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Debt

Capacity

Debt capacity is a very useful mental construct in valuation.

“Our research seeks to appraise the intrinsic value of a share of stock by estimating its acquisition value, or by estimating the collateral value of its

assets and/or cash flow.

“We believe the process is in many respects closely related to credit

analysis as we are seeking collateral net worth in excess of the cost of

our investment.”

Type 1 Securities

How do High Grade Bonds contrast with Equity?

In Bonds, focus is onAVOIDANCE OF LOSS

In equities, focus is on BOTH AVOIDANCE OF LOSS + A DESIRE TO MAKE PROFITS

What’s the best case scenario for a high-grade bond buyer?

Downside risk in bonds

NO offsetting trades

So

It’s better to be safe than sorry

In stocks, being loss averse can be costly. You have to take calculated risks...

You are SACRIFICING

Profit Sharing

In Exchange Of

A PRIOR CLAIM and DEFINITE

PROMISE

Bad exchange

High Grade Bond Selection is a

NEGATIVE art

Focus on exclusion

“The first chance you have, to avoid a loss from a foolish

loan is by refusing to make it. There is no

second chance.”

Graham’s Principles ofHigh Grade

Bond selection

1. Safety is measured not by specific lien or

other contractual rights but by the ability of

the issuer to meet ALL its obligations.

1. Lien vs. Ability

1. Lien unreliable form of safety

Safety is measured not by specific lien or other contractual rights but by the ability of the issuer to meet all its obligations.

The idea that a lien on the assets is a guarantee of protection independent of the success of the business itself is in most cases a complete fallacy.

In the typical case, the value of the pledged property is vitally dependent on the earning power of the enterprise.

Example: ITC

Railroads - lien on property not adaptable to other uses.

Indian Banks' NPAs - emphasis on security rather than ability.

Shrinkage of property

values when a business

fails.

Difficulty of asserting the bondholders' supposed legal rights.

Delays and other disadvantages incident to a receivership or bankruptcy.

http://fundooprofessor.wordpress.com/2012/10/19/virginity/

2. This ability should be measured

under conditions of depression rather than prosperity.

Any bond can do well when conditions are favorable.e.g. FCCB issues

3. Deficient safety cannot be compensated for by an abnormally

high coupon rate.

Yield TrapReturn ON money vs. Return OF money

4.The selection of all high grade bonds

should be subject to rules of exclusion and to specific

quantitative tests.

“What’s fascinating . . . is that you could now have a business that might have been selling for $10 billion where the business itself could probably not have

borrowed even $100 million.

“But the owners of that business, because its public, could borrow many billions of dollars on their little pieces of paper- because they had

these market valuations. But as a private business, the company itself couldn’t borrow even 1/20th of what the individuals could

borrow.”

Promoters aren’t borrowing. They are selling.

A sale in the garb of a loan.

Two Sources of safety:A. The character of the industry (the particular business is immune

from drastic shrinkage of earnings).

B. The amount of protection (the margin of safety is so large that

the company can undergo a drastic shrinkage of earnings without resultant danger).

4. Quantitative TestsThe selection of all senior

securities for investment should be subject to rules of exclusion and to specific quantitative tests.

“The past ability of the borrower to earn in excess of

interest requirements is counted on to

protect the investor against loss in the

event of some future decline in net

income.”

“The bond investor does not expect future earnings to be the

same as in the past. If he was sure of that, the margin demanded might be small. Nor

does the bond investor predicts whether

future earnings will be materially better or

poorer than the past.”

“ If he did that, he would have to measure his margin in terms of a

carefully projected profit and loss account instead of emphasizing

the margin shown in the past record. The role of the margin of safety, therefore, to render it unnecessary to make accurate predictions about the future.”

Factors in Bond Selection1. The nature of the

business2. The size of the

enterprise3.The terms of the issue4. The record of solvency and dividend payments

5. The relation of earnings to interest

requirementsInterest Cover

6. The relation of the value of the property to

debt7. The relation of stock

capitalization to debtDebt/Equity

Average Market Value of Enterprise/Debt

Fixed Charges Coverage

Fixed charges vs. InterestExample of leased vs owned outlets in retail operations. Rent is like interest.

Why Fixed charges cover instead of Debt service?1. Cover demanded is high2. Assumption of going concern - ability to refinance

Graham’s Version of Debt-equity ratio

Market Value of Enterprise/Debt ratio:

What is the logic of using this ratio?

“Before paying standard prices for

bonds of any enterprise, the investor must be

convinced that the business is worth a

great deal more than what it owes.”

Key term: Business worth a lot more than what it owes.

In this respect the bond buyer must take the same attitude as the lender of money on a house or a diamond ring, with the important difference that it is the value of the business as an entity which the investor must usually consider, and not that of the separate assets.

Why not use the conventional Debt/Equity ratio?

What about the silly Mr. Market??

“The market value of stock is generally

recognized as a better index of the fair going concern value of a business rather than balance

sheet figures.”

“The presence of a stock equity with market value many times as large as the total debt

carries a strong assurance of the

safety of the bond.”

“Conversely, an exceedingly small stock equity at

market prices must call the soundness of the bond into serious question.”

Why is this very important?

The Graham Standard:“Minimum stock equity at market prices for industrial bonds should

be at least 75% of total debt. This test must be passed both currently and over the average

of last five years.”

