Margin of Safety Seth Klarman

8/13/2019 Margin of Safety Seth Klarman

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MARGIN OF SAFETY Risk-Averse Value Investing Strategies for the Thoughtful Investor

Seth A. KlarmanHarperBusiness

A Division of Harper Colllins Publishers



Contents

Acknowledgments ix

Introduction xiii

I Where Most Investors Stumble 1

1 Speculators and Unsuccessful Investors 3

2 The Nature of Wall Street Works Against Investors 1

3 The Institutional !erfor"ance #er$%& The 'lient Is the (oser 3)

* #elusions of +alue& The ,%ths and ,isconceptions of -unk Bonds in the 1./s ))

II A alue!Investment "h#loso$h% &'

) #efining 0our Invest"ent oals .1

+alue Investing& The I"portance of a ,argin of Safet% .

At the 4oot of a +alue5Invest"ent !hilosoph% 1/)

. The Art of Business +aluation 11.

III The alue!Investment "ro(ess 1)'

Invest"ent 4esearch& The 'hallenge of 6inding Attractive Invest"ents 1)1

1/ Areas of 7pportunit% for +alue Investors& 'atal%sts8 ,arket Inefficiencies8 and Institutional 'onstraints12

11 Investing in Thrift 'onversions 1.2

12 Investing in 6inanciall% #istressed and Bankrupt Securities 1.

13 !ortfolio ,anage"ent and Trading 2/

1* Invest"ent Alternatives for the Individual Investor 222

Glossary **'

ibliography *)1Index *)+



A(,no-le/ments

While al9a%s interested in the 9orkings of Wall Street8 I 9as e:tre"el% fortunate in

"% first real ;o$ to have the opportunit% to 9ork alongside ,ichael !rice and the late

,a: (< Heine at ,utual Shares 'orporation =no9 ,utual Series 6und8 Inc<>5 ,% uncle

!aul 6ried"an al9a%s encouraged "% interest in investing and helped "e land that

;o$< I look $ack on "% e:perience at ,utual Shares ver% fondl%< ,% learning in the

t9o %ears 9orking 9ith ,a: and ,ike pro$a$l% eclipsed 9hat I learned in the

su$se?uent t9o %ears at Harvard Business School< It is to ,a:@s "e"or% that I

dedicate this $ook<

After earning "% ,BA at Harvard8 I 9as faced 9ith several e:citing career

choices< The unconventional offer to ;oin a startup invest"ent5"anage"ent fir" in

'a"$ridge8 ,assachusetts8 presented the opportunit% to $egin $uilding an

invest"ent track record earl% in "% career< And so it 9as that I ;oined Bill !oorvu8

Isaac Auer$ach8 -ordan Baruch8 Ho9ard Stevenson8 and -o5An Bos9orth in for"ing

the Baupost roup< ach of "% colleaguesHo9ard in particular9ent out on a

long8 thin li"$ to $et on "e and "% a$ilities8 not onl% to "anage their o9n "one%

$ut also that of their fa"ilies and close friends8 9hich 9as perhaps the greater act of

faith< It has $een "% great privilege to $e associated 9ith such kno9ledgea$le8

energetic8 9ar"8 and caring people< Together 9e have $uilt so"ething to $e proud

of<

It has also $een a privilege to 9ork alongside !aul 7@(ear%8 #avid A$ra"s8 and no9

To" Cnott8 "% $rilliant and dedicated

i:



0 ACKNOWE2GMENTS

invest"ent tea" and in5house dou$les ga"e< I a" grateful to each of the" for his

"an% insights and o$servations8 a nu"$er of 9hich appear in one for" or another in

this 9ork<

I a" also fortunate to have so"e of the finest clients a professional investor could

have< A nu"$er of the" encouraged "e in this endeavor< While I shall respect their

privac% $% not na"ing the"8 their patience8 interest8 and support have $een ke%

ele"ents in our invest"ent success<

,% nine %ears at Baupost have $rought "e into contact 9ith "an% of the

finest people in the invest"ent $usiness8 on $oth the $u% side and the sell side< I a"

grateful to each of the" for teaching "e so "uch a$out this $usiness and for putting

up 9ith "e 9hen I 9as having a $ad da%< Though the% are too nu"erous to thank

individuall%8 I o9e each of the" a great deal<

I do 9ish to thank the people 9ho have $een especiall% helpful 9ith this pro;ect< ,%

colleagues at BaupostHo9ard8 #avid8 !aul8 and To"each revie9ed the

"anuscript as it neared co"pletion as did four special friends8 (ou (o9enstein8 #avid

#arst8 Henr% "erson8 and Bret 6ro"son< A nu"$er of other friends "ade ver%

helpful suggestions at earlier stages of this pro;ect< -ess 4avich8 in particular8 offered

"an% valua$le insights into the ;unk5$ond and $ankruptc% sections< 6inall%8 -i"

rant8 perhaps 9ithout realiDing it8 inspired "e to take on this challenge< I thank

each of the" for their help8 and far "ore i"portant8 I 9ill al9a%s cherish their

friendship<

,% 9ife8 Beth Clar"an8 offered the fresh perspective of a non5financial5

professional as she devotedl% read ever% chapter and "ade nu"erous helpful

reco""endations< She also "ade ever% acco""odation to help free up ti"e for "e

to devote to this pro;ect and urged "e to press on to co"pletion the "an% ti"es

9hen progress 9as slo9< I thank her for $eing a great 9ife and "other and "% $est

friend<

,% father8 Her$ Clar"an8 9as perhaps the "ost careful reader of "ultiple

drafts of this "anuscript< He is a true crafts"an of the art of 9riting8 and his

co""ents are literall% incorporated on ever% page of this $ook< I thank hi" for histre"endous assistance<



Acknowledgments :i

I also 9ant to thank "% "other8 ,uriel Clar"an8 for teaching "e to ask ?uestions

and encouraging "e to discover the ans9ers<

6inall% I "ust ackno9ledge the e:traordinar% efforts of ,ark reen$erg8 "%

editor at HarperBusiness8 and ,itch Tuch"an8 "% develop"ental editor8 in i"provingthis "anuscript in so "an% 9a%s< I thank the" $oth for their help in seeing this

pro;ect to fruition< I also o9e thanks to ,artha -e9ett8 9ho "ade helpful co""ents

on an earl% draft8 and special thanks to +irginia S"ith8 9ho proposed this pro;ect out

of the $lue<

-ac?ui 6iorenDa8 ,ike Ha""ond8 and Susie Spero 9ere of enor"ous

assistance 9ith the t%ping and ret%ping of this "anuscript< Cathr%n !otts "ade

nu"erous editorial suggestions and helped to prepare the glossar%< 'arol%n

Beckedorff provided research assistance as needed<

As 9ith an% 9ork such as this8 full responsi$ilit% for errors "ust $e $orne $% the

author< I hope those that re"ain are "inor and fe9 in nu"$er<



Introu(t#onInvestors adopt "an% different approaches that offer little or no real prospect of long5

ter" success and considera$le chance of su$stantial econo"ic loss< ,an% are not

coherent invest"ent progra"s at all $ut instead rese"$le speculation or outright

ga"$ling< Investors are fre?uentl% lured $% the prospect of ?uick and eas% gain and

fall victi" to the "an% fads of Wall Street< ,% goals in 9riting this $ook are t9ofold<

In the first section I identif% "an% of the pitfalls that face investors< B% highlighting

9here so "an% go 9rong8 I hope to help investors learn to avoid these losing

strategies<

6or the re"ainder of the $ook I reco""end one particular path for investors

to follo9a value5invest"ent philosoph%< +alue investing8 the strateg% of investing

in securities trading at an apprecia$le discount fro" underl%ing value8 has a long his5

tor% of delivering e:cellent invest"ent results 9ith ver% li"ited do9nside risk< This

