Fructivore Investments

In case you haven’t noticed, China runs a substantial trade surplus with the world and the United States in particular, and its foreign reserves come to $3.3 trillion dollars equivalent, and just under $1 trillion US. Actually, the US holding has declined slightly from its record, partly from diversification and partly from interest rates going up, I speculate. However, there is considerable speculation as to what China intends to do with that money. Certainly not turning around and buying goods and services from the United States; that would defeat the purpose of the trade surplus. Is there a plan to use it in some nefarious plot to destabilize the US economy or the world?

In my opinion, probably not. China’s currency reserves are a side effect of China’s overall economic policy, and may indeed be causing them a bit of a headache. The large bolus of foreign currency is just sitting there, waiting to cause a burst of inflation in China if the country ever decided to something with it.

In order to understand what’s going in China, a good starting place is, of course, postwar Japan, which China studied in order to crib its development plans. Consider first the concept of autarky. Autarky is the notion that an entity, such as a nation, community, etc., should be able to provide all of its needs with resources that it already controls. For a nation the size of China, or a supranational organization like the Warsaw pact, it is theoretically feasible, while of course attempts to try it in North Korea or Pol Pot’s Cambodia ended in disaster. The idea has waxed and waned in popularity over the years and is not entirely associated with Communist regimes.

Prior to World War 2, Japan’s effort to organize the Greater East Asian Co-Prosperity Sphere was itself an autarkic effort, but after the war Japan itself did not have the natural resources to engage in autarky. However, per R. Taggart Murphy’s excellent The Weight of the Yen, it was Japan’s economic policy was instead to switch to financial autarky, by building up its capital base without relying on foreign investment. The key method was to force the Japanese to save a lot of money while keeping interest rates low so that firms would have profits to reinvest and money to pay their large debt balances, and allowing the economy to become cartelized so that the profit margins of the businesses were protected so the high degree of leverage to fund capital investments did not result in bankruptcy. It also required international capital controls so that Japanese firms and citizens had no alternative but to invest in Japanese assets.

I believe that key elements of this policy were followed by China, with the added convenience that China was a command economy and could use heavy-handed regulation and state-owned enterprises rather than trying to force the outcome through a nominally capitalist system.

The economic effects of this policy, if it is effective, is to lower consumption in favor of investment, and to lower interest rates because there is more savings chasing investments relative to what businesses would normally have to offer savers. Now, in a vacuum the chief determinant on demand for capital goods in a free economy, other than interest rates, is the future course of the aggregate wage, which will impact future consumption. If the policy is expected to be unchanged, with consumption being artificially suppressed it is inevitable that there will be excessive industrial capacity and also excessive unemployment since there is no need to employ people to produce goods that no one will buy.

So, what to do? Enter the trade surplus. If the economy can undercut other nations and export to them, the excess capacity and unemployment can both be solved. The excess capacity problem is solved automatically, as the lower required return on assets will inherently outcompete higher priced foreign producers, while the lower interest rates weaken the currency, making your exports cheaper as well. The enforced lower standard of living also lowers production costs, making one’s exports even more competitive. The only downside is an artificially low standard of living, which is a surprising policy goal for a Maoist regime, but here we are. Apparently, China sees this as a worthy price to pay to avoid inflation and instability.

So, the accumulation of dollar-denominated assets is really a side effect of China’s policy, not their intended goal. In fact, by increasing demand for foreign assets the effect is to lower interest rates in China’s trade partners, which in a free market would make them weaker and the yuan stronger. However, China is capable of keeping its currency peg in effect through capital controls. In theory, the lower interest rates facilitated in our country could result in inflation, so the Chinese are exporting inflation as well as importing employment.

One wonders, though, if at some point China will determine that the capital stock of the nation has become adequate and there is scope to reverse this policy. I think it will be a difficult adjustment, in the sense that there vested interests resulting in policy inertia, partly the fear of releasing inflation, and part of it simply that capital is not fully interchangeable, and goods desired in wealthy foreign countries are not suitable for the domestic market. The overhang of uncompetitive state-sponsored enterprises would also have to be dealt with.

Even so, we are seeing signs that this development is taking place. China is now allowing its trade partners to settle its accounts in yuan rather than dollars, and has opened swap facilities with many trading partners, but since the source of the yuan is the Peoples’ Bank at the official Peoples’ Exchange Rate, this seems to be more of a method to avoid having to convert foreign currency into dollars and then into yuan than to actually turn the yuan into an international currency. This same facility is also allowing foreign businesses operating in China to borrow money in yuan as long as the proceeds remain in the country. Moreover, the recent weakness in the yuan is caused not by their policy but by the Federal Reserve and the ECB raising interest rates to tamp down post-COVID inflation. Even so, these steps are in my view not indications that China is ready to allow the yuan to be a fully international currency, or to abandon its trade surplus uber alles policy, and certainly these liberalization steps could even be reversed by administrative fiat, potentially leaving many trading partners in the lurch.

I know that normally I am known for my investing and economic insight here, but I am also a lawyer and this has just come up. The decision by the New York Appellate Division to reduce the bond required to stay enforcement of the judgment against Donald Trump is incomprehensible. I mean that literally. I cannot even say that it is based on faulty legal reasoning; it is, as far as I can tell, based on no reasoning at all.

The New York Appellate Division issued a ruling reducing the required bond to stay enforcement of the state of New York’s judgment against him (called a supersedeas bond) to $175 million from $454 billion as calculated by statute. Notable in this ruling is the lack of any justification or analysis. Perhaps the court will issue a memorandum later, but this order alone contains not one shred of legal reasoning to justify the appellate court’s order. I have not been able to determine whether Letitia James will request leave to appeal the Appellate Division’s order to the Court of Appeals, but if so I can surmise the lack of any reasoning by the Appellate Division may become an issue.

Frankly, if the court had examined Trump’s reply brief, they would have found that he has been playing fast and loose with the decisions cited. Trump’s lawyers did cite certain cases wherein the supersedeas bond was not enforced fully, but all of those cases involved differing factual circumstances that did not apply here.

The first case cited was Texaco Inc. v. Pennzoil, and in fairness the court did reduce a $12 billion bond to $1 billion, but the court’s reasons were that it had been persuaded by evidence that there were not more than $1.5 billion in surety bonds available in the entire world (in 1986), and that the immediate enforcement of a judgment that was likely to be reduced on appeal anyway would cause apocalyptic havoc on the fifth largest company in the nation, affecting tens of thousands of people. Donald Trump has not even represented that he or any of his companies would be forced into insolvency by the enforcement of this judgment.

Trump’s next case was In re Adelphia Communications, which allowed an appellate bond of $1.3 billion against 111 million shares of stock, 9.4 billion tradeable interests, and $7.136 billion in cash. However, the decision under appeal in Adelphia was the final distribution of a Chapter 11 bankruptcy case, under which the shares were to be distributed to 14000 potential shareholders and the other assets to 10,000 interested parties, making it essentially impossible to track them down again if the decision was reversed on appeal. In Trump’s case, however, there is only one recipient of the res of the lawsuit: the State of New York; a key distinction that Trump’s lawyers conveniently leave out.