Interest coverage and debt-equity ratios

Do you see any similarity?What does interest-coverage

ratio measure?Cash flow available for interest/

Interest

They are very similar, therefore, they should produce similar

conclusions.i.e. if a company is creditworthy, it must be a lot more than what it owes. EV should be several

times its debt

Suppose, the minimum standard for interest-coverage ratio is barely met

but the stock-value ratio is considerably higher than the minimum prescribed.

Under such circumstances, the bond should be accepted as investment.

Why?

But what if they produce contradictory conclusions?

If interest coverage ratio is ample but the stock-value ratio is substantially

below the minimum required.“Under such circumstances, the

purchaser of the bonds will have to assume that the price of the stock is

too low.”This could happen for good or bad

reasons

Good Reason: Stock market is right you fool! - there are bad days

ahead, the earnings are suspect, or there may be a fraud!

Credit rating agencies vs. the stock market as predictors of distress.

Bad reason: Stock market is wrong - the stock is a bargain - buy it

instead! - its cheaper and safer!

In either case, the investor should not buy the bond as a type-I

security.

Time for some backward thinking

Lets do some reverse engineering

Recall The Graham Standard:“Minimum stock equity at market prices for industrial bonds should

be at least 75% of total debt. This test must be passed both currently and over the average

of last five years.”

For Graham, if a company is creditworthy, then its stock

should be worth at least 75% of the value of its debt.

(Business is worth at least 175% of debt)

Equity Value > 0.75 x Debt Capacity

A Valuation Rule

“An equity share representing the entire business cannot be less safe

[and less valuable] than a bond having a claim to only a part thereof.”

“There are instances where an equity share may be

considered sound because it enjoys a margin of safety as large as that of a

good bond.

“This will occur, for example, when a company

has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its

property and earning power.

“In such instances the investor can obtain the

margin of safety associated with a bond, plus all the chances of

larger income and principal appreciation inherent in an equity

share.”

“Our research seeks to appraise the intrinsic value of a share of stock by estimating its acquisition value, or by estimating the collateral value of its

assets and/or cash flow.

“We believe the process is in many respects closely related to credit

analysis as we are seeking collateral net worth in excess of the cost of

our investment.”

“A bondholder can enjoy no right or protection which the full owner of the business, without bonds ahead of him, does not also enjoy. Stated somewhat fancifully, the

owner (stockholder) can write out his own bonds, if he pleases, and give them to

himself.”

VST’s “Bonus Debentures”

Hidden inside the stock of a credit-worthy company is a bond...

Recent Cases of Debt Capacity Bargains

Satyam Effect

At Rs 60 in march 2009, market cap was R 190 cr.Surpus cash = Rs 70 cr.

Rs 120 cr for a business which generated average operating cash flow of Rs 56 cr. p.a. over last 4

years.

At Rs 60 in March 2009, market cap was Rs592 crSurplus cash = 100 cr. Rs 492 cr for a business

which generated Rs 120 cr. average annual operating cash flow over last 5 years.

India’s largest provider of inland transport by rail using containers.

Midterm Exam Question

Exercise done in Oct 2011Total cash flow for five years = Rs 4,896 cr.Average = Rs 979 cr.Interest expense = 979cr/3 = Rs 326cr.Debt business can easily support = Rs 326 cr./0.10 = Rs 3,260 cr. (ANSWER 1)Minimum value of business = Rs 3,260*1.75=Rs 5,705 cr.Minimum intrinsic value of the company = 5,705+2,000 cr= Rs 7,705 crMinimum intrinsic value of equity = Rs 7,705cr/13cr shares = Rs 592 per shareDid it fall to this level?

At 560, stock was a debt-

capacity bargain

Average cash flow from operations after W/C changes: Rs 1,000 cr.Interest expense = 1000cr/3 = Rs 333cr.Debt business can easily support = Rs 333 cr./0.10 = Rs 3,333 cr.Minimum value of business = Rs 3,333*1.75=Rs 5,833 cr.

Minimum intrinsic value of the company = 5,833+1,500 cr surplus cash= Rs 7,333 crMinimum intrinsic value of equity = Rs 7,333cr/13cr shares = Rs 564per shareNow let’s get REALLY creative

At 560, stock was a debt-

capacity bargain

THIS is what we mean by FAVORABLE ODDS

Value Investing in Las Vegas

The casino is a value investor because of:

1. Favorable odds on each bet2. Lots of play (diversification)3. Cap on maximum bet (protection from negative black swan)

In American roulette there are 38 slots numbered 1-36, 0, and 00. Pay-out is 35:1

If you bet Re 1 on your lucky # 8 and if the ba" lands on # 8, you win Rs 35, otherwise

you lose Re 1.

You wager Rs 1,000 on a single number, say number 7.

Probability of ba" landing on 7 = 1/38 = 2.63%. Probability of not landing on 7 = 37/38 = 97.37%

Event Payoff Probability Expected ValueBall lands on 7 36,000 2.63% 947.37Ball does not land on 7 0 97.37% 0

947.37Amount Bet -1,000NPV -52.63

What happens when Margin of Safety is -ve and you practice wide diversification?

Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38 numbers to “spread your risk”

Suppose you bet Rs 1000/38 or Rs 26.32 on each of the 38 numbers to “spread your risk”

What happens when Margin of Safety is -ve and you practice wide diversification?

Event Payoff Probability Expected Value

Ball will land on one of your numbers

947.37 (=26.32*36) 100% 947.37

Amount Bet -1,000.00

NPV -52.63

Lesson: Diversification does not work when Margin of Safety is absent.

Thank you