. Locating information on complex securities is more difficult, but as they often come into existence as byproducts of risk arbitrage transactions, investors who follow the latter may become aware of the former.
“Financially distressed and bankrupt securities, corporate recapitalizations, and exchange offers all fall into the category of asset conversions, in which investors' existing holdings are exchanged for one or more new securities. Distressed and bankrupt businesses are often identified in the financial press; specialized publications and research services also provide information on such companies and their securities. Fundamental information on troubled companies can be gleaned from published financial statements and in the case of bankruptcies, from court documents. Price quotations may only be available from dealers since many of these securities are not listed on any exchange. Corporate recapitalizations and exchange offers can usually be identified from a close reading of the daily financial press. Publicly available filings with the Securities and Exchange Commission (SEC) provide extensive detail on these extraordinary corporate transactions.
“Many undervalued securities do not fall into any of these specialized categories and are best identified through old-fashioned hard work, yet there are widely available means of improving the likelihood of finding mispriced securities. Looking at stocks on the Wall Street Journal's leading percentage-decline and new-low lists, for example, occasionally turns up an out-of-favor investment idea. Similarly, when a company eliminates its dividend, its shares often fall to unduly depressed levels. Of course, all companies of requisite size produce annual and quarterly reports, which they will send upon request. Filings of a company's annual and quarterly financial statements on Forms 10K and 10Q, respectively, are available from the SEC and often from the reporting company as well.
“Sometimes an attractive investment niche emerges in which numerous opportunities develop over time. One such area has been the large number of thrift institutions that have converted from mutual to stock ownership (see chapter 11). Investors should consider analyzing all companies within such a category in order to identify those that are undervalued. Specialized newsletters and industry periodicals can be excellent sources of information on such niche opportunities."
Kiko's notes: I've chosen to reproduce this segment in its entirety because of both its brevity and importance within the book.
Another important topic discussed by the author is just how much research and analysis is sufficient. This is a topic where the reader may find new, contrarian information, especially when Klarman's views are compared with those of other practitioners of value investing. He defends that information is a business of declining marginal returns, and as such, there is a break-even after which it is counterproductive to keep on researching. Therefore, "investors have to learn to live with less than complete information," because "even if an investor could know all the facts about an investment, he or she would not necessarily profit." Klarman also believes that a level of detachment is also interesting, allowing investors to compare different investments in different spaces altogether. Therefore, investors should allocate their time wisely, focusing on what matters.
Following this section on investment screening and research, Seth Klarman speaks briefly about market inefficiencies derived form institutional money management restrictions - a topic already covered extensively in the first section - and points to a couple of fresh examples, like mutual funds that can't trade on illiquid stocks, and equity holders that may need to sell at calendar year-end for tax purposes. In any case, he remembers us that "healthy skepticism applies to the stock market. A bargain should be inspected and reinspected for possible flaws."
This section explores the importance of contrarian thinking to value investing. Trendy stocks are hardly ever undervalued. But out-of-favor stocks, sectors, and asset classes may provide interesting opportunities to investors. "If value is not likely to exist in what the herd is buying, where may it exist? In what they are selling, unaware of, or ignoring. When the herd is selling a security, the market price may fall beyond reason. Ignored, obscure, or newly created securities may similarly be or become undervalued."
"It is often said on Wall Street that there are many reasons why an insider might sell a stock (need for cash to pay taxes, expenses, etc.), but there is only one reason for buying. Investors can track insider buying and selling in any of several specialized publications, such as Vickers Stock Research."
Key Ideas from Chapter 9
1. Great investments are hard to come by, so investors have to have a sharp process of screening and analyzing great opportunities
2. Sources vary according to different niches. Spreadsheets and stock guides can point in the right direction when looking for stocks trading at a discount to liquidation value. Lists of worst performers are also good sources. Industry publications and business dailies are the best sources for events (M&A, recaps, restructurings, etc). Asset conversions are usually the products of events, so whoever is following the later will learn about the first.
3. Time is of the essence, and information has diminishing returns. Eighty percent of the information can be gathered in twenty percent of the time. Learn to live with uncertainties, because it's worth it. Spend your time wisely.
4. Whenever faced with the prospect of insider information, err on the conservative side, and refrain from using the dubious information.
Chapter 10: Areas of Opportunity for Value Investors: Catalysts, Market Inefficiencies, and Institutional Constraints
Chapters 10, 11, and 13 discuss specific areas that may be of interest to value investors. I've skipped chapter 12 because it's too specific about a type of investment that isn't really relevant anymore (thrift conversions). We'll try to focus on what's atemporal, and useful for investors in today's market.
