margin of safety seth klarman
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8/13/2019 Margin of Safety Seth Klarman
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MARGIN OF SAFETY Risk-Averse Value Investing Strategies for the Thoughtful Investor
Seth A. KlarmanHarperBusiness
A Division of Harper Colllins Publishers
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Contents
Acknowledgments ix
Introduction xiii
I Where Most Investors Stumble 1
1 Speculators and Unsuccessful Investors 3
2 The Nature of Wall Street Works Against Investors 1
3 The Institutional !erfor"ance #er$%& The 'lient Is the (oser 3)
* #elusions of +alue& The ,%ths and ,isconceptions of -unk Bonds in the 1./s ))
II A alue!Investment "h#loso$h% &'
) #efining 0our Invest"ent oals .1
+alue Investing& The I"portance of a ,argin of Safet% .
At the 4oot of a +alue5Invest"ent !hilosoph% 1/)
. The Art of Business +aluation 11.
III The alue!Investment "ro(ess 1)'
Invest"ent 4esearch& The 'hallenge of 6inding Attractive Invest"ents 1)1
1/ Areas of 7pportunit% for +alue Investors& 'atal%sts8 ,arket Inefficiencies8 and Institutional 'onstraints12
11 Investing in Thrift 'onversions 1.2
12 Investing in 6inanciall% #istressed and Bankrupt Securities 1.
13 !ortfolio ,anage"ent and Trading 2/
1* Invest"ent Alternatives for the Individual Investor 222
Glossary **'
ibliography *)1Index *)+
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A(,no-le/ments
While al9a%s interested in the 9orkings of Wall Street8 I 9as e:tre"el% fortunate in
"% first real ;o$ to have the opportunit% to 9ork alongside ,ichael !rice and the late
,a: (< Heine at ,utual Shares 'orporation =no9 ,utual Series 6und8 Inc<>5 ,% uncle
!aul 6ried"an al9a%s encouraged "% interest in investing and helped "e land that
;o$< I look $ack on "% e:perience at ,utual Shares ver% fondl%< ,% learning in the
t9o %ears 9orking 9ith ,a: and ,ike pro$a$l% eclipsed 9hat I learned in the
su$se?uent t9o %ears at Harvard Business School< It is to ,a:@s "e"or% that I
dedicate this $ook<
After earning "% ,BA at Harvard8 I 9as faced 9ith several e:citing career
choices< The unconventional offer to ;oin a startup invest"ent5"anage"ent fir" in
'a"$ridge8 ,assachusetts8 presented the opportunit% to $egin $uilding an
invest"ent track record earl% in "% career< And so it 9as that I ;oined Bill !oorvu8
Isaac Auer$ach8 -ordan Baruch8 Ho9ard Stevenson8 and -o5An Bos9orth in for"ing
the Baupost roup< ach of "% colleaguesHo9ard in particular9ent out on a
long8 thin li"$ to $et on "e and "% a$ilities8 not onl% to "anage their o9n "one%
$ut also that of their fa"ilies and close friends8 9hich 9as perhaps the greater act of
faith< It has $een "% great privilege to $e associated 9ith such kno9ledgea$le8
energetic8 9ar"8 and caring people< Together 9e have $uilt so"ething to $e proud
of<
It has also $een a privilege to 9ork alongside !aul 7@(ear%8 #avid A$ra"s8 and no9
To" Cnott8 "% $rilliant and dedicated
i:
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0 ACKNOWE2GMENTS
invest"ent tea" and in5house dou$les ga"e< I a" grateful to each of the" for his
"an% insights and o$servations8 a nu"$er of 9hich appear in one for" or another in
this 9ork<
I a" also fortunate to have so"e of the finest clients a professional investor could
have< A nu"$er of the" encouraged "e in this endeavor< While I shall respect their
privac% $% not na"ing the"8 their patience8 interest8 and support have $een ke%
ele"ents in our invest"ent success<
,% nine %ears at Baupost have $rought "e into contact 9ith "an% of the
finest people in the invest"ent $usiness8 on $oth the $u% side and the sell side< I a"
grateful to each of the" for teaching "e so "uch a$out this $usiness and for putting
up 9ith "e 9hen I 9as having a $ad da%< Though the% are too nu"erous to thank
individuall%8 I o9e each of the" a great deal<
I do 9ish to thank the people 9ho have $een especiall% helpful 9ith this pro;ect< ,%
colleagues at BaupostHo9ard8 #avid8 !aul8 and To"each revie9ed the
"anuscript as it neared co"pletion as did four special friends8 (ou (o9enstein8 #avid
#arst8 Henr% "erson8 and Bret 6ro"son< A nu"$er of other friends "ade ver%
helpful suggestions at earlier stages of this pro;ect< -ess 4avich8 in particular8 offered
"an% valua$le insights into the ;unk5$ond and $ankruptc% sections< 6inall%8 -i"
rant8 perhaps 9ithout realiDing it8 inspired "e to take on this challenge< I thank
each of the" for their help8 and far "ore i"portant8 I 9ill al9a%s cherish their
friendship<
,% 9ife8 Beth Clar"an8 offered the fresh perspective of a non5financial5
professional as she devotedl% read ever% chapter and "ade nu"erous helpful
reco""endations< She also "ade ever% acco""odation to help free up ti"e for "e
to devote to this pro;ect and urged "e to press on to co"pletion the "an% ti"es
9hen progress 9as slo9< I thank her for $eing a great 9ife and "other and "% $est
friend<
,% father8 Her$ Clar"an8 9as perhaps the "ost careful reader of "ultiple
drafts of this "anuscript< He is a true crafts"an of the art of 9riting8 and his
co""ents are literall% incorporated on ever% page of this $ook< I thank hi" for histre"endous assistance<
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Acknowledgments :i
I also 9ant to thank "% "other8 ,uriel Clar"an8 for teaching "e to ask ?uestions
and encouraging "e to discover the ans9ers<
6inall% I "ust ackno9ledge the e:traordinar% efforts of ,ark reen$erg8 "%
editor at HarperBusiness8 and ,itch Tuch"an8 "% develop"ental editor8 in i"provingthis "anuscript in so "an% 9a%s< I thank the" $oth for their help in seeing this
pro;ect to fruition< I also o9e thanks to ,artha -e9ett8 9ho "ade helpful co""ents
on an earl% draft8 and special thanks to +irginia S"ith8 9ho proposed this pro;ect out
of the $lue<
-ac?ui 6iorenDa8 ,ike Ha""ond8 and Susie Spero 9ere of enor"ous
assistance 9ith the t%ping and ret%ping of this "anuscript< Cathr%n !otts "ade
nu"erous editorial suggestions and helped to prepare the glossar%< 'arol%n
Beckedorff provided research assistance as needed<
As 9ith an% 9ork such as this8 full responsi$ilit% for errors "ust $e $orne $% the
author< I hope those that re"ain are "inor and fe9 in nu"$er<
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Introu(t#onInvestors adopt "an% different approaches that offer little or no real prospect of long5
ter" success and considera$le chance of su$stantial econo"ic loss< ,an% are not
coherent invest"ent progra"s at all $ut instead rese"$le speculation or outright
ga"$ling< Investors are fre?uentl% lured $% the prospect of ?uick and eas% gain and
fall victi" to the "an% fads of Wall Street< ,% goals in 9riting this $ook are t9ofold<
In the first section I identif% "an% of the pitfalls that face investors< B% highlighting
9here so "an% go 9rong8 I hope to help investors learn to avoid these losing
strategies<
6or the re"ainder of the $ook I reco""end one particular path for investors
to follo9a value5invest"ent philosoph%< +alue investing8 the strateg% of investing
in securities trading at an apprecia$le discount fro" underl%ing value8 has a long his5
tor% of delivering e:cellent invest"ent results 9ith ver% li"ited do9nside risk< This
$ook e:plains the philosoph% of value investing and8 perhaps "ore i"portantl%8 the
logic $ehind it in an atte"pt to de"onstrate 9h% it succeeds 9hile other approaches
fail<
I have chosen to $egin this $ook8 not 9ith a discussion of 9hat value investors
do right8 $ut 9ith an assess"ent of 9here other investors go 9rong8 for "an% "ore
investors lose their 9a% along the road to invest"ent success than reach their desti5
nation< It is eas% to stra% $ut a continuous effort to re"ain disciplined<
3
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4#v INTRO25CTION
Avoiding 9here others go 9rong is an i"portant step in achieving invest"ent
success< In fact8 it al"ost ensures it<
0ou "a% $e 9ondering8 as several of "% friends have8 9h% I 9ould 9rite a
$ook that could encourage "ore people to $eco"e value investors< #on@t I run the
risk of encouraging increased co"petition8 there$% reducing "% o9n invest"ent
returnsE !erhaps8 $ut I do not $elieve this 9ill happen< 6or one thing8 value investing
is not $eing discussed here for the first ti"e< While I have tried to $uild the case for it
so"e9hat differentl% fro" "% predecessors and 9hile "% precise philosoph% "a%
var% fro" that of other value investors8 a nu"$er of these vie9s have $een
e:pressed $efore8 nota$l% $% Ben;a"in raha" and #avid #odd8 9ho "ore than fift%
%ears ago 9rote !ecurity Analysis" regarded $% "an% as the $i$le of value investing<
That single 9ork has illu"inated the 9a% for generations of value investors< ,ore
recentl% raha" 9rote #he Intelligent Investor" a less acade"ic description of the
value5invest"ent process< Warren Buffett8 the chair"an of Berkshire Hatha9a%8 Inc<8
and a student of raha"8 is regarded as toda%@s "ost successful value investor< He
has 9ritten countless articles and shareholder and partnership letters that together
articulate his value5invest"ent philosoph% coherentl% and $rilliantl%< Investors 9ho
have failed to heed such 9ise counsel are unlikel% to listen to "e<
The truth is8 I a" pained $% the disastrous invest"ent results e:perienced $% great
nu"$ers of unsophisticated or undisciplined investors< If I can persuade ;ust a fe9 of
the" to avoid dangerous invest"ent strategies and adopt sound ones that are
designed to preserve and "aintain their hard5earned capital8 I 9ill $e satisfied< If I
should have a 9ider influence on investor $ehavior8 then I 9ould gladl% pa% the price
of a "odest di"inution in "% o9n invest"ent returns<
In an% event this $ook alone 9ill not turn an%one into a successful value investor<
+alue investing re?uires a great deal of hard 9ork8 unusuall% strict discipline8 and a
long5ter" invest"ent horiDon< 6e9 are 9illing and a$le to devote sufficient ti"e and
effort to $eco"e value investors8 and onl% a fraction of those have the proper "ind5
set to succeed<
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Introduction .
This $ook "ost certainl% does not provide a surefire for"ula for invest"ent
success< There is8 of course8 no such for"ula< 4ather this $ook is a $lueprint that8 if
carefull% follo9ed8 offers a good possi$ilit% of invest"ent success 9ith li"ited risk< I
$elieve this is as "uch as investors can reasona$l% hope for<Ideall% this 9ill $e considered8 not a $ook a$out investing8 $ut a $ook a$out
thinking a$out investing< (ike "ost eighth5grade alge$ra students8 so"e investors
"e"oriDe a fe9 for"ulas or rules and superficiall% appear co"petent $ut do not
reall% understand 9hat the% are doing< To achieve long5ter" success over "an%
financial "arket and econo"ic c%cles8 o$serving a fe9 rules is not enough< Too "an%
things change too ?uickl% in the invest"ent 9orld for that approach to succeed< It is
necessar% instead to understand the rationale $ehind the rules in order to appreciate
9h% the% 9ork 9hen the% do and don@t 9hen the% don@t< I could si"pl% assert that
value investing 9orks8 $ut I hope to sho9 %ou why it 9orks and 9h% "ost other
approaches do not<
If interplanetar% visitors landed on arth and e:a"ined the 9orkings of our financial
"arkets and the $ehavior of financial5"arket participants8 the% 9ould no dou$t
?uestion the intelligence of the planet@s inha$itants< Wall Street8 the financial
"arketplace 9here capital is allocated 9orld9ide8 is in "an% 9a%s ;ust a gigantic
casino< The recipient of up5front fees on ever% transaction8 Wall Street clearl% is "ore
concerned 9ith the volu"e of activit% than its econo"ic utilit%< !ension and
endo9"ent funds responsi$le for the securit% and enhance"ent of long5ter"
retire"ent8 educational8 and philanthropic resources e"plo% invest"ent "anagers
9ho freneticall% trade long5ter" securities on a ver% short5ter" $asis8 each tr%ing to
outguess and conse?uentl% outperfor" others doing the sa"e thing< In addition8
hundreds of $illions of dollars are invested in virtual or co"plete ignorance of
underl%ing $usiness funda"entals8 often using inde:ing strategies designed to avoid
significant underperfor"ance at the cost of assured "ediocrit%<
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4# INTRO25CTION
Individual and institutional investors alike fre?uentl% de"onstrate an ina$ilit%
to "ake long5ter" invest"ent deci sions $ased on $usiness funda"entals < There are
a nu"$er of reasons for this& a"ong the" the perfor"ance pressures faced $%
institutional investors8 the co"pensation structure of Wall Street8 and the frenDied
at"osphere of the financial "arkets< As a result8 investors8 particularl% institutional
investors8 $eco"e en"eshed in a short5ter" relative5perfor"ance der$%8 9here$%
te"porar% price fluctuations $eco"e the do"inant focus< 4elative5perfor"ance5
oriented investors8 alread% focused on short5ter" returns8 fre?uentl% are attracted to
the latest "arket fads as a source of superior relative perfor"ance< The te"ptation
of "aking a fast $uck is great8 and "an% investors find it difficult to fight the cro9d<
Investors are so"eti"es their o9n 9orst ene"ies< When prices are generall%
rising8 for e:a"ple8 greed leads investors to speculate8 to "ake su$stantial8 high5risk
$ets $ased upon opti"istic predictions8 and to focus on return 9hile ignoring risk< At
the other end of the e"otional spectru"8 9hen prices are generall% falling8 fear of
loss causes investors to focus solel% on the possi$ilit% of continued price declines to
the e:clusion of invest"ent funda"entals< 4egardless of the "arket environ"ent8
"an% investors seek a for"ula for success< The unfortunate realit% is that invest"ent
success cannot $e captured in a "athe"atical e?uation or a co"puter progra"<
The first section of this $ook8 chapters 1 through *8 e:a"ines so"e of the places
9here investors stu"$le< 'hapter 1 e:plores the differences $et9een investing and
speculation and $et9een successful and unsuccessful investors8 e:a"ining in
particular the role of "arket price in investor $ehavior< 'hapter 2 looks at the 9a%
Wall Street8 9ith its short5ter" orientation8 conflicts of interest8 and up9ard $ias8
"a:i"iDes its o9n $est interests8 9hich are not necessaril% also those of investors<
'hapter 3 e:a"ines the $ehavior of institutional investors8 9ho have co"e to
do"inate toda%@s financial "arkets<
'hapter * uses the case stud% of ;unk $onds to illustrate "an% of the pitfallshighlighted in the first three chapters<
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Introduction 1/ The rapid gro9th of the "arket for ne9l% issued ;unk $onds 9as onl% "ade possi$le
$% the co"plicit% of investors 9ho suspended dis$elief< -unk5$ond $u%ers greedil%
accepted pro"ises of a free lunch and 9illingl% adopted ne9 and unproven "ethods
of anal%sis< Neither Wall Street nor the institutional invest"ent co""unit% o$;ected
vocall% to the 9idespread proliferation of these fla9ed instru"ents<
Investors "ust recogniDe that the ;unk5$ond "ania 9as not a once5in5a5
"illenniu" "adness $ut instead part of the historical e$$ and flo9 of investor
senti"ent $et9een greed and fear< The i"portant point is not "erel% that ;unk $onds
9ere fla9ed =although the% certainl% 9ere> $ut that investors "ust learn fro" this
ver% avoida$le de$acle to escape the ne:t enticing "arket fad that 9ill inevita$l%
co"e along<
A second i"portant reason to e:a"ine the $ehavior of other investors and
speculators is that their actions often inadvertentl% result in the creation of
opportunities for value investors< Institutional investors8 for e:a"ple8 fre?uentl% act
as lu"$ering $ehe"oths8 tra"pling so"e securities to large discounts fro"
underl%ing value even as the% ignore or constrain the"selves fro" $u%ing others<
Those the% decide to purchase the% $u% 9ith gustoF "an% of these favorites $eco"e
significantl% overvalued8 creating selling =and perhaps short5selling> opportunities<
Herds of individual investors acting in tande" can si"ilarl% $id up the prices of so"e
securities to craD% levels8 even as others are ignored or uncere"oniousl% du"ped<
A$etted $% Wall Street $rokers and invest"ent $ankers8 "an% individual as 9ell as
institutional investors either ignore or deli$eratel% disregard underl%ing $usinessvalue8 instead regarding stocks solel% as pieces of paper to $e traded $ack and forth<
The disregard for invest"ent funda"entals so"eti"es affects the entire stock
"arket< 'onsider8 for e:a"ple8 the enor"ous surge in share prices $et9een -anuar%
and August of 1. and the ensuing "arket crash in 7cto$er of that %ear< In the
9ords of Willia" 4uane and 4ichard 'unniff8 chair"an and
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11 INTRO25CTION
president of the Se?uoia 6und8 Inc<8 G#isregarding for the "o"ent 9hether the
prevailing level of stock prices on -anuar% 18 1. 9as logical8 9e are certain that the
value of A"erican industr% in the aggregate had not increased $% ** as of August
2)< Si"ilarl%8 it is highl% unlikel% that the value of A"erican industr% declined $% 23
on a single da%8 7cto$er 1<G1
Ulti"atel% investors "ust choose sides< 7ne sidethe 9rong choiceis a
see"ingl% effortless path that offers the co"fort of consensus< This course involves
succu"$ing to the forces that guide "ost "arket participants8 e"otional responses
dictated $% greed and fear and a short5ter" orientation e"anating fro" the relative5
perfor"ance der$%< Investors follo9ing this road increasingl% think of stocks like
so9$ellies8 as co""odities to $e $ought and sold< This ulti"atel% re?uires investors
to spend their ti"e guessing 9hat other "arket participants "a% do and then tr%ing
to do it first< The pro$le" is that the e:citing possi$ilit% of high near5ter" returns
fro" pla%ing the stocks5as5pieces5of5paper5that5%ou5trade ga"e $linds investors to
its foolishness<
The correct choice for investors is o$vious $ut re?uires a level of co""it"ent
"ost are un9illing to "ake< This choice is kno9n as funda"ental anal%sis8 9here$%
stocks are regarded as fractional o9nership of the underl%ing $usinesses that the%
represent< 7ne for" of funda"ental anal%sisand the strateg% that I reco""endis
an invest"ent approach kno9n as value investing<
There is nothing esoteric a$out value investing< It is si"pl% the process of
deter"ining the value underl%ing a securit% and then $u%ing it at a considera$le
discount fro" that value< It is reall% that si"ple< The greatest challenge is
"aintaining the re?uisite patience and discipline to $u% onl% 9hen prices are
attractive and to sell 9hen the% are not8 avoiding the short5ter" perfor"ance frenD%
that engulfs "ost "arket participants<
The focus of "ost investors differs fro" that of value investors< ,ost investors
are pri"aril% oriented to9ard return8 ho9 "uch the% can "ake8 and pa% little
attention to risk8 ho9 "uch the% can lose<
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Introduction 1* Throughout this $ook I criticiDe certain aspects of the invest"ent $usiness as
currentl% practiced< ,an% of these criticis"s of the industr% appear as
generaliDations and refer "ore to the pressures $rought a$out $% the structure of the
invest"ent $usiness than the failings of the individuals 9ithin it<
I also give nu"erous e:a"ples of specific invest"ents throughout this $ook<
,an% of the" 9ere "ade over the past nine %ears $% "% fir" for the $enefit of our
clients and indeed proved ?uite profita$le< The fact that 9e "ade "one% on the" is
not the point8 ho9ever< ,% goal in including the" is to de"onstrate the variet% of
value5invest"ent opportunities that have arisen and $eco"e kno9n to "e during the
past decadeF an e?uall% long and rich list of e:a"ples failed to "ake it into the final
"anuscript<
I find value investing to $e a sti"ulating8 intellectuall% challenging8 ever
changing8 and financiall% re9arding discipline< I hope %ou invest the ti"e to
understand 9h% I find it so in the pages that follo9<
Notes1< Se?uoia 6und8 Inc<8 third ?uarter report for 1.<
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IW6ERE MOST INESTORS
ST5M7E
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1 W6ERE MOST INESTORS ST5M7E
Investors in a stock thus e:pect to profit in at least one of three possi$le 9a%s& fro"
free cash flo9 generated $% the underl%ing $usiness8 9hich eventuall% 9ill $e
reflected in a higher share price or distri$uted as dividendsF fro" an increase in the
"ultiple that investors are 9illing to pa% for the underl%ing $usiness as reflected in ahigher share priceF or $% a narro9 ing of the gap $et9een share price and underl%ing
$usiness value<
Speculators8 $% contrast8 $u% and sell securities $ased on 9hether the%
$elieve those securities 9ill ne:t rise or fall in price< Their ;udg"ent regarding future
price "ove"ents is $ased8 not on funda"entals8 $ut on a prediction of the $ehavior
of others< The% regard securities as pieces of paper to $e s9apped $ack and forth
and are generall% ignorant of or indifferent to invest"ent funda"entals< The% $u%
securities $ecause the% GactG 9ell and sell 9hen the% don@t< Indeed8 even if it 9ere
certain that the 9orld 9ould end to"orro98 it is likel% that so"e speculators 9ould
continue to trade securities $ased on 9hat the% thought the "arket 9ould do toda%<
Speculators are o$sessed 9ith predictingguessingthe direction of stock
prices< ver% "orning on ca$le television8 ever% afternoon on the stock "arket
report8 ever% 9eekend in arron$s" ever% 9eek in doDens of "arket ne9sletters8 and
9henever $usinesspeople get together8 there is ra"pant con;ecture on 9here the
"arket is heading< ,an% speculators atte"pt to predict the "arket direction $% using
technical anal%sis past stock price fluctuationsas a guide< Technical anal%sis is
$ased on the presu"ption that past share price "eanderings8 rather than underl%ing
$usiness value8 hold the ke% to future stock prices< In realit%8 no one kno9s 9hat the
"arket 9ill doF tr%ing to predict it is a 9aste of ti"e8 and investing $ased upon that
prediction is a speculative undertaking<
,arket participants do not 9ear $adges that identif% the" as investors or
speculators< It is so"eti"es difficult to tell the t9o apart 9ithout stud%ing their
$ehavior at length< :a"ining 9hat the% o9n is not a givea9a%8 for an% securit% can
$e o9ned $% investors8 speculators8 or $oth< Indeed8 "an% Ginvest"ent
professionalsG actuall% perfor" as speculators "uch of the ti"e
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!peculators and %nsuccessful Investors &'
$ecause of the 9a% the% define their "ission8 pursuing short5ter" trading profits
fro" predictions of "arket fluctuations rather than long5ter" invest"ent profits
$ased on $usiness funda"entals< As 9e shall see8 investors have a reasona$le
chance of achieving long5ter" invest"ent successF speculators8 $% contrast8 are
likel% to lose "one% over ti"e<
Tra#n/ Sar#nes an Eat#n/ Sar#nes9The Essen(e o8 S$e(ulat#on
There is the old stor% a$out the "arket craDe in sardine trading 9hen the sardines
disappeared fro" their traditional 9aters in ,ontere%8 'alifornia< The co""odit%
traders $id the" up and the price of a can of sardines soared< 7ne da% a $u%er
decided to treat hi"self to an e:pensive "eal and actuall% opened a can and started
eating< He i""ediatel% $eca"e ill and told the seller the sardines 9ere no good< The
seller said8 G0ou don@t understand< These are not eating sardines8 the% are trading
sardines<G
(ike sardine traders8 "an% financial5"arket participants are attracted to
speculation8 never $othering to taste the sardines the% are trading< Speculation
offers the prospect of instant gratificationF 9h% get rich slo9l% if %ou can get rich
?uickl%E ,oreover8 speculation involves going along 9ith the cro9d8 not against it<
There is co"fort in consensusF those in the "a;orit% gain confidence fro" their ver%
nu"$er<
Toda% "an% financial5"arket participants8 kno9ingl% or unkno9ingl%8 have
$eco"e speculators< The% "a% not even realiDe that the% are pla%ing a Ggreater5fool
ga"e8G $u%ing overvalued securities and e:pectinghopingto find so"eone8 a
greater fool8 to $u% fro" the" at a still higher price<
There is great allure to treating stocks as pieces of paper that trade< +ie9ing
stocks this 9a% re?uires neither rigorous anal%sis nor kno9ledge of the underl%ing
$usinesses< ,oreover8 trading in and of itself can $e e:citing and8 as long as the "ar5
ket is rising8 lucrative< But essentiall% it is speculating8 not investing< 0ou "a% find a
$u%er at a higher price a greater foolor %ou "a% not8 in 9hich case %ou %ourself
are the greater fool<
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1 W6ERE MOST INESTORS ST5M7E
+alue investors pa% attention to financial realit% in "aking their invest"ent
decisions< Speculators have no such tether< Since "an% of toda%@s "arket
participants are speculators and not investors8 $usiness funda"entals are not
necessaril% a li"iting factor in securities pricing< The resulting propensit% of the stock"arket to periodicall% $eco"e and re"ain overvalued is all the "ore reason for
funda"ental investors to $e careful8 avoiding an% overpriced invest"ents that 9ill
re?uire selling to another8 even greater fool<
Speculative activit% can erupt on Wall Street at an% ti"e and is not usuall%
recogniDed as such until considera$le ti"e has passed and "uch "one% has $een
lost< In the "iddle of 1.38 to cite one e:a"ple8 the capital "arkets assigned a
co"$ined "arket value of over ) $illion to t9elve pu$licl% traded8 venture5capital5
$acked Winchester disk5drive "anufacturers< Bet9een 1 and 1.* fort%5three
different "anufacturers of Winchester disk drives received venture5capital financing<
A Harvard Business School stud% entitled G'apital ,arket ,%opiaG2 calculated that
industr% funda"entals =as of "id51.3> could not then nor in the foreseea$le future
have ;ustified the total "arket capitaliDation of these co"panies< The stud%
deter"ined that a fe9 fir"s "ight ulti"atel% succeed and do"inate the industr%8
9hile "an% of the others 9ould struggle or fail< The high potential returns fro" the
9inners8 if an% e"erged8 9ould not offset the losses fro" the others< While investors
at the ti"e "a% not have realiDed it8 the shares of these disk5drive co"panies 9ere
essentiall% Gtrading sardines<G This speculative $u$$le $urst soon thereafter8 9ith the
total "arket capitaliDation of these co"panies declining fro" )<* $illion in "id51.3
to 1<) $illion at %ear5end 1.*< Another e:a"ple of such speculative activit% took
place in Septe"$er 1.< The shares of the Spain 6und8 Inc<8 a closed5end "utual
fund investing in pu$licl% traded Spanish securities8 9ere $id up in price fro"
appro:i"atel% net asset value =NA+>the co"$ined "arket value of the underl%ing
invest"ents divided $% the nu"$er of shares outstandingto "ore than t9ice that
level< ,uch of the $u%ing e"anated fro" -apan8 9here underl%ing value 9as
evidentl% less i"portant to investors than other considerations<
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!peculators and %nsuccessful Investors ()
Although an identical portfolio to that o9ned $% the Spain 6und could have $een
freel% purchased on the Spanish stock "arket for half the price of Spain 6und shares8
these -apanese speculators 9ere not deterred< The Spain 6und priced at t9ice net
asset value 9as another e:a"ple of trading sardinesF the onl% possi$le reason for
$u%ing the Spain 6und rather than the underl%ing securities 9as the $elief that its
shares 9ould appreciate to an even "ore overpriced level< Within "onths of the
speculative advance the share price plunged $ack to pre5rall% levels8 once again
appro:i"ating the NA+8 9hich itself had never significantl% fluctuated<
6or still another e:a"ple of speculation on Wall Street8 consider the U<S<
govern"ent $ond "arket in 9hich traders $u% and sell $illions of dollars@ 9orth of
thirt%5%ear U<S< Treasur% $onds ever% da%< ven long5ter" investors seldo" hold
thirt%5%ear govern"ent $onds to "aturit%< According to Al$ert Wo;nilo9er8 the
average holding period of U<S< Treasur% $onds 9ith "aturities of ten %ears or "ore is
onl% t9ent% da%s<3 !rofessional traders and so5called investors alike priDe thirt%5%ear
Treasur% $onds for their li?uidit% and use the" to speculate on short5ter" interest
rate "ove"ents8 9hile never conte"plating the prospect of actuall% holding the" to
"aturit%< 0et so"eone 9ho $u%s long5ter" securities intending to ?uickl% resell
rather than hold is a speculator8 and thirt%5%ear Treasur% $onds have also effectivel%
$eco"e trading sardines< We can all 9onder 9hat 9ould happen if the thirt%5%ear
Treasur% $ond fell fro" favor as a speculative vehicle8 causing these short5ter"
holders to rush to sell at once and turning thirt%5%ear Treasur% $onds $ack into eatingsardines<
Investments an S$e(ulat#ons
-ust as financial5"arket participants can $e divided into t9o groups8 investors
and speculators8 assets and securities can often $e characteriDed as either
invest"ents or speculations<
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21 W6ERE MOST INESTORS ST5M7E
The distinction is not clear to "ost people< Both invest"ents and speculations can $e
$ought and sold< Both t%picall% fluctu ate in price and can thus appear to generate
invest"ent returns< But there is one critical difference& invest"ents thro9 off cash
flo9 for the $enefit of the o9nersF speculations do not<
*
The% return to the o9ners ofspeculations depends e:clusivel% on the vagaries of the resale "arket<
The greed% tendenc% to 9ant to o9n an%thing that has recentl% $een rising in
price lures "an% people into purchasing speculations< Stocks and $onds go up and
do9n in price8 as do ,onets and ,icke% ,antle rookie cards8 $ut there should $e no
confusion as to 9hich are the true invest"ents< 'ollecti$les8 such as art8 anti?ues8
rare coins8 and $ase$all cards8 are not invest"ents8 $ut rank speculations< This "a%
not $e of conse?uence to the 'hase ,anhattan Bank8 9hich in the late 1./s for"ed
a fund for its clients to invest in art8 or to #avid (< !aul8 for"er chair"an of the no9
insolvent 'enTrust Savings and (oan Association8 9ho spent 13 "illion of the thrift@s
"one% to purchase ;ust one painting< ven Wall Street8 9hich kno9s $etter8 chooses
at ti"es to $lur the distinction< Salo"on Brothers8 for e:a"ple8 no9 pu$lishes the
rate of return on various asset classes8 including in the sa"e list U<S< Treasur% $ills8
stocks8 i"pressionist and old "aster paintings8 and 'hinese cera"ics< In Salo"on@s
-une 1. rankings the latter categories 9ere ranked at the top of the list8 far
outdistancing the returns fro" true invest"ents<
Invest"ents8 even ver% long5ter" invest"ents like ne9l% planted ti"$er
properties8 9ill eventuall% thro9 off cash flo9< A "achine "akes 9idgets that are
"arketed8 a $uilding is occupied $% tenants 9ho pa% rent8 and trees on a ti"$er
propert% are eventuall% harvested and sold< B% contrast8 collecti$les thro9 off no
cash flo9F the onl% cash the% can generate is fro" their eventual sale< The future
$u%er is like9ise dependent on his or her o9n prospects for resale<
The value of collecti$les8 therefore8 fluctuates solel% 9ith suppl% and de"and<
'ollecti$les have not historicall% $een recogniDed as stores of value8 thus their prices
depend on the vagaries of taste8 9hich are certainl% su$;ect to change<
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!peculators and %nsuccessful Investors ((
The apparent value of collecti$les is $ased on circular reasoning& people $u% $ecause
others have recentl% $ought< This has the effect of $idding up prices8 9hich attracts
pu$licit% and creates the illusion of attractive returns< Such logic can fail at an% ti"e<
Invest"ent success re?uires an appropriate "ind5set< Investing is serious
$usiness8 not entertain"ent< If %ou participate in the financial "arkets at all8 it is
crucial to do so as an investor8 not as a speculator8 and to $e certain that %ou
understand the difference< Needless to sa%8 investors are a$le to distinguish !epsico
fro" !icasso and understand the difference $et9een an invest"ent and a collecti$le<
When %our hard5earned savings and future financial securit% are at stake8 the cost of
not distinguishing is unaccepta$l% high<
The 2#88eren(es bet-een Su((ess8ul an
5nsu((ess8ul Investors
Successful investors tend to $e une"otional8 allo9ing the greed and fear of others to
pla% into their hands< B% having confidence in their o9n anal%sis and ;udg"ent8 the%
respond to "arket forces not 9ith $lind e"otion $ut 9ith calculated reason<
Successful investors8 for e:a"ple8 de"onstrate caution in froth% "arkets and
steadfast conviction in panick% ones< Indeed8 the ver% 9a% an investor vie9s the
"arket and its price fluctuations is a ke% factor in his or her ulti"ate invest"entsuccess or 6ailure<
Taking Advantage of ,r< ,arket
I 9rote earlier that financial5"arket participants "ust choose $et9een
invest"ent and speculation< Those 9ho =9isel%> choose invest"ent are faced 9ith
another choice8 this ti"e $et9een t9o opposing vie9s of the financial "arkets< 7ne
vie98 9idel% held a"ong acade"ics and increasingl% a"ong institutional investors8
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23 W6ERE MOST INESTORS ST5M7E
is that the financial "arkets are efficient and that tr%ing to outperfor" the averages
is futile< ,atching the "arket return is the $est %ou can hope for< Those 9ho atte"pt
to outperfor" the "arket 9ill incur high transaction costs and ta:es8 causing the" to
underperfor" instead< The other vie9 is that so"e securities are inefficientl% priced8 creating
opportunities for investors to profit 9ith lo9 risk< This vie9 9as perhaps $est
e:pressed $% Ben;a"in raha"8 9ho posited the e:istence of a ,r< ,arket<) An ever
helpful fello98 ,r< ,arket stands read% ever% $usiness da% to $u% or sell a vast arra%
of securities in virtuall% li"itless ?uantities at prices that he sets< He provides this
valua$le service free of charge< So"eti"es ,r< ,arket sets prices at levels 9here
%ou 9ould neither 9ant to $u% nor sell< 6re?uentl%8 ho9ever8 he $eco"es irrational<
So"eti"es he is opti"istic and 9ill pa% far "ore than securities are 9orth< 7ther
ti"es he is pessi"istic8 offering to sell securities for considera$l% less than
underl%ing value< +alue investors9ho $u% at a discount fro" underl%ing valueare
in a position to take advantage of ,r< ,arket@s irrationalit%<
So"e investorsreall% speculators"istakenl% look to ,r< ,arket for
invest"ent guidance< The% o$serve hi" setting a lo9er price for a securit% and8
un"indful of his irrationalit%8 rush to sell their holdings8 ignoring their o9n
assess"ent of underl%ing value< 7ther ti"es the% see hi" raising prices and8 trusting
his lead8 $u% in at the higher figure as if he knew more than they* The realit% is that
,r< ,arket kno9s nothing8 $eing the product of the collective action of thousands of
$u%ers and sellers 9ho the"selves are not al9a%s "otivated $% invest"ent
funda"entals< "otional investors and speculators inevita$l% lose "one%F investors
9ho take advantage of ,r< ,arket@s peri odic irrationalit%8 $% contrast8 have a good
chance of en;o%ing long5ter" success<
,r< ,arket@s dail% fluctuations "a% see" to provide feed$ack for investors@
recent decisions< 6or a recent purchase decision rising prices provide positive
reinforce"entF falling prices8 negative reinforce"ent< If %ou $u% a stock that
su$se?uentl% rises in price8 it is eas% to allo9 the positive feed$ack provided $% ,r<
,arket to influence %our ;udg"ent<
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2) W6ERE MOST INESTORS ST5M7E
reflect $usiness realit% =or investor perceptions of that realit%> or to reflect short5ter"
variations in suppl% and de"and< 4ealit% can change in a nu"$er of 9a%s8 so"e
co"pan%5specific8 others "acroecono"ic in nature< If 'oca5'ola@s $usiness e:pands
or prospects i"prove and the stock price increases proportionall%8 the rise "a%si"pl% reflect an increase in $usiness value< If Aetna@s share price plunges 9hen a
hurricane causes $illions of dollars in catastrophic losses8 a decline in total "arket
value appro:i"atel% e?ual to the esti"ated losses "a% $e appropriate< When the
shares of 6und A"erican 'o"panies8 Inc<8 surge as a result of the une:pected
announce"ent of the sale of its "a;or su$sidiar%8 6ire"an@s 6und Insurance
'o"pan%8 at a ver% high price8 the price increase reflects the sudden and nearl%
co"plete realiDation of underl%ing value< 7n a "acroecono"ic level a $road5$ased
decline in interest rates8 a drop in corporate ta: rates8 or a rise in the e:pected rate
of econo"ic gro9th could each precipitate a general increase in securit% prices<
Securit% prices so"eti"es fluctuate8 not $ased on an% apparent changes in
realit%8 $ut on changes in investor perception< The shares of "an% $iotechnolog%
co"panies dou$led and tripled in the first "onths of 118 for e:a"ple despite a lack
of change in co"pan% or industr% funda"entals that could possi$l% have e:plained
that "agnitude of increase< The onl% e:planation for the price rise 9as that investors
9ere suddenl% 9illing to pa% "uch "ore than $efore to $u% the sa"e thing<
In the short run suppl% and de"and alone deter"ine "arket prices< If there
are "an% large sellers and fe9 $u%ers8 prices fall8 so"eti"es $e%ond reason< Suppl%5
and5de"and i"$alances can result fro" %ear5end ta: selling8 an institutional
sta"pede out of a stock that ;ust reported disappointing earnings8 or an unpleasant
ru"or< ,ost da%5to5da% "arket price fluctuations result fro" suppl%5and5de"and
variations rather than fro" funda"ental develop"ents<
Investors 9ill fre?uentl% not kno9 9h% securit% prices fluctuate< The% "a%
change $ecause of8 in the a$sence of8 or in co"plete indifference to changes in
underl%ing value< In the short run investor perception "a% $e as i"portant as realit%
itself in
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!peculators and %nsuccessful Investors 2
deter"ining securit% prices< It is never clear 9hich future events are anticipated $%
investors and thus alread% reflected in toda%@s securit% prices< Because securit%
prices can change for an% nu"$er of reasons and $ecause it is i"possi$le to kno9
9hat e:pectations are reflected in an% given price level8 investors "ust look $e%ond
securit% prices to underl%ing $usiness value8 al9a%s co"paring the t9o as part of
the invest"ent process<
5nsu((ess8ul Investors an The#r Costl% Emot#ons
Unsuccessful investors are do"inated $% e"otion< 4ather than responding cooll% and
rationall% to "arket fluctuations8 the% respond e"otionall% 9ith greed and fear< We
all kno9 people 9ho act 9ho act responsi$l% and deli$eratel% "ost of the ti"e $ut go$erserk 9hen investing "one%< It "a% take the" "an% "onths8 even %ears8 of hard
9ork and disciplined saving to accu"ulate
the "one% $ut onl% a fe9 "inutes to invest it< The sa"e people 9ould read several
consu"er pu$lications and visit nu"erous stores $efore purchasing a stereo or
ca"era %et spend little or no ti"e investigating the stock the% ;ust heard a$out fro"
a friend< 4ationalit% that is applied to the purchase of electronic or photo5graphic
e?uip"ent is a$sent 9hen it co"es to investing<
,an% unsuccessful investors regard the stock "arket as a 9a% to "ake
"one% 9ithout 9orking rather than as a 9a% to invest capital in order to earn a
decent return< An%one 9ould en;o% a ?uick and eas% profit8 and the prospect of an
effortless gain incites greed in investors< reed leads "an% investors to seek
shortcuts to invest"ent success< 4ather than allo9ing returns to co"pound over
ti"e8 the% atte"pt to turn ?uick profits $% acting on hot tips< The% do not stop to
consider ho9 the tipster could possi$l% $e in possession of valua$le infor"ation that
is not illegall% o$tained or 9h%8 if it is so valua$le8 it is $eing "ade availa$le to the"<
reed also "anifests itself as undue opti"is" or8 "ore su$tl%8 as co"placenc% in the
face of
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2 W6ERE MOST INESTORS ST5M7E
$ad ne9s< 6inall% greed can cause investors to shift their focus a9a% fro" the
achieve"ent of long5ter" invest"ent goals in favor of short5ter" speculation<
High levels of greed so"eti"es cause ne95era thinking to $e introduced $%
"arket participants to ;ustif% $u%ing or holding overvalued securities< 4easons aregiven as to 9h% this ti"e is different fro" an%thing that ca"e $efore< As the truth is
stretched8 investor $ehavior is carried to an e:tre"e< 'onservative assu"ptions are
revisited and revised in order to ;ustif% ever higher prices8 and a "ania can ensue< In
the short run resisting the "ania is not onl% ps%chologicall% $ut also financiall%
difficult as the participants "ake a lot of "one%8 at least on paper< Then8 predicta$l%8
the "ania reaches a peak8 is recogniDed for 9hat it is8 reverses course8 and turns into
a selling panic< reed gives 9a% to fear8 and investor losses can $e enor"ous<
As I discuss later in detail8 ;unk $onds 9ere definitel% such a "ania< !rior to
the 1./s the entire ;unk5$ond "arket consisted of onl% a fe9 $illion dollars of Gfallen
angels<G Although ne9l% issued ;unk $onds 9ere a 1./s invention and 9ere thus
untested over a full econo"ic c%cle8 the% $eca"e 9idel% accepted as a financial
innovation of great i"portance8 9ith total issuance e:ceeding 2// $illion< Bu%ers
greedil% departed fro" historical standards of $usiness valuation and credit9or5
thiness< ven after the $u$$le $urst8 "an% proponents stu$$ornl% clung to the
validit% of the concept<
Gree an the Y#el "#/s o8 the 1':;s
There are countless e:a"ples of investor greed in recent financial histor%<
6e98 ho9ever8 9ere as relentless as the decade5long Greach for %ieldG of the 1./s<
#ou$le5digit interest rates on U<S< govern"ent securities earl% in the decade 9hetted
investors@ appetites for high no"inal returns< When interest rates declined to single
digits8 "an% investors re"ained infatuated 9ith the attain"ent of higher %ields and
sacrificed credit ?ualit% to achieve the" either in the $ond "arket or in e?uities<
Cno9n
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!peculators and %nsuccessful Investors 2.
a"ong Wall Streeters as G%ield pigsG =or a nu"$er of "ore deris#ve na"es>8 such
individual and institutional investors 9ere suscepti$le to an% invest"ent product that
pro"ised a high rate of return< Wall Street responded 9ith gusto8 as Wall Street
tends to do 9hen there are fees to earn8 creating a variet% of instru"ents thatpro"ised high current %ields<
U<S< govern"ent securities are generall% regarded as Grisk5freeG invest"ents8
at least insofar as credit ?ualit% is concerned< To achieve current cash %ields
apprecia$l% a$ove those avail5a$le fro" U<S< govern"ent securities8 investors "ust
either risk the loss of principal or incur its certain depletion< (o95grade Securities8
such as ;unk $onds8 offer higher %ields than govern"ent $onds $ut at the risk of
principal loss< -unk5$ond "utual funds 9ere "arketed to investors in the 1./s
pri"aril% through the pro"ise of high current %ield< As 9ith a "agician perfor"ing
sleight of hand8 investors@ e%es 9ere focused al"ost e:clusivel% on the attractive
current %ield8 9hile the high principal I risk fro" defaults 9as hidden fro" vie9<
-unk $onds 9ere not the onl% slop served up to the %ield pigs of the 1./s<
Wall Street found "an% 9a%s to offer investors an enhanced current %ield $%
incorporating a return of the investors@ principal into the reported %ield< Ginnie
,aes8G 9hich are8 in fact8 high5grade securities8 are one such e:a"ple< These are
pools of "ortgages insured $% the overn"ent National ,ortgage Association
=N,A8 9hence innie ,ae>8 a US< govern"ent agenc%< N,A pools collect
"ortgage interest and principal pa%"ents fro" ho"eo9ners and distri$ute the" to
$ondholders< ver% "onth o9ners of N,As receive distri$utions that include $oth
interest inco"e and s"all principal repa%"ents. The principal portion includes
contractual pa%"ents as 9ell as voluntar% prepa%"ents< ,an% holders tend to think
of the %ield on N,As in ter"s of the total "onthl% distri$ution received< The true
econo"ic %ield is8 in fact8 onl% the
interest pa%"ents received divided $% the outstanding principal $alance< The
principal co"ponent of the "onthl% distri$utions is not a %ield on capital8 $ut a return
of capital< Thus investors 9ho spend the entire cash flo9 are eating into their seed
corn<
The sa"e principle is operative in option5inco"e "utual
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2 W6ERE MOST INESTORS ST5M7E
funds8 9hich t%picall% ac?uire a portfolio of U<S< govern"ent securities and then 9rite
=sell> call options against the"< =A call option is the right to $u% a securit% at a
specified price during a stated period of ti"e<> The cash distri$utions paid $% these
funds to shareholders are co"prised of $oth interest inco"e earned on the $ondportfolio and pre"iu"s generated fro" the sale of options< This total cash
distri$ution is touted as the current %ield to investors< When covered call options
9ritten against the portfolio are e:ercised8 ho9ever8 the 9riter forgoes appreciation
on the securities that are called a9a%< The upside potential on the underl%ing
invest"ents is truncated $% the sale of the call options8 9hile the do9nside risk
re"ains intact< This strateg% places investors in the position of uninsured ho"e5
o9ners8 9ho $enefit currentl% fro" the s"all pre"iu" not paid to the insurance
co"pan% 9hile re"aining e:posed to large future losses< As long as securit% prices
continue to fluctuate $oth up and do9n8 9riters of covered calls are certain to e:peri5
ence capital losses over ti"e8 9ith no possi$le offsetting capital gains< In effect8
these funds are eating into principal 9hile "is5leadingl% reporting the principal
erosion as %ield<
So"e investors8 fi:ated on current return8 reach for %ield not 9ith a ne9 Wall
Street product8 $ut a ver% old one& co""on stocks< 6inding $ond %ields unaccepta$l%
lo98 the% pour "one% into stocks at the 9orst i"agina$le ti"es< These investors fail
to consider that $ond "arket %ields are pu$lic infor"ation8 9ell kno9n to stock
investors 9ho incorporate the current level of interest rates into share prices< When
$ond %ields are lo98 share prices are likel% to $e high< 0ield5seeking investors 9ho
rush into stocks 9hen %ields are lo9 not onl% fail to achieve a free lunch8 the% also
tend to $u% in at or near a "arket top<
The Sear(h 8or an Investment Formula
,an% investors greedil% persist in the invest"ent 9orld@s version of a search for the
hol% grail& the atte"pt to find a successful invest"ent for"ula< It is hu"an nature to
seek si"ple
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!peculators and %nsuccessful Investors +)
solutions to pro$le"s8 ho9ever co"ple:< iven the co"ple:ities of the invest"ent
process8 it is perhaps natural for people to feel that onl% a for"ula could lead to
invest"ent success<
-ust as "an% generals persist in fighting the last 9ar8 "ost invest"ent
for"ulas pro;ect the recent past into the future< So"e invest"ent for"ulas involve
technical anal%sis8 in 9hich past: 5rock5price "ove"ents are considered predictive of
future prices< 7ther for"ulas incorporate invest"ent funda"entals such as price5to5
earnings =!J> ratios8 price5to5$ook5value ratio8 sales or profits gro9th rates8 dividend
%ields8 and the prevailing level of interest rates< #espite the enor"ous effort that has
$een put into devising such for"ulas8 none has $een proven to 9ork<
7ne si"plistic8 $ack9ard5looking for"ula e"plo%ed $% so"e investors is to
$u% stocks 9ith lo9 !J ratios< The idea is that $% pa%ing a lo9 "ultiple of earnings8
an investor is $u%ing an out5of5favor $argain< In realit% investors 9ho follo9 such afo"ula are essentiall% driving $% looking onl% in the rear5vie9 "irror< Stocks 9ith a
lo9 !J ratio are often depressed $ecause the "arket price has alread% discounted
the prospect of a sharp in earnings< Investors 9ho $u% such stocks "a% soon find
that the !J ratio has risen $ecause earnings have declined<
Another t%pe of for"ula used $% "an% investors involves pro;ecting their "ost
recent personal e:periences into the future8 As a result8 "an% investors have entered
the 1/s having GlearnedG a nu"$er of 9rong and potentiall% dangerous lessons
fro" the e$ullient 1./s "arket perfor"anceF so"e have co"e to regard the 1.
