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  • Money is Energy

    By

     

    Nathan Kawaguchi

    IgnoreTheMarket.com


     

    Because economics can be so complex, it is often helpful to break things down to their most fundamental origins.  Investors work hard at trying to make money, but many don’t even bother taking the time to ask the question, “What is money?”

     

    Before advancements in commerce, people were more or less self-sustaining.  You grew your own produce, raised your own cattle, built your own shelter, made your own clothing, etc.  While this self-reliance was essential to the security of one’s own life and that of immediate family, it was incredibly limiting to the progress of people as a whole.  After all, if you have to learn how to do so many different things, how could one develop an expertise in any one area to make things better and more efficient?

     

    People are creatures of the Earth.  Like any other living organisms, we need to consume energy in order to survive.  In a competitive world of survival, energy sources other than the sun don’t simply present themselves to us.  So we must expend our energy in order to obtain more energy on which we survive.  In early times, this meant expending energy for hunting and gathering.  In more recent times, this meant expending energy in farming.  It is only natural that we seek the most efficient expenditure of our energy to obtain more energy.  Being that we are a cooperative species, this eventually led us to the idea of specialization.

     

    Specialization allows for people to be experts in their respective tasks.  This allows for dramatic improvements in quality and efficiency.  Once people decided to specialize and cooperate by sharing ideas and trading with one another, a great wave of invention and innovation ensued, materializing in the agricultural, industrial and informational revolutions.

     

    Prior to specialization, people often worked hard early in life and saved up resources on which to survive when their bodies and minds were no longer able.  People were essentially storing energy by building self-sustaining farms and the like.  But farms still needed to be worked, which explains why children often took over and cared for their elders.  Specialization allowed the storing of a specific type of energy (food, clothing, etc.) and one’s surpluses could be exchanged for the surpluses of others that were needed.  This is where bartering first came into existence.

     

    Fast-forward to modern times.  Instead of directly bartering goods and services, people developed an even more efficient means of exchanging energy.  People started converting energy into currency, which could then be converted back into other goods and services that were needed or desired.  This was far more efficient because currency was much easier to transport and it was a common unit of exchange.  If someone had extra grain, they didn’t have to wait to find someone who both needed grain and had desirable goods to exchange.

     

    Viewed this way, money is simply stored energy.  We go to work each day, while our bodies and minds allow, and expend our energy.  This energy (our labor) is then converted into currency, which can then be exchanged for the goods and services that others provide.  Greed, which carries such a negative connotation in conjunction with money, is really no different than someone of yesteryear building and growing a great self-sustaining farm.  Because of specialization, many people only have one specific skill to utilize in obtaining more energy (money).  If that skill doesn’t command satisfactory income (energy), this often leads to the types of conduct that so often gives greed a bad name.

     

    Whether negotiating with an employer for pay or considering an investment, it is helpful to ask how efficiently energy is being used.  From a value investor’s perspective, is more value being produced than is being expended?  Placed into context, it is easy to see why automation in manufacturing has caused so many jobs to leave developed nations.  No longer does one need to really understand how something is made.  Only an understanding of the assembly line function is necessary, which requires far less education, experience and expertise—and thus, far less compensation to the worker.

     

    The value of a product, service or one’s labor hours is a function of two things:  1) The value which society places on that particular good, service or labor; and 2) The availability of others who are willing and able to provide that good, service or labor.  If you want to be paid a lot of money, it is best to specialize in a skill that is highly valued by society and do it better than everyone else.  If you want to make a lot of money on an investment, buy as cheaply as possible an investment that produces something highly valued by society that has no readily available competition.  Because money is stored energy and is generally convertible into any other goods and services, people and investments that can produce a lot of cash are usually worth the most in our world of commercial specialization.


    For additional insight, visit IgnoreTheMarket.com.



    Disclosure: No Positions
    Apr 28 2:56 PM | Link | Comment!
  • The Right Way to View Stocks

    By

     

    Nathan Kawaguchi

    IgnoreTheMarket.com

     

     

    Until a few years ago, I used to generalize investment risk in terms of asset classes and sectors.  Like many investors, I mistakenly focused on product labels instead of looking at the basics of how the different investments actually function.  By that I mean, how investors realize investment returns.  That led me to focus more on the nature of cash flows to the investor because paper profits eventually have to be converted into cash for the investor to realize a return.

     

    Most people understand the basics of how bonds work.  And because bonds have contractual cash flows to which we can compare other streams of cash flows, we can relate all investments to the various types of bonds.  For example, residential real estate is so easily understood because very stable monthly rent “coupons” are paid in cash and most residential real estate has a relatively stable face amount (property value).  Essentially, it performs much like a plain vanilla bond, except the coupons and face amounts vary gradually over time and it does not mature.  Alternatively, it’s easy to see why commodities and other non-cash producing assets can be so volatile when we view them as zero coupon bonds with highly variable face amounts and no maturity.

     

    The right way to view stocks is as junior bonds with variable coupons, variable face amounts and no maturity dates.  Judging a company’s ability to produce future free cash flows for the owners’ benefit is really not much different than a creditor judging a company’s ability to generate cash flows to make timely principal and interest payments.  Like bonds, stocks can have collateral in the form of shareholder equity that could possibly be recovered through liquidation.

     

    When comparing relative attractiveness of different investments, required returns make much more sense when relating all investments to bonds.  Stock investors should require a higher rate of return than bond investors because, 1) Stocks are junior to bonds in the capital structure; 2) Coupons of stocks (free cash flows) are variable in their amounts and timing; 3) Face amounts of stocks (business values) are variable; and 4) Businesses do not “mature,” so stocks should be viewed as perpetual bonds and, as such, are likely to be extremely sensitive to changes in interest rates and spreads on risk assets.

