Saturday, July 19, 2008

Security Analysis: Chapters 16 and 17

Security Analysis by Ben Graham and David Dodd is a must read for anyone serious about value investing.

In these two chapters, the authors discuss various other types of fixed-income investments (apart from straight bonds and preferred stocks).

Income bonds sit somewhere between straight bonds and preferreds. They have a definite maturity at which point the principal must be paid back. (In this regard, they are similar to bonds.) However, interest payments are discretionary. They're supposed to be paid as long income is sufficient, but in actuality, companies can set aside money for capital expenditures or other items before having to make these payments.

Despite the seniority income bonds enjoy over preferred stocks, their track records have been awful in comparison to both bonds and preferred stocks. The authors theorize that this is because this form of investment is only used when companies are in dire straights. The very fact that interest payments need to be based on income suggests the income itself is in doubt.

The authors also discuss the benefits and drawbacks of guaranteed issues. These issues are backed by at least one other company. Graham and Dodd remind investors that guarantees are only as good as the viability of the guarantor. Investors are also cautioned to be wary of the type of guarantee: often, a guarantee will cover only interest payments, not principals.

Joint guarantees are fully backed by several individual companies. This rare occurrence is quite a valuable form of guarantee, as it can happen that one company is unable to follow-through on its guarantee, but unlikely that several cannot at one point in time.

A popular type of guaranteed security is common in the real-estate mortgage market. A bank will sell investors a mortgage, and will guarantee payments on that mortgage. Unfortunately, for this type of self-guarantee to be worth anything, the following principles must be kept:

1) Loans must be conservatively financed
2) The guarantee must come from a company well-diversified

If loans are not conservative, then declines in real-estate values will result in deterioration in loan values. If the guarantor is not diversified, a general decline in real-estate values will serve to place the guarantor in receivership, which makes for a most dubious guarantee.

As simple as these principles are, in practice problems have arisen. In the roaring 20s, new and aggressive firms provided loans at levels so as to leave very little equity in the mortgaged property, despite the fact that appraisals were made at dubiously high levels. In order to compete with these firms, reputable ones would be forced to lower their standards. The industry spiraled out of control, and guarantees turned out to be useless in the ensuing carnage as firms were forced into receivership.

Finally, the authors discuss required lease payments. Two companies may appear to have similar financial statements, but if one has large leases that may not be canceled, it sits in a precarious position. When rental rates drop, or when business declines, such a company is in the unenviable position of wanting to shrink but being unable to.

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