Klarman makes a very good point at the start of the chapter that is reasonably overlooked by other investors: value investing, as an investment framework, isn't restricted to plain vanilla equities. Actually, since the market is reasonably crowded, plain vanilla equity bargains are getting rarer by the day, so that value-hunting investors have to increasingly consider more complex situations (be them complex securities, like convertibles and rights offerings, or complex companies, in distress, chapter 11 - which would be extreme distress -, or liquidation) to find dollar bills for fifty cents. "The attraction of some value investments is simple and straightforward: ongoing, profitable, and growing businesses with share prices considerably below conservatively appraised underlying value. Ordinarily, however, the simpler the analysis and steeper the discount, the more obvious the bargain becomes to other investors. The securities of high-return businesses, therefore, reach compelling levels of undervaluation only infrequently. Usually, investors have to work harder and dig deeper to find undervalued opportunities, either by ferreting out the hidden value or by comprehending a complex situation."
The start of chapter 10 is very relevant because it discusses the importance of catalysts in unlocking shareholder value. Once a security is purchased, only part of the investor's work is done. The rest is waiting for the value to be realized in the form of stock price appreciation, something that can take longer or shorter depending on how certain events bring about investor attention to the value aspects of the situation.
These events are called catalysts.
Kiko's notes: Klarman makes the following statement: "Once a security is purchased at a discount from underlying value, shareholders can benefit immediately if the stock price rises to better reflect underlying value or if an event occurs that causes that value to be realized by shareholders. Such an event eliminates investors' dependence on market forces for investment profits." This, in my opinion, is either unclear wording or unclear thought by the author (and I firmly believe he didn't express himself correctly, so unclear wording's my pick): what are catalysts, and consequently the market's perception of catalysts, if not "market forces"? It is my view that investors are never free of this dependence relationship. They will, by definition, have to sell securities at some point in order to realize their gains. It is a theoretical concept to think of an investor as a perpetual buyer-and-holder. Naivete, at best.
Some catalysts happen at the discretion of a company's management (executives and board of directors,) like share repurchase programs (buybacks,) mergers, acquisitions, sell-outs, divestitures, and liquidations. Other catalysts happen at the shareholder level, like change in control (the controlling stake changing hands) and changes in the elected board of directors. The third type of catalyst, still, could be wholly external factors, like government regulations and the failure of a competitor. We will go over the main aspects of each catalyst:
Kiko's notes: Although Klarman does not discuss most of the catalyst types in detail, I decided to spend some effort explaining them and discussing the main considerations of each
If there's excess cash and the company's management feels that buying its own shares would offer shareholders a higher rate of return than investing the money in its own available projects, the company may decide to repurchase its own stock on the market. In these cases, companies usually cancel the purchased shares, and therefore the percentage stakes of remaining shareholders increase proportionately;
Kiko's notes: When it decides to issue stock to pay for acquisitions, there may be a problem of the company's own management seeing it's stock as overvalued, and thus worth the trade.
Mergers, acquisitions, and divestitures (and merger arb)
Companies may decide to acquire competitors or relevant assets, merge with other companies, or sell subsidiaries or relevant assets in order to realize hidden value or invest at attractive rates of return; All these corporate events may draw attention to the stock and act as value catalysts;
The company may decide to sell itself to a shareholder at a premium to the trading price. This would be the most obvious and quick way to unlock shareholder value. Selling-out is sometimes preferable to liquidating: "A company involved in only one profitable line of business would typically prefer selling out to liquidating because possible double taxation (taxes both at the corporate and shareholder level) would be avoided. A company operating in diverse business lines, however, might find a liquidation or breakup to be the value-maximizing alternative, particularly if the liquidation process triggers a loss that results in a tax refund."
That's when the company decides to sell all its assets, pay all its obligations and debt, and return the remaining capital to shareholders if there's any left. The process may be long and laborious, but can offer great opportunities to investors: "Most equity investors prefer (or are effectively required) to hold shares in ongoing businesses. Companies in liquidation are the antithesis of the type of investment they want to make. Even some risk arbitrageurs (who have been known to buy just about anything) avoid investing in liquidations, believing the process to be too uncertain or protracted. Indeed, investing in liquidations is sometimes disparagingly referred to as cigar-butt investing, whereby an investor picks up someone else's discard with a few puffs left on it and smokes it. Needless to say, because other investors disparage and avoid them, corporate liquidations may be particularly attractive opportunities for value investors."