Trump’s next case is Cayuga Indian Nation v. Pataki, which did waive the bond requirement entirely, but in that case it was the State of New York that requested a waiver of a bond, and the court was persuaded that New York’s taxing power would suffice to provide adequate assurance of the collection of damages, and also there were some constitutional difficulties in a federal court imposing a bond requirement on a sovereign state. Furthermore, the case also contains language to the effect that it is a “well-established principle that quantifiable money damages cannot be deemed irreparable harm [citations omitted] Because the judgment herein is only for ‘quantifiable money damages,’ the State is unable to establish this particular stay element.” Or at least, not without some additional facts adduced by the appellant.

The next case up is International Distribution Centers v. Walsh Trucking, which is again complicated by a bankruptcy. The corporate defendant in this case had declared bankruptcy but the five individual defendants had not, and the court here declined to impose a bond requirement on the non-corporate defendants. This case at least is on point, but the Trump case has not yet been complicated by the bankruptcy filing of any defendant.

The next case Trump cites is TWA v Hughes, which his lawyers characterize as “granting a substantial reduction of the bond amount where “[b]ecause of the unprecedented size of the judgment, the obtaining of a supersedeas bond was impracticable.” However, Trump’s lawyers conveniently leave out that the judgment in TWA was for $145 million and the appellant was allowed to make a $75 million bond and satisfied the balance by stipulating to the condition that his company would maintain a net worth of at least three times the $83 million remaining, as determined by an independent auditor. In other words, the company still provided the additional assurance required, just not in the form of the bond. There is no sign in the instant case that Trump is even offering to put any other assets on the table.

Finally, Trump cites C. Albert Sauter v. Richard S Sauter, which was a federal anti-trust case. The court in Sauter did not require a full undertaking to be posted because “execution is most likely to terminate Richard S. Sauter Co., Inc. as a going concern and eliminate it as a competitor in interstate commerce,” and further required the defendants to escrow what looks like a significant chunk of their financial assets to the court, including all of the shares of Richard S. Sauter, Inc. Donald Trump has faced no such escrow requirements and his appeal does not even represent to the court that the judgment would require the insolvency of the Trump Organization.

In short, then, the cases cited by Trump and his co-defendants in the reply brief simply do not take him where he needed to go in order to meet the legal requirements for a modification of the appellate bond requirement (and frankly, Letitia James should have pointed out Trump’s attorneys’ sloppy research in her surreply brief), and this being the case, the reasoning of the New York Appellate Division is incomprehensible. Which is presumably why the Appellate Division didn’t bother to provide it in the first place.

Have you, like me, ever wondered how you might derive the zero curve from the par yield curve but don’t know where to start? If so, I have good news for you.

The yield curve, or more formally, the term structure of interest rates, is a vital tool for any fixed income analyst, and also of non-trivial interest for anyone who has anything to do with borrowing money. But how to construct the yield curve? What yield to use?

A good place to start in the United States is the yield on Treasury instruments, because Treasuries avoid the issues of credit risk, liquidity risk, and callability that plague other bonds, and those other risks can be assessed later. But even Treasuries offer their choice of yield curves. The first yield formula they teach you at yield curve formula school is the yield to maturity, but that formula assumes that all interim payments are reinvested at the same rate, which is a highly questionable assumption unless the yield curve itself is flat, which it never is. So one would expect the yield to maturity to have fallen by the wayside decades ago.

There is, however, a measure of yield that is completely agnostic as to reinvestment assumptions, and that is the zero curve. The zero curve treats every coupon from the bond as a separate maturity with no interim coupons to reinvest, so it is a much better approximation of the one true yield. One could, of course, call our friendly neighborhood investment banker or fire up the old Bloomberg for quotes on zeroes of various maturities, but there are data quality issues and not all of us have an investment banker on call.

Fortunately, the US Treasury, posts a daily yield curve we can use. Unfortunately, the Treasury publishes the par yield for any coupon bonds, not the zero curve. The par yield is a measure of what coupon rate would cause a bond with the stated maturity to trade at par, which Treasury assures us that they calculates using the finest and rarest of algorithms. The trouble is that as far as I can tell, the par yield can only be constructed from the zero curve, so the US Treasury has just added a step to our process that must be patiently undone. Fortunately analysts are accustomed to doing this anyway when dealing with accountants when examining a company’s financial reports.

Furthering our inconvenience, the Treasury doesn’t publish every rate, or even every yearly rate. It is kind enough to give us the six month and one year par rates, and it is simple algebra to compute the zero rates on a one year bond from these inputs. (I say simple algebra, but the one year rate must be solved numerically, which Excel is perfectly capable of). The method is essentially the same method as bootstrapping a forward rate curve.

However, the next par rate published by the Treasury is the 2 year rate, which is a problem because Treasuries pay semiannually, which means that even if we have the 6 month and 1 year rates, there are two interest rates to solve for here with only one equation, meaning that we have an infinite number of solutions.

Let us suppose, however, that the 18 month rate and the 2 year rate are mathematically related to each other in some manner, such as linearly. In other words, the 1 year rate + r equals the 18 month rate, and the 18 month rate plus r equals the 2 year rate. Brilliant, you think; we have just added a third variable to our problem. But in fact we have defined the 18 month rate and 2 year rate in terms of the one year rate and a single variable, making this an equation that we, and by “we” I mean Excel, can easily solve. And we may continue in this vein with the other stated Treasury par yield dates to fill in the entire yield curve for 30 years.

This will give us a nice chunky polygon which will somewhat resemble the par curve but generally with a slightly exaggerated slope. This is the one prepared using the published Treasury par yield curve of January 2, 2024.

The blue is the par yield curve; the orange is the calculated zero curve. It is usable, but I think there is room for improvement. It makes no sense to me that a yield curve should be discontinuous at each Treasury-published rate, as in my view a yield curve develops organically from the views of market participants and even if some participants are bound to bonds of a particular maturity, other participants are not, and even if the holder of a 2 year bond may not care about the yields on a 25 year bond, they should care about the yields on a 3 year bond, so some smoothing is in order.

So, what can we do? We can enforce continuity by assuming that the outgoing slope of one yield curve section will equal the incoming slope of the next section, and within the section use an approximation other than linear. The Treasury itself uses cubic hermite splines, but after extensive fiddling in Excel I’ve found that at least a sensible-looking graph can be created by using two methods, one by using a natural log function instead of linear, and also allowing the slope of the graph to shift from the incoming slope in each section to the slope implied by the next section (or zero, in the case of the 20-30 year), because I found that a pure backward-looking method was producing distortions because, as stated above, the 2 year and the 3 year interest rates, for example, should have some influence on each other because at least some market participants are capable of choosing between the two when constructing their portfolios.

Unfortunately, the Treasury does not publish rates between the 10, 20, and 30 year rates, and the unusual shape of the yield curve of January 2, 2024, which inverts, uninverts, and then reinverts, makes a wonky shape of the 20-30 year section no matter what reasonable modifications are attempted. I assume the natural log term is useful because, based on my observations, the yield curve tends towards flatness as opposed to more extreme slopes as yields extend into the future, and anyone who claims a genuine insight as to whether the difference between the 28 and 29 year rate should be larger than the 27-28 year rate spread had better have a very good reason for making such a claim.

