Sunday, March 22, 2009

Who uses preferred stock?

In my last post, I made the argument that preferred stock is very expensive debt. To give you a sense of the differences in costs between the different types of financing, consider a company like GE that has common stock, preferred stock and conventional debt outstanding. In March 2009, the cost of equity was close to 12%, the preferred dividend yield was about 9-10% and the pre-tax cost of debt was about 6-7%. On an after-tax basis, the pre-tax cost of debt was closer to 4%.

To understand why firms use preferred stock, given its high cost, we have to look at the two groups of firms that are its biggest users - financial service firms and young, growth companies.

1. With financial service firms, the allure comes from the way regulatory authorities define equity capital for capital ratios. They generally include preferred stock in equity. Thus, preferred stock may be considered expensive debt that gets treated as regulatory equity - a big bonus for firms that get judged based upon their capital ratios. (To add to the problem, ratings agencies also seem to treat preferred dividends as quasi-equity... giving higher ratings to these firms than they truly deserve, given their cash flow obligations).

2. With young, growth companies and some distressed companies, there is a different reason. Since these firms are often losing money, debt does not provide a tax advantage anyway. From, the firm's perspective the difference in costs between debt and preferred stock narrows, as a consequence. From the investors' perspective, the allure of preferred stock is that it is generally cumulative (dividends not paid have to be made up for in future years) and convertible to common stock. Thus, the investors, while running the risk of not receiving preferred dividends during the bad years, get priority in claims to cash flows (if the company starts making money) and can use the conversion option, if the firm's market value also climbs.

If nothing else, the existence of preferred stock is a testimonial to the effects that regulatory and tax laws have on financing choices. Bad laws (and regulatory definitions) will create bad financing choices. We may be seeing this play out in the current crisis. In my view, banks, insurance companies and investment banks that faced capital constraints would have been better off raising common equity early in this crisis rather than go for preferred stock from unconventional sources. Even those banks that thought they were getting a good deals on preferred stock (from the government) are discovering that there are implicit costs in these deals.

Saturday, March 21, 2009

Preferred Stock: Fish or Fowl?

In my last post, I talked about hybrids but I stuck with the conventional example of convertible debt. In this one, I would like to draw attention to another source of financing - preferred stock - which I find much more difficult to work with.

Before I begin, though, let me also draw a distinction between preferred stock in the United States and preferred stock in some other parts of the world (such as Brazil). In the United States, preferred stock commands a fixed dollar dividend that is set at the time of the issuance. If you buy preferred stock, your returns come primarily from the dividends - any price appreciation (or depreciation) is a side story. In much of Latin America, preferred stock is really common stock with preferential claims on dividends and limited voting rights. The dividends are usually specified as a percentage of earnings (rather than as an absolute number) and will go up, if the company is doing well, and go down, if not. Returns therefore mirror returns on common stock, with dividends and price appreciation.

Where should we put preferred stock in the cost of capital computation?
1. With the "common stock" variety preferred, the answer is easy. Treat it as equity, even though it may be called preferred stock.
2. With the "fixed dividend" preferred stock, our task becomes more difficult. It is clearly not equity, notwithstanding what it is called, since your claim is on a fixed dividend. (If you have preferred stock that is entitled to more cash flows, such as a share of the remaining profits, I would consider it equity). Including this item in debt creates a problem, since preferred dividends are not tax deductible (and attaching an after-tax cost of debt to the overall debt will understate the cost of preferred).

Here is my compromise solution. If the value of preferred stock is less than 5% of overall firm value (market), act like it does not exist for cost of capital purposes and subtract the preferred dividend out from earnings and cash flows. (It will make little difference to your cost of capital, if you do include it, and more headaches than it is worth) If it is more than 5%, we have no choice but to create a third source of capital and give it it's own cost. The cost of preferred stock should be the preferred dividend yield (which will be lower than the cost of equity but higher than the pre-tax cost of debt).
Preferred dividend yield = Preferred dividend per share/ Preferred stock price

The puzzle then becomes the following. Preferred stock is essentially very expensive debt (because you do not get the tax advantage). So, why would any sensible firm even use it to raise capital? More on that in my next post.

Thursday, March 19, 2009

My thoughts on the AIG fiasco

As I watch the AIG circus unfold, I don't whether to laugh or cry. First, the people running these banks must be tone-deaf not to recognize that once you appeal for government bailouts (and get them), the rules have changed. If something appears unseemly, it is so. And when there people are scared - about losing their jobs and seeing their savings meltdown - the notion that AIG paid bonuses in the millions strikes many as unfair.