Klarman stresses that investing in stocks that have upcoming catalysts is preferable, because returns can be realized quicker, and risk can be thus minimized because there's basically less time for something to go wrong: "Value investors are always on the lookout for catalysts. While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst is an important means of generating profits" and "owning securities with catalysts for value realization is, therefore, an important way for investors to reduce the risk within their portfolios, augmenting the margin of safety achieved by investing at a discount from underlying value."
Kiko's notes: It is very difficult to know how an investor, especially an individual one, can know in advance about upcoming catalysts in a stock. These events tend to be planned with great secrecy, and announced to the general public as material facts, with great regulatory scrutiny. Since these events have a material impact in stock price (thus are called catalysts) I can't think of acting on possession of such information as anything different than insider information, of course. So the skill for the investor would be to invest in securities where catalyst events would be more probable
Individual sections are dedicated to some areas of interest to investors: corporate liquidations, rights offerings, complex securities, risk arbitrage, and spin-offs. The rationale is that these obscure areas of the markets can be overlooked by the majority of investors, and especially institutional money managers, and thus may offer bargain opportunities to the savvy ones.
Discussed earlier as catalysts, liquidations are again talked about by the author, and an example is given, for the City Investing Liquidating Trust, that was settled in 1984 for the liquidation of the City Investing Company
When a company issues it's shareholders the right to subscribe to other securities, like equities, bonds, or the direct ownership of assets. "Rights offerings are more esoteric than many other investments and for this reason may occasionally be of interest to value investors. Some rights offerings present attractive bargains, but many are fully priced or even overpriced. Investors may find this an interesting area to examine but as usual, must do their homework."
Kiko's notes: Klarman dedicates ample space to discuss specific examples of these situations and also entering into greater depth into the asset class. He says "Unlike a typical underwritten share offering, where buying by new investors dilutes the percentage interest of current shareholders, in a rights offering shareholders are given the opportunity to preserve their proportional interest in the issuer by subscribing for additional shares. Those who subscribe retain the same percentage interest in the business but have more of their money at stake. Investors who fail to exercise their rights often leave money on the table, creating an opportunity for alert value investors."
Discussed in general, are "often brought into existence as a result of mergers or reorganizations." A historical example given by the author is the Missouri-Kansas-Texas Railroad Company (MKT), which was reorganized, and thus issued "participation certificates whose only entitlement to monetary benefit consisted of the right to have payments made into a sinking fund for their retirement." These securities can be of interest in future deals: "in 1985 MKT was merged into the Missouri Pacific Railroad Company, and the certificates were the target of a tender offer at several times the market price prevailing earlier that year." He stresses, though, that "Not all complex securities are worthwhile investments. They may be overpriced or too difficult to evaluate. Nevertheless, this area frequently is fertile ground for bargain hunting by value investors."
Risk arbitrage (risk arb)
It would be very easy to find tons of value investing enthusiasts that would argue vehemently against risk arbitrage being an area of interest to value investors. A risk arbitrage opportunity arises when a public company is the target of a takeover offer. Let's say, as an example, that Company A offered to buy 100% of Company B for $ 10 per share. Let's also say that Company B's shares were trading at $ 8, and after the announcement of the deal, which happened overnight, resumed trading at $ 9,50. The spread of $ 0,50 means that the market is pricing a chance of the deal not going through. Reasons for a deal not going through can be many: anti-trust regulators may have to sign-off on it; Company A may have conditioned the offer to obtain financing in the form of debt; in the case of a hostile bid, the deal may be subject to the approval of Company B's board of directors. In any case, risk arbitrageurs are the investors who evaluate these risks - of the deal not going through - and then decide to purchase the stock at $ 9,50: they'll make $ 0,50 in case of success, and lose something close to $ 1,50 in case the deal falls through. "Risk arbitrage differs from the purchase of typical securities in that gain or loss depends much more on the successful completion of a business transaction than on fundamental developments in the underlying company." This last statement by Klarman may be the strongest argument against "risk-arb," as it is nicknamed, is a type of value investing.