So, now that we have this cool curve, what are the applications? The benefit of casting the yield curve in sections of functions with defined coefficients that we have solved for is that we can calculate the interpolated rates at any future date, not simply at six month intervals, which will be helpful for the 363 days a year which are not the coupon days. And with these zero curves on any particular date we can apply them to any corporate, as opposed to Treasury bond, and neatly and accurately compute the zero volatility spread offered by that particular bond, in order to search for anomalies that may represent attractive investment opportunities, or, more ambitiously to work out a term structure of zero volatility spreads across several bonds, which may be of interest when constructing a fixed income portfolio, or even to evaluate multiple bonds of the same issuer to see if the market is anticipating some change in the financial situation of one issuer over time.

Also, getting back to yield to maturity, we can also calculate any implied forward rate we like. I said the flaw with the yield to maturity is that we assume that all intermediate cash flows must be reinvested at the same rate. But with this method we can instead assume that intermediate cash flows can be reinvested at the forward rate implied by the yield curve, and discount that future value back to present value, thus possibly identifying attractive opportunities among Treasury instruments or among corporate instruments with the same credit spreads, or even work out a term structure of the gaps between yield to maturity and forward curve implied spreads. I do not recall seeing anyone using this method, but it is a way of sieving out anomalies, and for analysts, anomalies are in theory worth investigating.

I was watching the latest hearing of Jerome Powell before the Senate Banking committee (as one does), and as expected the Democrats were congratulating themselves on unemployment being so low and workers finally having enough bargaining power in the labor market to acquire higher real incomes for the first time in forever. And then both parties added “And this is causing a notable uptick in inflation rates, so we’re hoping you can put an end to these developments as soon as possible.”

Naturally this led to thoughts about the aggregate supply and demand, and whether it is actually possible to get growth without increased prices and whether supply or demand is in the driver’s seat. And naturally my thoughts turned to Say’s law, beloved of supply-siders, which holds that supply creates demand. There is a certain logic here, since one cannot demand a good that is not supplied, although it is equally valid to say that one can be perfectly ready to supply a good, it will not be supplied until it is demanded.

But, consider an ordinary transaction whereby person A buys $1000 in goods and services from person B. Then B can buy $1000 in goods and services from C, and so on in that fashion throughout the entire world, so that one person’s decision to buy $1000 in goods, or $1 in goods, or 1 penny in goods, will echo around the world and produce an infinite GDP. And yet, GDP is obviously not infinite. Why?

Obviously, part of it is that it takes time to figure out what to demand and whom to demand it from, but that isn’t an issue in the time-compressed world of basic economic models (aside: economic models would be more acceptable if they all ended with the word “eventually”). But to Say, I suppose, the more fundamental reason is that the economy’s ability to supply goods beyond what is demanded is physically limited, and so GDP cannot rise beyond the economy’s ability to supply it.

The bigger problem, of course, is the invention of money. Keynes himself criticized Say’s Law as only valid in a barter economy, because with money it is feasible to supply a customer well in advance of demanding anything from him or anyone else. And since the marginal propensity to consume declines with income, obviously some of the money will be diverted to savings, so there’s a perfectly sensible reason why demand will eventually burn itself out.

So, as we all know from Econ 101, the supply curve is positively sloped and the demand curve negatively. However, those constructions do not rule out the possibility that the curves are horizontal or vertical. I do not believe that the aggregate demand curve is horizontal, at least until we have invented the Star Trek replicator, but it is conceivable that the demand curve is vertical at least in the short term, because, per Keynes, demand for consumer goods is a function of income, and demand for capital goods is a function of a lot of things, including the expected course of future income and opportunity costs, and setting aside “animal spirits,” those things do not change unless future developments change them. At any rate, it can be treated that way.

And what is the shape of the aggregate supply curve? Presumably it is not always horizontal; if it were possible to have any level of supply at a given price then we would just as soon have a high supply as a low one and the senators from the banking committee above would not be concerned with inflation. But the question remains, is it vertical?

However, one wonders if we are having Say say more than Say said. It is one thing to say that quantity supplied equals quantity demanded; it is quite another to say that supply = demand. The first statement is true by definition; the second one depends on assumptions that must be examined. Also, I was talking earlier about the relationship between GDP and price level, and if the supply curve is identical to the demand curve, price entirely falls out of the equation.

I would say that this is not the case, or at least not all the time. One of the implications of Say’s law is that ultimately supply cannot exceed demand since supply is what creates demand, but as is said, severe recessions and specifically the Great Depression would seem to refute this view, and if your economic model cannot predict something that has already happened, some revision is in order.

Fortunately, we have wikipedia to come to the rescue. In their view the supply curve is divided into three sections. In the Keynesian section, where severe recessions live, the supply curve is nearly horizontal, and any additional consumption is just drawing up slack in the market. We have seen this in our most recent financial crisis, wherby unemployment was halved, GDP increased for ten years straight, and somehow inflation actually came in below expectations. It would be tempting to think of the Keynesian section as a free lunch, but remember, the concept of the Keynesian section is drawing up the slack in the economy, and the slack had to have been created before the recession it. In other words, the lunch was already paid for but no one wants to eat it.

In the intermediate section, higher GDP does come at the cost of higher prices. I would suggest that this is the “normal” state of the economy, where there is a tradeoff between GDP growth and inflation and where we are living most of the time and the Federal Reserve tries to keep us.

But what is that vertical bar over there on the right side of the graph? It’s the “classical” section, where the supply curve is in fact vertical: the economy is firing on all cylinders and there is no slack to draw up. So, as discussed above, the GDP is in fact independent of the price level; Keynesian stimulus in this situation could increase inflation potentially infinitely without affecting the real GDP. I would argue that this is what was going on in the 70s’ stagflation.So, despite the temptation to throw Say’s Law onto the heap of failed ideas, it is clear that under some theoretical and even real-world circumstances where it would apply, and having made those circumstances clear we are in a better position to use it as a guide to policy.

The market has been going through some troubling times lately, and the financial sites are full of doomsday articles (although after a few quiet trading days in January, people seem to be in a much better mood). I can readily understand the desire to avoid making bold long moves in the market, as we may be in the last gasps of a bull market (just as we were last year, and the year before that).

Personally, I have not been inordinately worried about the historically high valuations because of the unusually low level of long term interest rates. Most financial articles I’ve read take pains to point out that bond prices and yields go in the opposite direction, but they never bother to point out that stocks and yields work the same way. At least in terms of basic financial theory, stocks are priced the same way as bonds in that expected future cash flows are discounted to present value, and to the extent that recent market movements are the result of expected long-term interest rate increases caused by normalization of Federal Reserve policy, a drop in valuations is only to be expected. My thinking is that we have less of a bubble and more of a balloon that can have the air let out of it without popping.

But, if people aren’t buying aggressively, they certainly need something to fill in their free time, and that makes me think about books. And not just the quality investing/finance/economics books (though I have recommendations in that vein), but in general.

A lifetime ago, when I was in college, it was natural for students to sell their textbooks back at the end of the quarter, and inevitably some books could not be sold back, possibly because a new edition came out, or because of the book’s condition, or (ideally) the course it was for was simply not being offered next quarter and the bookstore had no use for it. There was a large table next to the buyback window where the disappointed students could just dump their unsold books for anyone who was interested. And I, being an enterprising lad, would just scoop up those books by the armload to sell them online. They say that value investors are born, not made, and it seems to me that profiting off of other people’s cast-off books is not so different from profiting off their cast-off stocks. At any rate, having my rent paid was worth having every wall of my apartment taken over by bookcases.