     

    Additionally, companies don’t normally pay out all of their “coupon” free cash flows to shareholders via dividends.  This may require an additional risk premium because stock investors have to rely on management to intelligently allocate retained cash flows in order to preserve or increase value.  This can be done through, 1) Share repurchases; 2) Acquisitions; 3) Debt reduction; 4) Business growth; 5) Mergers; 6) Resource conversion; 7) Investments; or, 8) Buyouts.  All of these require skilled, shareholder-oriented management or a change in control.  Either way, investors are eventually dependent upon a higher price in order to sell and realize any increase in value.

     

    Viewing stocks in this manner should help investors better understand risk-reward relationships among different investments.  And this should ultimately help improve investment performance through more intelligent selection of the available risk-reward opportunities.


    For additional insight, visit IgnoreTheMarket.com.



    Disclosure: No Positions
    Apr 13 1:08 PM | Link | Comment!
  • Five Star Quality Care Gets No Stars (For Shareholder Friendliness)

    Five Star Quality Care Gets No Stars

    (For Shareholder Friendliness)

     

    By

     

    Nathan Kawaguchi

    IgnoreTheMarket.com

     

     

    Passive minority stock investors can realize value in a few different ways.  These include the payment of dividends, share repurchases, debt reduction, acquisitions, business growth, resource conversion, mergers, buyouts, change in control and market price appreciation. 

     

    A corporation’s primary obligation is to its owners, the shareholders.  In privately held businesses, any free cash flows are available to the owners in a very real, tangible way.  However, passive minority investors must rely on management to realize investment value through one of the methods listed above.

     

    Five Star Quality Care (FVE) is in the sweet spot of the senior living communities industry, with approximately 69% of its 2009 revenues coming from private payment resources and the balance from Medicare and Medicaid.  It should benefit from favorable demographic trends, but without being substantially dependent upon politically-sensitive government programs that put constant pressure on margins.

     

    It is important to understand the history of FVE.  FVE was spun-off from Senior Housing Properties Trust (SNH) in 2000.  SNH is managed by REIT Management & Research, or RMR, which is majority-owned by Barry Portnoy.  Portnoy has significant ownership and involvement in a web of real estate entities.  Portnoy and RMR have ownership and/or management in FVE, SNH, Hospitality Properties Trust (HPT), HRPT Properties Trust (HRP), Government Properties Income Trust (GOV), TravelCenters of America (TA) and numerous real estate investment funds.

     

    FVE leases a majority of its properties from former parent, SNH, which was founded by Portnoy.  According to recent ownership data and share prices, Portnoy owned stakes of approximately $500,000 in FVE, $3.9 million in SNH, $6.6 million in HPT and $5.8 million in HRP.  Additionally, SNH owns 9% of FVE shares; HRP owns 32% of GOV shares; and HPT owns 9% of TA shares.  Clearly, Portnoy has much greater financial interest in his non-FVE holdings.

     

    Simple reviews of SEC filings revealed that many of the value realization methods applied on behalf of passive minority investors simply aren’t available with FVE.  For example, FVE has five directors, including two managing directors and three “independent” directors who serve staggered three-year terms.  The “independent” directors have significant ties to Portnoy and his other entities.  The situation is similar on the boards of Portnoy’s other investments.  This reduces the possibility of a value catalyst through a change in control.

     

    Additionally, FVE’s CEO and CFO are employees of RMR and two of its managing directors (one of whom is Portnoy) are also directors for RMR.  And under their management agreement, RMR may act in SNH’s best interests in the event of a conflict between FVE and SNH.

     

    FVE’s charter places restrictions on ownership positions over 9.8% of any class of equity shares as long as SNH remains a REIT.  There are also restrictions on acquiring any new positions that would result in an ownership stake of 5% or more.  SNH and RMR have the ability to cancel lease rights upon an ownership acquisition of 9.8% or greater.  Lease rights are also cancelable upon the adoption of any shareholder proposal that is not approved by a majority of the board.

     

    Other tools that deter a change in control include the board of directors’ power to create new share classes and issue new shares without existing shareholder approval; specific requirements to serve as a director; limited shareholder ability to nominate directors; and the board of directors’ authority (not shareholders’) to adopt, amend, or repeal bylaws.

     

    What about relying on management to deliver value to shareholders?  FVE has never and does not plan to pay dividends; it has dramatically increased the number of shares outstanding since the spin-off, and it had increased debt each year until 2009.

     

    Yet another negative for shareholders is that as long as FVE has a management agreement with RMR, FVE cannot acquire or finance any real estate without giving SNH or other RMR-managed entities the first opportunity.

     

    The only capital decisions that could be seen as potentially adding value for shareholders are acquisitions and growth expenditures.  But even these are suspect.  SNH reimburses FVE for a majority of its expenditures and then FVE pays SNH a higher annual rent amount in return.  This arrangement appears to be in the long-term interest of SNH, which is essentially using FVE to help finance expenditures.

     

    Taking all of these factors into consideration, it’s difficult to see how passive minority investors can expect to realize any value creation in shares of Five Star Quality Care.  Unfortunately, it might be a situation in which Five Star exists only to serve its landlord, Senior Housing Properties Trust, and Barry Portnoy’s REIT Management & Research. 

     

    Five Star was spun-off on December 31, 2001 at $7.26 per share, has been as low as $1.04, and is currently around $3.04 per share.  Over half of shareholder’s value has been wiped out since the spin-off.  Considering the circumstances, this is not surprising and investors should not expect this to change in the near future.

     

    For additional insight, visit IgnoreTheMarket.com.




    Disclosure: No Positions
    Apr 05 3:13 AM | Link | Comment!
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