CHAPTER 7
Creditworthiness*
Creditworthiness from the Borrowing Entity Point of View
Capital Structure from the Corporate Perspective
Factors Affecting Capital Structure
Conservative Capital Structures
For those who hold or invest in junior securities—from unsecured obligations through common stocks—and for those interested in the general economy, it is hard not to overemphasize the importance of creditworthiness. Put simply, if an economic entity—corporate, government or individual—cannot be made creditworthy, sooner or later it will have to restructure its obligations or liquidate.
There are three tests of creditworthiness:
Few realize that in order to remain solvent—that is, creditworthy—an economic entity does not necessarily have to pass all three tests. Passing only one will often do. Paul Krugman, an eminent economist, wrote frequently in 2008 and 2009 about “zombie banks.” A zombie bank was one where the contractual obligations embedded in liabilities exceeded the fair value of assets. The fair value of liabilities was not, and could not be, the market value of obligations. Rather it was the dollar amount of claims that would have to be paid to all obligees, mostly depositors, both principal and interest. Krugman seems to have missed the point that these banks were not insolvent since they seemed to have the ability, however marginal, to meet their obligations as they became due. Also the banks had access to capital markets even as capital from the private sector froze up. The government could, and did, provide funds through its TARP program.
As is pointed out in Chapter 25 on Hertz Global Holdings, a highly leveraged company, barely profitable, remained more or less creditworthy only because the company had access to capital markets at all times subsequent to its 2005 change of ownership.
From the point of view of outside passive minority investors (OPMIs), we do not believe that most long-term common stock investing makes much sense unless the corporation embodies unquestioned creditworthiness. Thus our recommended investments are in the common stocks of companies that enjoy exceptional financial strength, sound operations and/or assets, and trustworthy management or control groups. Call it overkill, but it is also quite comfortable to be invested in the common stocks of companies whose solvency is not close to ever being in question. Besides the insurance provided to the OPMI holding junior securities, creditworthiness also affords management options to be opportunistic; that is, use it as an asset in resource conversion activities to create wealth.
The only OPMIs we think can safely ignore creditworthiness are secured creditors, where the value of the security pledged far exceeds the amounts of the claims against it, and where loan covenants prevent a dilution of that protection.
As bottom-up investors following a fundamental finance approach, we have always focused on creditworthiness much more than almost any other person or group writing about security analysis or economics. Thus, for us there exists the strict discipline of not investing in any common stock knowingly unless the issuing company enjoys a strong financial position. This is in contrast to almost all conventional market participants who view businesses as strict going concerns and as a result emphasize a primacy of the income account; that is, principal weight in an equity valuation goes to earnings from operations and/or cash flow from operations. Almost all other OPMIs seem to denigrate the importance of strong financial positions.
This tendency to downplay the importance of creditworthiness is prevalent also on the macro level, probably even more so than for bottom-up investors. This attitude has been well summarized by former Vice President Dick Cheney, who was quoted as saying, “Deficits don’t matter.” For the vast majority of people, the important economics statistics are gross domestic product, employment and unemployment levels, corporate earnings, and productivity increases. Creditworthiness is pretty much ignored.
CREDITWORTHINESS FROM THE BORROWING ENTITY POINT OF VIEW
Based, as always, upon a bottom-up, fundamental finance approach to analysis, our view of what is happening in the U.S. economy seems to be quite different from the views held by politicians and academics. Central to the economic debate and discussion throughout 2011 has been the question of the solvency of the United States government. Declaring the U.S. bankrupt is now in fashion and has been used to justify investment decisions and to sell investment strategies and products. Still, the question of U.S. solvency, or the solvency of any economic entity whether a government, a corporation or an individual, is worth considering.
The true test of solvency is the creditworthiness of the economic entity, not the amount of debt that it owes. The amount of debt is important, and we discuss corporate capital structure and its determination later in the chapter. Debt however, is only one element in determining creditworthiness. In fact, creditworthiness or credit capacity, is a function of three factors:
The first factor is how much indebtedness is being incurred via balance of payments deficits, other governmental borrowing, corporate borrowings, and borrowings by consumers. Of itself, increasing indebtedness is not a huge problem, provided the use of funds created by the borrowing is productive, that is, creates wealth. Insofar as the use of proceeds does not result in wealth creation, or it creates only modest increases in wealth—that is, there exists a negative multiplier, or a modest multiplier—the borrowing entity, sooner or later, has to face diminished creditworthiness (except if the entity can sell assets on a massive scale).