I don’t know that such a method would work nowadays. Textbook publishers use every trick in the book to come up with either frequent new editions or course-customized editions that cannot be resold; campus bookstores are getting better at finding a home for unwanted books anyway, and finally the used books at amazon.com are dominated by high-volume resellers such as Thriftbooks, Half Price Books, the various Goodwills, etc., who have a script to go through and undercut each other by a few pennies. And in the section where the condition of the book is supposed to go, they just copy-paste boilerplate descriptions or just a blurb about their own company; you often have to scroll through several pages of used offerings to find a single offer that looks like the seller actually had the book in their hands when they wrote it.

Even so, I still accumulate books, for use if not for resale. And my favorite source is library sales, where libraries sell off partly their discards, but mostly the donations they receive, typically at very reasonable prices. As Charlie Munger says, he has never known anyone who is successful in a field requiring broad knowledge who does not read pretty much all the time (an object lesson for more than a few politicians), and in terms of dollars per hour, used books are pretty much at the top of the list of ways to pass the time.

However, at the library sales also see a curious phenomenon of people going through with barcode scanners, feeding the UPCs of books to a mobile app which looks up the prices of books on amazon.com or other sites, in order to buy and resell them. This activity makes no sense to me for various reasons. Even setting aside the current state of used book sales,  most libraries sort through their donations for books that are worth selling online anyway, and either sell the valuable books themselves or set their sale prices accordingly. Furthermore, these online lookup tools are ubiquitous enough that any book being scanned at a library sale has no doubt been scanned and rescanned by other sellers, and been rejected by them. In other words, the only way for a seller to find a worthwhile book with these scanning tools would be to have lower standards, in terms of profit margin, than any other book scanner in the place, and I would think that low standards are a poor way to justify the time, effort, and storage space required of keeping an inventory of used books.

And then I think back to investing. Isn’t it true that buying a financial instrument is also a battle of who-has-the-lowest-standards, since any stock or bond has been examined by hundreds or thousands of market participants who has declined to pay a higher price? On the whole, though, I think not. The reason that scanning books at book sales is so unattractive is that there are only a few variables involved: the book’s sales rank at amazon and its lowest selling price. But with securities, there is not only the buying and future selling price, but also the cash flows generated by the security in the meantime, which of course influence the buying and selling prices, but it must be conceded that the market is quite capable of being far off the mark in either of them. And it is this characteristic (plus portfolio management issues such as beta, correlation, etc.), that makes the two distinct. It is the same old distinction between an investor, who studies a situation to find a reasonable return on investment with safety of principle, and a speculator who simply hopes that they can find someone who will pay more tomorrow than what they paid today.

Warren Buffett, when asked where he gets his investing ideas, was fond of replying “Start with the A’s.” This may seem like unhelpful advice now that so much data requires clicking around and waiting for webpages to load, instead of wading through nice archaic books. However, the Value Line Investment Survey still publishes data in a multiyear format. This allows one to perform visual scans of financial performance, with more room to identifying trends, results, and ratios that are in the “neighborhood of acceptable for investment purposes with more flexibility and “fuzziness” than could be accomplished by a database query. Although I do tend to start with the Z’s so I can get to them before Buffett does.

Yes, Value Line is generally a useful resource while screening for investments to analyze, but it cannot replace the importance of the analysis itself, particularly if the reported figures must be significantly adjusted. Value Line is partly a statistical service and partly an analyst firm, so they make adjustments to enhance comparability and clear out some confounding outcomes mandated by accounting rules. In most cases this adjustment has its intended effect, but sometimes, when dealing with companies that have substantial equity compensation, mergers, events generally viewed as nonrecurring, and other controversial matters, the effects of their adjustments can be large and distortionate.

For example, Cypress Semiconductor (CY) makes a wide array of memory products used in telecom and data communications equipment and the Internet of things. I should point out that I’m not an expert in the semiconductor industry, but it seems to be characterized by intense competition for price and margins and a great deal of merger activity. Cypress has indeed undertaken two mergers in the past year for a combined purchase price of over $2 billion for a company that has a current market cap of $4.66 billion as of this writing.

Dealing with mergers is an endless pain for analysts. Particularly when the mergers are large, sales and margins become incomparable to historical figures and even the capital structure of the company is significantly altered. In Cypress’s case, sales went from $725 million two years ago to $1.92 billion last year. Analysis is further complicated by the fact that companies may acquire other companies as a substitute for capital expenditures, which makes depreciation rates somewhat unreliable. This is a  particular problem for the amount of the purchase price that represents goodwill, which does not amortize but instead is tested for impairment. The effect is to make both depreciation and capital expenditures seem much less smooth and difficult to rely on for projections.

More than that, though, mergers are expensive both in investment banking and legal fees and in the inevitable restructuring that follows, and we analysts have to determine how to handle those costs. On the one hand, most companies are not in the business of selling products, not merging, so it would only be fair to treat these expenses, substantial though they are, as nonrecurring for purposes of calculating the firm’s overall earnings power. On the other hand, some companies make such a habit of merging that these expenses come to resemble a regular part of their operations. Other categories of nonrecurring expenses commonly ignored are impairments and writeoffs of goodwill, the latter of which is especially common in frequent acquirers.

As I stated before, the Value Line Investment Survey attempts to adjust these nonrecurring expenses, but their adjustments are not documented, at least on an individual basis. As a result, Value Line concludes that Cypress earned 21 cents per share in 2015 and estimated that Cypress would earn 48 cents per share in 2016. The actual figures were losses of $1.25 and $2.15, respectively. Furthermore, using Value Line’s earnings per share, capital expenditures, and depreciation figures to estimate free cash flow, one arrives at an estimate of $264 million in free cash flow in 2015 and a forecast of $360 million in 2016. And since Cypress’s current market cap is $4.66 billion, this represents a free cash flow yield of 7.7%, which appears to me to be high for a semiconductor company and also fairly attractive under modest assumptions about growth.

I have performed an estimate of the Cypress’s free cash flow based on the figures in the 10-K in my customary manner. Even giving the company every advantage by treating restructuring, merger-related expenses and inventory writeoffs, and impairments as nonrecurring, I arrived at an estimated free cash flow of $125 million in 2015 and $229 million in 2016, a discrepancy of well over $100 million for each year.

Futhermore, diving into Cypress’s 10-K filings, I discovered what I can only describe as a financial shenanigan. In the books I’ve read about financial shenanigans, such as Financial Shenanigans by Schilit & Perler,  one thing to watch for is a company trying to juice sales growth by accelerating the recognition of sales. The difference between a shenanigan and a fraud, of course, is that the shenanigan is fully disclosed in a footnote in the boring part of the 10-K. And in Cypress’s case, over the course of 2015 and 2016 the company began to recognize some, and eventually all, shipments to their distributors as sales, rather than their previous policy of recognizing sales upon shipment from the distributor to the end customers. The company justifies this treatment by concluding that, with suitable reserves, sales by distributors were sufficiently reliable to allow this treatment. Whether or not Cypress is correct in this view or not, the effect of adopting this treatment was to increase sales by $40 million in 2015 and $59 million in 2016. A financial shenanigan is mostly harmless to the actual figures once discovered and taken into account, but a company adopting them in the face of two large reported losses should tend to raise one’s level of suspicion about the company’s management and financial reporting overall.