stock "arket crash as nothing "ore than an a$erration and nothing less than a great
$u%ing opportunit%< The ?uick recover% after the 7cto$er 1. stock "arket
shakeout and 1/ ;unk5$ond "arket collapse provide reinforce"ent of this
shortsighted lesson< ,an% investors8 like !avlov@s dog8 9ill foolishl%look to the ne:t
"arket selloff8 regardless of its pro:i"ate as another $u%ing Gopportunit%<G
The financial "arkets are far too co"ple: to $e incorporated into a for"ula<
,oreover8 if an% successful invest"ent for"ula i $e devised8 it 9ould $e e:ploited $%
those 9ho possessed it until co"petition eli"inated the e:cess profits< The ?uest for
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31 W6ERE MOST INESTORS ST5M7E
a for"ula that 9orked 9ould then $egin ane9< Investors 9ould $e "uch $etter off to
redirect the ti"e and effort co""itted to devising for"ulas into funda"ental
anal%sis of specific invest"ent opportunities<
Con(lus#on The financial "arkets offer "an% te"ptations to vulnera$le investors< It is eas% to do
the 9rong thing8 to speculate rather than invest< "otion lies dangerousl% close to
the surface for "ost investors and can $e particularl% intense 9hen "arket prices
"ove dra"aticall% in either direction< It is crucial that investors understand the
difference $et9een speculating and investing and learn to take advantage of the
opportunities presented $% ,r< ,arket<
Notes
1< Se?uoia 6und8 Inc<8 annual report for 1.<
2< Willia" A< Sahl"an and Ho9ard H< Stevenson =Harvard raduate School of
Business Ad"inistration 'ase Stud%>8 G'apital ,arket ,%opiaG ='a"$ridge& Harvard
Business School8 1.)><
3< Al$ert Wo;nilo9er8 ?uoted in (ouis (o9enstein8 ,hat$s ,rong with ,all !treet
=4eading8 ,ass<& Addison5Wesle%8 1..>8 p< )<
*< The onl% possible e:ceptions to this cash flo9 test are precious "etals8 such as
gold8 9hich is a 9idel% recogniDed store of valueF throughout histor%8 for instance8 the
value of an ounce of gold has $een roughl% e?uivalent to the cost of a fine "en@s suit<
7ther precious "etals and ge"s have a less5esta$lished value than gold $ut "ight
$e considered $% so"e to $e a si"ilar t%pe of holding<
)< Ben;a"in raha"8 #he Intelligent Investor" *th ed< =Ne9 0ork& Harper K 4o98
13>8 p< 1/.<
< (o9enstein8 ,hat$s ,rong with ,all !treet" p< 3<
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*
The Nature o8 Wall Street Wor,s
A/a#nst Investorsinvestors in "arketa$le securities have little choice $ut to deal 9ith Wall Street< The
sad truth is8 ho9ever8 that "an% investors are not 9ell served in their dealings 9ith
Wall StreetF the% 9ould $enefit fro" developing a greater understanding of the 9a%
Wall Street 9orks< The pro$le" is that 9hat is good for Wall Street is not necessaril%
good for investors8 and vice versa<
Wall Street has three principal activities& trading8 invest"ent $anking8 and
"erchant $anking< As traders Wall Street fir"s act as agents8 earning a co""ission
=or trading spread> for $ringing $u%ers and sellers together< As invest"ent $ankers
the% arrange for the purchase and sale of entire co"panies $% others8 under9rite
ne9 securities8 provide financial advice8 and opine on the fairness of specific
transactions< As "erchant $ankers the% co""it their o9n capital 9hile acting as
principal in invest"ent $anking transactions< ,erchant $anking activit% $ecause
increasingl% i"portant to Wall Street in the late 1./s $ut al"ost co"pletel% ceased
in 1/ and earl% 11<
Wall Street fir"s perfor" i"portant functions for our econo"% the% raise
capital for e:panding $usinesses and =so"e5
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33 W6ERE MOST INESTORS ST5M7E
ti"es> provide li?uidit% to "arkets< As Wall Street pursues its various activities8
ho9ever8 it fre?uentl% is plagued $% conflicts of interest and a short5ter" orientation<
Investors need not conde"n Wall Street for this as long as the% re"ain a9are of it
and act 9ith cautious skepticis" in an% interactions the% "a% have<5$!Front Fees an Comm#ss#ons9
Wall Street<s "r#mar% Con8l#(t o8 Interest
Wall Streeters get paid pri"aril% for 9hat the% do8 not ho9 effectivel% the% do it< Wall
Street@s traditional co"pensation is in the for" of up5front fees and co""issions<
Brokerage co""issions are collected on each trade8 regardless of the outco"e for
the investor< Invest"ent $anking and under9riting fees are also collected up front8
long $efore the ulti"ate success or failure of the transaction is kno9n<
All investors are a9are of the conflict of interest facing stock$rokers< While
their custo"ers "ight $e $est off o9ning ="ini"al co""ission> U<S< Treasur% $ills or
=co""ission5free> no5load "utual funds8 $rokers are financiall% "otivated to sell
high5co""ission securities< Brokers also have an incentive to do e:cessive short5
ter" trading =kno9n as churning> on $ehalf of discretionar% custo"er accounts =in
9hich the $roker has discretion to transact> and to encourage such activit% in
nondiscretionar% accounts< ,an% investors are also accusto"ed to conflicts of
interest in Wall Street@s trading activities8 9here the fir" and custo"er are on
opposite sides of 9hat is often a Dero5su" ga"e<
A significant conflict of interest also arises in securities under9riting< This
function involves raising "one% for corporate clients $% selling ne9l% issued
securities to custo"ers< Needless to sa%8 large fees "a% "otivate a fir" to
under9rite either overpriced or highl% risk% securities and to favor the li"ited
nu"$er of under9riting clients over the "an% s"all $u%ers of those securities<
In "erchant $anking the conflict is "ore $latant still<
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#he -ature of ,all !treet ,orks Against Investors 3*
Street fir"s have $eco"e direct co"petitors of $oth their under9riting and
$rokerage clients8 $u%ing and selling entire co"panies or large corporate su$sidiaries
for their o9n accounts< Instead of acting as "iddle"en $et9een issuers and $u%ers
of securities8 fir"s have $eco"e issuers and investors the"selves8 No9ada%s 9henthe phone rings and %our $roker is on the line8 %ou don@t even kno9 in 9hat capacit%
or on 9hose $ehalf he or she is acting<
7$viousl% there is nothing 9rong 9ith providing a service and collecting a fee<
#octors8 la9%ers8 accountants8 and other professionals are paid this 9a%F their
co"pensation does not depend on the ulti"ate outco"e of their services< The point I
a" "aking is that investors should $e a9are of the "otivations of the people the%
transact $usiness 9ithF up5front fees clearl% create a $ias to9ard fre?uent8 and not
necessaril% profita$le8 transactions<
Wall Street Favors 5ner-r#t#n/s over
Se(onar%!Mar,et Transa(t#ons
B% acting as invest"ent $ankers as 9ell as $rokers8 "ost Wall Street fir"s create
their o9n products to sell< A stock or $ond under9riting generates high fees for an
invest"ent $ank< These are shared 9ith stock$rokers 9ho sell the under9ritten
securities to clients< The total Wall Street take fro" a stock under9riting for e:a"ple8
ranges fro" 2 to . percent of the proceeds raised the $rokers the"selves t%picall%
receive fifteen to thirt% cents of gross co""ission on a 1/ stock<B% contrast8 the co""issions earned $% $rokers on secondar%5"arket
transactions8 9hich involve the resale of securities fro" one investor to another8 are
"uch s"aller< (arge institutions generall% pa% as little as five cents per share and
so"eti"es as lo9 as t9o cents< S"all individual investors are t%picall% charged
considera$l% "ore< ven so8 $rokers earn on average several ti"es "ore "one%
fro" selling shares in a ne9
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3) W6ERE MOST INESTORS ST5M7E
under9riting than the% can earn fro" a secondar%5"arket transaction of si"ilar siDe<
The higher co""ission on ne9 under9ritings provides a strong incentive to
stock$rokers to sell the" to clients<
The strong financial incentive of $rokers touting ne9 securit% under9ritings isnot the onl% cause for investor concern< The "otivation of the issuer of securities is
also suspect and "ust $e thoroughl% investigated $% the $u%er< one are the da%s =if
the% ever e:isted> 9hen a ne9 issue 9as a colla$orative effort in 9hich a $usiness
that 9as long on prospects $ut short on capital could "eet investors 9ith capital in
hand $ut 9ith fe9 good outlets for it< Toda% the initial pu$lic offering "arket is 9here
hopes and drea"s are capitaliDed at high "ultiples< Indeed8 the under9riting of a
ne9 securit% "a% 9ell $e an overpriced or ill5conceived transaction8 fre?uentl%
involving the shuffling of assets through Gfinancial engineeringG rather than the
raising of capital to finance a $usiness@s internal gro9th<
Investors even re"otel% te"pted to $u% ne9 issues "ust ask the"selves ho9
the% could possi$l% fare 9ell 9hen a savv% issuer and greed% under9riter are on the
opposite side of every under9riting< Indeed8 ho9 attractive could an% securit% under5
9riting ever $e 9hen the issuer and under9riter have superior infor"ation as 9ell as
control over the ti"ing8 pricing8 and stock or $ond allocationE The deck is al"ost
al9a%s stacked against the $u%ers<
So"eti"es the lust for under9riting fees drives Wall Street to actuall% create
under9riting clients for the sole purpose of having securities to sell< ,ost closed5end
"utual funds8 for e:a"ple8 are for"ed al"ost e:clusivel% to generate co""issions
for stock$rokers and fees for invest"ent "anagers< There 9as a stor% a fe9 %ears
ago that an announce"ent to the sales force of a prestigious Wall Street
under9riting fir" regarding the for"ation of a closed5end $ond fund 9as "et 9ith a
standing ovation< The clients could have purchased the sa"e securities "uch less
e:pensivel% on a direct $asis8 $ut in the for" of a closed5end fund the $rokers stood
to "ake "an% ti"es "ore in co""issions<
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3 W6ERE MOST INESTORS ST5M7E
even greater pre"iu"s to NA+ suddenl% di""ed< As a result8 ne9l% $earish
investors du"ped the shares of countr% funds8 9hich had recentl% traded at large
pre"iu"s to NA+8 until virtuall% all of the" declined to levels apprecia$l% $elo9 NA+<
The periodic $oo" in closed5end "utual5fund issuance is a useful $aro"eter of"arket senti"entF ne9 issues a$ound 9hen investors are opti"istic and "arkets are
rising< Wall Street fir"s after all do not force investors to $u% these funds< The%
si"pl% stand read% to issue a virtuall% li"itless suppl% since the onl% real constraint is
the gulli$ilit% of the $u%ers< The $oo" is follo9ed $% a $ust8 during 9hich those funds
that fall to a sufficientl% large discount to NA+ are targeted $% investor groups and
either li?uidated or forced to $eco"e open5ended8 there$% per"itting the shares to
$e redee"a$le at NA+8 co"pleting the life c%cles of these entities< The under9riters
and so"eti"es the $argain hunters profitF the greater fools 9ho $u% on the initial
pu$lic offerings or later at large pre"iu"s to NA+ inevita$l% lose "one%<
Wall Street<s Short!Term Fo(us
Wall Street@s up5front5fee orientation "akes for a short5ter" focus as 9ell< Brokers8
traders8 and invest"ent $ankers all find it hard to look $e%ond the ne:t transaction
9hen the current one is so lucrative regardless of "erit< This 9as even "ore
applica$le than usual in the late 1./s and earl% 1/s8 a ti"e 9hen fees 9ere
enor"ous and 9hen "ost Wall Streeters felt less than secure a$out the per"anence
of their ;o$s8 and even their careers8 in the securities industr%< The utter h%pocris% of
Wall Street is e:e"plified $% the Ge?uitiDationG 9ave of earl% 118 9here$%
overleveraged co"panies issued e?uit% and used the proceeds to repa% de$t< Wall
Street collected invest"ent $anking and under9riting fees 9hen those co"panies
9ere ac?uired in highl% leveraged ;unk5$ond5financed takeovers and collected large
fees again 9hen the de$t 9as replaced 9ith ne9l% under9ritten e?uit%<
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3 W6ERE MOST INESTORS ST5M7E
The $ullish $ias of Wall Street "anifests itself in "an% 9a%s< Wall Street research is
strongl% oriented to9ard $u% rather than sell reco""endations8 for e:a"ple<
!erhaps this is the case $ecause an%one 9ith "one% is a candidate to $u% a stock or
$ond8 9hile onl% those 9ho o9n are candidates to sell< In other 9ords8 there is "ore$rokerage $usiness to $e done $% issuing an opti"istic research report than $%
9riting a pessi"istic one<
In addition8 Wall Street anal%sts are unlikel% to issue sell reco""endations
due to an understanda$le reluctance to sa% negative things8 ho9ever truthful the%
"a% $e8 a$out the co"panies the% follo9< This is especiall% true 9hen these co"5
panies are corporate5finance clients of the fir"< In 1/ ,arvin 4off"an8 an anal%st
at -anne% ,ontgo"er% Scott8 Inc<8 apparentl% lost his ;o$ for 9riting a negative
research report a$out the Atlantic 'it% hotelJcasinos o9ned $% #onald Tru"p8 a
prospective client of -anne%<
It is eas% for Wall Streeters to $e $ullish< A fe9 opti"istic assu"ptions 9ill
ena$le a reasona$le invest"ent case to $e "ade for practicall% an% stock or $ond<
The pro$le" is that 9ith so "uch attention $eing paid to the upside8 it is eas% to
lose sight of the risk<
7thers share Wall Street@s $ullish $ias< Investors naturall% prefer rising
securit% prices to falling ones8 profits to losses< It is "ore pleasant to conte"plate
upside potential than do9nside risk< 'o"panies too prefer to see their o9n shares
rise in priceF an increasing share price is vie9ed as a vote of confidence in
"anage"ent8 as a source of increase in the value of "anage"ent@s personal shares
and stock options8 and as a source of financial fle:i$ilit%8 facilitating a co"pan%@s
a$ilit% to raise additional e?uit% capital<
ven govern"ent regulators of the securities "arkets have a stake in the
"arkets@ $ullish $ias< 4ising "arkets are acco"panied $% investor confidence8 9hich
the regulators desire to "aintain< An% do9nturn8 according to the regulator%
"entalit%8 should $e orderl% and free of panic< =#isorderl% rising "arkets are of no
evident concern<>
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*1 W6ERE MOST INESTORS ST5M7E
tors8 illustrated $% the uneven application of circuit $reakers8 "a% itself encourage
investors to purchase and hold overvalued securities<
,an% of the sa"e factors that contri$ute to a $ullish $ias can cause the
financial "arkets8 especiall% the stock "arket8 to $eco"e and re"ain overvalued<'orrecting a "arket overvaluation is "ore difficult than re"ed%ing an undervalued
condition< With an undervalued stock8 for e:a"ple8 a value investor can purchase
"ore and "ore shares until control is achieved or8 $etter still8 until the entire
co"pan% is o9ned at a $argain price< If the value assess"ent 9as accurate8 this is an
attractive outco"e for the investor< B% contrast8 overvalued "arkets are not easil%5
correctedF short5selling8 as "entioned earlier8 is not an effective antidote< In addition8
overvaluation is not al9a%s apparent to investors8 anal%sts8 or "anage"ents< Since
securit% prices reflect investors@ perception of realit% and not necessaril% realit% itself8
overvaluation "a% persist for a long ti"e<
F#nan(#al!Mar,et Innovat#ons Are Goo 8or
Wall Street 7ut 7a 8or Cl#ents
Invest"ent $ankers in Wall Street fir"s are constantl% creating ne9 t%pes of
securities to offer to custo"ers< 7ccasionall% such offerings $oth solve the financial
pro$le"s of issuers and "eet the needs of investors< In "ost cases8 ho9ever8 the%
address onl% the needs of Wall Street8 that is8 the generation of fees andco""issions<
6inancial inter"ediariesWall Street invest"ent $ankers and institutional
investorsstand to $enefit the "ost fro" financial5"arket innovations< Wall Street
earns fees and co""issions 9ith no riskF institutional investors "a% $e a$le to
attract "ore "one% to "anage $% creating ne9 vehicles to invest in the innovative
securities< If the first investors in a financial5"arket innovation e:perience good
results8 "ore
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#he -ature of ,all !treet ,orks Against Investors .(
"one% 9ill $e raised and "ore securities 9ill $e issued8 generating additional
"anage"ent fees8 under9riting fees8 and co""issions< The $u% side and sell side in
effect $eco"e co5conspirators8 each having a vested interest in the continued
success of the innovation< An% long5ter" $enefit to the issuers or actual o9ners of
the ne9 securities is considera$l% less certain<
In the 1./s the financial "arkets 9ere flooded 9ith ne9 varieties of de$t and
derivative securities< -ust to na"e a fe98 an investor could $u% $onds that 9ere fi:ed
or floating rate8 #utch auction8 Dero5coupon8 pa%5in5kind or pa%5in5stock8 converti$le
into the issuers@ stock8 into so"eone else@s stock8 or into co""odities8 putta$le8
calla$le8 resetta$le8 e:tendi$le to a longer "aturit%8 e:changea$le into another
securit%8 or deno"inated in a foreign currenc% or "arket $asket of currencies< So"e
of these securities8 such as auction5rate preferred5stock and Dero5coupon ;unk $onds8
have $een discredited $% events< ,an% others8 like e:hi$its at a science fair8 "a%have achieved their original goals8 $ut al"ost no one reall% cared<
Investors "ust recogniDe that the earl% success of an innovation is not a
relia$le indicator of its ulti"ate "erit< Both $u%ers and sellers "ust $elieve that the%
9ill $enefit in the short run8 or the innovation 9ill not get off the dra9ing $oardF the
longer5ter" conse?uences of such innovations8 ho9ever8 "a% not have $een
considered carefull%< At the ti"e of issuance a ne9 t%pe of securit% 9ill appear to add
value in the sa"e 9a% that a ne9 consu"er product does< There is so"ethinglo9er
risk8 higher return8 greater li?uidit%8 an i"$edded put or call option to the holder or
issuer8 or so"e other 9rinklethat "akes it appear superior =ne9 and i"proved8 if
%ou 9ill> to an%thing that ca"e $efore< Although the $enefits are apparent fro" the
start8 it take longer for pro$le"s to surface< Neither cash5hungr% issuers nor greed%
investors necessaril% anal%De the perfor"ance of each financial5"arket innovation
under ever% conceiva$le econo"ic scenario< What appears to $e ne9 and i"proved
toda% "a% prove to $e fla9ed or even fallacious
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*3 W6ERE MOST INESTORS ST5M7E
to"orro9<
Wall Street is never satisfied 9ith its success< If one deal is successfull%
co"pleted8 Wall Street sees this as a sure sign that still another deal can $e done< In
virtuall% all financial innovations and invest"ent fads8 Wall Street creates additionalsuppl% until it e?uals and then e:ceeds "arket de"and< The profit "otivation of Wall
Street fir"s and the intense co"petition a"ong the" render an% other outco"e
unlikel%<
The eventual "arket saturation of Wall Street fads coincides 9ith a cooling of
investor enthusias"< When a particular sector is in vogue8 success is a self5fulfilling
prophec%< As $u%ers $id up prices8 the% help to ;ustif% their original enthusias"<
When prices peak and start to decline8 ho9ever8 the do9n9ard "ove "ent can also
$eco"e self5fulfilling< Not onl% do $u%ers stop $u%ing8 the% actuall% $eco"e sellers8
aggravating the over suppl% pro$le" that "arks the peak of ever% fad<
IOs an "Os9 Innovat#ons #n the Mort/a/e
Se(ur#t#es Mar,et
7ne financial5"arket innovation of the "id51./s involved h%$rid "ortgage
securities kno9n as I7s =interest onl%> and !7s =principal onl%>< I7s and !7s 9ere
created $% separating pool of "ortgages into its t9o cash5flo9 co"ponents& interest
pa%"ents and principal repa%"ents<
A conventional "ortgage5$acked securit% fluctuates in value inversel% to
interest rates for t9o reasons< 6irst8 the value of a "ortgage declines as interest
rates rise $ecause8 as 9ith an% interest5$earing securit%8 it is 9orth less 9hen its
periodic cash flo9s are discounted at the ne98 higher rate< Second8 the e:pected life
of a "ortgage lengthens 9ith higher interest rates as optional prepa%"ents lessen8
so that the relativel% less attractive interest pa%"ents last for a longer ti"e<
The responses of separate I7s and !7s to interest rate changes are ver%
different fro" those of an intact "ortgage5$acked securit%<
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#he -ature of ,all !treet ,orks Against Investors **
I7s8 interest pa%"ents stripped fro" a pool of "ortgages8 fluctuate in value for a
given change in interest rates in the opposite direction fro" conventional "ortgages<
The reason is8 if interest rates rise8 interest pa%"ents on an I7 9ill $e received for a
longer period< :perience sho9s that the present value of a larger nu"$er ofpa%"ents is "ore than that of a s"aller nu"$er of pa%"ents8 even at a so"e9hat
higher discount rate< Because of this counterfluctuation8 such "ortgage investors as
thrifts and insurance co"panies are attracted to I7s as a potential hedge against
changes in interest rates< The price of !7s8 conversel%8 "oves in the sa"e direction
as conventional "ortgages in response to interest rate changes $ut 9ith greater
volatilit%< Thus the% are potentiall% useful instru"ents for an%5art 9ishing to
speculate on interest rates<
Wall Street 9as a$le to earn su$stantial fees and trading prof5its $% creating
these h%$rid securities< The ?uestion8 as 9ith an% financial5"arket innovation8 is
9hether an%one else 9as $etter off. especiall% after allo9ing for the co""issions8
fees8 and dealer "arkups< The $u%ers8 fre?uentl% thrifts and insurance co"panies8
9ere $etting on their o9n a$ilit% to understand a
$rand ne9 securit%< The% needed to understand it $etter than other "arket
participants8 and at least as 9ell as Wall Street8 to avoid $eing e:ploited< The%
depended on the e"ergence of a sustained8 li?uid "arket for the securities the%
$ought< And the% 9ere i"plicitl% assu"ing that the t9o parts 9ere 9orth at least as
"uch as8 and perhaps "ore than8 the 9holeclearl% an
opti"istic assu"ption<
What if I7s or !7s failed to trade in a li?uid and orderl% "arket narro9
$idJasked spreadsE What if accurate and ti"el% infor"ation on these securities
ceased to $e availa$le on a continuing $asisE What if interest rate fluctuations
rendered each of these securities "ore volatile than e:pectedE Then holders 9ere in
trou$le8 for it is far easier to separate a "ortgage into t9o parts than it is to glue it
$ack together again< There 9as no assurance8 or even reason to think it likel%8 that
the holder of one piece 9ould $e interested in an% proposition "ade $% the holder of
the other piece to reco"$ine< It 9as8 in other 9ords8 possi$le
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* W6ERE MOST INESTORS ST5M7E
invest"ent fads originate in real $usiness trends8 9hich deserve to $e reflected in
stock prices< The fad $eco"es dangerous8 ho9ever8 9hen share prices reach levels
that are not supported $% the conservativel% appraised values of the underl%ing
$usinesses<
Con(lus#on
Wall Street can $e a dangerous place for investors< 0ou have no choice $ut to do
$usiness there8 $ut %ou "ust al9a%s $e on %our guard< The standard $ehavior of
Wall Streeters is to pursue "a:i"iDation of self5interestF the orientation is usuall%
shoe ter"< This "ust $e ackno9ledged8 accepted8 and dealt 9ith< If %ou transact
$usiness 9ith Wall Street 9ith these caveats in "ind8 %ou can prosper< If %ou depend
on Wall Street to help %ou8 invest"ent success "a% re"ain elusive<
Notes
1< The onl% advantage of closed5end over open5end "utual funds is that closed5end
funds can $e "anaged 9ithout considerations
of li?uidit% needs since the% are not su$;ect to shareholder rede"ptions< This "inor
advantage does not offset the high up5front co""issions charged to initial
purchasers of closed5end fund shares<
2< If the last price fluctuation 9as up9ard8 the ne:t trade at the sa"e price is called aDero5plus tickF short5selling "a% rake place on a Dero5plus tick<
3< ,an% Wall Streeters have a different vie9 of short5selling< The% $elieve that short5
sellers are dangerous "anipulators of securities prices8 driving prices do9n for their
personal financial gain< This pre;udice against short5sellers is consistent 9ith Wall
Street@s interest in "aintaining high stock prices<
*< !rogra" trading is an ar$itrage activit% in 9hich the stocks in an inde: are
purchased and futures contracts on that inde: are sold8 or vice versa8 in either event
locking in a riskless profit
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+
The Inst#tut#onal "er8orman(e2erb%9
The Cl#ent Is the oserro9ing pools of retire"ent and endo9"ent funds seeking sound invest"ent outlets
led to the "ost i"portant develop"ent in the invest"ent 9orld over the last three
decades& the ascendanc% of the institutional investor< Unfortunatel% institutional
investing has developed in 9a%s that are detri"ental to the returns generated on the
"one% under "anage"ent< The great "a;orit% of institutional investors are plagued
9ith a short5ter"8 relative5perfor"ance orientation and lack the long5ter"
perspective that retire"ent and endo9"ent funds deserve< /yriad rules and
restrictions8 often self5i"posed8 also i"pair the a$ilit% of institutional investors to
achieve good invest"ent result.
Several decades ago the financial "arkets 9ere do"inated $% individual
investors 9ho "ade their o9n invest"ent decisions8 invest"ent 9orld 9as then a
si"pler placeF stocks8 govern5
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* W6ERE MOST INESTORS ST5M7E
"ent $onds8 and high5grade corporate $onds co"prised virtuall% the entire
invest"ent "enu< That 9orld 9as a cautious one8 as "e"ories of the 12 stock
"arket crash and the reat #epression that follo9ed 9ere slo9 to fade<
In the %ears after World War II8 ho9ever8 increasing pools of retire"entsavings in corporate pension funds created an opportunit% for professional "one%
"anagers to go into $usiness< Total funds under "anage"ent rose fro" 1/ $illion
in 1)/ to "ore than )// $illion in 1.8 to appro:i"atel% 2 trillion in 1./8 and
trillion in 1/< 7ver the sa"e fort% %ears8 the share of institutional o9nership in
all pu$licl% traded U<S< e?uit% securities increased fro" . to *) percent<1
Under the "plo%ee 4etire"ent Inco"e Securit% Act of 1* =4ISA>
institutional investors 9ere re?uired to act as fiduciaries for future retirees $%
achieving accepta$le invest"ent returns 9ith li"ited risk< Adoption of the prudent5
"an standard8 under 9hich pension funds 9ould onl% "ake invest"ents that a
Gprudent "anG 9ould "ake8 9as intended to ensure conservative "anage"ent< 7ver
ti"e8 ho9ever8 the modus operandi of institutional investors $egan to diverge fro"
9hat the statute intended< A 1 U<S< #epart"ent of (a$or ruling that the prudent5
"an standard applied to an entire portfolio rather than to the individual securities
9ithin it opened the door to portfolio5oriented invest"ent strategies that ignore risk
on an invest"ent5$%5invest"ent $asis< In addition8 a great "an% institutional
investors have $een s9ept into the short5ter" relative5perfor"ance der$%8 an
orientation inconsistent 9ith the prudent5"an test<
Toda% institutional investors do"inate the financial "arkets8 accounting for
roughl% three5fourths of stock e:change trading volu"e<2 All investors are affected $%
9hat the institutions do8 o9ing to the i"pact of their enor"ous financial clout on
securit% prices<G Understanding their $ehavior is helpful in understanding 9h% certain
securities are overvalued 9hile others are $argain priced and "a% ena$le investors
to identif% areas of potential opportunit%<
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#he Institutional Performance Derby0 #he Client Is the 1oser =;
The Mone% Mana/ement 7us#ness
If the $ehavior of institutional investors 9eren@t so horrif%ing8 it "ight actuall% $e
hu"orous< Hundreds of $illions of other peoples hard5earned dollars are routinel%9hipped fro" invest"ent to invest"ent $ased on little or no in5depth research or
anal%sis< The prevalent "entalit% is consensus8 groupthink< Acting 9ith the cro9d
ensures an accepta$le "ediocrit%F acting independentl% runs the risk of unaccepta$le
underperfor"ance< Indeed8 the short5ter"8 relative5perfor"ance orientation of "an%
"one% "anagers has "ade Ginstitutional investorG a contradiction in ter"s<
Institutional investors are presu"a$l% "otivated $oth $% the ongoing
challenge of achieving good invest"ent results and $% the personal financial success
that accrues to participants in a profita$le "one% "anage"ent $usiness<
Unfortunatel% for invest"ent clients these o$;ectives fre?uentl% are at odds< ,ost
"one% "anagers are co"pensated8 not according to the results they achieve, $ut as
a percentage of the total assets under "anage"ent< The incentive is to e:pand
"anaged assets in order to generate "ore fees< 0et 9hile a "one% "anage"ent
$usiness t%picall% $eco"es "ore profita$le as assets under "anage"ent increase8
good invest"ent perfor"ance $eco"es increasingl% difficult< This conflict $et9een
the $est interests of the "one% "anager and that of the clients is t%picall% resolved
in the "anager@s favor<
The $usiness of "one% "anage"ent can $e highl% lucrative8 It re?uires ver%
little capital invest"ent8 9hile offering high co"pensation and the rapid develop"ent
of 9hat is effectivel% an annuit%< 7nce an invest"ent "anage"ent $usiness
$eco"es highl% profita$le8 it is likel% to re"ain that 9a% so long as clients do not
depart in large nu"$ers< In the "one% "anage"ent $usiness "anage"ent fees paid
$% ne9 clients constitute al"ost pure profit< Si"ilarl%8 lost fees resulting fro" client
departures affect profita$ilit% nearl% dollar for dollar8 since there are fe9 varia$le
costs to $e cut in order to offset lost revenues<
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=1 W6ERE MOST INESTORS ST5M7E
The pressure to retain clients e:erts a stifling influence on institutional investors<
Since clients fre?uentl% replace the 9orst5perfor"ing "anagers =and since "one%
"anagers live in fear of this>8 "ost "anagers tr% to avoid standing apart fro" the
cro9d< Those 9ith onl% average results are considera$l% less likel% to lose accounts
than are the 9orst perfor"ers< The result is that "ost "one% "anagers consider
"ediocre perfor"ance accepta$le< Although unconventional decisions that prove
successful could generate superior invest"ent perfor"ance and result in client
additions8 the risk of "istakes8 9hich 9ould di"inish perfor"ance and possi$l% lead
to client departures8 is usuall% considered too high<
The Short!Term> Relat#ve!"er8orman(e 2erb%
(ike dogs chasing their o9n tails8 "ost institutional investors have $eco"e locked
into a short5ter"8 relative5perfor"ance der$%< 6und "anagers at one institution have
suffered the distraction of hourl% perfor"ance calculationsF nu"erous "anagers are
provided dail% co"parisons of their results 9ith those of "anagers at other fir"s<
6re?uent co"parative ranking can onl% reinforce a short5ter" invest"ent
perspective< It is understanda$l% difficult to "aintain a long5ter" vie9 9hen8 faced
9ith the penalties for poor short5ter" perfor"ance8 the long5ter" vie9 "a% 9ell $e
fro" the une"plo%"ent line<
The short5ter" orientation of "one% "anagers "a% $e e:acer$ated $% the
increasing popularit% of pension fund consultants< These consultants evaluate
nu"erous "one% "anagers8 co"pare their perfor"ances8 contrast their invest"ent
st%les8 and then "ake reco""endations to their clients< Because their
reco""endations can have a significant influence on the health of a "one%
"anage"ent $usiness8 the need to i"press pension fund consultants "a% add to the
short5ter" perfor"ance pressures on "one% "anagers<
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#he Institutional Performance Derby0 #he Client Is the 1oser )2
What is a relative5perfor"ance orientationE 4elative perfor"ance involves "easuring
invest"ent results8 not against an a$solute standard8 $ut against $road stock "arket
indices8 such as the #o9 -ones Industrial Average or Standard K !oor@s )// Inde:8 or
against other investors@ results< ,ost institutional investors "easure their success orfailure in ter"s of relative perfor"ance< ,one% "anagers "otivated to outperfor"
an inde: or a peer group of "anagers "a% lose sight of 9hether their invest"ents
are attractive or even sensi$le in an a$solute sense<
Instead of $asing invest"ent decisions on independent and o$;ective anal%sis8
relative5perfor"ance5oriented investors reall% act as speculators< 4ather than "aking
sensi$le ;udg"ents a$out the attractiveness of specific stocks and $onds8 the% tr% to
guess 9hat others are going to do and then do it first< The pro$le" is that even as
one "anager is atte"pting to guess 9hat others "a% do8 others are doing the sa"e
thing< The task $eco"es increasingl% intricate& guess 9hat the other guessers "a%
guess< And so on<
Who is to $la"e for this short5ter" invest"ent focusE Is it the fault of
"anagers 9ho $elieve clients 9ant good short5ter" perfor"ance regardless of the
level of risk or the i"possi$ilit% of the taskE 7r is it the fault of clients 9ho8 in fact8 do
s9itch "one% "anagers 9ith so"e fre?uenc%E There is a"ple $la"e for $oth to
share<
There are no 9inners in the short5ter"8 relative5perfor"ance der$%<
Atte"pting to outperfor" the "arket in the short run is futile since near5ter" stock
and $ond price fluctuations are rando" and $ecause an e:traordinar% a"ount of
energ% and talent is alread% $eing applied to that o$;ective< The effort onl% distracts
a "one% "anager fro" finding and acting on sound longter" opportunities as he or
she channels resources into 9hat is essentiall% an un9inna$le ga"e< As a result8 the
clients e:perience "ediocre perfor"ance< The overall econo"% is also deprived8 as
funds are allocated to short5ter" trading rather than to long5ter" invest"ents< 7nl%
$rokers $enefit fro" the high level of activit%<
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)3 W6ERE MOST INESTORS ST5M7E
Other "eo$le<s Mone% versus Your O-n
0ou pro$a$l% 9ould not choose to dine at a restaurant 9hose chef al9a%s ate
else9here< 0ou should $e no "ore satisfied 9ith a "one% "anager 9ho does not eat
his or her o9n cooking< It is 9orth noting that fe9 institutional "one% "anagersinvest their o9n "one% along 9ith their clients@ funds< The failure to do so frees these
"anagers to single"indedl% pursue their fir"s@8 rather than their clients@8 $est
interests<
cono"ist !aul 4osenstein54odan has pointed to the Gtre"$le factorG in
understanding hu"an "otivation< GIn the $uilding practices of ancient 4o"e8 9hen
scaffolding 9as re"oved fro" a co"pleted 4o"an arch8 the 4o"an engineer stood
$eneath< If the arch ca"e crashing do9n8 he 9as the first to kno9< Thus his concern
for the ?ualit% of the arch 9as intensel% personal8 and it is not surprising that so
"an% 4o"an arches have survived<G3
Wh% should investing $e an% differentE ,one% "anagers 9ho invested their
o9n assets in parallel 9ith clients 9ould ?uickl% a$andon their relative5perfor"ance
orientation< Intellectual honest% 9ould $e restored to the institutional invest"ent
process as the focus of professional investors 9ould shift fro" tr%ing to outguess
others to "a:i"iDing returns under reasona$le risk constraints< If "ore institutional
investors strove to achieve good a$solute rather than relative returns8 the stock
"arket 9ould $e less prone to overvaluation and "arket fads 9ould less likel% $e
carried to e:cess< Invest"ents 9ould onl% $e "ade 9hen the% presented a
co"pelling opportunit% and not si"pl% to keep up 9ith the herd<
Im$e#ments to Goo Inst#tut#onal Investment "er8orman(e
7ne "a;or o$stacle to good institutional invest"ent perfor"ance is a
shortage of ti"e< There is "ore infor"ation availa$le
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#he Institutional Performance Derby0 #he Client Is the 1oser )*
a$out securities8 as 9ell as corporate and "acroecono"ics develop"ents8 than
an%one could reasona$l% digest< -ust sifting through the accu"ulating piles of annual
reports8 Wall Street research8 and financial periodicals could consu"e all of one@s
ti"e ever% da%< Thinking a$out and digesting all this "aterial8 of course8 9ould take
considera$l% longer<
An investor@s ti"e is re?uired $oth to "onitor current holdings and to
investigate potential ne9 invest"ents< Since "ost "one% "anagers are al9a%s
looking for additional assets to "anage8 ho9ever8 the% spend considera$le ti"e
"eeting 9ith prospective clients in addition to hand5holding current clientele< It is
ironic that all clients8 present and potential8 9ould pro$a$l% $e financiall% $etter off if
none of the" spent ti"e with the "one% "anagers8 $ut a free5rider pro$le" e:ists in
that each client feels ;ustified in re?uesting periodic "eetings<
No single "eeting places an intolera$le $urden on a "one% "anager@s ti"eFcu"ulativel%8 ho9ever8 the hours diverted to "arketing can take a toll on invest"ent
results<
Another difficult% plaguing institutional investors is a $ureaucratic decision5
"aking process< While "anaging "one% successfull% is not eas% for an%one8 "an%
institutional investors co"pound that difficult% 9ith a tendenc% to9ard confor"it%8
inertia8 and e:cessive diversification that results fro" group decision "aking<
An% institutional investor 9ith an innovative or contrarian invest"ent idea
goes out on a li"$< He or she assu"es a personal risk 9ithin the fir"8 9hich
co"pounds the invest"ent r#s,. The cost of $eing 9rong goes $e%ond the financial
loss to include the adverse "arketing i"plications as 9ell as the personal career
considerations< This helps e:plain 9h% institutional investors rarel% "ake
unconventional invest"ents< It also sho9s 9h% the% tend to hold onto full% priced or
overpriced invest"ents8 un9illing to reco""end sale unless a consensus 8or selling
has alread% e"erged< The "ultidi"ensional risk fro" holding too long is usuall% less
than the risk in selling too soon<
Selling is difficult for "one% "anagers for three additional
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)) W6ERE MOST INESTORS ST5M7E
reasons< 6irst8 "an% invest"ents are illi?uid8 and disposing of institutional5siDed
positions depends on "ore than si"pl% the desire to do so< Second8 selling creates
additional 9ork as sale proceeds "ust $e reinvested in a su$se?uent purchase<
4etaining current holdings is "uch easier< With so "an% de"ands on their ti"e8"one% "anagers have little incentive to create additional 9ork for the"selves<
6inall%8 the Securities and :change 'o""ission =S'>8 the govern"ental agenc%
9ith regulator% responsi$ilit% for "utual funds8 regards portfolio turnover
unfavora$l%< ,utual fund "anagers thus have %et another reason to avoid selling<
,an% large institutional investors separate anal%tical responsi$ilities fro"
portfolio5"anage"ent duties8 9ith the portfolio "anagers senior to the anal%sts< The
portfolio "anagers usuall% function on a top5do9n $asis8 integrating $road5scale
"arket vie9s 9ith the anal%sts@ reco""endations to "ake particular invest"ent
decisions< This approach is conducive to "istakes since the people "aking the
decisions have not personall% anal%Ded the securities the% are $u%ing and selling<
,oreover8 the anal%sts 9ho do have direct kno9ledge of the underl%ing co"panies
"a% $e s9a%ed in their reco""endations $% an% apparent top5do9n $ias "anifested
$% the portfolio "anagers<
There is one other i"pedi"ent to good institutional invest"ent perfor"ance&
institutional portfolio "anagers are hu"an $eings< In addition to the influences of the
invest"ent $usiness8 "one% "anagers8 despite $eing professionals8 fre?uentl% fall
victi" to the sa"e forces that operate on individual investors& the greed% search for
?uick and eas% profits8 the co"fort of consensus8 the fear of falling prices8 and all the
others< The t9in $urdens of institutional $aggage and hu"an e"otion can $e difficult
to overco"e<
Im$l#(at#ons o8 "ort8ol#o S#?e
Institutional investors are caught in a vicious circle< The "ore "one% the%
"anage8 the "ore the% earn< Ho9ever8 there are
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#he Institutional Performance Derby0 #he Client Is the 1oser )
disecono"ies of scale in the returns earned on increasingl% larrge su"s of "one%
under "anage"entF that is8 the return per dollar invested declines as total assets
increase< The principal reason is that good invest"ent ideas are in short suppl%<
,ost of the "a;or "one% "anage"ent fir"s consider onl% large5capitaliDationsecurities for invest"ent< These institutions cannot ;ustif% anal%Ding s"all and
"ediu"5siDed co"panies in 9hich onl% "odest a"ounts could ever $e invested< To
illustrate this point8 consider a "anager at a ver% large institution 9ho oversees a 1
$illion portfolio< To achieve reasona$le $ut not e:cessive diversification8 the "anager
"a% have a polic% of investing )/ "illion in each of t9ent% different stocks< To
avoid o9ning illi?uid positions8 invest"ents "ight $e li"ited to no "ore than )
percent of the outstanding shares of an% one co"pan%< In co"$ination these rules
i"pl% o9ning shares of co"panies 9ith a "ini"u" "arket capitaliDation of 1 $illion
each =) percent of 1 $illion is )/ "illion><
At the $eginning of 11 there 9ere onl% )) co"panies 9ith "arket capitaliDations
this large8 a fairl% s"all universe<
I refer to this t%pe of li"itation on institutional investors@ $ehavior as a self5
i"posed constraint< This one is not8 ho9ever8 a co"pletel% ar$itrar% rule adopted $%
"anagersF the siDe of the portfolio dictates such a restriction< Unfortunatel% for the
clients of large "one% "anagers8 like the one in this e:a"ple8 thousands of
co"panies are auto"aticall% e:cluded fro" invest"ent consideration regardless of
individual "erit<
Sel8!#m$ose Constra#nts on Inst#tut#onal Investors
,ost institutional investors are li"ited $% a nu"$er of other self5i"posed
constraints< In response to the prudent5"an standard and si"ilar rules of
accepta$ilit% "an% institutions have i"posed restrictions on their portfolios< So"e
esta$lish li"its on the cash co"ponent of a portfolio< 7thers "a% e:clude invest"ent
in stocks selling $elo9 five dollars a share8 securi5
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) W6ERE MOST INESTORS ST5M7E
ties not listed on an e:change8 stocks and $onds of co"panies in financial distress or
$ankruptc%8 and stocks not currentl% pa%ing a dividend<
Rema#n Full% Investe at All T#mes The fle:i$ilit% of institutional investors is fre?uentl% li"ited $% a self5i"posed
re?uire"ent to $e full% invested at all ti"es< ,an% institutions interpret their task as
stock picking8 not "arket ti"ingF the% $elieve that their clients have "ade the
"arket5ti"ing decision and pa% the" to full% invest all funds under their
"anage"ent<
4e"aining full% invested at all ti"es certainl% si"plifies the invest"ent task<
The investor si"pl% chooses the $est availa$le invest"ents< 4elative attractiveness
$eco"es the onl% invest"ent %ardstickF no a$solute standard is to $e "et<
Unfortunatel% the i"portant criterion of invest"ent "erit is o$scured or lost 9hen
su$standard invest"ents are ac?uired solel% to re"ain full% invested< Such
invest"ents 9ill at $est generate "ediocre returnsF at 9orst the% entail $oth a high
opportunit% costforegoing the ne:t good opportunit% to investand the risk of
apprecia$le loss<
4e"aining full% invested at all ti"es is consistent 9ith a relative5perfor"ance
orientation< If one@s goal is to $eat the "arket =particularl% on a short5ter" $asis>
9ithout falling significantl% $ehind8 it "akes sense to re"ain 1// percent invested<
6unds that 9ould other9ise $e idle "ust $e invested in the "arket in order not to
underperfor"s the "arket<
A$solute5perfor"ance5oriented investors8 $% contrast8 9ill $u% onl% 9hen
invest"ents "eet a$solute standards of value< The% 9ill choose to $e full% invested
onl% 9hen availa$le opportunities are $oth sufficient in nu"$er and co"pelling in
attractiveness8 preferring to re"ain less than full% invested 9hen $oth conditions are
not "et< In investing8 there are ti"es 9hen the $est thing to do is nothing at all< 0et
institutional "one% "anagers are unlikel% to adopt this alternative unless "ost of
their co"petitors are si"ilarl% inclined<
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) W6ERE MOST INESTORS ST5M7E
as intellectuall% insulting to clientsF it also e:acer$ates price "ove"ents in either
direction< ven so8 as depressed issues drop further in price8 attractive opportunities
"a% $e created for value investors<
!erhaps as a response to the difficulties of successfull% "anaging institutional
portfolios8 a nu"$er of professional investors have a$andoned funda"ental anal%sis
entirel%< 4ather than overco"ing the pro$le"s of professional "one% "anage"ent8
ho9ever8 the% have co"pounded the"< The re"ainder of this chapter descri$es their
activities<
The Abanonment o8 Funamental Investment
Anal%s#s b% Inst#tut#onal Investors
7ver the past several %ears there has $een an enor"ous increase in the a"ount of
"one% "anaged $% people 9ho kno9ingl% ignore the underl%ing funda"entals of the
invest"ents o9ned< Acade"ic notions8 such as the efficient5"arket h%pothesis and
the capital5asset5pricing "odel =three of 9hose "ost vociferous proponents received
the No$el !riDe for econo"ics in 1/>8 support these ne9 invest"ent strategies<
Inde:ing is the pri"ar% invest"ent outlet for investors 9ho $elieve in these ideas<
!ractices such as tactical asset allocation8 portfolio insurance8 and progra" trading
share to a greater or lesser e:tent the sa"e disregard for investing $ased on co"5pan%5$%5co"pan% funda"entals<
"ort8ol#o Insuran(e
,an% institutional investors are forever seeking to uncover a "agic for"ula
for invest"ent success< A successful for"ula 9ould greatl% si"plif% their livesF
investing 9ould $eco"e effortless8 "arketing 9ould $e a cinch8 and the% 9ould
al"ost
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1 W6ERE MOST INESTORS ST5M7E
As i"practical as portfolio insurance is for an% one investor8 it $eco"es ?uite
dangerous 9hen large nu"$ers of investors engage in it< With too "an%
practitioners8 frantic selling of stock inde: futures $% portfolio insurers could drive
futures prices $elo9 the underl%ing stock prices8 "aking it profita$le for ar$itrageursto $u% the cheap futures and sell the underl%ing stocks< Such selling 9ould put
additional pressure on stock prices8 perhaps necessitating "ore futures sales $%
portfolio insurers< A vicious circle could ensue<
This is e:actl% 9hat happened on ,onda%8 7cto$er 18 1.< After a sharp
"arket decline the previous 9eek $illions and $illions of dollars@ 9orth of stock inde:
futures 9ere du"ped in relentless 9aves $% portfolio insurers< This selling drove the
futures as "uch as 1/ percent $elo9 stock prices8 creating an attractive opportunit%
for ar$itrageurs to $u% futures and sell stocks< This selling drove share prices even
lo9er8 triggering "ore sales of futures $% hapless portfolio insurers< The notion that
%ou could escape do9nside risk $% selling futures 9as discredited in a couple of
hours that da% !ortfolio insurance had lured people 9ho 9ere not co"forta$le 9ith
the risks of stocks into $u%ing and holding the"< An apparentl% conservative strateg%
designed to prevent loss pla%ed an i"portant role in the 9orst de$acle in recent
financial histor%<
Ta(t#(al Asset Allo(at#on
B% 1.8 9ith portfolio insurance discredited8 institutional investors returned
to their co"puters searching for ne9 for"ulas< No9 their goal 9as to find a clear
signal that 9ould indicate 9hether stocks or $onds 9ere the $etter $u%< Although the
search for this ans9er has preoccupied investors over the %ears8 it is unlikel% that a
co"puter could ever $e progra""ed to "ake 9hat is clearl% a ;udg"ent call< 0et
9hat 9ould have $een considered a crackpot sche"e if adopted $% an individual
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3= W6ERE MOST INESTORS ST5M7E
transact< 0et even ver% large capitaliDation stocks have li"ited li?uidit% at a given
ti"e< 79ing to li"ited li?uidit%8 on the da% that a ne9 stock is added to an inde:8 it
often ;u"ps apprecia$l% in price as inde:ers rush to $u%< Nothing funda"ental has
changedF nothing "akes that stock 9orth "ore toda% than %esterda%< In effect8people are 9illing to pa% "ore for that stock ;ust $ecause it has $eco"e part of an
inde:<
B% 9a% of e:a"ple8 9hen Block$uster ntertain"ent 'orporation 9as added
to the Standard and !oor@s )// Inde: in earl% 118 its total "arket capitaliDation
increased in one da% $% over 1)) "illion8 or <1 percent8 $ecause so "an% fund
"anagers 9ere Go$ligedG to $u% it< Indeed8 arron$s has calculated that stocks added
to the Standard K !oor@s )// Inde: outperfor"ed the "arket $% al"ost * percent in
the first 9eek after their inclusion<
A related pro$le" e:ists 9hen su$stantial funds are co""itted to or
9ithdra9n fro" inde: funds specialiDing in s"all5capitaliDation stocks< =There are
no9 a nu"$er of such funds<> Such stocks usuall% have onl% li"ited li?uidit%8 and
even a s"all a"ount of $u%ing or selling activit% can greatl% influence the "arket
price< When s"all5capitaliDation5stock inde:ers receive "ore funds8 their $u%ing 9ill
push prices higherF 9hen the% e:perience rede"ptions8 their selling 9ill force prices
lo9er< B% unavoida$l% $u%ing high and selling lo98 s"all5stock inde:ers are al"ost
certain to underperfor" their inde:es<
7ther perverse effects of inde:ing are no9 e"erging 9ith increasing
fre?uenc%< When securities are o9ned onl% $ecause the% are part of an inde: and the
onl% stated goal of the o9ners is to "atch the "ove"ents of that inde:8 the portfolio
G"anagerG responsi$le for those securities has virtuall% no interest in influencing the
perfor"ance of the inde:< He or she is indifferent to 9hether the inde: rises or falls in
value8 other than to the e:tent that fees are $ased on total "anaged assets valued
at "arket prices<
This "eans that in a pro:% contest8 it "akes no real difference to the
"anager of an inde: fund 9hether the dissidents or the incu"$ent "anage"ent
9ins the fight8 even though the out5
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#he Institutional Performance Derby0 #he Client Is the 1oser
co"e "a% "ake a significant financial difference to the clients of the inde:er< =B%
choosing inde:ing8 investors have i"plicitl% e:pressed the $elief that their vote in a
pro:% contest could "ake no predicta$le financial difference an%9a%<> Ironicall%8
even if inde:ers 9anted to vote in a direction that "a:i"iDed value8 the% 9ould havea$solutel% no idea 9hich 9a% that 9ould $e $ecause inde: fund "anagers t%picall%
have no funda"ental invest"ent kno9ledge a$out the stocks the% o9n<.
It is note9orth% that the $oo" in inde:ing has occurred during a $ull "arket<
Bet9een 1./ and 1/ the esti"ated a"ount of "one% "anaged in inde:ed
accounts increased fro" 1/ $illion to a$out 1/ $illion8 9ith / percent of that
a"ount inde:ed to Standard K !oor@s portfolios< An additional 1// $illion or "ore is
$elieved to $e Gcloset inde:ed8G that is8 to track8 if not e:actl% "atch8 the SK! )//
Inde:< According to arron$s" GNo little i"petus has $een supplied to this "elanchol%
trend $% the harsh fact that the SK! has laid 9aste to the perfor"ance of
conventional "anagers during the ighties8 particularl% in the past five %ears< 6or
e:a"ple8 the SK! has $eaten the average e?uit% "utual fund in the (ipper Anal%tical
Service8 Inc<8 surve% in 2* out of the past 31 ?uarters<G1/ The SK! )// Inde: has also
significantl% $ettered the $roadl% $ased Wilshire )/// Inde: since the second half of
1.38 outperfor"ing it in t9ent%5three out of t9ent%5nine ?uartersF during that period
the co"pound annual total return for the SK! )// Inde: 9as 12< percent co"pared
9ith 1/< percent for the Wilshire )/// Inde:<
I $elieve that inde:ing 9ill turn out to $e ;ust another Wall Street fad< When it
passes8 the prices of securities included in popular inde:es 9ill al"ost certainl%
decline relative to those that have $een e:cluded< ,ore significantl%8 as arron$s has
pointed out8 GA self5reinforcing feed$ack loop has $een created8 9here the success of
inde:ing has $olstered the perfor"ance of the inde: itself8 9hich8 in turn pro"otes
"ore inde:ing<GG When the "arket trend reverses8 "atching the "arket 9ill not
see" so attractive8 the selling 9ill then adversel% affect the perfor"ance of the
inde:ers and further e:acer$ate the rush for the e:its<
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)2elus#ons o8 alue9
The M%ths an M#s(on(e$t#ons
o8 Bun, 7ons #n the 1':;s The ;unk5$ond $oo" 9ould not have occurred 9ithout the enthusiastic acceptance of
financial5"arket participants< The greed and possi$l% the ignorance of individual
investors8 the short5ter" orientation of institutional investors8 and the tendenc% of
Wall Street to "a:i"iDe its self5interest a$ove all ca"e together in the 1./s to allo9
a 2// $illion "arket to develop virtuall% fro" scratch< Although unproven over a
co"plete econo"ic c%cle8 ne9l% issued ;unk $onds 9ere hailed as a safe invest"ent
that provided a ver% attractive return to investors< B% 1/8 ho9ever8 the concept of
ne9l% issued ;unk $onds had $een e:posed as seriousl% fla9ed8 defaults reached
record levels8 and the prices of "an% issues plunged< ven so8 the ;unk5$ond "arket
staged a surprising recover% in earl% 11F "an% of the fla9s that had resulted in
tens of $illions of dollars of losses 9ere once again $eing ignored<
Historicall% "an% financial5"arket innovations have gained 9idespread
acceptance $efore $eing e:posed as ill conceived<
.
