CHAPTER 8
What Matters Is Investment Risk1
There Is No General Risk—Only Specific Risk
The Components of Investment Risk
Successful People Avoid Investment Risk
Methods to Avoid Investment Risk
Safe and Cheap Investing and Minimizing Investment Risk
On pages 440 and 441 of the 1988 edition of Graham and Dodd’s Security Analysis there is this remarkable statement:
Clearly, the bond contract is inherently unattractive. In exchange for limited rights to share in future earning power, the bondholder obtains a prior claim on cash generated by the borrower and a definite promise of repayment at a stated date. Profitable growth will bring confidence to the investor but no material increase in return. The deterioration of profitability, however, will bring both anxiety and a downward market valuation of the issue.2
Why would a downward deterioration in profitability not bring even greater anxiety and even greater downward market valuation to the holders of that company’s common stock issue? As a matter of fact, if the bond is adequately secured or otherwise well covenanted, no money defaults might occur, and bondholders would feel no anxiety about holding the debt instrument regardless of market price. Sophisticated bondholders would probably conclude that they were incapable of predicting bond prices in OPMI markets for lower-rated issues to begin with; most people involved with value investing would certainly so conclude.
Graham and Dodd were probably right that there is a large amount of market risk for outside passive minority investors (OPMIs) in holding the bonds of debtors experiencing deteriorating profitability. It seems obvious, however, that great investment opportunities are created when market risk is ignored and investment risk is examined and guarded against. Assuming good covenant protections, is the bond form not inherently attractive when purchases occur after a downward market valuation caused by anxiety and a deterioration in profitability? Were investors unwilling to ignore market risk, they would miss opportunities to acquire debt instruments that seem utterly devoid of investment risk (e.g., the GMAC senior unsecured debentures in 2009 selling at a yield to maturity of around 50 percent). The investment analysis of the GMAC Debentures revolved around the fact that it would have been utterly unreasonable to conclude that these issues were being acquired at prices that represented a market bottom or even anything close to a market bottom, because the OPMI consensus, which could have proved right, was that the near-term outlooks were horrible and that GMAC, as an operation, was in deep trouble.
THERE IS NO GENERAL RISK—ONLY SPECIFIC RISK
In fundamental finance, the word risk is always modified by an adjective. There is no general risk. There is market risk, investment risk, interest rate risk, inflation risk, failure to match maturities risk, securities fraud risk, excessive promoters’ compensation risk, and so on.
In value analysis, the tendency is to guard against investment risk, the prospect that things will go wrong for the business in which the activist has invested or in the securities issued by that business. Market risk, the prospect for price fluctuations in OPMI markets, is usually ignored. Put otherwise, the value analyst, in examining the risks in an investment, worries about permanent impairments of capital but not about unrealized market losses or a reduction in the amount of unrealized market profits.
The analysis of Kmart Debentures and Kmart Trade Claims (together, Kmart Credits) at the end of 1995 serves as a good example of the difference between investment risk and market risk. In late 1995, it seemed impossible to predict whether Kmart would seek reorganization under Chapter 11 of the U.S. bankruptcy code. It seemed a certainty that if Chapter 11 relief were sought, interest payments would stop and there would be no 18 percent yield-to-maturity. Further, the probability seemed to be that Kmart Credits would sell in the OPMI market at dollar prices well below the existing prices of around $74, if for no other reason than that the holders of debentures relying on interest income, which would no longer be paid, would dump their holdings by immediate sale into the OPMI market. Thus, Kmart Credits seemed to carry a high degree of market risk.
Despite the existence of market risk, however, Kmart Credits seemed to carry little or no investment risk. If Kmart did not file in Chapter 11, Kmart Credits would continue to be performing loans, affording a yield-to-maturity 700 to 900 basis points above comparable credits. Furthermore, it appeared that if Kmart were to file for Chapter 11 relief, the company would be readily reorganizable, and since Kmart Credits were, in effect, the most senior issue of Kmart, the holders of Kmart Credits seemed bound to receive, in a Chapter 11 reorganization, a value in new Kmart securities of not less than 100—more likely 100-plus accrued post–Chapter 11 interest.
The previous analysis is in sharp contrast to what Graham and Dodd recommended as the theoretically correct procedure for bond investment in an approach focused on market risk rather than on investment risk. Graham and Dodd stated, on page 310 of the 1962 edition of Security Analysis, that “safety is measured not by specific lien or other contractual rights, but by the ability of the issuer to meet all its obligations,” a valid statement if one is focused on market risk rather than investment risk. On page 313, they went on to say that “the theoretically correct procedure for bond investment, therefore, is first to select a company meeting every test of strength and soundness, and then to purchase its highest-yielding obligation,”3 which would usually mean its junior rather than its first-lien bonds. In value investing, there might be some merit to buying the junior issue only if the analyst were in a position to determine that a creditworthy company would continue to remain creditworthy until after the bond owned matured. Almost no one is that good at predicting future corporate outlooks. Moreover, many—if not most—companies issue junior debt and preferred obligations (i.e., mezzanine securities) because of senior lender requirements that the businesses have expanded borrowing bases. Put otherwise, if these companies were so creditworthy to begin with, they might never have issued mezzanine securities in the first place.