Now, from this article one might be left with the impression that I view the Value Line as defective and unreliable. This is not the case; I find Value Line’s figures generally much more reliable, at least as a first approximation, and Value Line’s analyst commentary is generally useful, although I tend to disagree with its timeliness ratings. My point, though, is that investment analysis cannot consist solely of taking numbers from a database and fashioning them into a portfolio. There has to be genuine digging into the financial reports to assess the reliability of the numbers and in the form that an analyst finds most useful.

As for Cypress Semiconductor, I cannot say that it is attractive as a value investment because of its not-outsize cash flow yield and heavy reliance on acquisitions. Value Line and other analysts are optimistic about Cypress’s growth prospects and future developments may justify this optimism, but a value investor would find it very dangerous to indulge growth assumptions, because under sufficiently high growth assumptions, no price is too high.

A chaotic January of 2016 is over, and given the dramatic downside excursion in the equity and oil markets, even committed value investors could be forgiven for wavering. Even though prices are somewhat above their nadirs, the frequent swings of several percent a day in the oil markets and stock indexes give the impression of market participants who have no idea what is going on but feel the need to join in anyway.

Now, my specialty is not in macro forecasting, as value investors pride ourselves on having a bottom-up approach. However, bottom-up doesn’t mean bottom-and-then-stop; and furthermore, the ability to handle hypothetical economic developments helps any market participant handle actual developments, even if detailed macroeconomic projections are more trouble than they are worth. Awareness of the current economic and financial situation and how it may validate or invalidate our views of a company’s earnings power is certainly a good thing.

The market’s current source of bad news, of course, is the collapse in the price of oil. Always keep an eye on the bad news; good news can take care of itself. I don’t claim to know the “correct” price of oil–remember, my view is that detailed macroeconomic projections are more trouble than they’re worth–but I can look at the effect of this dramatic decline on the broader markets.

First off, I hope this puts another nail in the coffin of the view that hyperinflation is lurking just around the corner and the only cure is growth-crippling austerity. Part of the collapse of the oil prices is to do with a stronger dollar, as the Federal Reserve has been largely unsuccessful in its efforts to create higher inflation expectations and recently made an unnecessary interest rate hike presumably in order to stop those annoying questions during Congressional hearings. If anything, the problem facing our monetary policy is the risk of deflation.

The other cause of oil’s strength is the supply glut brought on by the fracking boom meeting a determined Saudi Arabia. The chief difficulty facing the frackers is that apparently oil extraction is a capital-intensive industry, and in recent years they have taken advantage of low interest rates to fund their production with high yield debt. Some of them also may have had the foresight to hedge their future production by shorting oil and gas in the forwards and futures markets, which they are bound to deliver on whatever the price. Thus, there are two reasons why the frackers go on producing oil even if it is uneconomic to do so: if they have hedges in place they don’t care about the current price, and if they don’t have hedges in place they still need all the cash they can get to pay their debts down as fast as they can.

Bringing about such a situation may have been the original intent of Saudi Arabia, as a move to eliminate the United States fracking industry the way the Japanese were accused of doing to the consumer electronics industry in the 1980s. If so, their strategy is flawed, as fracking technology can be made uneconomical for a time but it can’t be un-invented, and oil doesn’t need a brand identity the way consumer products would. The destabilizing effects on other oil-producing nations may not be so minor, but they are outside my field of expertise.

As an aside, the obsession with United States energy indepedence on the part of some of pour presidential candidates seems at present an equally counterproductive strategy, given that Saudi Arabia’s cost of oil production is said to be about $10 per barrel, while in the United States it is $36 on average according to cnn.com. At first approximation, then, true energy independence could cost up to $26 a barrel for every barrel of oil no longer imported, which at an estimated 9 million barrels per day, would cost $87 billion dollars a year. Perhaps if oil were much higher I would see more strategic value in it, but directly taking on a determined supplier whose cost of production is less than one third of ours is not what I would expect from the party of businessmen.

At any rate, the drop in the price of oil and the frackers trying to drill their way out from under their leverage will only exacerbate the oil glut in the short term. It seems the recent levels of fracking investment and leverage could only be justified based on the assumption that oil prices would remain high forever, which has already invited comparisons to the subprime crisis. On the plus side, oil is unlike housing, in the sense that it doesn’t stick around for decades after it’s been drilled, and so eventually some bankruptcies and production shutdowns should resolve the problem eventually. I’ve seen estimates ranging from the second half of 2016 to 2017, and again I have no opinion on when it will happen.

What concerns me, though, is not the effects that are confined to the oil sector, but those that might spread through to the broader economy. As I stated above, the oil companies financed their operations by issuing debt that is in many cases beyond their present ability to repay, at least within the lifespan of their hedges. If I were a corporate strategist, and knowing as I do that the production curve for fracking is highly front-loaded, with the majority of production occurring in the first year of a multi-year project, and certainly within the lifespan of available hedges, then I would suggest a more project-financing-based approach, where the production of a set of wells, pre-sold through the forward markets, would pay off the principal and interest of all the investments required to develop them. Perhaps fracking production cannot be projected with sufficient accuracy before the wells are actually drilled, but there has to be some solution between what I propose and the current mess. Perhaps with oil above $60 a barrel no one bothered to look for it.

This overhang of debt, though, is sending shockwaves through the high yield market already, and a wave of bankruptcies will make things worse. Moreover, not all of this debt is in the form of junk bonds; a significant portion of it is in the form of bank debt, and now the analogy to the subprime crisis can be revived. Banks have been as hungry for yield as any other fixed income investor, and they are now looking forward to writeoffs.

The risk is that the banks will have to make up for these loan losses by diverting money from their other lines of business like lending to the non-oil portions of the economy, as well as finding themselves in the position of holding uneconomical oil assets the way they were holding unproductive real estate in 2008, all of which costs them a great deal more regulatory capital than performing loans would. JP Morgan, for example, claims that its loans were backed by physical assets, but these physical assets are oil fields that are not economical to develop at $30 a barrel, and oil drilling equipment that the market doesn’t currently need because the oil fields where they would be deployed are not economical to develop at $30 a barrel. And even if the banks’ ability to lend is not greatly hampered by responding to bad debts from frackers, their desire to lend may well be.

So, where does that leave us investors? Obviously we should avoid oil, anything that extracts oil, and anyone who primarily lends money to either of them. Furthermore, any products that are energy-intensive to produce should be viewed with caution as their historical results may not be reliable and it is not a given that they can keep the difference in oil prices for themselves rather than pass it on to their customers. Also, given the strong dollar and deflationary environment, it might be advisable to tread carefully with any company that makes “things,” at least things without a substantial labor component. It might also be advisable, given the possible mess in the high yield markets, to avoid companies that are going to need to borrow a lot of money in the near future. This leaves us with service companies and financial companies that have no exposure to petroleum, and there are probably any number of them that have been unfairly punished by the market’s retreat.

Happy hunting.