$ook e:plains the philosoph% of value investing and8 perhaps "ore i"portantl%8 the

logic $ehind it in an atte"pt to de"onstrate 9h% it succeeds 9hile other approaches

fail<

I have chosen to $egin this $ook8 not 9ith a discussion of 9hat value investors

do right8 $ut 9ith an assess"ent of 9here other investors go 9rong8 for "an% "ore

investors lose their 9a% along the road to invest"ent success than reach their desti5

nation< It is eas% to stra% $ut a continuous effort to re"ain disciplined<

3



4#v INTRO25CTION

Avoiding 9here others go 9rong is an i"portant step in achieving invest"ent

success< In fact8 it al"ost ensures it<

0ou "a% $e 9ondering8 as several of "% friends have8 9h% I 9ould 9rite a

$ook that could encourage "ore people to $eco"e value investors< #on@t I run the

risk of encouraging increased co"petition8 there$% reducing "% o9n invest"ent

returnsE !erhaps8 $ut I do not $elieve this 9ill happen< 6or one thing8 value investing

is not $eing discussed here for the first ti"e< While I have tried to $uild the case for it

so"e9hat differentl% fro" "% predecessors and 9hile "% precise philosoph% "a%

var% fro" that of other value investors8 a nu"$er of these vie9s have $een

e:pressed $efore8 nota$l% $% Ben;a"in raha" and #avid #odd8 9ho "ore than fift%

%ears ago 9rote !ecurity Analysis" regarded $% "an% as the $i$le of value investing<

That single 9ork has illu"inated the 9a% for generations of value investors< ,ore

recentl% raha" 9rote #he Intelligent Investor" a less acade"ic description of the

value5invest"ent process< Warren Buffett8 the chair"an of Berkshire Hatha9a%8 Inc<8

and a student of raha"8 is regarded as toda%@s "ost successful value investor< He

has 9ritten countless articles and shareholder and partnership letters that together

articulate his value5invest"ent philosoph% coherentl% and $rilliantl%< Investors 9ho

have failed to heed such 9ise counsel are unlikel% to listen to "e<

The truth is8 I a" pained $% the disastrous invest"ent results e:perienced $% great

nu"$ers of unsophisticated or undisciplined investors< If I can persuade ;ust a fe9 of

the" to avoid dangerous invest"ent strategies and adopt sound ones that are

designed to preserve and "aintain their hard5earned capital8 I 9ill $e satisfied< If I

should have a 9ider influence on investor $ehavior8 then I 9ould gladl% pa% the price

of a "odest di"inution in "% o9n invest"ent returns<

In an% event this $ook alone 9ill not turn an%one into a successful value investor<

+alue investing re?uires a great deal of hard 9ork8 unusuall% strict discipline8 and a

long5ter" invest"ent horiDon< 6e9 are 9illing and a$le to devote sufficient ti"e and

effort to $eco"e value investors8 and onl% a fraction of those have the proper "ind5

set to succeed<



Introduction .

This $ook "ost certainl% does not provide a surefire for"ula for invest"ent

success< There is8 of course8 no such for"ula< 4ather this $ook is a $lueprint that8 if

carefull% follo9ed8 offers a good possi$ilit% of invest"ent success 9ith li"ited risk< I

$elieve this is as "uch as investors can reasona$l% hope for<Ideall% this 9ill $e considered8 not a $ook a$out investing8 $ut a $ook a$out

thinking a$out investing< (ike "ost eighth5grade alge$ra students8 so"e investors

"e"oriDe a fe9 for"ulas or rules and superficiall% appear co"petent $ut do not

reall% understand 9hat the% are doing< To achieve long5ter" success over "an%

financial "arket and econo"ic c%cles8 o$serving a fe9 rules is not enough< Too "an%

things change too ?uickl% in the invest"ent 9orld for that approach to succeed< It is

necessar% instead to understand the rationale $ehind the rules in order to appreciate

9h% the% 9ork 9hen the% do and don@t 9hen the% don@t< I could si"pl% assert that

value investing 9orks8 $ut I hope to sho9 %ou why it 9orks and 9h% "ost other

approaches do not<

If interplanetar% visitors landed on arth and e:a"ined the 9orkings of our financial

"arkets and the $ehavior of financial5"arket participants8 the% 9ould no dou$t

?uestion the intelligence of the planet@s inha$itants< Wall Street8 the financial

"arketplace 9here capital is allocated 9orld9ide8 is in "an% 9a%s ;ust a gigantic

casino< The recipient of up5front fees on ever% transaction8 Wall Street clearl% is "ore

concerned 9ith the volu"e of activit% than its econo"ic utilit%< !ension and

endo9"ent funds responsi$le for the securit% and enhance"ent of long5ter"

retire"ent8 educational8 and philanthropic resources e"plo% invest"ent "anagers

9ho freneticall% trade long5ter" securities on a ver% short5ter" $asis8 each tr%ing to

outguess and conse?uentl% outperfor" others doing the sa"e thing< In addition8

hundreds of $illions of dollars are invested in virtual or co"plete ignorance of

underl%ing $usiness funda"entals8 often using inde:ing strategies designed to avoid

significant underperfor"ance at the cost of assured "ediocrit%<



4# INTRO25CTION

Individual and institutional investors alike fre?uentl% de"onstrate an ina$ilit%

to "ake long5ter" invest"ent deci sions $ased on $usiness funda"entals < There are

a nu"$er of reasons for this& a"ong the" the perfor"ance pressures faced $%

institutional investors8 the co"pensation structure of Wall Street8 and the frenDied

at"osphere of the financial "arkets< As a result8 investors8 particularl% institutional

investors8 $eco"e en"eshed in a short5ter" relative5perfor"ance der$%8 9here$%

te"porar% price fluctuations $eco"e the do"inant focus< 4elative5perfor"ance5

oriented investors8 alread% focused on short5ter" returns8 fre?uentl% are attracted to

the latest "arket fads as a source of superior relative perfor"ance< The te"ptation

of "aking a fast $uck is great8 and "an% investors find it difficult to fight the cro9d<

Investors are so"eti"es their o9n 9orst ene"ies< When prices are generall%

rising8 for e:a"ple8 greed leads investors to speculate8 to "ake su$stantial8 high5risk

$ets $ased upon opti"istic predictions8 and to focus on return 9hile ignoring risk< At

the other end of the e"otional spectru"8 9hen prices are generall% falling8 fear of

loss causes investors to focus solel% on the possi$ilit% of continued price declines to

the e:clusion of invest"ent funda"entals< 4egardless of the "arket environ"ent8

"an% investors seek a for"ula for success< The unfortunate realit% is that invest"ent

success cannot $e captured in a "athe"atical e?uation or a co"puter progra"<

The first section of this $ook8 chapters 1 through *8 e:a"ines so"e of the places

9here investors stu"$le< 'hapter 1 e:plores the differences $et9een investing and

speculation and $et9een successful and unsuccessful investors8 e:a"ining in

particular the role of "arket price in investor $ehavior< 'hapter 2 looks at the 9a%

Wall Street8 9ith its short5ter" orientation8 conflicts of interest8 and up9ard $ias8

"a:i"iDes its o9n $est interests8 9hich are not necessaril% also those of investors<

'hapter 3 e:a"ines the $ehavior of institutional investors8 9ho have co"e to

do"inate toda%@s financial "arkets<

'hapter * uses the case stud% of ;unk $onds to illustrate "an% of the pitfallshighlighted in the first three chapters<



Introduction 1/ The rapid gro9th of the "arket for ne9l% issued ;unk $onds 9as onl% "ade possi$le

$% the co"plicit% of investors 9ho suspended dis$elief< -unk5$ond $u%ers greedil%

accepted pro"ises of a free lunch and 9illingl% adopted ne9 and unproven "ethods

of anal%sis< Neither Wall Street nor the institutional invest"ent co""unit% o$;ected

vocall% to the 9idespread proliferation of these fla9ed instru"ents<

Investors "ust recogniDe that the ;unk5$ond "ania 9as not a once5in5a5

"illenniu" "adness $ut instead part of the historical e$$ and flo9 of investor

senti"ent $et9een greed and fear< The i"portant point is not "erel% that ;unk $onds