Fundamental finance investors involved in credit analysis are covenant driven, the exact opposite of Graham and Dodd investors.
EXAMPLE
From 1992 to 1997, Eljer Industries Secured Bank Debt represented a good example of the importance of covenants. Eljer Bank Debt was a performing loan secured by virtually all the assets of Eljer and its subsidiaries. A principal subsidiary of Eljer, U.S. Brass, had filed for Chapter 11 relief, however, and it remained theoretically possible that a huge amount of product liability claims would be perfected against Eljer. If so, those claims would become unsecured obligations, junior to Eljer Bank Debt. Overall coverage for Eljer obligations could have become quite weak; furthermore, there might even have been some market risk in holding Eljer Bank Debt. Given its senior secured position, however, it was hard to figure out how the Eljer Bank Debt would not be made whole, no matter what course the subsidiary’s Chapter 11 took.
THE COMPONENTS OF INVESTMENT RISK
The result of the previous discussion is that for analytical purposes investment risk for a security has three components:
The analysis of the GMAC credits focused on all of these. GMAC appeared to be readily reorganizable (quality of the issuer), in the event of a money default the credits were the most senior GMAC issue (terms of the issue), and they could be bought at prices that provided an adequate margin of safety and total return (price of the issue).
When the focus is on quality of the issuer and terms of the issue only, as is a basic precept of academic finance, a risk-to-reward ratio comes into existence. For academic finance, the higher the quality of the issuer and the more senior the terms of the issue, the less risk of loss the investor is taking. Also, the higher the quality of the issuer and the more senior the terms of the issue, the less the rewards are likely to be for the investor, thus the risk-to-reward ratio.
For academic finance, the price of the issue as it trades in OPMI markets reflects a universal price equilibrium; that is, it is the correct price for all purposes and all participants. Insofar as the price of the issue is too high or too low, however, no risk-to-reward ratio exists; it cannot exist. Suppose the price is too low. That means that the issue carries a reduced risk of loss and an enhanced potential for reward. In value investing, there usually is no risk-to-reward ratio simply because price of the issue becomes so important that it outweighs the risk-to-reward equation that appears to be valid insofar as an analysis is based on an assumption of the existence of a price equilibrium, so that the only factors to weigh are quality of the issuer and the terms of the issue.
SUCCESSFUL PEOPLE AVOID INVESTMENT RISK
In the book The Great Risk Shift (Oxford University Press, 2006), Jacob S. Hacker, a political science professor at Yale University, discusses how in recent years various risks—job risk, family stability risk, retirement risk, and health care risk—have been shifted increasingly from corporations and governments onto the backs of individuals. The raison d’être for the great risk shift is to foster the creation of an ownership society where the beneficiaries of, say, pension plans and health plans take the risks that go with ownership by being responsible for investing funds with no guarantees of minimum returns. What the proponents of this type of ownership risk fail to recognize is that the most successful owners don’t take risks. They lay off the risks onto someone else. Put simply, the vast majority of great individual fortunes built in this country, especially by Wall Streeters and corporate executives, were not built by people who took investment risks. Rather, the secret to building a great fortune is to avoid, as completely as possible, the taking of any investment risk. In terms of understanding corporate finance, economists have it all wrong when they say, “There is no free lunch.” Rather, the more appropriate comment ought to be “Somebody has to pay for lunch—and it isn’t going to be me.”
As we have discussed, investment risk consists of factors peculiar to a business itself or to the securities issued by that business. Investment risk is a risk separate and apart from market risk. Market risk involves fluctuations in the prices of securities and other readily tradable assets. A directory of those in the financial community who build great fortunes by avoiding investment risk includes the following:
METHODS TO AVOID INVESTMENT RISK
As an OPMI, it seems impossible to avoid investment risk altogether. The methods by which OPMIs can attempt to alleviate investment risk are:
SAFE AND CHEAP INVESTING AND MINIMIZING INVESTMENT RISK
The standards used to minimize investment risk limit the selection of attractive securities. Adherence to the safe and cheap approach4 results in missing many investment opportunities where securities are attractively priced by standards other than those used by value investors. In following the approach, an investor, whether activist or an OPMI, will forgo many equity investments regardless of price if they do not meet all essential conditions for safety.
Conditions for an issuer to be safe include:
EXAMPLE
An emphasis on financial position could prevent one from investing:
This does not mean that at certain prices such securities are not very attractive investments for many. They just do not happen to be attractive for us.
Under the safe and cheap approach, securities of issuers controlled by those believed to be predators should be avoided, regardless of price, by both activists and outsiders. The securities avoided are both equities and debt instruments. Significant clues as to whom the predators might be are publicly available from documents filed with the SEC. Especially pertinent in these documents are disclosures about management remuneration, and transactions between the company and insiders. These disclosures are contained either in the annual-meeting proxy statement or in Part II of the 10-K Annual Report. Disclosures about “litigation” in Part I of the 10-K Annual Report, Part II of the 10-Q Quarterly Report and in footnotes to audited financial statements can also give valuable clues to the caliber of management and control groups. Disclosure of grievances by creditors or securities holders that culminate in lawsuits brought against companies and insiders should serve as warnings that a particular company may not be a satisfactory investment using an investment risk minimization approach.