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3' W6ERE MOST INESTORS ST5M7E
What is uni?ue a$out ;unk $onds is the speed and "agnitude of their riseF their
strong and pernicious influence on other securities8 on financial "arkets8 and on the
$ehavior of $usinessesF and their continued popularit% in the face of large investor
losses< !erhaps "ost i"portant8 ;unk $onds gave an up9ard propulsion to $usinessvaluation8 as ti"e5tested anal%tical standards and trusted %ardsticks of value ca"e
to $e either overlooked $% investors or a$andoned for ne9 and unproven ones< This
chapter is intended as a cautionar% tale8 an illustration of ho9 seriousl% "isguided
investor thinking can $eco"e<
The ;unk5$ond de$acle 9as no great surprise< It had $een predicted pu$licl%
$% -a"es rant8 editor of Grant$s Interest 3ate 4bserver" (ouis (o9enstein8 author of
,hat$s ,rong with ,all !treet" Warren Buffett8 chair"an of Berkshire Hatha9a%8
Inc<8 and "e a"ong others< The ;unk5$ond "arket not onl% e:isted $ut actuall%
thrived in the face of continued criticis" and repeated 9arnings< The self5interest of
the participants in its perpetuation 9as so great8 ho9ever8 that the% used their
collective influence to effectivel% stave off for a nu"$er of %ears the gro9ing 9eight
of evidence against ;unk $onds<
A 7r#e8 6#stor% o8 the Bun,!7on Mar,et
To understand the ;unk5$ond "arket and its a"aDing gro9th in the 1./s8 one "ust
$egin 9ith ,ichael ,ilken8 its "aster"ind< In college and then at the Universit% of!enns%lvania@s Wharton School of Business in the earl% 1/s8 ,ilken studied the
9ork of acade"ician W< Braddock Hick"an< T9o decades earlier Hick"an had sho9n
that a 9ell5diversified8 lo95grade $ond portfolio could earn a greater rate of return
than a high5?ualit% $ond portfolioF in other 9ords8 the higher %ields on lo95rated
securities 9ould "ore than co"pensate for capital losses fro" an% defaults<1 This
opportunit% e:isted $ecause risk5averse investors shunned lo95grade $onds
regardless of potential return< Hence such $onds traded at depressed prices8 and lo9
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#he /yths and /isconceptions of 5unk onds in the &6')s /
prices8 not high coupons8 9ere the driving force $ehind the attractive returns< As 9e
shall see8 the legiti"ate opportunit% in a virtual handful of distressed securities that
9ere overlooked $% others 9as carried to e:cess 9hen ,ilken e:trapolated fro" a
historical relationship to an entirel% ne9 t%pe of securit%<After graduating fro" the Wharton School8 ,ilken took a ;o$ at #re:el
6irestone8 9here he traded the $onds of Gfallen angels8G co"panies that had
deteriorated in credit ?ualit% to $elo9 invest"ent grade< According to legend8 ,ilken
co""uted fro" his ho"e outside !hiladelphia to his Wall Street office $% $us8
spending the hours en route reading corporate financial state"ents $% the di" light
of a "iner@s headla"p that he 9ore< He soon $eca"e one of the "ost kno9ledgea$le
and visi$lepeople on Wall Street in the high5%ield "arket<
The argu"ents in favor of high5%ield5$ond investing represented a radical
departure fro" the conventional 9isdo" of the earl% 1./s< In the after"ath of the
1*5) recession and $ear "arket8 investors 9ere generall% loathe to incur credit
risk< !assage of the "plo%ee 4etire"ent Inco"e and Securit% Act of 1* =4ISA>
led "an% institutions to adopt stringent fiduciar% standards that precluded risk
taking< ,ilken overca"e investor reluctance $% purportedl% de"onstrating that
invest"ent in lo95rated securities historicall% provided higher total returns than
could $e earned on invest"ent5grade securities<
The %ield on lo95rated $onds 9as o$viousl% high< The ne98 radical clai" 9as
that the risk 9as also lo9& losses fro" defaults 9ould $e "ore than offset $%
incre"ental %ield< This clai" of a lo9 default rate 9as central to the $ullish case for
;unk $ondsa case that co"es apart under even casual scrutin%<
6allen5angel $onds t%picall% are illi?uid8 and potential $u%ers are put off $%
the fear of $eing virtuall% locked into their invest"ents< Another prere?uisite to the
esta$lish"ent of a ne95issue ;unk5$ond "arket then 9as ,ilken@s pro"ise of
li?uidit%< ,ilken pro"ised $u%ers that he 9ould "ake a "arket in all of his deals8
ensuring li?uidit%< In the earl% da%s of the ne95issue ;unk5$ond "arket a great
a"ount of paper 9as traded $ack and
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&1 W6ERE MOST INESTORS ST5M7E
forth a"ong a nu"$er of ,ilken disciples< This gave the appearance of li?uidit%8
9hich 9as8 in fact8 onl% as deep as ,ilken@s various pockets<
Before ,ichael ,ilken ca"e along8 the onl% ;unk $onds in e:istence 9ere a
fe9 $illion dollars@ face a"ount of fallen angels< Investors 9ere no "ore likel% to $u%
ne9l% issued ;unk $onds at par =the face value of a $ond8 the contractual a"ount of
the $ondholders@ clai"> than an offering of co""on stock in a $ankrupt issuer<
,ilken shaped financial histor% $% pioneering the issuance of ;unk $onds8 glossing
over the "a;or differences $et9een fallen angels and ne9 issues< This re?uired an
enor"ous leap of faith8 one 9hich ,ilken "ade and 9as a$le to persuade others to
"ake as 9ell<
Unfortunatel% ne9l% issued ;unk $onds 9ere not the lo95risk instru"ents that
$u%ers 9ere led to $elieve< The% have8 in fact8 ver% different risk and return
characteristics fro" fallen angels< Specificall%8 ne9l% issued ;unk $onds offer no"argin of safet% to investors< Trading around par value8 the% have ver% li"ited
appreciation potential8 $ut unlike high5grade $onds trading near par8 the% have
su$stantial do9nside risk< A fallen angel8 $% contrast8 trades considera$l% $elo9 par
and thus has less do9nside risk than ne9l% issued ;unk $onds of co"para$le credit
?ualit%< The other side of this coin is that $onds trading $elo9 par have "ore upside
price potential than $onds trading at par< If underl%ing credit ?ualit% i"proves or if
interest rates drop8 discount $onds have roo" for su$stantial appreciationF $onds
trading at par8 $% contrast8 are usuall% su$;ect to call prior to "aturit% and thus have
ver% li"ited upside potential< 7ther things $eing e?ual8 then8 ne9l% issued ;unk
$onds carr% greater risk of loss 9ith lo9er potential return than fallen angels8 an
i"portant distinction that ,ilken failed to "ake8 at least pu$licl%<
The Fla-s o8 the 2e8ault!Rate Cal(ulat#on
There 9as8 in fact8 no reasona$le $asis for ,ilken@s clai" that the default rate
of ;unk $onds issued in the late 1./s 9ould $e
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&+ W6ERE MOST INESTORS ST5M7E
cash5pa% ;unk $onds "a% actuall% $e in trou$le long $efore the actual event of
default<
In the "id51./s several acade"ics produced studies concluding that ;unk
$onds 9ere attractive invest"ents< In earl% 1/8 even as the "arket 9as collapsing8
d Alt"an edited #he High 7ield Debt /arket" an antholog% of "ore than a doDen
recent articles "ostl% lauding ;unk5$ond issuance and invest"ent< Such up$eat
anal%ses8 so"eti"es financed $% the leading high5%ield under9riters8 failed to take
into account the serious fla9s in the default5rate calculation<
The default rate 9as offered $% under9riters8 approved $% acade"ics8 and
accepted $% investors as a pro:% for investor losses fro" ;unk $onds that 9ent $ad<
Not onl% 9as its calculation an e:ercise in science fiction8 it also ignored the fact that
defaults and investor losses are not the sa"e thing< A fallen angel that defaults8 for
e:a"ple8 has not so far to drop as a ;unk $ond trading at par< The default rate also
failed to incorporate the financial i"pact of voluntar% e:change offers and restruc5
turings in 9hich $ondholders accepted i"pair"ent of their clai"s 9ithout an actual
default having taken place<
The Bun,!7on Crusae
-unk $onds appeared to perfor" a sort of financial alche"%8 as (ouis (o9enstein has
o$served<3 79ners of the ;unk $onds issued $% the "an% co"panies 9hose interest
e:penses 9ere greater than their preta: profits 9ere a$le to clai" to have earned
interest inco"e in e:cess of the profits earned $% the underl%ing $usinesses< As long
as investors 9ere 9illing to purchase $onds on such ter"s8 there 9ere ne9
under9ritings to $e done< And as long as the %ield illusion 9as perpetuated8 investors
kept $u%ing the $onds<
The tre"endous gro9th of the "arket 9as acco"panied $% a $uildup of the
;unk5$ond infrastructure on Wall Street< If investors the"selves failed to discern the
attractiveness of ;unk
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&= W6ERE MOST INESTORS ST5M7E
cient8 ad"inistrativel% $loated8 or even corrupt8 and in desperate need of ne9
"anagerial $lood< While there 9ere certainl% kernels of truth in this characteriDation
of corporate A"erica8 there 9as onl% scant consideration of 9hether the i"position of
a staggering de$t $urden 9as the $est re"ed% for this particular ail"ent< ,oreover8virtuall% no one noticed or cared that ;unk $onds 9ere no longer fulfilling their
for"er8 highl% pu$liciDed role of financing s"all co"panies<
It see"s incredi$le that an%one could get a9a% 9ith the portra%al of ;unk
$onds as a kind of financial aspirin good for 9hat ails %ou< Nevertheless8 ,ilken had
legions of lo%al follo9ers8 "an% of 9ho" he had helped "ake incredi$l% rich< ven
the $lue $loods of Wall Street like ,organ Stanle%8 6irst Boston8 and old"an Sachs8
once threatened $% ,ilken@s $urgeoning ;unk5$ond e"pire8 had $% the "id51./s
$uilt e:tensive ;unk5$ond under9riting8 "arketing8 and trading capa$ilities of their
o9n< Al$eit to a lesser degree than ,ilken8 the% too 9ere no9 $eneficiaries of the
$oo"ing ;unk5$ond "arket< The greatest iron% in the 9hole ;unk5$ond stor% "a% $e
that one of the $iggest financial s9indles of all ti"e8 ne9l% issued ;unk $onds8 had $%
the end of the 1./s co"e to en"esh ever% "a;or Wall Street fir" alongside #re:el
Burnha" (a"$ert< (ong after the de"ise of #re:el8 the rest of Wall Street 9ould $e
licking its ;unk5$ond5inflicted 9ounds8 a nagging re"inder of the 9idespread greed
that 9ouldn@t leave a shak% financial innovation to its po9er5hungr% founder<
Earl% Su((esses o8 Bun,!7on Investors e to
5nreal#st#( E0$e(tat#ons
Self5fulfilling prophesies contri$uted to the successful ;unk5$ond e:periences
of the earl% to "id51./s< The increasing availa$ilit% of nonrecourse ;unk5$ond de$t
=in 9hich the lender looks onl% to the $orro9ing entit% for pa%"ent> led to increasing
"ultiples $eing paid for corporate assets< This is $ecause
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#he /yths and /isconceptions of 8unk onds in the &6')s
$u%ers ar"ed 9ith other people@s "one% developed a ske9ed vie9 of risk and return
co"pared 9ith that of $u%ers using their o9n "one% and 9ere therefore 9illing to
pa% higher and higher prices< Business valuations started to increase at the sa"e
ti"eF the econo"% 9as re$ounding fro" the 1.2 recession8 and interest rates 9ere
falling fro" their earl% 1./s peak< cono"ic gro9th $oosted operating results for
"an% ;unk5$ond issuersF declining interest rates allo9ed a nu"$er of issuers to
refinance on advantageous ter"s< ven $ad deals 9ere $ailed out $% a gro9ing
econo"% and higher $usiness valuations8 reinforcing the notion of a lo9 default rate<
arl% investors did 9ell8 e"$oldening othersF su$se?uent deals 9ere perfor"ed at
still higher "ultiples of earnings and cash flo9< #r !epper8 -ack5in5the5Bo:8 and 'olt
Industries8 Inc<8 for e:a"ple8 9ere each $ought and sold "ore than once at
successivel% higher prices<
,ost ;unk5$ond $u%ers and issuers 9ere pro$a$l% una9are that the% 9erei"plicitl% assu"ing a great deal a$out the ongoing health of the econo"% and the
;unk5$ond "arket< ,an% ;unk5$ond issuers8 for e:a"ple8 had raDor5thin or
none:istent interest coverage =ratio of preta: earnings to interest e:pense> and
insufficient cash flo9 to "eet upco"ing de$t5principal repa%"ents< Issuers and
investors alike assu"ed that cash flo9 9ould al9a%s gro9 and that upco"ing
"aturities could $e refinanced< If gro9th did not "aterialiDe or if credit proved
unavaila$le8 a financial restructuring or $ankruptc% filing 9ould result< High5%ield
$onds 9ere not purchased $% cautious investors8 ho9ever8 $ut $% opti"istic8 short5
ter"5oriented8 and gulli$le ones< It is not surprising that ;unk5$ond holders did not
e:pect an econo"ic do9nturn or credit contractionF if the% had8 the% 9ould not have
$ought ;unk $onds<
The pervasive opti"is" of investors led to a rela:ation of invest"ent
standards< A stud% $% Barrie Wig"ore8 a li"ited partner at old"an Sachs8 sho9ed
that the t%pical interest coverage ratio for ne9l% issued ;unk $onds declined
drasticall% $et9een 1./ and 1.. to the point 9here it fell $elo9 1</that is8
preta: earnings 9ere less than interest e:pense for the aver5
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&' W6ERE MOST INESTORS ST5M7E
the rate paid on deposits< In the presence of deposit insurance8 the "arket could not
and did not i"pose discipline on the invest"ent $ehavior of thrift institutions< As long
as ;unk $onds did not default in large nu"$ers8 the thrifts that invested in the"
9ould achieve high reported returns that $elonged to the o9ners and to"anage"ent< If the $onds defaulted8 the 6S(I' 9ould $ear the losses<
The largest thrift o9ners of ;unk $onds'olu"$ia Savings and (oan
Association8 'enTrust Savings and (oan Association8 I"perial Savings and (oan
Association8 (incoln Savings and (oan Association8 and 6ar West 6inancial
'orporation9ere either insolvent or on the $rink of insolvenc% $% the end of 1/<
,ost of these institutions had gro9n rapidl% through $rokered deposits =deposits
raised 9ith the assistance of Wall Street> for the sole purpose of investing the
proceeds in ;unk $onds and other risk% assets< The legac% of thrift invest"ent in ;unk
$onds is that these invest"ents caused "a;or pro$le"s for institutions that
other9ise 9ould have $een $oth considera$l% s"aller and less trou$led<
Insuran(e Com$an#es
A nu"$er of insurance co"panies 9ere also caught up in a cost5of5funds s?ueeDe in
the earl% 1./s< To investors seeking high %ields the% $egan to offer guaranteed
invest"ent contracts =I's>8 9hose attraction 9as the reinvest"ent of interest at
contractual rates8 effectivel% eli"inating reinvest"ent risk<
When U<S< govern"ent $ond %ields 9ere dou$le digit8 insurers 9ere a$le to
offer attractive rates on I's 9hile taking on little or no credit risk< When interest
rates declined8 insurers continued to offer high I' %ields in order to avoid a runoff of
assets< To "aintain a positive %ield spread8 insurance co"panies 9ere forced to
reach for %ield8 and "an%8 like 6irst :ecutive 'orporation and 6irst 'apital Holdings
'orporation8 9ere lured into the ;unk5$ond "arket< Unfortunatel% a nu"$er of their
co"petitors felt co"pelled to $id for I' $usiness despite the risks of $eco"ing ;unk5
$ond investors the"selves< B% 1/ a nu"$er of leading insurance co"panies had to
take
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:1 W6ERE MOST INESTORS ST5M7E
"itring historicall% unprecedented "ultiples to $e paid for $usinesses in the "id5late
1./s<
ero5coupon and !IC financing can act as corporate life support s%ste"s8
preserving patients 9ho are ter"inall% ill< Such issuers can have lia$ilities thate:ceed assets and $e una$le to "eet de$t5service o$ligations in cash %et re"ain in
$usiness8 giving an appearance of financial health< As Buffett has o$served8 GIf (#'
govern"ents had issued no de$t in the 1/s other than long5ter" Dero5coupon
o$ligations8 the% 9ould no9 have a spotless record as de$tors<G*
Historicall% investors in $onds have en;o%ed a presu"ption of solvenc%8
safet%8 and even seniorit%< An investor in a U<S< Treasur% $ill8 for e:a"ple8 or GDero5
coupon U<S< govern"ent $ondG =created s%ntheticall% 9hen a Wall Street fir" strips
the cash flo9s fro" a U<S< Treasur% $ond and sells each pa%"ent seriall%> can $e
confident that inco"e and principal 9ill $e paid at "aturit%< A ;unk Dero5coupon
$ond8 ho9ever8 is a ga"$leF no cash is paid until "aturit%8 at 9hich point it either
pa%s or defaults< ,an% $u%ers of Dero5coupon or !IC ;unk $onds 9ho $elieved that
the% 9ere locking in an attractive %ield to "aturit% turned out to have ga"$led and
lost< Indeed8 "ost ;unk Dero5coupon and !IC instru"ents "ore closel% rese"$led
options on a future i"prove"ent in $usiness results than fi:ed and secure clai"s
against the current value of a co"pan%< 'alling ;unk Dero5coupon and !IC securities
$onds didn@t give the" the sa"e risk and return characteristics as other $onds8 $ut it
did "ake the" easier to sell to investors<
Interest Rate Resets Wor, #n Onl% One 2#re(t#on
In the late 1./s interest rate resets $eca"e a co""on and 9idel% accepted feature
of ne9l% issued ;unk $onds< An interest rate reset is a pro"ise "ade $% an issuer to
ad;ust the coupon on a $ond at a specified future date in order to cause it< to trade at
a predeter"ined price8 usuall% par<) This reset feature8 "as?uerading as a sort of
financial guarantee8 is reall% a financial place$o< It appears to provide a "eaningful
assurance of capital
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#he /yths and /isconceptions of 5unk onds in the &6')s .2
preservation $ut is virtuall% 9orthless< 'reated during an era 9hen al"ost an%one
could $orro9 a great deal of "one%8 the "isleading reset feature serves as a
re"inder that a pro"ise is onl% as good as the entit% that "akes it<
6or a $ond reset to 9ork properl%8 the underl%ing issuer "ust $e credit9orth%<!arado:icall%8 if the issuer is credit9orth%8 the reset feature is unnecessar% =other
than to ad;ust for apprecia$le interest rate "ove"ents in the econo"% or "inor
fluctuations in the issuer@s credit9orthiness>< There is no interest rate8 ho9ever8 that
9ill cause the $onds of a severel% distressed issuer to trade at parF no "atter ho9
"uch the interest coupon is raised8 the do9nside risk to prospective $u%ers holds
do9n the $ond@s "arket price< ,oreover8 the higher the rate at 9hich the coupon is
reset8 the 9orse off the issuer $eco"es8 as increased de$t5service re?uire"ents
e:acer$ate the financial distress<
Nu"erous ;unk5$ond resets failed in the late 1./s8 and onl% a fe9
succeeded< The $onds of ,a::a"8 Inc<8 9ere a near successF reset to trade at par8
the% failed to sell a$ove )8 despite ,a::a"@s strong $usiness results at the ti"e< An
issue of 1 percent Western Union 'orporation $onds 9as reset to a 1<2) percent
coupon at a ti"e 9hen Western Union alread% had one foot in the graveF the $ond
prices did not respond to the reset8 declining ?uickl% fro" the ./s to the */s and
then lo9er still< In 1. #re:el Burnha" (a"$ert 9as una$le to reset the $onds of
-i" Walter 'orporation8 9hich 9as then forced to file for $ankruptc%<
In a daring displa% of financial chutDpah8 Cohl$erg8 Cravis and 4o$erts =CC4>8 the
$u%er of 4-4 Na$isco8 Inc< =4-4>8 in 1.8 cra""ed do9n =distri$uted> ) $illion face
value of reset5ta$le !IC securities to for"er stockholders of that co"pan% as "erger
consideration< The perceived attractiveness of the reset feature "a% have allo9ed
CC4@s $id to prevail over co"peting offers8 although the entire reset "arket 9as far
less than the siDe of this issue alone and the record of previous reset atte"pts 9as
a$%s"al< The reset feature8 accepted $% $u%ers as an al"ost ironclad guarantee8
stirred enor"ous enthusias" for the 4-4 cra"5do9n paper< So"e of the de"and 9as
fro" investors
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:+ W6ERE MOST INESTORS ST5M7E
9ho didn@t usuall% purchase ;unk $onds $ut 9ere attracted $% the apparent pro"ise
of GassuredG par value<
The "ost 9idel% ?uoted %ield on the 4-4 Na$isco $onds and preferred stock
9as not the conventional current %ield or %ield to "aturit% $ut the ne9l% coinedG%ield to reset<G Su$stantial su"s 9ere invested $ased on this unproven concept8 one
that 9ould 9ork onl% if 4-4 Na$isco 9ere financiall% health% and if the ;unk5$ond
"arket 9ere not in disarra%< As it turned out8 even after a last5ditch infusion of 1<)
$illion of ne9 e?uit% capital into 4-4 Na$isco8 the $onds failed to trade a$ove 3
percent of par at the date of the reset< It 9as onl% later8 after the co"pan%
co"pleted a "ore significant deleveraging8 that the "arket price of the $onds
reached par value<
An Anal%t#(al Error o8 Bun,!7on Investors
The rela:ation of invest"ent standards $% ;unk5$ond investors 9as acco"panied $%
the dangerous "isconception that the a"ount of de$t and e?uit% in a co"pan%@s
capital structure ;unior to one@s o9n invest"ent provided a degree of protection< It
9as as if the value of a $usiness e:isted on the lia$ilit% side rather than on the asset
side of its $alance sheet< Although it "a% $e superficiall% reassuring to kno9 that
there are investors in a co"pan% 9hose clai"s are su$ordinated to %our o9n8 this
infor"ation is of little8 if an%8 value in assessing the "erits of %our invest"ent<
At the ti"e of the 2) $illion 4-4 Na$isco leveraged $u%out8 Wall Street
anal%sts argued that the issuance of ) $illion 9orth of cra"5do9n de$t and
preferred stock i"proved the credit9orthiness of 4-4@s senior de$t< To illustrate the
fallac% of this argu"ent8 suppose CC4 had paid 12 rather than 1/ per share for
4-4 in the for" of an additional * $illion of cra"5do9n preferred stock< The senior
lenders 9ould have $een no $etter off 9ith this additional * $illion of $ook e?uit%
;unior to theirs< No "ore tangi$le assets 9ould have $elonged to the co"pan% than
$eforeF onl% the intangi$le asset called good9ill 9ould have $een increased via a
$ookkeeping entr%< ,oreover8 the i"proved de$t5to5e?uit% ratio 9ould have $een
irrelevant
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#he /yths and /isconceptions of 5unk onds in the &6')s :)
to the safet% of the senior lenders< "phasis on the ;unior clai"s against a co"pan%
is a greater5fool argu"ent8 9herein one takes co"fort fro" the potentiall% foolish
actions of others rather than fro" the 9isdo" of one@s o9n<
A Fla-e 2e8#n#t#on o8 Cash Flo-> E7IT2A> eas to Overvaluat#on
Investors in pu$lic co"panies have historicall% evaluated the" on reported earnings<
B% contrast8 private $u%ers of entire co"panies have valued the" on free cash flo9<
In the latter half of the 1./s entire $usinesses 9ere $ought and sold al"ost as
readil% as securities8 and it 9as not unreasona$le for investors in securities to start
thinking "ore like $u%ers and sellers of entire $usinesses< There is8 of course8
nothing 9rong 9ith ree:a"ining an old anal%tical tool for continued validit% nor 9ith
replacing one that has $eco"e out"oded< Thus8 in a radical departure fro" thehistorical nor"8 "an% stock and ;unk5$ond $u%ers in the latter half of the 1./s
replaced earnings 9ith cash flo9 as the anal%tical "easure of value<
In their haste to anal%De free cash flo98 investors in the 1./s sought a si"ple
calculation8 a single nu"$er8 that 9ould ?uantif% a co"pan%@s cash5generating
a$ilit%< The cash5flo9 calculation the great "a;orit% of investors settled upon 9as
BIT#A =earnings $efore interest8 ta:es8 depreciation8 and a"ortiDation>< +irtuall% all
anal%ses of highl% leveraged fir"s relied on BIT#A as a principal deter"inant of
value8 so"eti"es as the onl% deter"inant< ven nonleveraged fir"s ca"e to $e ana5
l%Ded in this 9a% since virtuall% ever% co"pan% in the late 1./s 9as dee"ed a
potential takeover candidate< Unfortunatel% BIT#A 9as anal%ticall% fla9ed and
resulted in the chronic overvaluation of $usinesses<
Ho9 should cash flo9 $e "easuredE Before the ;unk5$ond era investors
looked at t9o co"ponents& after5ta: earnings8 that is8 the profit of a $usinessF plus
depreciation and a"ortiDation "inus capital e:penditures8 that is8 the net invest"ent
or disinvest"ent in the fi:ed assets of a $usiness< The availa$ilit% of large a"ounts of
nonrecourse financing changed things< Since
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:= W6ERE MOST INESTORS ST5M7E
interest e:pense is ta: deducti$le8 preta:8 not after5ta:8 earnings are availa$le to pa%
interest on de$tF "one% that 9ould have gone to pa% ta:es goes instead to lenders<
A highl% leveraged co"pan% thus has "ore availa$le cash flo9 than the sa"e $usi5
ness utiliDing less leverage<Not9ithstanding8 BIT =earnings $efore interest and ta:es> is not necessaril%
all freel% availa$le cash< If interest e:pense consu"es all of BIT8 no inco"e ta:es
are o9ed< If interest e:pense is lo98 ho9ever8 ta:es consu"e an apprecia$le portion
of BIT< At the height of the ;unk5$ond $oo"8 co"panies could $orro9 an a"ount so
great that all of BIT =or "ore than all of BIT> 9as fre?uentl% re?uired for pa%ing
interest< In a less froth% lending environ"ent co"panies cannot $eco"e so highl%
leveraged at 9ill< BIT is therefore not a reasona$le appro:i"ation of cash flo9 for
the"< After5ta: inco"e plus that portion of BIT going to pa% interest e:pense is a
co"pan%@s true cash flo9 derived fro" the ongoing inco"e strea"<
'ash flo98 as "entioned8 also results fro" the e:cess of depreciation and
a"ortiDation e:penses over capital e:penditures< It is i"portant to understand 9h%
this is so< When a co"pan% $u%s a "achine8 it is re?uired under generall% accepted
accounting principles =AA!> to e:pense that "achine over its useful life8 a
procedure kno9n in accounting parlance as depreciation< #epreciation is a noncash
e:pense that reduces net reported profits $ut not cash< #epreciation allo9ances con5
tri$ute to cash $ut "ust eventuall% $e used to fund capital e:penditures that are
necessar% to replace 9orn5out plant and e?uip"ent< 'apital e:penditures are thus a
direct offset to depreciation allo9ancesF the for"er is as certain a use of cash as the
latter is a source< The ti"ing "a% differ& a co"pan% "a% invest heavil% in plant and
e?uip"ent at one point and after9ard generate depreciation allo9ances 9ell in
e:cess of current capital spending< Whenever the plant and e?uip"ent need to $e
replaced8 ho9ever8 cash "ust $e availa$le< If capital spending is less than
depreciation over a long period of ti"e8 a co"pan% is undergoing gradual li?uidation<
A"ortiDation of good9ill is also a noncash charge $ut8 con5
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#he /yths and /isconceptions of 5unk onds in the &6')s .
versel%8 is "ore of an accounting fiction than a real $usiness e:pense< When a
co"pan% is purchased for "ore than its tangi$le $ook value8 accounting rules re?uire
the $u%er to create an intangi$le $alance5sheet asset kno9n as good9ill to "ake up
for the difference8 and then to a"ortiDe that good9ill over fort% %ears< A"ortiDation
of good9ill is thus a charge that does not necessaril% reflect a real decline in
econo"ic value and that likel% need not $e spent in the future to preserve the
$usiness< 'harges for good9ill a"ortiDation usuall% do represent free cash flo9<
It is not clear 9h% investors suddenl% ca"e to accept BIT#A as a "easure of
corporate cash flo9< BIT did not accuratel% "easure the cash flo9 fro" a co"pan%@s
ongoing inco"e strea"< Adding $ack 1// percent of depreciation and a"ortiDation to
arrive at BIT#A rendered it even less "eaningful< Those 9ho used BIT#A as a
cash5flo9 pro:%8 for e:a"ple8 either ignored capital e:penditures or assu"ed that
$usinesses 9ould not "ake an%8 perhaps $elieving that plant and e?uip"ent do not9ear out< In fact8 "an% leveraged takeovers of the 1./s forecast steadil% rising cash
flo9s resulting partl% fro" anticipated sharp reductions in capital e:penditures< 0et
the realit% is that if ade?uate capital e:penditures are not "ade8 a corporation is
e:tre"el% unlikel% to en;o% a steadil% increasing cash flo9 and 9ill instead al"ost
certainl% face declining results<
It is not eas% to deter"ine the re?uired level of capital e:penditures for a
given $usiness< Businesses invest in ph%sical plant and e?uip"ent for "an% reasons&
to re"ain in $usiness8 to co"pete8 to gro98 and to diversif%< :penditures to sta% in
$usiness and to co"pete are a$solutel% necessar%< 'apital e:penditures re?uired for
gro9th are i"portant $ut not usuall% essential8 9hile e:penditures "ade for
diversification are often not necessar% at all< Identif%ing the necessar% e:penditures
re?uires inti"ate kno9ledge of a co"pan%8 infor"ation t%picall% availa$le onl% to
insiders< Since detailed capital5spending infor"ation 9as not readil% availa$le to
investors8 perhaps the% si"pl% chose to disregard it<
So"e anal%sts and investors adopted the vie9 that it 9as not
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:& W6ERE MOST INESTORS ST5M7E
necessar% to su$tract capital e:penditures fro" BIT#A $ecause all the capital
e:penditures of a $usiness could $e financed e:ternall% =through lease financing8
e?uip"ent trusts8 nonrecourse de$t8 etc<>< 7ne hundred percent of BIT#A 9ould
thus $e free preta: cash flo9 availa$le to service de$tF no "one% 9ould $e re?uiredfor reinvest"ent in the $usiness< This vie9 9as fla9ed8 of course< (easehold
i"prove"ents and parts of a "achine are not t%picall% financea$le for an% co"pan%<
'o"panies e:periencing financial distress8 "oreover8 9ill have li"ited access to
e:ternal financing for an% purpose< An over5leveraged co"pan% that has spent its
depreciation allo9ances on de$t service "a% $e una$le to replace 9orn5out plant and
e?uip"ent and eventuall% $e forced into $ankruptc% or li?uidation<
BIT#A "a% have $een used as a valuation tool $ecause no other valuation
"ethod could have ;ustified the high takeover prices prevalent at the ti"e< This
9ould $e a clear case of circular reasoning< Without high5priced takeovers there 9ere
no upfront invest"ent $anking fees8 no under9riting fees on ne9 ;unk5$ond issues8
and no "anage"ent fees on ;unk5$ond portfolios< This 9ould not $e the first ti"e on
Wall Street that the "eans 9ere adapted to ;ustif% an end< If a historicall% accepted
invest"ent %ardstick proves to $e overl% restrictive8 the path of least resistance is to
invent a ne9 standard<
E7IT2A Anal%s#s Obs(ures the 2#88eren(e bet-een Goo an 7a 7us#nesses
BIT#A8 in addition to $eing a fla9ed "easure of cash flo98 also "asks the
relative i"portance of the several co"ponents of corporate cash flo9< !reta:
earnings and depreciation allo9ance co"prise a co"pan%@s preta: cash flo9F
earnings are the return on the capital invested in a $usiness8 9hile depreciation is
essentiall% a return of the capital invested in a $usiness< To illustrate the confusion
caused $% BIT#A anal%sis8 consider the e:a"ple portra%ed in e:hi$it 1<
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#he /yths and /isconceptions of 5unk onds in the &6')s ''9xhibit & Companies : and 7
In(ome Statement 8or 1''; @H #n m#ll#ons
Serv#(e Com$an% 4
Revenue H1;;Cash E0$enses :; 2e$re(#at#on an
Amort#?at#on JE7IT H*;E7IT2A H *;
Manu8a(tur#n/ Com$an% Y
Revenue H1;;Cash E0$enses :; 2e$re(#at#on an
Amort#?at#on *;E7IT H;E7IT2A H *;
Investors rel%ing on BIT#A as their onl% anal%tical tool 9ould value these t9o
$usinesses e?uall% At e?ual prices8 ho9ever8 "ost investors 9ould prefer to o9n
'o"pan% O8 9hich earns 2/ "illion8 rather than 'o"pan% 08 9hich earns nothing<
Although these $usinesses have identical BIT#A8 the% are clearl% not e?uall%
valua$le< 'o"pan% O could $e a service $usiness that o9ns no deprecia$le assets<
'o"pan% 0 could $e a "anufacturing $usiness in a co"petitive industr%< 'o"pan% 0
"ust $e prepared to reinvest its depreciation allo9ance =or possi$l% "ore8 due to
inflation> in order to replace its 9orn5out "achiner%< It has no free cash flo9 over
ti"e< 'o"pan% O8 $% contrast8 has no capital5spending re?uire"ents and thus has
su$stantial cu"ulative free cash flo9 over ti"e<
An%one 9ho purchased 'o"pan% 0 on a leveraged $asis 9ould $e in trou$le<
To the e:tent that an% of the annual 2/ "illion in BIT#A 9ere used to pa% cash
interest e:pense8 there 9ould $e a shortage of funds for capital spending 9hen plant
and e?uip"ent needed to $e replaced< 'o"pan% 0 9ould eventuall% go $ankrupt8
una$le $oth to service its de$t and "aintain its $usiness< 'o"pan% O8 $% contrast8
"ight $e an attractive $u%out candidate< The shift of investor focus fro"
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'1 WH4 ,7ST IN+ST74S STU,B(
received $% e?uit% investors fro" ;unk5$ond5financed ac?uisitions returned to the stock
"arket8 $idding up the prices of shares in still independent co"panies< The "arket prices of
securities involved in ar$itrage transactions8 e:change offers8 and corporate reorganiDations
9ere all influenced $% the e:cessive valuations "ade possi$le $% the ;unk5$ond "arket< As a
result8 even those 9ho avoided o9ning ;unk $onds found it difficult to escape their influence
co"pletel%<
We "a% confidentl% e:pect that there 9ill $e ne9 invest"ent fads in the future< The%
too 9ill e:pand $e%ond the rational li"itations of the innovation< As surel% as this 9ill happen8
it is e?uall% certain that no $ells 9ill toll to announce the e:cess< Investors 9ho stud% the ;unk5
$ond de$acle "a% $e a$le to identif% these ne9 fads for 9hat the% are and avoid the"< And as
9e shall see in the chapters that follo98 avoiding losses is the "ost i"portant prere?uisite to
invest"ent success<
Notes
1< 'onnie Bruck8 The Predators !all =Ne9 0ork& !enguin8 1.>8 p< 2.<2< A "ore appropriate "ethod 9ould have $een to e:a"ine defaults or8 $etter still8 total
invest"ent returns for ;unk $onds grouped $% %ear of issuance8 9hich 9ould have eli"inated
the arith"etic fla9s in the custo"ar% default5rate calculation<
3< (ouis (o9enstein8 G(essons for Wall Street fro" ,ain Street8G "olu#$ia %aga&ine =7cto$er
1.>& 252<
*< Berkshire Hatha9a%8 Inc<8 annual report for 1.8 p< 1<
)< !ar is usuall% 18///8 $ut $ond prices are e:pressed as percentages of parF a $ond trading
at / is 9orth / percent of its 18/// par value8 or //<
< Anal%sts fre?uentl% co"pounded the error of using BIT#A as a pro:% for free cash flo9 $%
co"paring it 9ith cash interest e:pense rather than 9ith total interest e:pense in deter"ining
the cash flo9 coverage of interest< The ratio of the cash generated if a $usiness fails to
reinvest8 to onl% the interest that it "ust have pa% currentl%8 is not onl% "eaninglessF it
s"acks of deli$erate deception<
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IIA A5E!INESTMENT
"6IOSO"6Y
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=2e8#n#n/ Your Investment
GoalsWarren Buffett likes to sa% that the first rule of investing is G#on@t lose "one%8G and
the second rule is8 GNever forget the first rule<G I too $elieve that avoiding loss should
$e the pri"ar% goal of ever% investor< This does not "ean that investors should
never incur the risk of an% loss at all< 4ather Gdon@t lose "one%G "eans that over
several %ears an invest"ent portfolio should not $e e:posed to apprecia$le loss of
principal<
While no one 9ishes to incur losses8 %ou couldn@t prove it fro" an e:a"ination
of the $ehavior of "ost investors and speculators< The speculative urge that lies
9ithin "ost of us is strongF the prospect of a free lunch can $e co"pelling8 especiall%
9hen others have alread% see"ingl% partaken< It can $e hard to concentrate on
potential losses 9hile others are greedil% reaching for gains and %our $roker is on the
phone offering shares in the latest GhotG initial pu$lic offering< 0et the avoidance of
loss is the surest 9a% to ensure a profita$le outco"e<
A loss5avoidance strateg% is at odds 9ith recent conventional "arket 9isdo"<
Toda% "an% people $elieve that risk co"es8
3
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') A A5E!INESTMENT "6IOSO"6Y
not fro" o9ning stocks8 $ut fro" not o9ning the"< Stocks as a group8 this line of
thinking goes8 9ill outperfor" $onds or cash e?uivalents over ti"e8 ;ust as the% have
in the past< Inde:ing is one "anifestation of this vie9< The tendenc% of "ost institu5
tional investors to $e full% invested at all ti"es is another< There is an ele"ent of truth to this notionF stocks do figure to outperfor"
$onds and cash over the %ears< Being ;unior in a co"pan%@s capital structure and
lacking contractual cash flo9s and "aturit% dates8 e?uities are inherentl% riskier than
de$t instru"ents< In a corporate li?uidation8 for e:a"ple8 the e?uit% onl% receives the
residual after all lia$ilities are satisfied< To persuade investors to venture into
e?uities rather than safer de$t instru"ents8 the% "ust $e enticed $% the prospect of
higher returns< Ho9ever8 as discussed at greater length in chapter 8 the actual risk
of a particular invest"ent cannot $e deter"ined fro" historical data< It depends on
the price paid< If enough investors $elieve the argu"ent that e?uities 9ill offer the
$est long5ter" returns8 the% "a% pour "one% into stocks8 $idding prices up to levels
at 9hich the% no longer offer the superior returns< The risk of loss ste""ing fro"
e?uit%@s place in the capital structure is e:acer$ated $% pa%ing a higher price<
Another co""on $elief is that risk avoidance is inco"pati$le 9ith invest"ent
success< This vie9 holds that high return is attaina$le onl% $% incurring high risk and
that long5ter" invest"ent success is attaina$le onl% $% seeking out and $earing8
rather than avoiding8 risk< Wh% do I $elieve8 conversel%8 that risk avoidance is the
single "ost i"portant ele"ent of an invest"ent progra"E If %ou had 18///8 9ould
%ou $e 9illing to 9ager it8 dou$le or nothing8 on a fair coin tossE !ro$a$l% not< Would
%ou risk %our entire net 9orth on such a ga"$leE 7f course not< Would %ou risk the
loss of8 sa%8 3/ percent of %our net 9orth for an e?uivalent gainE Not "an% people
9ould $ecause the loss of a su$stantial a"ount of "one% could i"pair their standard
of living 9hile a co"para$le gain "ight not i"prove it co""ensuratel%< If %ou are
one of the vast "a;orit% of investors 9ho are risk averse8 then loss avoidance "ust
$e the cornerstone of %our invest"ent philosoph%<
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Defining 7our Investment Goals )reed%8 short5ter"5oriented investors "a% lose sight of a sound "athe"atical reasonfor avoiding loss& the effects of co"pounding even "oderate returns over "an%%ears are co"pelling8 if not do9nright "ind $oggling< Ta$le 1 sho9s the delightfuleffects of co"pounding even relativel% s"all a"ounts<
#able &
Com$oun alue o8 H1>;;; Investe at 2#88erent Rates o8 Return an 8or ar%#n/ 2urat#ons
Rate = vears 1; vears *; vears +; vears
3 H 1>++: H 1>&'1 H +>*;& H =>&)+
: 1>)3' *>1=' )>331 1;>;3+
1; 1>311 *>=') 3>&*& 1&>))'
1* 1>&3* +>1;3 '>3)3 *'>'3;
13 *>1;; )>)11 1'>)31 :=>:=;
*; *>):: 3>1'* +:>++: *+&>+&3
As the ta$le illustrates8 perseverance at even relativel% "odest rates of return is ofthe ut"ost i"portance in co"pounding %our net 9orth< A corollar% to the i"portance
of co"pounding is that it is ver% difficult to recover fro" even one large loss8 9hich
could literall% destro% all at once the $eneficial effects of "an% %ears of invest"ent
success< In other 9ords8 an investor is "ore likel% to do 9ell $% achieving
consistentl% good returns 9ith li"ited do9nside risk than $% achieving volatile and
so"eti"es even spectacular gains $ut 9ith considera$le risk of principal< An investor
9ho earns 1 percent annual returns over a decade8 for e:a"ple8 9ill8 perhaps
surprisingl%8 end up 9ith "ore "one% than an investor 9ho earns 2/ percent a %ear
for nine %ears and then loses 1) percent the tenth %ear<
There is an understanda$le8 al$eit unecono"ic8 appeal to the latter pattern of
returns8 ho9ever< The second investor 9ill outperfor" the for"er nine %ears out of
ten8 gaining considera$le ps%chic inco"e fro" this apparentl% superior perfor"ance<
If $oth investors are "one% "anage"ent professionals8 the latter
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Defining 7our Investment Goals
9orker earns "ore the "ore he or she produces< An investor cannot decide to think
harder or put in overti"e in order to achieve a higher return< All an investor can do is
follo9 a consistentl% disciplined and rigorous approachF over ti"e the returns 9ill
co"e< Targeting invest"ent returns leads investors to focus on upside potential
rather than on do9nside risk< #epending on the level of securit% prices8 investors
"a% have to incur considera$le do9nside risk to have a chance of "eeting predeter5
"ined return o$;ectives< If Treasur% $ills %ield percent8 "ore cannot $e achieved
fro" o9ning the"< If thirt%5%ear govern"ent $onds %ield . percent8 it is possi$le8 for
a 9hile8 to achieve a 1) percent annual return through capital appreciation resulting
fro" a decline in interest rates< If the $onds are held to "aturit%8 ho9ever8 the return
9ill $e . percent<
Stocks do not have the fir" "athe"atical tether afforded $% the contractual
nature of the cash flo9s of a high5grade $ond< Stocks8 for e:a"ple8 have no "aturit%
date or price< ,oreover8 9hile the value of a stock is ulti"atel% tied to the
perfor"ance of the underl%ing $usiness8 the potential profit fro" o9ning a stock is
"uch "ore a"$iguous< Specificall%8 the o9ner of a stock does not receive the cash
flo9s fro" a $usinessF he or she profits fro" appreciation in the share price8
presu"a$l% as the "arket incorporates funda"ental $usiness develop"ents into
that price< Investors thus tend to predict their returns fro" investing in e?uities $%
predicting future stock prices< Since stock prices do not appreciate in a predicta$le
fashion $ut fluctuate unevenl% over ti"e8 al"ost an% forecast can $e "ade and
;ustified< It is thus possi$le to predict the achieve"ent of an% desired level of return
si"pl% $% fiddling 9ith one@s esti"ate of future share prices<
In the long run8 ho9ever8 stock prices are also tethered8 al$eit "ore loosel%
than $onds8 to the perfor"ance of the underl%ing $usinesses< If the prevailing stock
price is not 9arranted $% underl%ing value8 it 9ill eventuall% fall< Those 9ho $ought in
at a price that itself reflected overl% opti"istic assu"ptions 9ill incur losses<
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. A +A(U5IN+ST,NT !HI(7S7!H0
4ather than targeting a desired rate of return8 even an e"inentl% reasona$le one8
investors should target risk< Treasur% $ills are the closest thing to a riskless
invest"entF hence the interest rate on Treasur% $ills is considered the risk5free rate<
Since investors al9a%s have the option of holding all of their "one% in T5$ills8invest"ents that involve risk should onl% $e "ade if the% hold the pro"ise of
considera$l% higher returns than those availa$le 9ithout risk< This does not e:press
an invest"ent preference for T5$illsF to the contrar%8 %ou 9ould rather $e full%
invested in superior alternatives< But alternatives 9ith so"e risk attached are
superior onl% if the return "ore than full% co"pensates for the risk<
,ost invest"ent approaches do not focus on loss avoidance or on an
assess"ent of the real risks of an invest"ent co"pared 9ith its return< 7nl% one that
I kno9 does& value investing< 'hapter descri$es value investingF chapter
ela$orates on three of its central underpinnings< Both chapters e:pand on the the"e
of loss avoidance and consider various "eans of achieving this o$;ective<
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3alue Invest#n/9 The
Im$ortan(e o8 a Mar/#n o8 Sa8et%+alue investing is the discipline of $u%ing securities at a significant discount fro"
their current underl%ing values and holding the" until "ore of their value is realiDed<
The ele"ent of a $argain is the ke% to the process< In the language of value
investors8 this is referred to as $u%ing a dollar for fift% cents< +alue investing
co"$ines the conservative anal%sis of underl%ing value 9ith the re?uisite discipline
and patience to $u% onl% 9hen a sufficient discount fro" that value is availa$le< The
nu"$er of availa$le $argains varies8 and the gap $et9een the price and value of an%
given securit% can $e ver% narro9 or e:tre"el% 9ide< So"eti"es a value investor 9ill
revie9 in depth a great "an% potential invest"ents 9ithout finding a single one that
is sufficientl% attractive< Such persistence is necessar%8 ho9ever8 since value is often
9ell hidden<
The disciplined pursuit of $argains "akes value investing ver% "uch a risk5
averse approach< The greatest challenge for
''
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Value Investing: The I#portance of a %argin of Safety 1/1
$allpla%ers8 si"pl% can@t distinguish a good pitch fro" a 9ild one< Both
undiscri"inating individuals and constrained institutional investors can take solace
fro" kno9ing that "ost "arket participants feel co"pelled to s9ing ;ust as
fre?uentl% as the% do<6or a value investor a pitch "ust not onl% $e in the strike Done8 it "ust $e in
his Gs9eet spot<G 4esults 9ill $e $est 9hen the investor is not pressured to invest
pre"aturel%< There "a% $e ti"es 9hen the investor does not lift the $at fro" his
shoulderF the cheapest securit% in an overvalued "arket "a% still $e overvalued< 0ou
9ouldn@t 9ant to settle for an invest"ent offering a safe 1/ percent return if %ou
thought it ver% likel% that another offering an e?uall% safe 1) percent return 9ould
soon "aterialiDe<
An invest"ent must $e purchased at a discount fro" underl%ing 9orth< This
"akes it a good a$solute value< Being a good a$solute value alone8 ho9ever8 is not
sufficient for investors "ust choose onl% the $est a$solute values a"ong those that
are currentl% availa$le< A stock trading at one5half of its underl%ing value "a% $e
attractive8 $ut another trading at one5fourth of its 9orth is the $etter $argain< This
dual discipline co"pounds the difficult% of the invest"ent task for value investors
co"pared 9ith "ost others<
+alue investors continuall% co"pare potential ne9 invest"ents 9ith their
current holdings in order to ensure that the% o9n onl% the "ost undervalued
opportunities availa$le< Investors should never $e afraid to ree:a"ine current
holdings as ne9 opportunities appear8 even if that "eans realiDing losses on the sale
of current holdings< In other 9ords8 no invest"ent should $e considered sacred 9hen
a $etter one co"es along<
So"eti"es doDens of good pitches are thro9n consecutivel% to a value
investor< In panick% "arkets8 for e:a"ple8 the nu"$er of undervalued securities
increases and the degree of undervaluation also gro9s< In $uo%ant "arkets8 $%
contrast8 $oth the nu"$er of undervalued securities and their degree of
undervaluation declines< When attractive opportunities are plentiful8 value investors
are a$le to sift carefull% through all the
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1;* A A5E!INESTMENT "6IOSO"6Y
$argains for the ones the% find "ost attractive< When attractive opportunities are
scarce8 ho9ever8 investors "ust e:hi$it great self5discipline in order to "aintain the
integrit% of the valuation process and li"it the price paid< A$ove all8 investors "ust
al9a%s avoid s9inging at $ad pitches<The Com$le0#t% an ar#ab#l#t% o8 7us#ness aluat#on
It 9ould $e a serious "istake to think that all the facts that descri$e a particular
invest"ent are or could $e kno9n< Not onl% "a% ?uestions re"ain unans9eredF all
the right ?uestions "a% not even have $een asked< ven if the present could so"e5
ho9 $e perfectl% understood8 "ost invest"ents are dependent on outco"es that
cannot $e accuratel% foreseen<
ven if ever%thing could $e kno9n a$out an invest"ent8 the co"plicating
realit% is that $usiness values are not carved in stone< Investing 9ould $e "uch
si"pler if $usiness values did re"ain constant 9hile stock prices revolved predicta$l%
around the" like the planets around the sun< If %ou cannot $e certain of value8 after
all8 then ho9 can %ou $e certain that %ou are $u%ing at a discountE The truth is that
%ou cannot<
There are "an% e:planations for volatilit% in $usiness value< The Gcredit
c%cle8G the periodic tightening and rela:ation of the availa$ilit% of credit8 is a "a;or
factor8 for e:a"ple8 $ecause it influences the cost and ter"s upon 9hich "one% can
$e $orro9ed< This in turn affects the "ultiples that $u%ers are 9illing to pa% for
$usinesses< Si"pl% put8 $u%ers 9ill 9illingl% pa% higher "ultiples if the% receive lo95
rate nonrecourse financing than the% 9ill in an unleveraged transaction<
Trends in inflation or deflation also cause $usiness values to fluctuate< That
said8 value investing can 9ork ver% 9ell in an inflationar% environ"ent< If for fift%
cents %ou $u% a dollar of value in the for" of an asset8 such as natural resource
properties or real estate8 9hich increases in value 9ith inflation8 a
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Value Investing: The I#portance of a %argin of Safety 1/3fift%5cent invest"ent toda% can result in the realiDation of value apprecia$l% greaterthan one dollar< In an inflationar% environ"ent8 ho9ever8 investors "a% $eco"eso"e9hat careless< As long as assets are rising in value8 it 9ould appear attractive torela: one@s standards and purchase 1 of assetsP not for )/ cents8 $ut for / or ./cents =or perhaps even 1<1/>< Such la:it% could prove costl%8 ho9ever8 in the event
that inflation co"es to $e anticipated $% "ost investors8 9ho respond $% $idding upsecurit% prices< A su$se?uent slo9do9n in the rate of inflation could cause a pricedecline<
In a deflationar% environ"ent assets tend to decline in value< Bu%ing a dollar@s9orth of assets for fift% cents "a% not $e a $argain if the asset value is dropping<Historicall% investors have found attractive opportunities in co"panies 9ith su$stan5tial Ghidden assets8G such as an overfunded pension fund8 real estate carried on the$alance sheet $elo9 "arket value8 or a profita$le finance su$sidiar% that could $esold at a significant gain< A"idst a $road5$ased decline in $usiness and asset values8ho9ever8 so"e hidden assets $eco"e less valua$le and in so"e cases "a% $eco"ehidden lia$ilities< A decline in the stock "arket 9ill reduce the value of pension fundassetsF previousl% overfunded plans "a% $eco"e underfunded< 4eal estate8 carriedon co"panies@ $alance sheets at historical cost8 "a% no longer $e undervalued<7verlooked su$sidiaries that 9ere once hidden ;e9els "a% lose their luster<
The possi$ilit% of sustained decreases in $usiness value is a dagger at theheart of value investing =and is not a $arrel of laughs for other invest"entapproaches either>< +alue investors place great faith in the principle of assessingvalue and then $u%ing at a discount< If value is su$;ect to considera$le erosion8 thenho9 large a discount is sufficientE
Should investors 9orr% a$out the possi$ilit% that $usiness value "a% declineEA$solutel%< Should the% do an%thing a$out itE There are three responses that "ight$e effective< 6irst8 since investors cannot predict 9hen values 9ill rise or fall8valuation should al9a%s $e perfor"ed conservativel%8 giving considera$le 9eight to9orst5case li?uidation value as 9ell as to other
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1;) A A5E!INESTMENT "6IOSO"6Y
"ethods< Second8 investors fearing deflation could de"and a greater than usual
discount $et9een price and underl%ing value in order to "ake ne9 invest"ents or to
hold current positions< This "eans that nor"all% selective investors 9ould pro$a$l%
let even "ore pitches than usual go $%< 6inall%8 the prospect of asset deflation placesa heightened i"portance on the ti"e fra"e of invest"ents and on the presence of a
catal%st for the realiDation of underl%ing value< In a deflationar% environ"ent8 if %ou
cannot tell 9hether or 9hen %ou 9ill realiDe underl%ing value8 %ou "a% not 9ant to
get involved at all< If underl%ing value is realiDed in the near5ter" directl% for the
$enefit of shareholders8 ho9ever8 the longer5ter" forces that could cause value to
di"inish $eco"e "oot<
The Im$ortan(e o8 a Mar/#n o8 Sa8et%
Ben;a"in raha" understood that an asset or $usiness 9orth 1 toda% could $e
9orth ) cents or 1<2) in the near future< He also understood that he "ight even $e
9rong a$out toda%@s value< Therefore raha" had no interest in pa%ing 1 for 1 of
value< There 9as no advantage in doing so8 and losses could result< raha" 9as onl%
interested in $u%ing at a su$stantial discount fro" underl%ing value< B% investing at a
discount8 he kne9 that he 9as unlikel% to e:perience losses< The discount provided a
"argin of safet%<
Because investing is as "uch an art as a science8 investors need a "argin of
safet%< A "argin of safet% is achieved 9hen securities are purchased at prices
sufficientl% $elo9 underl%ing value to allo9 for hu"an error8 $ad luck8 or e:tre"e
volatilit% in a co"ple:8 unpredicta$le8 and rapidl% changing 9orld< According to
raha"8 GThe "argin of safet% is al9a%s dependent on the price paid< 6or an%
securit%8 it 9ill $e large at one price8 s"all at so"e higher price8 none:istent at so"e
still higher price<G1
Buffett descri$ed the "argin of safet% concept in ter"s of tol5
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;alue Investing0 #he Importance of a /argin of !afety 1;=
erances& GWhen %ou $uild a $ridge8 %ou insist it can carr% 3/8/// pounds8 $ut %ou
onl% drive 1/8///5pound trucks across it< And that sa"e principle 9orks in
investing<G2
What is the re?uisite "argin of safet% for an investorE The ans9er can var%fro" one investor to the ne:t< Ho9 "uch $ad luck are %ou 9illing and a$le to
tolerateE Ho9 "uch volatilit% in $usiness values can %ou a$sor$E What is %our
tolerance for errorE It co"es do9n to ho9 "uch %ou can afford to lose<
,ost investors do not seek a "argin of safet% in their holdings< Institutional
investors 9ho $u% stocks as pieces of paper to $e traded and 9ho re"ain full%
invested at all ti"es fail to achieve a "argin of safet%< reed% individual investors
9ho follo9 "arket trends and fads are in the sa"e $oat< The onl% "argin investors
9ho purchase Wall Street under9ritings or financial5"arket innovations usuall%
e:perience is a "argin of peril<
ven a"ong value investors there is ongoing disagree"ent concerning the
appropriate "argin of safet%< So"e highl% successful investors8 including Buffett8
have co"e increasingl% to recogniDe the value of intangi$le assets$roadcast
licenses or soft5drink for"ulas8 for e:a"ple9hich have a histor% of gro9ing in value
9ithout an% invest"ent $eing re?uired to "aintain the"< +irtuall% all cash flo9
generated is free cash flo9<
The pro$le" 9ith intangi$le assets8 I $elieve8 is that the% hold little or no
"argin of safet%< The "ost valua$le assets of #r !epperJSeven5Up8 Inc<8 $% 9a% of
e:a"ple8 are the for"ulas that give those soft drinks their distinctive flavors< It is
these intangi$le assets that cause #r !epperJSeven5Up8 Inc<8 to $e valued at a high
"ultiple of tangi$le $ook value< If so"ething goes 9rongtastes change or a
co"petitor "akes inroadsthe "argin of safet% is ?uite lo9<
Tangi$le assets8 $% contrast8 are "ore precisel% valued and therefore provide
investors 9ith greater protection fro" loss< Tangi$le assets usuall% have value in
alternate uses8 there$% providing a "argin of safet%< If a chain of retail stores
$eco"es unprofita$le8 for e:a"ple8 the inventories can $e li?uidated8
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1;3 A A5E!INESTMENT "6IOSO"6Y
receiva$les collected8 leases transferred8 and real estate sold< If consu"ers lose their
taste for #r !epper8 $% contrast8 tangi$le assets 9ill not "eaningfull% cushion
investors@ losses<
Ho9 can investors $e certain of achieving a "argin of safet%E B% al9a%s$u%ing at a significant discount to underl%ing $usiness value and giving preference to
tangi$le assets over intangi$les< =This does not "ean that there are not e:cellent
invest"ent opportunities in $usinesses 9ith valua$le intangi$le assets<> B% replacing
current holdings as $etter $argains co"e along< B% selling 9hen the "arket price of
an% invest"ent co"es to reflect its underl%ing value and $% holding cash8 if
necessar%8 until other attractive invest"ents $eco"e availa$le<
Investors should pa% attention not onl% to whether $ut also to why current
holdings are undervalued< It is critical to kno9 9h% %ou have "ade an invest"ent
and to sell 9hen the reason for o9ning it no longer applies< (ook for invest"ents 9ith
catal%sts that "a% assist directl% in the realiDation of underl%ing value< ive
preference to co"panies having good "anage"ents 9ith a personal financial stake
in the $usiness< 6inall%8 diversif% %our holdings and hedge 9hen it is financiall%
attractive to do so< ach of these points is discussed in the chapters co"prising the
re"ainder of this $ook<
To appreciate the "argin of safet% concept8 consider the stock of rie
(acka9anna8 Inc<8 in late 1.8 9hen it 9as $acked $% nearl% 1*/ per share in cash
as 9ell as a siDa$le and 9ell5supported ta: refund clai" against the I4S< The stock
sold at prices as lo9 as 11/ per share8 a discount fro" the net cash per share even
e:clusive of the refund clai"< The do9nside risk appeared to $e Dero< The onl%
foreseea$le loss on the stock 9ould $e a te"porar% "arket5price decline8 a
develop"ent that 9ould "erel% render the shares a still $etter $u%< Ulti"atel% rie
(acka9anna 9on its ta: case< Through "id511 cu"ulative li?uidating distri$utions
of 1 per share had $een paid =11) 9as paid in 1..8 returning all of a $u%er@s
late 1. cost>8 and the stock still traded at appro:i"atel% . per share<
Si"ilarl% !u$lic Service 'o"pan% of Ne9 Ha"pshire =!SNH> 1. percent
second5"ortgage $onds traded in earl% 1. at a$out par value< Although for"all% in
$ankruptc% !SNH had
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;alue Investing0 #he Importance of a /argin of !afety &)<
continued to pa% current interest on these $onds $ecause their principal a"ount 9as
covered "an% ti"es over $% the value of the utilit% assets securing the"< The
contractual "aturit% date of these $onds 9as -une 1.8 $ut investors 9ere
uncertain 9hether or not the% 9ould $e retired if the co"pan% 9ere then still in
'hapter 11< 7ther than the possi$ilit% of a near5dou$ling of interest rates8 there 9as
i""aterial do9nside risk other than fro" short5ter" price fluctuations< !SNH
ulti"atel% raised "one% to retire the $onds in Nove"$er 1.8 several "onths after
their contractual "aturit% date< Investors 9ere a$le to earn annualiDed returns of 1.