The third factor—productivity or growth—seems by far the most important of the three factors for the U.S. government. Historically, certain U.S. government uses of proceeds have been unbelievably productive, such as the Homestead Act of 1862 and the Servicemen’s Readjustment Act of 1944 (the G.I. Bill of Rights).
While it is relatively easy to measure the productivity of use of proceeds at the corporate level—profits and/or growth in net asset values—it tends to be much harder (although not impossible) to measure productivity where the expenditures are made by a government not motivated primarily by seeking profits.
EXAMPLE
The U.S. government did run budget surpluses in the mid to late 1990s, as a direct result of decades of debt-financed, productive spending. Much of the credit for that performance seems attributable to the dot-com bubble, made possible by the widespread adoption of the Internet and the vast electrical and telecommunications infrastructure of the United States. Various newly minted billionaires paid huge amounts of capital gain taxes, and the tax base was broadened, as a new industry created demand for highly skilled, and mostly well paid, workers. Much of the growth in high tech during that time seems to have been triggered, in part, by the initial public offering (IPO) Boom and, in part, by defense cutbacks, which compelled smart engineers and nerds to get involved in attractive start-ups, rather than taking jobs with Lockheed Martin and General Dynamics. The speculative excesses of the 1990s seem to have contributed much permanent good to the economy with the development of extremely able, extremely productive, high-tech industries. All of this occurred while causing huge harm to passive market participants who speculated in dotcoms and did not sell their commitments in time.
As investors using a fundamental finance approach, we measure the creditworthiness of a company by looking at the entity’s ability to have and to create liquidity either:
Since most conventional approaches view creditworthiness only through the lens of how much debt the economic entity has in relation to the some measure of the value of its assets (the balance sheet test), a discussion of capital structure from the corporate point of view will be instructive.
CAPITAL STRUCTURE
Modern financial theorists, and Graham and Dodd fundamentalists, for that matter, look at corporate capital structure exclusively from the point of view of what impact a capital structure is likely to have on the market price of a corporation’s common stock. In fundamental finance we view capital structure as something that arises out of a process that involves meeting the needs and desires of a multiplicity of constituencies, including various creditors, regulators, rating agencies, managements and other control groups, outside passive minority investors (OPMIs), and the company itself. Below we enumerate factors that ought to be weighted in the determination of capital structure.
Adopting the modern capital theory (MCT) approach to appropriate capital structure, which theorizes about the probable impacts of capital structure on OPMI market prices, is akin to studying the solar system by assuming the sun revolves around the earth. In this analogy, the earth is an OPMI, and it is given an importance in the solar system completely out of sync with readily observable reality. Although this perspective might be fine for an OPMI, it is inappropriate for an investor following a fundamental finance approach or anyone wishing to take a corporate perspective on capital structure.
CAPITAL STRUCTURE FROM THE CORPORATE PERSPECTIVE
An understanding of the specific factors affecting capital structure requires knowledge of the several conceptual differences that arise from taking a corporate perspective rather than the traditional efficient-market or Graham and Dodd views.
Substantive Consolidation
An underlying assumption found in MCT and in Graham and Dodd is that there is a substantive consolidation between the interests of the OPMI and corporate feasibility.3 These theories hold that the exclusive way to determine the value of a corporation is to find the total market value of all its outstanding equity securities and add to this the amount of corporate obligations outstanding, either as measured by claim amount or market value.
From the value-investing perspective, there is no substantive consolidation. Furthermore, OPMI desires frequently conflict with corporate feasibility. There are three obvious cases in which such conflicts are common:
Accessing Equity Markets
Corporate feasibility and OPMI stock price are essentially equivalent when the corporation is seeking access to capital markets to raise funds through the sale of new issues of equity, especially common stock equity. Here, though, the close relationship is measured by whether the corporation can access capital markets at all, not by the per-share price the corporation will receive for the sale of a new issue of common stock that does not pay a cash dividend. In this instance, per-share price can have a more or less dilutive effect on common shares. The price has no real effect, however, on corporate feasibility.
