Mike Lipper’s Monday Morning Musings
Fire Drill:
On board ships and in schools, why not in investing?
Editors: Frank
Harrison 1997-2018, Hylton Phillips-Page 2018
Any Smoke?
Implications: US stock index returns are almost normal for the
full year if we use the year-to-date performance of the Dow Jones Industrial
Average +7.16% and the S&P 500 +8.14%. Even the NASDAQ +18.64% is
representative of a good speculative year, perhaps benefitting from short
covering. The VIX indicator is almost asleep at 15.76, compared to 30 in past
mildly troubling times.
There are some whiffs of smoke in the air, including a continuing 2 to 10-year yield inversion spread of 4.08% - 3.45%. Updating one of the oldest technical indicators with a more modern twist. In the latest week the 30-stock DJIA had 20 stocks rising to 10 declining, but the 20 transports split 6/14. (In the original Dow Theory, it was only the rails in the index. Today the number of rails has dropped, and a number of airlines, trucks, and other transportation securities have been added.) This could be significant if the normal buyers of rails, which are freight driven, are looking for future declines.
Another group that appears to be worried are the CEOs of traditional
financial services companies. The latest to announce a 10% layoff from both
their investment banking and investment management functions was Lazard. (Mid-market
M&A industry revenues hit a 9-year low in the first quarter.)
Publishers Note
The popular distinction between a recession and a depression is your neighbor losing his job in a recession and you losing yours in a depression. It can be helpful to explore the possible roads to a depression by focusing on the needs of securities analysts regarding layoffs. In focusing on the way companies handle layoffs, they should first be aware of the lost art of making money from bankruptcies. All too often layoffs are the first act of self-inflicted worsening conditions. Since they don’t teach about surviving bankruptcies today, they are unequipped to adequately analyze layoffs. (I admit the thought came to me in a recent meeting with the Dean of an upcoming Business School, where there are no classes on bankruptcies.)
While a Columbia College undergraduate I was
privileged to take Securities Analysis from Professor David Dodd, who was both
an academic and investment partner with Benjamin Graham. David Dodd
collaborated in producing the seminal work on Securities Analysis based on
their experiences in the 1920s and 30s. It occurred to me that the whole basis
for the course was the knowledge necessary for those who’d lived through the
depression. This knowledge could be important in the coming era, and I will consequently
devote the rest of this blog to the types of things one should look for prior to
and during such a period.
The Fixed Income World is Different
There are two critical differences between fixed income and equity.
- The first is the legal relationship. Fixed income is a contractual relationship with an initial investment, periodic payments, maturity, and rank in the order of payments in a bankruptcy.
- Owners of fixed income securities are expected to be paid a pre-determined amount of interest and pre-payments of principal, as well as a final payment.
If payments are not delivered as promised, the default
process is governed by the issuing documents. Things change dramatically when a
bankruptcy begins. All debts immediately come due, sourced from the potential
sale of all assets. Debts are paid in priority order, as specified in the
issuing documents.
However, compromises are often made to get agreement from
the holders of different classes of claims. This helps expedite payments rather
than having to endure long, expensive court hearings. The size of the payments
is a function of the price paid for the assets, less the costs of the sale. The
cost of the sale includes the cost of highly specialized attorneys,
accountants, and other experts.
Fixed income securities rights and privileges are senior to
common stock rights. Owners of common stock will probably be wiped out, as there
is generally no additional money to pay out after the senior debt holders have been
paid. However, to avoid long and expensive court battles by equity owners, they
will often be awarded a small amount of a subsequent new equity class.
What is a Bankruptcy Worth
Up to this time the focus has been on the current appraised
value, usually in a quick liquidation. To the extent there is a belief that a
“going concern” will survive bankruptcy, a different kind of analysis is needed
based on the current use of the assets and their user in the future.
Growing up in Manhattan there were neighborhood cigar stores on many commercial street corners. They were good business in the late 1920s and became less good as time went on. By the early 1940s those businesses had effectively died. A chain of these went bankrupt, but their stock went up in price!!! The reason for this was that these stores were on busy corners and had long-term leases. A classic case of being worth more dead than alive.
There were a couple of cases of railroads who lost lots of
money throughout the depression and went bankrupt. However, a couple of sharp
investors saw a similar situation, as the railroads had considerable land along
their right-of-way. In the WWII expansion of plants and military camps, these
lands and their proximity to the rails became very valuable.
The unfortunate attitude of too many of today’s analysts
and portfolio managers is that “value” is found on the published financial
statements. To them, stock selling at a discount to book value is a bargain. In
truth, book value is a collection of unamortized assets not written off.
Because of changes in the market for a company’s products, the use of their
facilities is less than their original purpose. For example, strip shopping
malls in poor locations today.
What is not reflected in the financial reports are the developed
new products, self-generated patents, a good sales force, key employees, etc.
These are the types of assets we look for as investments.
The items mentioned in the last paragraph are critical in
evaluating various layoffs. To the extent the layoff managers husband these
types of assets I am not concerned, but if they are shedding valuable assets I
am.
How Do You Evaluate Layoffs of Owned Stocks?
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