There do seem to be two separate components to the AIG actions. One relates to the billions that AIG supposedly funneled out to investment and commercial banks. I noticed Goldman Sachs at the top of the list. I really have no idea what these payments were for but if these institutions were counter parties on positions that AIG had taken, I see nothing wrong with this. After all, was this not what the bailout money was supposed to be for? To ensure that AIG did not default on its obligations and bring other institutions down with it!

The second story (and the one getting press) comes from the retention bonuses that AIG paid out, after it received the bailout money. While the payments may fail the political and populist tests, they too may have been merited. Why should you reward those who created the problems with bonuses, you ask? Remember that the vast majority of the employees at AIG did their jobs and added value to the organization. They had no role in creating this mess. A handful or risk takers brought the firm down. In the aftermath of the crisis, the firm had to do everything it could to keep the good employees from fleeing. After all, what would be the point of saving the institution, if its biggest asset (human capital) departs? I don't know enough to pass judgment, but methinks that the legislators protest too much.

Dealing with Hybrids

One of my favorite devices to introduce concepts in valuation and corporate finance is a financial balance sheet. Unlike an accounting balance sheet, a financial balance sheet is a forward looking instrument. On the asset side of this balance sheet, there are only two categories for assets: assets in place, i.e., the value of investments that have already been made by the firm and growth assets, i.e., the value added by investments that I expect the firm to make in the future. On the liability side of the balance sheet, there are only two items as well: Borrowed money (debt) or owners' funds (equity).

While I hold fast to the belief that all financing has to come from debt or equity, and that the cost of capital is a weighted average of the costs of these two funding sources, hybrid securities pose both a conceptual and a practical challenge. Hybrids, of course, are financing choices that are part debt and part equity. A classic is convertible debt, where the lender (bondholder) has the option to convert to equity at a fixed price. Convertible debt has a debt component (the traditional bond or loan, with a finite maturity and interest payments) and an equity component (the conversion option).

While I see companies and analysts treating convertible debt as a source of funding, separated from debt and equity, it is a bad idea for two reasons. First, it makes any attempt to optimize capital structure much more difficult - it is easier to find the optimal mix when you have two elements to work with, rather than three. Second, and this is my real problem with this approach, is that it can lead firms to make bad choices and here is why. Analysts who treat convertible debt as a financing choice often use the coupon rate on the convertible debt as the cost of convertible debt. This coupon rate will be low, because of the presence of the conversion option. A corporate treasurer who compares the cost of convertible debt to straight debt will then jump to the unsurprising conclusion that convertible debt is cheaper than straight debt and will lower the cost of capital... And analysts feed the illusion!

So, what should we do with hybrids? I would attempt to break the hybrid security down into its debt and equity components. With convertible debt, this is simple to do. Ignore the conversion option and value the convertible debt as if it were straight debt, i.e, take the present value of coupon payments and the face value using the pre-tax cost of debt for the firm's straight debt. With its low coupon rate, you will arrive at an estimate of value that is well below both face value and market value. That is the debt portion. Subtracting this from the market value of the convertible bond will yield the conversion option value: this is the equity portion. If the convertible debt is not traded, the conversion option will have to be valued using an option pricing model. Add the debt portion to the rest of the debt, the conversion option value to equity and presto: there is no hybrid left.

Almost debt hybrids can be dealt with using this technique. The one exception is preferred stock, a hybrid that is tough to categorize. More about what to do with that source of financing in my next post.

Wednesday, March 11, 2009

The Yankee infield and debt...

I have been a sports fan all my life, following (and playing) cricket, tennis and now baseball (especially since my sons are all big baseball fans). Since I have lived in New York now for almost 25 years, I have become a New York Yankee fan.. As some of you may know that Yankees have built a new billion dollar stadium (actually the city did...) and opening day is April 17. I was able to get on EBay and buy three tickets for the game.

I am really looking forward to that day but as the Yankees run on to the field, my thoughts will turn to debt and leverage and here is why. The Yankees have the most expensive infield in baseball history (and perhaps the highest payroll of any team in any sport):
At first base: Mark Teixeira: $22.5 million every year for the next 8 years
At second base: Robinson Cano, $7.5 million every year for the next 4 years
At short stop: Derek Jeter, $19 million every year for the next 2 years
At third base: Alex Rodriguez (injury healed and steroid free), $27.5 million a year for the next 9 years
Behind the plate: Jorge Posada, $13.5 million every year for the next 3 years
On the mound: CC Sabathia, $ 23 million every year for next 7 years

These contracts represent commmitments that have be met, no matter how well or badly the Yankees do as a team, and independently of how these stars play. In other words, they are debt commitments. Taking the present value of these commitments, using a pre-tax cost of debt of 6%, we arrive at an astounding sum of $561 million. Here are the implications:

1. Looking at the Yankee balance sheet will give us a misleading measure of how much they owe as a business Their conventional debt is a small number but adding the present value of commitments gives us a debt ratio that is much higher. (General lesson: Firms with significant fixed commitments, such as retailers and restaurants are much more highly levered than they look, based upon conventiional measures.)