Those of us who watch Federal Reserve Chair Janet Yellen’s hearings before Congress will often hear complaints from the majority that the Dodd-Frank regulations are overreaching in that the Treasury has the power to designate non-bank financial entities, including mutual funds, as being systemically important. However, the recent collapse of the Third Avenue Focused Credit Fund, a junk bond fund focusing on the kind of distressed junk bonds that are one of my favorite asset classes, shows that an institution does not need to hold assets in the hundreds of billions of dollars in order to wreak havoc as it fails. This fund, which a year ago had only $3 billion in assets, was down to less than $800 million owing to losses and redemptions, was forced to suspend redemptions in order to liquidate in an orderly fashion, and its forced liquidation has spread shock waves through the entire high yield market, although they seem to have been contained.

I should state that I am generally a fan of additional financial regulation, and I am concerned that the complaining about designating nonbanks as systemically important is motivated by trying to force a wedge into a crack of Dodd-Frank with the goal of dismantling the entire law.

Anyway, the trouble here is that Third Avenue’s junk bond fund encountered arose from its ran afoul of one of a mutual fund’s main selling points, that the fund owners can redeem their investments at any time on one day’s notice, which, if many of them do at the same time, will require the fund to liquidate assets to raise the cash. In the case of most mutual funds (or in the case of markets being efficient), this is not a problem, but Third Avenue focuses on distressed bonds which are generally illiquid.

The causes for this illiquidity essentially boil down to the natural constituency of the asset class. Distressed debt, by definition, is corporate debt where default by the issuer is more than a theoretical possibility. The distressed debt marketplace, it seems to me, is a small and fairly specialized niche of the fixed income market, populated by some very price-conscious experts commonly described as “vultures.”

The ideal owner of distressed debt, then, is one who does not worry about cash flow interruptions, who has the analytical ability to compute what a company would look like and be worth after a restructuring or bankruptcy, and who is not a slavish observer of daily or quarterly price reports, since the price of these assets both fluctuate wildly and depart from true value. These characteristics would commonly be found in a private equity fund, in a hedge fund with limited redemption rights, or possibly in an endowment or in an eccentric millionaire. They would not normally be found in a typical mutual fund shareholder.

I think much of Third Avenue’s liquidation mess is the natural consequence of reaching for yield, climbing down the credit quality ladder until eventually one falls off the bottom rung. From a value investing perspective, it is what happens when buyers focus on the naive indicators of returns, like yields, rather than on true value. The wise investor would prefer a demonstrably undervalued asset with no yield than a demonstrably overvalued asset no matter how high the stated yield is. This lesson was pointed out originally by Benjamin Graham and reiterated in many places, especially The Only Guide to Alternative Investments You’ll Ever Need: As individual assets, junk bonds can be attractive, but as an asset class they are not.

This liquidity problem is compounded by the cascade of redemptions that Third Avenue has already experienced over its recent history. If the fund has to sell assets to meet redemption calls, and does not wish to give up too much in spreads in order to meet them, then logically it will sell its more liquid assets first and keep holding the less liquid ones, which will eventually leave it holding only illiquid assets and being forced into its present predicament.

Moving beyond the troubles of this particular fund, I am concerned about the issue of contagion. Contagion played a role in the financial crisis, as banks that sponsored synthetic mortgage backed securities products through special-purpose entities faced the distasteful choice of either propping up these entities by diverting money from their other lines of business like lending money to the real economy, or by letting these products be liquidated in a falling market, thus making the defects of these products obvious to the financial community as a whole. The parallels between these banks and what Focused Credit went through are obvious, and as with Focused Credit, the banks tried the first approach, and when it failed, were forced to try the latter.

Now, in an efficient market, the last reported price is the only true and correct price, forever and ever, amen, but the market seems to have been more or less aware of the situation and has managed to shrug it off. As a result of Focused Credit’s collapse, high yield ETFs declined by a total of nearly 3% on Monday and Tuesday of the week of the announcement, although they have staged a recovery. The New York Times claims to have identified the missing ingredient that separates the Third Avenue Focused Credit situation from the typical market crash: no leverage.

However, leverage as such is not the issue; any situation involving a forced sale can become a problem in the market. Excessive leverage is one source of forced sales, but the right of mutual fund owners to redeem their assets at any time is one source of leverage. An angry phone call from a boss or a client demanding to know what you’re doing holding these assets while they’re collapsing in value is another. And for that reason, any collapse in prices, no matter what the asset or leverage in question, is theoretically capable of setting off a contagion if it is severe enough.

As another window on this subject, I will look at it in terms of options theory. Ever since options were invented, people have been trying to put them into situations where they don’t entirely belong. For example, one model in the CFA curriculum is that a company that borrows money is short a put option on itself, with a strike price equal to the amount of borrowing. This model is somewhat complicated in that the option premium is difficult to define and the Chapter 11 bankruptcy process tends to complicate the payout method, but as Charlie Munger says, wise investors should be fluent in as many models of reality as as there are, in case one of them comes in handy one day.

At any rate, Focused Credit was effectively short a put option on its own assets, or specifically the liquidity spread between the price under “normal” conditions and the fire sale conditions that arise from having to sell on a day’s notice. Relatively illiquid assets like high yield bonds already trade with a liquidity discount intended to cover this gap, but as market conditions change, this liquidity premium can become inadequate. And unfortunately, there is no market instrument that tracks liquidity in a particular sector of the market, making hedging this risk impossible. Dynamic Hedging: Managing Vanilla and Exotic Options, the book Nassim Taleb wrote before becoming famous, is a lengthy text dealing with mathematics and financial philosophy, but its key lesson is that no market participant should ever be short an unhedged option, because sooner or later they will find themselves on the wrong end of the market.

The bitterest irony, though, is that in the case of Focused Credit, the counterparty of this liquidity option is the other holders of the mutual fund, who chose to exercise it by selling early before the crisis hit. Basic game theory requires an investor who is aware of a potential liquidity problem to get out as soon as the prospect of a liquidity crisis is raised; it is no different from standing near the exit of a building in case of fire. The decision by Focused Credit to suspend distributions and liquidate in an orderly fashion cut off this process, a move which was reasonable but almost unheard of in the mutual fund industry. But at any rate, investors who genuinely cannot be forced out of their positions can happily sit like a dragon and suck up a liquidity premium they never will need. Anyone else should avoid a situation where other people can sell out first and leave them holding the bag.

Park-Ohio Holdings Corp. is a niche manufacturer and logistics servicer for other, larger manufacturers. It offers a large free cash flow yield of 9.4%, and has been expanding sales through well-chosen bolt-on acquisitions. Read more at

http://seekingalpha.com/article/3667746-park-ohio-an-undervalued-niche-manufacturer-with-well-chosen-acquisitions

Long-time readers will know that rural telecom companies have been a particular favorite of mine. Although these companies’ core residential landline business is in decline as mobile phones become the primary phone line among an ever-increasing proportion of the U.S. population, rural telephone companies can respond by lowering capital expenditures accordingly and refocusing their offerings to embrace broadband, comprehensive business services, and fiber optic television. As a result, they have frequently shown themselves to be capable of spinning off a great deal of free cash flow even as overall sales are declining. Furthermore, these companies tend to come with unusually high dividend yields, for people who care about that sort of thing.

