In Bonds, focus is onAVOIDANCE OF LOSSIn equities, focus is on BOTH AVOIDANCE OF LOSS + A DESIRE TO MAKE PROFITS
What’s the best case scenario for a high-grade bond buyer?
Downside risk in bonds NO offsetting trades So It’s better to be safe than sorryIn stocks, being loss averse can be costly. You have to take calculated risks...
You are SACRIFICINGProﬁt SharingIn Exchange OfA PRIOR CLAIM and DEFINITE PROMISE Bad exchange
High Grade Bond Selection is a NEGATIVE artFocus on exclusion
“The ﬁrst chance you have, to avoid a loss from a foolishloan is by refusing to make it. There is no second chance.”
Graham’s Principles of High GradeBond selection
1. Safety is measured not by speciﬁc lien orother contractual rights but by the ability of the issuer to meet ALL its obligations.
1. Lien unreliable form of safety 1. Lien vs. AbilitySafety is measured not by speciﬁc lien or other contractual rights but by the ability of the issuer to meet allits obligations.The idea that a lien on the assets is a guarantee of protection independent of the success of the businessitself is in most cases a complete fallacy.In the typical case, the value of the pledged property is vitally dependent on the earning power of theenterprise.Example: ITCRailroads - lien on property not adaptable to other uses.Indian Banks NPAs - emphasis on security rather than ability.
Shrinkage of property values when a business fails.Difﬁculty of asserting the bondholders supposed legal rights.Delays and other disadvantages incident to a receivership or bankruptcy.
2. This ability should be measured under conditions of depression rather than prosperity.Any bond can do well when conditions are favorable.e.g. FCCB issues
3. Deﬁcient safety cannot be compensated for by an abnormally high coupon rate.Yield TrapReturn ON money vs. Return OF money
4.The selection of all high grade bondsshould be subject to rules of exclusion and to speciﬁc quantitative tests.
“What’s fascinating . . . is that you could now have a business that might have been selling for $10 billion where the business itself could probably not have borrowed even $100 million.
“But the owners of that business, because its public, could borrow many billions of dollars on their little pieces of paper- because they had these market valuations. But as a private business, the company itself couldn’t borrow even 1/20th of what the individuals could borrow.”Promoters aren’t borrowing. They are selling.A sale in the garb of a loan.
Two Sources of safety: A. The character of the industry(the particular business is immune from drastic shrinkage of earnings).
B. The amount of protection (themargin of safety is so large that the company can undergo a drastic shrinkage of earnings without resultant danger).
4. Quantitative Tests The selection of all seniorsecurities for investment should be subject to rules of exclusionand to speciﬁc quantitative tests.
“The past ability of the borrower to earn in excess ofinterest requirements is counted on to protect the investor against loss in theevent of some future decline in net income.”
“The bond investor does not expect future earnings to be the same as in the past. If he was sure of that, the margin demanded might be small. Nor does the bond investor predicts whetherfuture earnings will be materially better or poorer than the past.”
“ If he did that, he would have to measurehis margin in terms of a carefully projected proﬁt and loss account instead of emphasizingthe margin shown in thepast record. The role of the margin of safety, therefore, to render it unnecessary to make accurate predictions about the future.”
Factors in Bond Selection1. The nature of the 6. The relation of the business value of the property to2. The size of the debt enterprise 7. The relation of stock3.The terms of the issue capitalization to debt4. The record of solvency Debt/Equity and dividend payments Average Market Value of5. The relation of Enterprise/Debt earnings to interest requirements Interest Cover
Fixed Charges CoverageFixed charges vs. InterestExample of leased vs owned outlets in retail operations. Rent is like interest.Why Fixed charges cover instead of Debt service?1. Cover demanded is high2. Assumption of going concern - ability to reﬁnance
Graham’s Version of Debt-equity ratio Market Value of Enterprise/ Debt ratio:What is the logic of using this ratio?
“Before paying standard prices for bonds of any enterprise, the investor must be convinced that the business is worth a great deal more than what it owes.”Key term: Business worth a lot more than what it owes.In this respect the bond buyer must take the same attitude as the lender of money on a house ora diamond ring, with the important difference that it is the value of the business as an entitywhich the investor must usually consider, and not that of the separate assets.Why not use the conventional Debt/Equity ratio?What about the silly Mr. Market??
“The market valueof stock is generally recognized as abetter index of the fair going concern value of a businessrather than balance sheet ﬁgures.”
“The presence of a stock equity with market value many times as large as the total debt carries a strong assurance of thesafety of the bond.”
“Conversely, an exceedingly small stock equity at market prices must call the soundness of the bond into serious question.”Why is this very important?
The Graham Standard:“Minimum stock equity at marketprices for industrial bonds should be at least 75% of total debt. This test must be passed both currently and over the average of last ﬁve years.”
