Fructivore Investments

Every financial panic needs a good person to blame. This one can be blamed on securitizers and financial derivatives engineers; the one before on deluded dot-com investors, the one before (the junk bond collapse) on frenzied, ill-advised mergers, and the one before that (the Latin American debt crisis) on the oil crisis. I’ve skipped the savings and loan crisis since at least part of it was just bad timing. However, three of these four panics can be explained by the tendency towards yield hoggery.

A yield hog is, simply enough, an investor who is dazzled by high yield investments. A big fat coupon impresses investors and also serves to erase a few embarrassing mistakes. In fact, an investment that produces a large cash flow that is reasonably safe is the kind of low-hanging fruit that the investor should be seeking out. The emphasis, though, is on “reasonably safe,” whereas a yield hog sees “large cash flow” and stops reading. They are willing to reach for yield, and either get it by ignoring established standards of investing safety, or worse, they make up new standards that show that what they’re doing is now safe.

The central concept in yield hoggery is that risk can be made up for with a higher interest rate. I discussed that in the Capital One context, and in theory, it works as long as the risk premium does adequately capture the default risk and pays a premium to the holder on top of that. In other words, it works until it stops working. But worse for the sleepy investor, a risk that fails to materialize seems to fall out of the view of the typical market participant, and the risk premium narrows even as the risk becomes more and more likely. If, say, a certain class of bonds has a 4% annual default rate, this does not mean that 4% of them will default every year like clockwork; it means that they will see 1% default rates for years at a time and then suddenly get hit with a 20% default rate all at once. However, the investor that invested in those bonds will, until that happens, make more money than the more conservative investor who avoids them, and will also steal all of the latter’s clients. After all, clients pride themselves on not being cowardly and very risk averse–until the risk actually happens.

This was the view held during the Latin American debt crisis, wherein according to Nassim Nicholas Taleb, American banks lost, in nominal terms, all the money they had made in the history of American banking (which makes it kind of amazing they scraped together more money to lose so quickly in the subprime crisis). Latin America was growing at a fast pace and investors were naturally attracted to the higher yields available. After all, surely a government is safer than a corporation they could be lending to, and really, what are the odds that many countries would default at the same time? I mean, it’s not like defaults are likely to be correlated or anything.

However, at the very least they were following established financial standards rather than writing new ones, which is what they did during the junk bond explosion. The priests of the junk bond religion argued that since debt financing was generally cheaper than the cost of equity, it was entirely feasible to do leveraged buyouts, saddling companies with irresponsible levels of debt.The traditional corporate financier looked at the money a corporation could spare for debt service in terms of earnings, or at least EBIT, but the new method was to expand it to EBITDA, on the theory that capital expenditures could be delayed and so depreciation and amortization were basically “free money.” Of course capital expenditures can be delayed for a time, but not indefinitely and almost certainly not for the entire term of a junk bond. The switch to EBITDA provided a justification (i.e. excuse) for all manner of crazy, ill-advised mergers, and formerly solid companies were even pushed into borrowing large sums of money and distributing it to shareholders to hold off the acquirers.

Subprime securitizers had their own version of changing standards; the CMO structure allows investors in the lower credit tranches to absorb credit losses so that the higher tranches are not likely to be invaded by losses (again, what are the odds that many borrowers would default at the same time?). Their safety also depended on the availability of refinancing and and the ability of the housing markets to continue producing the ridiculously high returns they had been, and, although it went unmentioned, they also depended on the health of the foreclosure market. At least the Latin American debt investors were honest about the risks they had taken; junk bond and subprime investors just reached for yield and rewrote the rules in order to get it. The yield hog was absent during the triple-digit-PE craze of the dot com era, since with that kind of PE it is more profitable to reinvest any earnings into the company. (Is there such a thing as an appreciation hog? I think so.).

Since I seem to be in the habit of raising problems and not solving them, I suppose I should mention a holding that a yield hog can get behind. Windstream (WIN) is a rural telecom company that as of this writing sells for a little over $8 and pays $1 per share annually in dividends, which is dramatically impressive in a time of low interest rates. Their earnings have been stable over time, true, but have been stable at just a hair under a dollar. Using the trick we learnt from Qwest (see below), we find that their depreciation exceeds their capital expenditures, which gives them some extra free cash flow. As a result, their dividend is covered by distributable earnings, but just barely. On the plus side, they have recently announced an acquisition that in the opinion of management (ha ha) will begin to enhance their bottom line by the end of the year, which will enhance the safety of their dividend. They also have a debt maturity coming up in 2011, and hopefully the financial markets will have recovered by then enough to make rolling their debt over reasonably cost effective. Obviously, the company is unlike to appreciate significantly since they are paying out every penny they earn in dividends, but given their stability in earnings it is not too likely to drop either. Of course, in the unlikely but not impossible event of a dividend cut, the company would probably would drop in price, but they would still be earning somewhere in the area of $1 a share, and that money is still the shareholders’ whether or not they have it in their hands.

