Value Investing means different things to different people. I consider it to involve the acquisition of a position for which the expected return exceeds generally prevalent investment returns. The expected return is the array of possible outcomes of the investment, in each case multiplied by the probability of the outcome. Thus, a ticket selling for $5 in a lottery in which the ticket holder has a one in a million chance of winning $200 million is a value investment because the expected return is $200. Most value investments do not involve such low probabilities and high returns: instead, they generally provide a very high probability of an above average return. However, there are important "cheap lottery tickets" out there and they are worth analysis.
My initial assumption is that true value investments are rare because of the "efficient market" phenomenon. Of course, the market is not perfectly efficient but the prevalence of stock analysis, the wide scale use of stock repurchase programs, and the availability of leveraged buy outs all tend to remove from circulation the kinds of bargains that Graham found in the 1950s. Therefore, I am generally skeptical of formulas for finding value stocks; value stocks tend to appear like pearls in oysters as a result of peculiar circumstances. It is not quite like finding money in the street but it is often the result of circumstances which can not be anticipated. I recently found a 1952 silver quarter in my change; value investments are somewhat like that.
Distressed financial stocks have been an important feature of the market for the past three years - at one point almost all financial stocks were distressed. In many cases, these stocks took enormous tumbles and then had impressive rebounds. In other cases, the tumble was simply a step on the way to bankruptcy. In the category of distressed financials, I am generally referring to companies which lend money in one form or another and simultaneously borrow thereby creating leverage. It is no mystery why this sector was a disaster area. The market for debt instruments as reflected in bond spreads totally collapsed in 2008-09 and thus the assets of these companies quickly became less valuable in many cases, creating solvency issues and usually creating anxiety on the part of lenders to these companies. The lenders refused to roll over revolving loans, the financial companies were forced to sell off their debt instruments at a loss, and a powerful downward spiral was set in motion.
The companies I followed most closely were Business Development Companies (BDCs) and mortgage REITs (MREITs) although I also looked at some depository institutions. Some names that I will refer to are Allied Capital (now taken over by Ares Capital (NASDAQ:ARCC)), American Capital (NASDAQ:ACAS), Kohlberg Capital (NASDAQ:KCAP), Gladstone Investment (NASDAQ:GAIN), iStar Financial (SFI), Capital Trust (CT), Gramercy Capital (GKK), Municipal Mortgage and Equity (MMAB.PK), Anthracite Capital (AHR), NorthStar Financial (NYSE:NRF) and Rait Financial (NYSE:RAS). Most of these companies were substantial players before the 2008 panic and, in many cases, these stocks would have been viewed as "conservative" investments.
The carnage in this group was breathtaking. CT at one time trading as high as 50; it almost got down to 1. MMAB.PK was once as high as $30; it now trades for 15 cents. ACAS was over 30; I bought some for less than 2. Some of these companies stopped filing financials for several quarters. Others had delisting problems. Some of the Yahoo message boards were laced with obscenities as investors got more and more frustrated. And, of course, there were lawsuits. Almost all of them had issues with lenders - KCAP went into litigation, GAIN was faced with an unreasonable lender who forced the liquidation of valuable assets at a discount, GKK still is putting out periodic notices concerning its ongoing negotiations to extend terms with its lenders. And, of course, dilution has been an issue as some distressed financial companies have resorted to secondary offerings below book value in order to build up capital.
As the panic unfolded, there were and perhaps still are some situations in this group in which investor revulsion has produced pricing which provides a value investor with an extremely high expected return. There is no single formula for deciding when to pull the trigger on one of these but I think that there are some important general principles that should guide the intelligent investor.
1. Consider Buying the Bonds - When Allied Capital hid the skids, I discovered that it had publicly traded bonds - symbol AFC - maturing almost 40 years from now with a coupon of 6 7/8%. These bonds were trading below 30% of par and thus provided a yield of over 20%. Allied was a mess but its assets exceeded its liabilities by a comfortable margin and bondholders would get more than 30% in a bankruptcy. There were issues about subordination, but, on balance, this was a lay up. Bondholders don't have to worry about dilution (in fact, a secondary offering is music to the bondholders' ears). The bonds are now trading near par. I made a similar successful investment in SFI bonds. However, many of these companies do not have publicly traded bonds. Preferred stock is not necessarily the equivalent of a bond. Ideally, you want to be a creditor in these situations. If publicly traded bonds are not available, the stock has to be analyzed.
2. The Balance Sheet is All Important - What is generally important in analyzing whether these companies will survive is the balance sheet and whether the value of the assets exceeds the liabilities by enough of a margin to provide true value. If you analyze matters correctly, you can literally buy debt in the equity market at enormous discounts to fair value. As these companies run into problems, net income becomes a poor metric for understanding what is going on. CT has recently worked out things with its lenders and the stock has had a very nice bounce. But earnings in the first quarter of this year were $11.35 a share, while the stock trades at $4.72. The reason is that the earnings reflect the one-time event of cancellation of debt at a discount; CT is likely to do well from here but it is not on track to earn $45 per share on an annual basis. Earnings jump around enormously as assets are written down, as debt is repurchased at a discount, and other financial events occur that do not represent the long term earnings power of the company. And don't even think about dividends - you are probably better off as an investor if the company holds onto its cash and uses it to appease creditors so that the probability of survival will increase. The balance sheet (and quarter to quarter changes in the balance sheet) tell you much more about whether the company is likely to survive and, if so, exactly what will be left after the antsy creditors are paid off. One key metric is the net appreciation or depreciation of debt instruments on the company's balance sheet; in the early stages of the panic, each quarter brought more net depreciation. As things bottomed out, this stabilized and some net appreciation began to take hold. Stocks did not always move up immediately upon this change and this provided investors with a window of opportunity Having said this, I must point out that BDCs have much more understandable financial statements that MREITs. And, of course, those companies that simply took a vacation from their obligation to file financial statements make this analysis virtually impossible.
3. Follow the Leader - I got a lot of comfort about a year ago when John Paulson bought a load of ACAS stock for $5.25. Insiders have been buying RAS of late. CT's resolution of issues with its lenders led the stock to pop up nicely and are likely the signal that the future is at least beginning to get brighter. I bought NRF after reading through the new terms the lenders agreed to. Lenders and larger investors are likely to be able to delve into the valuation issues more deeply than retail investors. Of course, waiting for the big players to act means that you are not buying at the bottom, but ACAS has moved up nicely from 5.25 and will likely move up some more.
4. Play for the Upside - If you invest in these securities, you will take some lumps. The only way you will net out well is if your winners are bigger than your losers and you have to win big on some positions for this to happen. Again, the balance sheet analysis gives you some sense of the upside - the latent value is there if the company can steer through the storm and come out relatively intact on the other side. Unless there is a substantial upside, it does not make sense to fool around with these type of securities. I got wiped out in AHR but more than doubled my money in AFC, ACAS and GAIN.
I still like GAIN, ACAS and NRF. I think KCAP is on the mend. I am warming up to RAS. I am kicking the tires on some of the others because the upside is theoretically enormous. Investors should be aware that these stocks are generally not long term buy and hold dividend plays (although GAIN has stabilized, KCAP and NRF are paying nice returns, and I am reasonably confident that ACAS will resume dividends). These stocks are risky investments and no retiree should bet the ranch on one of these names. But if there is a part of your portfolio in which you can take somewhat of a risk, distressed financial stocks offer some interesting opportunities.
Disclosure: I am long AFC, NRF, ACAS, GAIN, KCAP.