Financing with Retained Earnings
For most corporations, accessing equity markets for new funds is a sometime thing, rather capricious in its doability and almost always very expensive in terms of overall underwriting costs. Consequently, the vast majority of public corporations fill their equity needs through retaining earnings. Only a small percentage of earnings, or none at all, are paid out to shareholders as cash dividends. The indicated percentage payout for Standard & Poor’s (S&P) 500 Index in August 2011 was 41.6 percent.
There are important exceptions, though, to financing with retained earnings. The most notable one has been the electric utility industry. From 1945 through the late 1970s, most companies in the industry were experiencing average annual growth in the demand for electric kilowatts of about 7 percent per annum. Massive capital expenditures were needed to produce $1 of annual revenue (estimated at about $5 of capital expenditures for every $1 of annual revenue). Normal capitalization consisted of 50 to 60 percent long-term mortgage debt, 10 percent preferred stock, and 30 to 40 percent equity. Equity had to be increased relatively regularly and in relatively major doses. The industry ensured for itself access to equity markets by paying out as dividends 70 to 80 percent of earnings, which then made their securities attractive to income investors. Furthermore, per-share dividends were increased modestly as often as once a year. Every 18 to 24 months, however, the companies marketed new issues of common stock to obtain requisite funds to finance massive capital expenditures while keeping debt-to-stock ratios in line with mortgage debt covenants and with industry custom and usage. Thus, appeal to a constituency that wanted regular and increasing dividends ensured that utilities would have access to a capital source they needed.
There remain a number of companies in other industries that follow the electric utility model of paying out dividends representing a high percentage of their earnings and then periodically marketing new issues of common stocks. Real estate investment trusts (REITs) and many finance companies follow such policies. Indeed, REITs are required to pay out at least 90 percent of net income as dividends if they are to remain REITs and enjoy a flow-through income-tax status, where the REIT itself is not subject to income tax because otherwise taxable income is paid out to shareholders.
The concept of high dividends combined with frequent access to equity markets that is implicit in the efficient market hypothesis (EMH) and Graham and Dodd views of capital structures, however, is not common.
Dividend Policy
Benjamin Graham and David Dodd, in discussing dividend policy, focused on substantive consolidation. According to Graham and Dodd and the EMH, a company that enjoys a high return on equity (ROE) should retain earnings, and a company with a low ROE should pay out its earnings as dividends when its shareholders could earn more than the company could by reinvesting the net proceeds from dividend payments. For fundamental finance investors, dividends are to be viewed as a residual use of cash, something to be paid to shareholders only after a company’s needs to retain cash are met. The company’s reasonable needs come first. The company’s needs are of three types: to acquire assets, to pay or otherwise satisfy creditors, and to provide a margin of safety against an unpredictable future. Many high-ROE companies have little or no need to retain cash and can afford high dividend payouts (e.g., money-management companies). Many low-ROE companies had better retain most cash generated from operations if they are to survive (e.g., integrated aluminum producers, discount retailers, and meatpackers). ROE should not be a test for a firm’s ability to pay dividends.
Constituency Stakes in Corporate Feasibility
There seems to be a view that the common stockholder community has a consuming interest in corporate feasibility but that other constituencies (notably creditors) do not. Creditors, it is postulated, just want to receive back principal plus interest even if it bankrupts the company, but such a view is unrealistic. The vast majority of creditors have continuing relationships with the companies to whom they lend, so they are interested in refinancing maturing debt and/or continuing to ship goods or rent properties. Everyone—not just common shareholders—has a stake in corporate feasibility.
Constituency Conflicts with Corporate Feasibility
Every constituency, including OPMI shareholders, also has conflicts with corporate feasibility. Each wants things from companies that detract from feasibility. Holders of common shares want dividends, creditors want cash payments and tough covenants, and managements want huge compensation packages.
