As it became clear to me from the smell of napalm following the cataclysmic bombing the market endured in Q4, this time really is different. I suggested in December that new metrics are necessary for this new environment and urged any readers to try to shift away from any earnings-based or other traditional valuation methods to ones that incorporate balance-sheet or liquidity risk and asset-based valuation.
This is not an easy process, and, while I know that many market participants have begun to change the way they look at things, we still have lots of work to do collectively. This different way of thinking has clearly helped me to identify high-risk situations. In what I believe was one of my most popular blog postings to Seeking Alpha and which apparently continues to drive traffic to my websites (Dividends on Death Row), I shared a screen (using StockVal) that I constructed using some of the different metrics I have been discussing. The 22 stocks that met the screen's criteria fell an average of 12.5% and a median of 13.9% over the past 4 weeks, while the S&P 500 has declined in price by 8.5% despite some improvement on the huge rally this week.
At the end of 2007, my shift to a focus on the balance sheet led me to publish on Seeking Alpha "8 Balance Sheet Accidents Waiting to Happen". While the metrics I used at the time weren't as refined as the ones that I have been using lately, the list fell an average of 61% in 2008, well below the S&P 500's return of -38.5%. In fact, every one of those stocks fell in excess of the market. Impressively, not one of the stocks comes from the beleaguered Financials sector. The carnage continues, as you can see in the table below (click to enlarge):
While I have obviously found it helpful to have been early in changing how I view equities, I believe that we still have a way to go in terms of everyone being on the same page. I continue to see and hear too much talk about earnings. While solid companies, most of which will be very challenged, need to be contemplated with respect to "potential earnings" once the recovery begins (not soon!), shareholders of many companies won't have the luxury of participating in those profits. The ugly truth is that hundreds of publicly traded stocks will be either massively diluted or forced into bankruptcy before the recovery begins. Today, I am sharing further my thoughts about how one can avoid having one's stock stolen out from under him during this economic crisis.
Stepping back, I believe that many investors don't quite get a very simple concept: Equity. Owning common stock is essentially a call option on the future earnings of a company or the ability to participate in the upside over time. When I read articles that suggest that General Motors (NYSE:GM) is "worth less than $2 billion", I realize that many mistakenly assume that the equity value is the same as the enterprise value or the real value of a company, but it's not. Equity can represent all of the value of a company, but the presence of debt or other securities in the capital structure, all of which are senior to equity, muddies the picture. GM is "worth" $1.7 billion PLUS the market value of the debt.
In any event, equity holders in publicly-traded companies are limited to 100% loss, like an option. The option can be very complicated when things go bad, and that is what is going on now. Equities as options aren't perpetual! There are events that can lead to their "early maturity". My guess is that the vast majority of professional equity investors not only didn't know about covenants a year ago, but they probably didn't even know where to find them! As credit contracts and the economy eats into profits and forces losses, equity holders in companies that are leveraged are facing serious challenges. What can companies in this situation do as they face maturing debt?
- Roll it over by refinancing it with public debt
- Renegotiate terms with banks
- Sell assets
- Cut the dividend
- Raise equity
- Swap debt for equity
- Seek bankruptcy protection
Unless one of the first four things happens, it's likely to be a very bad thing for equity holders. At a bare minimum in the good cases, they likely face lower earnings in the future, perhaps significantly, due to higher interest expense or less return on any productive asset that they dispose. Other solutions entail dilution, perhaps completely. There are many other secondary issues, such as management distraction, customer or supplier fear, ability to invest in the future, etc.
There are potential scenarios lurking that can heighten the risk to equity holders. Take the scenario where the bonds or bank-debt trade very cheaply and end up in the hands of vultures. They may very well WANT the company to go bankrupt, using their senior position to take control of the entire company. I have written about the potential for asset impairments to degrade balance sheets further and trigger covenant violations (Goodwill Hunting). As time passes, I learn more each day about how poor the position of equity holders in leveraged companies can be. If there was ever a time to exercise caution or at least be as informed as possible, it is now!
Before I go on, please allow me to share that I have severe limitations. I am going to provide the detail and output of a screen that I have created that will try to identify potential companies at risk, but a LOT of work is required to make a judgment regarding the probabilities of the potential outcomes as well as the potential valuations in different scenarios. In looking at these distressed equity situations, one has to be able to understand the entire capital structure and the types of entities that control the senior elements. If one doesn't know who controls the bonds (or bank debt) and doesn't know where publicly traded debt securities trade, it is impossible to make an informed judgment on the value of the equity.