9ere fla9ed =although the% certainl% 9ere> $ut that investors "ust learn fro" this

ver% avoida$le de$acle to escape the ne:t enticing "arket fad that 9ill inevita$l%

co"e along<

A second i"portant reason to e:a"ine the $ehavior of other investors and

speculators is that their actions often inadvertentl% result in the creation of

opportunities for value investors< Institutional investors8 for e:a"ple8 fre?uentl% act

as lu"$ering $ehe"oths8 tra"pling so"e securities to large discounts fro"

underl%ing value even as the% ignore or constrain the"selves fro" $u%ing others<

Those the% decide to purchase the% $u% 9ith gustoF "an% of these favorites $eco"e

significantl% overvalued8 creating selling =and perhaps short5selling> opportunities<

Herds of individual investors acting in tande" can si"ilarl% $id up the prices of so"e

securities to craD% levels8 even as others are ignored or uncere"oniousl% du"ped<

A$etted $% Wall Street $rokers and invest"ent $ankers8 "an% individual as 9ell as

institutional investors either ignore or deli$eratel% disregard underl%ing $usinessvalue8 instead regarding stocks solel% as pieces of paper to $e traded $ack and forth<

The disregard for invest"ent funda"entals so"eti"es affects the entire stock

"arket< 'onsider8 for e:a"ple8 the enor"ous surge in share prices $et9een -anuar%

and August of 1. and the ensuing "arket crash in 7cto$er of that %ear< In the

9ords of Willia" 4uane and 4ichard 'unniff8 chair"an and



11 INTRO25CTION

president of the Se?uoia 6und8 Inc<8 G#isregarding for the "o"ent 9hether the

prevailing level of stock prices on -anuar% 18 1. 9as logical8 9e are certain that the

value of A"erican industr% in the aggregate had not increased $% ** as of August

2)< Si"ilarl%8 it is highl% unlikel% that the value of A"erican industr% declined $% 23

on a single da%8 7cto$er 1<G1

Ulti"atel% investors "ust choose sides< 7ne sidethe 9rong choiceis a

see"ingl% effortless path that offers the co"fort of consensus< This course involves

succu"$ing to the forces that guide "ost "arket participants8 e"otional responses

dictated $% greed and fear and a short5ter" orientation e"anating fro" the relative5

perfor"ance der$%< Investors follo9ing this road increasingl% think of stocks like

so9$ellies8 as co""odities to $e $ought and sold< This ulti"atel% re?uires investors

to spend their ti"e guessing 9hat other "arket participants "a% do and then tr%ing

to do it first< The pro$le" is that the e:citing possi$ilit% of high near5ter" returns

fro" pla%ing the stocks5as5pieces5of5paper5that5%ou5trade ga"e $linds investors to

its foolishness<

The correct choice for investors is o$vious $ut re?uires a level of co""it"ent

"ost are un9illing to "ake< This choice is kno9n as funda"ental anal%sis8 9here$%

stocks are regarded as fractional o9nership of the underl%ing $usinesses that the%

represent< 7ne for" of funda"ental anal%sisand the strateg% that I reco""endis

an invest"ent approach kno9n as value investing<

There is nothing esoteric a$out value investing< It is si"pl% the process of

deter"ining the value underl%ing a securit% and then $u%ing it at a considera$le

discount fro" that value< It is reall% that si"ple< The greatest challenge is

"aintaining the re?uisite patience and discipline to $u% onl% 9hen prices are

attractive and to sell 9hen the% are not8 avoiding the short5ter" perfor"ance frenD%

that engulfs "ost "arket participants<

The focus of "ost investors differs fro" that of value investors< ,ost investors

are pri"aril% oriented to9ard return8 ho9 "uch the% can "ake8 and pa% little

attention to risk8 ho9 "uch the% can lose<







Introduction 1* Throughout this $ook I criticiDe certain aspects of the invest"ent $usiness as

currentl% practiced< ,an% of these criticis"s of the industr% appear as

generaliDations and refer "ore to the pressures $rought a$out $% the structure of the

invest"ent $usiness than the failings of the individuals 9ithin it<

I also give nu"erous e:a"ples of specific invest"ents throughout this $ook<

,an% of the" 9ere "ade over the past nine %ears $% "% fir" for the $enefit of our

clients and indeed proved ?uite profita$le< The fact that 9e "ade "one% on the" is

not the point8 ho9ever< ,% goal in including the" is to de"onstrate the variet% of

value5invest"ent opportunities that have arisen and $eco"e kno9n to "e during the

past decadeF an e?uall% long and rich list of e:a"ples failed to "ake it into the final

"anuscript<

I find value investing to $e a sti"ulating8 intellectuall% challenging8 ever

changing8 and financiall% re9arding discipline< I hope %ou invest the ti"e to

understand 9h% I find it so in the pages that follo9<

Notes1< Se?uoia 6und8 Inc<8 third ?uarter report for 1.<



IW6ERE MOST INESTORS

ST5M7E





1 W6ERE MOST INESTORS ST5M7E

Investors in a stock thus e:pect to profit in at least one of three possi$le 9a%s& fro"

free cash flo9 generated $% the underl%ing $usiness8 9hich eventuall% 9ill $e

reflected in a higher share price or distri$uted as dividendsF fro" an increase in the

"ultiple that investors are 9illing to pa% for the underl%ing $usiness as reflected in ahigher share priceF or $% a narro9 ing of the gap $et9een share price and underl%ing

$usiness value<

Speculators8 $% contrast8 $u% and sell securities $ased on 9hether the%

$elieve those securities 9ill ne:t rise or fall in price< Their ;udg"ent regarding future

price "ove"ents is $ased8 not on funda"entals8 $ut on a prediction of the $ehavior

of others< The% regard securities as pieces of paper to $e s9apped $ack and forth

and are generall% ignorant of or indifferent to invest"ent funda"entals< The% $u%

securities $ecause the% GactG 9ell and sell 9hen the% don@t< Indeed8 even if it 9ere

certain that the 9orld 9ould end to"orro98 it is likel% that so"e speculators 9ould

continue to trade securities $ased on 9hat the% thought the "arket 9ould do toda%<

Speculators are o$sessed 9ith predictingguessingthe direction of stock

prices< ver% "orning on ca$le television8 ever% afternoon on the stock "arket

report8 ever% 9eekend in arron$s" ever% 9eek in doDens of "arket ne9sletters8 and

9henever $usinesspeople get together8 there is ra"pant con;ecture on 9here the

"arket is heading< ,an% speculators atte"pt to predict the "arket direction $% using

technical anal%sis past stock price fluctuationsas a guide< Technical anal%sis is

$ased on the presu"ption that past share price "eanderings8 rather than underl%ing

$usiness value8 hold the ke% to future stock prices< In realit%8 no one kno9s 9hat the

"arket 9ill doF tr%ing to predict it is a 9aste of ti"e8 and investing $ased upon that

prediction is a speculative undertaking<

,arket participants do not 9ear $adges that identif% the" as investors or

speculators< It is so"eti"es difficult to tell the t9o apart 9ithout stud%ing their

$ehavior at length< :a"ining 9hat the% o9n is not a givea9a%8 for an% securit% can

$e o9ned $% investors8 speculators8 or $oth< Indeed8 "an% Ginvest"ent

professionalsG actuall% perfor" as speculators "uch of the ti"e



!peculators and %nsuccessful Investors &'