percent 9ith ver% lo9 risk due to the uncertain ti"ing of the $onds@ rede"ption<
!erhaps the $est recent e:a"ple of investing 9ith a "argin of safet% occurred
in the de$t securities of Te:aco8 Inc< In 1. Te:aco filed for $ankruptc% as a result
of uncertaint% surrounding a 1/ $illion legal verdict against it in favor of !ennDoil<
Although the value of Te:aco@s assets appeared to "ore than full% cover all of itslia$ilities even under a 9orst5case scenario8 in the i""ediate after"ath of Te:aco@s
'hapter 11 filing its stock and $onds plunged in price< As 9ith an% $ankruptc%8 "an%
investors 9ere suddenl% constrained fro" o9ning Te:aco securities< ven the
co"pan%@s pu$lic state"ent that $ondholders 9ould receive all principal and
postpetition as 9ell as prep5etition interest failed to $oost prices "uch<
The specific opportunit% in Te:aco securities 9as e:e"plified $% the Te:aco
11<.) percent de$entures due ,a% 181*< These $onds traded activel% at the /
level =the% traded flatF the price incorporated appro:i"atel% eighteen "onths of
accrued interest> in the 9ake of the 7cto$er 1. stock "arket crash< Assu"ing the
full pa%"ent of principal and interest upon e"ergence fro" 'hapter 118 these $onds
purchased at / 9ould provide annualiDed returns of **<1 percent8 2)<* percent8 and
1<) percent8 respectivel%8 assu"ing a one5%ear8 t9o5%ear8 and three5%ear holding
period fro" Nove"$er 18 1.< 'ould these $onds have declined further in priceE
'ertainl%8 $ut the% 9ould si"pl% have $eco"e a $etter $u%< Uncertaint% regarding
the ti"ing and e:act resolution of the $ankruptc% created an outstanding opportunit%
for value investors 9ho 9ere content
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1;: A A5E!INESTMENT "6IOSO"6Y
9ith doing 9ell under an% scenario 9hile al9a%s having a considera$le "argin of
safet%<
alue Invest#n/ Sh#nes #n a 2e(l#n#n/ Mar,et
When the overall "arket is strong8 the rising tide lifts "ost ships< !rofita$le
invest"ents are eas% to co"e $%8 "istakes are not costl%8 and high risks see" to pa%
off8 "aking the" see" reasona$le in retrospect< As the sa%ing goes8 G0ou can@t tell
9ho@s s9i""ing naked till the tide goes out<G
A "arket do9nturn is the true test of an invest"ent philosoph%< Securities
that have perfor"ed 9ell in a strong "arket are usuall% those for 9hich investors
have had the highest e:pectations< When these e:pectations are not realiDed8 the
securities8 9hich t%picall% have no "argin of safet%8 can plu""et< Stocks that fit this
description are so"eti"es referred to as Gtorpedo stocks8G a ter" that descri$es the
disastrous effect o9ning the" can have on one@s invest"ent results< 'o"pa?
'o"puter 'orporation traded at 2 on ,arch 8 11< B% April 2* the shares had
fallen to 1 The ne:t da% the% plunged 6= points< Then on ,a% 1* the% plunged
13, points to close at 3< The ,arch share price had reflected investor
e:pectations of high earnings gro9th< When the co"pan% su$se?uentl% announced a
decline in first5?uarter earnings8 the stock 9as torpedoed<
The securities o9ned $% value investors are not $uo%ed $% such high
e:pectations< To the contrar%8 the% are usuall% unheralded or ;ust ignored< In
depressed financial "arkets8 it is said8 so"e securities are so out of favor that %ou
cannot give the" a9a%< So"e stocks sell $elo9 net 9orking capital per share8 and a
fe9 sell at less than net cash =cash on hand less all de$t> per shareF "an% stocks
trade at an unusuall% lo9 "ultiple of current earnings and cash flo9 and at a
significant discount to $ook value<
A nota$le feature of value investing is its strong perfor"ance in periods of
overall "arket decline< Whenever the financial "arkets fail to full% incorporate
funda"ental values into securi5
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;alue Investing0 #he Importance of a /argin of !afety &)6
ties prices8 an investor@s "argin of safet% is high< Stock and $ond prices "a%
anticipate continued poor $usiness results8 %et securities priced to reflect those
depressed funda"entals "a% have little roo" to fall further< ,oreover8 securities
priced as if nothing could go right stand to $enefit fro" a change in perception< If
investors refocused on the strengths rather than on the difficulties8 higher securit%
prices 9ould result< When funda"entals do i"prove8 investors could $enefit $oth
fro" $etter results and fro" an increased "ultiple applied to the"<
In earl% 1. the shares of Telefonos de ,e:ico8 S<A<8 sold for prices as lo9 as
ten cents< The co"pan% 9as not doing $adl%8 and anal%sts 9ere forecasting for the
shares annual earnings of fifteen cents and a $ook value of appro:i"atel% sevent%5
five cents in 1..< Investors see"ed to focus onl% on the continual dilution of the
stock8 ste""ing fro" ?uarterl% <2) percent stock dividends and fro" the issuance
of shares to ne9 telephone su$scri$ers8 ostensi$l% to fund the re?uired capital out5la%s to install their phones< The "arket ignored virtuall% ever% criterion of value8
pricing the shares at e:tre"el% lo9 "ultiples of earnings and cash flo9 9hile
co"pletel% disregarding $ook value<
In earl% 11 Telefonos@s share price rose to over 3<2)< The shares8 out of
favor several %ears earlier8 $eca"e an institutional favorite< True8 so"e i"prove"ent
in operating results did contri$ute to this enor"ous price appreciation8 $ut the
pri"ar% e:planation 9as an increase in the "ultiple investors 9ere 9illing to pa%<
The higher "ultiple reflected a change in investor ps%cholog% "ore than an%
funda"ental develop"ents at the co"pan%<
alue Invest#n/ Is "re#(ate on the
E88#(#ent!Mar,et 6%$othes#s 7e#n/ Wron/
Investors should understand not onl% 9hat value investing is $ut also 9h% it is
a successful invest"ent philosoph%< At the ver% core of its success is the recurrent
"ispricing of securities
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11; A A5E!INESTMENT "6IOSO"6Y
in the "arketplace< +alue investing is8 in effect8 predicated on the proposition that
the efficient5"arket h%pothesis is fre?uentl% 9rong< If8 on the one hand8 securities
can $eco"e undervalued or overvalued8 9hich I $elieve to $e incontrovert5i$l% true8
value investors 9ill thrive< If8 on the other hand8 all securities at so"e future date
$eco"e fairl% and efficientl% priced8 value investors 9ill have nothing to do< It is
i"portant8 then8 to consider 9hether or not the financial "arkets are efficient<
The efficient5"arket h%pothesis takes three for"s<3 The 9eak for" "aintains
that past stock prices provide no useful infor"ation on the future direction of stock
prices< In other 9ords8 technical anal%sis =anal%sis of past price fluctuations> cannot
help investors< The se"istrong for" sa%s that no pu$lished infor"ation 9ill help
investors to select undervalued securities since the "arket has alread% discounted all
pu$licl% availa$le infor"ation into securities prices< The strong for" "aintains that
there is no infor"ation8 pu$lic or private8 that 9ould $enefit investors< Thei"plication of $oth the se"i5strong and strong for"s is that funda"ental anal%sis is
useless< Investors "ight ;ust as 9ell select stocks at rando"<
7f the three for"s of the efficient5"arket h%pothesis8 I $elieve that onl% the
9eak for" is valid< Technical anal%sis is indeed a 9aste of ti"e<
As to the other for"s& %es8 the "arket does tend to incorporate ne9
infor"ation into pricessecurities prices are neither rando" nor do the% totall%
ignore availa$le infor"ation%et the "arket is far fro" efficient< There is si"pl% no
?uestion that investors appl%ing disciplined anal%sis can identif% inefficientl% priced
securities8 $u% and sell accordingl%8 and achieve superior returns< Specificall%8 $%
finding securities 9hose prices depart apprecia$l% fro" underl%ing value8 investors
can fre?uentl% achieve a$ove5average returns 9hile taking $elo95average risks<
The pricing of large5capitaliDation stocks tends to $e "ore efficient than that
of s"all5capitaliDation stocks8 distressed $onds8 and other less5popular invest"ent
fare< While hundreds of invest"ent anal%sts follo9 IB,8 fe98 if an%8 cover thousands
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;alue Investing0 #he Importance of a /argin of !afety &&&
of s"all5capitaliDation stocks and o$scure ;unk $onds< Investors are "ore likel%8
therefore8 to find inefficientl% priced securities outside the Standard and !oor@s 1//
than 9ithin it< ven a"ong the "ost highl% capitaliDed issues8 ho9ever8 investors are
fre?uentl% $linded $% groupthink8 there$% creating pricing inefficiencies<
Is it reasona$le to e:pect that in the future so"e securities 9ill continue to $e
significantl% "ispriced fro" ti"e to ti"eE I $elieve it is< The elegance of the efficient5
"arket theor% is at odds 9ith the realit% of ho9 the financial "arkets operate<
An entire $ook could $e 9ritten on this su$;ect alone8 $ut one enlightening
article cleverl% re$uts the efficient5"arket theor% 9ith living8 $reathing refutations<
Buffett@s GThe Superinvestors of raha"5and5#oddsvilleG de"onstrates ho9 nine
value5invest"ent disciples of Ben;a"in raha"8 holding varied and independent
portfolios8 achieved pheno"enal invest"ent success over long periods<*
Buffett considers the possi$ilit% that the e:traordinar% perfor"ance of theseinvestors could so"eho9 $e a rando" event8 such as correctl% calling a se?uence of
coin tosses8 or that the value investors discussed in his article co"prise a $iased
sa"ple8 i"itating rather than e"ulating raha"@s invest"ent strateg%< Buffett
strongl% argues other9ise< His vie9 is that the onl% thing the "an% value investors
have in co""on is a philosoph% that dictates the purchase of securities at a discount
fro" underl%ing value< The e:istence of so "an% independent successes is
inconsistent 9ith the efficient5"arket theor%< If the "arkets 9ere efficient8 then ho9
could so "an% investors8 identifia$le $% Buffett %ears ago as sharing a co""on
philosoph% $ut having little overlap in their portfolios8 all have done so 9ellE Buffett@s
argu"ent has never8 to "% kno9ledge8 $een addressed $% the efficient5"arket
theoristsF the% evidentl% prefer to continue to prove in theor% 9hat is refuted in
realit%<
Wh% do stock prices tend to depart fro" underl%ing value8 there$% "aking the
financial "arkets inefficientE There are nu"erous reasons8 the "ost o$vious $eing
that securities prices are deter"ined in the short run $% suppl% and de"and< The
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11* A A5E!INESTMENT "6IOSO"6Y
forces of suppl% and de"and do not necessaril% correlate 9ith value at an% given
ti"e< Also8 "an% $u%ers and sellers of securities are "otivated $% considerations
other than underl%ing value and "a% $e 9illing to $u% or sell at ver% different prices
than a value investor 9ould<If a stock is part of a "a;or "arket inde:8 for e:a"ple8 there 9ill $e de"and
fro" inde: funds to $u% it regardless of 9hether it is overpriced in relation to
underl%ing value< Si"ilarl%8 if a stock has recentl% risen on increasing volu"e8
technical anal%sts "ight consider it attractiveF $% definition8 underl%ing value 9ould
not $e a part of their calculations< If a co"pan% has e:hi$ited rapid recent gro9th8 it
"a% trade at a Ggro9thG "ultiple8 far higher than a value investor 9ould pa%<
'onversel%8 a co"pan% that recentl% reported disappointing results "ight $e du"ped
$% investors 9ho focused e:clusivel% on earnings8 depressing the price to a level
considera$l% $elo9 underl%ing value< An investor una$le to "eet a "argin call is in
no position to hold out for full valueF he or she is forced to sell at the prevailing
"arket price<
The $ehavior of institutional investors8 dictated $% constraints on their
$ehavior8 can so"eti"es cause stock prices to depart fro" underl%ing value<
Institutional selling of a lo95priced s"all5capitaliDation spinoff8 for e:a"ple8 can
cause a te"porar% suppl%5de"and i"$alance8 resulting in a securit% $eco"ing
undervalued< If a co"pan% fails to declare an e:pected dividend8 institutions
restricted to o9ning onl% dividend5pa%ing stocks "a% unload the shares< Bond funds
allo9ed to o9n onl% invest"ent5grade de$t 9ould du"p their holdings of an issue
i""ediatel% after it 9as do9ngraded $elo9 BBB $% the rating agencies< Such
pheno"ena as %ear5end ta: selling and ?uarterl% 9indo9 dressing can also cause
"arket inefficiencies8 as value considerations are su$ordinated to other factors<
Ben;a"in raha" and #avid #odd e:plained stock "ispric5ings this 9a%& GThe
"arket is not a 9eighing "achine8 on 9hich the value of each issue is recorded $% an
e:act and i"personal
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11* A A5E!INESTMENT "6IOSO"6Y
underl%ing value8 for e:a"ple8 a "a;orit% of shareholders can force it to $eco"e
open5ended =9here$% shares can $e redee"ed at net asset value> or to li?uidate8
delivering underl%ing value directl% to shareholders< The open5ending or li?uidation of
a closed5end fund is one of the purest e:a"ples of value ar$itrage< The ar$itrage profit fro" purchasing the undervalued stock of an ongoing
$usiness can $e "ore difficult to realiDe< The degree of difficult% in a given instance
depends8 a"ong other things8 on the "agnitude of the gap $et9een price and value8
the e:tent to 9hich "anage"ent is entrenched8 the identit% and o9nership position
of the "a;or shareholders8 and the availa$ilit% of credit in the econo"% for corporate
takeover activit%<
7e-are o8 alue "reteners
G+alue investingG is one of the "ost overused and inconsistentl% applied ter"s in the
invest"ent $usiness< A $road range of strategies "ake use of value investing as a
pseudon%"< ,an% have little or nothing to do 9ith the philosoph% of investing
originall% espoused $% raha"< The "isuse of the value la$el accelerated in the "id5
1./s in the 9ake of increasing pu$licit% given to the long5ter" successes of true
value investors such as Buffett at Berkshire Hatha9a%8 Inc<8 ,ichael !rice and the
late ,a: (< Heine at ,utual Series 6und8 Inc<8 and Willia" 4uane and 4ichard 'unniff
at the Se?uoia 6und8 Inc<8 a"ong others< Their results attracted a great "an% Gvalue
pretenders8G invest"ent cha"eleons 9ho fre?uentl% change strategies in order to
attract funds to "anage<
These value pretenders are not true value investors8 disciplined craftspeople
9ho understand and accept the 9isdo" of the value approach< 4ather the% are
charlatans 9ho violate the conservative dictates of value investing8 using inflated
$usiness valuations8 overpa%ing for securities8 and failing to achieve a "argin of
safet% for their clients< These investors8 despite =or
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;alue Investing0 #he Importance of a /argin of !afety 11)
perhaps as a direct result of> their i"prudence8 are a$le to achieve good invest"ent
results in ti"es of rising "arkets< #uring the latter half of the 1./s8 value
pretenders gained 9idespread acceptance8 earning high8 even spectacular8 returns<
,an% of the" $enefitted fro" the overstated private5"arket values that 9ereprevalent during those %earsF 9hen $usiness valuations returned to historical levels
in 1/8 ho9ever8 "ost value pretenders suffered su$stantial losses<
To so"e e:tent value8 like $eaut%8 is in the e%e of the $eholderF virtuall% an%
securit% "a% appear to $e a $argain to so"eone< It is hard to prove an overl%
opti"istic investor 9rong in the short run since value is not precisel% "easura$le and
since stocks can re"ain overvalued for a long ti"e< Accordingl%8 the $u%er of
virtuall% an% securit% can clai" to $e a value investor at least for a 9hile<
Ironicall%8 "an% true value investors fell into disfavor during the late 1./s<
As the% avoided participating in the full% valued and overvalued securities that the
value pretenders clai"ed to $e $argains8 "an% of the" te"poraril% underperfor"ed
the results achieved $% the value pretenders< The "ost conservative 9ere actuall%
criticiDed for their Ge:cessiveG caution8 prudence that proved 9ell founded in 1/<
ven toda% "an% of the value pretenders have not $een defrocked of their value5
investor "antle< There 9ere "an% articles in financial periodicals chronicling the poor
invest"ent results posted $% "an% so5called value investors in 1/< The top of the
list8 needless to sa%8 9as do"inated $% value pretenders<
Con(lus#on
+alue investing is si"ple to understand $ut difficult to i"ple"ent< +alue
investors are not supersophisticated anal%tical 9iDards 9ho create and appl%
intricate co"puter "odels to find attractive opportunities or assess underl%ing value<
The hard part is discipline8 patience8 and ;udg"ent< Investors need disci5
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113 A A5E!INESTMENT "6IOSO"6Y
pline to avoid the "an% unattractive pitches that are thro9n8 patience to 9ait for the
right pitch8 and ;udg"ent to kno9 9hen it is ti"e to s9ing<
Notes
1. 7enam#n Graham> #he Intelligent Investor" )th e. @Ne- Yor,9 6ar$er Ro->1'&+> $. *:1.
*. Warren E. 7u88ett> DThe Su$er#nvestors o8 Graham!an!2osv#lle>D Hermes
@Columb#a 7us#ness S(hool ma/a?#ne @Fall 1':)9)!1=.
+. 7urton G. Mal,#el> A 3andom ,alk down ,all !treet" )th e. @Ne- Yor,9 W. W.
Norton> 1':=> $$. 1&)!&=.
). 7u88ett> $$.1)!1=.
=. 7enam#n Graham> 2av# . 2o> an S#ne% Cottle> !ecurity Analysis @Ne- Yor,9
M(Gra-!6#ll> 1'3*> $. )*.
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&At the Root o8 a
alue!Investment "h#loso$h% There are three central ele"ents to a value5invest"ent philosoph%< 6irst8 value
investing is a $otto"5up strateg% entailing the identification of specific undervalued
invest"ent opportunities< Second8 value investing is a$solute5perfor"ance58 not
relative5perfor"ance oriented< 6inall%8 value investing is a risk5averse approachF
attention is paid as "uch to 9hat can go 9rong =risk> as to 9hat can go right
=return><
The Mer#ts o8 7ottom!5$ Invest#n/
In the discussion of institutional investing in chapter 38 it 9as noted that a great
"an% professional investors e"plo% a top5do9n approach< This involves "aking a
prediction a$out the future8 ascertaining its invest"ent i"plications8 and then acting
upon the"< This approach is difficult and risk%8 $eing vulnera$le to error at ever%
step< !ractitioners need to accuratel% fore5
11
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11. A A5E!INESTMENT "6IOSO"6Y
cast "acroecono"ic conditions and then correctl% interpret their i"pact on various
sectors of the overall econo"% on particular industries8 and finall% on specific
co"panies< As if that 9ere not co"plicated enough8 it is also essential for top5do9n
investors to perfor" this e:ercise ?uickl% as 9ell as accuratel%8 or others "a% getthere first and8 through their $u%ing or selling8 cause prices to reflect the forecast
"acroecono"ic develop"ents8 there$% eli"inating the profit potential for
lateco"ers<
B% 9a% of e:a"ple8 a top5do9n investor "ust $e correct on the $ig picture
=e<g<8 are 9e entering an unprecedented era of 9orld peace and sta$ilit%E>8 correct in
dra9ing conclusions fro" that =e<g<8 is er"an reunification $ullish or $earish for
er"an interest rates and the value of the deutsche "ark>8 correct in appl%ing those
conclusions to attractive areas of invest"ent =e<g<8 $u% er"an $onds8 $u% the
stocks of U<S< co"panies 9ith "ultinational presence>8 correct in the specific
securities purchased =e<g<8 $u% the ten5%ear er"an govern"ent $ond8 $u% 'oca5
'ola>8 and8 finall%8 $e earl% in $u%ing these securities<
The top5do9n investor thus faces the daunting task of predicting the
unpredicta$le "ore accuratel% and faster than thousands of other $right people8 all
of the" tr%ing to do the sa"e thing< It is not clear 9hether top5do9n investing is a
greater5fool ga"e8 in 9hich %ou 9in onl% 9hen so"eone else overpa%s8 or a greater5
genius ga"e8 9inna$le at $est onl% $% those fe9 9ho regularl% possess superior
insight< In either case8 it is not an attractive ga"e for risk5averse investors<
There is no "argin of safet% in top5do9n investing< Top5do9n investors are
not $u%ing $ased on valueF the% are $u%ing $ased on a concept8 the"e8 or trend<
There is no defina$le li"it to the price the% should pa%8 since value is not part of their
purchase decision< It is not even clear 9hether top5do9n5oriented $u%ers are
investors or speculators< If the% $u% shares in $usinesses that the% trul% $elieve 9ill
do 9ell in the future8 the% are investing< If the% $u% 9hat the% $elieve others 9ill
soon $e $u%ing8 the% "a% actuall% $e speculating<
Another difficult% 9ith a top5do9n approach is gauging the level of e:pectations
alread% reflected in a co"pan%@s current
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At the 3oot of a ;alue>Investment Philosophy 11
share price< If %ou e:pect a $usiness to gro9 1/ percent a %ear $ased on %our top5
do9n forecast and $u% its stock $etting on that gro9th8 %ou could lose "one% if the
"arket price reflects investor e:pectations of 1) percent gro9th $ut a lo9er rate is
achieved< The e:pectations of others "ust therefore $e considered as part of an%top5do9n invest"ent decision< =See the discussion of torpedo stocks in chapter <>
B% contrast8 value investing e"plo%s a $otto"5up strateg% $% 9hich individual
invest"ent opportunities are identified one at a ti"e through funda"ental anal%sis<
+alue investors search for $argains securit% $% securit%8 anal%Ding each situation on
its o9n "erits< An investor@s top5do9n vie9s are considered onl% insofar as the%
affect the valuation of securities<
!arado:icall% a $otto"5up strateg% is in "an% 9a%s si"pler to i"ple"ent
than a top5do9n one< While a top5do9n investor "ust "ake several accurate
predictions in a ro98 a $otto"5up investor is not in the forecasting $usiness at all<
The entire strateg% can $e concisel% descri$ed as G$u% a $argain and 9ait<G Investors
"ust learn to assess value in order to kno9 a $argain 9hen the% see one< Then the%
"ust e:hi$it the patience and discipline to 9ait until a $argain e"erges fro" their
searches and $u% it8 regardless of the prevailing direction of the "arket or their o9n
vie9s a$out the econo"% at large<
7ne significant and not necessaril% o$vious difference $et9een a $otto"5up
and top5do9n strateg% is the reason for "aintaining cash $alances at ti"es< Botto"5
up investors hold cash 9hen the% are una$le to find attractive invest"ent oppor5
tunities and put cash to 9ork 9hen such opportunities appear< A $otto"5up investor
chooses to $e full% invested onl% 9hen a diversified portfolio of attractive
invest"ents is availa$le< Top5do9n investors8 $% contrast8 "a% atte"pt to ti"e the
"arket8 so"ething $otto"5up investors do not do< ,arket ti"ing involves "aking a
;udg"ent a$out the overall "arket directionF 9hen top5do9n investors $elieve the
"arket 9ill decline8 the% sell stocks to hold cash8 a9aiting a "ore $ullish opinion<
Another difference $et9een the t9o approaches is that $otto"5up investors
are a$le to identif% si"pl% and precisel% 9hat
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12/ A A5E!INESTMENT "6IOSO"6Y
the% are $etting on< The uncertainties the% face are li"ited& 9hat is the underl%ing
$usiness 9orthF 9ill that underl%ing value endure until shareholders can $enefit fro"
its realiDationF 9hat is the likelihood that the gap $et9een price and value 9ill
narro9F and8 given the current "arket price8 9hat is the potential risk and re9ardEBotto"5up investors can easil% deter"ine 9hen the original reason for "aking
an invest"ent ceases to $e valid< When the underl%ing value changes8 9hen
"anage"ent reveals itself to $e inco"petent or corrupt8 or 9hen the price
appreciates to "ore full% reflect underl%ing $usiness value8 a disciplined investor can
reevaluate the situation and8 if appropriate8 sell the invest"ent< Huge su"s have
$een lost $% investors 9ho have held on to securities after the reason for o9ning
the" is no longer valid< In investing it is never 9rong to change %our "ind< It is onl%
9rong to change %our "ind and do nothing a$out it<
Top5do9n investors8 $% contrast8 "a% find it difficult to kno9 9hen their $et is
no longer valid< If %ou invest $ased on a ;udg"ent that interest rates 9ill decline $ut
the% rise instead8 ho9 and 9hen do %ou decide that %ou 9ere 9rongE 0our $et "a%
eventuall% prove correct8 $ut then again it "a% not< Unlike ;udg"ents a$out value
that can easil% $e reaffir"ed8 the possi$le grounds for reversing an invest"ent
decision that 9as "ade $ased upon a top5do9n prediction of the future are si"pl%
not clear<
Ao$t an Absolute!"er8orman(e Or#entat#on
,ost institutional and "an% individual investors have adopted a relative5
perfor"ance orientation =as discussed in chapter 3>< The% invest 9ith the goal of
outperfor"ing either the "arket8 other investors8 or $oth and are apparentl%
indifferent as to 9hether the results achieved represent an a$solute gain or loss<
ood relative perfor"ance8 especiall% short5ter" relative per5
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122 A A5E!INESTMENT "6IOSO"6Y
unlike an% other holding8 cash does not involve an% risk of incurring opportunit% cost
=losses fro" the ina$ilit% to take advantage of future $argains> since it does not drop
in value during "arket declines<
R#s, an ReturnWhile "ost other investors are preoccupied 9ith ho9 "uch "one% the% can "ake
and not at all 9ith ho9 "uch the% "a% lose8 value investors focus on risk as 9ell as
return< To the e:tent that "ost investors think a$out risk at all8 the% see" confused
a$out it< So"e insist that risk and return are always positivel% correlatedF the greater
the risk8 the greater the return< This is8 in fact8 a $asic tenet of the capital5asset5
pricing "odel taught in nearl% all $usiness schools8 %et it is not al9a%s true< 7thers
"istakenl% e?uate risk 9ith volatilit%8 e"phasiDing the GriskG of securit% price
fluctuations 9hile ignoring the risk of "aking overpriced8 ill5conceived8 or poorl%
"anaged invest"ents<
A positive correlation $et9een risk and return 9ould hold consistentl% onl% in
an efficient "arket< An% disparities 9ould $e i""ediatel% correctedF this is 9hat
9ould "ake the "arket efficient< In inefficient "arkets it is possi$le to find
invest"ents offering high returns 9ith lo9 risk< These arise 9hen infor"ation is not
9idel% availa$le8 9hen an invest"ent is particularl% co"plicated to anal%De8 or 9hen
investors $u% and sell for reasons unrelated to value< It is also co""onplace to
discover high5risk invest"ents offering lo9 returns< 7verpriced and therefore risk%
invest"ents are often availa$le $ecause the financial "arkets are $iased to9ard
overvaluation and $ecause it is difficult for "arket forces to correct an overvalued
condition if enough speculators persist in overpa%ing< Also8 unscrupulous operators
9ill al9a%s "ake overpriced invest"ents availa$le to an%one 9illing to $u%F the% are
not legall% re?uired to sell at a fair price<
Since the financial "arkets are inefficient a good deal of the
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At the 3oot of a ;alue>Investment Philosophy 123
ti"e8 investors cannot si"pl% select a level of risk and $e confident that it 9ill $e
reflected in the acco"pan%ing returns< 4isk and return "ust instead $e assessed
independentl% for ever% invest"ent<
In point of fact8 greater risk does not guarantee greater return< To thecontrar%8 risk erodes return $% causing losses< It is onl% 9hen investors shun high5risk
invest"ents8 there$% depressing their prices8 that an incre"ental return can $e
earned 9hich "ore than full% co"pensates for the risk incurred< B% itself risk does
not create incre"ental returnF onl% price can acco"plish that<
The Nature o8 R#s,
The risk of an invest"ent is descri$ed $% $oth the pro$a$ilit% and the potential
a"ount of loss< The risk of an invest"ent the pro$a$ilit% of an adverse outco"eis
partl% inherent in its ver% nature< A dollar spent on $iotechnolog% research is a riskier
invest"ent than a dollar used to purchase utilit% e?uip"ent< The for"er has $oth a
greater pro$a$ilit% of loss and a greater percentage of the invest"ent at stake<
In the financial "arkets8 ho9ever8 the connection $et9een a "arketa$le
securit% and the underl%ing $usiness is not as clear5cut< 6or investors in a "arketa$le
securit% the gain or loss associated 9ith the various outco"es is not totall% inherent
in the underl%ing $usinessF it also depends on the price paid8 9hich is esta$lished $%
the "arketplace< The vie9 that risk is dependent on $oth the nature of invest"ents
and on their "arket price is ver% different fro" that descri$ed $% $eta =9hich is
considered in the ne:t section><
While securit% anal%sts atte"pt to deter"ine 9ith precision the risk and
return of invest"ents8 events alone acco"plish that< 6or "ost invest"ents the
a"ount of profit earned can $e kno9n onl% after "aturit% or sale< 7nl% for the safest
of invest"ents is return kno9a$le at the ti"e of purchase& a one5%ear
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12* A A5E!INESTMENT "6IOSO"6Y
percent T5$ill returns percent at the end of one %ear< 6or riskier invest"ents the
outco"e "ust $e kno9n $efore the return can $e calculated< If %ou $u% one hundred
shares of 'hr%sler 'orporation8 for e:a"ple8 %our return depends al"ost entirel% on
the price at 9hich it is trading 9hen %ou sell< 7nl% then can the return $e calculated<Unlike return8 ho9ever8 risk is no "ore ?uantifia$le at the end of an
invest"ent than it 9as at its $eginning< 4isk si"pl% cannot $e descri$ed $% a single
nu"$er< Intuitivel% 9e understand that risk varies fro" invest"ent to invest"ent& a
govern"ent $ond is not as risk% as the stock of a high5technolog% co"pan%< But
invest"ents do not provide infor"ation a$out their risks the 9a% food packages
provide nutritional data<
4ather8 risk is a perception in each investor@s "ind that results fro" anal%sis
of the pro$a$ilit% and a"ount of potential loss fro" an invest"ent< If an e:plorator%
oil 9ell proves to $e a dr% hole8 it is called risk%< If a $ond defaults or a stock plunges
in price8 the% are called risk%< But if the 9ell is a gusher8 the $ond "atures on
schedule8 and the stock rallies strongl%8 can 9e sa% the% 9eren@t risk% 9hen the
invest"ent 9as "adeE Not at all< The point is8 in "ost cases no "ore is kno9n a$out
the risk of an invest"ent after it is concluded than 9as kno9n 9hen it 9as "ade<
There are onl% a fe9 things investors can do to counteract risk& diversif%
ade?uatel%8 hedge 9hen appropriate8 and invest 9ith a "argin of safet%< It is
precisel% $ecause 9e do not and cannot kno9 all the risks of an invest"ent that 9e
strive to invest at a discount< The $argain ele"ent helps to provide a cushion for
9hen things go 9rong<
For 7eta or Worse
,an% "arket participants $elieve that invest"ent risk is intrinsic to specific
securities8 as it is to activities like hang gliding and "ountain cli"$ing< Using "odern
financial the5
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At the 3oot of a ;alue>Investment Philosophy 12)
or%8 acade"ics and "an% "arket professionals have atte"pted to ?uantif% this risk
9ith a single statistical "easure8 $eta< Beta co"pares a securit%@s or portfolio@s
historical price fluctuations 9ith those of the "arket as a 9hole< High5$eta stocks are
defined as those that tend to rise $% a higher percentage than the average stock in arising "arket and decline "ore than the average stock in a falling "arket< #ue to
their greater volatilit%8 high5$eta stocks are dee"ed to $e riskier than lo95$eta
stocks<
I find it preposterous that a single nu"$er reflecting past price fluctuations
could $e thought to co"pletel% descri$e the risk in a securit%< Beta vie9s risk solel%
fro" the perspective of "arket prices8 failing to take into consideration specific $usi5
ness funda"entals or econo"ic develop"ents< The price level is also ignored8 as if
IB, selling at )/ dollars per share 9ould not $e a lo9er5risk invest"ent than the
sa"e IB, at 1// dollars per share< Beta fails to allo9 for the influence that investors
the"selves can e:ert on the riskiness of their holdings through such efforts as pro:%
contests8 shareholder resolutions8 co""unications 9ith "anage"ent8 or the ulti"ate
purchase of sufficient stock to gain corporate control and 9ith it direct access to
underl%ing value< Beta also assu"es that the upside potential and do9nside risk of
an% invest"ent are essentiall% e?ual8 $eing si"pl% a function of that invest"ent@s
volatilit% co"pared 9ith that of the "arket as a 9hole< This too is inconsistent 9ith
the 9orld as 9e kno9 it< The realit% is that past securit% price volatilit% does not
relia$l% predict future invest"ent perfor"ance =or even future volatilit%> and
therefore is a poor "easure of risk<
The Relevan(e o8 Tem$orar% "r#(e Flu(tuat#ons
In addition to the pro$a$ilit% of per"anent loss attached to an invest"ent8
there is also the possi$ilit% of interi" price fluctuations that are unrelated to
underl%ing value< =Beta fails to distin5
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12 A A5E!INESTMENT "6IOSO"6Y
guish $et9een the t9o<> ,an% investors consider price fluctuations to $e a significant
risk& if the price goes do9n8 the invest"ent is seen as risk% regardless of the
funda"entals< But are te"porar% price fluctuations reall% a riskE Not in the 9a% that
per"anent value i"pair"ents are and then onl% for certain investors in specificsituations<
It is8 of course8 not al9a%s eas% for investors to distinguish te"porar% price
volatilit%8 related to the short5ter" forces of suppl% and de"and8 fro" price
"ove"ents related to $usiness funda"entals< The realit% "a% onl% $eco"e apparent
after the fact< While investors should o$viousl% tr% to avoid overpa%ing for
invest"ents or $u%ing into $usinesses that su$se?uentl% decline in value due to
deteriorating results8 it is not possi$le to avoid rando" short5ter" "arket volatilit%<
Indeed8 investors should e:pect prices to fluctuate and should not invest in securities
if the% cannot tolerate so"e volatilit%<
If %ou are $u%ing sound value at a discount8 do short5ter" price fluctuations
"atterE In the long run the% do not "atter "uchF value 9ill ulti"atel% $e reflected in
the price of a securit%< Indeed8 ironicall%8 the long5ter" invest"ent i"plication of
price fluctuations is in the opposite direction fro" the near5ter" "arket i"pact< 6or
e:a"ple8 short5ter" price declines actuall% enhance the returns of long5ter"
investors<1 There are8 ho9ever8 several eventualities in 9hich near5ter" price
fluctuations do "atter to investors< Securit% holders 9ho need to sell in a hurr% are at
the "erc% of "arket prices< The trick of successful investors is to sell 9hen the% 9ant
to8 not 9hen the% have to< Investors 9ho "a% need to sell should not o9n "arketa$le
securities other than U<S< Treasur% $ills<
Near5ter" securit% prices also "atter to investors in a trou$led co"pan%< If a
$usiness "ust raise additional capital in the near ter" to survive8 investors in its
securities "a% have their fate deter"ined8 at least in part8 $% the prevailing "arket
price of the co"pan%@s stock and $onds< ='hapter . contains a "ore co"plete
discussion of this effect8 kno9n as refle:ivit%<>
The third reason long5ter"5oriented investors are interested in short5ter"
price fluctuations is that ,r< ,arket can create
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At the 3oot of a ;alue>Investment Philosophy 12
ver% attractive opportunities to $u% and sell< If %ou hold cash8 %ou are a$le to take
advantage of such opportunities< If %ou are full% invested 9hen the "arket declines8
%our portfolio 9ill likel% drop in value8 depriving %ou of the $enefits arising fro" the
opportunit% to $u% in at lo9er levels< This creates an opportunit% cost8 the necessit%to forego future opportunities that arise< If 9hat %ou hold is illi?uid or un"arketa$le8
the opportunit% cost increases furtherF the illi?uidit% precludes %our s9itching to
$etter $argains<
The "ost i"portant deter"inant of 9hether investors 9ill incur opportunit%
cost is 9hether or not part of their portfolios is held in cash< ,aintaining "oderate
cash $alances or o9ning securities that periodicall% thro9 off apprecia$le cash is
likel% to reduce the nu"$er of foregone opportunities< Investors can "anage portfolio
cash flo9 =defined as the cash flo9ing into a portfolio "inus outflo9s> $% giving
preference to so"e kinds of invest"ents over others< !ortfolio cash flo9 is greater
for securities of shorter duration =9eighted average life> than those of longer
duration< !ortfolio cash flo9 is also enhanced $% invest"ents 9ith catal%sts for the
partial or co"plete realiDation of underl%ing value =discussed at greater length in
chapter 1/>< ?uit% invest"ents in ongoing $usinesses t%picall% thro9 off onl%
"ini"al cash through the pa%"ent of dividends< The securities of co"panies in
$ankruptc% and li?uidation8 $% contrast8 can return considera$le li?uidit% to a
portfolio 9ithin a fe9 %ears of purchase< 4isk5ar$itrage invest"ents t%picall% have
ver% short lives8 usuall% turning $ack into cash8 li?uid securities8 or $oth in a "atter
of 9eeks or "onths< An added attraction of investing in risk5ar$itrage situations8
$ankruptcies8 and li?uidations is that not onl% is one@s initial invest"ent returned to
cash8 one@s profits are as 9ell<
Another 9a% to li"it opportunit% cost is through hedging< A hedge is an
invest"ent that is e:pected to "ove in a direction opposite that of another holding
so as to cushion an% price decline< If the hedge $eco"es valua$le8 it can $e sold8
providing funds to take advantage of ne9l% created opportunities< =Hedging is
discussed in greater depth in chapter 13<>v
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12. A A5E!INESTMENT "6IOSO"6Y
Con(lus#on
The pri"ar% goal of value investors is to avoid losing "one%< Three ele"ents of a value5
invest"ent strateg% "ake achieve"ent of that goal possi$le< A $otto"5up approach8 searching
for lo95risk $argains one at a ti"e through funda"ental anal%sis8 is the surest 9a% I kno9 to
avoid losing "one%< An a$solute5perfor"ance orientation is consistent 9ith loss avoidanceF a
relative5perfor"ance orientation is not< 6inall%8 pa%ing careful attention to riskthe pro$a$ilit%
and a"ount of loss due to per"anent value i"pair"ents9ill help investors avoid losing
"one%< So long as generating portfolio cash inflo9 is not inconsistent 9ith earning accepta$le
returns8 investors can reduce the opportunit% cost resulting fro" interi" price declines even as
the% achieve their long5ter" invest"ent goals<
Notes
1< 'onsider the e:a"ple of a five5%ear 1/ percent $ond pa%ing interest se"iannuall%
9hich is purchased at par =1//>< Assu"ing that interest rates re"ain unchanged over the life
of the $ond8 interest coupons can also $e invested at 1/ percent8 resulting in an annual rate of
return of 1/ percent for that $ond< If i""ediatel% after the $ond is purchased8 interest rates
decline to ) percent8 the $ond 9ill initiall% rise to 121<.. fro" 1//< The $ond rises in price to
reflect the present value of 1/ percent interest coupons discounted at a ) percent interest rate
over five %ears< The $ond could $e sold for a profit of nearl% 22 percent< Ho9ever8 if the
investor decides to hold the $ond to "aturit%8 the annualiDed return 9ill $e onl% <1/ percent<
This is less than in the flat interest case $ecause the interest coupons are reinvested at )
percent8 not 1/ percent< #espite the potential short5ter" profit fro" a decline in interest rates8
the return to the investor 9ho holds on to the $onds is actuall% reduced< Si"ilarl%8 if interest
rates rise to 1) percent i""ediatel% after purchase8 the investor is faced 9ith a "arket
decline fro" par to .2<.*8 a 1 percent loss< The total return8 if he holds the $ond for ) %ears8
is increased8 ho9ever8 to 1/< percent as
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At the 3oot of a ;alue>Investment Philosophy 1*'
coupons are reinvested at 1) percent< This e:a"ple de"onstrates ho9 the short5ter"
and long5ter" perspectives on an invest"ent can diverge< In a rising "arket8 "an% people feel
9ealth% due to unrealiDed capital gains8 $ut the% are likel% to $e 9orse off over the long run
than if securit% prices had re"ained lo9er and the returns to incre"ental invest"ent higher<
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:
The Art o8 7us#ness aluat#on,an% investors insist on affi:ing e:act values to their invest"ents8 seeking precision
in an i"precise 9orld8 $ut $usiness value cannot $e precisel% deter"ined< 4eported
$ook value8 earnings8 and cash flo9 are8 after all8 onl% the $est guesses of
accountants 9ho follo9 a fairl% strict set of standards and practices designed "ore to
achieve confor"it% than to reflect econo"ic value< !ro;ected results are less precise
still< 0ou cannot appraise the value of %our ho"e to the nearest thousand dollars<
Wh% 9ould it $e an% easier to place a value on vast and co"ple: $usinessesE
Not onl% is $usiness value i"precisel% kno9a$le8 it also changes over ti"e8
fluctuating 9ith nu"erous "acroecono"ic8 "icroecono"ic8 and "arket5related
factors< So 9hile investors at an% given ti"e cannot deter"ine $usiness value 9ith
precision8 the% "ust nevertheless al"ost continuousl% reassess their esti"ates of
value in order to incorporate all kno9n factors that could influence their appraisal<
An% atte"pt to value $usinesses 9ith precision 9ill %ield values that are
precisel% inaccurate< The pro$le" is that it is
1+;
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#he Art of usiness ;aluation 1+1eas% to confuse the capa$ilit% to "ake precise forecasts 9ith the a$ilit% to "ake
accurate ones< An%one 9ith a si"ple8 hand5held calculator can perfor" net present
value =N!+> and internal rate of return =I44> calculations< The N!+ calculation
provides a single5point value of an invest"ent $% discounting esti"ates of future
cash flo9 $ack to the present< I448 using assu"ptions 7f future cash flo9 and price
paid8 is a calculation of the rate of return on an invest"ent to as "an% deci"al
places as desired< The see"ing precision provided $% N!+ and I44 calculations can
give investors a false sense of certaint% for the% are reall% onl% as accurate as the
cash flo9 assu"ptions that 9ere used to derive the"<
The advent of the co"puteriDed spreadsheet has e:acer$ated this pro$le"8
creating the illusion of e:tensive and thoughtful anal%sis8 even for the "ost
haphaDard of efforts< T%picall%8 investors place a great deal of i"portance on the
output8 even though the% pa% little attention to the assu"ptions< Gar$age in8
gar$age outG is an apt description of the process<
N!+ and I44 are 9onderful at su""ariDing8 in a$solute and percentage ter"s8
respectivel%8 the returns for a given series of cash flo9s< When cash flo9s are
contractuall% deter"ined8 as in the case of a $ond8 and 9hen all pa%"ents are
received 9hen due8 I44 provides the precise rate of return to the investor 9hile N!+
descri$es the value of the invest"ent at a given discount rate< In the case of a $ond8
these calculations allo9 investors to ?uantif% their returns under one set of assu"p5
tions8 that is8 that contractual pa%"ents are received 9hen due< These tools8
ho9ever8 are of no use in deter"ining the likelihood that investors 9ill actuall%receive all contractual pa%"ents and8 in fact8 achieve the pro;ected returns<
A Ran/e o8 alue
Businesses8 unlike de$t instru"ents8 do not have contractual cash flo9s< As a
result8 the% cannot $e as precisel% valued as
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132 A A5E!INESTMENT "6IOSO"6Y
$onds< Ben;a"in raha" kne9 ho9 hard it is to pinpoint the value of $usinesses and
thus of e?uit% securities that represent fractional o9nership of those $usinesses< In
!ecurity Analysis he and #avid #odd discussed the concept of a range of value&
The essential point is that securit% anal%sis does not seek to deter"inee:actl% 9hat is the intrinsic value of a given securit%< It needs onl% to
esta$lish that the value is ade?uatee<g<8 to protect a $ond or to ;ustif% a
stock purchaseor else that the value is considera$l% higher or considera$l%
lo9er than the "arket price< 6or such purposes an indefinite and appro:i"ate
"easure of the intrinsic value "a% $e sufficient<1
Indeed8 raha" fre?uentl% perfor"ed a calculation kno9n as net 9orking capital per
share8 a $ack5of5the5envelope esti"ate of a co"pan%@s li?uidation value< His use of
this rough appro:i"ation 9as a tacit ad"ission that he 9as often una$le to ascertain
a co"pan%@s value "ore precisel%<
To illustrate the difficult% of accurate $usiness valuation8 investors need onl%
consider the 9ide range of Wall Street esti"ates that t%picall% are offered 9henever
a co"pan% is put up for sale< In 1.8 for e:a"ple8 'a"peau 'orporation "arketed
Bloo"ingdales to prospective $u%ersF Harcourt Brace -ovanovich8 Inc<8 held an
auction of its Sea World su$sidiar%F and Hilton Hotels8 Inc<8 offered itself for sale< In
each case Wall Street@s value esti"ates ranged 9idel%8 9ith the highest esti"ate as
"uch as t9ice the lo9est figure< If e:pert anal%sts 9ith e:tensive infor"ation cannot
gauge the value of high5profile8 9ell5regarded $usinesses 9ith "ore certaint% than
this8 investors should not fool the"selves into $elieving the% are capa$le of greater
precision 9hen $u%ing "arketa$le securities $ased onl% on li"ited8 pu$licl% availa$le
infor"ation<
,arkets e:ist $ecause of differences of opinion a"ong investors< If securities
could $e valued precisel%8 there 9ould $e "an% fe9er differences of opinionF "arket
prices 9ould fluctuate less fre?uentl%8 and trading activit% 9ould di"inish< To fun5
da"entall% oriented investors8 the value of a securit% to the $u%er "ust $e greater
than the price paid8 and the value to the
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1+) A A5E!INESTMENT "6IOSO"6Y
$usinesses using the "ultiples paid 9hen co"para$le $usinesses 9ere previousl%
$ought and sold in their entiret%<
The second "ethod of $usiness valuation anal%Des li?uidation value8 the
e:pected proceeds if a co"pan% 9ere to $e dis"antled and the assets sold off<
Breakup value8 one variant of li?uidation anal%sis8 considers each of the co"ponents
of a $usiness at its highest valuation8 9hether as part of a going concern or not<
The third "ethod of valuation8 stock "arket value8 is an esti"ate of the price
at 9hich a co"pan%8 or its su$sidiaries considered separatel%8 9ould trade in the
stock "arket< (ess relia$le than the other t9o8 this "ethod is onl% occasionall% useful
as a %ardstick of value<
ach of these "ethods of valuation has strengths and 9eaknesses< None of
the" provides accurate values all the ti"e< Unfortunatel% no $etter "ethods of
valuation e:ist< Investors have no choice $ut to consider the values generated $%each of the"F 9hen the% apprecia$l% diverge8 investors should generall% err on the
side of conservatis"<
"resent!alue Anal%s#s an the 2#88#(ult% o8
Fore(ast#n/ Future Cash Flo-
When future cash flo9s2 are reasona$l% predicta$le and an appropriate discount rate
can $e chosen8 N!+ anal%sis is one of the "ost accurate and precise "ethods of
valuation< Unfortunatel% future cash flo9s are usuall% uncertain8 often highl% so<,oreover8 the choice of a discount rate can $e so"e9hat ar$itrar%< These factors
together t%picall% "ake present5value anal%sis an i"precise and difficult task<
A perfect $usiness in ter"s of the si"plicit% of valuation 9ould $e an annuit%F
an annuit% generates an annual strea" of cash that either re"ains constant or gro9s
at a stead% rate ever% %ear< 4eal $usinesses8 even the $est ones8 are unfortunatel%
not annuities< 6e9 $usinesses occup% i"penetra$le "arket niches
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13 A A5E!INESTMENT "6IOSO"6Y
fore alread% discounted in securities prices8 shortfalls 9ill disappoint investors and
result in share price declines< As Warren Buffett has said8 G6or the investor8 a too5
high purchase price for the stock of an e:cellent co"pan% can undo the effects of a
su$se?uent decade of favora$le $usiness develop"ents<G
)
Another difficult% 9ith investing $ased on gro9th is that 9hile investors tend
to oversi"plif% gro9th into a single nu"$er8 gro9th is8 in fact8 co"prised of
nu"erous "oving parts 9hich var% in their predicta$ilit%< 6or an% particular $usiness8
for e:a"ple8 earnings gro9th can ste" fro" increased unit sales related to
predicta$le increases in the general population8 to increased usage of a product $%
consu"ers8 to increased "arket share8 to greater penetration of a product into the
population8 or to price increases< Specificall%8 a $re9er "ight e:pect to sell "ore
$eer as the drinking5age population gro9s $ut 9ould aspire to selling "ore $eer per
capita as 9ell< Bud9eiser 9ould hope to increase "arket share relative to ,iller< The
$re9ing industr% "ight 9ish to convert 9hiske% drinkers into $eer drinkers or reach
the a$ste"ious seg"ent of the population 9ith a $rand of nonalcoholic $eer< 7ver
ti"e co"panies 9ould seek to increase price to the e:tent that it 9ould $e e:pected
to result in increased profits<
So"e of these sources of earnings gro9th are "ore predicta$le than others<
ro9th tied to population increases is considera$l% "ore certain than gro9th
ste""ing fro" changes in consu"er $ehavior8 such as the conversion of 9hiske%
drinkers to $eer< The reaction of custo"ers to price increases is al9a%s uncertain< 7n
the 9hole it is far easier to identif% the possi$le sources of gro9th for a $usiness than
to forecast ho9 "uch gro9th 9ill actuall% "aterialiDe and ho9 it 9ill affect profits<
An unresolva$le contradiction e:ists& to perfor" present5value anal%sis8 %ou
"ust predict the future8 %et the future is not relia$l% predicta$le< The "isera$le
failure in 1/ of highl% leveraged co"panies such as Southland 'orporation and
Interco8 Inc<8 to "eet their o9n allegedl% reasona$le pro;ections "ade ;ust a fe9
%ears earlierin $oth cases underperfor"ing
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13. A A5E!INESTMENT "6IOSO"6Y
an investor indifferent $et9een present and future dollars< Investors 9ith a strong
preference for present over future consu"ption or 9ith a preference for the certaint%
of the present to the uncertaint% of the future 9ould use a high rate for discounting
their invest"ents< 7ther investors "a% $e "ore 9illing to take a chance on forecastsholding trueF the% 9ould appl% a lo9 discount rate8 one that "akes future cash flo9s
nearl% as valua$le as toda%@s<
There is no single correct discount rate for a set of future cash flo9s and no
precise 9a% to choose one< The appropriate discount rate for a particular invest"ent
depends not onl% on an investor@s preference for present over future consu"ption
$ut also on his or her o9n risk profile8 on the perceived risk of the invest"ent under
consideration8 and on the returns availa$le fro" alternative invest"ents<
Investors tend to oversi"plif%F the 9a% the% choose a discount rate is a good
e:a"ple of this< A great "an% investors routinel% use 1/ percent as an all5purpose
discount rate regardless of the nature of the invest"ent under consideration< Ten
percent is a nice round nu"$er8 eas% to re"e"$er and appl%8 $ut it is not al9a%s a
good choice<
The underl%ing risk of an invest"ent@s future cash flo9s "ust $e considered in
choosing the appropriate discount rate for that invest"ent< A short5ter"8 risk5free
invest"ent =if one e:ists> should $e discounted at the %ield availa$le on short5ter"
U<S< Treasur% securities8 9hich8 as stated earlier8 are considered a pro:% for the risk5
free interest rate< (o95grade $onds8 $% contrast8 are discounted $% the "arket at
rates of 12 to 1) percent or "ore8 reflecting investors@ uncertaint% that the
contractual cash flo9s 9ill $e paid<
It is essential that investors choose discount rates as conservativel% as the% forecast
future cash flo9s< #epending on the ti"ing and "agnitude of the cash flo9s8 even
"odest differences in the discount rate can have a considera$le i"pact on the