As a group, though, rural telecoms have shown disappointing results in the first half of 2015. Perhaps this is to be expected; I first became interested in them in the first half of 2009, when stocks were depressed and interest rates had been recently cut to zero and were likely to remain there. But as of now, in June 2015, the market is at its highs and the Federal Reserve is totally definitely planning to probably raise interest rates any time now, just you wait. Rising interest rates can present a problem for these companies, as they tend to operate under heavy debt loads. Still, this pullback makes me wonder if some of the companies have dropped back into the zone of being attractively priced.

Frontier Communications presents an interesting challenge in this regard. It has recently entered a contract to purchase some of Verizon’s landline assets, which follows two other significant but smaller landline acquisitions from AT & T and Verizon in the last few years. This larger purchase was announced February of 2015 and is expected to close in the first half of 2016, pending regulator approval. The purchase will nearly double the size of Frontier’s balance sheet, and in order to pay for it, the company has issued a new series of preferred stock, as well as a block of common stock, and apparently intends to finance the balance through taking on a great deal of debt. For reasons I will discuss later, I think the preferred stock is where the action should be for prospective purchasers.

Although the new acquisition will no doubt fundamentally alter the earnings power of Frontier, I still think it is appropriate to look at the earning power of Frontier’s existing assets. For one reason, I generally assume as a first approximation that most acquisitions do no better than earn the cost of the capital used to make them, which per Damodaran’s Investment Fables: Exposing the Myths of “Can’t Miss” Investment Strategies might even be optimistic treatment. For another reason, based on what information Frontier has disclosed about this acquisition, I think this particular acquisition will, when viewed conservatively, do little more than pay for itself, as I shall explore later.

In 2014, Frontier’s sales were $4.77 billion and reported operating income was $820 million. Depreciation was $1.14 billion and capital expenditures, not including the cost of integrating the large purchase from AT & T this year, were $572 million, leaving $567 million in excess depreciation and an overall operating cash flow to the firm of $1.39 billion. Interest expense that year was $696 million, and taxes were $30 million, although based on Frontier’s reported income about $57 million would have been more typical. This works out to free cash flow to equity of $634 million, which is a yield of roughly 12.5% not counting the stock issued to pay for the acquisition.

I have chosen not to count the capital expenditures required to integrate the AT & T purchase and the pending Verizon purchase because first, they are presumably one-time expenses that do not have anything to do with Frontier’s ongoing earnings power, and second, logically speaking they should be considered part of the purchase price of the acquisition anyway.

In 2013, sales were $4.76 billion, reported operating income was $966 million (not counting the sale of a partnership interest (which was included in Frontier’s reported operating results despite not being operating). Depreciation was $1.17 billion and capital expenditures were $635 million, producing operating cash flow of $1.51 billion. Interest was $667 million and taxes were $47 million, producing free cash flow of $787 million. Much of the decline in free cash flows between 2013 and 2014 can be attributed to operating expenditures resulting from integration the AT & T purchase, although there is still a gap of about $50 million, which can be attributed to the low-to-mid single-digit percentage declines in Frontier’s customer base, which was masked by the acquisition itself.

In 2012, though, sales were $5.01 billion, reported operating income was $987 million, depreciation was $1.27 billion and capital expenditures were $748 million, producing operating cash flow of $1.51 billion again. Interest expense was $688 million and taxes were $76 million, resulting in free cash flow of $742 million.

The reported earnings for the first quarter of 2015 were apparently disappointing to the market. Sales were $1.37 billion as compared to $1.15 billion for the same quarter last year. Operating income was $163 million as compared to $226, and operating cash flow $334 million as compared to $380, not counting integration expenses. Interest expense was $245 million as compared to $171 million, and taxes were $-30 million as compared to $17 million, producing free cash flow of $119 million as compared to $192 million for the first quarter of 2014. However, integration operating expenses for Frontier’s various acquisitions were $57 million as compared to $11 million last quarter, and removing these expenses, net of taxes, would improve that $119 million to $156 million, which is broadly consistent with the free cash flow that Frontier generated over the full year 2014. So, the earnings may have been disappointing but they were hardly disastrous, and they still represent a free cash flow yield of 12.3%.

The pending Verizon acquisition, as I stated before, will roughly double the size of the company. The Verizon landline assets to be purchased cover 3.7 million voice connections, 2.2 million broadband subscriptions, and 1.2 million FiOS (fiber optic) television connections, while the pre-acquisition company has 3.5 million voice connections, 2.4 million broadband subscriptions, and 0.6 million FiOS subscribers. Although it would be nice if we could just double Frontier’s existing figures and go home, we have to consider the possibility the assets Frontier is purchasing may be of better or worse quality than Frontier’s assets in place, or that the alteration to the capital structure caused by this purchase changes the free cash flow situation, as indeed it does.

Our first clue is the purchase price. Frontier’s current assets have a value of roughly $14.5 billion, based on a market cap of roughly $5 billion and the $9.5 billion face value of Frontier’s long term debt. The purchase price of the Verizon assets is $10.5 billion, and Frontier is projecting an additional $450 million in integration capital and operating expenses. In other words, Frontier is acquiring 3.7 million new customers for $11 billion, while the market is currently estimating the value of its current 3.5 million customers at $14.5 billion.

Because this acquisition is of a portion of Verizon’s assets, not a standalone company, there are no audited financial statements  and we are forced to rely on Frontier’s disclosures about the deal, which are naturally going to be self-serving.

At any rate, Frontier claims that the deal will improve free cash flow by 35% in the first year after the merger is completed. Frontier calculates free cash flow differently from how I do, because their figure for 2014 was $793 million rather than my $634 million, so 35% of that is $277 million or $222 million, depending on whose calculation you use. To this free cash flow to equity must be added about $675-775 million in additional interest payments on the $8.5 billion in debt Frontier will be taking on to finance this acquisition, producing a range of free cash flow to the firm (which is the amount of money the firm has available to distribute to all of its capital assets, whether in the form of interest, dividends/share repurchases, or undistributed earnings) of between $900 million and $1.05 billion, depending on whose estimates you use. The free cash flow to the firm to Frontier’s assets in place, recall, was about $1.4 billion for fiscal year 2014.

So, the purchased assets are projected to produce $1 billion in free cash flow to the firm for a purchase price of $11 billion (counting integration costs), while the existing assets produce a free cash flow to firm of about $1.4 billion for an enterprise value of $14.5 billion. In either case, then, the free cash flow yield is just a hair under 10%, so at least as a first approximation the assets purchased from Verizon seem to be of the same quality as Frontier’s existing assets.

As I said above, Frontier is intending to take on $8.5 billion in debt to purchase Verizon’s wireline assets, but on top of that the company has issued roughly $2 billion in equity, consisting largely of preferred stock but with some common stock added as well. For reasons I will go into, I believe the preferred stock is an attractive method to participate in Frontier, as compared to the common stock.

Preferred stock generally ranks alongside high yield bonds as a generally unattractive asset class, as it typically represents equity-like risk without the equity-like unlimited upside. This point has been hammered home in both Security Analysis and The Only Guide to Alternative Investments You’ll Ever Need. Preferred stock has the added disadvantage that, unlike with junk bonds, the company is at liberty to suspend its dividends without being forced into bankruptcy (although the company’s actual creditors will definitely take note).

Frontier’s preferred stock issue consists of $1.925 billion of preferred stock that pays a dividend of 11.125%. This preferred stock trades under the symbol FTRPR and is currently priced at just above its face value of $100 per share.