$ecause of the 9a% the% define their "ission8 pursuing short5ter" trading profits

fro" predictions of "arket fluctuations rather than long5ter" invest"ent profits

$ased on $usiness funda"entals< As 9e shall see8 investors have a reasona$le

chance of achieving long5ter" invest"ent successF speculators8 $% contrast8 are

likel% to lose "one% over ti"e<

Tra#n/ Sar#nes an Eat#n/ Sar#nes9The Essen(e o8 S$e(ulat#on

There is the old stor% a$out the "arket craDe in sardine trading 9hen the sardines

disappeared fro" their traditional 9aters in ,ontere%8 'alifornia< The co""odit%

traders $id the" up and the price of a can of sardines soared< 7ne da% a $u%er

decided to treat hi"self to an e:pensive "eal and actuall% opened a can and started

eating< He i""ediatel% $eca"e ill and told the seller the sardines 9ere no good< The

seller said8 G0ou don@t understand< These are not eating sardines8 the% are trading

sardines<G

(ike sardine traders8 "an% financial5"arket participants are attracted to

speculation8 never $othering to taste the sardines the% are trading< Speculation

offers the prospect of instant gratificationF 9h% get rich slo9l% if %ou can get rich

?uickl%E ,oreover8 speculation involves going along 9ith the cro9d8 not against it<

There is co"fort in consensusF those in the "a;orit% gain confidence fro" their ver%

nu"$er<

Toda% "an% financial5"arket participants8 kno9ingl% or unkno9ingl%8 have

$eco"e speculators< The% "a% not even realiDe that the% are pla%ing a Ggreater5fool

ga"e8G $u%ing overvalued securities and e:pectinghopingto find so"eone8 a

greater fool8 to $u% fro" the" at a still higher price<

There is great allure to treating stocks as pieces of paper that trade< +ie9ing

stocks this 9a% re?uires neither rigorous anal%sis nor kno9ledge of the underl%ing

$usinesses< ,oreover8 trading in and of itself can $e e:citing and8 as long as the "ar5

ket is rising8 lucrative< But essentiall% it is speculating8 not investing< 0ou "a% find a

$u%er at a higher price a greater foolor %ou "a% not8 in 9hich case %ou %ourself

are the greater fool<




+alue investors pa% attention to financial realit% in "aking their invest"ent

decisions< Speculators have no such tether< Since "an% of toda%@s "arket

participants are speculators and not investors8 $usiness funda"entals are not

necessaril% a li"iting factor in securities pricing< The resulting propensit% of the stock"arket to periodicall% $eco"e and re"ain overvalued is all the "ore reason for

funda"ental investors to $e careful8 avoiding an% overpriced invest"ents that 9ill

re?uire selling to another8 even greater fool<

Speculative activit% can erupt on Wall Street at an% ti"e and is not usuall%

recogniDed as such until considera$le ti"e has passed and "uch "one% has $een

lost< In the "iddle of 1.38 to cite one e:a"ple8 the capital "arkets assigned a

co"$ined "arket value of over ) $illion to t9elve pu$licl% traded8 venture5capital5

$acked Winchester disk5drive "anufacturers< Bet9een 1 and 1.* fort%5three

different "anufacturers of Winchester disk drives received venture5capital financing<

A Harvard Business School stud% entitled G'apital ,arket ,%opiaG2 calculated that

industr% funda"entals =as of "id51.3> could not then nor in the foreseea$le future

have ;ustified the total "arket capitaliDation of these co"panies< The stud%

deter"ined that a fe9 fir"s "ight ulti"atel% succeed and do"inate the industr%8

9hile "an% of the others 9ould struggle or fail< The high potential returns fro" the

9inners8 if an% e"erged8 9ould not offset the losses fro" the others< While investors

at the ti"e "a% not have realiDed it8 the shares of these disk5drive co"panies 9ere

essentiall% Gtrading sardines<G This speculative $u$$le $urst soon thereafter8 9ith the

total "arket capitaliDation of these co"panies declining fro" )<* $illion in "id51.3

to 1<) $illion at %ear5end 1.*< Another e:a"ple of such speculative activit% took

place in Septe"$er 1.< The shares of the Spain 6und8 Inc<8 a closed5end "utual

fund investing in pu$licl% traded Spanish securities8 9ere $id up in price fro"

appro:i"atel% net asset value =NA+>the co"$ined "arket value of the underl%ing

invest"ents divided $% the nu"$er of shares outstandingto "ore than t9ice that

level< ,uch of the $u%ing e"anated fro" -apan8 9here underl%ing value 9as

evidentl% less i"portant to investors than other considerations<



!peculators and %nsuccessful Investors ()

Although an identical portfolio to that o9ned $% the Spain 6und could have $een

freel% purchased on the Spanish stock "arket for half the price of Spain 6und shares8

these -apanese speculators 9ere not deterred< The Spain 6und priced at t9ice net

asset value 9as another e:a"ple of trading sardinesF the onl% possi$le reason for

$u%ing the Spain 6und rather than the underl%ing securities 9as the $elief that its

shares 9ould appreciate to an even "ore overpriced level< Within "onths of the

speculative advance the share price plunged $ack to pre5rall% levels8 once again

appro:i"ating the NA+8 9hich itself had never significantl% fluctuated<

6or still another e:a"ple of speculation on Wall Street8 consider the U<S<

govern"ent $ond "arket in 9hich traders $u% and sell $illions of dollars@ 9orth of

thirt%5%ear U<S< Treasur% $onds ever% da%< ven long5ter" investors seldo" hold

thirt%5%ear govern"ent $onds to "aturit%< According to Al$ert Wo;nilo9er8 the

average holding period of U<S< Treasur% $onds 9ith "aturities of ten %ears or "ore is

onl% t9ent% da%s<3 !rofessional traders and so5called investors alike priDe thirt%5%ear

Treasur% $onds for their li?uidit% and use the" to speculate on short5ter" interest

rate "ove"ents8 9hile never conte"plating the prospect of actuall% holding the" to

"aturit%< 0et so"eone 9ho $u%s long5ter" securities intending to ?uickl% resell

rather than hold is a speculator8 and thirt%5%ear Treasur% $onds have also effectivel%

$eco"e trading sardines< We can all 9onder 9hat 9ould happen if the thirt%5%ear

Treasur% $ond fell fro" favor as a speculative vehicle8 causing these short5ter"

holders to rush to sell at once and turning thirt%5%ear Treasur% $onds $ack into eatingsardines<

Investments an S$e(ulat#ons

-ust as financial5"arket participants can $e divided into t9o groups8 investors

and speculators8 assets and securities can often $e characteriDed as either

invest"ents or speculations<




The distinction is not clear to "ost people< Both invest"ents and speculations can $e

$ought and sold< Both t%picall% fluctu ate in price and can thus appear to generate

invest"ent returns< But there is one critical difference& invest"ents thro9 off cash

flo9 for the $enefit of the o9nersF speculations do not<

*

The% return to the o9ners ofspeculations depends e:clusivel% on the vagaries of the resale "arket<

The greed% tendenc% to 9ant to o9n an%thing that has recentl% $een rising in

price lures "an% people into purchasing speculations< Stocks and $onds go up and

do9n in price8 as do ,onets and ,icke% ,antle rookie cards8 $ut there should $e no

confusion as to 9hich are the true invest"ents< 'ollecti$les8 such as art8 anti?ues8

rare coins8 and $ase$all cards8 are not invest"ents8 $ut rank speculations< This "a%

not $e of conse?uence to the 'hase ,anhattan Bank8 9hich in the late 1./s for"ed

a fund for its clients to invest in art8 or to #avid (< !aul8 for"er chair"an of the no9

insolvent 'enTrust Savings and (oan Association8 9ho spent 13 "illion of the thrift@s

"one% to purchase ;ust one painting< ven Wall Street8 9hich kno9s $etter8 chooses

at ti"es to $lur the distinction< Salo"on Brothers8 for e:a"ple8 no9 pu$lishes the

rate of return on various asset classes8 including in the sa"e list U<S< Treasur% $ills8

stocks8 i"pressionist and old "aster paintings8 and 'hinese cera"ics< In Salo"on@s

