Security Analysis Part III: Senior Securities with Speculative Features

Similar to straight bonds, senior securities with speculative features should be primarily selected on the basis of the enterprise not the contractual rights of the security.

“It is undoubtedly true that it is more profitable to select the right company than to select the issue with the most desirable terms.”

Of course, while it is relatively easy to determine that one enterprise is better than another it is much more difficult to determine that one stock at a certain price is better than another.

Main Types

The main types of securities with speculative issues are:

1. Preferred Stocks or Bonds trading at a discount from par
2. Convertible bonds or convertible preferreds
3. Bonds or preferreds with profit participation on top of interest or dividend.

And the main elements of profit sharing privileges are:

1. The extent of the profit sharing (cap).
2. The closeness to realizing the profit sharing (i.e. moneyness).
3. Duration of the privilege (time to expiry).

Decision Rule

Issues with speculative characteristics should be purchased for either their investment characteristics or speculative characteristics. Combining both reasons inevitably leads to over-justification and poor results. This approach reminisces of Nassim Taleb’s heuristic that good decisions are made by one main reason alone, a conflation of reasons does not lead to good decisions. If the analyst needs to justify the purchase on both pillars it is because the main characteristic of either are not met and thus the investment should generally be avoided.

Mispricing

Many of these issues have no natural buyers which tends to lead to a general undervaluation of the issues that the intelligent investor can take advantage of. This is particularly true of low grade bond issues (less true today than at writing but the idea remains, look for securities that the market does not appreciate or want). In general there are three stages of mispricings:

1. Original issue, when investors buy at par despite investment not being justified.
2. Lack of merit becomes obvious and stock drops significantly, almost always beyond what is justifiable by the situation.
3. Stock advances past intrinsic value due to certain indicators being over-emphasised above their true worth (i.e. dividend coverage).

The intelligent investor would be wise to step in at the second point.

Limited Investment Gain and Holding Period

An investor who purchased one of these issues for safety and then benefited from the speculative feature will likely need to dispose of the security at about a 30% gain. At that point the speculative feature will dominate the value of the security and thus no longer be a good investment but rather a potentially successful (or unsuccessful) speculation.

Rule of Maximum Valuation

Senior issues have an inversion rule (a la Jacobi) of what they are not worth, referred to as the “Rule of Maximum Valuation”.

“A senior issue cannot be worth, intrinsically any more than a common stock would be worth if it occupied the position of that senior issue, with no junior securities outstanding.”

With small exceptions for the impact of beneficial capital structures, a senior bond or preferred cannot be worth more than the common would be worth if that security did not exist. The difference in contractual rights between these two shares does not create value but rather divides it between the senior and the junior holders.

Comments on the Introduction

Distressed investing is the ultimate value play as it is looking for value at large discounts when sentiment is most negative. The two main types of bankruptcy investing are:

1. Liquidations are a pure IRR play. Investor looks at assets, see that they are higher than the price and then estimate that they will get their money back in a reasonable time for the IRR to be successful.
2. Reorganizations result in two scenarios, either a melange of securities and cash, or the investor seeks to acquire control of the business. Generally in the second type a wide variety of securities result, preferred shares, senior bonds, mezzanine debt, etc. The complexity of these securities and generally small size leads to the market tending to undervalue them at issue (see You Can Be a Stock Market Genius).

Distressed investors need a combination of skill identifying financial value as well as the legal ability to determine how this value is ultimately going to be split up.

Great investment opportunities tend to occur when a marvelous business encounters a one time huge but solvable problem. The negative sentiment from the problem tends to move the pendulum of value far away from the middle. A couple examples of great investments in this situation are Carl Icahn in the Texaco bankruptcy and Warren Buffett in the American Express ‘Salad-Oil’ Scandal.

A key feature of distressed markets are the quantity of forced sellers that lead to significant mispricings and negative supply.

A paradox of distressed investing is that when the opportunities are the largest (spreads the widest) there is the fewest amount of capital to deploy (maybe circular reasoning?). Intelligent investors will structure their operations so that they are liquid when these opportunities arise. An example of this is Elliot Capital working on a ‘capital-call’ basis to deploy money. Another is Buffett keeping a lot of cash to invest in sweet-heart deals when he is the only liquid party in the market (Goldman deal in 2008).

Markets experience paradigm shifts. Until 1951 the Dow had traded below 200 every year, but then it never did again. In 1953 dividend yields dropped below bond yields for the first time and many expected that to revert but it never happened, and a new valuation standard was born. Many staying outside until it reverted missed out on substantial gains. Despite trends changing, human nature will always allow for profitable opportunities to those who understand and can mitigate their own irrationality.

“Bull markets are born in pessimism, grow on skepticism, mature on optimism, and die on euphoria.”

“You go into a steady decline, and then you fall of a cliff.”