present5value calculation<
Business value is influenced $% changes in discount rates and therefore $%
fluctuations in interest rates< While it 9ould $e eas5
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#he Art of usiness ;aluation 1+'
ier to deter"ine the value of invest"ents if interest rates and thus discount rates
9ere constant8 investors "ust accept the fact that the% do fluctuate and take 9hat
action the% can to "ini"iDe the effect of interest rate fluctuations on their portfolios<
Ho9 can investors kno9 the GcorrectG level of interest rates in choosing a
discount rateE I $elieve there is no GcorrectG level of rates< The% are 9hat the "arket
sa%s the% are8 and no one can predict 9here the% are headed< ,ostl% I give current8
risk5free interest rates the $enefit of the dou$t and assu"e that the% are correct<
(ike "an% other financial5"arket pheno"ena there is so"e c%clicall% to interest rate
fluctuations< High interest rates lead to changes in the econo"% that are precursors
to lo9er interest rates and vice versa< Cno9ing this does not help one "ake
particularl% accurate forecasts8 ho9ever8 for it is al"ost i"possi$le to envision the
econo"ic c%cle until after the fact<
At ti"es 9hen interest rates are unusuall% lo98 ho9ever8 investors are likel%to find ver% high "ultiples $eing applied to share prices< Investors 9ho pa% these
high "ultiples are dependent on interest rates re"aining lo98 $ut no one can $e
certain that the% 9ill< This "eans that 9hen interest rates are unusuall% lo98
investors should $e particularl% reluctant to co""it capital to long5ter" holdings
unless outstanding opportunities $eco"e availa$le8 9ith a preference for either
holding cash or investing in short5ter" holdings that ?uickl% return cash for possi$le
redeplo%"ent 9hen availa$le returns are "ore attractive<
Investors can appl% present5value anal%sis in one of t9o 9a%s< The% can
calculate the present5value of a $usiness and use it to place a value on its securities<
Alternativel%8 the% can calculate the present5value of the cash flo9s that securit%
holders 9ill receive& interest and principal pa%"ents in the case of $ondholders and
dividends and esti"ated future share prices in the case of stockholders<
'alculating the present value of contractual interest and principal pa%"ents is
the $est 9a% to value a $ond< Anal%sis of the underl%ing $usiness can then help to
esta$lish the pro$a$ilit% that those cash flo9s 9ill $e received< B% contrast8 anal%Ding
the cash flo9s of the underl%ing $usiness is the $est 9a% to
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#he Art of usiness ;aluation 1*1
the sa"e8 $ut private5"arket value fails to distinguish a"ong the"< ,oreover8 the
"ultiples paid to ac?uire $usinesses var% over ti"eF valuations "a% have changed
since the "ost recent si"ilar transaction< 6inall%8 $u%ers of $usinesses do not neces5
saril% pa% reasona$le8 intelligent prices< The validit% of private5"arket value depends on the assu"ption that
$usinesspeople kno9 9hat the% are doing< In other 9ords8 9hen $usinesspeople
consistentl% pa% a certain "ultiple of revenues8 earnings8 or cash flo9 for a $usiness8
it is assu"ed that the% are doing so after having perfor"ed an insightful anal%sis of
the underl%ing econo"ics< 7ften the% have< After all8 if the prices paid 9ere routinel%
too high8 the eventual losses incurred 9ould infor" su$se?uent $u%ers 9ho 9ould
pa% less in the future< If the prices paid 9ere too lo98 the $u%ers 9ould earn high
returnsF seeing this8 others 9ould eventuall% $id prices up to levels 9here e:cess
profits could no longer $e achieved< Nevertheless8 the fact is that the prices paid $%
$u%ers of $usinesses can diverge fro" the underl%ing econo"ics of those $usinesses
for long stretches of ti"e<
In the latter half of the 1./s8 for e:a"ple8 the Gprivate5"arket valuesG that
investors ca"e to rel% on ceased to $e the prices that sophisticated8 prudent
$usinesspeople 9ould pa% for $usinesses< 6inanciers ar"ed 9ith the proceeds of
nonrecourse ;unk5$ond offerings and using al"ost none of their o9n "one% 9ere
"otivated $% a tre"endous ske9ing of their o9n risk and re9ard8 as 9ell as $%
enor"ous up5front fees8 to overpa% for corporate takeovers< Indeed8 investors@
assess"ent of private5"arket value in "an% cases $eca"e the price that a ;unk5
$ond5financed $u%er "ight pa%F investors failed to consider that those ac?uirers 9ere
starting to go $ankrupt $ecause the prices the% had paid 9ere e:cessive<
As the prices paid for $usinesses rose a$ove historic "ultiples of underl%ing
$usiness value8 traditional private5"arket $u%ers 9ere shut out of the "arket<
Television stations8 9hich had $een valued for "an% %ears at roughl% ten ti"es
preta: cash flo98 ca"e to sell at prices as high as thirteen to fifteen
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#he Art of usiness ;aluation 1*3
rel%ing on the ;udg"ent of a $u%er of $usinesses8 9ho "a% or "a% not $e trul%
kno9ledgea$le and insightful8 can cause investors to $eco"e co"placent and to
neglect to perfor" their o9n independent valuations as a check< ,% personal rule is
that investors should value $usinesses $ased on 9hat the% the"selves8 not others89ould pa% to o9n the"< At "ost8 private5"arket value should $e used as one of
several inputs in the valuation process and not as the e:clusive final ar$iter of value<
#Lu#at#on alue
The li?uidation value of a $usiness is a conservative assess"ent of its 9orth in 9hich
onl% tangi$le assets are considered and intangi$les8 such as going5concern value8 are
not< Accordingl%8 9hen a stock is selling at a discount to li?uidation value per share8 a
near rock5$otto" appraisal8 it is fre?uentl% an attractive invest"ent<
A li?uidation anal%sis is a theoretical e:ercise in valuation $ut not usuall% an
actual approach to value realiDation< The assets of a co"pan% are t%picall% 9orth
"ore as part of a going concern than in li?uidation8 so li?uidation value is generall% a
9orst5case assess"ent< ven 9hen an ongoing $usiness is dis"antled8 "an% of its
co"ponent parts are not actuall% li?uidated $ut instead are sold intact as operating
entities< Breakup value is one for" of li?uidation anal%sisF this involves deter"ining
the highest value of each co"ponent of a $usiness8 either as an ongoing enterprise
or in li?uidation< ,ost announced corporate li?uidations are reall% $reakupsF ongoing
$usiness value is preserved 9henever it e:ceeds li?uidation value<
Ho9 should investors value assets in a li?uidation anal%sisE An orderl%
li?uidation over ti"e is virtuall% certain to realiDe greater proceeds than a Gfire sale8G
$ut ti"e is not al9a%s availa$le to a co"pan% in li?uidation< When a $usiness is in
financial distress8 a ?uick li?uidation =a fire sale> "a% "a:i"iDe the estate value< In a
fire sale the value of inventor%8 depending on
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1)) A A5E!INESTMENT "6IOSO"6Y
its nature8 "ust $e discounted steepl% $elo9 carr%ing value< 4eceiva$les should
pro$a$l% $e significantl% discounted as 9ellF the nature of the $usiness8 the identit%
of the custo"er8 the a"ount o9ed8 and 9hether or not the $usiness is in an% 9a%
ongoing all influence the ulti"ate realiDation fro" each receiva$le<
When no crisis is at hand8 li?uidation proceeds are usuall% "a:i"iDed through
a "ore orderl% 9inding up of a $usiness< In an orderl% li?uidation the values realiDed
fro" disposing of current assets 9ill "ore closel% appro:i"ate stated $ook value<
'ash8 as in an% li?uidation anal%sis8 is 9orth one hundred cents on the dollar<
Invest"ent securities should $e valued at "arket prices8 less esti"ated transaction
costs in selling the"< Accounts receiva$le are appraised at close to their face
a"ount< The realiDa$le value of inventoriestens of thousands of progra""ed
co"puter diskettes8 hundreds of thousands of purple sneakers8 or "illions of sticks of
che9ing gu"is not so easil% deter"ina$le and "a% 9ell $e less than $ook value<
The discount depends on 9hether the inventories consist of finished goods8 9ork in
process8 or ra9 "aterials8 and 9hether or not there is the risk of technological or
fashion o$solescence< The value of the inventor% in a super"arket does not fluctuate
"uch8 $ut the value of a 9arehouse full of co"puters certainl% "a%< 7$viousl%8 a
li?uidation sale 9ould %ield less for inventor% than 9ould an orderl% sale to regular
custo"ers<
The li?uidation value of a co"pan%@s fi:ed assets can $e difficult to deter"ine<
The value of plant and e?uip"ent8 for e:a"ple8 depends on its a$ilit% to generate
cash flo9s8 either in the current use or in alternative uses< So"e "achines andfacilities are "ultipurpose and 9idel% o9nedF others "a% have value onl% to the
present o9ner< The value of restaurant e?uip"ent8 for e:a"ple8 is "ore readil%
deter"ina$le than the value of an aging steel "ill<
In appro:i"ating the li?uidation value of a co"pan%8 so"e value investors8
e"ulating Ben;a"in raha"8 calculate Gnet5net 9orking capitalG as a shortcut< Net
9orking capital consists of current assets =cash8 "arketa$le securities8 receiva$les8
and inventories> less current lia$ilities =accounts8 notes8 and ta:es pa%a$le 9ithin one
%ear<> Net5net 9orking capital is defined as
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#he Art of usiness ;aluation 1*)
net 9orking capital "inus all long5ter" lia$ilities< ven 9hen a co"pan% has little
ongoing $usiness value8 investors 9ho $u% at a price $elo9 net5net 9orking capital
are protected $% the appro:i"ate li?uidation value of current assets alone< As long
as 9orking capital is not overstated and operations are not rapidl% consu"ing cash8 aco"pan% could li?uidate its assets8 e:tinguish all its lia$ilities8 and still distri$ute
proceeds in e:cess of the "arket price to investors< 7ngoing $usiness losses can8
ho9ever8 ?uickl% erode net5net 9orking capital< Investors "ust therefore al9a%s
consider the state of a co"pan%@s current operations $efore $u%ing< Investors should
also consider an% off5$alance sheet or contingent lia$ilities8 such as underfunded
pension plans8 as 9ell as an% lia$ilities that "ight $e incurred in the course of an
actual li?uidation8 such as plant closing and environ"ental la9s<
A corporate li?uidation t%picall% connotes $usiness failureF $ut ironicall%8 it
"a% correspond 9ith invest"ent success< The reason is that the li?uidation or
$reakup of a co"pan% is a catal%st for the realiDation of underl%ing $usiness value<
Since value investors atte"pt to $u% securities trading at a considera$le discount
fro" the value of a $usiness@s underl%ing assets8 a li?uidation is one 9a% for
investors to realiDe profits<
A li?uidation is8 in a sense8 one of the fe9 interfaces 9here the essence of the
stock "arket is revealed< Are stocks pieces of paper to $e endlessl% traded $ack and
forth8 or are the% proportional interests in underl%ing $usinessesE A li?uidation settles
this de$ate8 distri$uting to o9ners of pieces of paper the actual cash proceeds
resulting fro" the sale of corporate assets to the highest $idder< A li?uidation
there$% acts as a tether to realit% for the stock "arket8 forcing either undervalued or
overvalued share prices to "ove into line 9ith actual underl%ing value<
Sto(, Mar,et alue
7ccasionall% investors "ust rel% on the pu$lic e?uit% and de$t "arkets to
provide an appro:i"ation of the 9orth of a securit%< So"eti"es8 as in the case of a
closed5end "utual fund8 this is the
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1* A A5E!INESTMENT "6IOSO"6Y
onl% relevant valuation "ethod< 7ther ti"es8 especiall% if the ti"e fra"e in 9hich the
value "ust $e realiDed is short8 the stock "arket "ethod "a% $e the $est of several
poor alternatives<
'onsider the valuation of an invest"ent co"pan%< In "id51/ the Schaefer+alue Trust8 Inc<8 a closed5end "utual fund8 scheduled a vote of its shareholders to
consider li?uidation< The "ost relevant "easure of the li?uidation value of Schaefer
9as its stock "arket value8 the value that its holdings 9ould $ring 9hen sold at once
in the stock "arket< No other valuation "ethod 9ould have $een appropriate<
Stock "arket value applies in other situations as 9ell< In atte"pting to value a
co"pan%@s interest in an unrelated su$sidiar% or ;oint venture8 for e:a"ple8 investors
9ould certainl% consider the discounted anticipated future cash flo9 strea" =net
present value>8 the valuation of co"para$le $usinesses in transactions =private5
"arket value>8 and the value of tangi$le assets net of lia$ilities =li?uidation value><
Investors 9ould also $enefit fro" considering stock "arket value8 the valuation of
co"para$le $usinesses in the stock "arket< While the stock "arket@s vote8 especiall%
over the long run8 is not necessaril% accurate8 it does provide an appro:i"ate near5
ter" appraisal of value<
I kno9 9hat %ou "ust $e thinking< If the prices at 9hich stocks trade in the
"arket is a reasona$le appro:i"ation of their value8 then isn@t this an ad"ission that
the stock "arket is efficient8 the antithesis of one of the $asic tenets of value invest5
ingE ,% ans9er is decidedl% no< The stock "arket valuation of co"para$le
$usinesses is $ut one of several valuation tools and provides a %ardstick of 9hat a
securit%8 if not a $usiness8 "ight $ring if sold to"orro9<
Stock "arket value has its shortco"ings as a valuation tool< 0ou 9ould not
use stock "arket value to appraise each of the co"panies in an industr%< It 9ould $e
circular reasoning to o$serve that since ne9spaper co"panies tend to trade in the
"arket at8 sa%8 eight ti"es preta: cash flo98 that is 9hat the% "ust $e 9orth<
Cno9ing the stock "arket@s appraisal for the
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1*. A A5E!INESTMENT "6IOSO"6Y
The Re8le0#ve Relat#onsh#$ 7et-een Mar,et "r#(e
an 5nerl%#n/ alue
A co"plicating factor in securities anal%sis is the refle:ive or reciprocal relationship
$et9een securit% prices and the values of the underl%ing $usinesses< In #he Alchemy
of 2inance eorge Soros stated8 G6unda"ental anal%sis seeks to esta$lish ho9
underl%ing values are reflected in stock prices8 9hereas the theor% of refle:ivit%
sho9s ho9 stock prices can influence underl%ing values<G In other 9ords8 Soros@s
theor% of refle:ivit% "akes the point that its stock price can at ti"es significantl%
influence the value of a $usiness< Investors "ust not lose sight of this possi$ilit%<
,ost $usinesses can e:ist indefinitel% 9ithout concern for the prices of their
securities as long as the% have ade?uate capital< When additional capital is needed8
ho9ever8 the level of securit% prices can "ean the difference $et9een prosperit%8
"ere via$ilit%8 and $ankruptc%< If8 for e:a"ple8 an undercapitaliDed $ank has a high
stock price8 it can issue "ore shares and $eco"e ade?uatel% capitaliDed8 a for" of
self5fulfilling prophec%< The stock "arket sa%s there is no pro$le"8 so there is no
pro$le"< In earl% 118 for e:a"ple8 'iticorp stock traded in the teens and the
co"pan% 9as a$le to find $u%ers for ne9l% issued securities< If its stock price had
$een in the lo9 single digits8 ho9ever8 it 9ould have $een una$le to raise additional
e?uit% capital8 9hich could have resulted in its eventual failure< This is another8 al$eit
negative for" of self5fulfilling prophec%8 9here$% the financial "arkets@ perception of
the via$ilit% of a $usiness influences the outco"e<
The sa"e holds true for a highl% leveraged co"pan% 9ith an upco"ing de$t
"aturit%< If the "arket dee"s a co"pan% credit9orth%8 as it did ,arriott 'orporation
in earl% 118 the co"pan% 9ill $e a$le to refinance and fulfill the prophec%< If the
"arket votes thu"$s do9n on the credit8 ho9ever8 as it did 9ith ,ortgage and
4ealt% Trust in 1/8 that prophec% 9ill also $e fulfilled since the co"pan% 9ill then
fail to "eet its o$ligations<
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1)/ A A5E!INESTMENT "6IOSO"6Y
"arket prices 9as 9orth onl% fifteen cents per "erson share =9hich itself traded
around */>< Needless to sa%8 "an% holders of "erson ?uickl% sold their trivial sco
holdings<
What 9as sco 9orth at the ti"e of spinoffE Was it undervalued in the"arketplace8 and if so8 9h%E Was it an attractive value5invest"ent opportunit%E The
9a% to ans9er these ?uestions is to evaluate sco using each of the "ethods that
value investors e"plo%<
To $egin 9ith8 sco is a su$stantial co"pan%8 having appro:i"atel% )//
"illion in annual sales and si: thousand e"plo%ees8 9ho occup% 3<2 "illion s?uare
feet of space8 1< "illion of 9hich are o9ned $% the co"pan%< sco@s onl% recent
gro9th has co"e fro" its ac?uisition of HaDeltine 'orporation in late 1. for 1/
"illion =over 1) per sco share>< A "a;or consideration leading to the spinoff 9as
that sco@s after5ta: profits had declined fro" 3<3 "illion in 1.) =actual> to <
"illion =pro for"a8 to reflect ad;ust"ents related to the spinoff> in 1. after .<2
"illion of nonrecurring charges and to a loss of )<2 "illion =pro for"a> in 1/ after
13<. "illion of nonrecurring charges< The co"pan% 9as spun off 9ith a conservative
capitaliDation8 having onl% *) "illion in de$t co"pared 9ith al"ost )// "illion in
e?uit%< Tangi$le $ook value e:ceeded 2) per share8 and net5net 9orking capital8
current assets less all lia$ilities8 e:ceeded 1) per share<
T9o ?uestions regarding sco@s future 9orried investors< 7ne 9as 9hether the
sharp recent drop in profita$ilit%8 related to "one%5losing defense contracts the
co"pan% had taken on8 9ould reverse< The second concerned the outco"e of t9o
pending contract disputes $et9een sco and the U<S< govern"entF an adverse
outco"e could have cost sco tens of "illions of dollars in cash and forced it to
report siDa$le losses< These uncertainties caused "erson to spin off8 not shares of
co""on stock8 $ut co""on stock trust receipts held in escro9 in order to ensure
that sco 9ould "eet its o$ligation to inde"nif% "erson for certain custo"er5
contract guarantees<
The first step in valuing sco in 7cto$er 1/ 9as to tr% to understand its
$usiness results& earnings and cash flo9< sco@s
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#he Art of usiness ;aluation 1)1
future earnings 9ere particularl% difficult to forecast8 especiall% $ecause in each of
the preceding t9o %ears the co"pan% had taken significant nonrecurring charges< An
anal%st at Bear Stearns esti"ated $reak5even earnings for fiscal %ear 11< This
esti"ate 9as after the deduction of a ne9l% instituted charge of <* "illion8 pa%a$le$% sco to "erson each %ear fro" 11 to 1)8 for guaranteeing outstanding
defense contracts< Although this charge 9ould have the effect of reducing reported
earnings for five %ears8 it 9as not a true $usiness e:pense $ut rather "ore of an
e:traordinar% ite"<
Another ongoing depressant to earnings 9as sco@s appro:i"atel% ) "illion
per %ear charge for nondeducti$le good9ill a"ortiDation resulting fro" the HaDeltine
ac?uisition< Since good9ill is a noncash e:pense8 free cash flo9 fro" this source
alone 9as ) "illion8 or fort%5five cents per share<
In order to value sco using N!+ anal%sis8 investors 9ould need to forecast
sco@s likel% future cash flo9s< ood9ill a"ortiDation of fort%5five cents a %ear8 as
stated8 9as free cash< Beginning in 1 there 9ould $e an additional fort%5five cents
of after5ta: earnings per %ear as the <* "illion guarant% fee ended< Investors 9ould
have to "ake so"e assu"ptions regarding future earnings< 7ne reasona$le
assu"ption8 perhaps the "ost likel% case8 9as that earnings8 currentl% Dero8 9ould
graduall% increase over ti"e< Unprofita$le contracts 9ould eventuall% $e co"pleted8
and interest 9ould $e earned on accu"ulated cash flo9< An alternative possi$ilit%
9as that results 9ould re"ain at current depressed levels indefinitel%<
In addition to predicting future earnings8 investors 9ould also need to
esti"ate sco@s future cash invest"ent or disinvest"ent in its $usiness in order to
assess its cash flo9< #epreciation in recent %ears had appro:i"ated capital spending8
for e:a"ple8 and assu"ing it 9ould do so in the future see"ed a conservative
assu"ption< Also8 9orking capital tied up in currentl% unprofita$le contracts 9ould
eventuall% $e freed for other corporate uses8 $ut the ti"ing of this 9as uncertain<
Were sco@s 9orking capital5to5sales ratio8 currentl% $loated8 to "ove into line 9ith
that of co"para$le defense elec5
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1)2 A A5E!INESTMENT "6IOSO"6Y
tronics fir"s8 roughl% ./ "illion in additional cash 9ould $eco"e availa$le< To
ensure conservatis"8 ho9ever8 I chose to pro;ect no free cash flo9 fro" this source<
What 9as sco 9orth if it never did $etter than its current depressed level of
resultsE 'ash flo9 9ould e?ual fort%5five cents per share for five %ears and ninet%cents thereafter 9hen the guarant% pa%"ents to "erson had ceased< The present
value of these cash flo9s is )<. and *</ per share8 calculated at 12 percent and
1) percent discount rates8 respectivel%8 9hich the"selves reflect considera$le
uncertaint%< If cash flo9 proved to $e higher8 the value 9ould8 of course8 $e greater<
What if sco "anaged to increase its free cash flo9 $% ;ust 2<2 "illion a
%ear8 or t9ent% cents per share8 for the ne:t ten %ears8 after 9hich it leveled offE The
present value of these flo9s at 12 percent and 1) percent discount rates is 1*<
and 1/<.38 respectivel%< #epending on the assu"ptions8 then8 the net present value
per share of sco is conservativel% calculated at *</ and less pessi"isticall% at
1*< per share8 clearl% a 9ide range $ut in either case 9ell a$ove the 3 stock
price and in no case "aking highl% opti"istic assu"ptions<
Investors in sco 9ould certainl% 9ant to consider alternative scenarios for
future operating results< 7$viousl% there 9as so"e chance that the co"pan% 9ould
lose one or "ore of its contract disputes 9ith the U<S< govern"ent< There 9as so"e
possi$ilit% that a 9idel% anticipated reduction in national defense spending 9ould
cause the co"pan% to lose profita$le contracts or fail to receive ne9 ones< There 9as
a chance that the ne9l% independent co"pan%8 s"aller than "ost of its co"petitors8
9ould face difficulties in tr%ing to operate apart fro" "erson<
Alternativel%8 there 9as so"e prospect that sco 9ould either 9in $oth of its
contract disputes outright or settle 9ith the govern"ent on accepta$le ter"s<
Indeed8 the ne9 top "anage"ent 9ould likel% 9ish to start afresh8 putting past
difficulties $ehind the"< =The disputes 9ere8 in fact8 tentativel% settled 9ithin "onths
of the spinoff on ter"s favora$le to sco<> 6urther8 ne9 "anage"ent e:pressed its
intention to "a:i"iDe
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#he Art of usiness ;aluation 1)3
cash flo9 rather than salesF ne9 contracts 9ould $e accepted on the $asis of lo95risk
profita$ilit% rather than prestige or the desire to achieve revenue gro9th< Thus it 9as
not unreasona$le to think that earnings 9ould gro9 over ti"e as unprofita$le
contracts 9ere concluded and profita$le contracts added<Investors 9ould 9ant to consider other valuation "ethods in addition to N!+<
The private5"arket value "ethod8 ho9ever8 9as not applica$le in the case of sco
$ecause there had $een fe9 recent $usiness transactions involving siDa$le defense
co"panies< ven if there had $een8 sco@s pending contract disputes 9ould put a
da"per on an%one@s enthusias" to $u% all of sco e:cept at an e:tre"e $argain
price< Indeed sco had $een put up for sale prior to spinoff8 and no $u%ers e"erged
at prices accepta$le to "erson<
'onversel% "erson had onl% four %ears earlier paid 1/ "illion for
HaDeltine8 9hich co"prised onl% a fraction of sco@s $usiness at the ti"e of spinoff<
At a takeover "ultiple even close to that of the HaDeltine transaction8 all of sco
9ould $e 9orth "an% ti"es its prevailing stock "arket price8 9ith HaDeltine alone
9orth 1) per sco share<
A li?uidation anal%sis 9as also not particularl% applica$leF defense co"panies
cannot $e easil% li?uidated< The assets have fe9 alternate uses8 and inventor% and
receiva$le valuations are realiDa$le onl% for an ongoing defense concern< sco could
$e valued8 ho9ever8 on the $asis of a gradual li?uidation8 9here$% e:isting contracts
9ould $e allo9ed to run to co"pletion and no ne9 $usiness 9ould $e sought< The
value in such a scenario is uncertain8 $ut it is hard to i"agine the proceeds realiDed
over ti"e $eing less than the net5net 9orking capital of 1) per share<
Stock "arket value is another useful %ardstick8 especiall% for gauging 9here a
spinoff ne9 to the "arket "ight reasona$l% $e e:pected to trade< This "ethod 9ould
not deter"ine over5 or undervaluation8 $ut si"pl% relative valuation co"pared 9ith
other defense5electronics co"panies< In this case sco see"ed to trade as if its
$usiness 9ere located on a different planet< At 3 per share8 the stock sold for onl%
12 percent of tangi$le $ook
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1)* A A5E!INESTMENT "6IOSO"6Y
value8 a staggeringl% lo9 level for a via$le co"pan% 9ith positive cash flo9 and little
de$t< Indeed8 the shares could rise *// percent fro" that level and still $e $elo9 half
of tangi$le $ook value< 7f course8 other defense co"pan% shares 9ere also
depressed at the ti"e8 9ith "ost of the" trading at onl% four to si: ti"es earningsFanother recent defense spinoff8 Alliant Techs%ste"s8 traded at onl% t9o ti"es
esti"ated earnings< Ho9ever8 "ost co"para$le fir"s 9ere trading at $et9een /
and 1// percent of $ook value and had historicall% traded considera$l% a$ove that<
Although sco 9as less profita$le than "ost other defense co"panies8 it 9as selling
for onl% three ti"es earnings if $oth good9ill a"ortiDation and the <* "illion
special charge 9ere ignored< The e:tre"el% lo9 valuation see"ed to "ore than full%
discount sco@s current shortco"ings as a $usiness<
It is difficult8 if not i"possi$le8 to deter"ine precisel% 9hat sco stock 9as
9orth< It is far si"pler to deter"ine that it 9as 9orth considera$l% "ore than the
"arket price< With the shares selling for 38 %et having 2) per share of tangi$le
$ook value and little de$t8 investors@ "argin of safet% 9as high<
sco appeared to $e 9orth easil% t9ice its 3 "arket price8 a level that 9as
onl% si: ti"es ad;usted earnings8 */ percent of net5net 9orking capital8 and less than
2) percent of tangi$le $ook value< Was it 9orth 1/ per shareE !ro$a$l%8 either on
the $asis of N!+ using "ildl% opti"istic assu"ptions or on a gradual li?uidation $asis<
The nice thing a$out sco at 3 per share is that one didn@t have to kno9
e:actl% 9hat it 9as 9orth< The price reflected disasterF an% other outco"e see"ed
certain to %ield a higher price< A siDa$le loss on the disputed contracts 9as the 9orst5
case scenario8 $ut even that 9as pro$a$l% alread% reflected in the lo9 share price<
,anage"ent certainl% $elieved that these disputes could $e favora$l% resolved<
According to pu$lic filings8 shortl% after the spinoff the chair"an of sco@s $oard
purchased shares on the open "arket for his personal account< B% earl% 11 selling
pressure related to the spinoff su$sided8 defense stocks rallied8 and sco rose to over
. per share<
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#he Art of usiness ;aluation 1))
Convent#onal aluat#on Yarst#(,s9
Earn#n/s> 7oo, alue> an 2#v#en Y#el
arnings and arnings ro9th
We are near the end of a chapter on $usiness valuation8 and there has $een virtuall%
no "ention of earnings8 $ook value8 or dividend %ield< Both earnings and $ook value
have a place in securities anal%sis $ut "ust $e used 9ith caution and as part of a
"ore co"prehensive valuation effort<
arnings per share has historicall% $een the valuation %ardstick "ost
co""onl% used $% investors< Unfortunatel%8 as 9e shall see8 it is an i"precise
"easure8 su$;ect to "anipulation and accounting vagaries< It does not atte"pt to
"easure the cash generated or used $% a $usiness< And as 9ith an% prediction of the
future8 earnings are nearl% i"possi$le to forecast<
'orporate "anage"ents are generall% a9are that "an% investors focus on
gro9th in reported earnings8 and a nu"$er of the" gentl% "assage reported
earnings to create a consistent up9ard trend< A fe9 particularl% unscrupulous
"anage"ents pla% accounting ga"es to turn deteriorating results into i"proving
ones8 losses into profits8 and s"all profits into large ones<
ven 9ithout "anipulation8 anal%sis of reported earnings can "islead
investors as to the real profita$ilit% of a $usiness< enerall% accepted accounting
practices =AA!> "a% re?uire actions that do not reflect $usiness realit%< B% 9a% of
e:a"ple8 a"ortiDation of good9ill8 a noncash charge re?uired under AA!8 can
artificiall% depress reported earningsF an anal%sis of cash flo9 9ould $etter capture
the true econo"ics of a $usiness< B% contrast8 nonrecurring gains can $oost earnings
to unsustaina$le levels8 and should $e ignored $% investors<1/
,ost i"portant8 9hether investors use earnings or cash flo9 in their valuation
anal%sis8 it is i"portant to re"e"$er that the nu"$ers are not an end in the"selves<
4ather the% are a "eans to understanding 9hat is reall% happening in a co"pan%<
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1) A A5E!INESTMENT "6IOSO"6Y
7oo, alue
What so"ething cost in the past is not necessaril% a good "easure of its value toda%<
Book value is the historical accounting of shareholders@ e?uit%8 the residual after
lia$ilities are su$tracted fro" assets< So"eti"es historical $ook value =carr%ingvalue> provides an accurate "easure of current value8 $ut often it is 9a% off the
"ark< 'urrent assets8 such as receiva$les and inventories8 for e:a"ple8 are usuall%
9orth close to carr%ing value8 although certain t%pes of inventor% are su$;ect to rapid
o$solescence< !lant and e?uip"ent8 ho9ever8 "a% $e out"oded or o$solete and
therefore 9orth considera$l% less than carr%ing value< Alternativel%8 a co"pan% 9ith
full% depreciated plant and e?uip"ent or a histor% of 9rite5offs "a% have carr%ing
value considera$l% $elo9 real econo"ic value<
Inflation8 technological change8 and regulation8 a"ong other factors8 can
affect the value of assets in 9a%s that historical cost accounting cannot capture< 4eal
estate purchased decades ago8 for e:a"ple8 and carried on a co"pan%@s $ooks at
historical cost "a% $e 9orth considera$l% "ore< The cost of $uilding a ne9 oil
refiner% toda% "a% $e "ade prohi$itivel% e:pensive $% environ"ental legislation8
endo9ing older facilities 9ith a scarcit% value< Aging integrated steel facilities8 $%
contrast8 "a% $e technologicall% out"oded co"pared 9ith ne9l% $uilt "ini"ills< As a
result8 their $ook value "a% $e significantl% overstated<
4eported $ook value can also $e affected $% "anage"ent actions< Write5offs
of "one%5losing operations are so"e9hat ar$itrar% %et can have a large i"pact on
reported $ook value< Share issuance and repurchases can also affect $ook value<
,an% co"panies in the 1./s8 for e:a"ple8 perfor"ed recapitaliDations8 9here$%
"one% 9as $orro9ed and distri$uted to shareholders as an e:traordinar% dividend<
This served to greatl% reduce the $ook value of these co"panies8 so"eti"es $elo9
Dero< ven the choice of accounting "ethod for "ergerspurchase or pooling of
interestscan affect reported $ook value<
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#he Art of usiness ;aluation 1)
To $e useful8 an anal%tical tool "ust $e consistent in its valuations< 0et8 as a result of
accounting rules and discretionar% "anage"ent actions8 t9o co"panies 9ith
identical tangi$le assets and lia$ilities could have ver% different reported $ook
values< This renders $ook value not terri$l% useful as a valuation %ardstick< As 9ith
earnings8 $ook value provides li"ited infor"ation to investors and should onl% $e
considered as one co"ponent of a "ore thorough and co"plete anal%sis<
2#v#en Y#el
Wh% is "% discussion of dividend %ield so shortE Although at one ti"e a "easure of a
$usiness@s prosperit%8 it has $eco"e a relic& stocks should si"pl% not $e $ought on
the $asis of their dividend %ield< Too often struggling co"panies sport high dividend
%ields8 not $ecause the dividends have $een increased8 $ut $ecause the share prices
have fallen< 6earing that the stock price 9ill drop further if the dividend is cut8
"anage"ents "aintain the pa%out8 9eakening the co"pan% even "ore< Investors$u%ing such stocks for their ostensi$l% high %ields "a% not $e receiving good value<
7n the contrar%8 the% "a% $e the victi"s of a pathetic "anipulation< The high
dividend paid $% such co"panies is not a return on invested capital $ut rather a
return of capital that represents the li?uidation of the underl%ing $usiness< This
"anipulation 9as 9idel% used $% "one%5center $anks through "ost of the 1./s and
had the =desired> effect of propping up their share prices<
Con(lus#on
Business valuation is a co"ple: process %ielding i"precise and uncertain
results< ,an% $usinesses are so diverse or difficult to understand that the% si"pl%
cannot $e valued< So"e investors 9illingl% vo%age into the unkno9n and $u% into
such $usinesses8 i"patient 9ith the discipline re?uired $% value investing< Investors
"ust re"e"$er that the% need not s9ing at ever%
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1=: A A5E!INESTMENT "6IOSO"6Y
pitch to do 9ell over ti"eF indeed8 selectivit% undou$tedl% i"proves an investor@s
results< 6or ever% $usiness that cannot $e valued8 there are "an% others that can<
Investors 9ho confine the"selves to 9hat the% kno98 as difficult as that "a% $e8
have a considera$le advantage over ever%one else<
Notes
1. 7enam#n Graham an 2av# . 2o> #n Charles 2. Ell#s an Bames R. ert#n> es.>
Classics0 An Investor$s Anthology @6ome-oo> 111.9 2o- Bones!Ir-#n> 1':'> $. =;.
*. Some #nvestors value bus#nesses b% #s(ount#n/ earn#n/s rather than (ash 8lo-.
For some bus#nesses> su(h as ban,s an thr#8ts> earn#n/s a$$ro0#mate (ash 8lo-
an ma% be use #nstea. In most (ases> ho-ever> (ash 8lo- #s the a$$ro$r#ate
valuat#on %arst#(,. The (al(ulat#on o8 (ash 8lo- #s #s(usse at len/th #n (ha$ter ).
+. Mana/ements not onl% res$on to un(erta#nt% the% somet#mes enhan(e #t b%
ta,#n/ un$re#(table or #ll!(ons#ere a(t#ons.
). See W#ll#am A. Sahlman @6arvar Grauate S(hool o8 7us#ness Am#n#strat#on
Case Stu%> Bune 1'';> DA Caut#onar% Tale about 2#s(ounte Cash Flo- Anal%s#s>D
8or a su$erb #s(uss#on o8 the #88#(ult#es o8 /enerat#n/ use8ul valuat#ons 8rom #s!
(ounte (ash 8lo- anal%s#s.
=. 7er,sh#re 6atha-a%> In(.> annual re$ort 8or 1':*> $. =.
3. There #s (ons#erable a(aem#( ebate (on(ern#n/ -hether short!term or lon/!
term #nterest rates shoul be a$$l#e. M% v#e- #s to mat(h the t#m#n/ o8 the (ash
8lo-s to the matur#t% o8 the 5.S. Treasur% se(ur#t%.
&. Geor/e Soros> #he Alchemy of 2inance @Ne- Yor,9 S#mon S(huster> 1':&> $.
=1.
:. A #s(uss#on o8 the o$$ortun#t% 8or #nvestors #n (or$orate s$#no88s (an be 8oun #n
(ha$ter 1;.
< 6a the same 8lo- o8 (ash 8rom Es(o to Emerson been stru(ture as an
#nterest!bear#n/ note $a%able> 8or e0am$le> the same H&.) m#ll#on annual $a%ment
-oul have ha less than hal8 the #m$a(t on re$orte earn#n/s. In that (ase> mu(h
o8 the H&.) m#ll#on $a%ment -oul have re$resente re$a%ment o8 $r#n(#$al> -h#(h
#s not an e0$ense.
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#he Art of usiness ;aluation 1)
1;. While cash flo9 is less distorted $% accounting ?uirks than earnings8 it too
can $e "anipulated if a co"pan% is so inclined< 'ash flo9 can $e te"poraril%
increased8 for e:a"ple8 $% a reduction in capital spendingF ho9ever8 this eventuall%
leads to deterioration of the $usiness<
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IllT6E A5E!INESTMENT
"ROCESS
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'Investment Resear(h9 The
Challen/e o8 F#n#n/
Attra(t#ve InvestmentsWhile kno9ing ho9 to value $usinesses is essential for invest"ent success8 the first
and perhaps "ost i"portant step in the invest"ent process is kno9ing 9here to look
for opportunities< Investors are in the $usiness of processing infor"ation8 $ut 9hile
stud%ing the current financial state"ents of the thousands of pu$licl% held
co"panies8 the "onthl%8 9eekl%8 and even dail% research reports of hundreds of Wall
Street anal%sts8 and the "arket $ehavior of scores of stocks and $onds8 the% 9ill
spend virtuall% all their ti"e revie9ing fairl% priced securities that are of no special
interest<
ood invest"ent ideas are rare and valua$le things8 9hich "ust $e ferreted
out assiduousl%< The% do not fl% in over the transo" or "aterialiDe out of thin air<
Investors cannot assu"e that good ideas 9ill co"e effortlessl% fro" scanning the
reco""endations of Wall Street anal%sts8 no "atter ho9 highl% regarded8 or fro"
punching up co"puters8 no "atter ho9 clev5
131
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12 T6E A5E!INESTMENT "ROCESS
erl% progra""ed8 although $oth can so"eti"es indicate interesting places to hunt<
Upon occasion attractive opportunities are so nu"erous that the onl% li"iting
factor is the availa$ilit% of funds to investF t%picall% the nu"$er of attractive
opportunities is "uch "ore li"ited< B% identif%ing 9here the "ost attractiveopportunities are likel% to arise $efore starting one@s ?uest for the e:citing handful of
specific invest"ents8 investors can spare the"selves an often fruitless surve% of the
hu"dru" "a;orit% of availa$le invest"ents<
+alue investing enco"passes a nu"$er of specialiDed invest"ent niches that
can $e divided into three categories& securities selling at a discount to $reakup or
li?uidation value8 rate5of5return situations8 and asset5conversion opportunities< Where
to look for opportunities varies fro" one of these categories to the ne:t<
'o"puter5screening techni?ues8 for e:a"ple8 can $e helpful in identif%ing
stocks of the first categor%& those selling at a discount fro" li?uidation value<
Because data$ases can $e out of date or inaccurate8 ho9ever8 it is essential that
investors verif% that the co"puter output is correct<
4isk ar$itrage and co"ple: securities co"prise a second categor% of
attractive value invest"ents 9ith kno9n e:it prices and appro:i"ate ti"e fra"es8
9hich8 taken together8 ena$le investors to calculate e:pected rates of return at the
ti"e the invest"ents are "ade< ,ergers8 tender offers8 and other risk5ar$itrage
transactions are 9idel% reported in the dail% financial pressthe ,all !treet 5ournal
and the $usiness section of the -ew 7ork #imesas 9ell as in specialiDed
ne9sletters and periodicals< (ocating infor"ation on co"ple: securities is "ore
difficult8 $ut as the% often co"e into e:istence as $%products of risk ar$itrage
transactions8 investors 9ho follo9 the latter "a% $eco"e a9are of the for"er<
6inanciall% distressed and $ankrupt securities8 corporate recapitaliDations8 and
e:change offers all fall into the categor% of asset conversions8 in 9hich investors@
e:isting holdings are e:changed for one or "ore ne9 securities< #istressed and
$ankrupt $usinesses are often identified in the financial pressF specialiDed
pu$lications and research services also provide
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#he Challenge of 2inding Attractive Investments 13
infor"ation on such co"panies and their securities< 6unda"ental infor"ation on
trou$led co"panies can $e gleaned fro" pu$lished financial state"ents and in the
case of $ankruptcies8 fro" court docu"ents< !rice ?uotations "a% onl% $e availa$le
fro" dealers since "an% of these securities are not listed on an% e:change<'orporate recapitaliDations and e:change offers can usuall% $e identified fro" a close
reading of the dail% financial press< !u$licl% availa$le filings 9ith the Securities and
:change 'o""ission =S'> provide e:tensive detail on these e:traordinar%
corporate transactions<
,an% undervalued securities do not fall into an% of these specialiDed
categories and are $est identified through old5fashioned hard 9ork8 %et there are
9idel% availa$le "eans of i"proving the likelihood of finding "ispriced securities<
(ooking at stocks on the ,all !treet 5ournal$s leading percentage5decline and ne95
lo9 lists8 for e:a"ple8 occasionall% turns up an out5of5favor invest"ent idea<
Si"ilarl%8 9hen a co"pan% eli"inates its dividend8 its shares often fall to undul%
depressed levels< 7f course8 all co"panies of re?uisite siDe produce annual and
?uarterl% reports8 9hich the% 9ill send upon re?uest< 6ilings of a co"pan%@s annual
and ?uarterl% financial state"ents on 6or"s 1/C and 1/Q8 respectivel%8 are availa$le
fro" the S' and often fro" the reporting co"pan% as 9ell<
So"eti"es an attractive invest"ent niche e"erges in 9hich nu"erous
opportunities develop over ti"e< 7ne such area has $een the large nu"$er of thrift
institutions that have converted fro" "utual to stock o9nership =see chapter 11><
Investors should consider anal%Ding all co"panies 9ithin such a categor% in order to
identif% those that are undervalued< SpecialiDed ne9sletters and industr% periodicals
can $e e:cellent sources of infor"ation on such niche opportunities<
Mar,et Ine88#(#en(#es an Inst#tut#onal Constra#nts
The research task does not end 9ith the discover% of an apparent $argain< It
is incu"$ent on investors to tr% to find out 9h%
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1* T6E A5E!INESTMENT "ROCESS
the $argain has $eco"e availa$le< If in 1/ %ou 9ere looking for an ordinar%8 four5
$edroo" colonial ho"e on a ?uarter acre in the Boston su$ur$s8 %ou should have
$een prepared to pa% at least 3//8///< If %ou learned of one availa$le for 1)/8///8
%our first reaction 9ould not have $een8 GWhat a great $argainRG $ut8 GWhat@s 9rong9ith itEG
The sa"e health% skepticis" applies to the stock "arket< A $argain should $e
inspected and reinspected for possi$le fla9s< Irrational or indifferent selling alone
"a% have "ade it cheap8 $ut there "a% $e "ore funda"ental reasons for the
depressed price< !erhaps there are contingent lia$ilities or pending litigation that %ou
are una9are of< ,a%$e a co"petitor is preparing to introduce a superior product<
When the reason for the undervaluation can $e clearl% identified8 it $eco"es
an even $etter invest"ent $ecause the outco"e is "ore predicta$le< B% 9a% of
e:a"ple8 the legal constraint that prevents so"e institutional investors fro"
purchasing lo95priced spinoffs =see chapter 1/> is one possi$le e:planation for
undervaluation< Such reasons give investors so"e co"fort that the price is not
depressed for an undisclosed funda"ental $usiness reason<
7ther institutional constraints can also create opportunities for value
investors< 6or e:a"ple8 "an% institutional investors $eco"e "a;or sellers of
securities involved in risk5ar$itrage transactions on the grounds that their "ission is
to invest in ongoing $usinesses8 not speculate on takeovers< The resultant selling
pressure can depress prices8 increasing the returns availa$le to ar$itrage investors<
Institutional investors are co""onl% un9illing to $u% or hold lo95priced
securities< Since an% co"pan% can e:ercise a degree of control over its share price
through splitting or reverse5splitting its outstanding shares8 the financial rationale for
this constraint is hard to understand< Wh% 9ould a co"pan%@s shares $e a good $u%
at 1) a share $ut not at 3 after a five5for5one stock split or vice versaE
,an% attractive invest"ent opportunities result fro" "arket inefficiencies8
that is8 areas of the securit% "arkets in 9hich
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#he Challenge of 2inding Attractive Investments 1)
infor"ation is not full% disse"inated or in 9hich suppl% and de"and are te"poraril%
out of $alance< Al"ost no one on Wall Street8 for e:a"ple8 follo9s8 let alone
reco""ends8 s"all co"panies 9hose shares are closel% held and infre?uentl%
tradedF there are at "ost a handful of "arket "akers in such stocks< #epending onthe nu"$er of shareholders8 such co"panies "a% not even $e re?uired $% the S' to
file ?uarterl% or annual reports< 7$scurit% and a ver% thin "arket can cause stocks to
sell at depressed levels<
0ear5end ta: selling also creates "arket inefficiencies< The Internal 4evenue
'ode "akes it attractive for investors to realiDe capital losses $efore the end of each
%ear< Selling driven $% the calendar rather than $% invest"ent funda"entals
fre?uentl% causes stocks that declined significantl% during the %ear to decline still
further< This generates opportunities for value investors<
alue Invest#n/ an Contrar#an Th#n,#n/
+alue investing $% its ver% nature is contrarian< 7ut5of5favor securities "a% $e
undervaluedF popular securities al"ost never are< What the herd is $u%ing is8 $%
definition8 in favor< Securities in favor have alread% $een $id up in price on the $asis
of opti"istic e:pectations and are unlikel% to represent good value that has $een
overlooked<
If value is not likel% to e:ist in 9hat the herd is $u%ing8 9here "a% it e:istE In
9hat the% are selling8 una9are of8 or ignoring< When the herd is selling a securit%8 the
"arket price "a% fall 9ell $e%ond reason< Ignored8 o$scure8 or ne9l% created
securities "a% si"ilarl% $e or $eco"e undervalued<
Investors "a% find it difficult to act as contrarians for the% can never $e
certain 9hether or 9hen the% 9ill $e proven correct< Since the% are acting against
the cro9d8 contrarians are al"ost al9a%s initiall% 9rong and likel% for a ti"e to suffer
paper losses< B% contrast8 "e"$ers of the herd are nearl%
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1 T6E A5E!INESTMENT "ROCESS
al9a%s right for a period< Not onl% are contrarians initiall% 9rong8 the% "a% $e 9rong
"ore often and for longer periods than others $ecause "arket trends can continue
long past an% li"its 9arranted $% underl%ing value<
Holding a contrar% opinion is not al9a%s useful to investors8 ho9ever< When9idel% held opinions have no influence on the issue at hand8 nothing is gained $%
s9i""ing against the tide< It is al9a%s the consensus that the sun 9ill rise to"orro98
$ut this vie9 does not influence the outco"e< B% contrast8 9hen "a;orit% opinion
does affect the outco"e or the odds8 contrar% opinion can $e put to use< When the
herd rushes into ho"e health5care stocks8 $idding up prices and there$% lo9ering
availa$le returns8 the "a;orit% has altered the riskJre9ard ratio8 allo9ing contrarians
to $et against the cro9d 9ith the odds ske9ed in their favor< When investors in 1.3
either ignored or panned the stock of Na$isco8 causing it to trade at a discount to
other food co"panies8 the riskJre9ard ratio $eca"e "ore favora$le8 creating a
$u%ing opportunit% for contrarians<
6o- Mu(h Resear(h an Anal%s#s Are Su88#(#ent
So"e investors insist on tr%ing to o$tain perfect kno9ledge a$out their i"pending
invest"ents8 researching co"panies until the% think the% kno9 ever%thing there is to
kno9 a$out the"< The% stud% the industr% and the co"petition8 contact for"er
e"plo%ees8 industr% consultants8 and anal%sts8 and $eco"e personall% ac?uainted
9ith top "anage"ent< The% anal%De financial state"ents for the past decade and
stock price trends for even longer< This diligence is ad"ira$le8 $ut it has t9o
shortco"ings< 6irst8 no "atter ho9 "uch research is perfor"ed8 so"e infor"ation
al9a%s re"ains elusiveF investors have to learn to live 9ith less than co"plete
infor"ation< Second8 even if an investor could kno9 all the facts a$out an
invest"ent8 he or she 9ould not necessaril% profit<
This is not to sa% that funda"ental anal%sis is not useful< It certainl% is< But
infor"ation generall% follo9s the 9ell5kno9n
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13: T6E A5E!INESTMENT "ROCESS
avoiding situations in 9hich infor"ation is difficult to o$tain< 0et high uncertaint% is
fre?uentl% acco"panied $% lo9 prices< B% the ti"e the uncertaint% is resolved8 prices
are likel% to have risen< Investors fre?uentl% $enefit fro" "aking invest"ent
decisions 9ith less than perfect kno9ledge and are 9ell re9arded for $earing the risk
of uncertaint%< The ti"e other investors spend delving into the last unans9ered
detail "a% cost the" the chance to $u% in at prices so lo9 that the% offer a "argin of
safet% despite the inco"plete infor"ation<
Ins#er 7u%#n/ an Mana/ement Sto(, O$t#ons Can S#/nal
O$$ortun#t%
In their search for co"plete infor"ation on $usinesses8 investors often overlook one
ver% i"portant clue< In "ost instances no one understands a $usiness and its
prospects $etter than the "anage"ent< Therefore investors should $e encouraged
9hen corporate insiders invest their o9n "one% alongside that of shareholders $%
purchasing stock in the open "arket< It is often said on Wall Street that there are
"an% reasons 9h% an insider "ight sell a stock =need for cash to pa% ta:es8
e:penses8 etc<>8 $ut there is onl% one reason for $u%ing< Investors can track insider
$u%ing and selling in an% of several specialiDed pu$lications8 such as ;ickers !tock
3esearch*
The "otivation of corporate "anage"ent can $e a ver% i"portant force in
deter"ining the outco"e of an invest"ent< So"e co"panies provide incentives for
their "anage"ents 9ith stock5option plans and related vehicles< Usuall% these plans
give "anage"ent the specific incentive to do 9hat the% can to $oost the co"pan%@s
share price<
While "anage"ent does not control a co"pan%@s stock price8 it can greatl%
influence the gap $et9een share price and underl%ing value and over ti"e can have
a significant influence on value itself< If the "anage"ent of a co"pan% 9ere
co"pensated $ased on revenues8 total assets8 or even net inco"e8 it
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1/ T6E A5E!INESTMENT "ROCESS
The trou$led de$t "arket8 for e:a"ple8 is event driven< Takeovers8 e:change offers8
and open5"arket $ond repurchases are fairl% routine< What is pu$lic kno9ledge8 and
9hat is notE If %ou sell $onds $ack to a co"pan%8 9hich then retires the"8 is
kno9ledge of that trade inside infor"ationE #oes it "atter ho9 "an% $onds 9ere
sold or 9hen the trade occurredE If this constitutes inside infor"ation8 in 9hat 9a%
does it restrict %ouE If %ou are a large $ondholder and the issuer contacts %ou to dis5
cuss an e:change offer8 in 9hat 9a% can that $e construed as inside infor"ationE
When does inside infor"ation $eco"e sufficientl% old to no longer $e
protectedE When do internal financial pro;ections $eco"e outdatedE When do
a$orted "erger plans cease to $e secretE
There are no fir" ans9ers to these ?uestions< Investors "ust $end over
$ack9ard to sta% 9ithin the la98 of course8 $ut it 9ould $e far easier if the la9 9ere
"ore clearl% enunciated< Since it is not8 la9 a$iding investors "ust err on the side ofignorance8 investing 9ith less infor"ation than those 9ho are not so ethical< When
investors are unsure 9hether the% have crossed the line8 the% 9ould $e 9ell advised
to ask their sources and perhaps their attorne%s as 9ell $efore "aking an% trades<
Con(lus#on
Invest"ent research is the process of reducing large piles of infor"ation to
"anagea$le ones8 distilling the invest"ent 9heat fro" the chaff< There is8 needless
to sa%8 a lot of chaff and ver% little 9heat< The research process itself8 like the factor%
of a "anufacturing co"pan%8 produces no profits< The profits "aterialiDe later8 often
"uch later8 9hen the undervaluation identified during the research process is first
translated into portfolio decisions and then eventuall% recogniDed $% the "arket< In
fact8 often there is no i""ediate $u%ing opportunit%F toda%@s research "a% $e
advance preparation for to"orro9@s opportu5
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#he Challenge of 2inding Attractive Investments 11
nities< In an% event8 ;ust as a superior sales force cannot succeed if the factor% does
not produce ?ualit% goods8 an invest"ent progra" 9ill not long succeed if high5
?ualit% research is not perfor"ed on a continuing $asis<
Notes1. Charles 2. Ell#s an Bames R. ert#n> es.> Classics0 An Investor$s
Anthology @6ome-oo> 111.9 2o- Bones!Ir-#n> 1':'> $. =1+.