"Spinoffs often present attractive opportunities for value investors. A spinoff is a distribution of the shares of a subsidiary company to the shareholders of the parent company. A partial spinoff involves the distribution (or, according to the definition of some analysts, the initial public offering) of less than 100 percent of the subsidiary's stock. Spinoffs permit parent companies to divest themselves of businesses that no longer fit their strategic plans, are faring poorly, or adversely influence investor perceptions of the parent, thereby depressing share prices. When a company owns one or more businesses involved in costly litigation, having a poor reputation, experiencing volatile results, or requiring an extremely complex financial structure, its share price may also become depressed. The goal of spinning off such businesses is to create parts with a combined market value greater than the present whole.
Many parent-company shareholders receiving shares in a spinoff choose to sell quickly, often for the same reasons that the parent company divested itself of the subsidiary in the first place. Shareholders receiving the spinoff shares will find still other reasons to sell: they may know little or nothing about the business that was spun off and find it easier to sell than to learn; large institutional investors may deem the newly created entity too small to bother with, and index funds will sell regardless of price if the spinoff is not a member of their assigned index. For reasons such as these, not to mention the fact that spinoffs frequently go unnoticed by most investors, spinoff shares are likely to initially trade at depressed prices, making them of special interest to value investors. Moreover, unlike most other securities, when shares of a spinoff are being dumped on the market, it is not because the sellers know more than the buyers. In fact, it is fairly clear that they know a lot less.
Wall Street analysts do not usually follow spinoffs, many of which are small capitalization companies with low trading volumes that cannot generate sufficient commissions to justify analysts' involvement. Furthermore, since a spinoff is likely to be in a different line of business from its corporate parent, analysts who follow the parent will not necessarily follow the spinoff. Finally, most analysts usually have more work than they can handle and are not eager to take on additional analytical responsibilities.
Some spinoff companies may choose not to publicize the attractiveness of their own stocks because they prefer a temporarily undervalued market price. This is because management often receives stock options based on initial trading prices; until these options are, in fact, granted, there is an incentive to hold the share price down. Consequently, a number of spinoff companies make little or no effort to have the share price reflect underlying value. The management of companies with depressed share prices would usually fear a hostile takeover at a low price, however "shark-repellent," anti-takeover provisions inserted into the corporate bylaws of many spinoffs, serve to protect management from corporate predators.
Another reason that spinoffs may be bargain-priced is that there is typically a two- or three-month lag before information on them reaches computer databases. A spinoff could represent the best bargain in the world during its first days of trading, but no computer-dependent investors would know about it."
Key Ideas from Chapter 10
1. Investors should be on the lookout for catalyst events. Main types are share buybacks, mergers, acquisitions, sell-outs, divestitures, and liquidations
2. Bargains in plain-vanilla equities are hard to find. Investors may have to look for them in more complex instruments and situations, like liquidations, rights offerings, risk arbitrage, spinoffs, and other complex securities
Chapter 12: Investing in Financially Distressed and Bankrupt Securities
Chapter 12 discusses the opportunities that value investors may find in distressed assets. Securities of financially distressed companies, such as those undergoing chapter 11 or bankruptcy, are fertile ground for value investors: many factors scare mainstream investors, such as the analytical challenge, since there are many more variables to consider, and the stigma that makes them perceive these securities as too risky and imprudent. Illiquidity follows.
Kiko's notes: Klarman states - curiously on the conclusion of the chapter - what should have been the introduction to it: "This chapter only touches on some of the reasons why financially distressed and bankrupt securities may be attractive to investors. It is certainly not a primer on how to successfully invest in these securities, and I do not expect readers to immediately become successful bankruptcy investors. My main point is that an extensive search for opportunities combined with insightful analysis can uncover attractive investment opportunities in all kinds of interesting places."
The analytical challenge is obvious: more than find value, investors have a great challenge in finding exactly which asset class in the company's capital structure that presents the best risk-return. But that's only possible if investors develop some knowledge of the bankruptcy and reorganization process, a legal field, that may deeply affect outcomes, and may be very morose. Finally, like junk bonds, distressed companies carry a lot of stigmas, and therefore most investors keep away from them, deeming them as too risky, imprudent, and illiquid. These are all, as we've seen, nutrients for bargains.
Companies get into distress for three main reasons: operational, legal, or financial. Klarman narrates it in detail: "Financial distress is typically characterized by a shortfall of cash to meet operating needs and scheduled debt-service obligations. When a company runs short of cash, its near-term liabilities, such as commercial paper or bank debt, may not be re-financeable at maturity. Suppliers, fearing that they may not be paid, curtail or cease shipments or demand cash on delivery, exacerbating the debtor's woes. Customers dependent on an ongoing business relationship may stop buying. Employees may abandon ship for more secure or less stressful jobs."