2. Last year's Forbes estimate of the values of different sporting franchises put the Yankees on top of the list, with an estimated value of about $1.5 to $ 2 billion, with Manchester United just behind them. If you are wealthy enough to buy the Yankees for $ 1.5 billion, you really are paying close to $ 2.1 billion (since you are assuming the player contracts when you buy the team) (General lesson: When we use ratios like EV/EBITDA to value firms, and define EV = Debt + Equity - Cash, we should be including the present value of commitments in debt in computing enterprise value.)

3. From a corporate finance standpoint, firms that already have substantial fixed commitments for extended periods should be cautious about adding to these commitments. In other words, if the Yankees had decide to pay for their own stadium, I would have cautioned them against borrowing; I would have suggested selling a portion of the equity. (General lesson: A typical airline makes huge lease commitments to buy its planes. To add to these commitments by borrowing conventional debt seems to be asking for trouble. Yet, the typical airline still does it.. Any wonder that the sector is full of distressed companies?)

I am sure that I will be able to put all these thoughts out of my mind before the first pitch is thrown, but it adds to my contention that life is full of corporate finance lessons.

Saturday, March 7, 2009

What is debt?

Figuring out how much debt a company has outstanding is not only critical to assessing its default risk but is a central input into much of what we do in corporate finance (cost of capital, cost of equity and valuing equity). It is a topic we have been examining in both the corporate finance and valuation classes this week. 

I use three criteria to classify an item as debt. 
1. It gives rise to contractual (fixed) payments that have be made in both good times and bad.
2. These payments are tax deductible.
3. Failure to make these payments results in loss of control

Using these criteria, it is quite clear that all interest bearing debt (whether short term or long term, bank loans or corporate bonds) should be considered debt. Here are the more controversial items:

a. Accounts payable and supplier credit:  Generally, I would not include these items as debt and here is why. The interest expenses on accounts payable and supplier are not explicitly broken out. Consider how supplier credit works. You buy items from a supplier, and he lets you pay in 10 days or 50 days. If you pay in 10 days, you get a 2% discount, which you lose if you take the entire 50 days. When you use supplier credit to increase your cash flows, you give up the discount, which effectively is the interest you are paying on the credit. However, when you account for the expense, you record the total cost you pay as part of cost of goods sold and do not break out the discount lost as an interest payment. So, here is the trade off. If you want to count accounts payable as debt, you will have to go into your cost of good sold and break out the portion of that cost that is the foregone discount and show it as interest expense. That can be tough to do.

b. Lease commitments: By the same token, lease commitments should be treated as debt because they are (a) contactual commitments (b) tax deductible and (c) failing to pay them can expose you to legal consequences. We can debate whether they are closer to unsecured debt than secured debt, but not whether they are debt. For any retail or restaurant company, the bulk of the debt is in the form of  lease commitments and we should be considering the present value of these commitments as debt. For firms like the Gap, Walmart and Starbucks, 80-90% of the debt takes the form of lease commitments.

c. Under funded pension and health care obligations: We are trained in accounting classes to be conservative when it comes to debt and to count everything we can as debt. That advice serves us badly in valuation. If we start including under funded pension and health care obligations as debt, we will inflate debt ratios and reduce cost of capital. That does not strike me as conservative. I would ignore these as debt for cost of capital purposes, but will consider them as debt, later in the valuation, when I am intent on getting from firm value to equity value.

More posts on this as we go on, but that is it for now.

Friday, March 6, 2009

My favorite novels on financial markets

After that last rant, I am ready to get back to matters that are more pleasant. I love reading crime fiction and I consume everything I can get my hands on. Since I love reading about markets as well, a few of my favorite novels combine the best of both genres.

One of my favorite authors is David Liss. For those who have never had the pleasure of reading his novels, I would recommend his first novel, titled "The Conspiracy of Paper". Set in London at the time of the South Sea Bubble, the book is a fascinating period piece, describing the social setting of the city then. What makes it fun to read, though, is its description of the financial markets of the time and how swindlers took advantage of investors. In fact, as you read about the starting of rumors in pubs that then circulated among stock traders, you see the primitive versions of the financial press today. In fact, there are so many parallels that you can draw between then and now, that you realize that the more things change, the more they stay the same.

