A Company's Losses Can Be Valuable

Yes, a company can certainly learn from its mistakes, but that's not the kind of value in losses that I'm talking about. Companies that lose money can actually apply those losses against income from other years, thus lowering their tax bill. A profitable company we recently analyzed, which had a market cap of under $1 billion, was carrying $500 million in future tax assets from such losses...and not showing a penny of it on the balance sheet! This could be hidden value...but how much are those tax assets really worth?

For a company that lost money this year but that has had profits in the past, it is relatively straightforward to calculate what those tax assets are worth. Simply apply the company's losses against the past profits (assuming they are larger than the losses), and the government now owes the company an amount equal to the difference between what they paid and what they should have paid in retrospect of these losses. Generally, companies can apply these losses on profits of the past three years.

But in this company's case, they had run out of past profits to apply these losses to. They can, however, apply these losses to future profits, but now their value becomes uncertain. Companies are now required to recognize (i.e. show on their balance sheet) such future tax assets "when it is more likely than not that the asset will be realized". This requires some estimates of future profits up until the expiry of these loss carryforwards.

Whatever value the company recognizes today, however, still has to be adjusted to present value due to the time value of money. Therefore, any tax asset shown on the balance sheet will often be an overstatement of the present value of that asset.

Further complicating matters, firms with losses they can't use up right away can prove to be acquisition targets for firms with higher absolute profits, as means to shield profits from taxes. However, the government has put in measures to prevent companies from buying losers just to shield themselves from taxes, but where there's a will, there's a loophole!

Paul Sonkin

Paul Sonkin isn't going to impress anyone at cocktail parties by discussing the companies he owns. He would probably impress with his returns, however.

Where does Sonkin find value? Small-caps and micro-caps: companies so small, that value can often be found for one of several reasons:

1) Many funds can't own them
2) Fewer analysts following the company

In addition, smaller companies are more nimble, and have better growth prospects (size can be a hindrance when trying to grow in percentage terms).

Sonkin adds another reason. Smaller companies are easier to understand. Their business models are far more simple, and thus value can be found without having to understand several lines of business or complex financial statements.

As we've seen with other value investors, Sonkin also looks for stocks that have been beaten down. He screens for stocks that are at lows, looking for stocks that have been neglected or punished by the market. Like Greenwald says, "If it ain't broke, don't buy it"

Schloss

You'll note that for this value investor description, I use only one name. It's not because this investor is trying to make headlines with a one-name moniker like Madonna or Cher. Rather, I'm trying to do a 2 in 1 here, by covering both Walter and Edwin Schloss. Walter is yet another successful value investor who trained under Ben Graham. Edwin joined his father Walter's partnership in the 70s.

Walter and Edwin practice a brand of value investing that's very basic to grasp. They look for cheap stocks, and sell them when their value has been realized. No hedging, no bonds, no convertibles, no indexes...nothing complex. Yet following this simple strategy, they have been able to beat the S&P by about 4% per year for over 50 years. Four percent may not sound like much, but over that time period it would turn $1 into $662 as opposed to $118...big difference!

There are a few neat things about how the Schloss' operate. First, they don't charge a fee for assets under management. They only get paid off of the profits they make for their clients. I love it!

Second, they don't disclose to their clients as to what stocks they own. The knowledge of the stocks they own can sometimes strike fear and uneasiness in their clients and they would rather do without!

Third, the way they find their stocks is by looking at what's been beaten down. They like stocks that have disappointed other investors who have then gone on to punish the stock. Then, they are interested in the replacement value of the assets. If the assets are selling on the cheap, good things will happen.

Event-Driven Hedge Funds

Hedge funds can be broadly classified into three categories:

1) Relative Value
2) Event-Driven
3) Directional

In event-driven hedge funds, managers look for stocks trading at discounts due to unusual circumstances. Such circumstances can include merger arbitrage, distressed securities, and private placements.

Here's an example of merger arbitrage. Let's say Blockbuster and Circuit City agree on a buyout whereby each share of Circuit City would receive 1 Blockbuster share. But Circuit City's price only jumps to $9, while Blockbuster's shares trade for $10. A merger arbitrageur might buy Circuit City shares, and short Blockbuster shares, hoping to profit from the eventual convergence of these values.