Those using the approach restrict investments to situations where considerable knowledge about companies can be obtained. This is true for both control and non-control investors. While reliance on public information only is sufficient—or even more than sufficient for certain types of investments, such as investment companies registered under the Investment Act of 1940 and public utilities—in other areas required public information frequently provides insufficient data for making intelligent decisions, as is usually the case when a company is engaged primarily in mineral exploration activities.
There is a close correlation between the usefulness of financial accounting and the usefulness of public disclosures as tools for making investment decisions. As accounting becomes more reliable, so do required public disclosures.
Most important, since the control and non-control groups value using the same standards, there tend to be clear conflicts of interest between insiders and outsiders. Insiders sometimes will create additional values for themselves by forcing out outsiders via the corporation’s proxy machinery that they control, by short-form mergers, or by the use of coercive tender offers. Force-outs sometimes can be at extremely low prices, because the insiders, by their actions (or lack of actions), have contributed to the depression of stock prices.
This conflict of interest presents a realistic threat that limits the appeal of a number of equity securities that would otherwise seem attractive using our approach. Although attempted force-outs at prices we would consider unconscionably low are relatively infrequent, they do happen.
EXAMPLE*
Wilmington Trust had three core businesses: (1) regional banking (primarily commercial and retail banking in the mid-Atlantic region); (2) wealth advisory (wealth preservation, transfer and estate planning services for high net worth individuals); and (3) corporate client services (asset administration and management, trustee and agency services for institutional clients). Wilmington also owned 80 percent of value equity manager Cramer Rosenthal McGlynn and 40 percent of growth manager Roxbury.
The company came under financial pressure in the wake of the 2008–2009 credit crisis owing to problems in its construction and mortgage loan books. Anticipating credit issues and the need for shoring up its capital base in Q4 2008 the company had issued preferred stock along with warrants and a small amount of common stock. In May 2010 Wilmington had hired an outside consultancy to review its loan book and to assist it with a full-scope regulatory exam slated to begin in late June. By September 2010, Wilmington appeared to have adequate liquidity at the holding company level and a modest amount of excess capital at the regulated banking subsidiary. Wilmington seemed to be adequately capitalized for regulatory purposes even under stress-case scenarios of heavy losses in the loan book. A sum-of-the-parts analysis suggested a range of value for the common stock from $8 to $14.
By October 2010 market rumors suggested that Wilmington had been contacting buyers, including a number of Canadian banks and was separately looking to raise capital from private investors to shore up its balance sheet. On November 1, 2010, Wilmington announced that it had agreed to sell itself to M&T Bank of Buffalo in a stock deal that valued Wilmington Common at $3.84, translating to a 46 percent discount to the previous week’s market price.
The deal valuation apparently surprised many observers who suggested that M&T was able to steal Wilmington. M&T management maintained that the deal was struck at pro forma tangible book value (pro forma for anticipated credit losses). Underestimating “regulatory risk” was one main failure of the analysis. In the early days following the Credit Crisis, the Feds seemed to care little about shareholders’ interests or economic values but wanted to protect depositors at all costs. When the Feds told the management team of a regulated entity to do the deal, managements like Wilmington’s had no alternative. In this case, M&T offer appeared to ascribe no value to Wilmington’s non-banking business and affiliated investment management businesses.
* This example was extracted from a report titled: “Takeunder Case Study—Wilmington Trust,” by Curtis Jensen, Third Avenue Management, August 2012.
SUMMARY
In fundamental finance, the word risk is always modified by an adjective. There is no general risk. There is market risk, investment risk, interest rate risk, inflation risk, failure to match maturities risk, securities fraud risk, excessive promoters’ compensation risk, and so on. In value analysis, the tendency is to guard against investment risk, the prospect that things will go wrong for the business in which the activist has invested or in the securities issued by that business. Market risk, the prospect for price fluctuations in OPMI markets, is usually ignored. Great investment opportunities are created when market risk is ignored and investment risk is examined and guarded against. For analytical purposes investment risk for a security is a function of three factors: the quality of the issuer, the terms of the issue, and the price of the issue. Even though it is almost impossible to avoid investment risk altogether as an OPMI, we provide a list of methods by which an OPMI can attempt to alleviate this type of risk.
1 This chapter contains original material, and parts of the chapter are based on ideas contained in the 1999 4Q, 2003 4Q, 2006 2Q, 2007 2Q letters to shareholders.
2 Benjamin Graham, David L. Dodd, Sidney Cottle, Roger F. Murray, and Frank E. Block, Graham and Dodd’s Security Analysis, Fifth Edition, (New York: McGraw-Hill, 1988).
3 emphasis added
4 The approach is discussed at length in Chapter 15.