Interest coverage and debt-equity ratios Do you see any similarity? What does interest-coverage ratio measure?Cash ﬂow available for interest/ Interest
They are very similar, therefore, they should produce similar conclusions.i.e. if a company is creditworthy,it must be a lot more than what it owes. EV should be several times its debt
Suppose, the minimum standard for interest-coverage ratio is barely metbut the stock-value ratio is considerably higher than the minimum prescribed. Under such circumstances, the bond should be accepted as investment. Why?
But what if they producecontradictory conclusions?
If interest coverage ratio is ample but the stock-value ratio is substantially below the minimum required. “Under such circumstances, the purchaser of the bonds will have toassume that the price of the stock is too low.” This could happen for good or bad reasons
Good Reason: Stock market is right you fool! - there are bad daysahead, the earnings are suspect, or there may be a fraud!Credit rating agencies vs. the stock market as predictors of distress.
Bad reason: Stock market is wrong - the stock is a bargain - buy it instead! - its cheaper and safer! In either case, the investor should not buy the bond as a type-I security.
Time for some backward thinkingLets do some reverse engineering
Recall The Graham Standard:“Minimum stock equity at marketprices for industrial bonds should be at least 75% of total debt. This test must be passed both currently and over the average of last ﬁve years.”
For Graham, if a company is creditworthy, then its stockshould be worth at least 75% of the value of its debt.(Business is worth at least 175% of debt) Equity Value > 0.75 x Debt Capacity
A Valuation Rule “An equity share representing the entire business cannot be less safe[and less valuable] than a bond having a claim to only a part thereof.”
“There are instances where an equity share may be considered sound because it enjoys amargin of safety as large as that of a good bond.
“This will occur, forexample, when a company has outstanding onlyequity shares that underdepression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power.
“In such instances theinvestor can obtain the margin of safetyassociated with a bond,plus all the chances of larger income and principal appreciation inherent in an equity share.”
“Our research seeks to appraise theintrinsic value of a share of stock byestimating its acquisition value, or by estimating the collateral value of its assets and/or cash ﬂow.
“We believe the process is in many respects closely related to creditanalysis as we are seeking collateral net worth in excess of the cost of our investment.”
“A bondholder can enjoy noright or protection which the full owner of the business, without bonds ahead of him, does not also enjoy. Stated somewhat fancifully, theowner (stockholder) can write out his own bonds, if he pleases, and give them to himself.”
Exercise done in Oct 2011Total cash ﬂow for ﬁve years = Rs 4,896 cr.Average = Rs 979 cr.Interest expense = 979cr/3 = Rs 326cr.Debt business can easily support = Rs 326 cr./0.10 = Rs 3,260 cr. (ANSWER 1)Minimum value of business = Rs 3,260*1.75=Rs 5,705 cr.Minimum intrinsic value of the company = 5,705+2,000 cr= Rs 7,705 crMinimum intrinsic value of equity = Rs 7,705cr/13cr shares = Rs 592 per shareDid it fall to this level?
Average cash ﬂow from operations after W/C changes: Rs 1,000 cr.Interest expense = 1000cr/3 = Rs 333cr.Debt business can easily support = Rs 333 cr./0.10 = Rs 3,333 cr.Minimum value of business = Rs 3,333*1.75=Rs 5,833 cr.
Minimum intrinsic value of the company = 5,833+1,500 cr surplus cash= Rs 7,333 crMinimum intrinsic value of equity = Rs 7,333cr/13cr shares = Rs 564per shareNow let’s get REALLY creative
At 560, stock was a debt- capacity bargainTHIS is what we mean by FAVORABLE ODDS
Value Investing in Las VegasThe casino is a value investor because of:1. Favorable odds on each bet2. Lots of play (diversiﬁcation)3. Cap on maximum bet (protection from negative black swan)
In American roulette there are 38 slotsnumbered 1-36, 0, and 00. Pay-out is 35:1
If you bet Re 1 on your lucky # 8 and if theba" lands on # 8, you win Rs 35, otherwise you lose Re 1.
You wager Rs 1,000 on a single number, say number 7.Probability of ba" landing on 7 = 1/38 = 2.63%.Probability of not landing on 7 = 37/38 = 97.37%
Event Payoff Probability Expected Value Ball lands on 7 36,000 2.63% 947.37 Ball does not land on 7 0 97.37% 0 947.37 Amount Bet -1,000 NPV -52.63What happens when Margin of Safety is -ve and you practice wide diversiﬁcation?Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38 numbers to “spread your risk”
Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38 numbers to “spread your risk”What happens when Margin of Safety is -ve and you practice wide diversiﬁcation?
Event Payoff Probability Expected Value Ball will land on one of your 947.37 100% 947.37 numbers (=26.32*36) Amount Bet -1,000.00 NPV -52.63Lesson: Diversiﬁcation does not work when Margin of Safety is absent.