The company's profit margins, and thus its cash generation, may be undermined by the entrance of cheap imports into its market. These tend to be slow deaths, that happen because management refuses to take bold actions like selling unprofitable plants and/or send manufacturing abroad. It's hard to decide if a company that suffers a huge spike in the price of one of its main cost components, like oil for airlines, is undergoing an operational or financial problem. On one side, it's operational because it's the company's core business and core capability. On the other, the lack of a hedge could be deemed as financial imprudence. We'll leave it to that.
Huge suits, like class-action suits, may cause considerable uncertainty, and drive a company to seek Chapter 11 protection in court. These can erupt in various areas, such as labor relations, environmental issues, and anti-trust laws.
Some (bad) businesses have a negative cash conversion cycle, depending on constant, short-term financing for their ongoing operations. Other businesses, victims of bad management teams, are wrongly financed, and also depend on constant renewals for longer-term project funding, like the construction of a plant. In any case, these companies may face distress if they fail to refinance, due, for example, to a drought in the commercial paper market. Financially reckless management teams have also bankrupted companies speculating on hedging contracts, like futures and swaps.
When investing in distressed companies, it is important to evaluate the effect of distress in its ongoing business operations.
"The operations of capital-intensive businesses are, over the long run, relatively immune from financial distress, while those that depend on public trust, like financial institutions, or on image, like retailers, may be damaged irreversibly. For some businesses the decline in operating results is limited to the period of financial distress. After a successful exchange offer, an injection of fresh capital, or a bankruptcy reorganization, these businesses recover to their historic levels of profitability. Others, however, remain shadows of their former selves.
"The capital structure of a business also affects the degree to which operations are impacted by financial distress. For debtors with most or all of their obligations at a holding company one or more levels removed from the company's primary assets, the impact of financial distress can be minimal. Overleveraged holding companies, for example, can file for bankruptcy protection while their viable subsidiaries continue to operate unimpaired; Texaco entered bankruptcy while most of its subsidiaries did not file for court protection. Companies that incur debt at the operating-subsidiary level may face greater dislocations."
In the process of deteriorating financial conditions, a company goes from paying its obligations timely (both interest and principal on the debt, and face value on other non-financial obligations), to withholding payments, and then deciding to offer creditors some deal (in the form of an exchange offer and/or renegotiation of terms), to filing for bankruptcy, where the company can negotiate a restructuring plan under court protection. In parallel, it may resort to cost-cutting, selling non-core assets, or even raising fresh equity and debt to finance its operations.
Exchange offers and renegotiations are tricky. Debtors will offer creditors some easier terms on their loans, either through a discount in the principal amount outstanding, or an extension of the maturity of the loan, or both, in exchange for a greater chance of repayment. Interest rates can also be dialed down, and interest payments are forgiven in the near future.
The problem arises on bond issues, where holders are very fragmented: the company may have trouble identifying all the bondholders, and communicating with them; each and every holder has to approve of any term restructuring, so there is no majority vote, like in the equity space; and finally, there is a difficult free-rider problem that investors face: "Suppose Company X needs to cut its debt from $100 million to $75 million and offers bondholders an opportunity to exchange their bonds, currently trading at fifty cents on the dollar, for new bonds of equal seniority valued at seventy-five. This offer may be acceptable to each holder; individually they would be willing to forego the full value of their claims in order to avoid the uncertainty and the delay of bankruptcy proceedings as well as the loss of the time-value of their money. They may be concerned, however, that if they agree to exchange while others do not, they will have sacrificed 25 percent of the value owed them when others have held out for full value. Moreover, if they make the sacrifice and others do not, the debtor may not be sufficiently benefitted and could fail anyway. In that event, those who exchanged would be rendered worse off than those who did not because, by holding a lower face amount of securities, they would have a smaller claim in bankruptcy. An exchange offer is somewhat like the Prisoner's Dilemma."
Kiko's notes: In Klarman's words, "In this paradigm two prisoners, held incommunicado, are asked to confess to a crime. If neither confesses, they both go free. If both confess, they incur a severe punishment but not a lethal one. If one confesses and the other holds out, however, the holdout will be executed. If they could collude, both prisoners would hold out and go free; held in isolation, each fears that the other might confess. The Prisoner's Dilemma is directly applicable to the bondholders in an exchange offer. Each might be willing to go along if he or she could be certain that other holders would also, but since no bondholder could be certain of others' cooperation, each has a financial incentive to hold out. Exchange offers often require a very high acceptance rate in order to mitigate this problem. If all bondholders could be brought together, there might be a chance to achieve voluntary cooperation. Historically, however, bondholders have been a disparate group, not always even identifiable by the debtor and hard to bring together for negotiations."