So, good luck and remember that even hogs can be eating low hanging fruit if they’re careful about it.

The deeper I get into investing, the more I find my interests are aligned with those of our corporate overlords. Thus, even though a piece of legislation is objectively progressive and fair, I also have to view it in terms of how it tilts the power away from the fat cats. Such is the case with the recent credit card legislation. Among other things, it bans universal default clauses, prohibits credit card companies from raising rates on existing balances, and requires charges and late penalties to be reasonably related to what they cost the company.

Capital One stated that, unlike mortgage lenders, credit card companies have the ability to build expected default rates into the interest they charge their customers. The ability to raise rates on existing balances may be viewed by them as an attempt by them to fine-tune this ability. In fact, universal default, a policy by which credit card companies impose large rate hikes if their customers default on other debt payments or even utilities, is an attempt to fine tune this process, since when it comes to defaults it’s hard to stop with just one. Even the legal test for insolvency is that the borrower is not paying bills as they come due. As the credit card companies probably pointed out in their meeting with President Obama before the bill passed, the alternative is serving less customers and pushing some of them into the less-regulated, less-convenient, more loan-sharky market. More likely, however, they told him it would mean higher rates for everyone, a principle that companies have certainly demonstrated by slipping in an across-the-board rate hike before the new law comes into effect. Under the new law, they can only raise rates on existing accounts after there have been two missed payments, which is probably inadequate for the companies to protect themselves, since after missing two payments it reasonably becomes more and more likely that they will miss the next four and be written off.

Even with the new legislation in place, and credit card default rates hovering around 10%, credit card companies and pretty much all corporations have short memories. Any credit manager under pressure to produce bigger numbers will eventually roll the dice on relaxing the lending standards just a little, in exchange for a higher initial rate, even if it can’t be adjusted so easily. So, with or without this legislation, when the shock of this recession is over it should be back to business as usual, apart from greater volatility in chargeoff rates. . Oh and the bit about fees and penalties being reasonably related to the actual cost to the credit card company? Who, exactly, is going to be telling the regulators what their costs are?

So, this legislation is probably not a good thing for credit card companies, but I don’t think it will be too bad of a thing either. Long live the corporate overlords.

Benjamin Graham wrote in Security Analysis that  there are few tests of management competence and none of them scientific. This was in the 1951 edition of his book, and in almost 60 years there have been few improvements.

One reasonable test, however, is management’s opportunism and understanding of the broad economic climate. Although “proactive” is viewed as a desirable quality to the point of being cliche, being reactive is also a good quality. Although there is a risk of confirmation bias (remembering what management did but forgetting what management didn’t do), developing a history of management actions is about the only way to assess their competence.

At this point it may seem unusual for me to hold up Capital One, a credit card company that is writing off its accounts at an annualized 10% rate, as an example of management competence. Well, first of all, I didn’t say they had to be a positive example, but my focus is more on the financial than the operations aspect. Yes, they overexposed themselves to a risky credit market, but short of liquidating themselves it’s not immediately clear what they could have done to avoid it (not that they deserve a free pass for it). Given that their chargeoff situation is going to dominate their earnings at least until the recession ends, I cannot say they are an unqualified buy.

In terms of their financial maneuvering, however, Capital One has not done too badly. Like all credit card companies, they rely on securitization of their credit card holdings as a source of funding, In order to diversify their funding sources, in 2006 Capital One acquired North Fork bank. In 2007 they divested the bank’s subprime mortgage origination unit, when the housing situation was still a slowdown instead of a meltdown. Their reason for doing so was that, on top of the housing situation, credit cards are capable of pricing the default rate into the interest charged to people, rather than relying on a potentially nonfunctional foreclosure market. Earlier this year they acquired Chevy Chase bank, for the same reason. Also, during the brief euphoria that accompanied the initial passing of the TARP, when their stock jumped from 30 to nearly 60, they made a secondary offering of stock at 48, which, given the current share price of $20 and change, also shows some fairly prescient timing.