-une 1. rankings the latter categories 9ere ranked at the top of the list8 far

outdistancing the returns fro" true invest"ents<

Invest"ents8 even ver% long5ter" invest"ents like ne9l% planted ti"$er

properties8 9ill eventuall% thro9 off cash flo9< A "achine "akes 9idgets that are

"arketed8 a $uilding is occupied $% tenants 9ho pa% rent8 and trees on a ti"$er

propert% are eventuall% harvested and sold< B% contrast8 collecti$les thro9 off no

cash flo9F the onl% cash the% can generate is fro" their eventual sale< The future

$u%er is like9ise dependent on his or her o9n prospects for resale<

The value of collecti$les8 therefore8 fluctuates solel% 9ith suppl% and de"and<

'ollecti$les have not historicall% $een recogniDed as stores of value8 thus their prices

depend on the vagaries of taste8 9hich are certainl% su$;ect to change<



!peculators and %nsuccessful Investors ((

The apparent value of collecti$les is $ased on circular reasoning& people $u% $ecause

others have recentl% $ought< This has the effect of $idding up prices8 9hich attracts

pu$licit% and creates the illusion of attractive returns< Such logic can fail at an% ti"e<

Invest"ent success re?uires an appropriate "ind5set< Investing is serious

$usiness8 not entertain"ent< If %ou participate in the financial "arkets at all8 it is

crucial to do so as an investor8 not as a speculator8 and to $e certain that %ou

understand the difference< Needless to sa%8 investors are a$le to distinguish !epsico

fro" !icasso and understand the difference $et9een an invest"ent and a collecti$le<

When %our hard5earned savings and future financial securit% are at stake8 the cost of

not distinguishing is unaccepta$l% high<

The 2#88eren(es bet-een Su((ess8ul an

5nsu((ess8ul Investors

Successful investors tend to $e une"otional8 allo9ing the greed and fear of others to

pla% into their hands< B% having confidence in their o9n anal%sis and ;udg"ent8 the%

respond to "arket forces not 9ith $lind e"otion $ut 9ith calculated reason<

Successful investors8 for e:a"ple8 de"onstrate caution in froth% "arkets and

steadfast conviction in panick% ones< Indeed8 the ver% 9a% an investor vie9s the

"arket and its price fluctuations is a ke% factor in his or her ulti"ate invest"entsuccess or 6ailure<

Taking Advantage of ,r< ,arket

I 9rote earlier that financial5"arket participants "ust choose $et9een

invest"ent and speculation< Those 9ho =9isel%> choose invest"ent are faced 9ith

another choice8 this ti"e $et9een t9o opposing vie9s of the financial "arkets< 7ne

vie98 9idel% held a"ong acade"ics and increasingl% a"ong institutional investors8




is that the financial "arkets are efficient and that tr%ing to outperfor" the averages

is futile< ,atching the "arket return is the $est %ou can hope for< Those 9ho atte"pt

to outperfor" the "arket 9ill incur high transaction costs and ta:es8 causing the" to

underperfor" instead< The other vie9 is that so"e securities are inefficientl% priced8 creating

opportunities for investors to profit 9ith lo9 risk< This vie9 9as perhaps $est

e:pressed $% Ben;a"in raha"8 9ho posited the e:istence of a ,r< ,arket<) An ever

helpful fello98 ,r< ,arket stands read% ever% $usiness da% to $u% or sell a vast arra%

of securities in virtuall% li"itless ?uantities at prices that he sets< He provides this

valua$le service free of charge< So"eti"es ,r< ,arket sets prices at levels 9here

%ou 9ould neither 9ant to $u% nor sell< 6re?uentl%8 ho9ever8 he $eco"es irrational<

So"eti"es he is opti"istic and 9ill pa% far "ore than securities are 9orth< 7ther

ti"es he is pessi"istic8 offering to sell securities for considera$l% less than

underl%ing value< +alue investors9ho $u% at a discount fro" underl%ing valueare

in a position to take advantage of ,r< ,arket@s irrationalit%<

So"e investorsreall% speculators"istakenl% look to ,r< ,arket for

invest"ent guidance< The% o$serve hi" setting a lo9er price for a securit% and8

un"indful of his irrationalit%8 rush to sell their holdings8 ignoring their o9n

assess"ent of underl%ing value< 7ther ti"es the% see hi" raising prices and8 trusting

his lead8 $u% in at the higher figure as if he knew more than they* The realit% is that

,r< ,arket kno9s nothing8 $eing the product of the collective action of thousands of

$u%ers and sellers 9ho the"selves are not al9a%s "otivated $% invest"ent

funda"entals< "otional investors and speculators inevita$l% lose "one%F investors

9ho take advantage of ,r< ,arket@s peri odic irrationalit%8 $% contrast8 have a good

chance of en;o%ing long5ter" success<

,r< ,arket@s dail% fluctuations "a% see" to provide feed$ack for investors@

recent decisions< 6or a recent purchase decision rising prices provide positive

reinforce"entF falling prices8 negative reinforce"ent< If %ou $u% a stock that

su$se?uentl% rises in price8 it is eas% to allo9 the positive feed$ack provided $% ,r<

,arket to influence %our ;udg"ent<





2) W6ERE MOST INESTORS ST5M7E

reflect $usiness realit% =or investor perceptions of that realit%> or to reflect short5ter"

variations in suppl% and de"and< 4ealit% can change in a nu"$er of 9a%s8 so"e

co"pan%5specific8 others "acroecono"ic in nature< If 'oca5'ola@s $usiness e:pands

or prospects i"prove and the stock price increases proportionall%8 the rise "a%si"pl% reflect an increase in $usiness value< If Aetna@s share price plunges 9hen a

hurricane causes $illions of dollars in catastrophic losses8 a decline in total "arket

value appro:i"atel% e?ual to the esti"ated losses "a% $e appropriate< When the

shares of 6und A"erican 'o"panies8 Inc<8 surge as a result of the une:pected

announce"ent of the sale of its "a;or su$sidiar%8 6ire"an@s 6und Insurance

'o"pan%8 at a ver% high price8 the price increase reflects the sudden and nearl%

co"plete realiDation of underl%ing value< 7n a "acroecono"ic level a $road5$ased

decline in interest rates8 a drop in corporate ta: rates8 or a rise in the e:pected rate

of econo"ic gro9th could each precipitate a general increase in securit% prices<

Securit% prices so"eti"es fluctuate8 not $ased on an% apparent changes in

realit%8 $ut on changes in investor perception< The shares of "an% $iotechnolog%

co"panies dou$led and tripled in the first "onths of 118 for e:a"ple despite a lack

of change in co"pan% or industr% funda"entals that could possi$l% have e:plained

that "agnitude of increase< The onl% e:planation for the price rise 9as that investors

9ere suddenl% 9illing to pa% "uch "ore than $efore to $u% the sa"e thing<

In the short run suppl% and de"and alone deter"ine "arket prices< If there

are "an% large sellers and fe9 $u%ers8 prices fall8 so"eti"es $e%ond reason< Suppl%5

and5de"and i"$alances can result fro" %ear5end ta: selling8 an institutional

sta"pede out of a stock that ;ust reported disappointing earnings8 or an unpleasant

ru"or< ,ost da%5to5da% "arket price fluctuations result fro" suppl%5and5de"and

variations rather than fro" funda"ental develop"ents<

Investors 9ill fre?uentl% not kno9 9h% securit% prices fluctuate< The% "a%

change $ecause of8 in the a$sence of8 or in co"plete indifference to changes in

underl%ing value< In the short run investor perception "a% $e as i"portant as realit%

itself in



!peculators and %nsuccessful Investors 2

deter"ining securit% prices< It is never clear 9hich future events are anticipated $%

investors and thus alread% reflected in toda%@s securit% prices< Because securit%

prices can change for an% nu"$er of reasons and $ecause it is i"possi$le to kno9

9hat e:pectations are reflected in an% given price level8 investors "ust look $e%ond

securit% prices to underl%ing $usiness value8 al9a%s co"paring the t9o as part of

the invest"ent process<

5nsu((ess8ul Investors an The#r Costl% Emot#ons

Unsuccessful investors are do"inated $% e"otion< 4ather than responding cooll% and

rationall% to "arket fluctuations8 the% respond e"otionall% 9ith greed and fear< We

all kno9 people 9ho act 9ho act responsi$l% and deli$eratel% "ost of the ti"e $ut go$erserk 9hen investing "one%< It "a% take the" "an% "onths8 even %ears8 of hard

