## Saturday, November 05, 2005

### One Valuation Rule, Two Paradoxes

In his book, Security Analysis, Benjamin Graham gives an elegant rule on valuation of equities which I call as the rule of minimum valuation. This rule states that:

"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."

The wisdom of the rule of minimum valuation arises out of the fact that it allows you to use elementary math to prove the cheapness of a stock. To see how, let me use the very example that Graham used in the 1934 edition of Security Analysis. It’s the example of the American Laundry Machinery.

American Laundry Machinery
In early 1933, the stock of this debt-free company was quoting at \$7 per share. The company had 614,000 shares outstanding. The market cap came to \$4.3 mil. Graham gave the following additional information about the company:

Cash assets: \$ 4.13 mil
Other current assets: \$ 17.4 mil
Current liabilities: \$ 0.20 mil
Average 10 years earnings before interest: \$ 3.15 mil
Average earnings per share: \$ 5.13

At \$7 per share, the stock of this company was selling for less than 2 times average earnings. Moreover the company classified as a net-current-asset bargain. So, it was a cheap stock. But Graham wanted to prove it mathematically. How did he do that?

Graham Plays a Mental Game
He played a mental game. He said that let us make this debt-free company issue 45,000 hypothetical bonds of \$100 each and let us make this company distribute these hypothetical bonds to its shareholders without taking any cash from them. Since the hypothetical bonds were to carry an interest rate of 5% p.a., they would represent an annual interest expense of \$ 225,000 to the company. This was not a problem at all since the company’s average annual earnings of \$3.15 million were 14 times annual (hypothetical) interest. With such a healthy interest coverage ratio, the bonds deserved to be classified as high-grade bonds. Because market interest rates were slightly higher than the 5% interest which these bonds were paying, Graham valued these bonds at \$94 each.

So, the total market value of the 45,000 bonds came to approximately \$4.3 million, which, not co-incidentally, was the same as the market value of the entire company before it issued the bonds!

The interesting thing is that shareholders of American Laundry Machinery did not have to pay anything to receive the bonds distributed by the company. If you owned 1% of its equity shares, you'd automatically recieve 1% of its bonds. Moreover, the shareholders did not have to surrender their shares in exchange of the bonds. Even so, the insersion of a prior claim reduced the fair value of the equity shares of the company. However, since the market value of the bonds received was the same as the market value of all the shares in the un-leveraged American Laundry Machinery, the shareholders who receieved the bonds had no cause for complaint. They now simply held two pieces of paper – one representing ownership stake in the corporation and the other a claim against its assets and earning power. And the combined market value of two pieces of paper they now held in the leveraged American Laundry Machinery was bound to be significantly more than the market value of the shares in the unleveraged American Laundry Machinery they held earlier.

This process of creating and distributing bonds, which we now call as leveraged recapitalization, proved that the stock of the unleveraged American Laundry Machinery simply cannot be less than the value of the 45,000 bonds issued by the leveraged American Laundry Machinery. Graham explained:

“The purpose of this analysis is to show that at \$7 per share for American Laundry Machinery stock in early 1933- equivalent to only \$4,300,000 for the entire business- the purchaser was getting as much safety of principal as would be required of a good bond, and in addition he was obtaining all the profit opportunities attaching to common stock ownership.

Our contention is that if American Laundry Machinery had happened to have outstanding a \$4,500,000 bond issue, this issue would have been considered adequately secured by the standards of fixed-value investment.

There would have been no question about the continuance of interest payments, in view of the powerful cash position revealed by balance sheet. Nor could the investor fail to be impressed by the fact that the net current assets alone were nearly five times the amount of the bond issue.

If a \$4,500,000 bond issue of American Laundry Machinery would have been safe, then the purchase of the entire company for \$4,300,000 would also have been safe. For a bondholder can enjoy no right or protection which the full owner of the business, without bonds ahead of him, does not also enjoy. Stated somewhat fancifully, the owner (stockholder) can write out his own bonds, if he pleases, and give them to himself.”

Debt Capacity Bargains
Over the last ten years, I have frequently used the rule of minimum valuation to identify stocks for further research that appear to be ridiculously cheap. I call this theme of deep value investing as debt capacity bargains. The process used to identify stocks using this theme, is derived from Graham’s rule of minimum value. It's a very simple process but it requires one to do a bit of backward thinking, which is Mr. Charlie Munger’s favorite thinking style (more on this thinking style in a future blog post).

Before I lay down the process of how I use the debt capacity bargains theme, let me restate the rule of minimum valuation, in Graham’s own words, this time, from his other book, The Intelligent Investor:

“There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression 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 the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in an equity share.”