Filing for bankruptcy is the company's last resort: "Filing for bankruptcy halts efforts by creditors (lenders) to collect repayment from the debtor (borrower). Payment of principal and interest other than that due on fully secured debt is suspended. Payments to trade creditors and even employees are withheld. The different classes of creditors — secured, senior, and junior lenders, trade creditors, employees, and others — will be dealt with in a plan or sometimes competing plans of reorganization proposed and supported by either the debtor and/or by a major creditor group or groups. As stated previously, to be confirmed a plan must be approved by the bankruptcy judge as well as by a majority in number and two-thirds in the dollar amount of each class of creditors."
In these cases, creditors and debtors may have opposite competing interests: companies will - of course - want to maximize post reorganization cash, and minimize debt while maintaining high CAPEX levels that will ensure it's sound life after bankruptcy. Creditors, on the other hand, will want to maximize cash distributions, and therefore minimize CAPEX, while fighting for the minimum amount of claim haircut possible. The bankruptcy process may also be used to alter previously unnegotiable long-term contracts, like joint ventures, labor arrangements, and long-term supplying obligations.
In a very interesting passage, Klarman states that "Owing to a debtor's ability to reject contracts of nearly all types, a bankrupt company is frequently in a position to become a low-cost competitor in its industry upon reorganization. Unprofitable, high-cost facilities are closed or sold, above-market lease costs are reduced to market levels, and a company's overstated assets are typically written down on its books to fair-market value, thereby reducing future depreciation charges. The bankruptcy process can sometimes serve as a salutary catharsis, allowing troubled firms the opportunity to improve their business operations."
According to the author, who builds on work by Mutual Series Fund, Inc's Michael Price, there are three stages of bankruptcy investing: the first begins when the company files Chapter 11, and investors face the most uncertainty regarding future prospects. It is also usually when prices are cheapest and potential returns largest. The second stage is when a reorganization plan is being negotiated. In it, analysts and investors have a much clearer picture of the company's financials (mainly the real value of assets, and the real chance of profitability). The third and last phase starts when the plan is passed, and the company emerges from bankruptcy. It is also when risks are lowest.
Klarman states that bankruptcy investing is a great sea of opportunity: "when properly implemented, troubled-company investing may entail less risk than traditional investing, yet offer significantly higher returns." But its risks are greater too: "when badly done, the results can be disastrous; junior securities, for example, can be completely wiped out."
Key risks are:
Liquidity: Distressed securities can be very illiquid
Information asymmetry: "traders can take advantage of unsophisticated investors. Quoted prices may bear little relationship to actual trading levels, and an uninformed buyer can significantly overpay." So individual investors have to pay doubled attention
Timing: Fully covered claims - claims on which investors receive 100 cents on the dollar - are essentially zero-coupon bonds without a clear maturity. Therefore, timing is (et ceteris paribus) the sole driver of returns, and is derived from the court proceedings and investor coordination during bankruptcy
Type of business: On one end of the spectrum are the higher risk bankruptcy investments, which are asset-light, and highly dependant on key personnel, or financial companies that are particularly dependant on investor confidence. Klarman cites dated examples of Ames Department Store (a discount store in a fiercely competitive market) and Integrated Resources ("a highly leveraged financial services company.") On the other end of the same spectrum are "over-leveraged capital-intensive debtors, possibly having a monopoly or near-monopoly positions in their industries, and business producing homogeneous or undifferentiated products." Low-risk bankruptcies also have little legal and regulatory players involved. Utilities and heavy industries are cited as examples.
In the last portion of the chapter, Klarman goes over the financially distressed and bankrupt security investing process, which is basically a process of defining the size of the pie (the value of a company's assets) and then figuring out how it'll be divided (by analyzing the different seniority levels of liabilities, and if there is enough pie to cover everybody's claims.)
On the asset side, the investor should value both on and off-balance sheet assets. It is key to aggregate them in two main buckets: operational assets, which are required by the company's ongoing business operations, and non-operational assets, that may be distributed to investors in kind in a reorganization procedure. In both cases, it is important to note that a company may try to "uglify" its financials to make it look like there are fewer assets to be distributed to investors (and therefore more to be kept by the company.) Investors should also pay a lot of attention to potential distortions that the bankruptcy process may cause in the company's financials. For one, interest accruals may have halted during Chapter 11 protection.