9ork and disciplined saving to accu"ulate

the "one% $ut onl% a fe9 "inutes to invest it< The sa"e people 9ould read several

consu"er pu$lications and visit nu"erous stores $efore purchasing a stereo or

ca"era %et spend little or no ti"e investigating the stock the% ;ust heard a$out fro"

a friend< 4ationalit% that is applied to the purchase of electronic or photo5graphic

e?uip"ent is a$sent 9hen it co"es to investing<

,an% unsuccessful investors regard the stock "arket as a 9a% to "ake

"one% 9ithout 9orking rather than as a 9a% to invest capital in order to earn a

decent return< An%one 9ould en;o% a ?uick and eas% profit8 and the prospect of an

effortless gain incites greed in investors< reed leads "an% investors to seek

shortcuts to invest"ent success< 4ather than allo9ing returns to co"pound over

ti"e8 the% atte"pt to turn ?uick profits $% acting on hot tips< The% do not stop to

consider ho9 the tipster could possi$l% $e in possession of valua$le infor"ation that

is not illegall% o$tained or 9h%8 if it is so valua$le8 it is $eing "ade availa$le to the"<

reed also "anifests itself as undue opti"is" or8 "ore su$tl%8 as co"placenc% in the

face of




$ad ne9s< 6inall% greed can cause investors to shift their focus a9a% fro" the

achieve"ent of long5ter" invest"ent goals in favor of short5ter" speculation<

High levels of greed so"eti"es cause ne95era thinking to $e introduced $%

"arket participants to ;ustif% $u%ing or holding overvalued securities< 4easons aregiven as to 9h% this ti"e is different fro" an%thing that ca"e $efore< As the truth is

stretched8 investor $ehavior is carried to an e:tre"e< 'onservative assu"ptions are

revisited and revised in order to ;ustif% ever higher prices8 and a "ania can ensue< In

the short run resisting the "ania is not onl% ps%chologicall% $ut also financiall%

difficult as the participants "ake a lot of "one%8 at least on paper< Then8 predicta$l%8

the "ania reaches a peak8 is recogniDed for 9hat it is8 reverses course8 and turns into

a selling panic< reed gives 9a% to fear8 and investor losses can $e enor"ous<

As I discuss later in detail8 ;unk $onds 9ere definitel% such a "ania< !rior to

the 1./s the entire ;unk5$ond "arket consisted of onl% a fe9 $illion dollars of Gfallen

angels<G Although ne9l% issued ;unk $onds 9ere a 1./s invention and 9ere thus

untested over a full econo"ic c%cle8 the% $eca"e 9idel% accepted as a financial

innovation of great i"portance8 9ith total issuance e:ceeding 2// $illion< Bu%ers

greedil% departed fro" historical standards of $usiness valuation and credit9or5

thiness< ven after the $u$$le $urst8 "an% proponents stu$$ornl% clung to the

validit% of the concept<

Gree an the Y#el "#/s o8 the 1':;s

There are countless e:a"ples of investor greed in recent financial histor%<

6e98 ho9ever8 9ere as relentless as the decade5long Greach for %ieldG of the 1./s<

#ou$le5digit interest rates on U<S< govern"ent securities earl% in the decade 9hetted

investors@ appetites for high no"inal returns< When interest rates declined to single

digits8 "an% investors re"ained infatuated 9ith the attain"ent of higher %ields and

sacrificed credit ?ualit% to achieve the" either in the $ond "arket or in e?uities<

Cno9n



!peculators and %nsuccessful Investors 2.

a"ong Wall Streeters as G%ield pigsG =or a nu"$er of "ore deris#ve na"es>8 such

individual and institutional investors 9ere suscepti$le to an% invest"ent product that

pro"ised a high rate of return< Wall Street responded 9ith gusto8 as Wall Street

tends to do 9hen there are fees to earn8 creating a variet% of instru"ents thatpro"ised high current %ields<

U<S< govern"ent securities are generall% regarded as Grisk5freeG invest"ents8

at least insofar as credit ?ualit% is concerned< To achieve current cash %ields

apprecia$l% a$ove those avail5a$le fro" U<S< govern"ent securities8 investors "ust

either risk the loss of principal or incur its certain depletion< (o95grade Securities8

such as ;unk $onds8 offer higher %ields than govern"ent $onds $ut at the risk of

principal loss< -unk5$ond "utual funds 9ere "arketed to investors in the 1./s

pri"aril% through the pro"ise of high current %ield< As 9ith a "agician perfor"ing

sleight of hand8 investors@ e%es 9ere focused al"ost e:clusivel% on the attractive

current %ield8 9hile the high principal I risk fro" defaults 9as hidden fro" vie9<

-unk $onds 9ere not the onl% slop served up to the %ield pigs of the 1./s<

Wall Street found "an% 9a%s to offer investors an enhanced current %ield $%

incorporating a return of the investors@ principal into the reported %ield< Ginnie

,aes8G 9hich are8 in fact8 high5grade securities8 are one such e:a"ple< These are

pools of "ortgages insured $% the overn"ent National ,ortgage Association

=N,A8 9hence innie ,ae>8 a US< govern"ent agenc%< N,A pools collect

"ortgage interest and principal pa%"ents fro" ho"eo9ners and distri$ute the" to

$ondholders< ver% "onth o9ners of N,As receive distri$utions that include $oth

interest inco"e and s"all principal repa%"ents. The principal portion includes

contractual pa%"ents as 9ell as voluntar% prepa%"ents< ,an% holders tend to think

of the %ield on N,As in ter"s of the total "onthl% distri$ution received< The true

econo"ic %ield is8 in fact8 onl% the

interest pa%"ents received divided $% the outstanding principal $alance< The

principal co"ponent of the "onthl% distri$utions is not a %ield on capital8 $ut a return

of capital< Thus investors 9ho spend the entire cash flo9 are eating into their seed

corn<

The sa"e principle is operative in option5inco"e "utual




funds8 9hich t%picall% ac?uire a portfolio of U<S< govern"ent securities and then 9rite

=sell> call options against the"< =A call option is the right to $u% a securit% at a

specified price during a stated period of ti"e<> The cash distri$utions paid $% these

funds to shareholders are co"prised of $oth interest inco"e earned on the $ondportfolio and pre"iu"s generated fro" the sale of options< This total cash

distri$ution is touted as the current %ield to investors< When covered call options

9ritten against the portfolio are e:ercised8 ho9ever8 the 9riter forgoes appreciation

on the securities that are called a9a%< The upside potential on the underl%ing

invest"ents is truncated $% the sale of the call options8 9hile the do9nside risk

re"ains intact< This strateg% places investors in the position of uninsured ho"e5

o9ners8 9ho $enefit currentl% fro" the s"all pre"iu" not paid to the insurance

co"pan% 9hile re"aining e:posed to large future losses< As long as securit% prices

continue to fluctuate $oth up and do9n8 9riters of covered calls are certain to e:peri5

ence capital losses over ti"e8 9ith no possi$le offsetting capital gains< In effect8

these funds are eating into principal 9hile "is5leadingl% reporting the principal

erosion as %ield<

So"e investors8 fi:ated on current return8 reach for %ield not 9ith a ne9 Wall

Street product8 $ut a ver% old one& co""on stocks< 6inding $ond %ields unaccepta$l%

lo98 the% pour "one% into stocks at the 9orst i"agina$le ti"es< These investors fail

to consider that $ond "arket %ields are pu$lic infor"ation8 9ell kno9n to stock

investors 9ho incorporate the current level of interest rates into share prices< When

