Leverage: Natural vs. Unnatural

10 07 2011

Most value investors are against the use of financial leverage as a general rule. Leverage is defined as “The use of credit to increase ones speculative capacity” but it can also take other more modern forms such as derivative instruments.  The essential of leverage is that it gives the investor the ability to make (or lose) more on his investment than he would otherwise be able to. Common wisdom says, leverage can and will bite you at the worst possible time. Many great investors and firms have juiced their returns via leverage only to watch their concerns be wiped out entirely. Buffet is quoted as saying:

I’ve seen more people fail because of liquor and leverage – leverage being borrowed money. You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing.

Even the dictionary definition refers to leverage as speculative in nature. Clearly, victims of too much leverage created a risk for themselves that couldn’t have existed apart from their use of leverage. Is this risk intrinsic to leverage or is it a result of its misuse? Can one use leverage to increase long term returns without excessively endangering ones capital? I think so.

First, I believe it’s important to distinguish between what I see as two essentially different types of leverage: natural and unnatural. I’ve never seen these concepts used outside of my conversations with a friend so I will define them. Loosely speaking, natural leverage is the leverage a common stock investor is exposed to by the nature of his investment’s capital structure. For instance, an investment in a company with a high debt to equity ratio such as SuperValu Inc. (SVU). The debt exists on the company level.

In contrast, unnatural leverage is leverage that is employed by the investor in an unleveraged business. Borrowing money on margin or purchasing LEAPS are two examples. The leverage exists on the investor level.

I believe that there is a world of difference between the two types. While there are obviously exemptions to the rule, unnatural leverage tends to be much more potent than natural leverage. In terms of risk, the difference between buying options, where risk of total capital loss is very real, and owning a company with a leveraged balance sheet is immense. I believe that the most important difference between natural and unnatural leverage is the incentive distribution. Management of a company with a poor balance sheet has an immense incentive to reduce the debt. They are incentivized (above and beyond the norm) to act in the best interests of the shareholders. No such incentive exists for unnatural leverage. In my opinion, this is not a trivial point. The power of incentives cannot be over exaggerated (introspection will solidify this point). For what it’s worth, Charlie Munger agrees too.

This isn’t to say that all natural leverage is inherently good. A crappy balance sheet is still a crappy balance sheet. In fact, it’s probably evidence of crappy management. The cases to look out for are the ones where the current management didn’t create the balance sheet issues. Management changes are an obvious instance of this. Special situation are another. Spinoffs, for example, are often times loaded down with debt to relieve the parent company. The spinoff is structured in such a way as to satisfy the purpose of the spinoff- not to create the optimal capital structure for success. Once it’s an independent company, the odds are better that management will be interested in making the best of the situation and reducing debt if necessary.

So what about Buffett’s statement that you don’t need leverage to be successful? The premise behind his statement is that leverage is dangerous by its very nature. I don’t agree and I don’t think that using leverage means you need to leverage up 10 to 1 or even .5 to 1. If using small amounts of leverage will increase your long term results (imagine if Buffett had used leverage prudently), you ought to use it.

Moody’s Flawed Business Model

18 06 2010

Recently, Buffett has been parading around defending Moody’s from congressional and public scrutiny. Since so much money was contingent upon the rating given by the rating agencies, it’s quite understandable that people would be upset. And certainly, the rating agencies do deserve some blame. After all, who thought it was a good idea to give, what essentially amounted to a crappy loan, a AAA rating? People cite Moody’s so called “conflict of interest” that arises from its business model.

Companies that want their debt rated by a rating agency pay the agency, and the agency issues a rating. Not too complicated. However, a lot of people contend that there arises a “conflict of interest” because Moody’s can take more money (essentially be bribed) to issue a higher rating than is deserved. To declare that there is a “conflict of interest” implies that it is actually in Moody’s best interest to take these bribes. But is it?

In a market free of government force, would a rational business man accept these bribes? Clearly not. A rational company management should have the ultimate goal of producing shareholder value. The way to do that is by growing the business over the long-term. Keep in mind that we are discussing an industry where a company’s most important asset is its reputation. If a rating agency can’t be trusted, it’s going to be out of business. Plain and simple. It would be a terribly short-sighted and irrational for a company to sacrifice its reputation (and therefore long term viability) in order to make a little extra money in the short term. Anyone who says that screwing over the future of a company is ever in the company’s self interest is probably trying to sell you on the idea of more government regulation.