As is stated in previous chapters, each constituency related to a corporation has objectives concerning the company that combine communities of interest and conflicts of interest. There is usually nothing special about OPMIs compared with other constituencies except that most OPMIs need not have a permanent or semipermanent stake in the company and that once an OPMI owns common stock, the OPMI has no further obligation to do things for the company. Thus, OPMIs are not smarter or better informed than other constituencies, and OPMIs do not have an exclusive interest in corporate feasibility. Two things, however, do distinguish many OPMIs from other constituencies: they have no particular need for a cash return, and they have no need for elements of control. All other constituencies tend to be intelligent, their markets tend toward efficiency, and they each seek to maximize their financial interests. (These characteristics are not exclusive to OPMI shareholders; they are shared with creditors, regulators, rating agencies, managements, and control shareholders.)
Actually, other things being equal, OPMIs are often a lot less knowledgeable than others who have to rely exclusively on the performance of the business for a cash bailout and who cannot, unlike OPMIs, look to a sale to a market for a cash bailout. Put simply, a life insurance company making a long-term private-placement unsecured loan to a company is probably a lot more knowledgeable about the company than are the OPMIs trading common stock on the New York Stock Exchange (NYSE). First, the insurance company can do due-diligence research beyond the public record. Second, the insurance company does not waste time and energy analyzing factors that probably have no relationship to specific corporate values (e.g., the level of interest rates or of the gross domestic product [GDP], dividend policy, or technical market considerations). Offsetting this somewhat is the likelihood that the insurance company knows that the more senior the issue and the shorter its maturity, the less the corporate analysis that needs or ought to be undertaken.
Capitalization in Resource Conversion
Capitalization becomes extremely important in resource conversion activities. The resource conversion topics that are discussed in this book—mergers and acquisitions (M&As), leveraged buyouts (LBOs) or management buyouts (MBOs), initial public offerings (IPOs), and restructuring troubled companies—all involve major recapitalizations. For example, LBO analysis involves first a determination of an enterprise’s value and dynamics and then an examination of the cost of money and an application of a new capitalization. Exactly the same economic procedures are followed when reorganizing troubled companies, either out of court or in Chapter 11. In the case of LBOs, however, the capitalization is leveraged up, in that debt is substituted for equity. In the reorganization of troubled companies, the capitalization is leveraged down, in that equity, debt with soft terms, or both are substituted for senior debt and other onerous obligations.
An easy way of remembering the above is to recall that in the reorganization of troubled companies, recapitalization tends to make sick companies healthy, whereas in LBOs, recapitalization tends to make healthy companies sick.
FACTORS AFFECTING CAPITAL STRUCTURE
In all financial activities, there is a tendency toward efficiency: All participants in a process attempt to do as well as they reasonably can under the circumstances, given their agendas and the agendas of other participants. This certainly holds true for capitalization. Creditors comport, regarding this tendency toward efficiency, in the same way as do OPMIs, although the primary item on a creditor’s agenda might be the avoidance of a money default whereas the primary item on an agenda of an OPMI involved in short-term trading would be the maximization of total return.
Efficient corporate capital structure, the financing layer cake of the corporation, takes into account myriad factors, including the following:
Investors using a bottom-up approach should appreciate all of these.
The Composition and Characteristics of Assets
Asset management is mainly a function of liability management; by contrast, liability management is mainly a function of asset management.
What amount and types of liabilities that ought to be part of a corporate capitalization has to be very much a function of having assets employed in the business in ways that produce sufficient resources to service the liabilities. There are two sources from which liabilities can normally be serviced: internal cash flow obtained either from employment of assets or sale of assets, and access to capital markets for new financings (this is usually a function of the business’s having earnings—the ability to create wealth).
The overall insurance industry provides a good case study of how the character and amount of liabilities influence—indeed, govern—the management of asset portfolios. Insurance companies’ assets consist essentially of investments in debt instruments and other securities. Liabilities consist essentially of estimated obligations to policyholders in the form of policyholder reserves (life companies) and reserve for losses and unearned premiums (property and casualty companies).