As I mentioned before, the credit card situation allows the issuer to price the default risk into the interest charged. As I shall explain in my next post, this assumption may be called into question by the upcoming legislation.

Well, it’s official. Bernie Madoff is to be locked up for 150 years. Although it’s not exactly investing related, the largest fraud in history cannot pass without comment.

Madoff’s attorney must have been dreaming when he offered 12 years; Madoff’s fraud lasted longer than that, and it makes no sense to me that he should be punished for less time than he was a criminal. It should be recalled that at any time during his fraud, Madoff could have said “Enough” and turned himself in, but in fact it seems that he was raising money to shore up his scheme right up until the end. And, even if he can’t live out his sentence he can’t pay off all of his investors either and that didn’t stop them from seizing his assets.

So, what else is there to say, apart from some old advice involving eggs and baskets? (It’s hard for a crooked hedge fund manager to steal all your life savings if you don’t give them all to him.) The sad fact is that investors are generally powerless against fraud. Investing is hard enough without worrying about data quality, and so any remedy for fraud has to come from outside the investment world. That is why we have auditors and that is why Enron took Arthur Andersen with it. Madoff had an auditor (who has also been charged with securities fraud), but apparently his auditor avoided the peer review process among accountants by publicly denying to the AICPA that his firm does any audits. Again, this might have been a red flag, but a typical investor has enough demands on his time, and fraud on a scale big enough to be worth guarding against is so rare, that it would be more productive to invest in a straightforward manner and leave the fraud prevention to the existing system of accountants and regulators. Trouble is, sometimes that system has a Madoff-sized hole in it.

Shorting stocks is widely considered dangerous. The old adage is that “Stocks can only fall to zero, but they can rise to infinity.” I’ve always been unsatisfied with this explanation, because I’ve never seen a stock actually rise to infinity, and if I did see one I would short it.

The problem with shorting is that it is impossible to open a position and forget it. Unlike a long position in a solid and stable company, no one opens a short position without planning to close it. No one ever inherited a short position from a distant great-aunt, and if a brokerage needs the shares back it can close the position without the shorter’s consent. Furthermore, the best candidates for shorts are those that the market is most optimistic about. If their exuberance continues, the price can stay high and climb higher, giving the shorter a great deal of stress. And generally, shorting a situation of excessive optimism is the only way to do it; if everyone already knows that the stock is a losing proposition the share price will indicate this by being very low and there is really no profit left in shorting it.

Short selling may also be inconsistent with the low-hanging fruit approach. Purchasing an underpriced investment with strong present or potential cash flow gives investors assurance that, if they did their research correctly, the investment’s apparent underpricing will resolve itself. After all, cash is always worth cash. Short sellers have no similar assurances. They are reduced to waiting for the rest of the investment community to wake up to the fact that the company is nowhere near as good as the “story” they bought indicated (Ideally this process would be accelerated by accounting scandals, but you can’t have everything). The waking-up process, since it doesn’t involve cash piling up, has no time pressure to occur, and in the meantime, as Mohnish Pabrai indicated, the company can turn that fake value into real value by issuing new stock for cash, acquiring a real company with its overpriced stock, or allowing itself to be bought out.

On the plus side, shorting stocks, if you have a knack for it, is a way to find a use for unused margin (a margin account is nearly always required, and don’t use up all your margin because optimism has a tendency to feed on itself) and to reduce your market exposure in the face of a broad-based downturn. There definitely are times when optimism is clearly unjustified, and if, after seeing the downside of shorting we still want to short, finding excessive optimism is definitely the place to do it.

Coinstar presents such a situation. It has a market cap of $782 million as of this writing, made only $2 million last quarter, and $14 million the year before, which is an improvement from the previous year in which it lost money. That works out to a P/E ratio of 55, which strikes me as just the tiniest bit high.

I have to admit that when Coinstar came out, I was optimistic. Rolling coins is not most people’s idea of fun and any company that is in a position to exploit the laziness of the average person should have a bright future. However, the execution proved not to be as bright as the idea; the business proved itself to be high in capital requirements and expenses and I never really found an entry point I liked. But when such a company reaches a P/E ratio of 50 what could be more natural than looking for an entry point on the other side?