$ond %ields are lo98 share prices are likel% to $e high< 0ield5seeking investors 9ho

rush into stocks 9hen %ields are lo9 not onl% fail to achieve a free lunch8 the% also

tend to $u% in at or near a "arket top<

The Sear(h 8or an Investment Formula

,an% investors greedil% persist in the invest"ent 9orld@s version of a search for the

hol% grail& the atte"pt to find a successful invest"ent for"ula< It is hu"an nature to

seek si"ple



!peculators and %nsuccessful Investors +)

solutions to pro$le"s8 ho9ever co"ple:< iven the co"ple:ities of the invest"ent

process8 it is perhaps natural for people to feel that onl% a for"ula could lead to

invest"ent success<

-ust as "an% generals persist in fighting the last 9ar8 "ost invest"ent

for"ulas pro;ect the recent past into the future< So"e invest"ent for"ulas involve

technical anal%sis8 in 9hich past: 5rock5price "ove"ents are considered predictive of

future prices< 7ther for"ulas incorporate invest"ent funda"entals such as price5to5

earnings =!J> ratios8 price5to5$ook5value ratio8 sales or profits gro9th rates8 dividend

%ields8 and the prevailing level of interest rates< #espite the enor"ous effort that has

$een put into devising such for"ulas8 none has $een proven to 9ork<

7ne si"plistic8 $ack9ard5looking for"ula e"plo%ed $% so"e investors is to

$u% stocks 9ith lo9 !J ratios< The idea is that $% pa%ing a lo9 "ultiple of earnings8

an investor is $u%ing an out5of5favor $argain< In realit% investors 9ho follo9 such afo"ula are essentiall% driving $% looking onl% in the rear5vie9 "irror< Stocks 9ith a

lo9 !J ratio are often depressed $ecause the "arket price has alread% discounted

the prospect of a sharp in earnings< Investors 9ho $u% such stocks "a% soon find

that the !J ratio has risen $ecause earnings have declined<

Another t%pe of for"ula used $% "an% investors involves pro;ecting their "ost

recent personal e:periences into the future8 As a result8 "an% investors have entered

the 1/s having GlearnedG a nu"$er of 9rong and potentiall% dangerous lessons

fro" the e$ullient 1./s "arket perfor"anceF so"e have co"e to regard the 1.

stock "arket crash as nothing "ore than an a$erration and nothing less than a great

$u%ing opportunit%< The ?uick recover% after the 7cto$er 1. stock "arket

shakeout and 1/ ;unk5$ond "arket collapse provide reinforce"ent of this

shortsighted lesson< ,an% investors8 like !avlov@s dog8 9ill foolishl%look to the ne:t

"arket selloff8 regardless of its pro:i"ate as another $u%ing Gopportunit%<G

The financial "arkets are far too co"ple: to $e incorporated into a for"ula<

,oreover8 if an% successful invest"ent for"ula i $e devised8 it 9ould $e e:ploited $%

those 9ho possessed it until co"petition eli"inated the e:cess profits< The ?uest for




a for"ula that 9orked 9ould then $egin ane9< Investors 9ould $e "uch $etter off to

redirect the ti"e and effort co""itted to devising for"ulas into funda"ental

anal%sis of specific invest"ent opportunities<

Con(lus#on The financial "arkets offer "an% te"ptations to vulnera$le investors< It is eas% to do

the 9rong thing8 to speculate rather than invest< "otion lies dangerousl% close to

the surface for "ost investors and can $e particularl% intense 9hen "arket prices

"ove dra"aticall% in either direction< It is crucial that investors understand the

difference $et9een speculating and investing and learn to take advantage of the

opportunities presented $% ,r< ,arket<

Notes

1< Se?uoia 6und8 Inc<8 annual report for 1.<

2< Willia" A< Sahl"an and Ho9ard H< Stevenson =Harvard raduate School of

Business Ad"inistration 'ase Stud%>8 G'apital ,arket ,%opiaG ='a"$ridge& Harvard

Business School8 1.)><

3< Al$ert Wo;nilo9er8 ?uoted in (ouis (o9enstein8 ,hat$s ,rong with ,all !treet

=4eading8 ,ass<& Addison5Wesle%8 1..>8 p< )<

*< The onl% possible e:ceptions to this cash flo9 test are precious "etals8 such as

gold8 9hich is a 9idel% recogniDed store of valueF throughout histor%8 for instance8 the

value of an ounce of gold has $een roughl% e?uivalent to the cost of a fine "en@s suit<

7ther precious "etals and ge"s have a less5esta$lished value than gold $ut "ight

$e considered $% so"e to $e a si"ilar t%pe of holding<

)< Ben;a"in raha"8 #he Intelligent Investor" *th ed< =Ne9 0ork& Harper K 4o98

13>8 p< 1/.<

< (o9enstein8 ,hat$s ,rong with ,all !treet" p< 3<



*

The Nature o8 Wall Street Wor,s

A/a#nst Investorsinvestors in "arketa$le securities have little choice $ut to deal 9ith Wall Street< The

sad truth is8 ho9ever8 that "an% investors are not 9ell served in their dealings 9ith

Wall StreetF the% 9ould $enefit fro" developing a greater understanding of the 9a%

Wall Street 9orks< The pro$le" is that 9hat is good for Wall Street is not necessaril%

good for investors8 and vice versa<

Wall Street has three principal activities& trading8 invest"ent $anking8 and

"erchant $anking< As traders Wall Street fir"s act as agents8 earning a co""ission

=or trading spread> for $ringing $u%ers and sellers together< As invest"ent $ankers

the% arrange for the purchase and sale of entire co"panies $% others8 under9rite

ne9 securities8 provide financial advice8 and opine on the fairness of specific

transactions< As "erchant $ankers the% co""it their o9n capital 9hile acting as

principal in invest"ent $anking transactions< ,erchant $anking activit% $ecause

increasingl% i"portant to Wall Street in the late 1./s $ut al"ost co"pletel% ceased

in 1/ and earl% 11<

Wall Street fir"s perfor" i"portant functions for our econo"% the% raise

capital for e:panding $usinesses and =so"e5




ti"es> provide li?uidit% to "arkets< As Wall Street pursues its various activities8

ho9ever8 it fre?uentl% is plagued $% conflicts of interest and a short5ter" orientation<

Investors need not conde"n Wall Street for this as long as the% re"ain a9are of it

and act 9ith cautious skepticis" in an% interactions the% "a% have<5$!Front Fees an Comm#ss#ons9

Wall Street<s "r#mar% Con8l#(t o8 Interest

Wall Streeters get paid pri"aril% for 9hat the% do8 not ho9 effectivel% the% do it< Wall

Street@s traditional co"pensation is in the for" of up5front fees and co""issions<

Brokerage co""issions are collected on each trade8 regardless of the outco"e for

the investor< Invest"ent $anking and under9riting fees are also collected up front8

long $efore the ulti"ate success or failure of the transaction is kno9n<

All investors are a9are of the conflict of interest facing stock$rokers< While

their custo"ers "ight $e $est off o9ning ="ini"al co""ission> U<S< Treasur% $ills or

=co""ission5free> no5load "utual funds8 $rokers are financiall% "otivated to sell

high5co""ission securities< Brokers also have an incentive to do e:cessive short5

ter" trading =kno9n as churning> on $ehalf of discretionar% custo"er accounts =in