In life companies, the policyholder reserve is a very long term, reasonably certain, and actuarially determined (on a year-to-year basis) liability. Given this type of liability, life companies’ investment assets usually consist mainly of long-term privately placed loans. By contrast, property and casualty companies are subject to dramatic and relatively unpredictable (on a year-to-year basis) demands for cash payouts arising from, say, hurricanes or earthquakes. Thus, property and casualty companies’ investment portfolios consist largely of marketable securities, salable to meet the businesses’ sudden needs for cash to satisfy claims. Furthermore, property and casualty companies generally fund the dollar amount of their liabilities by investing in credit instruments (debt securities). Common stock investments are only a small portion of property and casualty company portfolios, limited to dollar amounts no greater than the firm’s statutory surplus. Statutory surplus is net worth computed in accordance with insurance regulations, rather than Generally Accepted Accounting Principles (GAAP). Each net worth figure, statutory or GAAP, is reconcilable with the other.
The analysis of capital structure is very much a function of where you sit. In some contexts, consolidated financial statements are useful, but in other, parent and subsidiary financial statements are key. From the perspective of common stockholders in a holding company, the consolidated financial statements present a useful indication of what the overall results and overall resources are for the company. From the point of view of a lender to the parent holding company, however, parent-company financials are crucial to determining creditworthiness. The parent company directly owns only the common stock of its subsidiaries, not the specific assets of the subsidiaries, even though these subsidiary assets are reflected in the consolidated financial statements.
To service their debts, most parent companies have to receive cash from their subsidiaries. There are essentially four ways in which this cash can be received: dividends, home-office charges, tax treaties, and sales by the parent of the common stock owned. Sales of common stock of the subsidiaries may be impractical. If the holding company is in a regulated industry (e.g., insurance or banking), cash payments by the subsidiaries to the parent may be vigorously proscribed. If the subsidiary—say, a finance company or department store chain—borrows money, then the loan covenant may limit payments to the parent. Thus, a parent company that may appear, on a consolidated basis, to be quite solid really may not be creditworthy at all.
The Needs and Desires of the Several Classes of Creditors
Creditors as a group are probably the most important force determining what corporate capital structures will be. By and large, creditors are intelligent, and many are relatively knowledgeable about the businesses they finance. Put otherwise, they operate in a market with strong tendencies toward efficiency.
Credit markets seem to be much bigger than equity markets and can be deemed to include all payables owed by businesses including accrued expenses, accounts payable, rents payable, taxes payable, and borrowing from banks, other institutions, and the public. Creditors are often a lot more knowledgeable about the business in which they invest than are OPMIs. They are much more serious analysts than are OPMIs. This is understandable because most creditors have to look to corporations for their bailouts. It is actual business performance that will generate cash to pay them principal and interest. It is quite understandable that creditors tend to have strong views about the amount of money they will let a company borrow. By contrast, most OPMIs look to a sale to a stock market for their bailout. Many, as for example those with a technical chartist approach, could not care less about the business. Their knowledge of it can be as restricted as knowing what the stock ticker symbol is.
Creditors of corporations, when financing their own businesses, often have far greater access to borrowings to finance their assets (portfolios of loans to corporations) than would be the case if their assets were common stocks. Portfolios consisting of performing loans generate contractually assured cash to service their obligations, but common stocks usually do not. Market price volatility is considerably less for performing loans than for common stocks.
Predictable cash return on an asset has an importance independent of total return. An asset holder cannot expect to service obligations existing in most capital structures with unrealized appreciation; service has to be made in cash.
Intelligent creditors usually base investment decisions much more on reasonable worst-case assumptions than on base-case assumptions. As knowledgeable and analysis-oriented as creditors are about corporate values, though, they are not immune from making bad decisions. This is probably true because throughout U.S. history, forecasts of cash and earnings flows have been notoriously unreliable. Witness commercial bank lending to less-developed countries (LDCs) in the 1970s, energy lending before the oil bubble burst in the early 1980s, commercial real estate lending prior to 1986, and savings and loans’ unacceptable interest rate risk and then credit risk in the 1980s and residential mortgage lending before 2007. Still, their understanding of corporate values tends to be much better than is that of the typical OPMI—bankers need to know how to read, but OPMIs do not!