Unfortunately, Moody’s does not exist in a free market. Government regulations and rules decree that certain companies and funds need to hold debt with a minimum rating. In other words, the government creates the vast majority of the rating agency’s market. And worst of all, the government only allows the companies and funds to use government sponsored rating agencies. Currently, there are 10 firms that are classified by the government as Nationally Recognized Statistical Rating Organizations. These 10 firms that are lucky enough to get government sponsorship have guaranteed market share. When market share is guaranteed, a firm no longer has to worry about its reputation. Because of the government, these companies can essentially do whatever they want and still keep their customers. All of a sudden, it actually IS in Moody’s interest to sacrifice its reputation for bribes. The only reason this is a real “conflict of interest” is because Moody’s exists as part of a government created oligopoly.

So, while Moody’s is partly to blame, there is a more fundamental reasons for the failure of the rating agencies. That reason is the government.

Manhattan Bridge Capital (LOAN): Let’s Not Get Too Repetitive

8 06 2010

By any standards, LOAN is not an investment for the faint of heart. Its market cap is only $4.4 million, but it has a net current asset value of $7.4 million. This is a textbook example of the famous Graham Net-Net.

I first found out about LOAN via an investor that I follow on seekingalpha.com (and I suggest that you follow him too!).

Hester does a great analysis in the above article, so writing one here would be mostly repetitive. However, there are a few extra things I’d like to point out. First of all, Hester writes that “LOAN does two things, it provides bridge loans and it does something called factoring.” Once Hester’s article was published, LOAN took notice and released this statement concerning the article.

LOAN writes that they actually don’t take part in factoring anymore. One other thing that I noticed was the number of potentially dilutive stock options that insiders have. Hester addresses this concern (quite intelligently IMO) by pointing out that most have strike prices above where an intelligent investor would sell LOAN anyways. Another possible risk is that of inflation. While inflation is a risk for any company, LOAN does not earn a very high ROE, so inflation could possibly demolish their value.

I think that LOAN is a great deal, and it’s in these sort of micro-cap stocks that small investors have the advantage over large investors. Buffett once said:

There are little tiny areas, as I said, in that Adam Smith interview a few years ago, where if you start with A and you go through and look at everything — and look for small securities in your area of competence where you can understand the business and occasionally find little arbitrage situations or little wrinkles here and there in the market — I think working with a very small sum, there is an opportunity to earn very high returns.But that advantage disappears very rapidly as the money compounds. As the money goes from $1 million to $10 million, I’d say it would fall off dramatically in terms of the expected return — because you find very, very small things you’re almost certain to make high returns on. But you don’t find very big things in that category today.

LOAN is about as good of an example of this as I’ve seen.

Disclosure: Long LOAN

The Next Bubble: Bonds

3 06 2010

As an Objectivist, I see the massive amount of government intervention into the economy, the ridiculously low interest rates, and the ballooning amount of government debt and worry about the future of the economy. Inflation seems, if not inevitable, highly likely. As a value investor, I can’t bring myself to buy gold when it’s near or at its all time high. So I began searching for other hedges and I came across Seth Klarman’s strategy:

“To protect against that “tail risk,” said Mr. Klarman, Baupost is buying “way out-of-the-money puts on bonds”—options that have no value unless Treasury bonds plummet. “It’s cheap disaster insurance for five years out,” he said.”

As I began to look at treasury bonds (I don’t normally look at bonds very much), it became apparent that something very goofy is going on in the bond market. Look at the yield of the ten year treasury:

Besides the dip in ’08, the yield has not been lower since the data begins in 1962. And the story is the same for the 30 year treasury. The first thing that comes to mind when seeing this is BUBBLE! The yield on a treasury has to price current inflation, risk of higher inflation, risk of default, and a sensible rate of return into it. What is a sensible rate of return? I have no idea. But I do know that inflation has averaged somewhere between 3% and 4% since 1913. Well there goes the vast majority of the bond yield. And to think that we’re not going to have higher than average inflation is insanity.