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1;Areas o8 O$$ortun#t% 8or alue
Investors9 Catal%sts> Mar,et
Ine88#(#en(#es> an Inst#tut#onal
Constra#nts The attraction of so"e value invest"ents is si"ple and straightfor9ard& ongoing8
profita$le8 and gro9ing $usinesses 9ith share prices considera$l% $elo9
conservativel% appraised underl%ing value< 7rdinaril%8 ho9ever8 the si"pler theanal%sis and steeper the discount8 the "ore o$vious the $argain $eco"es to other
investors< The securities of high5return $usinesses therefore reach co"pelling levels
of undervaluation onl% infre?uentl%< Usuall% investors have to 9ork harder and dig
deeper to find undervalued opportunities8 either $% ferreting out hidden value or $%
co"prehending a co"ple: situation<
7nce a securit% is purchased at a discount fro" underl%ing value8
shareholders can $enefit i""ediatel% if the stock price
12
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Areas of 4pportunity for ;alue Investors 13
rises to $etter reflect underl%ing value or if an event occurs that causes that value to
$e realiDed $% shareholders< Such an event eli"inates investors@ dependence on
"arket forces for invest"ent profits< B% precipitating the realiDation of underl%ing
value8 "oreover8 such an event considera$l% enhances investors@ "argin of safet%< Irefer to such events as catal%sts<
So"e catal%sts for the realiDation of underl%ing value e:ist at the discretion of
a co"pan%@s "anage"ent and $oard of directors< The decision to sell out or
li?uidate8 for e:a"ple8 is "ade internall%< 7ther catal%sts are e:ternal and often
relate to the voting control of a co"pan%@s stock< 'ontrol of the "a;orit% of a
co"pan%@s stock t%picall% allo9s the holder to elect the "a;orit% of the $oard of
directors< Thus accu"ulation of stock leading to voting control8 or si"pl%
"anage"ent@s fear that this "ight happen8 could lead to steps $eing taken $% a
co"pan% that cause its share price to "ore full% reflect underl%ing value<
'atal%sts var% in their potenc%< The orderl% sale or li?uidation of a $usiness
leads to total value realiDation< 'orporate spinoffs8 share $u%$acks8 recapitaliDations8
and "a;or asset sales usuall% $ring a$out onl% partial value realiDation<
The e"ergence of a co"pan% fro" $ankruptc% serves as a catal%st for
creditors< Holders of senior de$t securities8 for e:a"ple8 t%picall% receive cash8 de$t
instru"ents8 andJor e?uit% securities in the reorganiDed entit% in satisfaction of their
clai"s< The total "arket value of these distri$utions is likel% to $e higher than the
"arket value of the $ankrupt de$tF securities in the reorganiDed co"pan% 9ill
t%picall% $e "ore li?uid and avoid "ost of the stig"a and uncertaint% of $ankruptc%
and thus trade at higher "ultiples< ,oreover8 co""ittees of creditors 9ill have
participated in deter"ining the capital structure of the reorganiDed fir"8 seeking to
create a structure that "a:i"iDes "arket value<
+alue investors are al9a%s on the lookout for catal%sts< While $u%ing assets at
a discount fro" underl%ing value is the defining characteristic of value investing8 the
partial or total realiDa5
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1* T6E A5E!INESTMENT "ROCESS
tion of underl%ing value through a catal%st is an i"portant "eans of generating
profits< 6urther"ore8 the presence of a catal%st serves to reduce risk< If the gap
$et9een price and underl%ing value is likel% to $e closed ?uickl%8 the pro$a$ilit% of
losing "one% due to "arket fluctuations or adverse $usiness develop"ents isreduced< In the a$sence of a catal%st8 ho9ever8 underl%ing value could erodeF
conversel%8 the gap $et9een price and value could 9iden 9ith the vagaries of the
"arket< 79ning securities 9ith catal%sts for value realiDation is therefore an
i"portant 9a% for investors to reduce the risk 9ithin their portfolios8 aug"enting the
"argin of safet% achieved $% investing at a discount fro" underl%ing value<
'atal%sts that $ring a$out total value realiDation are8 of course8 opti"al<
Nevertheless8 catal%sts for partial value realiDation serve t9o i"portant purposes<
6irst8 the% do help to realiDe underl%ing value8 so"eti"es $% placing it directl% into
the hands of shareholders such as through a recapitaliDation or spinoff and other
ti"es $% reducing the discount $et9een price and underl%ing value8 such as through
a share $u%$ack< Second8 a co"pan% that takes action resulting in the partial real5
iDation of underl%ing value for shareholders serves notice that "anage"ent is
shareholder oriented and "a% pursue additional value5realiDation strategies in the
future< 7ver the %ears8 for e:a"ple8 investors in Teled%ne have repeatedl% $enefitted
fro" ti"el% share repurchases and spinoffs<
Invest#n/ #n Cor$orate #Lu#at#ons
So"e trou$led co"panies8 lacking via$le alternatives8 voluntaril% li?uidate in
order to pree"pt a total 9ipeout of shareholders@ invest"ents< 7ther8 "ore
interesting corporate li?uidations are "otivated $% ta: considerations8 persistent
stock "arket undervaluation8 or the desire to escape the grasp of a corporate
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Areas of 4pportunity for ;alue Investors 1)
raider< A co"pan% involved in onl% one profita$le line of $usiness 9ould t%picall%
prefer selling out to li?uidating $ecause possi$le dou$le ta:ation =ta:es $oth at the
corporate and shareholder level> 9ould $e avoided< A co"pan% operating in diverse
$usiness lines8 ho9ever8 "ight find a li?uidation or $reakup to $e the value5"a:i"iDing alternative8 particularl% if the li?uidation process triggers a loss that
results in a ta: refund< So"e of the "ost attractive corporate li?uidations in the past
decade have involved the $reakup of conglo"erates and invest"ent co"panies<
,ost e?uit% investors prefer =or are effectivel% re?uired> to hold shares in
ongoing $usinesses< 'o"panies in li?uidation are the antithesis of the t%pe of
invest"ent the% 9ant to "ake< ven so"e risk ar$itrageurs =9ho have $een kno9n
to $u% ;ust a$out an%thing> avoid investing in li?uidations8 $elieving the process to $e
too uncertain or protracted< Indeed8 investing in li?uidations is so"eti"es
disparagingl% referred to as cigar5$utt investing8 9here$% an investor picks up
so"eone else@s discard 9ith a fe9 puffs left on it and s"okes it< Needless to sa%8
$ecause other investors disparage and avoid the"8 corporate li?uidations "a% $e
particularl% attractive opportunities for value investors<
C#t% Invest#n/ #Lu#at#n/ Trust
In 1.* shareholders of 'it% Investing 'o"pan% voted to li?uidate< The assets
of this conglo"erate 9ere diverse8 and the "ost valua$le su$sidiar%8 Ho"e
Insurance 'o"pan%8 9as particularl% difficult for investors to appraise< fforts to sell
Ho"e Insurance failed8 and it 9as instead spun off to 'it% Investing shareholders<
The re"aining assets 9ere put into a ne9l% for"ed entit% called 'it% Investing
(i?uidating Trust8 9hich $eca"e a 9onderful invest"ent opportunit%<
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1 T6E A5E!INESTMENT "ROCESS
#able (Assets o8 C#t% Invest#n/ #Lu#at#n/ Trust at Its In(e$t#on> Se$tember *=>1':=
Assets Est#mate value @H #n m#ll#ons 2er#vat#on o8 value
H' m#ll#on (ash H '.; (ash value
General 2evelo$ment Cor$.
(ommon sto(, an -arrants
)3.; mar,et $r#(e
&.+ m#ll#on shares "a(e
Inustr#es
+3.= (ost
H== m#ll#on ebentures "a(e
Grou$ 6ol#n/s
);.; est#mate net$resent value
H1& m#ll#on subor#nate ebt
@Woo 7rothers 6omes
'.; est#mate
H1: m#ll#on 7ra?#l#an
re(e#vables @H1; m#ll#on
re(e#ve to ate not (ounte#n (ash
1*.; est#mate
H1= m#ll#on m#s(ellaneous
notes an mort/a/es
1;.; est#mate
H11 m#ll#on m#s(ellaneous
#nvestments
3.; est#mate
H+= m#ll#on est#mate 8eeral
#n(ome ta0es re(overable
+1.; net $resent value
total assets H1''.=less ,no-n l#ab#l#t#es ).;net assets H1'=.=or H =.;* $er un#t>e0(lus#ve o8 m#s(ellaneous (ont#n/ent l#ab#l#t#es
As sho9n in ta$le 28 'it% Investing (i?uidating Trust 9as a hodgepodge of
assets< 6e9 investors had the inclination or sta"ina to evaluate these assets or the
9illingness to o9n the" for the duration of a li?uidation likel% to take several %ears<
Thus8 9hile the units 9ere ignored $% "ost potential $u%ers8 the% sold in high volu"e
at appro:i"atel% 38 or su$stantiall% $elo9 underl%ing value<
The shares of 'it% Investing (i?uidating Trust traded initiall% at depressed
levels for a nu"$er of additional reasons< ,an% investors in the li?uidation of 'it%
Investing had $een disap5
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Areas of 4pportunity for ;alue Investors 1
pointed 9ith the prices received for assets sold previousl% and 9ith 'it%@s apparent
ina$ilit% to sell Ho"e Insurance and co"plete its li?uidation< 'onse?uentl% "an%
disgruntled investors in 'it% Investing ?uickl% du"ped the li?uidating trust units to
"ove on to other opportunities< 7nce the intended spinoff of Ho"e Insurance 9as
announced8 "an% investors purchased 'it% Investing shares as a 9a% of esta$lishing
an invest"ent in Ho"e Insurance $efore it $egan trading on its o9n8 $u%ing in at
9hat the% perceived to $e a $argain price< ,ost of these investors 9ere not
interested in the li?uidating trust8 and sold their units upon receipt of the Ho"e
Insurance spinoff< In addition8 the per unit "arket price of 'it% Investing (i?uidating
Trust 9as $elo9 the "ini"u" price threshold of "an% institutional investors< Since
'it% Investing 'o"pan% had $een 9idel% held $% institutional investors8 those 9ho
hadn@t sold earlier $eca"e natural sellers of the li?uidating trust due to the lo9
"arket price< 6inall%8 after the Ho"e Insurance spinoff8 'it% Investing (i?uidating Trust 9as delisted fro" the Ne9 0ork Stock :change< Trading initiall% onl% in the
over5the5counter pink5sheet "arket8 the units had no ticker s%"$ol< Quotes 9ere
uno$taina$le either on5line or in "ost ne9spapers< This pro"pted further selling
9hile si"ultaneousl% discouraging potential $u%ers<
The calculation of 'it% Investing (i?uidating Trust@s underl%ing value in ta$le 2
is deli$eratel% conservative< An i"portant co"ponent of the eventual li?uidating
proceeds8 and so"ething investors "ostl% overlooked =a hidden value>8 9as that
'it%@s invest"ent in the stock of !ace Industries8 Inc<8 9as at the ti"e al"ost
certainl% 9orth "ore than historical cost< !ace 9as a co"pan% for"ed $% Cohl$erg8
Cravis and 4o$erts =CC4> to purchase the 4hee"8 Uarco8 and World 'olor !ress
$usinesses of 'it% Investing in a #ece"$er 1.* leveraged $u%out< This $u%out 9as
profita$le and perfor"ing 9ell nine "onths later 9hen the 'it% Investing (i?uidating
Trust 9as for"ed<
The $usinesses of !ace had $een purchased $% CC4 fro" 'it% Investing in a
financial environ"ent ?uite different fro" the one that e:isted in Septe"$er 1.)<
The interest rate on U<S< govern"ent $onds had declined $% several hundred $asis
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1. T6E A5E!INESTMENT "ROCESS
points in the intervening nine "onths8 and the "a;or stock "arket inde:es had
spurted sharpl% higher< These changes had al"ost certainl% increased the value of
'it%@s e?uit% interest in !ace< This increased the apparent value of 'it% Investing
(i?uidating Trust units 9ell a$ove the )</2 esti"ate8 "aking the" an even "oreattractive $argain<
As 9ith an% value invest"ent8 the greater the undervaluation8 the greater the
"argin of safet% to investors< ,oreover8 appro:i"atel% half of 'it%@s value 9as
co"prised of li?uid assets and "arketa$le securities8 further reducing the risk of a
serious decline in value< Investors could reduce risk even "ore if the% chose $%
selling short pu$licl% traded eneral #evelop"ent 'orporation =#+> shares in an
a"ount e?ual to the nu"$er of #+ shares underl%ing their invest"ent in the trust
in order to lock in the value of 'it%@s #+ holdings<
As it turned out8 'it% Investing (i?uidating Trust "ade rapid progress in
li?uidating< #+ shares surged in price and 9ere distri$uted directl% to unitholders<
Wood Brothers Ho"es 9as sold8 various receiva$les 9ere collected8 and "ost
lucrative of all8 'it% Investing received large cash distri$utions 9hen !ace Industries
sold its !diee" and Uarco su$sidiaries at a su$stantial gain< The !ace roup
de$entures 9ere redee"ed prior to "aturit% 9ith proceeds fro" the sa"e asset
sales< ,ean9hile a nu"$er of the trust@s contingent lia$ilities 9ere e:tinguished at
little or no cost< B% 11 investors 9ho purchased 'it% Investing (i?uidating Trust at
inception had received several li?uidating distri$utions 9ith a co"$ined value of
appro:i"atel% nine dollars per unit8 or three ti"es the Septe"$er 1.) "arket price8
9ith "uch of the value received in the earl% %ears of the li?uidation process<
Invest#n/ #n Com$le0 Se(ur#t#es
I define co"ple: securities as those 9ith unusual contractual cash flo9
characteristics< Unlike $onds8 9hich provide a con5
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Areas of 4pportunity for ;alue Investors 1
stant cash strea" to investors8 a co"ple: securit% t%picall% distri$utes cash
according to so"e contingent event8 such as the future achieve"ent of a specified
level of earnings8 the price of a particular co""odit%8 or the value of specified
assets< 7ften $rought into e:istence as a result of "ergers or reorganiDations8 theirinherent co"ple:it% falls outside the invest"ent para"eters and scope of "ost
investors< Indeed8 9hile so"e co"ple: securities are stocks or $onds8 "an% of the"
are neither< As a result of their o$scurit% and uni?ueness8 co"ple: securities "a%
offer to value investors unusuall% attractive returns for a given level of risk<
'o"ple: securities have e:isted throughout "odern financial histor%< In the
13/s8 for e:a"ple8 railroad $ankruptcies often resulted in the creation of inco"e
$onds8 9hich paid interest onl% if the issuer attained certain levels of inco"e< In 1).
the ,issouri5Cansas5Te:as 4ailroad 'o"pan% =,CT> reorganiDed and issued
participation certificates 9hose onl% entitle"ent to "onetar% $enefit consisted of the
right to have pa%"ents "ade into a sinking fund for their retire"ent< Such pa%"ents
9ere re?uired to $e "ade onl% after accu"ulated earnings reached a specified level
as defined in the indenture< The certificates traded for %ears in the illi?uid pink sheet
"arket at ver% lo9 prices8 partl% as a result of investor neglect< In 1.) ,CT 9as
"erged into the ,issouri !acific 4ailroad 'o"pan%8 and the certificates 9ere the
target of a tender offer at several ti"es the "arket price prevailing earlier that %ear<
As another e:a"ple of a co"ple: securit%8 9hen Bank5A"erica 'orporation
ac?uired Seafirst 'orporation in 1.38 a series of preferred stock 9as issued as
partial consideration to Seafirst shareholders< The dividend 9as fi:ed for five %ears
and then 9ould fluctuate $ased on prevailing "arket conditions< The rede"ption
price could also $e reset8 $ased on the value of certain pro$le" loans in Seafirst@s
portfolio< In effect8 if losses e:ceeded )// "illion on a specified 1<2 $illion pool of
trou$led loans8 the preferred stock 9ith a 2) original par value 9ould likel% $e
retired $% BankA"erica at onl% 2 per share< Since fe9 investors understood ho9 to
value such an at%pical
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1./ T6E A5E!INESTMENT "ROCESS
securit%8 fro" ti"e to ti"e its price dropped to levels that 9ere attractive even on a
9orst5case $asis<
Another e:a"ple of a co"ple: securit% 9as the contingent5value rights issued
to ,arion (a$oratories8 Inc<8 shareholders $% #o9 'he"ical 'o"pan% as part of theco"$ination of ,arion 9ith #o9@s ,errell #o9 !har"aceuticals8 Inc<8 su$sidiar% in
#ece"$er 1.< T9o or three %ears after then5issuance =at #o9@s option> these
separatel% trada$le rights 9ould $e redee"ed for cash if ,arion stock failed to reach
designated levels< Specificall%8 the rights entitled holders to the difference on
Septe"$er 3/8 118 $et9een *)< and the average ,arion share price $et9een
-une 1 and Septe"$er 1.8118 up to a "a:i"u" of 1)< per right< In effect8
these 9ere put options on ,arion stock 9hich had a ceiling on their value< #o9
'he"ical o9ned roughl% percent of ,arion ,errell #o98 Inc<F the pu$lic o9ned the
re"aining 2 "illion shares8 as 9ell as a si"ilar nu"$er of contingent5value rights<
The highl% unusual nature of these securities ensured ver% li"ited de"and fro"
institutional and individual investors and increased the likelihood that the% 9ould at
ti"es $eco"e undervalued co"pared 9ith other pu$licl% traded options<
Not all co"ple: securities are 9orth9hile invest"ents< The% "a% $e
overpriced or too difficult to evaluate< Nevertheless this area fre?uentl% is fertile
ground for $argain hunting $% value investors<
Invest#n/ #n R#/hts O88er#n/s
4ights offerings are "ore esoteric than "an% other invest"ents and for this reason
"a% occasionall% $e of interest to value investors< So"e rights offerings present
attractive $argains8 $ut "an% are full% priced or even overpriced< Investors "a% find
this an interesting area to e:a"ine $ut as usual "ust do their ho"e9ork<
Unlike a t%pical under9ritten share offering8 9here $u%ing
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Areas of 4pportunity for ;alue Investors 1.1
b% ne9 investors dilutes the percentage interest of current shareholders8 in a rights
offering shareholders are given the opportunit% to preserve their proportional interest
in the issuer b% su$scri$ing for additional shares< Those 9ho su$scri$e retain the
sa"e percentage interest in the $usiness $ut have "ore of their "one% at stake<Investors 9ho fail to e:ercise their rights often leave "one% on the ta$le8 creating an
opportunit% for alert value investors<
4ights offerings can effectivel% co"pel current shareholders to put up "ore
"one% in order to avoid considera$le dilution of their invest"ents< B% 9a% of
e:a"ple8 assu"e O0 is a closed5end "utual fund 9ith one "illion shares
outstanding8 9hich trade at a price e?ual to the fund@s net asset value of 2)<
6urther assu"e that O08 seeking to raise an additional 1) "illion to take
advantage of "arket opportunities8 issues ever% holder a nontransfera$le right to
$u% another O0 share for S1)< If all holders su$scri$e8 then i""ediatel% after the
rights offering O0 9ill have t9o "illion shares outstanding and */ "illion of total
assets8 or 2/ per share< If holders of )/8/// shares do not e:ercise their rights8
9hile holders of )/8/// shares do8 the 18)/8/// shares outstanding after the rights
offering 9ill have a net asset value of 2/<13< The investors 9ho su$scri$ed 9ill have
an average cost of 2/ per share8 9hile those 9ho did not 9ill have an average cost
of 2)< Since nonsu$scri$ers 9ill suffer an i""ediate loss of al"ost 2/ percent of
their underl%ing value8 all holders have a po9erful incentive to
Fsu$scri$e<
So"e rights offerings give holders the opportunit% to oversu$scri$e $e%ond their o9n
proportional interest for shares that others do not $u%< In the case of O08 investors
9ho chose to oversu$scri$e for the )/8/// shares left unsold at the original offering
could have "ade a ?uick 2)/8/// $u%ing those shares at 1) and pro"ptl% selling
the" at the pro for"a net asset value of 2/<
'o"panies occasionall% e"plo% a rights offering to effectuate the initial pu$lic
offering of shares in a su$sidiar%< In 1.*8 for e:a"ple8 'onsolidated 7il and as8
Inc<8 utiliDed a rights offer5
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1.2 T6E A5E!INESTMENT "ROCESS
ing to $ring its !rinceville #evelop"ent 'orporation su$sidiar% pu$lic< 'onsolidated
9as an overleveraged energ% co"pan% that o9ned so"e attractive Ha9aiian real
estate properties8 9hich 9ere held $% its !rinceville su$sidiar%< To separate the
Ha9aiian properties fro" the rest of the $usiness 9hile preserving the value of thoseproperties in shareholders@ hands8 'onsolidated conducted a rights offering< Under its
ter"s shareholders of 'onsolidated 9ere offered the right to purchase one share of
!rinceville for each share of 'onsolidated the% o9ned< The initial offering price8 3<2)
per share8 9as ar$itrar%8 according to the prospectus8 and considera$l% $elo9
'onsolidated@s cost $asis in !rinceville<
When the rights started to trade8 little infor"ation had $een released $%
'onsolidated 7il and as concerning !rinceville< The prospectus 9as apparentl% not
%et pu$licl% availa$le< In the a$sence of pu$licl% availa$le infor"ation8 so"e rights
traded for as little as 1J32 and 1J* of a dollar per right< Alert investors 9illing to
"ake an educated guess 9ere a$le to earn an enor"ous profit on this o$scure rights
offeringF upon co"pletion of the offering8 the "arket price of !rinceville ?uickl% rose
a$ove ) per share< 4ights that traded as lo9 as 1 1J2 cents rose in price to nearl%
2 onl% a fe9 9eeks later<
Invest#n/ #n R#s, Arb#tra/e
4isk ar$itrage is a highl% specialiDed area of value investing< Ar$itrage8 as noted
earlier8 is a riskless transaction that generates profits fro" te"porar% pricing
inefficiencies $et9een "arkets< 4isk ar$itrage8 ho9ever8 involves investing in far5
fro"5riskless takeover transactions< Spinoffs8 li?uidations8 and corporate
restructurings8 9hich are so"eti"es referred to as long5ter" ar$itrage8 also fall into
this categor%<
4isk ar$itrage differs fro" the purchase of t%pical securities in that gain or
loss depends "uch "ore on the successful co"pletion of a $usiness transaction than
on funda"ental develop5
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Areas of 4pportunity for ;alue Investors 1.3
"ents at the underl%ing co"pan%< The principal deter"inant of investors@ return is
the spread $et9een the price paid $% the investor and the a"ount to $e received if
the transaction is successfull% co"pleted< The do9nside risk if the transaction fails to
$e co"pleted is usuall% that the securit% 9ill return to its previous trading level89hich is t%picall% 9ell $elo9 the takeover price<
The ?uick pace and high stakes of takeover investing have attracted "an%
individual investors and speculators as 9ell as professional risk ar$itrageurs< It is "%
vie9 that those ar$itrageurs 9ith the largest portfolios possess an advantage that
s"aller investors cannot easil% overco"e< #ue to the siDe of their holdings8 the
largest ar$itrageurs can afford to e"plo% the $est la9%ers8 consultants8 and other
advisors to ac?uire infor"ation 9ith a $readth8 depth8 and ti"eliness unavaila$le to
other investors< As 9e have learned fro" recent cri"inal indict"ents8 so"e have
even en;o%ed access to inside infor"ation8 although their infor"ational edge 9as
great even 9ithout circu"venting the la9<
The infor"ational advantage of the largest risk ar$itrageurs is not so
co"pelling in situations such as long5ter" li?uidations8 spinoffs8 and large friendl%
tender offers< In the largest friendl% corporate takeovers8 for e:a"ple8 the
professional risk5ar$itrage co""unit% depletes its purchasing po9er relativel%
?uickl%8 leaving an unusuall% attractive spread for other investors< A careful and
selective s"aller investor "a% $e a$le to profita$l% e:ploit such an opportunit%<
At ti"es of high investor uncertaint%8 risk5ar$itrage5related securities "a%
$eco"e unusuall% attractive< The #ece"$er 1. takeover of Becor Western Inc< $%
B5 Holdings8 Inc<8 fit this description< In -une 1. Becor sold its aerospace $usiness
for 1/<3 "illion cash< This left the co"pan% 9ith 1.) "illion in cash =over 11 per
share> and onl% 3/ "illion in de$t< The co"pan% also operated an unprofita$le $ut
asset5rich "ining5"achiner% $usiness under the Buc%rus5rie na"e<
The offer $% B5 Holdings to $u% Becor Western 9as the last in a series of
offers $% several suitors< The ter"s of this pro5
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1.* T6E A5E!INESTMENT "ROCESS
posed "erger called for Becor holders to receive either 1 per share in cash or a
package of the follo9ing&
3 principal a"ount of 12<) percent one5%ear senior notes in B5 HoldingsF
1/ principal a"ount of 12<) percent fifteen5%ear senior de$entures in B5HoldingsF
/<2 shares preferred stock in B5 Holdings8 li?uidation preference 2)F and
/< 9arrants to $u% co""on stock in B5 Holdings at </1 per share<
A "a:i"u" of )<) percent of Becor shares 9ere eligi$le to receive the cash
consideration< Assu"ing that all stockholders elected to receive cash for as "an%
shares as possi$le8 each 9ould receive per share of Becor o9ned&
8) cash
182) principal a"ount one5%ear notes *<2) principal a"ount fifteen5%ear
de$entures </.) shares preferred stock <2)) 9arrants
The cash option 9as al"ost certain to $e 9orth "ore than the package of
securities< Thus the total value of the consideration to holders 9ho elected cash 9as
greater than for those 9ho did not< Nevertheless8 a s"all proportion of Becor holders
failed to choose the cash alternative8 increasing the value to $e received $% the vast
"a;orit% of holders 9ho did<
What "ade Becor particularl% attractive to investors 9as that in the after"ath of the
1. stock "arket crash8 the shares fell in price to $elo9 1/< Investors could thus
purchase Becor stock for less than the underl%ing cash on the co"pan%@s $ooks8 and
for an a"ount appro:i"atel% e?ual to the cash that 9ould $e distri$uted upon
consu""ation of the "erger8 9hich 9as e:pected either in #ece"$er 1. or
-anuar% 1..<
The shares 9ere a real $argain at 1/8 9hether or not the
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Areas of 4pportunity for ;alue Investors 1.)
"erger occurred< The total value of the "erger consideration 9as certainl% greater
than the 1/ stock pricethe cash co"ponent alone 9as nearl% 1/< ,oreover8 there
9as nearl% enough cash on the $ooks of B5 Holdings pro for"a for the "erger to
retire the one5%ear notes< These appeared to $e 9orth close to par value< Based onthe "arket price of co"para$le securities8 the fifteen5%ear de$entures see"ed likel%
to trade at a "ini"u" of )/ percent of face value and perhaps significantl% higher<
The preferred stock 9as "ore difficult to evaluate8 $ut 2) percent of its li?uidation
preference see"ed conservative co"pared 9ith other preferred issues< The 9arrants
9ere virtuall% i"possi$le to value< ven assu"ing the% 9ould trade at negligi$le
prices8 ho9ever8 the total value of the "erger consideration appeared to $e at least
1* per share<
Better still8 the do9nside risk to investors 9as "ini"al< The $ook value of
Becor 9as 12 per share8 nearl% all of it in cash< There 9ere several siDa$le holders of
Becor stock8 a fact that increased the likelihood that underl%ing value 9ould $e real5
iDed in so"e fashion< ven if the "erger 9ere re;ected $% shareholders8 a corporate
li?uidation appeared likel% to %ield si"ilar value< At prices of 12 or $elo98 investors
faced little do9nside risk and the prospect of an apprecia$le and pro"pt return< As it
turned out8 the "erger consideration 9as 9orth a$out 1*<2) at "arket prices< Becor
shares had declined in the 9ake of a $road "arket rout to a level $elo9 underl%ing
value8 creating an opportunit% for value investors<
The C%(les o8 Investment Fash#on9
The R#s,!Arb#tra/e C%(le
,an% participants in specialiDed areas of investing such as $ankruptc% and
risk ar$itrage have e:perienced inferior results in recent %ears< 7ne reason is the
proliferation of investors in these areas< In a sense8 there is a c%cle of invest5
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1:3 T6E A5E!INESTMENT "ROCESS
"ent results attendant on an% invest"ent philosoph% or "arket niche due to the
relative popularit% or lack of popularit% of that approach at a particular ti"e<
When an area of invest"ent such as risk ar$itrage or $ankruptc% investing
$eco"es popular8 "ore "one% flo9s to specialists in the area< The increased $u%ing
$ids up prices8 increasing the short5ter" returns of investors and to so"e e:tent
creating a self5fulfilling prophec%< This attracts still "ore investors8 $idding prices up
further< While the influ: of funds helps to generate strong invest"ent results for the
earliest investors8 the resultant higher prices serve to reduce future returns<
Ulti"atel% the good invest"ent perfor"ance8 9hich 9as generated largel% $%
those 9ho participated in the area $efore it $eca"e popular8 ends and a period of
"ediocre or poor results ensues< As poor perfor"ance continues8 those 9ho rushed
into the area $eco"e disillusioned< 'lients 9ithdra9 funds as ?uickl% as the% added
the" a fe9 %ears earlier< The rede"ptions force invest"ent "anagers to raise cash
$% reducing invest"ent positions< This selling pressure causes prices to drop8
e:acer$ating the poor invest"ent perfor"ance< ventuall% "uch of the Ghot "one%G
leaves the area8 allo9ing the s"aller nu"$er of re"aining investors to e:ploit
e:isting opportunities as 9ell as the ne9l% created $argains resulting fro" the forced
selling< The stage is set for another up5c%cle<
4isk ar$itrage has undergone such a c%cle during the past several %ears< In
the earl% 1./s there 9ere onl% a fe9 doDen risk ar$itrageurs8 each of 9ho"
"anaged relativel% s"all pools of capital< Their repeated successes received
considera$le pu$licit%8 and a nu"$er of ne9 ar$itrage $outi?ues 9ere esta$lished< The increased co"petition did not i""ediatel% destro% the invest"ent returns fro"
risk ar$itrageF the suppl% of such invest"ents increased at the sa"e ti"e8 due to a
si"ultaneous acceleration in corporate takeover activit%<
B% the late 1./s "an% ne9 participants had entered risk ar$itrage<
4elativel% unsophisticated individual investors and corporations had $eco"e
significant pla%ers< The% tended to
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Areas of 4pportunity for ;alue Investors 1.