The Needs and Desires of Regulators
Corporate capital structure is partially determined by well-informed analytic regulators who have as an agenda seeing that corporate capital structures are not too risky—that there is capital adequacy. These include bank regulators, insurance regulators, the Small Business Administration (SBA), and securities industries regulators, especially those working under the amended Investment Act of 1940 and also the Financial Industry Regulatory Authority (FINRA).
The Needs and Desires of Rating Agencies
An investment-grade imprimatur is essential for many companies operating in certain industries or seeking access to public markets for new issues of debt securities. Agencies providing investment ratings include Moody’s Investors Service, Standard & Poor’s Rating Services, Fitch Investors Service, Duff & Phelps Credit Rating Company, and A.M. Best Company. Corporate managements are very much aware of how capital structure affects the opinions of these agencies.
Creditors, regulators, and rating agencies tend to be efficient (and are probably smarter than most OPMIs). Most corporate loans are performing loans, and most corporations remain solvent. This remains generally true despite the rating agencies’ ineptitude before 2007, which contributed importantly to the meltdown after 2007 and to the Great Recession of 2008–2010.
The Needs, Desires, and Proclivities of Managements and Control Groups
Once it is observed that managements and control groups have multiple agendas that combine communities of interest and conflicts of interest with various of their constituencies, disparate factors affect managements’ and control groups’ influence on what an appropriate capitalization will be. Few managements are likely to conclude that the appropriate capitalization is that structure which will maximize the trading price of the OPMI common stock.
Custom and Usage
Custom is one of the strongest determinants of capital structure. Industry capital structures tend toward uniformity as the various providers of capital adopt common standards or norms. For example, historically, electric utilities have often been financed 50 to 60 percent with publicly held mortgage debt, 10 percent with preferred stock, and 30 to 40 percent with common stock and surplus.
In the LBO arena, senior secured lenders will lend approximately four to five times operating income (minus the excess of capital expenditures over depreciation plus a working capital facility) to finance a deal. Sometimes subordinated debentures, preferred stock held by the sellers or others, or both are available, though nowadays, almost always some meaningful common stock investment is made by the purchasers. The purchase price for the business might be 7 to 12 times the above-mentioned operating income.
Similar custom-and-usage ratios exist for finance companies, hotels, banks, cable companies, insurance holding companies, airlines, and others. Good investors become familiar with these ratios industry by industry.
Most custom-and-usage capitalizations are the most efficient way to capitalize companies, but this is not always true. Take department store and discount-store capital structures. Despite the general economic prosperity of the 1990s, a plethora of department store and discount store chains (Federated Department Stores, Macy’s, Caldor, Kmart, Wards, Bradlees, Zayre) have had to reorganize their capital structure either out of court or in Chapter 11. The main reason was too much credit granted from three sources—financial institutions, trade creditors, and landlords.
The Professional Advice of Investment Bankers, Attorneys, and Accountants
Such fee-based advisors as investment bankers, attorneys, and accountants are important influences in determining corporate capital structure. Investment bankers tend to have great expertise in structuring the terms of securities so as to sell the securities in private placement and OPMI markets. Attorneys are key in dealing with securities questions as they effect the terms to be included in securities issues. GAAP is the province of accountants while both attorneys and accountants deal with income tax issues.
The Needs and Desires of Outside Passive Minority Investors and Their Representatives
The OPMI market is the only constituency addressed by Graham and Dodd fundamentalism and proponents of the EMH in their discussions of capital structure and dividend policy. Indeed, the emphasis is even narrower because the focus is almost exclusively on estimated near-term impacts on OPMI market prices.
This emphasis seems misplaced. It has validity when the company itself and control shareholders are seeking access to capital markets to sell common stock to an OPMI market. This is an occasional occurrence, and the interests of the company itself revolve around being able to market common stock at all rather than around the price at which common can be marketed (an OPMI interest).
It is not that OPMI interests are ignored in determining a capital structure, but that those needs are tempered by requirements of other constituencies. In terms of capitalization, it is a good rule of thumb that satisfying creditor requirements is a lot more important than meeting OPMI desires in structuring a capitalization.
Risk is a word that should not be used without an adjective in front of it. Just because a common stock might have a lot of market risk (i.e., a plunge in OPMI market price) and a company might have a lot of investment risk (i.e., the business is unlikely to survive as a going concern) does not mean that adequately secured lenders to the corporation are taking any credit risk at all. Creditors can be confident that the loan will remain a performing loan or that in a reorganization, they will receive a value of principal amount plus interest and interest on interest. General risk really does not exist.
