Value Investing 8: Fishing In Shallow Waters

by: Philip Mause

When I was practicing law, I had a case involving a large, complex and extremely expensive fishing vessel. It used advanced electronics to find and catch large quantities of fish and could travel far out in the ocean in search of ideal fishing grounds. I began to wonder how smaller scale fishermen could possibly compete in this business. One thing about the vessel; it had a very deep "draft" or in boating parlance, it "took a lot of water." In other words, it would run aground in relatively shallow water. The shallower the water, the more boats are eliminated as potential competitors. At the extreme of shallow water, only men using spears and bears using their paws can fish effectively.

What does this have to do with investments? Large sophisticated organizations have enormous advantages over small individual investors. They can produce and access more research and they may have subtle ways of obtaining inside or borderline inside information. But they have one major disadvantage; they can't fish in shallow water.

Large institutional investors look for targets of opportunity that are meaningful in size and have sufficient liquidity so that the institutional investor can, within a reasonable period of time, enter and exit a large position without having an enormous impact on the price. An illiquid security is not attractive to the investor who wants to establish a large position and wants to be able to exit that position quickly because the investor will drive the price up on the way in and drive the price down on the way out. This is the reason that many small companies aren't "covered" by analysts - even if an analyst discovered a deeply undervalued stock, it would not be worth his while unless liquidity allowed for the establishment and ultimate exit from a large position.

In some situations, liquidity issues create opportunities when large investors have to exit positions and discover liquidity problems on the way out the door. Of course, the nature of the "discovery" is that the price goes down substantially as soon as the big investor heads for the door and much of the position has to be sold into a rapidly declining market for the stock. In such cases, the price of the stock can be driven down dramatically for reasons which have nothing to do with the economic prospects of the company.

In recent months, I have been on the prowl for securities that have exhibited dramatic price declines that may be liquidity related. I tend to look for extreme value situations in which the stock is trading well below book value and book value represents a reasonable estimate of liquidation value. What this means is that, if I can buy the stock at a low enough price, I will make money even in a liquidation.

The first situation of this type is a debt security - the symbol AFC represents debt of Ares Capital (NASDAQ:ARCC). Each share of AFC entitles the holder to receive $25 upon maturity in 2047 and interest at the rate of 6.875% until that date. In a world of low interest rates this is attractive and AFC has generally traded in the $22-23 range (it closed Monday at $23.17). AFC is a pretty safe bet: ARCC is strong financially and, as a Business Development Company, is limited in the leverage it can assume. It was therefore very surprising when, on August 8, AFC briefly dropped to $18.16 a share. This was almost certainly due to the forced liquidation of a sizable position somewhere. I was frankly surprised that ARCC didn't jump in and buy up as much of its own debt as it could at a discount when the window briefly opened. I sure did.

Two other opportunities in the BDC arena are Kohlberg Capital (NASDAQ:KCAP) and American Capital (NASDAQ:ACAS). KCAP's book value as of the last reporting period was $8.29 and it is trading at $6.03. What is really remarkable is that it got down to $3.42 on August 8. KCAP still has some issues but its major lender problems are behind it and book value represents primarily debt securities which have already been written down aggressively. I didn't buy in at $3.42 but I am watching carefully and would jump in with both feet if it went below $4 again.

I have written in the past about ACAS which I believe is very attractive at its current price of $6.42. ACAS has a book value as of the close of the most recent reporting period of $11.92 so the current price is less than 60% of book. What is really remarkable is that ACAS has traded as low as $3.40 on October 4 and $3.50 on August 8 (in each case, less than one third book value). ACAS has had a very large hedge fund holder rush for the exit door and discover that it is painful to try to squeeze through quickly.

These situations all offered and are likely to periodically offer opportunities for small investors. If an investor tried to establish a $10 million position during one of these windows of opportunity, his purchasing activity would drive up the price and fairly quickly close the window. For small investors, however, these windows can be attractive opportunities to establish and increase positions in these securities.

Disclosure: I am long AFC, ARCC, ACAS, KCAP.