Besides inflation, there is the risk of default. Of course, treasuries are thought of as risk free because the government can’t default. Despite this, Moody’s has discussed downgrading federal treasuries. Honestly, they’re not going to actually downgrade the treasuries. The government will just print its way out of default. So in reality, the default risk for treasuries is not gone, it’s just relocated into the ‘inflation risk’ category. Keep in mind that this is going on as the government is issuing an unbelievable amount of debt– bringing total American debt to $13 trillion.

People are buying gold, and driving it to record levels, because of the risk of inflation as well as the ballooning government debt. Gold provides safety from these risks (depending on what price you buy it at…). What safety does a government bond provide when it’s yielding such outrageously low rates? None. When two markets are so wildly out of sync, the markets are eventually going to HAVE to correct. Either gold is going down or treasuries are going down. However there are objective reasons for gold’s price. The same cannot be said about treasuries.

And this is why I’m a bottom up investor. Having realized a macro economic trend, it’s difficult to profit from it. I think I’m going to go the Klarman route and buy put options on ishares Barclays 20+ year treasury bond ETF (ticker TLT). I still have to decide which put options I’m going to buy, but I’m leaning towards a few that are way out of the money.

BWLD: Buffalo Wild Wings

7 05 2010

I ran across BWLD a couple weeks ago when I was skimming through 10-ks. I think the best strategy to find undervalued businesses is to just read 10-ks, determine what I think the business is worth, and THEN check to see what the company is selling for. Let’s look at BWLD’s financials:

Owner Earnings:

A quick glance at morningstar’s free cash flow data (which many use as a substitute for owner earnings) shows that BWLD has earned $5.5 million in 2009, used $1.3 million in 2008, earned $2.2 million in 2007, and earned $9.3 million in 2006. For a company with over $200 million in equity, these are anemic cash flows to say the least. However, when we convert the free cash flow numbers to owner earnings (OE), we can see the true earnings of BWLD.

Owner earnings are defined as (Net Income)+(Depreciation/Amortization)+(Other Non-cash Charges)-(Maintenance Capital Expenditures)-(Any Working Capital Requirements). The largest difference between free cash flow and owner earnings is a result of the maintenance capex category. In the 2004 10-k, BWLD estimates that each restaurant opened in 2005 will cost $1 million a piece. In 05 they estimated ’06 costs at $1.1 million; ’07 costs were estimated at $1.2 million; 08 costs were estimated at $1.4 million, and the 09 costs were estimated to be $1.5 million per new restaurant. Since the company opened 19, 17, 22, 36, and 35 stores in 2005, 2006, 2007, 2008, and 2009 respectively. This means that 19 million was spent on new restaurants for 2005, $18.7 million in 2006, $26.4 million in 2007, $50.4 million in 2008, and $52.5 million in 2009. Subtracting this “growth capex” from the reported cap ex, we get a maintenance  expenditures of $3 million, $5.1 million, $15 million, $17 million, and $21.3 million for 2007, 2008, 2009 respectively.

To check the validity of these numbers, we can divide each maintenance capex by the number of existing restaurants and see if the the per restaurant capex is relatively consistent. In 2005 we get $25,000 spent per existing restaurant; in 2006 we get $37,000 spent per existing restaurant; in 2007 we get $93,000 spent per existing restaurant; in 2008 we get $86,000 per existing restaurant; in 2009 we get $91,000 spent per existing restaurant. It’s clear that maintenance capex greatly increased in 2007 and has stayed relatively constant in per restaurant terms. Remember that these capex estimates are just that- they’re estimates based upon the company’s estimates. In other words, they could be way off. The 2009 10-k says that BWLD estimates 2010 expenditures of “approximately $20 million for the upgrades and remodels of existing restaurants.” Thus, our estimations are in the ball park. As Buffet once quoted Keynes:

“It is better to be roughly right than precisely wrong.”

Subtracting our maintenance capex from the cash from operations gives us 2005 OE of $21.7 million, 2006 OE of $27.9 million OE,  2007 OE of $28.6 million, 2008 OE of $49.1 million, and 2009 OE of $58 million. Not too shabby. BWLD grew its owner earnings from $21.7 million to $58 million in the last four years of operations–that’s a 28% growth rate! Keep in mind that this was through a recession.

The Balance Sheet

From the latest quarter 10-Q, BWLD has $15 million in cash, $113 million in current assets, $324 million in total assets, $104 million in total liabilities, and $221 million in equity. They could pay off all of their liabilities with their current assets only! But how are they employing those assets?