Almost as good is his third book called "The Coffee Trader", about the very first derivatives markets in coffee and commodities. Again, the close linkage between the development of market and commerce come alive as you read about the antics of traders in Amsterdam. Short squeezes and momentum investing have been around as long as markets have existed.

I must confess that I did not like his most recent book, "The Whiskey Rebels' as much. While it is built around the Whiskey Rebellion of 1794, it weaves in the story of Alexander Hamilton, the first Secretary of the Treasury of the United States, and his attempt to create a central bank... While it is about finance, I think that Liss is much better at describing the chaos of markets than he is in high finance.

Thursday, March 5, 2009

Why I cannot stand George Soros!

Let me start with a confession. There are some people I will pay not to listen to, and one of them is George Soros. First, let's dispense with the myth that this guy is a great investor. I don't know Buffett, but if I did, I would tell you that Soros is no Buffett. George Soros is a speculator who got lucky at two levels. The first was timing.. betting against the British pound in the early 1990s was perfect. The second was that he has made his big score betting against central banks that refused to face the facts.

There are many investors who mistake luck for skill and I would not blame Soros for doing the same, if it were his only fault. There are two things about the man that I find distasteful:
1. Moral high ground: I find it hard to listen to lectures on morality and ethics from Mr. Soros, A speculator who made his money on a few big bets should not be telling the rest of the world what constitutes good or moral behavior and why hard work should be rewarded.
2. False expertise: The Financial Times has been publishing a series of articles by Soros on how banking can be fixed in developed markets. A few years ago, Soros also told us what was wrong with the derivatives markets and why options and futures should be restricted, regulated or banned because they could be misused. Unfortunately, the man knows little about either. But, he made a lot of money on derivatives, you say... True! But we don't consider a guy who hits the jackpot on a slot machine in a casino to be an expert on probabilities, do we?

My point is a larger one. We assume that people who have been successful in investing know a great deal more about investing than we do. We buy their books, we listen to them on television and radio and worst of all, we entrust our savings to them at substantial cost. While this may be true in a few cases, it is not true in most. Most successful investors and traders are successful because they are lucky and not because of their intellectual prowess or investing smarts... it is better to be lucky than smart. A few of these investors (like Soros) let success get to their heads and start believing their own hype. They should be ignored!

Monday, March 2, 2009

Buffett: Man or Myth

Warren Buffett is now more myth than man. The investors who claim to follow Buffetology, read the Berkshire Hathaway annual report and actually make the trip to Omaha (the value investing Woodstock) numbers in the tens of thousands, if not millions. I think that we do a disservice to Buffett, when we put him on a pedestal and treat every word he says as gospel. At the risk of sounding like a curmudgeon, here is my take on Mr. Buffett.

Let's start with the obvious. Warren Buffett has been an incredibly successful investor and his string of successess cannot be explained by luck. He has been able to make money with diverse investment strategies, but with a core philosophy that has remained unchanged over the last four decades. That core philosophy: you buy a business, not a stock. Hence, his competitive advantage has been assessing the value of an underlying business, especially in chaotic times, and buying stock in that business, when the price is down.

Buffett has never been an activist investor, i.e., he has seldom taken positions in poorly managed companies and tried to change the management. In fact, one of his criteria for investing in a company is that he admires the management. He has also never been comfortable straying from his niche, which is mature businesses: I cannot think of a single, big investment that he has made in a technology or young company.

I like to read Buffett's comments on the markets. Unlike many market strategists at investment banks, who cloak their recommendations in buzz words and hedge them until they are meaningless, Buffett is to the point and says what he means. His emphasis on corporate governance puts most institutional investors to shame.

My only real issue with Buffett is that he sometimes lets his "Aw, shucks! I am just a regular investor" persona cover up two things that he does that contribute to his success. One is his careful focus on cash flows; he might not use the terminology of valuation but Buffett has been using free cash flows to measure investments for as long as he has been investing. The second is that he is now an insider in many of the companies that he invests in; he has an advantage over you or I, when taking the same investments.

One final point about Buffett. The mythology is that Buffett does not adjust for risk, when he invests. I have even heard people say that he settles for the riskfree rate. Right? Buffett may not use betas or risk-adjusted discount rates but he certainly factors risk into the analysis by making conservative estimates of the cash flows. In effect, he reduces the expected cash flows of riskier businesses, i.e., uses certainty equivalents.

Be like Buffett, if that is what you want to do. But don't view this as a license to ignore risk and to just buy companies with good management (no matter what the price). You are almost certainly not going to make money that way.