We've discussed action on distressed securities here.

Private placements are allow securities to be sold through private buyers rather than public offerings. In this way, companies can receive funding or help their owners get paid out, while avoiding the costs and rigour of having to go public. As such, these companies are sold at a discount to what they would sell on the public market.

Relative Value Hedge Funds

So...how much is your cousin Dave from across town worth to you? No, not that kind of relative value. Here, we're interested in the relative performance between two securities.

Hedge funds can be broadly classified into three categories:

1) Relative Value
2) Event-Driven
3) Directional

In relative value hedge funds, we don't actually care whether the market goes up or down, because its not going to affect us. Why? Because we're long one security, and short another.

Let's illustrate with an example. Let's say you think WestJet will outperform Air Canada. You buy shares in WestJet and you short shares in Air Canada. The only way you make (or lose) any money is on the relative performance between the two securities. If the airline industry is hit with a September 12th (some sort of sequel to Sept 11th), it doesn't affect you at all, because your short position in Air Canada will cover the losses in your long position in WestJet.

The advantage of this strategy is its ability to perform well in both bull and bear markets. And this strategy is not limited to stocks; it's just what I used in the illustration above. You can use this strategy on sectors, countries, indexes, and even convertible securities (buy a company's convertible debt, short its stock...you get the interest payments for the debt you hold, but aren't subject to the fluctuations in the stock price!).

Bankruptcy Pays for Michael Price

Most of the value investors you hear about are super old. This is mainly because, to have proven yourself successful as a value investor, you've had to put in years of patience and shown that you can beat the market over long periods of time. Michael Price was fortunate enough to be recognized as a great value investor by the time he was 40.

After graduating from college, Price worked for 13 years for Heine Securities. When Max Heine died in 1988, Price assumed direction. A few years later, he sold the company to Franklin Resources, and soon started his own smaller company. He has kept his fund private, so as not to succumb to the quarterly pressures inherent in public companies.

One area where price has made a killing is on bankruptcies. For those diligent enough to study a company in or entering bankruptcy, an investment does not correspond to a random spin of a wheel.

As outlined by Bruce Greenwald, there are four main stages to most bankruptcies:

1. Before filing for bankruptcy: Here, the company may be desperate for cash to keep afloat, and thus may be willing to grant equity or debt at attractive prices. If an investor is confident the company will eventually return to normal, there are large gains to be made here.
2. The filing itself: Many funds are forbidden to own securities in companies that involved in such reorganization, and thus many of these securities can be acquired at fire-sale prices
3. A reorganization plan: Two-thirds of each class of security holders must approve the plan for it to go through, so controlling one-third of the votes of any class garners some control, which can result in payoffs if used well.
4. Liquidation or re-emergence of the firm: Either liquidation, whereby stakeholders are paid with senior debt holders first in line, or re-emergence, where debt is substantially reduced, and the company is now in a position to be more profitable than it was before.

A lot of people invest in bankruptcies looking for dead-cat bounces or other random movements in prices. But there is value to be found for those willing to put the effort into doing the work!

Should You Invest in a Hedge Fund or Mutual Fund?

You want to focus on your career, so you don't have time to research individual securities to invest in. But you want returns that are higher than the GIC rates banks are offering. One decision you might be faced with is whether you should invest in a hedge fund or a mutual fund.

Alfred Winslow Jones came up with the concept of hedge funds in 1949. His strategy was simple: buy undervalued stocks while simultaneously selling overvalued stocks. That way, even if the entire market drops, you're hedged! Today there are many flavours of hedge funds, but for the most part, they seek to "hedge" for atleast some of the possible risks inherent in investing.

Some Differences Between Hedge Funds and Mutual Funds

Because many hedge funds "hedge out" market risks, they are often judged by their absolute returns, while the mutual funds are judged against an index. Hedge fund managers also tend to have substantial investments in their own funds as compared to mutual funds, which lends itself to an alignment of interests between investors and the managers of their money. The fee structure also tends to be different, with hedge funds tending to reward their managers on largely performance-based metrics, rather than simply on assets under management, which is common for mutual funds.

To hedge or not to hedge? As an investor, it will depend on your individual preferences.