On the liabilities side, the investor should also screen both on and off-balance sheet claims. Balance sheet claims must be accounted for in a most senior to least senior order.
"Secured debt should be evaluated first. If the value of the security interest is determined, whether through negotiation or a valuation proceeding, to be equal to or greater than the amount of claim, the claim is said to be fully secured or oversecured. An oversecured claim entitles the holder to post-petition accrued interest (interest that would have accrued during the bankruptcy proceeding) to the extent of the amount of oversecurity. If secured debt is determined to be less than fully secured, holders will typically receive value equal to the extent of their security plus a senior but unsecured claim against the debtor for the amount of the undersecurity. There may be some investment opportunities in distressed securities at every rank in the debt hierarchy. Risk-averse investors will generally prefer to hold senior securities; the potential return from senior securities is frequently less than that available from junior claims, but the risk is also much lower. Senior securities are first in priority, and unless they are fully or almost fully repaid, junior classes are unlikely to receive significant value.
"Fulcrum securities" — the class of securities partly but not fully covered by asset value — can also be attractive investments at the right price, ranking midway on the risk spectrum. Fulcrum securities benefit most directly from value increases and likewise are most directly impaired by any value diminution.
Investing in junior securities can provide spectacular returns but can also prove disastrous. These securities often serve as out-of-the-money options — effectively, bets — on an improvement in operating results or an increase in value.
The common stock of bankrupt companies frequently trades considerably above its reorganization value, which is often close to zero. While there may be an occasional home run, as a rule investors should avoid the common stock of bankrupt entities at virtually any price; the risks are great and the returns very uncertain. Unsophisticated investors have lost a great deal of money buying the overpriced common stock of bankrupt companies, even after the unfavourable terms of the reorganization plan have been widely disseminated."
Off-balance-sheet claims, like underfunded pensions, legal suits and government claims like the IRS must be accounted for if they're not registered in the balance sheet.
Key ideas from Chapter 12
1. Companies get in financial distress for three main reasons: operational, legal, and financial. Operational issues are the worst - the company's business isn't sound as it is; Legal issues may be large lawsuits or regulatory actions; Financial issues are management's wrong decisions regarding a company's capital structure, like financing long-term CAPEX with short-term debt
2. Investors have to assess the impact of bankruptcy on a company's ongoing business operations. The bankruptcy of a holding company, for example, can go on with little or no impact on its subsidiaries' businesses
3. Bankruptcy investing is divided into three states: just after Chapter 11 filing, during a reorganization plan negotiations, and after a plan has been approved and the company is emerging from the process. Risks are greater in the earlier stages, as are opportunities
4. The main risks of bankruptcy investing are lack of liquidity, information asymmetry, and the type of business conducted by the bankrupt company. Lower risks are associated with more assets, less dependency on key people and their minds, and little importance for "confidence" or "reputation" as in financial companies
5. Bankrupt investment analysis should focus on the size of the pie - the value of a company's assets - and how it'll be distributed among creditors. Investors should value operational and non-operational (distributable) assets separately, and then go on to analyze liabilities in descending seniority order. Opportunities may be found in all seniority levels
Chapter 13: Portfolio Management and Trading
Klarman regards portfolio management as a very important part of any investment framework. According to him, it entails three main groups of activities: trading, which is buying and selling securities; portfolio monitoring, which is deciding when to add, when to reduce, and when to sell positions; and portfolio construction, which entails diversification, hedging, cash flow, and liquidity management.
Liquidity and cash flow: "since no investor is infallible and no investment is perfect, there is considerable merit in being able to change one's mind." Liquidity enables that, by allowing investors to easily sell current holdings or use excess cash to make new investments. Liquidity can also be sourced from portfolio cash flows, derived from dividends, buy-outs, and other corporate events.
According to the author, investors should accept lower liquidity only when being compensated by the higher risks, in the form of lower prices and therefore higher expected returns. Liquidity is also to be taken with a grain of salt. Klarman cites Louis Lowenstein: "In the stock market, there is liquidity for the individual but not for the whole community. The distributable profits of a company are the only rewards for the community." He means that there must be a buyer for every seller in the market, and therefore the only sources of liquidity that don't depend on the will of other investors. Finally, liquidity tends to fluctuate with market sentiment. Bull markets tend to be more liquid than bear markets, and individual stocks more liquid when in favor, i.e. fashionable.