Some Ratios (Using Owner Earnings)

CROE for 2007: 22%;   CROE for 2008: 31%;   CROE for 2009: 30%

CROIC for 2007: 19%; CROIC for 2008: 27%; CROIC for 2009: 26%

These are great numbers.

Intrinsic Value

Using the average between 2008 and 2009’s owner earnings as my initial cash flow, a growth rate of 10 percent for the first 5 years (admittedly arbitrary, although significantly less than what I think BWLD is capable of achieving), a growth rate of 8 percent for the second five years, and a growth rate of 3% for the second 10 years, I arrive at an intrinsic value calculation of $1.14 billion for the business. Whenever I calculate an intrinsic value, I like to look at the value of the infinitely projected cash flow and see what impact that has upon the valuation. This final cash flow is often a source of controversy and is cited as a reason that projected cash flows are imprecise. In this case, the intrinsic value would have been 1.05 billion without that final cash flow– an 8% difference. Right now, BWLD is selling for a little less than $700 million or a 40% discount to our estimated intrinsic value.

Disclosure: Author is long BWLD.

Lesson 1: Don’t Buy Crappy Businesses

21 04 2010

When Mr. Buffett isn’t selling out stadiums, he offers us priceless investment advice. One of his most famous quotes:

“It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”

While I can’t say I agree with that statement, I’ve discovered the truth of another: ‘It’s far better to buy a good company at a good price than a terrible company at an amazing price.’ In my last post, I detailed China 3C Company and indicated that it was grossly undervalued. While I still believe that to be true, I now realize that buying CHCG was a mistake.

When you invest in a crappy company, you’re introducing a speculative element. In the case of CHCG, the intrinsic value of the company is decreasing with the passage of time. Whether I make money on the investment is dependent upon whether the market price rises to the intrinsic value before the intrinsic value drops below my purchase price. And what controls this? Sheer luck. Contrast this with the purchase of a great business below its intrinsic value. As the intrinsic value rises, a rational investor shouldn’t care whether the market takes a week or 3 years to realize the value of the company.

And this is why I admit that investing in CHCG was not a good idea. I don’t want the success of my portfolio to be based on luck. Maybe Buffett could also teach us a thing or two about women.

China 3C Group: A Good Deal?

14 04 2010

What if you could buy a company with $28 million in cash, a total of $60 mil in tangible assets, and only $7 mil in liabilities for a purchase price of $24 mil dollars? Would you? Of course, you’d need more information. If I were given this deal, I’d immediately assume that the company has negative earnings. But no. This company only has declining earnings, making $2.5 mil in net income for the 9 months ending September 30th. Certainly the company must be bleeding cash. Nope. It had a positive free cash flow for quarters 1-3 of $5 mil and hasn’t had a year of negative cash flow for the past 4 years.

The company is China 3C Group (CHCG.OB) and it’s on sale for only $24 million. The stock has been absolutely hammered. Down from its 5 year high of $16.00 per share ($800 mil market cap) to only $.45 a share, there are certainly reasons for the stock’s collapse.

The Business Model:

According to CHCG’s 10-Q, “The Company is engaged in the resale and distribution of mobile phones, facsimile machines, DVD players, stereos, speakers, MP3 and MP4 players, iPods, electronic dictionaries, CD players, radios, Walkmans, and audio systems. The Company sell and distribute these products through retail stores and secondary distributors. Following the acquisition of Jinhua, the Company also provide logistics for businesses in China.” CHCG uses what is known as a “store in-store” model. The company basically sells electronics from a space rented out in a retail store. As of march 2008, CHCG operated in a little over 1,000 stores. The plus side of the store in-store model is that the company does not have to deal with the costs of running an entire store. Also, I’d imagine that they’d sell more products from a store that brings in people looking to buy other goods as well as electronic goods. One negative of the store in-store model is the management fees that CHCG has to pay in order to rent space. These fees amounted to about $6.5 million for the nine months ended September 30th 2009.