Here is the process I use to identify stocks for further research which are cheap under my debt capacity bargains theme of deep value investing:

1. Look for debt-free companies which have displayed stable earning power in the past and are expected to continue to do the same in the future as well;
2. Average the past earning power (use cash flow from operations after deducting increase in working capital and maintenance capex).
3. Use a desired interest coverage ratio of 3x to 5x, depending on the character of the industry – Use 3x for highly stable businesses, 5x for cyclical businesses;
4. Using data from the above two steps, work backwards to estimate the amount of interest expense that can easily be serviced by the company;
5. Divide the interest expense arrived at in step 4. into the current interest rate to determine debt-capacity of the company;
6. Compare this debt-capacity with the current market cap, and if the market cap is less than debt-capacity, consider buying the stock.

An example would explain. Suppose that the past annual average cash flow from operations of a debt-free company after adjusting for working capital changes and maintenance capex is \$100 million. Assuming that its business operations are fairly stable, by using the desired interest coverage ratio of 4x, we estimate that this company can easily afford to carry debt which would require payment of \$25 million (\$100 million/4) of interest payments every year. Given that the current rate of interest for such companies is 5% p.a., the company’s comfortable debt capacity comes to \$500 million (\$25 million/0.05). In other words, if this company had bonds in issue having a face value of \$500 million, then these bonds would easily classify as high-grade bonds with little credit risk, worthy of investment-grade credit rating, and worthy of selling in the market at near \$500 million value.

Now, if the market cap of this company is less than \$500 million it means that the stock is selling for less than this debt-free company's debt-capacity – making it similar to Graham’s American Laundry Machinery. That is, if you buy the stock of this unleveraged company for less than a total value of \$500 million, you’re, in effect, acquiring a high-grade bond having a market value of \$500 million, plus you're getting equity stake for free. In other words, a free lunch!

Basically, by buying the stock at that ridiculously low price, you're exploing the deep truth in the rule of minimum valuation, which is that hidden inside every stock of a debt-free company is a high-grade bond which can easily be valued.

Paradox # 1: The Bond Fund Manager
This brings me to the first paradox which is:

A bond fund manager will refuse to buy shares of a debt-free company quoting at a price implying a market value of the company to be less than its debt-capacity and yet, he’d gladly buy the bonds of this very company created thru the process of a leveraged recapitalization.

This irrational behavior on the part of the fund manager would, to a very substantial degree, be due to the ignorance of the fundamental truth in the principle of minimum value. And even if the bond fund manager understood the principle, he’d rationalize his unwillingness to buy the stock and his willingness to buy the bond by stating that he is not allowed to buy stocks for his bond fund. And if he gave you that rationalization, he’d display his ignorance of Shakespeare’s famous quote from Romeo and Juliet:

“What’s in a name?
That which we call a rose by any other word would smell as sweet."

His third argument rationalizing his behavior could be that the act of buying bonds entitles him to receive contractual interest payments, but if he had bought the stock instead, he’d get a right to receive only discretionary dividends. This silliness of this argument is obvious from the fact that its not contractual rights, but the cash generating ability of a corporation which overwhelmingly determines its value and investment merit.

Paradox # 2: The Miracle of Financial Engineering
The second related paradox is this:

A banker will refuse to lend money to an uncreditworthy, speculative company (think “dotcoms”) whose stock may be selling at a ridiculously high price, but the same banker will gladly advance loans to the shareholders of that very company against the security of its highly liquid shares!

This “miracle” of financial engineering which makes the owners of a corporation creditworthy, even though the corporation is anything but, has its roots in: (1) the incorrect treatment of difference between the market price of the shares given as collateral and the loan advanced as genuine margin of safety; and (2) almost blind faith in liquidity of the stock market which will presumably allow the banker to offload the shares when needed (he forgets Keynes’ acute observation that “of the maxims of orthodox finance none, surely, is more anti-social than the fetish of liquidity, the doctrine that it is a positive virtue on the part of investment institutions to concentrate their resources upon the holding of "liquid" securities. It forgets that there is no such thing as liquidity of the investment for the community as a whole.”)

Mr. Charlie Munger knows this paradox very well. It was him, after all, who brought it to my attention a few years ago when dotcoms were the rage. At that time he had said:

“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.”

This example of a "miracle" of financial engineering is by no means the only example. There are others but their discussion will have to wait for another day.

Let me end, though, by quoting Michael Aronstein, who, in the excellent book, Five Eminent Contrarians, pretty much agreed with my own views on the subject, by saying:

“Of the many advances in the long history of commerce, the advent of sausage stands out as one of the greatest. The idea of taking something which, in pure form, would be repellent to potential customers, and by thorough grinding, mixing, reshaping and adulterating, creating an entirely new entity that could be marketed free from the taint of its original ingredients, marked a milestone in the annals of business thought. . . Sausage making is the prototype for an entire class of merchandising technique that has become particularly common in modern finance . . . The financial marketer who uses commingling as an approach is responding to the same general conditions that drive the sausage stuffer: an abundance of lower grade ingredients along with hungry and credulous public.”