While I think that there is a lot more differentiation to occur between companies with good balance sheets and those with risky ones, the low-hanging fruit has now been harvested. I mentioned above my own limitations (primarily as one who is not a full-time credit analyst), but even my screening system (and most likely all screening systems) doesn't have the data embedded necessary to really hone in. If I were designing the perfect screen, it would allow me to incorporate the debt maturity schedule over the next five years and would tell me if the banks still own the loans (dangerous if not, as that kills renegotiation). This information is available, but it is time-consuming to gather (note to self: this could be a good time to create a database and sell the output). In any event, this cut at identifying potential goose eggs is my latest iteration. The main addition to this model is to compare debt load to historical free cash-flow.
In earlier screens, I incorporated several different measures, including price to tangible equity, total liabilities to tangible equity, and liabilities to EBITDA. This enhancement takes the additional step of looking for claims on the EBITDA. Some companies must spend cash just to maintain their existence - they are "capital intensive". Some companies have only built and reinvested, showing economic profit but no cash to show for it. While there are some problems with looking back at FCF that can both understate or overstate its utility, I believe that this is a variable to consider nonetheless. Unfortunately, limitations of the screener and my concerns about data impacted this metric, so I shifted to comparing to operating cash flow. Again, there are problems (one-time charges or real losses can lead to operating losses and create a negative ratio), so I have included these metrics but not filtered upon them. As I have written in the past, many balance sheets understate their true risk due to the presence of liabilities that are beyond debt, so I focus on all liabilities rather than just the debt. Here is what I did and why:
- Universe: Russell 3000
- Market-Cap: >$250mm (get rid of tiny stocks)
- Price: >1 (story is already out!)
- Tangible Assets / Liabilities: <30% (identify obligations without hard assets backing)
- Liabilities / Current Assets: >3 (identify potential liquidity issues)
- Liablities / Adjusted Current Assets: >5 (haircut AR and Inventory to further define liquidity issues)
- Liabilities / EBITDA: >6 (identify long-term solvency concerns)
- Exclude Utilities (Many fit the parameters but are regulated and don't face the same risks)
Here is a link to the 43 names that meet the criteria: Download Capitally Challenged. You will note that I have highlighted 4 stocks that I have evaluated and agree should be on the list. The list isn't a prediction as much as both a potential starting point of names and/or a frame-work for evaluating stocks.
- Many of these companies are involved in businesses that could be viewed as resistant to the economic contraction
- Many of these stocks may already reflect the risks (especially the ones trading below tangible book value)
- There are probably multiples of companies out there that I have missed due to their possibly being excluded on the basis of just one factor.
The point of this exercise, again, is to encourage investors to look at things in a different light and to think about how companies will address debt refinancing events in the coming years. If the equity is a small sliver of the entire "value" of the company, it is a very volatile instrument. It can be wiped out through dilution or bankruptcy, but it can also be a huge gainer if the company emerges. Investors need to be aware of the risks and to be able to understand the potential opportunities.
What if one wants to own stocks but either can't do the work necessary to understand how the capital structure factors in or doesn't have the time to do so? Good news! There are plenty of stocks out there with little debt or even net cash, and they are beaten down in price too. As a firm believer that simplicity wins before complexity, at least initially, I have opted to invest in those types of names, many of which are deeply discounted to historic cash-flows or asset values. There are many risks and complexities here too, but not any different than the capitally challenged companies face as well. I won't mention them here, but, as always, I disclose my holdings daily on my company website and also allow the general public to see the holdings in my model portfolios. If, like me, you are operating under the assumption that the economy won't rebound robustly for quite some time due to the massive headwinds following decades of credit-growth induced economic expansion, I would use this rally to upgrade holdings by shifting to companies with better balance sheets. I don't believe we are anywhere close to the point where the valuations in aggregate for companies with "good" balance sheets and ones with "bad" ones efficiently reflect the future, but this is more anecdotal than tangible.
One of my favorite lines from a television show was the recurring advice from the Police Chief on Hill Street Blues, and it applies here: Let's be careful out there...