The Balance Sheet (in millions):

Cash and Cash Equivalents: $28.3

Accounts Receivable: $22.5

Inventory: $8.2

Other Current Assets: $2.6

Intangibles: $35.7

Total Liabilities: $7.4

That leaves us with an equity of $90.3. If we’re talking liquidation value, the intangibles are worthless and we get $54.6. Since CHCG has no long term assets, $54.6 is also the net current asset value as Graham defined it in the 1951 edition of Security Analysis. Assuming the company only receives 75% of its accounts receivable and its inventory is really only worth half of its carried value, we arrive at a liquidation value of $42. Thus, we are buying CHCG at a 43% discount to a conservative estimation of its liquidation value. However, the company most likely won’t be liquidated.

Net Income (in millions):

2006: $11.3

2007: $22.9

2008: $26.8

TTM: $9.8

So what gives for the last twelve months? As usual, it’s not just one factor. There has been an overall (temporary?) dip in the Chinese consumer electronics market due to the poor global economy. Also, CHCG has changed its business model pretty drastically. They no longer own retail stores but rather sell electronics using a store in-store system. Both of these have led to a drop in revenues (which were $310.6 for 2008 and 257.4 for TTM).I encourage people to read the 10-Q for management’s discussion of revenues, but there are a variety of other reasons for the dip (most cell phones for sale have become 3G, yet the 3G network in China hasn’t been completed, causing many consumers to wait to purchase new phones-a temporary issue, China is offering temporary rebates which incentivize consumer purchases of electronic appliances-yet CHCG isn’t eligible for these rebates due to its store in-store business model, etc.)

Coupled with the lower gross profit, CHCG is experiencing a rise in selling, general, and administration expenses. SG&A costs have risen from $14.1 in 2008 to $20 in TTM. The 10-Q explains the cause of these increased costs as a rise in the fees paid for their store in-store model, as well as an all around raise in employee salaries. For the three months ending Sept. 30th, SG&A expenses were $5.6 or about a quarter of the TTM costs- possibly signifying a stabilization of costs.

Cash Flows:

Once again, I encourage readers to check out the latest 10-Q. There isn’t a whole lot to say about CHCG’s free cash flow other than that they are actually collecting on their accounts receivable.


One of the risks I see with CHCG is the fact that it’s in China. Most investors think that this is a great thing because of China’s economic growth. However, China is not exactly a pro-freedom country. Changing regulations and government decrees could have a negative impact on CHCG- and that is one risk which I have no idea how to quantify. Also, CHCG’s income for the three months ending Sept. 30th 2009 is ($1.7) million. That is, they lost $1.7 million in the third quarter. Financial results for all of 2009 come out April 15th or 16th, and we’ll see then how the 4th quarter went. Perhaps the company lost even more money. The amount that CHCG could lose in the 4th quarter is not substantial, yet this thing is priced for a financial Armageddon.

Why the discount?

When I see a company that is highly undervalued at first glance, I immediately assume it’s too good to be true (because it almost ALWAYS IS). In this case, I don’t see a valid reason for the discount. A glance at the Yahoo! Finance message board reveals a couple reasons investors hate CHCG. As the market cap began to fall from its $800 mil high, large investors were forced to sell their shares and further depress the price.  The company seems to have lost its analyst, surely causing even more investors to flee. Watching your investment fall to nearly nothing is going to cause some pissed off investors. If you knew that the underlying value of the company was actually much higher than the stock price, you wouldn’t mind watching the price fall so you could invest more. Although most people seem to understand this principle, very very few actually follow it. Personally, if the price of CHCG fell to $.25, I’d very happily purchase more. Further pissing off investors, the company has failed to file its earnings on time for the 3rd straight earnings release. I’m not sure why this bothers investors since the earnings are usually only 15 days late. Perhaps it shows management’s disregard for its American investors. Finally, the latest reason to hate CHCG is that it could be demoted to trading on the pink sheets. Since its 10-K is going to be late, there is a risk that CHCG will no longer be traded OTC. As one Yahoo! Finance user put it, “if the OTC is the gutter the pinks are the sewer.” However, any rational investor realizes that the exchange that a stock is traded on has nothing to do with the company’s value. Liquidity is the only thing that will suffer as a result of trading on the pinks. As a long-term investor, I’m not bothered by a lack of liquidity.

To sum it up, I think CHCG is a heck of a deal. Unless the 10-K announces that China has sunk into the sea, I’m going to be an investor in this company until Mr. Market realizes his error.

Disclosure: Author is long CHCG with a cost basis of $.45.