The cause for the latest round of optimism is Redbox, the DVD rental kiosks in grocery stores and some McDonald’s. They are certainly the driver of Coinstar’s recent sales growth; in the last reported quarter they produced $150 million in sales and $27 million in operating income.It is obviously difficult to value a fast growing entity, but Coinstar’s own latest 10-Q gives us a hint. Redbox used to be a joint venture with Coinstar and several other investors, but last February they acquired GetAMovie’s 44.4% interest in Redbox, plus a note for $10 million from Redbox, for $10 million plus a lot of stock. The company has already paid about $115  million in stock and expects to pay up to $20.8 million more. Taking out the cash and the note, we get at most $135.8 million for 44.4% of Redbox, which suggests that the whole of Redbox is worth no more than $305  million. This price was negotiated between two sophisticated buyers, each in possession of all the inside information they could want. Of course, Coinstar intends to expand this business, and presumably hopes to realize a decent return on capital by doing so, but presumably GetAMovie considered the same course of action and thought it was better to get out. Take away $305 million for Redbox, and that leaves a valuation of $477 million for the rest of Coinstar’s operations, which as I’ve said have not been at all impressive over the years. When Coinstar’s investors wake up to this fact the price should drop accordingly.

So, having heard the drawbacks and benefits of shorting stocks, if you want a stock to short I suggest this one.

On a forum I visit regularly there was a post when a novice investor asked if there was a good beginner stock that he could learn the ropes with. The general consensus was that there is no such thing as a beginner stock; all stocks were viewed as extremely complex generators of investment returns, full of capital issues, economic outlook situations, regulatory environments, etc.

The advice was to find a company in an area that interests you. However, most of the stocks on parade to the investing public are likely to be large, diverse, and to present a more complicated analytical situation than some of the smaller issues. The perennial advice is to invest in companies you understand, but there are different levels of understanding. “Of course I understand what Enron does. It trades energy derivatives.” “Of course I understand what AIG does. It’s an insurance company.” “Of course I understand what Citigroup does. Everything.”

So, even though the onus is on the investor to do his homework, some stocks are more amenable to valuation than others, and although complicated situations are more likely to have hidden value to unlock (or to have hidden traps), there is an argument to be said for finding a simple and understandable situation that allows the investor just to leap on it whenever the price is right.

Capstead Mortgage (CMO) probably qualifies as such a situation. It’s more of a fund than a company; it produces no products and has no customers. Their business plan is to purchase adjustable-rate mortgage passthroughs from federal mortgage agencies (Fannie, Freddie, and Ginnie) and to finance these purchases through short term borrowing, thus profiting on the spread the adjustable rate mortgage charges over the cost of financing. Also, since they are dealing with agency securities, and the federal government is now explicitly guaranteeing them (just as investors always thought they would), the risk of default is off the table.  Stock investors nowadays are often asking themselves “Where’s my bailout,” and here it is.

So, given these advantages, how can Capstead Mortgage lose money? Or, to be precise, Capstead Mortgage has lost money in the past and here’s how. First off, many of their holdings were until recently in the “teaser rate” phase, so their interest payments were lower than they would be once the teaser rate expires. Second, the company’s short term financing runs for a term of 30 days, while the reset period for many adjustable rate mortgages is a year or six months, and they have a “soft cap” where interest rates cannot rise beyond a certain limit per reset period. For this reason, it is possible that the interest on the mortgage will not always keep pace with rising interest rates. Capstead claims to use fixed/floating interest rate swaps to handle this, which allows them to receive the prevailing short term interest rate in exchange for them paying fixed interest payments. If their hedging is sufficient investors have nothing to worry about from rising interest rates. And when interest rates are low and declining, as they have been, the company has produced returns of about 15% on equity, which is not bad for a situation with theoretically so little risk.

So, what prevents Capstead Mortgage from being a screaming buy? The price. I mentioned the return on equity, but the investor cannot buy the equity for the same price the company paid for it. Net of the liquidation preference of its preferred stock, Capstead has a book value per share of about $10.40, and its current price is about $13. Although in theory a high cash flow producer like this is entitled to a premium, the economic situation of mortgage investing counsels against buying into a high premium situation. A mortgage borrower can refinance his mortgage at any time, and mortgage defaults also result in principal being returned to the holder of the mortgage passthrough. Therefore, a mortgage security that the market currently values at $13 will be paid back at $10.40, and the premium paid vanishes into thin air. The annualized prepayment rate was 16.6% last quarter. It is possible that even at current prices the high cash flows produced will justify the premium, and at a lower share price they definitely will. So, a significant price drop will turn Capstead Mortgage into the low-hanging fruit we all know and love.

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.