CONSERVATIVE CAPITAL STRUCTURES
In practice, many corporations operate with conservative capitalizations that provide an insurance policy for holders of junior securities and the corporation itself. In addition, trade creditors and public bondholders are not made nervous. The cost of doing this is a lower ROE (and perhaps stock price) than would otherwise be the case in buoyant periods when the business is prospering. If you pay to insure your house, however, and it does not burn down, that does not mean the expenditure for insurance was wasted.
Conservatively capitalized and well-managed companies are also more likely candidates for hostile takeovers. Raiders must rely solely on publicly available information; therefore they see good management and a strong balance sheet as insurance against a bad purchase. Not surprisingly, increasing corporate leverage is a standard tactic used by corporation managements to thwart takeovers.
Should OPMIs acquire the common stocks of companies with conservative capitalizations? Presumably, such common stocks will sell at lower prices, have greater potential for appreciation if they are to become leveraged in the future, and are more likely targets for takeovers. In addition, such investments would be more conservative because if operations are not as profitable as expected, there should be less downside.
On the other hand, there are offsets to make an OPMI want more leverage. If the company is unleveraged, the OPMI, as an investor, is not as likely to capture as much of the upside. The OPMI might also be in bed with managements or control groups who do not need access to stock markets and who do not care about the stock price in the short run. Investors on margin might not be able to wait an indefinite period of time for a return; or if they change their mind and need to cash out in the short run, they may do so without appreciation. Professional money managers who are primarily asset allocators and are evaluated on the basis of short-run performance might not want to take this kind of risk.
There is no universal answer to the question of whether to buy the stocks of leveraged or unleveraged companies. It depends on who you are and what you know. If you are a conventional asset allocator who does not know too much about finance or companies, then you might be better off taking the more conventional approach to choosing your portfolio. On the other hand, if you read all the literature, understand individual companies and industries, and can appreciate the nuances of capital structure, then you might be better off going the underleveraged investment route. If you believe in the precepts of value investing, however, conservative capitalizations become highly desirable for OPMIs.
SUMMARY
If an economic entity—corporate, government, or individual—cannot be made creditworthy, sooner or later it will have to restructure its obligations or liquidate. There are three tests of creditworthiness: a balance sheet test, a cash flow or income test, and a liquidity test. Few seem to realize that in order to remain solvent, that is, creditworthy, an economic entity does not necessarily have to pass all three tests. Ignorance of this simple fact was evident in market commentary about both financial institution and sovereign discussions of solvency in the wake of the 2008–2009 crisis. Focus on the absolute or relative levels of debt is misguided since creditworthiness is a function of the amount of debt, the terms of the debt, and most importantly, the productivity of the use of proceeds from the borrowing. Investors using a fundamental finance approach, should measure the creditworthiness of a company by looking at the entity’s ability to have and to create liquidity either: from surplus cash, from other assets readily convertible into cash, by an ability to generate surplus cash from operations, by an ability to access capital markets, and by the relative absence of liabilities. We provide a primer on capital structure from the corporate point of view to debunk the substantive consolidation view of capital structure that is prevalent in Graham and Dodd and modern capital theory.
* This chapter contains original material, and parts of the chapter are based on material contained in Chapter 7 of Value Investing by Martin J. Whitman (© 1999 by Martin J. Whitman), and ideas contained in the 2007 3Q, 2009 3Q, 2011 3Q letters to shareholders. This material is reproduced with permission of John Wiley & Sons, Inc.
1 We discuss the quality of assets and how useful GAAP is in the appraisal of asset quality in Chapter 6 on net asset values.
2 We discuss access to capital markets on a super-attractive basis in Chapter 25 on the economics of private equity leveraged buyouts.
3 Corporate feasibility is a concept that originates in the bankruptcy code in the context of a court approving a plan of reorganization (POR). A court will not approve a POR if it makes the debtor unfeasible; i.e. if its implementation will likely lead the debtor to seek another reorganization in the future.