"ent often receives stock options $ased on initial trading pricesF until these options
are8 in fact8 granted8 there is an incentive to hold the share price do9n< 'onse?uentl%
a nu"$er of spinoff co"panies "ake little or no effort to have the share price reflect
underl%ing value< The "anage"ent of co"panies 9ith depressed share prices 9ould
usuall% fear a hostile takeover at a lo9 price8 ho9ever Gshark5repellent8G anti5
takeover provisions inserted into the corporate $%la9s of "an% spinoffs8 serve to
protect "anage"ent fro" corporate predators<
Another reason that spinoffs "a% $e $argain priced is that there is t%picall% a
t9o5 or three5"onth lag $efore infor"ation on the" reaches co"puter data$ases< A
spinoff could represent the $est $argain in the 9orld during its first da%s of trading8
$ut no co"puter5dependent investors 9ould kno9 a$out it<
Shares of spinoffs t%picall% do not fit 9ithin institutional constraints and
conse?uentl% are ?uickl% sold $% institutional investors< 'onsider8 for e:a"ple8 thespinoff of InterTAN8 Inc<8 $% Tand% 'orporation in late 1.< InterTAN had a $ook
value of a$out 1) per share8 net5net 9orking capital after all de$t of roughl% 11 per
share8 and highl% profita$le 'anadian and Australian retailing operations< (arge
operating losses in urope ca"ouflaged this profita$ilit% and caused a s"all overall
loss< It 9as clear to an%one 9ho looked $ehind the aggregate losses to the separate
geographic divisions that the 'anadian and Australian operations alone 9ere 9orth
considera$l% "ore than the price of 11 per share at 9hich InterTAN stock 9as
trading<
An institutional investor "anaging 1 $illion "ight hold t9ent%5five securit%
positions 9orth appro:i"atel% */ "illion each< Such an investor "ight have o9ned
one "illion Tand% shares trading at */< He or she 9ould have received a spinoff of
2//8/// InterTAN shares having a "arket value of 2<2 "illion< A 2<2 "illion
position is insignificant to this investorF either the stake in InterTAN 9ill $e increased
to the average position siDe of */ "illion8 or it 9ill $e sold< Selling the shares is the
path of least resistance8 since the t%pical institutional investor pro$a$l% kno9s little
and cares even less a$out
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1/ T6E A5E!INESTMENT "ROCESS
InterTAN< ven if that investor 9anted to8 though8 it is unlikel% that he or she could
accu"ulate */ "illion 9orth of InterTAN stock8 since that 9ould a"ount to *)
percent of the co"pan% at prevailing "arket prices =and that al"ost certainl% 9ould
violate a different constraint a$out o9nership and control<> Needless to sa%8 the great"a;orit% of Tand%@s institutional shareholders si"pl% du"ped their InterTAN shares<
InterTAN received no Wall Street pu$licit%8 and $rokers had no particular incentive to
dru" up interest in the stock< As a result8 9aves of institutional selling created a
te"porar% suppl%5and5de"and i"$alance8 and nu"erous value investors 9ere a$le
to accu"ulate large InterTAN positions at attractive prices< B% 1. the co"pan%
had turned its "one%5losing operations around8 Wall Street anal%sts 9ho had once
ignored the stock had suddenl% fallen in love 9ith it8 and investors no longer 9orried
a$out 9hat could go 9rong8 focusing instead on 9hat "ight go right< The shares
peaked that %ear at 2 <
7pportunities can so"eti"es arise not in the spinoff $ut in the parent5
co"pan% shares< As an e:a"ple8 at the end of 1.. Burlington Northern8 Inc< =BNI>8
9hich o9ned a "a;or railroad and a natural resources co"pan%8 spun off its
invest"ent in Burlington 4esources8 Inc< =B4>8 to shareholders< A nu"$er of unusual
"arket forces 9ere at 9ork at the ti"e that created an invest"ent opportunit% in the
ongoing parent co"pan%8 BNI< What happened is this& "an% investors held BNI
pri"aril% $ecause of its o9nership of B48 9hich represented a$out t9o5thirds of the
dollar value of the co"$ined co"pan%< A nu"$er of these investors apparentl% sold
BNI $efore the spinoff 9as co"pleted and $ought the ne9l% for"ed B48 causing BNI
to decline in price relative to B4< This created an opportunit% for other investors to
$u% BNI stock pre5spinoff and sell B4 stock short in order to lock in a cost of
appro:i"atel% 1 per share for the ne9l% separated railroad $usiness< Since the
railroad 9as e:pected $% anal%sts to earn 3<)/ per share and pa% a 1<2/ annual
dividend8 esta$lishing an invest"ent in the railroad at 1 appeared to $e an
attractive opportunit% co"pared
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Areas of 4pportunity for ;alue Investors 11
9ith $oth a$solute %ardsticks of value and 9ith the prices of shares in co"para$le
co"panies< B% 1/ the shares had appro:i"atel% dou$led fro" the 1.. level<
Con(lus#on
This chapter has identified a nu"$er of niches 9here value investors so"eti"es findattractive opportunities< It is $% no "eans an e:haustive list and is not "eant to $e<
4ather it sho9s ho9 securities in a variet% of "arket sectors can $eco"e inefficientl%
priced8 creating potential $argains for those 9illing to hunt for the"<
The ne:t t9o chapters offer in5depth e:a"ples of t9o areas of opportunit% for
value investors< 'hapter 11 e:a"ines the conversion of thrifts fro" "utual to stock
o9nership and sho9s ho9 the arith"etic of this ver% unusual transaction creates
fre?uent opportunities for value investors< 'hapter 12 e:plores the opportunities for
investors in financiall% distressed and $ankrupt securities< These chapters $oth
ela$orate on the the"e of this one& that attractive opportunities to purchase
undervalued invest"ents arise 9ith so"e fre?uenc% in a nu"$er of areas and that
these opportunities can $e identified and e:ploited $% value investors<
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11Invest#n/ #n Thr#8t Convers#ons
,utual thrift institutions 9ere first for"ed in this countr% in the "id5nineteenthcentur% and toda% nu"$er in the thousands< The "utual for" of o9nership gave
depositors co"fort that the% 9ould $e fairl% treated since8 in theor%8 the% o9ned the
institutions< Since 1.3 the conversion of hundreds of "utual thrift institutions to
stock o9nership has created nu"erous opportunities for value investors< Negative
pu$licit% coupled 9ith the econo"ics of thrift conversions served to undul% depress
the share prices of "an% thrifts<
Before deregulation in the late 1/s the thrift industr% 9as "anaged8
according to the old ;oke8 $% the 3553 principle& take in deposits at 3 percent8 lend
the" out at percent8 and $e on the golf course $% 3 o@clock< A thrift e:ecutive@s life
9as si"ple8 fairl% re"unerative8 and of high status in the co""unit%< Before
deregulation forced their hands8 fe9 thrift e:ecutives 9ere 9illing to face the
uncertainties of a "utual5to5stock conversion<
B% the 1./s8 ho9ever8 "uch of the thrift industr% 9as he"orrhaging "one%<
6inancial deregulation had adversel% i"pacted
1'*
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Investing in #hrift Conversions 13
"ost thrifts in that the interest rates paid on deposit lia$ilities 9ere suddenl% allo9ed
to fluctuate 9ith "arket interest rates8 9hile "ost thrift assets8 in the for" of ho"e
"ortgage loans8 $ore fi:ed interest rates< 6or "an% thrifts8 the cost of funds soon
rose a$ove the %ield on their assets8 resulting in a negative interest rate spread< The arn5St< er"ain Act of 1.2 per"itted thrifts to engage in ne98
increasingl% risk% lending and investing activities8 ulti"atel% resulting in hundreds of
$illions of dollars in losses8 9hich rendered nu"erous thrifts insolvent< #espite a
proliferation in the earl% 1./s of accounting gi""ickr% designed to prop up the net
9orth of trou$led institutions8 "an% thrifts desperatel% needed additional capital to
survive< ,one%5losing thrifts 9ere generall% una$le to raise ne9 funds8 and those
that 9ere "utuall% o9ned re"ained "utuall% o9ned< 7nl% profita$le and ade?uatel%
capitaliDed thrifts 9ere in a position to sell shares $% converting to stock o9nership8
and "an% of the" atte"pted to do so<
In a t%pical initial pu$lic offering =I!7> all preoffering shares are o9ned $%
insiders8 9ho t%picall% $ought in earlier at a s"all fraction of the offering price< To
illustrate the diluting effect of a t%pical under9riting8 if insiders have $ought one "il5
lion shares of O0 at 1 per share and the pu$lic is su$se?uentl% offered one "illion
ne9l% issued shares at 11 each8 there 9ill then $e t9o "illion shares outstanding
9ith total proceeds to the co"pan% of 12 "illion =ignoring under9riting costs>< The
pro for"a $ook value of the co"pan%@s stock is per share< The pu$lic@s invest"ent
has $een diluted $% ) per "are =*) percent of the purchase price>8 9hile the
insiders have gained a 9indfall of the sa"e ) per share<
Thrift conversions 9ork differentl%< A thrift institution 9ith a net 9orth of 1/
"illion "ight issue one "illion shares of stock at )1/ per share< Again ignoring costs
of the offering8 the proceeds of 1/ "illion are added to the institution@s pree:isting
net 9orth8 resulting in pro for"a shareholders@ e?uit% of 2/ "illion< Since the one
"illion shares sold on the I!7 are the
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1* T6E A5E!INESTMENT "ROCESS
onl% shares outstanding8 pro for"a net 9orth is 2/ per share< The pree:isting net
9orth of the institution ;oins the investors@ o9n funds8 resulting i""ediatel% in a net
9orth per share greater than the investors@ o9n contri$ution<
The "echanics of a "utual5to5stock conversion are fairl% si"ple< #epositors ina converting thrift have a pree"ptive right to purchase shares< ,anage"ent is
t%picall% granted the right to purchase shares alongside depositors< 4e"aining
shares are offered to the general pu$lic8 9ith preference so"eti"es given to
custo"ers or to an%one living in the thrift@s geographic area<
So long as the thrift has positive $usiness value $efore the conversion8 the
arith"etic of a thrift conversion is highl% favora$le to investors< Unlike an% other t%pe
of initial pu$lic offering8 in a thrift conversion there are no prior shareholdersF all of
the shares in the institution that 9ill $e outstanding after the offering are issued and
sold on the conversion< The conversion proceeds are added to the pree:isting capital
of the institution8 9hich is indirectl% handed to the ne9 shareholders 9ithout cost to
the"< In a real sense8 investors in a thrift conversion are $u%ing their o9n "one% and
getting the pree:isting capital in the thrift for free<
There is another uni?ue aspect to thrift conversions< Unlike "an% I!7s8 in
9hich insiders 9ho $ought at ver% lo9 prices sell so"e of their shares at the ti"e of
the offering8 in a thrift conversion insiders virtuall% al9a%s $u% shares alongside the
pu$lic and at the sa"e price< Thrift conversions are the onl% invest"ent in 9hich
$oth the volu"e and price of insider $u%ing is full% disclosed ahead of ti"e and in
9hich the pu$lic has the opportunit% to ;oin the insiders on e?ual ter"s<
The t9in attractions of $u%ing on e?ual ter"s 9ith insiders and the favora$le
arith"etic of a thrift conversion "ake for a co"pelling invest"ent opportunit% as
long as the preconver5sion thrift has a positive value< ,an% thrifts8 of course8 are
9orth less than their stated $ook value8 and so"e are insolvent< 6unds raised on the
conversion of such institutions 9ould pa% to resolve pree:isting pro$le"s rather than
add to pree:isting value<
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Investing in #hrift Conversions 1)
Wh% 9ere thrift stocks so depressed in the 1./sE The sell side of Wall Street has
historicall% e"plo%ed fe9 thrift anal%sts8 and the $u% side even fe9er< The handful of
sell5side anal%sts on dut% t%picall% follo9ed onl% the ten or t9ent% largest pu$lic
thrifts8 pri"aril% those $ased in 'alifornia and Ne9 0ork< No "a;or Wall Street house9as a$le to get a handle on all of the "an% hundreds of converted thrifts8 and fe9
institutional investors even "ade the effort< As a result8 shares in ne9 thrift
conversions 9ere fre?uentl% issued at an apprecia$le discount to the valuation
"ultiples of other pu$licl% traded thrifts in order to get investors to notice and $u%
the"<
7f course8 funda"ental invest"ent anal%sis applies to thrifts as it 9ould to
other $usinesses< Thrifts incurring high risks8 such as e:panding into e:otic areas of
lending or venturing far fro" ho"e8 should si"pl% $e avoided as unanal%Da$le<
Thrifts speculating in ne9fangled instru"ents such as ;unk $onds or co"ple:
"ortgage securities =those $ased on interest or principal onl%8 for e:a"ple> should
$e shunned for the sa"e reason< A si"ple rule applies& if %ou don@t ?uickl%
co"prehend 9hat a co"pan% is doing8 then "anage"ent pro$a$l% doesn@t either<
This initial test li"its investors to lo95risk thrifts< This does not "ean that investors
could not profit fro" investing in risk% institutions $ut rather that the potential return
is not usuall% ;ustified $% the risk and uncertaint%< 79ing to the high degree of
financial leverage involved in thrifts8 there can $e no "argin of safet% fro" investing
in the shares of thinl% capitaliDed financial institutions that o9n esoteric or risk%
assets<
While all $usinesses should $e valued conservativel%8 conservatis" is even
"ore i"portant in the case of highl% leveraged financial institutions 9here operating
risks are "agnified $% the capital structure< In evaluating such thrifts8 $ook value is
usuall% a lo9 esti"ate of private5"arket valueF "ost thrift takeovers occur at a
pre"iu" to $ook value< Investors should ad;ust $ook value up9ard8 ho9ever8 to
reflect understated assets8 such as appreciated invest"ent securities8 $elo95"arket
leases8 real estate carried $elo9 current 9orth8 and the value of a sta$le8 lo95cost
deposit $ase< Si"ilarl% $ook value should $e
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1 T6E A5E!INESTMENT "ROCESS
ad;usted do9n9ard to reflect $alance sheet intangi$les8 $ad loans8 and invest"ents
9orth less than cost<
As part of the funda"ental anal%sis of a thrift8 its earnings should $e ad;usted
for such nonrecurring ite"s as securities gains and losses8 real estate gains andlosses8 $ranch sales8 real estate develop"ent profits8 and accounting changes<
Qualit% of earnings is e:tre"el% i"portant since earnings derived fro" the recurring
spread $et9een interest earned on loans and interest paid on deposits are far "ore
valua$le than nonrecurring gains or volatile inco"e fro" loan origination fees< Thrifts
9ith lo9 overhead costs are prefera$le to high5cost institutions $oth $ecause the%
are "ore profita$le and $ecause the% en;o% greater fle:i$ilit% in ti"es of narro9
interest rate spreads<
Although thrift conversions are attractive8 the% are not a sure thing< While "an% of
the thrift conversions of the 1./s ulti"atel% proved re9arding to investors8 there
9as never certaint% a$out the outco"e< There are "an% risks in an% thrift
invest"ent8 including asset ?ualit%8 interest rate volatilit%8 "anage"ent discretion8
and the unpredicta$le actions of co"petitors< Investors8 as al9a%s8 "ust anal%De
each potential thrift conversion invest"ent not as an instance of an often attractive
"arket niche $ut individuall% on its "erits<
Bama#(a Sav#n/s 7an,
In -une 1/ -a"aica Savings Bank converted fro" "utual to stock o9nership
through a ne9l% for"ed holding co"pan%8 -SB 6inancial =-SB>< It is i"portant to recall
the "acroecono"ic conte:t of this share offering< At the ti"e of the -SB conversion8
the United States had e:perienced a nation9ide real estate do9nturn< sti"ates of
the total cost of the thrift industr% $ailout 9ere reaching as high as )// $illion<
(ending standards had $een tightened for real estate $orro9ers in al"ost all regions<
,ost thrift and $ank stocks had declined sharpl% in price8 and "an% trou$led
institutions had $een seiDed $% federal regula5
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Investing in #hrift Conversions 1
tors< A"idst these circu"stances -SB "ade the i"pro$a$le atte"pt to convert to
pu$lic o9nership<
-SB 9as not a t%pical thrift< 7rganiDed in 1. in Ne9 0ork8 it had on
#ece"$er 3181.8 total assets of 1<) $illion and retained earnings of 1<1"illion8 a ratio of tangi$le capital to total assets of 13<) percent prior to conversion<
This 9as a"ong the highest ratios in the countr%< T9o5thirds of the assets of -SB 9ere
held in U<S< Treasur% and other federal agencies@ securities or cash e?uivalents8 9hile
onl% 3/ percent 9as in loans8 virtuall% all residential "ortgages< -SB 9as in a class $%
itself& li?uid8 9ell capitaliDed8 and 9ithout "aterial $usiness risk<
#epositors in -SB 9ere offered the opportunit% of $u%ing 1 "illion shares at
1/ each< The econo"ics of a thrift conversion are such that even 9ith -SB@s o$vious
"erits8 the shares 9ere offered to investors at onl% * percent of $ook value and a
pro for"a priceJearnings "ultiple of ten ti"es< The gloo"% real estate environ"ent
and the depressed "arket for thrift stocks no dou$t contri$uted to the lo9 initial
offering price<
As an invest"ent -SB 9as e:tre"el% lo9 risk in ever% respect< The credit risk 9as
"ini"al8 the high capital ratio reflected lo9 financial leverage8 and the stock sold
9ell $elo9 -SB@s tangi$le $ook value8 a %ardstick of its underl%ing 9orth<
7ne interesting 9a% to evaluate the risk of investing in -SB 9as to consider
that half the proceeds fro" the stock conversion8 or ./ "illion8 9ere to $e retained
at the holding co"pan%< This cash represented e:cess capital that could $e used to
repurchase -SB shares su$se?uent to the pu$lic offering< If the cash had $een used in
its entiret% to repurchase -SB shares at t9o5thirds of $ook value =a */ percent
pre"iu" to the I!7 price>8 the co"pan% could have repurchased one5third of the
shares of -SB that had ;ust $een issued<
While "ost shareholders "ight have chosen not to sell at that price8 the effect
of such a progra" 9ould al"ost certainl% have $een to raise the price of -SB shares<
In fact8 the pro for"a $ook value per share8 ad;usted to reflect this h%pothetical
repurchase8 9ould have increased fro" 21<12 to 2)<//8 an 1. percent increase<
This illustrates the opportunit% to investors of o9ning
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1*Invest#n/ #n F#nan(#all%
2#stresse an
7an,ru$t Se(ur#t#esAs 9e have learned fro" the histor% of the ;unk5$ond "arket8 investors have
traditionall% attached a stig"a to the securities of financiall% distressed co"panies8
perceiving the" as highl% risk% and therefore i"prudent< 6inanciall% distressed and
$ankrupt securities are anal%ticall% co"ple: and often illi?uid< The reorganiDation
process is $oth tedious and highl% uncertain< Identif%ing attractive opportunities
re?uires painstaking anal%sisF investors "a% evaluate doDens of situations to uncover
a single 9orth9hile opportunit%<
Although the nu"$er of varia$les is high in an% t%pe of investing8 the issues
that "ust $e considered 9hen investing in the securities of financiall% distressed or
$ankrupt co"panies are greater in nu"$er and in co"ple:it%< In addition to co"par5
ing price to value as one 9ould for an% invest"ent8 investors in financiall% distressed
securities "ust consider8 a"ong other things8 the effect of financial distress on
$usiness resultsF the
1
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2// T6E A5E!INESTMENT "ROCESS
availa$ilit% of cash to "eet upco"ing de$t5service re?uire"entsF and likel%
restructuring alternatives8 including a detailed understanding of the different classes
of securities and financial clai"s outstanding and 9ho o9ns the"< Si"ilarl%8
investors in $ankrupt securities "ust develop a thorough understanding of the
reorganiDation process in general as 9ell as the specifics of each situation $eing
anal%Ded<
Because "ost investors are una$le to anal%De these securities and un9illing
to invest in the"8 the securities of financiall% distressed and $ankrupt co"panies can
provide attractive value5invest"ent opportunities< Unlike ne9l% issued ;unk $onds8
these securities sell considera$l% $elo9 par value 9here the riskJre9ard ratio can $e
attractive for kno9ledgea$le and patient investors<
F#nan(#all% 2#stresse an 7an,ru$t 7us#nesses'o"panies get into financial trou$le for at least one of three reasons& operating
pro$le"s8 legal pro$le"s8 andJor financial pro$le"s< A serious $usiness deterioration
can cause continuing operating losses and ulti"atel% financial distress< Unusuall%
severe legal pro$le"s8 such as those that plagued -ohns ,anville8 Te:aco8 and A< H<
4o$ins8 caused tre"endous financial uncertaint% for these co"panies8 leading the"
ulti"atel% to seek $ankruptc% court protection< 6inancial distress so"eti"es results
al"ost entirel% fro" the $urdens of e:cessive de$tF "an% of the ;unk5$ond issuers of
the 1./s shared this e:perience<
6inancial distress is t%picall% characteriDed $% a shortfall of cash to "eet
operating needs and scheduled de$t5service o$ligations< When a co"pan% runs short
of cash8 its near5ter" lia$ilities8 such as co""ercial paper or $ank de$t8 "a% not $e
refinancea$le at "aturit%< Suppliers8 fearing that the% "a% not $e paid8 curtail or
cease ship"ents or de"and cash on deliver%8 e:acer$ating the de$tor@s 9oes<
'usto"ers dependent on an
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Investing in 2inancially Distressed and ankrupt !ecurities 2/1
ongoing $usiness relationship "a% stop $u%ing< "plo%ees "a% a$andon ship for
"ore secure or less stressful ;o$s<
Since the effect of financial distress on $usiness results can var% fro"
co"pan% to co"pan%8 investors "ust e:ercise considera$le caution in anal%Ding
distressed securities< The operations of capital5intensive $usinesses are8 over the
long run8 relativel% i""une fro" financial distress8 9hile those that depend on pu$lic
trust8 like financial institutions8 or on i"age8 like retailers8 "a% $e da"aged
irreversi$l%< 6or so"e $usinesses the decline in operating results is li"ited to the
period of financial distress< After a successful e:change offer8 an in;ection of fresh
capital8 or a $ankruptc% reorganiDation8 these $usinesses recover to their historic
levels of profita$ilit%< 7thers8 ho9ever8 re"ain shado9s of their for"er selves<
The capital structure of a $usiness also affects the degree to 9hich operations
are i"pacted $% financial distress< 6or de$tors 9ith "ost or all of their o$ligations ata holding co"pan% one or "ore levels re"oved fro" the co"pan%@s pri"ar% assets8
the i"pact of financial distress can $e "ini"al< 7verleveraged holding co"panies8
for e:a"ple8 can file for $ankruptc% protection 9hile their via$le su$sidiaries
continue to operate uni"pairedF Te:aco entered $ankruptc% 9hile "ost ofits
su$sidiaries did not file for court protection< 'o"panies that incur de$t at the
operating5su$sidiar% level "a% face greater dislocations<
The popular "edia i"age of a $ankrupt co"pan% is a rusting hulk of a factor%
vie9ed fro" $e%ond a padlocked gate< Although this is so"eti"es the unfortunate
realit%8 far "ore often the $ankrupt enterprise continues in $usiness under court
protection fro" its creditors< Indeed8 9hile there "a% $e a need to re$uild da"aged
relationships8 a co"pan% that files for $ankruptc% has usuall% reached rock $otto"
and in "an% cases soon $egins to recover< As soon as ne9 lenders can $e assured of
their senior creditor position8 de$tor5in5possession financing $eco"es availa$le8
providing cash to "eet pa%roll8 to restock depleted inventories8 and to give
confidence $oth to custo"ers and suppliers< Since postpetition suppliers to the
de$tor have a
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2/2 T6E A5E!INESTMENT "ROCESS
senior clai" to unsecured prepetition creditors8 "ost suppliers rene9 ship"ents< As
restocked inventories and increased confidence sti"ulate $usiness and as deferred
"aintenance and dela%ed capital e:penditures are undertaken8 results "a% $egin to
i"prove< 'ash usuall% starts to $uild =for a nu"$er of reasons to $e discussed later><When necessar%8 ne9 "anage"ent can $e attracted $% the prospect of a sta$le and
i"proving $usiness situation and $% the lure of lo95priced stock or options in the
reorganiDed co"pan%< While 'hapter 11 is not a panacea8 $ankruptc% can provide a
sheltered opportunit% for so"e trou$led $usinesses to return to financial health<
Issuer Res$onses to F#nan(#al 2#stress
There are three principal alternatives for an issuer of de$t securities that encounters
financial distress& continue to pa% principal and interest 9hen due8 offer to e:change
ne9 securities for securities currentl% outstanding8 or default and file for $ankruptc%<
A potential investor in distressed securities "ust consider each of these three
possi$le scenarios $efore co""itting capital<
6inanciall% trou$led co"panies can tr% to survive outside $ankruptc% $%
resorting to cost cutting8 asset sales8 or an infusion of outside capital< Such efforts
can $e successful8 depending on the precise cause of the de$tor@s 9oes< Short5ter"
palliatives8 ho9ever8 can contri$ute to the erosion of long5ter" $usiness value<
fforts to conserve cash $% cutting $ack inventor%8 stretching out accounts pa%a$le8
or reducing salaries8 for e:a"ple8 can get a $usiness through a short5ter" crisis8 $ut
in the long run so"e of these "easures "a% hurt relationships 9ith custo"ers8
suppliers8 and e"plo%ees and result in a di"inution of $usiness value<
A second option for a co"pan% is to "ake an e:change offer to replace
outstanding de$t and8 9here relevant8 preferred stock 9ith ne9 securities< The
possi$ilit% of an e:change offer adds a
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Investing in 2inancially Distressed and ankrupt !ecurities 2/)
overleveraged co"panies in order to e:pedite the reorganiDation process8 avoid the
high ad"inistrative costs of a traditional 'hapter 11 filing8 and circu"vent the free5
rider pro$le"<
If "easures to keep the patient alive prove unsuccessful8 the third option is to file forcourt protection under 'hapter 11 of the federal $ankruptc% code and atte"pt to
reorganiDe the de$tor 9ith a "ore via$le capital structure< This is t%picall% a t
resort8 ho9ever8 for there is still considera$le stig"a attached to $ankruptc%<
The Im$l#(at#ons o8 a 7an,ru$t(% F#l#n/
6iling for $ankruptc% halts efforts $% creditors =lenders> to collect repa%"ent fro" the
de$tor =$orro9er>< !a%"ent of principal and interest other than that due on full%
secured de$t is suspended< !a%"ents to trade creditors and even e"plo%ees are
9ithheld< The different classes of creditorssecured8 senior8 and ;unior lenders8 trade
creditors8 e"plo%ees8 and others9ill $e dealt 9ith in a plan or so"eti"es
co"peting plans of reorganiDation proposed and supported $% either the de$tor
andJor $% a "a;or creditor group or groups< As stated previousl%8 to $e confir"ed a
plan "ust $e approved $% the $ankruptc% ;udge as 9ell as $% a "a;orit% in nu"$er
and t9o5thirds in dollar a"ount of each class of creditors<
The interests of a $ankrupt de$tor and its creditors can and fre?uentl% do
diverge considera$l%< The de$tor8 seeking to e"erge fro" $ankruptc% as strong as
possi$le8 "a% atte"pt to "a:i"iDe postreorganiDation cash and "ini"iDe
postreorganiDation de$t< Si"ilarl% the de$tor "a% tr% to "aintain high levels of
capital spending during the 'hapter 11 process in order to ensure a via$le $usiness
after reorganiDation< B% contrast8 creditors 9ill generall% prefer to "a:i"iDe cash
distri$utions to the"selves< The% "a% oppose 9hat the% consider to $e e:cessive
capital e:penditures $% the de$tor during the reorganiDation process8 preferring a
cash $uildup that 9ill su$se?uentl%
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2/ T6E A5E!INESTMENT "ROCESS
$e distri$uted to the"< These conflicting interests 9ill $e resolved during the
negotiation of a plan of reorganiDation and finall% $% the $ankruptc% court<
A co"pan% "a% use a $ankruptc% filing to void leases and e:ecutor%
contracts such as long5ter" suppl% arrange"ents< In the past even la$or agree"entshave $een ter"inated under $ankruptc%< The 1. $ankruptc% of 6ood 6air Stores
resulted in a nu"$er of voided store leases8 the present value of 9hich $eca"e
clai"s against the de$tor< The 1.) $ankruptc% of Wheeling !itts$urgh Steel resulted
in the re;ection of e:isting iron ore5 and coal5purchase contracts8 9hich 9ere
su$se?uentl% renegotiated at lo9er pricesF suppliers such as 'leveland5'liffs and
Hanna ,ining $eca"e su$stantial clai"ants in $ankruptc%< Although this could no
longer $e done toda%8 in 1.3 'ontinental Airlines used a $ankruptc% filing to void its
la$or agree"ent8 effectivel% replacing a unioniDed 9ork force 9ith nonunion la$or<
79ing to a de$tor@s a$ilit% to re;ect contracts of nearl% all t%pes8 a $ankrupt
co"pan% is fre?uentl% in a position to $eco"e a lo95cost co"petitor in its industr%
upon reorganiDation< Unprofita$le8 high5cost facilities are closed or sold8 a$ove5
"arket lease costs are reduced to "arket levels8 and a co"pan%@s overstated assets
are t%picall% 9ritten do9n on its $ooks to fair5"arket value8 there$% reducing future
depreciation charges< The $ankruptc% process can so"eti"es serve as a salutar%
catharsis8 allo9ing trou$led fir"s the opportunit% to i"prove their $usiness
operations<
6or several reasons $ankrupt co"panies tend to $uild up su$stantial cash
$alances< 'osts "a% $e reduced either through contract re;ections or through
ordinar% cost5cutting efforts8 resulting in increased cash flo9< ,ore of a co"pan%@s
free cash flo9 is retained as interest pa%"ents on unsecured de$t are suspended and
co""on and preferred dividend pa%"ents are halted< ,an% $ankrupt fir"s have
su$stantial net operating loss =N7(> carr%5for9ards8 resulting fro" prior ta: losses or
fro" 9rite5offs incurred during $ankruptc%F these N7(s offset ta:es currentl% due8
also aug"enting cash< 'apital spending8 in par5
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Investing in 2inancially Distressed and ankrupt !ecurities 2/
ticular spending on unrelated diversification and on ne9 or risk% activities8 is
curtailed< Unrelated8 unprofita$le8 or other9ise ill5fitting $usinesses "a% $e divested8
again resulting in cash $uildup< Since cash is not availa$le for distri$ution until a plan
of reorganiDation is approved and consu""ated8 cash 9ill gro9 fro" co"poundinterest earned on e:isting cash $alances and fro" interest on interest< All this has
led to 9hat one leading $ankruptc% advisor has ter"ed the "one%5"arket theor% of
$ankruptc%& if enough cash $uilds up8 it can si"plif% the process of devising a plan of
reorganiDation that is accepta$le to all parties $ecause there are no differences of
opinion concerning the value of cash and $ecause "ore creditors can $e paid in full<
The Investment Attra(t#ons o8 7an,ru$t(%
Investing in $ankrupt securities differs fro" investing in co"panies operating
nor"all%< An o$vious difference is that in a solvent co"pan%8 an investor can $e
relativel% certain of 9hat $elongs to 9ho"< In a $ankruptc% the treat"ent of valid
clai"s is precisel% 9hat is to $e decided in court& the disposition of the assets is to $e
deter"ined $% the o9ners of the lia$ilities 9ho8 along 9ith the e?uit% o9ners8 9ill
receive the assets either directl% or "ore t%picall% in the for" of ne9l% issued
securities of the reorganiDed de$tor<
As "entioned in chapter 1/8 one attractive feature of $ankruptc% investing is
that the reorganiDation process can serve as a catal%st for realiDing underl%ing value<
An undervalued stock "a% re"ain cheap forever and an attractive $ond "a% have to
$e held until a distant "aturit% date to pa% off8 $ut a $ankrupt co"pan% 9ill t%picall%
reorganiDe 9ithin t9o or three %ears of filing under 'hapter 11< Upon e"ergence
fro" $ankruptc%8 the fir"@s creditors t%picall% e:change their clai"s for so"e
co"$ination of cash8 ne9 de$t securities8 and e?uit% in the reorganiDed de$tor<
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2/. T6E A5E!INESTMENT "ROCESS
"ergence fro" 'hapter 11 also serves as a li?uef%ing event for clai"holders<
79ners of s"all8 illi?uid trade clai"s or large a"ounts of $ank de$t 9ill e:perience a
su$stantial enhance"ent in the li?uidit% of their holdings< ,a:i"u" li?uidit% 9ould
co"e fro" an all5cash distri$ution8 $ut even de$t or e?uit% securities 9ould likel%provide holders "ore li?uidit% than clai"s against a $ankrupt de$tor<
An additional attraction of $ankruptc% investing is that $ankrupt de$t
securities8 particularl% senior securities8 are not ver% sensitive to fluctuations in the
stock or $ond "arket< Bankrupt securities tend to $ehave so"e9hat like risk5
ar$itrage invest"entsF the% fluctuate in price "ore 9ith the progress of the
reorganiDation than 9ith the overall "arket<
The Three Sta/es o8 7an,ru$t(% Invest#n/
,ichael !rice of ,utual Series 6und8 Inc<8 speaks of three stages of $ankruptc%< The
first stage8 i""ediatel% after the 'hapter 11 filing8 is the ti"e of greatest uncertaint%
$ut perhaps also of greatest opportunit% for investors< The de$tor@s financial situation
is in tur"oil8 financial state"ents "a% $e late or unavaila$le8 off5$alance5sheet
lia$ilities are not i""ediatel% evident8 and the underl%ing $usiness "a% not have
sta$iliDed< In addition the "arket for the de$tor@s securities is in disarra%8 9ith "an%
holders forced to sell their holdings regardless of price<
The second stage of $ankruptc%8 involving the negotiation of a plan of
reorganiDation8 $egins an%9here fro" a fe9 "onths to several %ears after filing< B%
then anal%sts 9ill have pored over the de$tor@s $usiness and financial situation< ,uch
"ore is kno9n a$out the de$tor8 and securit% prices 9ill incorporate the availa$le
infor"ation< 'onsidera$le uncertaint% re"ains8 ho9ever8 a$out the eventual plan of
reorganiDation< The treat"ent of various classes of creditors is still to $e resolved<
The third and final stage of $ankruptc% occurs $et9een the finaliDation of a
reorganiDation plan and the de$tor@s e"ergence
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Investing in 2inancially Distressed and ankrupt !ecurities 2/
fro" $ankruptc%< Unless the plan is contested8 is re;ected $% one or "ore classes of
creditors8 or falls through $ecause a ke% condition is not "et8 this stage usuall% takes
three "onths to one %ear< Although the ti"e fra"e and legal process are less
certain8 the last stage "ost closel% rese"$les a risk5ar$itrage invest"ent<
ach stage of $ankruptc% affords different opportunities to the investor< The
$est $argains appear a"idst the uncertaint% and high risk of the first stage< The
lo9est $ut "ost predicta$le returns are availa$le in the third stage8 after the
reorganiDation plan $eco"es pu$licl% availa$le<
R#s,s o8 Invest#n/ #n F#nan(#all% 2#stresse an
7an,ru$t Se(ur#t#es
Investing in financiall% distressed and $ankrupt securities re?uires patience to 9ait
for the right situation and the right securit% at the right price and discipline to adhere
to value5investing criteria< When properl% i"ple"ented8 trou$led5co"pan% investing
"a% entail less risk than traditional investing8 %et offer significantl% higher returns<
When $adl% done8 the results of investing in distressed and $ankrupt securities can
$e disastrousF ;unior securities8 for e:a"ple8 can $e co"pletel% 9iped out< The
"arket for distressed and $ankrupt securities is illi?uid8 and traders can take
advantage of unsophisticated investors< Quoted prices "a% $ear little relationship to
actual trading levels8 and an uninfor"ed $u%er can significantl% overpa%< In a "arket
9here "ost $u%ers are highl% sophisticated8 caution is the order of the da% for the
ordinar% investor<
,an% things can go 9rong 9ith $ankruptc% invest"ents< 6or one thing8 the
rate of return is highl% dependent on ti"ing< In $ankruptc% unsecured $ut Gfull%
coveredG clai"s =clai"s that 9ill receive one hundred cents on the dollar upon
reorganiDation are kno9n as full% covered> in essence $eco"e Dero5coupon $ondsF
9ith par received at the end of the reorganiDation pro5
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21/ T6E A5E!INESTMENT "ROCESS
cess8 the rate of return to $u%ers depends on the duration of the $ankruptc%< An
investor 9ho anticipates a long $ankruptc% 9ould naturall% pa% less than a "ore
opti"istic investor if he or she is to achieve the sa"e rate of return<
The risk of investing in financiall% distressed and $ankrupt securities varies9ith the specifics of each situation< At the riskiest end of the spectru" are highl%
co"petitive or fashion5oriented $usinesses dependent on a li"ited nu"$er of their
ke% personnel and o9ning fe9 tangi$le assetsF co"panies that sell custo"iDed or
user5specific productsF and financial co"panies that are particularl% dependent on
investor and custo"er confidence< :a"ples include A"es #epart"ent Stores in the
fiercel% co"petitive discount store "arket and Integrated 4esources8 a highl%
leveraged financial5services co"pan%<
At the lo95risk end of the spectru" are overleveraged capital5intensive
de$tors8 possi$l% having "onopol% or near5"onopol% positions in their industries8 and
$usinesses producing ho"ogeneous or undifferentiated products< (o95risk
$ankruptcies also do not have pu$lic5polic% legal issues to $e resolved< The secured
$onds of !u$lic Service 'o"pan% of Ne9 Ha"pshire8 an electric utilit%8 or of -ones K
(aughlin Steel8 a su$sidiar% of (T+ 'orporation8 a "a;or integrated steel producer8
are located at the lo95risk end of the spectru"<
Investors should $e 9ar% of purchasing or holding the fi:ed5inco"e securities
of rapidl% deteriorating $usinesses< It is eas% to look at the apparent asset protection
of a $ond 9hile ignoring earnings or cash flo9 pro$le"s< When a $usiness loses cash
fro" operations even $efore interest e:pense8 it 9ill often e:perience accelerating
losses8 especiall% if it is highl% leveraged< If a turnaround does not co"e ?uickl%8 it
"a% not co"e at all<
Although no investor can ignore price8 investors in distressed or $ankrupt
securities "ust "ake price a pri"ar% focus< Both casual o$servers and so"e full5ti"e
acade"ics tend to think of the financial "arkets as efficient and continuous8 9ith
prices deter"ined $% underl%ing $usiness develop"ents< B% contrast8 the "arket for
a distressed or $ankrupt $ond "a% consist of onl% a fe9 $u%ers and sellers and
so"eti"es onl% the "arket5
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Investing in 2inancially Distressed and ankrupt !ecurities 211
"akers the"selves< In an illi?uid "arket the price at 9hich a securit% transaction
takes place is deter"ined not so "uch $% invest"ent funda"entals as $% the trading
savv% of the participants< In the illi?uid "arket for distressed and $ankrupt $onds8
$eing a s"art trader "a% so"eti"es $e "ore i"portant than $eing a s"art anal%st<
The F#nan(#all% 2#stresse an 7an,ru$t Se(ur#t%
Invest#n/ "ro(ess
Investors in financiall% distressed and $ankrupt securities "ust concentrate on the
corporate $alance sheet< (ike kno9ing the opposing lineups at a $ase$all ga"e8
understanding the a"ounts and priorities of a co"pan%@s lia$ilities can tell investors
a great deal not onl% a$out ho9 the various securit% holders are likel% to $e treated
$ut also ho9 the financial distress is likel% to $e resolved<
The first step is to value the assets of the de$tor< 7nce the siDe of the pie is
kno9n8 it is possi$le to consider ho9 it "a% $e divided< To facilitate this process8 an
investor "ust divide the de$tor@s assets into t9o parts& the assets of the ongoing
$usinessF and the assets availa$le for distri$ution to creditors upon reorganiDation8
such as e:cess cash8 assets held for sale8 and invest"ent securities< Investors in A,
International8 Inc<8 senior clai"s received su$stantial a"ounts of A,@s e:cess cash
upon reorganiDationF investors in Braniff Airlines@ first $ankruptc% in 1.3 received
li?uidating trust certificates $acked $% a direct interest in aircraft assets<In valuing an ongoing $usiness operating in 'hapter 118 investors should
e"plo% each of the valuation "ethodologies descri$ed in chapter .< In "an%
instances the investor is in the difficult position of anal%Ding a "oving target since
the $usiness of the de$tor is unsta$le8 if not in tur"oil< It is essential that investors
take into account an% inco"e state"ent and cash flo9 distortions caused $% the
'hapter 11 process itself< Interest
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212 T6E A5E!INESTMENT "ROCESS
earned on e:cess cash that $uilds up during $ankruptc%8 for e:a"ple8 9ill not $e a
source of inco"e for the reorganiDed co"pan%< Si"ilarl%8 interest e:pense on
reinstated de$t8 9hich does not accrue during $ankruptc%8 9ill once again accrue<
Then8 again8 the high invest"ent $anking8 legal8 and ad"inistrative costs of a
'hapter 11 proceeding8 often cu"ulativel% totaling several percent or "ore of the
value of the de$tor@s estate8 9ill cease upon e"ergence fro" $ankruptc%< Bankrupt
co"panies "a% even intentionall% Guglif%G their financial state"ents =for e:a"ple8 $%
e:pensing rather than capitaliDing certain e:penses or $% $uilding e:cessive $alance
sheet reserves> in order to "ini"iDe the assets apparentl% availa$le for distri$ution
to creditors< This value is ulti"atel% revealed after reorganiDation8 $ut $% then
insiders have picked up cheap stock or options<
Anal%sis of the assets and lia$ilities of financiall% distressed or $ankrupt
co"panies "ust e:tend $e%ond the $alance sheet ho9ever< 7ff5$alance5sheet assets"a% include real estate carried $elo9 current value8 an overfunded pension plan8
patents o9ned8 and the like< 7ff5$alance5sheet lia$ilities "a% include underfunded
pension plans8 Internal 4evenue Service8 nviron"ental !rotection Agenc%8 !ension
Benefit uarant% 'orporation =!B'>8 and other govern"ental clai"s8 and clai"s
resulting fro" re;ected e:ecutor% contracts and leases< In recent steel industr%
$ankruptcies8 for e:a"ple8 Wheeling !itts$urgh Steel and (T+ 'orporation
transferred their underfunded pension plans to the !B'8 resulting in a $ankruptc%
clai" $% the !B' against Wheeling and protracted litigation $et9een the !B' and
(T+<
7nce a de$tor@s assets have $een valued8 investors should turn their attention
to the lia$ilit% side of the $alance sheet< The lia$ilities of a $ankrupt co"pan% are
$est evaluated in descending order of seniorit%< Secured de$t should $e evaluated
first< If the value of the securit% interest is deter"ined8 9hether through negotiation
or a valuation proceeding8 to $e e?ual to or greater than the a"ount of clai"8 the
clai" is said to $e full%
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Investing in 2inancially Distressed and ankrupt !ecurities 213
secured or oversecured< An oversecured clai" entitles the holder to postpetition
accrued interest =interest that 9ould have accrued during the $ankruptc%
proceeding> to the e:tent of the a"ount of oversecurit%< If secured de$t is
deter"ined to $e less than full% secured8 holders 9ill t%picall% receive value e?ual tothe e:tent of their securit% plus a senior $ut unsecured clai" against the de$tor for
the a"ount of the undersecurit%<
There "a% $e so"e invest"ent opportunities in distressed securities at ever%
rank in the de$t hierarch%< 4isk5averse investors 9ill generall% prefer to hold senior
securitiesF the potential return fro" senior securities is fre?uentl% less than that
availa$le fro" ;unior clai"s8 $ut the risk is also "uch lo9er< Senior securities are first
in priorit%8 and unless the% are full% or al"ost full% repaid8 ;unior classes are unlikel%
to receive significant value<
G6ulcru" securitiesGthe class of securities partl% $ut not full% covered $% asset
valuecan also $e attractive invest"ents at the right price8 ranking "id9a% on the
risk spectru"< 6ulcru" securities $enefit "ost directl% fro" value increases and
like9ise are "ost directl% i"paired $% an% value di"inution<
Investing in ;unior securities can provide spectacular returns $ut can also
prove disastrous< These securities often serve as out5of5the5"one% options
effectivel%8 $etson an i"prove"ent in operating results or an increase in value<
The co""on stock of $ankrupt co"panies fre?uentl% trades considera$l% a$ove its
reorganiDation value8 9hich is often close to Dero< While there "a% $e an occasional
ho"e run8 as a rule investors should avoid the co""on stock of $ankrupt entities at
virtuall% an% priceF the risks are great and the returns ver% uncertain<
Unsophisticated investors have lost a great deal of "one% $u%ing the overpriced
co""on stock of $ankrupt co"panies8 even after the unfavora$le ter"s of the
reorganiDation plan have $een 9idel% disse"inated<
It is 9orth re"e"$ering that restructurings and $ankruptc% reorganiDations
are negotiated processes< Negotiations can $e affected $% the relative $argaining
strengths and 9eaknesses of
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21* T6E A5E!INESTMENT "ROCESS
the different classes of creditors8 the skills of the negotiators8 and the dollar a"ounts
at stake<
B% 9a% of e:a"ple8 4on (a$o9 headed an investor group that $ought up "ost
of Wheeling !itts$urgh Steel@s $ank de$t and dictated a reorganiDation plan that lefthi" in control of the reorganiDed co"pan%< A $locking positionone5third of the
outstanding a"ount of de$tin a s"all8 closel% held de$t issue "a% ena$le that
class to o$tain $etter treat"ent than si"ilar $ut "ore 9idel% held de$t issues< The
holder of a $locking position in even the "ost ;unior $ankrupt securit%8 $ecause of his
or her a$ilit% to dela% the de$tor@s e"ergence fro" $ankruptc%8 "a% gain far $etter
treat"ent for his or her class than allo9ed $% an% allocation "ade strictl% according
to priorit% ranking< A $locking position is said to have Ghold5upG value in t9o senses&
the o9ner can hold up =dela%> the $ankruptc% process as 9ell as hold up =ro$> other
classes of creditors8 e:tracting nuisance value fro" 9hat "ight other9ise $e a nearl%
9orthless clai"<
67B Falls 8rom Gra(e9 An O$$ortun#t% #n
F#nan(#all% 2#stresse Se(ur#t#es
The nature of opportunities that can e:ist in the "arket for distressed
securities is 9ell e:e"plified $% the fall fro" grace of Harcourt Brace -ovanovich8 Inc<
=HB->< HB- 9as once a favorite of ;unk5$ond investors and as recentl% as August 1.
had a total "arket capitaliDation of de$t and e?uit% securities of *< $illion< Its ;unk
$onds traded a$ove par value< At the ti"e HB- operated a 9ell5kno9n pu$lishing
$usiness8 an insurance co"pan%8 and the"e parksF the parks 9ere up for sale< In
Septe"$er 1. HB- announced the sale of the the"e parks to Anheuser5Busch for
1<1 $illion =1</ $illion net of ta:es>8 a disappointing nu"$er to Wall Street anal%sts
9ho had e:pected 1<) $illion< Bank de$t 9as repaid 9ith the after5ta: proceeds<
(ogicall% the total capitaliDation should have declined fro" *< $illion to 3< $illion<
Instead8 on -anuar% 318 1/8 the total
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Investing in 2inancially Distressed and ankrupt !ecurities 21)
"arket capitaliDation 9as onl% 1 $illion8 a decline of "ore than t9o5thirds fro" the
i"plied capitaliDation onl% four "onths earlier< The "agnitude of this decline can $e
e:plained onl% in the conte:t of the shattering of investors@ perceptions of Harcourt
as Ggood ;unk<G 7nce it $eca"e apparent that the co"pan% 9as seriousl%overleveraged8 9idespread selling took place8 and securit% prices plunged<
!rice decline alone does not "ake a securit% a $argainF an apprecia$le
discount fro" underl%ing value is also re?uired< In the case of HB- the su$ordinated
$onds 9ere no9 an attractive $argain8 for in -anuar% 1/ the $usiness 9as al"ost
certainl% 9orth $et9een 1<* and 1< $illion and possi$l% even "ore< =This valuation
9as $orne out $% the 1<) $illion takeover offer "ade $% eneral 'ine"a 'orporation
a %ear laterF the su$ordinated $onds 9ere to receive nearl% fift% cents on the dollar<>
The face value of senior de$t 9as onl% a$out .// "illion8 leaving $et9een //
"illion and // "illion of value against )/ "illion of su$ordinated de$t< Trading
at t9ent%5five cents on the dollar8 this de$t 9as e:traordinaril% attractive even under
a pessi"istic valuation scenario and even if $usiness results 9orsened< In fact8 in
$ankruptc% the value of these su$ordinated $onds 9ould ulti"atel% have $een
enhanced $ecause interest pa%"ents to senior unsecured de$t holders 9ould $e
haltedF an% cash savings 9ould accu"ulate "ostl% to the $enefit of the su$ordinated
$onds<1
2#stresse 7ons ersus O$t#m#st#( Sto(,9
Intermar,et Arb#tra/e #n 7an, o8
Ne- En/lan Se(ur#t#es
,an% ti"es securit% prices in the stock "arket 9ill $e inconsistent 9ith those
in the $ond "arket8 as if investors in one "arket do not co""unicate 9ith those in
another< 6inancial distress created such an opportunit% in the de$t and e?uit%
securities of the Bank of Ne9 ngland 'orporation =BN>< A large loss
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21 T6E A5E!INESTMENT "ROCESS
announced in -anuar% 1/ caused the su$ordinated $onds of BN to plunge to 1/ to
13 fro" levels in the /s< At the sa"e ti"e the co""on stock of the Bank of Ne9
ngland traded at appro:i"atel% 3<)/ per share<
7verall BN had roughl% // "illion face a"ount of senior and su$ordinatedde$entures outstanding 9ith a total "arket value of less than 1// "illion< The
co""on stock8 9hich 9as8 of course8 ;unior to the holding co"pan% $onds8 had a
total "arket capitaliDation of appro:i"atel% 2)/ "illion<
7pportunistic investors $ought the BN $onds and sold BN co""on stock
short to lock in an apparent valuation disparit%< Specificall%8 investors could purchase
the $onds at 1/ to 13 and sell short co""on stock in e?ual dollar a"ounts< A $u%er
of 1 "illion face a"ount of su$ordinated $onds at 1/ 'A =for 1/)8///> could sell
short 3/8/// shares of co""on stock at 3<)/ for e?uivalent net proceeds<
!erfor"ing these si"ultaneous transactions appeared to $e a lo95risk strateg% under
an% conceiva$le scenario<
If BN $eca"e insolvent =as happened in earl% 11>8 for e:a"ple8
$ondholders 9ould at 9orst lose their invest"ent and "ight possi$l% achieve so"e
recover%F the co""on stock 9ould certainl% $e rendered 9orthless< The loss on the
$onds 9ould at least $e offset $% the gain on the short sale of co""on stock< In
addition8 investors 9ould earn interest on the short5sale proceeds and "ight receive
one or "ore interest pa%"ents fro" BN =t9o se"iannual coupons8 as it turned out><
If BN survived8 the $onds see"ed likel% to rall% $% a greater percentage than
the co""on stock< If the co""on stock tripled to 1/<)/ a"idst a surprising
recover%8 for e:a"ple8 the $onds see"ed likel% to trade 9ell a$ove the 3/ to */ level
that $ondholders 9ould need to $reak even< Again8 investors 9ould also $enefit fro"
interest pa%"ents received on the $onds as 9ell as interest earned on the short
credit $alance<
Another possi$le scenario 9as a financial restructuring8 9here$% BN 9ould
offer $ondholders the opportunit% to convert into e?uit%< This alternative8 9hich 9as
seriousl% consid5
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Investing in 2inancially Distressed and ankrupt !ecurities 21
ered $% the $ank $ut ulti"atel% proved to $e un9orka$le8 9ould have $een highl%
favora$le for those 9ho 9ere long $onds and short stock< The $onds 9ould have
$enefitted fro" the pre"iu" a$ove "arket that the co"pan% 9ould have had to
offer to induce holders to e:change8 9hile the co""on stock 9ould likel% havedeclined due to the dilution and selling pressure resulting fro" the issuance of large
a"ounts of co""on stock to $ondholders<
Con(lus#on
Investing in $ankrupt and financiall% distressed securities is a sophisticated8 highl%
specialiDed activit%< ach situation offers its o9n anal%tical challenges8 risks8 and
opportunities< A relative handful of savv%8 hard5nosed8 and e:perienced practitioners
co"pete for the availa$le opportunities< #ue to the stig"a of $ankruptc%8 the
uncertain outco"es of financial distress8 and the anal%tical co"ple:it% involved8 onl%
a s"all nu"$er of investors 9ill $u% or even hold these securities< In fact8 invest"ent
opportunities in this area result largel% fro" the unecono"ic $ehavior of other
investors< When such an area $eco"es popular8 as it did in earl% 118 investors
"ust "ake sure to avoid overpa%ing<
!erhaps ,ichael ,ilken 9as not craD%8 "erel% greed%8 9hen he e:trapolated
the invest"ent opportunit% in financiall% distressed and $ankrupt securities to ne9l%
issued securities that he under9rote< It is certainl% ironic that "an% of %esterda%@s
;unk5$ond "anagers and anal%sts have $eco"e toda%@s financiall% distressed and
$ankrupt pla%ers<
This chapter onl% touches on so"e of the reasons 9h% financiall% distressed
and $ankrupt securities "a% $e attractive to investors< It is certainl% not a pri"er on
ho9 to successfull% invest in these securities8 and I do not e:pect readers to i""e5
diatel% $eco"e successful $ankruptc% investors< ,% "ain point
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1+"ort8ol#o Mana/ement an
Tra#n/
No $ook on investing 9ould $e co"plete 9ithout a discussion of trading and portfolio
"anage"ent< Tradingthe process of $u%ing and selling securitiescan have a
significant i"pact on one@s invest"ent results< ood trading decisions can so"eti"es
add to an invest"ent@s profita$ilit% and other ti"es can "ean the difference $et9een
e:ecuting a transaction and failing to do so< !ortfolio "anage"ent enco"passes
trading activit% as 9ell as the regular revie9 of one@s holdings< In addition8 an
investor@s portfolio "anage"ent responsi$ilities include "aintaining appropriate
diversification8 "aking hedging decisions8 and "anaging portfolio cash flo9 and
li?uidit%<
All investors "ust co"e to ter"s 9ith the relentless continuit% of the
invest"ent process< Although specific invest"ents have a $eginning and an end8
portfolio "anage"ent goes on forever< Unlike "an% areas of endeavor8 there is no
near5annuit% of profita$le $usiness8 no $acklog of upco"ing invest"ent returns<
HeinD ketchup 9ill have a reasona$l% predicta$le volu"e of sales %ear in and %ear
out< In a sense8 its profits of
*1'
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**; T6E A5E!INESTMENT "ROCESS
to"orro9 9ere partiall% earned %esterda% 9hen its franchise 9as esta$lished<
Investors in "arketa$le securities 9ill not have predicta$le annual results8 ho9ever8
even if the% possess shares representing fractional o9nership of the sa"e co"pan%<
,oreover8 attractive returns earned $% HeinD "a% not correlate 9ith the returns
achieved $% investors in HeinDF the price paid for the stock8 and not ;ust $usiness
results8 deter"ines their return<
The Im$ortan(e o8 #Lu##t% #n Mana/#n/ an
Investment "ort8ol#o
Since no investor is infalli$le and no invest"ent is perfect8 there is considera$le "erit
in $eing a$le to change one@s "ind< If an investor purchases a li?uid stock such as
IB, $ecause he thinks that a ne9 product 9ill $e successful or $ecause he e:pects
the ne:t ?uarter@s results to $e strong8 he can change his "ind $% selling the stock at
an% ti"e $efore the anticipated event8 pro$a$l% 9ith "inor financial conse?uences<
An investor 9ho $u%s a nontransfera$le li"ited partnership interest or stock in a non5
pu$lic co"pan%8 $% contrast8 is una$le to change his "ind at an% priceF he is
effectivel% <locked in< When investors do not de"and co"pensation for $earing
illi?uidit%8 the% al"ost al9a%s co"e to regret it<
,ost of the ti"e li?uidit% is not of great i"portance in "anaging a long5ter"5
oriented invest"ent portfolio< 6e9 investors re?uire a co"pletel% li?uid portfolio that
could $e turned rapidl% into cash< Ho9ever8 une:pected li?uidit% needs do occur<Because the opportunit% cost of illi?uidit% is high8 no invest"ent portfolio should $e
co"pletel% illi?uid either< ,ost portfolios should "aintain a $alance8 opting for
greater illi?uidit% 9hen the "arket co"pensates investors 9ell for $earing it<
A "itigating factor in the tradeoff $et9een return and li?uidit% is duration<
While %ou "ust al9a%s $e 9ell paid to sacrifice li?uidit%8 the re?uired co"pensation
depends on ho9 long %ou
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Portfolio /anagement and #rading 221
9ill $e illi?uid< Ten or t9ent% %ears of illi?uidit% is far riskier than one or t9o "onthsF
in effect8 the short duration of an invest"ent itself serves as a source of li?uidit%<
Investors "aking venture5capital invest"ents8 for e:a"ple8 "ust $e e:ceptionall%
9ell co"pensated to offset the high pro$a$ilit% of loss8 the large proportion of theinvest"ent that is at risk =losses are often co"plete 9ipeouts>8 and the illi?uidit%
e:perienced for the duration of the invest"ent< The cost of illi?uidit% is ver% high in
such situations8 rendering venture capitalists virtuall% una$le to change their "inds
and "aking it difficult for the" to cash in even 9hen the $usinesses the% invested in
are successful<
(i?uidit% can $e illusor%< As (ouis (o9enstein has stated8 GIn the stock "arket8
there is li?uidit% for the individual $ut not for the 9hole co""unit%< The distri$uta$le
profits of a co"pan% are the onl% re9ards for the co""unit%<G1 In other 9ords8 9hile
an% one investor can achieve li?uidit% $% selling to another investor8 all investors
taken together can onl% $e "ade li?uid $% generall% unpredicta$le e:ternal events
such as takeover $ids and corporate5share repurchases< :cept for such
e:traordinar% transactions8 there "ust $e a $u%er for ever% seller of a securit%<
In ti"es of general "arket sta$ilit% the li?uidit% of a securit% or class of
securities can appear high< In truth li?uidit% is closel% correlated 9ith invest"ent
fashion< #uring a "arket panic the li?uidit% that see"ed "iles 9ide in the course of
an ups9ing "a% turn out onl% to have $een inches deep< So"e securities that traded
in high volu"e 9hen the% 9ere in favor "a% hardl% trade at all 9hen the% go out of
vogue<
When %our portfolio is co"pletel% in cash8 there is no risk of loss< There is
also8 ho9ever8 no possi$ilit% of earning a high return< The tension $et9een earning a
high return8 on the one hand8 and avoiding risk8 on the other8 can run high< The
appropriate $alance $et9een illi?uidit% and li?uidit%8 $et9een seeking return and
li"iting risk8 is never eas% to deter"ine<
Investing is in so"e 9a%s an endless process of "anaging li?uidit%< T%picall%
an investor $egins 9ith li?uidit%8 that is8 9ith cash that he or she is looking to put to
9ork< This initial li?uidit% is converted into less li?uid invest"ents in order to
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222 T6E A5E!INESTMENT "ROCESS
earn an incre"ental return< As invest"ents co"e to fruition8 li?uidit% is restored<
Then the process $egins ane9<
This portfolio li?uidit% c%cle serves t9o i"portant purposes< 6irst8 as discussed in
chapter .8 portfolio cash flo9the cash flo9ing into a portfoliocan reduce aninvestor@s opportunit% costs< Second8 the periodic li?uidation of parts of a portfolio
has a cathartic effect< 6or the "an% investors 9ho prefer to re"ain full% invested at
all ti"es8 it is eas% to $eco"e co"placent8 sinking or s9i""ing 9ith current
holdings< G#ead 9oodG can accu"ulate and $e neglected 9hile losses $uild< B%
contrast8 9hen the securities in a portfolio fre?uentl% turn into cash8 the investor is
constantl% challenged to put that cash to 9ork8 seeking out the $est values availa$le<
Reu(#n/ "ort8ol#o R#s,
The challenge of successfull% "anaging an invest"ent portfolio goes $e%ond "aking
a series of good individual invest"ent decisions< !ortfolio "anage"ent re?uires
pa%ing attention to the portfolio as a 9hole8 taking into account diversification8
possi$le hedging strategies8 and the "anage"ent of portfolio cash flo9< In effect8
9hile individual invest"ent decisions should take risk into account8 portfolio
"anage"ent is a further "eans of risk reduction for investors<
Appropriate #iversification
ven relativel% safe invest"ents entail so"e pro$a$ilit%8 ho9ever s"all8 of do9nside
risk< The deleterious effects of such i"pro$a$le events can $est $e "itigated through
prudent diversification< The nu"$er of securities that should $e o9ned to reduce
portfolio risk to an accepta$le level is not greatF as fe9 as ten to fifteen different
holdings usuall% suffice<
#iversification for its o9n sake is not sensi$le< This is the inde: fund
"entalit%& if %ou can@t $eat the "arket8 $e the "arket< Advocates of e:tre"e
diversification9hich I think of as
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22* T6E A5E!INESTMENT "ROCESS
gold futures< A portfolio of i"port5 or e:port5sensitive stocks could $e partiall%
hedged through appropriate transactions in the foreign e:change "arkets<
It is not al9a%s s"art to hedge< When the availa$le return is sufficient8 for
e:a"ple8 investors should $e 9illing to incur risk and re"ain unhedged< Hedges can$e e:pensive to $u% and ti"e5consu"ing to "aintain8 and overpa%ing for a hedge is
as poor an idea as overpa%ing for an invest"ent< When the cost is reasona$le8
ho9ever8 a hedging strateg% "a% allo9 investors to take advantage of an
opportunit% that other9ise 9ould $e e:cessivel% risk%< In the $est of all 9orlds8 an
invest"ent that has valua$le hedging properties "a% also $e an attractive
invest"ent on its o9n "erits<
B% 9a% of e:a"ple8 fro" "id51.. to earl% 1/ the -apanese stock "arket
rose repeatedl% to record high levels< The "arket@s valuation appeared e:cessive $%
U<S< valuation criteria8 $ut in -apan the vie9 that the stock "arket 9as indirectl%
controlled $% the govern"ent and 9ould not necessaril% $e constrained $%
underl%ing funda"entals 9as 9idel% held< -apanese financial institutions8 9hich had
$eco"e accusto"ed to receiving large and gro9ing annual inflo9s of funds for
invest"ent8 9ere so confident that the "arket 9ould continue to rise that the% 9ere
9illing to sell -apanese stock "arket puts =options to sell> at ver% lo9 prices< To the"
sale of the puts generated i""ediate inco"eF since in their vie9 the "arket 9as
al"ost certainl% headed higher8 the puts the% sold 9ould e:pire 9orthless< If the
"arket should te"poraril% dip8 the% 9ere confident that the shares $eing put $ack to
the" 9ould easil% $e paid for out of the "assive cash inflo9s the% had co"e to
e:pect<
Wall Street $rokerage fir"s acted as inter"ediaries8 originating these put
options in -apan and selling the" in private transactions to U<S< investors<2 These
ine:pensive puts 9ere in theor% an attractive8 if i"precise8 hedge for an% stock
portfolio< Since the -apanese stock "arket 9as considera$l% overvalued co"pared
9ith the U<S< "arket8 investors in U<S< e?uities could hedge the risk of a decline in
their do"estic holdings through the purchase of -apanese stock "arket puts< These
puts 9ere
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Portfolio /anagement and #rading 22
tage of "arket dips to increase one@s holdings8 a user of this techni?ue acts as if the
"arket kno9s the "erits of a particular invest"ent $etter than he or she does<
(i?uidit% considerations are also i"portant in the decision to sell< 6or "an%
securities the depth of the "arket as 9ell as the ?uoted price is an i"portantconsideration< 0ou cannot sell8 after all8 in the a$sence of a 9illing $u%erF the likel%
presence of a $u%er "ust therefore $e a factor in the decision to sell< As the
president of a s"all fir" specialiDing in trading illi?uid over5the5counter =pink5sheet>
stocks once told "e& G0ou have to feed the $irdies 9hen the% are hungr%<G
If selling still see"s difficult for investors 9ho follo9 a value5invest"ent
philosoph%8 I offer the follo9ing rhetorical ?uestions& If %ou haven@t $ought $ased
upon underl%ing value8 ho9 do %ou decide 9hen to sellE If %ou are speculating in
securities trading a$ove underl%ing value8 9hen do %ou take a profit or cut %our
lossesE #o %ou have an% guide other than Gho9 the% are acting8G 9hich is reall% no
guide at allE
5se a 7ro,er to Whom You Are Im$ortant
Whether $u%ing or selling8 there are distinct advantages to finding and doing
$usiness 9ith long5ter"5oriented stock$rokers 9ho recogniDe that it is in their
interest to $uild and "aintain "utuall% $eneficial relationships 9ith clients< If
custo"ers feel that their $est interests are $eing served and that $rokerage
co""issions are a secondar% consideration8 long5ter" relationships are likel% to
ensue< B% contrast8 $rokers 9ho charge e:or$itant co""issions or routinel%
reco""end trades designed "ore to generate co""issions than invest"ent profits
9ill eventuall% lose custo"ers< The challenge is to find one or "ore $rokers 9ith
9ho" %ou feel co"forta$le<
An appropriate $roker 9ill possess a $alance of e:perience and desire8 a
co""it"ent to the invest"ent $usiness8 and a 9illingness to sacrifice i""ediate
co""issions for the sake of
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23/ T6E A5E!INESTMENT "ROCESS
long5ter" relationships< 0ou 9ant a $roker 9ith sufficient clout 9ithin his or her fir"
to provide %ou 9ith access to anal%sts and traders8 one 9ith e:perience to handle
%our account properl% and to kno9 9hen to call %ou and 9hen not to 9aste %our
ti"e< 0ou don@t 9ant a totall% ine:perienced $roker 9ho is learning at %our e:pense8
a co"placent $roker satisfied 9ith "ediocre results8 or one so successful that %our
account is relativel% uni"portant< ,ichael !rice and Bill 4uane 9ould have no
pro$le" capturing the undivided attention of an% $rokerF the% 9ould $e ver%
i"portant clients for an%one< 7ther investors "ust 9ork harder to find one or "ore
$rokers to 9ho" the% 9ill $e i"portant clients< 7ne possi$ilit% is to develop a
relationship 9ith a fairl% %oung $ut capa$le $roker to 9ho" %our account is currentl%
ver% i"portant and one 9ho 9ill gain i"portance and clout 9ithin the fir" over ti"e<
Con(lus#on This chapter has identified a nu"$er of issues that investors should consider in
"anaging their portfolios< While individual personalities and goals can influence one@s
trading and portfolio "anage"ent techni?ues to so"e degree8 sound $u%ing and
selling strategies8 appropriate diversification8 and prudent hedging are of i"portance
to all investors< 7f course8 good portfolio "anage"ent and trading are of no use
9hen pursuing an inappropriate invest"ent philosoph%F the% are of "a:i"u" value
9hen e"plo%ed in con;unction 9ith a value5invest"ent approach<
Notes
1< (ouis (o9enstein8 ,hat$s ,rong with ,all !treet =4eading8 ,ass<& Addison5
Wesle%8 1..>8 p< *3<
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Portfolio /anagement and #rading 231
2< At ti"es Wall Street also acted as principal in the sale of -apanese stock "arket
put options8 rel%ing on option5pricing "odels to esta$lish correct values for the puts
the% 9rote and on Gd%na"ic hedging strategiesG to protect the" fro" loss< #%na"ic
hedging operates ver% "uch like portfolio insurance8 re?uiring the sale of increasing?uantities of futures contracts as "arket prices decline<
3< Ta: considerations "a% $e an additional factor in the decision to sell<
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1)Investment Alternat#ves
8or the In#v#ual InvestorIf this $ook 9ere a fair% tale8 perhaps it 9ould have a happier ending< The
unfortunate fact is that the individual investor has fe98 if an%8 attractive invest"ent
alternatives< Investing8 it should $e clear $% no98 is a full5ti"e ;o$< iven the vast
a"ount of infor"ation availa$le for revie9 and anal%sis and the co"ple:it% of the
invest"ent task8 a part5ti"e or sporadic effort $% an individual investor has little
chance of achieving long5ter" success< It is not necessar%8 or even desira$le8 to $e a
professional investor8 $ut a significant8 ongoing co""it"ent of ti"e is a prere?uisite<
Individuals 9ho cannot devote su$stantial ti"e to their o9n invest"ent activities
have three alternatives& "utual funds8 discretionar% stock$rokers8 or "one%
"anagers<
232
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Investment Alternatives for the Individual Investor 23)
the validit% of their invest"ent approaches =do the% "ake senseE> and their integrit%
=do the% do 9hat is pro"ised8 and is it in %our $est interestE><
Ho9 do %ou $egin to evaluate stock$rokers and "one% "anagersE There are
several i"portant areas of in?uir%8 and one or "ore personal intervie9s area$solutel% essential< There is no $etter place to $egin one@s investigation than 9ith
personal ethics< #o the% Geat ho"e cookingG"anaging their o9n "one% in parallel
9ith their clients@E I can think of no "ore i"portant test of the integrit% of a "anager
and the likelihood of invest"ent success than his or her o9n confidence in the
approach pursued on $ehalf of clients< It is interesting to note that fe98 if an%8 ;unk5
$ond "anagers invested their o9n "one% in ;unk $onds< In other 9ords8 the% ate out<
Another area of in?uir% concerns the fair treat"ent of clients< Are all clients
treated e?uall%E If not8 9h% not8 and in 9hat 9a%sE Are transactions perfor"ed for all
clients conte"poraneousl%E If not8 9hat "ethod is used to ensure fairnessE
A third area of interest concerns the likelihood of achieving good invest"ent
results< Specificall%8 does the $roker or "one% "anager oversee a reasona$l% siDed
portfolio8 or have the assets under "anage"ent gro9n e:ceedingl% largeE 7ne 9a%
to ;udge is to e:a"ine the "anager@s track record since the assets under his or her
control reached appro:i"atel% the current level< Investors can also e:a"ine the
records of other "anagers to deter"ine in general ho9 increased siDe affects
perfor"ance< In "% e:perience8 large increases in assets under "anage"ent
adversel% affect returns< The precise a"ount that can $e "anaged successfull%
depends on the specific invest"ent strateg% e"plo%ed as 9ell as the skills of the
"anager under consideration<
A fourth area of in?uir% concerns the invest"ent philosoph% of the "anager<
#oes the $roker or "one% "anager have an intelligent strateg% that is likel% to result
in long5ter" invest"ent successE =7$viousl% in "% vie98 a value5invest"ent strateg%
9ould $e opti"al<> #oes he or she 9orr% a$out a$solute
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23 T6E A5E!INESTMENT "ROCESS
returns8 a$out 9hat can go 9rong8 or is he or she caught up in the relative5
perfor"ance ga"eE Are ar$itrar% constraints and sill% rules8 such as re"aining full%
invested at all ti"es8 a$sentE
Evaluat#n/ Investment Results
The decision to e"plo% an invest"ent professional should onl% $e "ade after a
thorough anal%sis of the past invest"ent perfor"ance of the individual or
organiDation under consideration< So"e ?uestions are o$vious& Ho9 long a track
record is thereE Was it achieved over one or "ore "arket and econo"ic c%clesE Was
it achieved $% the sa"e person 9ho 9ill "anage %our "one%8 and does it represent
the co"plete results of this "anager@s entire invest"ent career or onl% the results
achieved during so"e favora$le periodE =ver%one8 of course8 9ill $e a$le to e:tract
so"e period of good perfor"ance even fro" a length% record of "ediocrit%<> #id this
"anager invest conservativel% in do9n "arkets8 or did clients lose "one%E Were the
results fairl% stead% over ti"e8 or 9ere the% volatileE Was the record the result of one
or t9o spectacular successes or of nu"erous "oderate 9innersE If this "anager@s
record turns "ediocre after one or t9o spectacular successes are e:cluded8 is there a
sound reason to e:pect "ore ho"e runs in the futureE Is this "anager still follo9ing
the sa"e strateg% that 9as e"plo%ed to achievehis or her past successesE
7$viousl% a "anager 9ho has achieved dis"al long5ter" results is not
so"eone to hire to "anage %our "one%< Nevertheless8 %ou 9ould not necessaril%
hire the $est5perfor"ing "anager for a recent period either< 4eturns "ust al9a%s $e
e:a"ined in the conte:t of risk< 'onsider asking 9hether the "anager 9as full%
invested at all ti"es or even "ore than 1// percent invested through the use of
$orro9ed "one%< =(everage is neither necessar% nor appropriate for "ost investors<>
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Investment Alternatives for the Individual Investor 23
'ontrari9ise8 if the "anager achieved good results despite having held su$stantial
a"ounts of cash and cash e?uivalents8 this could indicate a lo95risk approach< Were
the invest"ents in the underl%ing portfolio the"selves particularl% risk%8 such as the
shares of highl% leveraged co"paniesE 'onversel%8 did the "anager reduce portfoliorisk through diversification or hedging or $% investing in senior securitiesE
When %ou get right do9n to it8 it is si"ple to co"pare "anagers $% their
invest"ent returns< As discussed in chapter 8 it is far "ore difficulti"possi$le
e:cept in retrospectto evaluate the risks that "anagers incurred to achieve their
results<
Invest"ent returns for a $rief period are8 of course8 affected $% luck< The la9s
of pro$a$ilit% tell us that al"ost an%one can achieve pheno"enal success over an%
given "easure"ent period< It is the task of those evaluating a "one% "anager to
ascertain ho9 "uch of their past success is due to luck and ho9 "uch to skill<
,an% investors "istakenl% choose their "one% "anagers the sa"e 9a% the%
pick horses at the race track< The% see 9ho has perfor"ed 9ell latel% and $et on
the"< It is helpful to recogniDe that there are c%cles of invest"ent fashionF different
invest"ent approaches go into and out of favor8 coincident 9ith recent fluctuations in
the results o$tained $% practitioners< If a "anager 9ith a good long5ter" record has
a poor recent one8 he or she "a% $e specialiDing in an area that is te"poraril% out of
favor< If so8 the returns achieved could regress to their long5ter" "ean as the c%cle
turns over ti"eF several poor %ears could certainl% $e follo9ed $% several strong
ones<
6inall%8 one of the "ost i"portant "atters for an investor to consider is
personal co"pati$ilit% 9ith a "anager< If personal rapport 9ith a financial
professional is lacking8 the relationship 9ill not last< Si"ilarl%8 if there is not a level of
co"fort 9ith the particular invest"ent approach8 the choice of "anager is a poor
one< A conservative investor "a% not feel co"forta$le 9ith a professional short5seller
no "atter ho9 favora$le the resultsF $% contrast8 an aggressive investor "a% not $e
co"pati$le 9ith a "anager 9ho $u%s securities and holds the"<
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*+: T6E A5E!INESTMENT "ROCESS
7nce a "one% "anager has $een hired8 clients "ust "onitor his or her
$ehavior and results on an ongoing $asis< The issues that 9ere addressed in hiring a
"anager are the sa"e ones to consider after %ou have hired one<
Con(lus#on
7nce %ou choose to venture $e%ond U<S< Treasur% $ills8 9hatever %ou do 9ith %our
"one% carries so"e risk< #on@t think %ou can avoid "aking a choiceF inertia is also a
decision< It took a long ti"e to accu"ulate 9hatever 9ealth %ou haveF %our financial
9ell5$eing is definitel% not so"ething to trifle 9ith< 6or this reason8 I reco""end that
%ou adopt a value5invest"ent philosoph% and either find an invest"ent professional
9ith a record of value5invest"ent success or co""it the re?uisite ti"e and attention
to investing on %our o9n<
Notes
1. Close!en 8uns shoul never be $ur(hase on the #n#t#al $ubl#( o88er#n/
@as #s(usse #n (ha$ter +. 6o-ever> there ma% be an o$$ortun#t% to #nvest #n
(lose!en mutual 8uns at an a$$re(#able #s(ount to net asset value a8ter the%
have been #ssue an trae 8or a -h#le. I8 the 8un mana/er #s (a$able an the 8ee
stru(ture #s 8a#r> a (lose!en 8un sell#n/ at least 1; $er(ent belo- unerl%#n/ net
asset value ma% be attra(t#ve.