He sums up: "Investing is in some ways an endless process of managing liquidity. Typically an investor begins with liquidity, that is, with cash that he or she is looking to put to work. This initial liquidity is converted into less liquid investments in order to earn an incremental return. As investments come to fruition, liquidity is restored. Then the process begins anew.
This portfolio liquidity cycle serves two important purposes. First, as discussed in chapter 8, portfolio cash flow — the cash flowing into a portfolio — can reduce an investor's opportunity costs. Second, the periodic liquidation of parts of a portfolio has a cathartic effect. For the many investors who prefer to remain fully invested at all times, it is easy to become complacent, sinking, or swimming with current holdings. "Deadwood" can accumulate and be neglected while losses build. By contrast, when the securities in a portfolio frequently turn into cash, the investor is constantly challenged to put that cash to work, seeking out the best values available."
"Even relatively safe investments entail some probability, however small, of downside risk. The deleterious effects of such improbable events can best be mitigated through prudent diversification. The number of securities that should be owned to reduce portfolio risk to an acceptable level is not great; as few as ten to fifteen different holdings usually suffice.
Diversification for its own sake is not sensible. This is the index fund mentality: if you can't beat the market, be the market. Advocates of extreme diversification — which I think of as over-diversification — live in fear of company-specific risks; their view is that if no single position is large, losses from unanticipated events cannot be great. My view is that an investor is better off knowing a lot about a few investments than knowing only a little about each of a great many holdings. One's very best ideas are likely to generate higher returns for a given level of risk than one's hundredth or the thousandth best idea."
Investors may seek to protect certain risks when conditions - prices - are favorable. For example, overall stock market risk may be reduced by selling index futures. Other examples given are hedging the exposure of interest rate sensitive stocks by selling short interest rate futures, reducing the price risk of commodity-sensitive stocks by selling metal futures or hedging the foreign currency risk of heavy importers of materials. But investors should bear in mind that "hedges can be expensive to buy and time-consuming to maintain, and overpaying for a hedge is as poor an idea as overpaying for an investment."
"In my view, investors should usually refrain from purchasing a "full position" (the maximum dollar commitment they intend to make) in given security all at once. Those who fail to heed this advice may be compelled to watch a subsequent price decline helplessly, with no buying power in reserve. Buying a partial position leaves reserves that permit investors to "average down," lowering their average cost per share, if prices decline. Evaluating your own willingness to average down can help you distinguish prospective investments from speculations. If the security you are considering is truly a good investment, not a speculation, you would certainly want to own more at lower prices. If, prior to purchase, you realize that you are unwilling to average down, then you probably should not make the purchase in the first place."
It's easier to buy than to sell, because, for one, it's hard to know exactly what a security is worth. Also, "as the market price appreciates, ... safety margin decreases; the potential return diminishes and the downside risk increases." To deal with this difficulty, some investors set to return, price, and multiple targets designed to trigger selling out of positions. But "decisions to sell must be based on underlying business value." Liquidity may also influence selling: whenever liquidity is a constraint, finding a willing and able buyer for the position may anticipate the timing for a sell. Investors have to refrain, however, from setting tight stop-loss orders just below cost. "Although this strategy may seem an effective way to limit downside risk, it is, in fact, crazy Instead of taking advantage of market dips to increase one's holdings, a user of this technique acts as if the market knows the merits of a particular investment better than he or she does."
Kiko's notes: Seth Klarman offers no rule of thumb for selling, as he does for buying. He hints, nonetheless, that being fundamentally driven, vis-a-vis setting artificial triggers, is the way to go.
Lastly, the author highlights the importance of having the right broker working for you: one that is willing to put the customer-broker partnership in front of his immediate interests. He hints that being a relevant customer in terms of revenues helps, as well as using a broker that has a good level of influence within his or her firm, enabling you access to analysts and experts, and one that is not too successful as to not work hard for your account.
Key Ideas from Chapter 14
1. Portfolio management is an integral part of any investment framework
2. Portfolio management comprises portfolio construction, trading, and monitoring
3. Good portfolios are correctly diversified, hedged, and have a good liquidity profile
4. When trading, you should aim at building positions (buying) gradually, so as to be able to average down on prices
5. When selling, refrain from artificial selling triggers, and instead aim at selling when a good portion of the value is realized
6. Choose your broker wisely
Thanks a lot for sticking with me.