7 September 2013 – The Aleph Blog

The Rules, Part LII

Posted on 7 September 2013 by David Merkel

g_e + E/P > i_{longest bond}

Let me explain.? The first term is the growth rate of earnings for a company.? The second term is the earnings yield of a company.? The last term is the yield on the longest, most subordinated bond or preferred stock a company has issued.

The idea here, is that the more risk you take with a company, the more return you should invest for.? Bank debt should yield less than senior unsecured debt, which should yield less than preferred stock, which should yield less than the expected total return from the common stock.

This is a simple idea, but it can occasionally yield good buy or sell ideas when the equation seemingly does not work.? If it does not work, consider buying the bonds and/or selling the stock.? On the other hand, when the equation works, and the gap is wide, consider buying the stock and/or selling the bonds.

The idea is to look for the best risk-adjusted returns, and not be wedded to one particular type of asset.

Another way to think about it is when a company would buy back its shares.? Would it buy them back when it costs more to borrow on safe terms than the company is earning, including likely increases? in earnings?? No, that’s not likely, they might even issue more shares in such a situation.? Buying the shares back requires that the debt or excess cash is less valuable than the stock being bought.

The main point of this rule is to think through the capital structure of a corporation, and look at the relative valuations.? Deviations of expected returns from likely risk deserve attention.

Here’s an example: my boss called me one day and told me he sold short two stocks that afterward doubled on him.? What should he do?? I looked at the bonds of the stocks and saw that they were trading above par.? He thought they were going bankrupt, but the bond market did not agree.? I told him to cover.? He objected, but I said, do you want to cover at a higher level?? Eventually he covered.

Pay attention to all of the securities in the capital structure of companies that you own (or short).? They may give you valuable data that the stock market does not know.

Should You Buy Shares of Stock or Not?

Posted on 7 September 20137 September 2013 by David Merkel

Well, I was honored to be tweeted to by Mark Cuban.? Here it is:

@howardlindzon @AlephBlog the real question is why would an individual buy a share of stock? It no longer reps ownership in company

Now let me try to answer the question.? Yes, average people buying stocks with the small amount of money that they have, have no control over their investments.? What is worse is that those who invest through mutual funds have less control, because the mutual funds don’t care much about governance except when something critical comes to them: an acquisition, a spinoff, a merger, etc.

Small investors need to realize that they are riding on the bus of the company (ies) that they own.? They have little ability to affect the board of the company, much less management.

So why buy, if you don’t get control?

Well, let’s talk about institutional investing in alternatives.? Many institutions ride on the buses of general partners with expertise, while they are limited partners.? They have little to no control, and they invest because they think their LP interests will be worth more by the time the partnership matures.? The partnership must raise liquidity by the end of the term, and players get paid, even if they are rolling into the next deal.

The key here is a liquidity event, or the threat of one.? Something that forces the investment to interact with the cash world.? It can be a spinoff, selling a subsidiary, an outright sale of the company, etc.

But liquidity events are rare with publicly traded equities.?? Maybe not *so* rare, when you consider dividends and buybacks.? But full acquisitions happen rarely, and individuals play a small role in M&A.

So here is the answer, which only makes sense if you are a value investor: we buy stocks that we think will compound value.? We may not have control, but we look for situations where management honors the investments of outside passive minority shareholders.

We may be aided by larger investors that seek control, or not.? When you own an undervalued company, catalysts appear. It may take time, but the effort to make value emerge will work more than half of the time.

My view is to focus on companies that are growing value and own them.? That will result in increases in the underlying value of the companies held, which will result in high market values.

Yes, we may not have control.? But if we focus on undervalued equities, we may own companies that those large enough to buy whole companies will buy out, rewarding our patience in holding neglected companies.

And so, Mr. Cuban, though I am nowhere as successful as you, I regularly do better than the S&P 500 by picking stocks with my value discipline, buying stuff that few want to own, and profiting when the stocks exceed expectations.

That is why I own individual stocks, for myself and my clients.? I note that you on rare occasion buy common stocks, including this purchase of Apollo Group.? Guess what?? I own that as well.

I buy the stocks of companies that are out of favor, but have a margin of safety — if I am wrong, I won’t get killed.

That’s why I buy shares of common stock even though I know my ability to control is limited.? (That said, at least in the insurance industry, if I call they will listen to me, at least among the midcap and smallcap firms.)

But I agree with you.? Small investors ride on the backs of larger control investors.? Thus small investors should ask, “What will the large control investors like?? And that is why clever small investors should buy shares of stock, despite the lack of control.

Full Disclosure: Long APOL