These preferred shares have the typical features of preferred stock, meaning that the dividend is cumulative, i.e. if Frontier declines to pay a dividend on the preferred stock it is theoretically required to make it up in subsequent quarters, and that unless the dividends on the preferred stock are current, the common stock will not receive a dividend either. Since Frontier’s management is aware that most people invest in it for its 8% dividend yield, it is equally aware that missing a preferred dividend would be shooting itself in the foot. However, Frontier disturbingly reserves the right to pay the dividend in common shares rather than in cash, and this action would not cut off the right to dividends on the common stock. However, paying a dividend in common shares would also probably be a sign of weakness that Frontier’s management would be reluctant to make lightly. But, if they do, look out below.

The key provision that separates this preferred stock from the vanilla preferred stock, though, is the mandatory conversion privilege. At the end of June of 2018, this preferred stock will automatically convert to common shares of Frontier at a rate depending on Frontier’s common stock price at the time. If Frontier is at $5 or below, each $100 preferred share will convert into 20 shares of common stock. If Frontier is between $5 and $5.875, each preferred share will convert into a number of shares equal to $100 divided by the share price. And if Frontier is above $5.875, the preferred shares will convert into 17.01213 common shares (equal to 100/5.875) no matter how high the price is. Thus, the holders of these preferred shares are allowed to participate in the upside of the common shares under certain circumstances. As of Wednesday, June 2015, the time of this writing, Frontier is at $5.065.

In order to properly evaluate this preferred stock, then, it would be helpful to look at option theory, because the holder of these preferred stock is essentially short a $5 put and long a $5.875 call that expire at the end of June, 2018. In between those two points the exposure to the price of the common stock is purely linear. In order to evaluate these options I will be using the Black-Scholes, not because it produces necessarily accurate results (in fact, its results almost never even match the market prices of different options on the same stock), but because its defects are well-understood by options traders, who can react accordingly, as stated wisely in Nassim Taleb’s Dynamic Hedging: Managing Vanilla and Exotic Options

As a starting point, the January 2016 $5 put has a market price of 62.5 cents, and the January 2016 $6 call has a price of 20 cents. Using my Black-Scholes calculator on Excel (which works essentially like everyone else’s Black-Scholes calculator on Excel, so I needn’t go into detail), I find that changing the strike price of to $5.875 produces an implied value of 23 cents. Then, extending the options’ lifespan to the end of June 2018, I get a value of $1.33 for the put and 93.6 cents for the call. Furthermore, the delta of the put is -.3856 and the call is .5181, which will come up later.

As an aside about my methods, the price one uses in the Black-Scholes model should technically be the forward price, i.e. the expected price stock will have at expiration. Normally, this technicality is ignored, since the forward price is simply the current price compounded at the risk-free rate and adjusted for expected dividends, and at typical interest rates in Western countries and for typical option lifespans, the difference between the forward and the current price is negligible.

However, when looking three years into the future, the price of a stock is going to be dominated by earnings and cash flows, not risk-free compounding and dividends. Although Frontier is likely to pay out its 8% dividends for three years, it is also likely to make the capital investments necessary to maintain its earnings power to produce the money that pays the dividends . Therefore,  assume for purposes of these calculations that the best guess for the forward price of Frontier is the current price of Frontier, without adjusting for dividends. There are other reasons for making this assumption that I will speak of later.

Returning to the value of the preferred stock, the above options prices are based on a 100-share contract, but the preferred stock converts into 20 shares at $5 or below and 17.02 shares at 5.85 or above. Thus, each share of preferred stock is short $26.6 worth of puts and long $15.92 worth of calls. This further implies that the value of the preferred stock without these two options would be $110.68 ($100 + $26.6 – $15.92) and offer a dividend yield of 10.16%.

The reason I calculated the deltas above is to determine how closely the preferred stock will track the price movements of the common stock. The dollar delta of the short put is $7.73, and for the long call it is $8.82, total $16.55. In other words, at the current price if the common stock moves up by $1, each $100 share of the preferred stock would be expected to appreciate by $16.55 as a result of these options.  At current prices, $100 of common stock is 19.74 shares, so if it appreciates by $1 the gain would be simply $19.74. So at this moment, despite the fact that any appreciation of the common stock before $5.875 a share is not reflected in the conversion amount, the preferred still captures 83.8% of the price movements of the common stock.

As I said, I have other reasons for assuming that the future price of Frontier is likely to be its current price. The first one is that this asset purchase is not likely to increase the value of Frontier’s existing equity in the short term. I calculated above that based on Frontier’s own disclosures the conservative estimate of increased free cash flows to equity is $222 million in the first year. However, the company has issued $1.925 billion in preferred stock at 11.125%, and the dividends required on that amount are $214 million, and the $80 million or so in common stock, bearing a dividend yield of roughly 8%, will suck up the rest. It is true that Frontier is projecting an additional $175 million in annual synergies by the third year after the merger, i.e. 2019, but the company is more likely to use that additional money to pay down its substantially increased debt load, rather than let it flow to shareholders. Also, as Damodaran concludes from examining many studies in his Investment Fables, synergy is difficult to count on anyway.

The second reason the future price is likely to stay between the two option prices is because of the dilutive effects of the conversion itself. Unlike ordinary options, which are basically side bets that don’t affect the performance of the underlying stock, these preferred shares, when converted, will become additional shares of the common stock, and since there are about $2 billion in preferred shares and $5.1 billion in common shares, the effect of converting at a favorable or unfavorable level will be significant. If the shares are significantly below $5 at the time of conversion, the common shares will have received $2 billion in financing for a price significantly below $2 billion in common shares, but if the price is significantly above $5.875, the preferred shareholders will receive much more than $2 billion for their equity purchase. As a result, it is easy to see that the price will have a much harder time moving beyond $5 or $5.875, because each such move will produce negative feedback from the dilution effect.

And that is the key provision, in my view, that makes the preferred shares a superior bet to the common. As stated above, at current share prices the preferred shares are projected to gain 183.8% of the common price movements anyway (although it is the nature of options that this is unstable and will require recalculating as time passes or the price of the common stock moves).

Furthermore, because they have a mandatory conversion, their upside is also going to be subject to the braking force the common stock will receive to the upside. Therefore, the income-oriented investors who tend to follow rural telecoms in the first place would be better off having the preferred stock, which has a higher dividend yield and largely similar price behavior properties. Also, because the common shares of Frontier are currently at the bottom end of their likely price range, and the preferred are expected to gain roughly 183.8% of the current price movements (at least at the current price range; that percentage will likely decline as the price rises), the preferred shares are actually more responsive than the common shares to Frontier’s upside at current prices.

So, there are three reasons why I think the price of Frontier is likely to stay flat over the foreseeable future. The first is because the Verizon acquisition seems to be for assets of no better quality than the existing Frontier assets. The second is that if the assets prove to be of better quality due to synergy, the cash flows resulting from that synergy will go to pay down debt, not to the equity holders directly. The third is because the structure of the preferred stock enforces a price range for the common shares of $5 to $5.875, which Frontier is at the low end of, and any upward movement in the common stock at these prices will help the preferred stock more than the common. Therefore, those investors who are considering going long in Frontier would probably be better off with the higher-yielding preferred shares.