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Glossar%Absolute!$er8orman(e or#entat#onthe tenen(% to evaluate #nvestment results b%
measur#n/ one<s #nvestment $er8orman(e a/a#nst an absolute stanar su(h as the
r#s,!8ree rate o8 return
Annu#t%a stream o8 (ash #n $er$etu#t%
Arb#tra/ethe $ra(t#(e o8 #nvest#n/ #n r#s,!8ree transa(t#ons to ta,e avanta/e o8
$r#(#n/ #s(re$an(#es bet-een mar,ets @see r#s, arb#tra/e
Arb#tra/eur#nvestor #n r#s,!arb#tra/e transa(t#ons
As,e $r#(e @o88erthe $r#(e at -h#(h a se(ur#t% #s o88ere 8or sale @see b# $r#(e
Assetsometh#n/ o-ne b% a bus#ness or #n#v#ual
Avera/e o-nto bu% more o8 a se(ur#t% 8or less than one<s earl#er $ur(hase
$r#(e@s> result#n/ #n a reu(t#on o8 the avera/e (ost
7alan(e sheeta((ount#n/ statement o8 a (om$an%<s assets> l#ab#l#t#es> an net
-orth7an,ru$t(%a le/al state -here#n a ebtor @borro-er #s tem$orar#l% $rote(te
8rom (re#tors @leners uner Cha$ter 11 o8 the 8eeral ban,ru$t(% (oe>
(om$an#es ma% (ont#nue to o$erate @see Cha$ter 11> 7ear mar,etan env#ronment
(hara(ter#?e b% /enerall% e(l#n#n/ share $r#(es @see bull mar,et
7etaa stat#st#(al measure use b% some a(aem#(s an mar,et $ro8ess#onals to
Luant#8% #nvestment r#s, b% (om$ar#n/ a se(ur#t%<s or
*+'
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2*/ GOSSARY
$ort8ol#o<s h#stor#(al $r#(e $er8orman(e -#th that o8 the mar,et as a -hole
7# $r#(ethe $r#(e a $otent#al bu%er #s -#ll#n/ to $a% 8or a se(ur#t% @see as,e
$r#(e
7lo(,#n/ $os#t#onthe o-nersh#$ o8 a su88#(#ent $er(enta/e o8 a (lass o8 se(ur#t#es
to $revent unes#rable a(t#ons 8rom o((urr#n/ @a (re#tor o-n#n/ one!th#r or more
o8 a (lass o8 ban,ru$t ebt se(ur#t#es #s able to Dblo(,D a$$roval o8 a $lan o8
reor/an#?at#on not to h#s or her l#,#n/
7ona se(ur#t% re$resent#n/ a loan to a bus#ness or /overnment ent#t%
7oo, valuethe h#stor#(al a((ount#n/ o8 shareholers< eLu#t% th#s #s> #n e88e(t> the
res#ual a8ter l#ab#l#t#es are subtra(te 8rom assets
7ottom!u$ #nvest#n/strate/% #nvolv#n/ the #ent#8#(at#on o8 s$e(#8#( unervalue
#nvestment o$$ortun#t#es one at a t#me throu/h 8unamental anal%s#s
7rea,u$ valuethe e0$e(te $ro(ees #8 the assets o8 a (om$an% -ere sol to the
h#/hest b#er> -hether as a /o#n/ (on(ern or not @see l#Lu#at#on value
7ull mar,etan env#ronment (hara(ter#?e b% /enerall% r#s#n/ share $r#(es @see
bear mar,et
Callable bona bon that ma% be ret#re b% the #ssuer at a s$e(#8#e $r#(e $r#or to
#ts (ontra(tual matur#t% @see $uttable bon
Call o$t#ona (ontra(t enabl#n/ the o-ner to $ur(hase a se(ur#t% at a 8#0e $r#(e on
a $art#(ular ate @see $ut o$t#on
Cash 8lo-the (ash /a#n or loss e0$er#en(e b% a bus#ness ur#n/ a $art#(ular
$er#o o8 o$erat#ons
Cash!$a% se(ur#t#esse(ur#t#es reLu#re to ma,e #nterest or #v#en $a%ments #n
(ash @see non!(ash!$a% se(ur#t#esCatal%stan #nternall% or e0ternall% #nst#/ate (or$orate event that results #n
se(ur#t% holers real#?#n/ some or all o8 a (om$an%<s unerl%#n/ value
Cha$ter 11a se(t#on o8 the 8eeral ban,ru$t(% (oe -hereb% a ebtor #s
reor/an#?e as a /o#n/ (on(ern rather than l#Lu#ate @see ban,ru$t(%
Close!en mutual 8unmutual 8un hav#n/ a 8#0e number o8 outstan#n/ shares
that trae base on su$$l% an eman at $r#(es not ne(essar#l% eLual to
unerl%#n/ net asset value @see o$en!en mutual 8un
Collateral#?e bon obl#/at#on @C7O#vers#8#e #nvestment $ools o8 un,
bons that #ssue the#r o-n se(ur#t#es> usuall% #n several
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Glossary 2*1
tranches8 each of 9hich has risk and return characteristics that differ fro" those of
the underl%ing ;unk $onds the"selves
'o""ercial papershort5ter" loans fro" institutional investors to $usinesses
'o""issiona charge for transacting in securities'o"ple: securitiessecurities 9ith unusual cash flo9 characteristics
'ontingent5value rightstrada$le rights that are redee"a$le for cash if a stock fails
to reach specified price levels
'onverti$le ar$itragear$itrage transactions designed to take advantage of price
discrepancies $et9een converti$le securities and the securities into 9hich the% are
converti$le
'onverti$le $onds$onds that can $e e:changed for co""on stock or other assets
of a co"pan% at a specified price
'ouponthe specified interest pa%"ent on a $ond e:pressed as a percentage
'overed5call 9ritingthe practice of purchasing co""on stocks and then selling call
options against the"
'ra"5do9n securit%securit% distri$uted in a "erger transaction8 not sold $% an
under9riter
'redit c%clethe e$$ and flo9 in the availa$ilit% of credit
#e$tor5in5possession financingloan to a $ankrupt co"pan% operating in 'hapter 11
#e$t5to5e?uit% ratiothe ratio of a co"pan%@s outstanding de$t to the $ook value of
its e?uit%F a "easure of a co"pan%@s financial leverage
#efaultthe status of a co"pan% that fails to "ake an interest or principal pa%"ent
on a de$t securit% on the re?uired date
#efault rate of ;unk $ondscalculated $% "an% ;unk5$ond5"arket participants as the
dollar volu"e of ;unk5$ond defaults occurring in a particular %ear divided $% the total
volu"e of ;unk $onds outstanding
#epreciationan accounting procedure $% 9hich long5lived assets are capitaliDed
and then e:pensed over ti"e
#iscount ratethe rate of interest that 9ould "ake an investor indifferent $et9een
present and future dollars
#iversificationo9nership of "an% rather than a s"all nu"$er of securitiesF the goal
of diversification is to li"it the risk of co"pan%5specific events on one@s portfolio as a
9hole
#ividendcash distri$uted $% a co"pan% to its shareholders out of after5ta:
earnings
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2*2 GOSSARY
Earn#n/s be8ore #nterest> ta0es> e$re(#at#on> an amort#?at#on @E7IT2Aa
nonsens#(al number thou/ht b% some #nvestors to re$resent the (ash 8lo- o8 a
bus#ness
Earn#n/s $er sharea (om$an%<s a8ter!ta0 earn#n/s #v#e b% the total number o8
shares outstan#n/
E88#(#ent!mar,et h%$othes#ss$e(ulat#ve not#on that all #n8ormat#on about se(ur#t#es
#s #ssem#nate an be(omes 8ull% re8le(te #n se(ur#t% $r#(es #nstantaneousl%
Em$lo%ee Ret#rement In(ome Se(ur#t% A(t o8 1'&) @ERISAle/#slat#on that reLu#res
#nst#tut#onal #nvestors to a(t as 8#u(#ar#es 8or 8uture ret#rees b% ao$t#n/ the
D$ruent!man stanarD @see $ruent!man stanar
ELu#t% DstubsDlo-!$r#(e> h#/hl% levera/e sto(,s> o8ten result#n/ 8rom a
(or$orate re(a$#tal#?at#on @see re(a$#tal#?at#on
E0(han/e o88eran o88er mae b% a (om$an% to #ts se(ur#t% holers to e0(han/e
ne-> less!onerous se(ur#t#es 8or those outstan#n/
DFallen an/elsDbons o8 (om$an#es that have eter#orate beneath #nvestment
/rae #n (re#t Lual#t%
F#nan(#al #stressthe (on#t#on o8 a bus#ness e0$er#en(#n/ a short8all o8 (ash to
meet o$erat#n/ nees an s(heule ebt!serv#(e reLu#rements
Fr#enl% ta,eover(or$orate a(Lu#s#t#on #n -h#(h the bu%er an seller both su$$ort
the transa(t#on enthus#ast#(all%
Ful(rum se(ur#t#esthe (lass o8 se(ur#t#es -hose str#(t $r#or#t% ban,ru$t(% (la#m #s
most #mme#atel% a88e(te b% (han/es #n the ebtor<s value
Full $os#t#ono-nersh#$ o8 as mu(h o8 a /#ven se(ur#t% as an #nvestor #s -#ll#n/ to
holFunamental anal%s#sanal%?#n/ se(ur#t#es base on the o$erat#n/ $er8orman(e
@8unamentals o8 the unerl%#n/ bus#ness
G#nn#e Mae @GNMA$ool o8 mort/a/es #nsure b% the Government Nat#onal
Mort/a/e Asso(#at#on> a 5.S. /overnment a/en(%
Go#n/ lon/bu%#n/ a se(ur#t% @see short!sell#n/ Goo-#ll amort#?at#onthe
/raual e0$ens#n/ o8 the #ntan/#ble asset ,no-n as /oo-#ll> -h#(h (omes #nto
e0#sten(e -hen a (om$an% #s $ur(hase 8or more than #ts tan/#ble boo, value
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Glossary 2*3
Guarantee!#nvestment (ontra(t @GICan #nsuran(e!(om$an%!s$onsore
#nvestment $rou(t that automat#(all% re#nvests #nterest at a (ontra(tual rate
6e/ean #nvestment that> b% a$$re(#at#n/ @e$re(#at#n/ #nversel% to another> has
the e88e(t o8 (ush#on#n/ $r#(e (han/es #n the latter
6ol#n/ (om$an%a (or$orate stru(ture #n -h#(h one (om$an% @the hol#n/
(om$an% #s the o-ner o8 another
6ol!u$ valuebene8#ts a((ru#n/ to $art#(#$ants #n a (lass o8 se(ur#t#es -ho are able
to e0tra(t (ons#erable nu#san(e value 8rom the holers o8 other (lasses o8
se(ur#t#es
Ill#Lu# se(ur#t%a se(ur#t% that traes #n8reLuentl%> usuall% -#th a lar/e s$rea
bet-een the b# an as,e $r#(es @see l#Lu# se(ur#t%
In(ome statementa((ount#n/ statement (al(ulat#n/ a (om$an%<s $ro8#t or loss
Ine0#n/the $ra(t#(e o8 bu%#n/ all the (om$onents o8 a mar,et #ne0> su(h as the
Stanar an "oor<s =;; #ne0> #n $ro$ort#on to the -e#/ht#n/s o8 that #ne0 an
then $ass#vel% hol#n/ them
In#t#al $ubl#( o88er#n/ @I"Ouner-r#t#n/ o8 a sto(, be#n/ o88ere to the $ubl#( 8or
the 8#rst t#me
Ins#e #n8ormat#on#n8ormat#on unava#lable to the $ubl#(> u$on -h#(h #t #s #lle/al to
base transa(t#ons
Inst#tut#onal #nvestorsmone% mana/ers> $ens#on 8un mana/ers> an mana/ers o8
mutual 8uns
Intan/#ble assetan asset -#thout $h%s#(al $resen(e e0am$les #n(lue #ntelle(tual
$ro$ert% r#/hts @$atents or /o#n/!(on(ern value @/oo-#ll
Interest$a%ment 8or the use o8 borro-e mone%Interest!(overa/e rat#othe rat#o o8 $reta0 earn#n/s to #nterest e0$ense
Interest!onl% mort/a/e se(ur#t% @IO#nterest $a%ments str#$$e 8rom a $ool o8
mort/a/es -h#(h> 8or a /#ven (han/e #n #nterest rates> 8lu(tuates #n value #nversel%
to (onvent#onal mort/a/es @see $r#n(#$al!onl% mort/a/e se(ur#t%
Interest rate reseta $rom#se mae b% an #ssuer to aust the (ou$on on a bon at
a s$e(#8#e 8uture ate #n orer to (ause #t to trae at a $reeterm#ne $r#(e
Internal rate o8 return @IRR(al(ulat#on o8 the rate o8 return o8 an
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2** GOSSARY
invest"ent that assu"es reinvest"ent of cash flo9s at the sa"e rate of return theinvest"ent itself offersInvest"entan asset purchased to provide a returnF invest"ents8 in contrast tospeculations8 eventuall% generate cash flo9 for the $enefit of the o9ners =seespeculation>Invest"ent $ankingprofession involving raising capital for co"panies as 9ell asunder9riting and trading securities8 arranging for the purchase and sale of entireco"panies8 providing financial advice8 and opining on the fairness of specifictransactionsInvest"ent gradefi:ed inco"e securit% rated BBB or higher
-unk $ondfi:ed5inco"e securit% rated $elo9 invest"ent grade
(everaged $u%out =(B7>ac?uisition of a $usiness $% an investor group rel%ingheavil% on de$t financing(ia$ilit%a de$t or other o$ligation to pa%(i?uidating distri$utioncash or securities distri$uted to shareholders $% a co"pan%in the process of li?uidation(i?uidating trustan entit% esta$lished to co"plete a corporate li?uidation(i?uidation valuethe e:pected proceeds if the assets of a co"pan% 9ere sold off8$ut not as part of an ongoing enterprise(i?uidit%having a"ple cash on hand(i?uid securit%a securit% that trades fre?uentl% and 9ithin a narro9 spread$et9een the $id and asked prices,aking a "arketacting as a securities dealer $% si"ultaneousl% $idding for andoffering a securit%,argin of safet%investing at considera$le discounts fro" underl%ing value8 anindividual provides hi"self or herself roo" for i"precision8 $ad luck8 or anal%ticalerror =i<e<8 a G"argin of safet%G> 9hile avoiding siDa$le losses,arket pricethe price of the "ost recent transaction in a co"pan%@s pu$licl% tradedstock or $onds,aturit%the date on 9hich the face value of a de$t securit% is due and pa%a$le
,erchant $ankingan activit% 9here$% Wall Street fir"s co""it their o9n
capital 9hile acting as principal in invest"ent5$anking transactions
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Glossary 2*)
,ergera co"$ination of t9o corporations into one
,utual funda pooled invest"ent portfolio "anaged $% professional investors
Net asset value =NA+>the per share value of a "utual fund calculated $% dividing
the total "arket value of assets $% the nu"$er of shares outstandingNet5net 9orking capitalnet 9orking capital less all long5ter" lia$ilities
Net operating5loss carr%for9ard =N7(>the carr%for9ard of past losses for ta:
purposes8 ena$ling a co"pan% to shield future inco"e fro" ta:ation
Net present value =N!+>calculation of the value of an invest"ent $% discounting
future esti"ates of cash flo9 $ack to the present
Non5cash5pa% securitiessecurities per"itted to pa% interest or dividends in kind or
at a later date rather than in cash as due =see cash5pa% securities8 pa%5in5kind8 and
Dero5coupon $ond>
Nonrecoursethe lender looks onl% to the $orro9ing entit% for pa%"ent
7pen5end "utual fund"utual fund offering to issue or redee" shares at a price
e?ual to underl%ing net asset value
7pportunit% costthe loss represented $% forgone opportunities
7ptionthe right to $u% =call> or sell =put> specified ite"s at specified prices $%
specified dates
7ver5the5counter =7T'>the "arket for stocks not listed on a securities e:change
=e<g<8 Ne9 0ork8 A"erican8 !hiladelphia8 Boston8 !acific8 Toronto>
!arthe face a"ount of a $ondF the contractual a"ount of the $ondholder@s clai"
!a%5in5kind =!IC>a securit% pa%ing interest or dividends in kind rather than in cash
!lan of reorganiDationthe ter"s under 9hich a co"pan% e:pects to e"erge fro"
'hapter 11 $ankruptc%
!ortfolio cash flo9the cash flo9ing into a portfolio net of outflo9s
!ortfolio insurancea strateg% involving the periodic sale of stock5inde:
futures designed to eli"inate do9nside risk in a portfolio at a "inor up5front cost
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2* GOSSARY
!ostpsetition interestinterest accruing fro" the date of a $ankruptc% filing for9ard
!referred stockan e?uit% securit% senior in priorit% to co""on stock 9ith a
specified entitle"ent to dividend pa%"ents
!repackaged $ankruptc%a techni?ue 9here$% each class of creditors in a$ankruptc% agree on a plan of reorganiDation prior to the $ankruptc% filing
!repetition interestinterest accruing fro" the "ost recent coupon pa%"ent up to
the date of a $ankruptc% filing
!riceJearnings =!J> ratio"arket price of a stock divided $% the annualiDed earnings
per share
!rice5to5$ook5value ratio"arket price of a stock divided $% $ook value per share
!rincipalthe face a"ount or par value of a de$t securit%
!rincipal5onl% "ortgage securit% =!7>principal pa%"ents stripped fro" a pool of
"ortgages 9hich8 in response to changes in interest rates8 fluctuate in value in the
sa"e direction as conventional "ortgages $ut 9ith greater volatilit%
!rivate5"arket valuethe price that a sophisticated $usinessperson 9ould $e likel%
to pa% for a $usiness $ased on the valuation "ultiples paid on si"ilar transactions
!ro for"a financial infor"ationearnings and $ook value ad;usted to reflect a recent
or proposed "erger8 recapitaliDation8 tender offer8 or other e:traordinar% transaction
!ro:% contesta fight for corporate control through the solicitation of pro:ies or the
election of directors
!rudent5"an standardthe o$ligation under 4ISA to restrict one@s invest"ents to
those a GprudentG =conservative> person 9ould "ake =see "plo%ee 4etire"ent
Inco"e Securit% Act of 1* =4ISA>
!ut optiona contract ena$ling the purchaser to sell a securit% at a fi:ed price on a
particular date
!utta$le $ond$ond 9ith e"$edded put features allo9ing holders to sell the $onds
$ack to the issuer at a specified price and ti"e =see calla$le $ond>
4ecapitaliDationfinancial restructuring of a co"pan% 9here$% the co"pan% $orro9s
against its assets and distri$utes the proceeds to shareholders
4elative5perfor"ance orientationthe tendenc% to evaluate invest5
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Glossary 2*
ment results b% (om$ar#n/ one<s #nvestment $er8orman(e -#th that o8 the mar,et as
a -hole
Return$otent#al /a#n
R#/hts o88er#n/a 8#nan(#n/ te(hn#Lue -hereb% a (om$an% #ssues to #ts
shareholers the $reem$t#ve r#/ht to $ur(hase ne- sto(, @or bons #n the (om$an%
or o((as#onall% #n a subs##ar% (om$an%
R#s,amount an $robab#l#t% o8 $otent#al loss
R#s, arb#tra/ea s$e(#al#?e area #nvolv#n/ #nvestment #n 8ar!8rom!r#s,!8ree
ta,eovers as -ell as s$#no88s> l#Lu#at#ons> an other e0traor#nar% (or$orate
transa(t#ons
Se(ure ebtebt ba(,e b% a se(ur#t% #nterest #n s$e(#8#( assets
Se(ur#t%a mar,etable $#e(e o8 $a$er re$resent#n/ the 8ra(t#onal o-nersh#$ o8 a
bus#ness or loan to a bus#ness or /overnment ent#t%
Sel8!teneran o88er b% a (om$an% to re$ur(hase #ts o-n se(ur#t#es
Sen#or!ebt se(ur#t%se(ur#t% -#th the h#/hest $r#or#t% #n the h#erar(h% o8 a
(om$an%<s (a$#tal stru(ture
Sens#t#v#t% anal%s#sa metho o8 as(erta#n#n/ the sens#t#v#t% o8 bus#ness value to
small (han/es #n the assum$t#ons mae b% #nvestors
Share bu%ba(,s(or$orate sto(, re$ur(hases <
Shareholer<s @o-ner<s eLu#t%the res#ual a8ter l#ab#l#t#es are subtra(te 8rom
assets
Short!sell#n/the sale o8 a borro-e se(ur#t% @see /o#n/ lon/
Short!term relat#ve!$er8orman(e erb%man#8estat#on o8 the tenen(% b%
#nst#tut#onal #nvestors to measure #nvestment results> not a/a#nst an absolutestanar> but a/a#nst broa sto(, mar,et #n#(es result#n/ #n an o8ten s$e(ulat#ve
or#entat#on
S#n,#n/ 8unobl#/at#on o8 a (om$an% to $er#o#(all% ret#re $art o8 a bon #ssue
$r#or to matur#t%
S$e(ulat#onan asset hav#n/ no unerl%#n/ e(onom#(s an thro-#n/ o88 no (ash
8lo- to the bene8#t o8 #ts o-ner @see #nvestment
S$#no88the #str#but#on o8 the shares o8 a subs##ar% (om$an% to the shareholers
o8 the $arent (om$an%
Sto(,a mar,etable $#e(e o8 $a$er re$resent#n/ the 8ra(t#onal o-nersh#$ o8 an
unerl%#n/ bus#ness
Sto(, #ne0 8utures(ontra(ts 8or the 8uture el#ver% o8 a mar,et bas,et o8 sto(,s
Sto(, mar,et $ro0%est#mate o8 the $r#(e at -h#(h a (om$an%> or #ts
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Glossary 2*+olu"ethe nu"$er of shares tradedWindo9 dressingthe practice of "aking a portfolio look good for ?uarterl% reportingpurposesWorking capitalcurrent assets "inus current lia$ilities Writing call optionssellingcall options on securities o9ned
0ieldreturn calculated over a specific periodero5coupon $onda $ond that accrues interest until "aturit% rather than
pa%ing it in cash
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*=1Ine0Absolute "er8orman(e> ))>1;:!11;
A. 6. Robb#ns> 1';
Alchemy of 2inance" #he @Soros> 1+3
All#ant Te(hs%stems> 1)*
Altman> E> 3;
AM Internat#onal> In(.> *;1
Amort#?at#on9 /oo-#ll> &+>1)*
Arb#tra/e9 value> 1;1!1;*. !ee also r#s,9 arb#tra/e transa(t#ons
Assets9 (onvers#ons> 1=*!1=+ h#en> bus#ness valuat#on> '1 tan/#ble> '+> 1+) ut#l#t%> '=
valuat#on> 1))
Au(t#on!$re8erre sto(,> *' Avera/#n/ o-n> *1&
7an, Amer#(a Cor$orat#on> 13' 7an, o8 Ne- En/lan> +*> *;=!*;& 7an,ru$t(%9 e0(han/e
o88ers> 1'+!') 8ull% (overe (la#ms> 1'' #m$l#(at#ons o8 8#l#n/> 1'=!'& #nvestment attra(t#ons>
1'&!': me#a #ma/e> 1'1 net o$erat#n/ loss (arr%!8or-ars> 1'3 o$$ortun#t% 8or #nvestors>
13+ reor/an#?at#on an> 1'&> *;* stav#n/ o88> 1'+ three sta/es o8 #nvest#n/> 1':!''
7an,ru$t se(ur#t#es9 asset (onvers#ons as> 1=*!1=+ #nvest#n/ #n> 1:'!*;: r#s,> 1''!*;1. See
also F#nan(#all% #stresse se(ur#t#es.
7ar/a#ns9 value #nvest#n/> :&!::
7arron<s> )'>=+
7e(or Wester> In(. 1&+!&=
7ehav#or o8 #nvestors> 0v##
7!E 6ol#n/s> In(. 1&+
7er,sh#re 6atha-a%> In(.> 0#v> =3> 1;*
7lo(,buster Enterta#nment Cor$orat#on> =*
7ons> 2ut(h au(t#on bons> *' 8allen an/el bons> 1)>=&!=: 8#ve!%ear 1; $er(ent bons>
113nl> 8#0e!rate bons> *' 8loat#n/!rate bons> *' l#Lu##t%> =& lo-!rate bons> %#el on>
=& no 8#rst (ou$on bons> =' $a%!#n!,#n bons> *' $a%!#n!sto(, bons> *' sto(,s>
(om$ar#son> :1 valuat#on> 1*& ?ero!(ou$on bons> *'> 3&!3:. See also Bun, bons 5. S.
Treasur% bons
7oo, value9 bus#ness valuat#on> 1))!)=
2)1
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*=* MARGIN OF SAFETY
7ottom!u$ #nvest#n/> 1;=!1;: 7ran#88> In(.> ='>*;1 7ro,ers> *1'!**;
7u88et> Warren9 #ne0#n/> =1 un, bons> =3> 3: mar/#n o8 sa8et% (on(e$t> '*!'+ rules o8
#nvest#n/> :1 sto(, $ur(hase $r#(e> 1*) value #nvest#n/> 0#v> ::> 1;1> 1;* ?ero!(ou$on
8#nan(#n/> 3: 7ull#sh b#as o8 Wall Street> *=!*: 7url#n/ton Northern> In(.> 1:; 7url#n/ton
Resour(es> In(.> 1:; 7us#ness valuat#on9 boo, value> 1))!)= (ash 8lo- 8ore(ast#n/> 1**!*=
(ho#(e o8 methos> 1+= (onvent#onal %arst#(,s> 1)+!)= (urrent assets> 1)) ebt matur#t%>
1+3 #s(ount rate (ho#(e> 1*=!*: #v#en %#el> 1)= earn#n/s an earn#n/s /ro-th> 1)+
E(so Ele(tron#(s Cor$orat#on> 1+&!)*> 1)3n' /enerall% a((e$te a((ount#n/ $r#n(#$les> 1)+
h#en assets> '1 #nternal rate o8 return (al(ulat#ons> 11:!1'> l#Lu#at#on value> 1**> 1+1!++>
1+=> 1)1 methos> 1*1!**> 1+= net -or,#n/ (a$#tal> 1+* nonre(ourse ebt> 1+; $r#vate!
mar,et value> 1*:!+1> 1)1 ran/e o8 value> 11'!*1 re8le0#v#t%> 1+3!+& sto(, mar,et value>
1**> 1++!+= 1)1!)* var#ab#l#t% o8> ';!'* -r#teo88s> 1))
Ca$#tal e0$en#tures> &) Ca$#tal /a#ns an losses> &3>11&nl DCa$t#al Mar,et M%o$#a>D 3 Cash
8lo-9 a((ount#n/ Lu#r,s> 1)&nl; bus#nesses> 11'!*; (ontrast bet-een sto(,s an bons>
:= earn#n/s be8ore #nterest> ta0es> e$re(#at#on> an amort#?at#on> &* #nst#tut#onal
#nvest#n/> )= net $resent value an 8ore(ast#n/> 1**!*= $ort8ol#o> 11= s$e(ulat#on an> )
Catal%sts9 value real#?at#on> 13+!3) Cha$ter 11. See 7an,ru$t(%
DC#r(u#t brea,ers>D *& C#t#(or$> 1+3
C#t% Investment #Lu#at#n/ Trust> 13=!3:
Clevelan!Cl#88s> 1'3
Close!en mutual 8uns> **!*)> +)nl> 1+)>1&&>**+>**:nl
Co(a!Cola> 1*>++>1*+
Collateral#?e un, bon obl#/at#ons> &3
Colle(t#bles9 #nvestment #n> :!'
Comm#ss#ons> *;!*1
Com$aL Com$uter Cor$orat#on> '3
Com$le0 se(ur#t#es> 1=*>13:!&;
Com$uter!s(reen#n/9 #nvestment resear(h an> 1=*
Consol#ate O#l an Gas> In(.> 1&1!&*
Cont#nental A#rl#nes> +*>1'3 Contrar#an th#n,#n/> 1==!=3 Cre#t> 3=!3&>'; Cunn#88> R#(har> 0v##>
1;* C%(les o8 #nvestment 8ash#on> 1&=!&&
2e(l#n#n/ mar,et> '3!'& 2e8ault!rate (al(ulat#on> =:!3; 2e8lat#on9 bus#ness valuat#on> ';!'*
2e$re(#at#on9 (ash 8lo-> &* 2#s(ount> '*>11)>1*=!*:>1)3n*>13+ 2#stresse se(ur#t#es. See
F#nan(#all%
#stresse se(ur#t#es 2#vers#8#(at#on> *1*!1+>**& 2#v#ens> 1*&!*:>1)= 2o> 2av#> 0#v>
''>1*; 2o- Chem#(al Com$an%> 1&; 2o- Bones Inustr#al Avera/e> *&>
+'
2re0el 7urnham ambert> 3*> 3' 2re0el F#restone> =& 2r "e$$er> 3+>'+!') 2ut(h au(t#on
bons> *'
Earn#n/s be8ore #nterest> ta0es> e$re(#at#on> an amort#?at#on> &1!&3> &:n3
E88#(#ent mar,et h%$othes#s> '&!1;* Emerson Ele(tr#( Com$an%> 1+&!)*> 1)3n'
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2)* MARGIN OF SAFETY
un, bons> )= levera/e bu%outs> )= l#m#tat#ons> )+!)3 mana/ement 8ees> +& mone%
mana/ement> +&!+: mutual 8un or/an#?at#ons> **+ narro- (ate/or#?at#on> )= $ort8ol#o s#?e>
#m$l#(at#ons o8> )*!)+ ret#rement 8uns> += short!term> relat#ve $er8orman(e erb%> +:!+'
s$#no88s> 1&' ta(t#(al asset allo(at#on> ):!=; value #nvest#n/> :: -#no- ress#n/> )=!)3
Insuran(e (om$an#es> 33!3&Interest onl% mort/a/e se(ur#t#es> +;!+*
Interest rates> 3:!&;> 113!11&nl> 1*&> 13&!3:
Internal rate o8 return (al(ulat#ons> 11:!1'
Internal Revenue Coe> 1==
Internal Revenue Serv#(e> *;*
InterTAN> In(.> 1&'!:;
Investment resear(h9 1=1!31 amount o8 resear(h> 1=3!=: #ns#e #n8ormat#on> 1='!3; #ns#er
bu%#n/> 1=:!='
Investment su((ess> '!1+ la(, o8> 1+!1)
Investors9 behav#or> 0v##> emot#onal 8a(tors o8 #nvest#n/> '!1;> 1+!1)> 1: /ree> 1+!13
#nvestment 8ormulas> sear(h> 1+!13 s$e(ulat#on> +!1: stumbl#n/ blo(,s o8> +!&: su((ess> '!1+ Wall Street an> 1'!+) D%#el $#/s>D 1)!13
Bama#(a Sav#n/s 7an,s> 1:3!:: Banne% Mont/omer% S(ott> In(.> *3 Ba$anese sto(, mar,et> *1)!
1=>**1n* B#m Walter Cor$orat#on> 3' Bohns Manv#lle> 1'; Bones au/hl#n Steel> 1='> *;; Bun,
bons9 anal%t#(al errors o8 #nvestors> &;!&1 ba(,/roun> 0#v!0v## bu%ers o8 3)!3& (a$#tal
losses> &3 (olla$se o8 mar,et> && (ollateral#?e obl#/at#ons> &3 e8ault!rate (al(ulat#on>
8la-s o8>
=:!3;> &:n* earn#n/s be8ore #nterest> ta0es> e$re(#at#on an amort#?at#on> &1!&3
e0$e(tat#ons> earl% su((ess an> 31!3) 8#nan(#all% #stresse (om$an#es> 1:'!'; /ree an>
1)>1=> && DGresham<s a- o8 Bun, 7ons>D 3) /ro-th o8 mar,et> 3;!3* /uarantee
#nvestment (ontra(ts> 33 h#/h!%#el bon mutual 8uns> 3)!3= h#stor% o8 mar,et> =3!=: #nsol!
vent ban,s as $ur(hasers> 33 #nst#tut#onal #nvest#n/> )= #nsuran(e (om$an#es as $ur(hasers>33!3& #nterest rate resets> 3:!&; #nvestment stanars> rela0at#on o8> 3&!&) less evelo$e
(ountr% borro-ers> =' m#s(on(e$t#ons> ==!&: $a%!#n!,#n se(ur#t#es> 3&!3: $r#vate!mar,et
value> 1+; ta,eovers 8#nan(e b%> *) thr#8ts> $ur(hases b%> 3=!33 Ton,a (or$orat#on> 1*1
value #nvest#n/> 1;;> D%#el $#/s>D &3 ?ero!(ou$on bons> *'>3&!3:
Kohlber/> Krav#s an Roberts> 3'> 13&
abo-> Ron> *;)
#ab#l#t#es9 h#en> '1
#Lu#at#on> 1**> 1+1!++> 1+=> 1)1>
13)!3:>1&* #Lu##t%> =&> *1;!1*>*1' oss avo#an(e> :1!:= o-enste#n> ou#s>
11>=1>=3>3;>*11 T (or$orat#on> *;*
Mana/ement sto(, o$t#ons> 1=:!=' Mar/#n o8 sa8et%> #m$ortan(e o8> :&!1;)Mar#on aborator#es> In(.> 1&; Mar#on Merrell 2o-> In(.> 1&; Mathemat#(s9 loss avo#an(e an>
:+>:= Ma00am> In(. 3' Mer(hant ban,#n/> 1'!*1
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Index 2))
M#l,en> M#(hael> =3!=:>31> *;&
M#ssour#!Kansas!Te0as Ra#lroa Com$an%> 13'
Mone% mana/ement> +&!+:> **)!*3
Mort/a/e loans> 1:+
Mort/a/e Realt% an Trust> 1+3Mort/a/es> +;!+*
Mr. Mar,et> '!1+>1:>11)!1=
Mutual 8uns9 (lose!en 8uns> **!*)> +)nl> 1+)> **+> **:nl h#/h!%#el bon mutual 8uns>
3)!3= #n#v#ual #nvestors> **+!*) o$en!en 8uns> **+ o$t#on!#n(ome> 1=!13
Mutual Ser#es Funs> In(.> 1;* 1': **)
Mutual Shares Cor$orat#on> 00
Nab#s(o> 3'!&;>1=3 NA. See Net asset value Net asset value> 3!&> *+!*)>**+ Net!net -or,#n/
(a$#tal> 1+*!++>1&' Net o$erat#n/ loss (arr%8or-ars> 1'3
Net $resent value> 1*1> 1*=!*:> 1+=>
1+'>1)1 Net -or,#n/ (a$#tal> 1+* -ew 7ork #imes" #he" 1=* No 8#rst (ou$on bons> ='
Nonre(ourse ebt> 1+; N". See Net $resent valueO#l $r#(es> *+
O$en!en mutual 8uns> **+ O$$ortun#t#es 8or #nvestors9 13*!:1 ban,ru$t(%> 13+ (om$le0
se(ur#t#es> 13:!&; (%(les> 1&=!&& l#Lu#at#ons> 13)!3:> 1&* reor/an#?at#ons> 13+ 1&* r#/hts
o88er#n/s> 1&;!&* r#s, arb#tra/e> 1&*!&& s$#no88s> 13&> 1&*> 1&&!:1 thr#8t (onvers#ons> 1:*!::
O$t#on!#n(ome mutual 8uns> 1=!13
"a(e Inustr#es> In(.> 13&!3: "an#(> :'>*13>*1&
"aul> 2av# .> : "a%!#n!,#n bons> *' "a%!#n!,#n se(ur#t#es9 un, bons> 3&!3:
"a%!#n!sto(, bons> *' "enn?o#l> '=
"ens#on 7ene8#t Guarant% Cor$orat#on> *;* "ens#on 8uns9 over8une> '1 "E rat#o. See "r#(e!
to!earn#n/s rat#o "ort8ol#o #nsuran(e> )3!): "ort8ol#o mana/ement9 avera/#n/ o-n> *1&
bro,ers> *1'!*; #vers#8#(at#on> *1*!1+ he/#n/> *1+!1= l#Lu##t% an> *1;!*1* $an#(> *13r#s, reu(t#on> *1*!1= sta%#n/ #n tou(h -#th mar,et> *13!1& tra#n/ an> *;'!**1 "ort8ol#o
s#?e> )*!)+ "re$a%ments9 mort/a/es> +; "resent!value anal%s#s. See Net $resent value
D"reteners>D value #nvest#n/> 1;*!1;+
"r#(e> M#(hael> 00 1;*>1':
"r#(es9 avera/#n/ o-n> *1& #sasters an> 1* o#l $r#(es> *+ sto(, m#s$r#(#n/> '' su$$l% an
eman an> 1* value #nvest#n/> 11+!1=. See also Flu(tuat#ons #n $r#(e o8 sto(, an se(ur#t#es
"r#n(ev#lle 2evelo$ment Cor$orat#on> 1&*
"r#n(#$al onl% mort/a/e se(ur#t#es> +;!+*
"r#soner<s 2#lemma> 1') "r#vate!mar,et value9 1*:!+1> 1)1
thr#8t (onvers#ons> 1:= "ro/ram tra#n/> +)n) "ubl#( Serv#(e Com$an% o8 Ne-
6am$sh#re> ')!'=> *;;Real estate9 valuat#on> 1)) Re(a$#tal#?at#ons9 asset (onvers#ons>
as> 1=*!=+ Re8le0#v#t%9 bus#ness valuat#on> 1+3!
1+&
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2) MARGIN OF SAFETY
Relat#ve!$er8oman(e> +:!+'> 1;:!1;'> **+
Rena#ssan(e Investment Mana/ement> In(.> )'
Reor/an#?at#ons> 13+>1&*>1'&>*;*
Ret#rement 8uns> +=>'1
Return!r#s, relat#onsh#$> 11;!11>**3Rheem> 13&!3:
R#/hts o88er#n/s> 1&;!&*
R#s,9 avers#t%> #m$l#(at#ons o8> 00 arb#tra/e transa(t#ons> 1=*> 1=)> 1&*!&& avo#an(e
strate/%> :1!:*> :)> :&!:: ban,ru$t se(ur#t#es> 1''!*;1 7eta an> 11*!1+ 8#nan(#all%
#stresse se(ur#t#es> 1''!*;1 nature o8> 111!1* $ort8ol#o mana/ement> reu(t#on o8 r#s,>
*1*!1= $otent#al> 8o(us on #nstea> := 5. S. Government se(ur#t#es> r#s,!8ree #nvestment> 1=
value #nvest#n/> :&!:: volat#l#t% an> 11; See also Return!r#s, relat#onsh#$
RBR Nab#s(o> In(. 3'!&;
Ro88man> Marv#n> *3
Rosenste#n!Roan> "aul> );
Ruane> W#ll#am> 0v##> 1;*Salomon 7rothers> :
S(hae8er alue Trust> In(. 1+)
SEC. See Se(ur#t#es an E0(han/e Comm#ss#on
Se(ur#t#es9 (om$le0 se(ur#t#es> 1=* 8ul(rum se(ur#t#es> *;+ h%br# mort/a/e se(ur#t#es> +;
#nnovat#ons #n mar,et> +;!+* #nterest onl% mort/a/e se(ur#t#es> +;!+* un#or se(ur#t#es> *;+
$a%!#n!,#n se(ur#t#es> 3&!3: $r#n(#$al onl% mort/a/e se(ur#t#es> +;!+* $ur(hase o8> *1&
resale o8> *1 sale o8> *1:!1' **1n* sen#or se(ur#t#es> **&. See also 7an,ru$t se(ur#t#es
Flu(tuat#ons #n $r#(e o8 sto(, an se(ur#t#es 5. S. /overnment se(ur#t#es
Se(ur#t#es an E0(han/e Comm#ss#on> )*>1=+>1==
Se(ur#t% Anal%s#s @Graham an
2o> 0#v> 1*; Sen#or se(ur#t#es> **& SeLuo#a Fun> In(.> 0v##> 1;*> **) Short!sell#n/> +)n+Short!term #nvestors> +:!+'>:+ Soros> Geor/e> 1+3 S$a#n Fun> In(.> 3!& S$e(ulat#on> +!1:
S$#no88s9 Es(o Ele(tron#(s Cor$orat#on> 1+&!)* #nst#tut#onal sell#n/> ': o$$ortun#t#es 8or
#nvestors> 13&>1&*>1&&!:1
Stanar "oor<s 1;; Ine0> 1;;
Stanar "oor<s =;; Ine0> +'> =;> =*>=+> *1+
Stanars o8 #nvestment> rela0at#on o8> 3&!&)Sto(,9 au(t#on!rate $re8erre sto(,> *'> bons> (om$ar#son> :1 (ash 8lo-> := #re(t sto(,o-nersh#$> **+ /ro-th mult#$le> ': lar/e!(a$#tal#?at#on sto(,> 1;; m#s$r#(!#n/> '' mutual!to!sto(, (onver s#ons> 1:) o$t#m#st#( sto(, vs. #stresse bons> *;=!*;& $a%!#n!sto(, bons>*' value #nvest#n/> '&!':Sto(,bro,ers9 *= evaluat#on o8> **)!*3Sto(, mar,et9 bus#ness valuat#on> 1**> 1++!+=> 1)1!)* #ne88#(#en(#es> 1=+!== Ba$anese sto(,mar,et> *1)!1=> **1n*Sto(, mar,et (rash9 1'*'> +3 1':&> 0v###> 1&>*&>):>'=Sto$!loss orers> *1:DSu$er#nvestors o8 Graham!an!2osv#lle> TheD @7u88ett> 1;1Su$$l% an eman9 $r#(es an> 1*Ta(t#(al asset allo(at#on> ):!=;Ta,eovers> *)>1*'!1+;>1&+>1&&Tan% Cor$orat#on> 1&'!:;
Ta0at#on9 ban,ru$t(%> 1'3 earn#n/s be8ore #nterest> ta0es> e$re(#at#on anamort#?at#on> &)!&= sale o8 se(ur#t#es> **1n* sto(, mar,et
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Index 2)
#ne88#(#en(#es an> 1== -r#teo88s> 1))
T!b#lls. See 5. S. Treasur% b#lls Tele8onos e Me0#(o> S. A.> '& Te0a(o> In(.> '=>1'; Thr#8t
(onvers#ons> 3=!33>1:*!:: Ton,a Cor$orat#on> 1*1 To$!o-n #nvest#n/> 1;3!1;: Tra#n/9
avera/#n/ o-n> *1&> bro,ers> *1'!*; #m$ortan(e o8> *1=!13 $ort8ol#o mana/ement an> *;'!
**1 sell#n/> *1:!1'> **1n* Trens. See Fas
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