9hich the $roker has discretion to transact> and to encourage such activit% in

nondiscretionar% accounts< ,an% investors are also accusto"ed to conflicts of

interest in Wall Street@s trading activities8 9here the fir" and custo"er are on

opposite sides of 9hat is often a Dero5su" ga"e<

A significant conflict of interest also arises in securities under9riting< This

function involves raising "one% for corporate clients $% selling ne9l% issued

securities to custo"ers< Needless to sa%8 large fees "a% "otivate a fir" to

under9rite either overpriced or highl% risk% securities and to favor the li"ited

nu"$er of under9riting clients over the "an% s"all $u%ers of those securities<

In "erchant $anking the conflict is "ore $latant still<



#he -ature of ,all !treet ,orks Against Investors 3*

Street fir"s have $eco"e direct co"petitors of $oth their under9riting and

$rokerage clients8 $u%ing and selling entire co"panies or large corporate su$sidiaries

for their o9n accounts< Instead of acting as "iddle"en $et9een issuers and $u%ers

of securities8 fir"s have $eco"e issuers and investors the"selves8 No9ada%s 9henthe phone rings and %our $roker is on the line8 %ou don@t even kno9 in 9hat capacit%

or on 9hose $ehalf he or she is acting<

7$viousl% there is nothing 9rong 9ith providing a service and collecting a fee<

#octors8 la9%ers8 accountants8 and other professionals are paid this 9a%F their

co"pensation does not depend on the ulti"ate outco"e of their services< The point I

a" "aking is that investors should $e a9are of the "otivations of the people the%

transact $usiness 9ithF up5front fees clearl% create a $ias to9ard fre?uent8 and not

necessaril% profita$le8 transactions<

Wall Street Favors 5ner-r#t#n/s over

Se(onar%!Mar,et Transa(t#ons

B% acting as invest"ent $ankers as 9ell as $rokers8 "ost Wall Street fir"s create

their o9n products to sell< A stock or $ond under9riting generates high fees for an

invest"ent $ank< These are shared 9ith stock$rokers 9ho sell the under9ritten

securities to clients< The total Wall Street take fro" a stock under9riting for e:a"ple8

ranges fro" 2 to . percent of the proceeds raised the $rokers the"selves t%picall%

receive fifteen to thirt% cents of gross co""ission on a 1/ stock<B% contrast8 the co""issions earned $% $rokers on secondar%5"arket

transactions8 9hich involve the resale of securities fro" one investor to another8 are

"uch s"aller< (arge institutions generall% pa% as little as five cents per share and

so"eti"es as lo9 as t9o cents< S"all individual investors are t%picall% charged

considera$l% "ore< ven so8 $rokers earn on average several ti"es "ore "one%

fro" selling shares in a ne9



3) W6ERE MOST INESTORS ST5M7E

under9riting than the% can earn fro" a secondar%5"arket transaction of si"ilar siDe<

The higher co""ission on ne9 under9ritings provides a strong incentive to

stock$rokers to sell the" to clients<

The strong financial incentive of $rokers touting ne9 securit% under9ritings isnot the onl% cause for investor concern< The "otivation of the issuer of securities is

also suspect and "ust $e thoroughl% investigated $% the $u%er< one are the da%s =if

the% ever e:isted> 9hen a ne9 issue 9as a colla$orative effort in 9hich a $usiness

that 9as long on prospects $ut short on capital could "eet investors 9ith capital in

hand $ut 9ith fe9 good outlets for it< Toda% the initial pu$lic offering "arket is 9here

hopes and drea"s are capitaliDed at high "ultiples< Indeed8 the under9riting of a

ne9 securit% "a% 9ell $e an overpriced or ill5conceived transaction8 fre?uentl%

involving the shuffling of assets through Gfinancial engineeringG rather than the

raising of capital to finance a $usiness@s internal gro9th<

Investors even re"otel% te"pted to $u% ne9 issues "ust ask the"selves ho9

the% could possi$l% fare 9ell 9hen a savv% issuer and greed% under9riter are on the

opposite side of every under9riting< Indeed8 ho9 attractive could an% securit% under5

9riting ever $e 9hen the issuer and under9riter have superior infor"ation as 9ell as

control over the ti"ing8 pricing8 and stock or $ond allocationE The deck is al"ost

al9a%s stacked against the $u%ers<

So"eti"es the lust for under9riting fees drives Wall Street to actuall% create

under9riting clients for the sole purpose of having securities to sell< ,ost closed5end

"utual funds8 for e:a"ple8 are for"ed al"ost e:clusivel% to generate co""issions

for stock$rokers and fees for invest"ent "anagers< There 9as a stor% a fe9 %ears

ago that an announce"ent to the sales force of a prestigious Wall Street

under9riting fir" regarding the for"ation of a closed5end $ond fund 9as "et 9ith a

standing ovation< The clients could have purchased the sa"e securities "uch less

e:pensivel% on a direct $asis8 $ut in the for" of a closed5end fund the $rokers stood

to "ake "an% ti"es "ore in co""issions<






even greater pre"iu"s to NA+ suddenl% di""ed< As a result8 ne9l% $earish

investors du"ped the shares of countr% funds8 9hich had recentl% traded at large

pre"iu"s to NA+8 until virtuall% all of the" declined to levels apprecia$l% $elo9 NA+<

The periodic $oo" in closed5end "utual5fund issuance is a useful $aro"eter of"arket senti"entF ne9 issues a$ound 9hen investors are opti"istic and "arkets are

rising< Wall Street fir"s after all do not force investors to $u% these funds< The%

si"pl% stand read% to issue a virtuall% li"itless suppl% since the onl% real constraint is

the gulli$ilit% of the $u%ers< The $oo" is follo9ed $% a $ust8 during 9hich those funds

that fall to a sufficientl% large discount to NA+ are targeted $% investor groups and

either li?uidated or forced to $eco"e open5ended8 there$% per"itting the shares to

$e redee"a$le at NA+8 co"pleting the life c%cles of these entities< The under9riters

and so"eti"es the $argain hunters profitF the greater fools 9ho $u% on the initial

pu$lic offerings or later at large pre"iu"s to NA+ inevita$l% lose "one%<

Wall Street<s Short!Term Fo(us

Wall Street@s up5front5fee orientation "akes for a short5ter" focus as 9ell< Brokers8

traders8 and invest"ent $ankers all find it hard to look $e%ond the ne:t transaction

9hen the current one is so lucrative regardless of "erit< This 9as even "ore

applica$le than usual in the late 1./s and earl% 1/s8 a ti"e 9hen fees 9ere

enor"ous and 9hen "ost Wall Streeters felt less than secure a$out the per"anence

of their ;o$s8 and even their careers8 in the securities industr%< The utter h%pocris% of

Wall Street is e:e"plified $% the Ge?uitiDationG 9ave of earl% 118 9here$%

overleveraged co"panies issued e?uit% and used the proceeds to repa% de$t< Wall

Street collected invest"ent $anking and under9riting fees 9hen those co"panies

9ere ac?uired in highl% leveraged ;unk5$ond5financed takeovers and collected large

fees again 9hen the de$t 9as replaced 9ith ne9l% under9ritten e?uit%<






The $ullish $ias of Wall Street "anifests itself in "an% 9a%s< Wall Street research is

strongl% oriented to9ard $u% rather than sell reco""endations8 for e:a"ple<

!erhaps this is the case $ecause an%one 9ith "one% is a candidate to $u% a stock or

$ond8 9hile onl% those 9ho o9n are candidates to sell< In other 9ords8 there is "ore$rokerage $usiness to $e done $% issuing an opti"istic research report than $%

9riting a pessi"istic one<

In addition8 Wall Street anal%sts are unlikel% to issue sell reco""endations

due to an understanda$le reluctance to sa% negative things8 ho9ever truthful the%

"a% $e8 a$out the co"panies the% follo9< This is especiall% true 9hen these co"5

panies are corporate5finance clients of the fir"< In 1/ ,arvin 4off"an8 an anal%st

at -anne% ,ontgo"er% Scott8 Inc<8 apparentl% lost his ;o$ for 9riting a negative

research report a$out the Atlantic 'it% hotelJcasinos o9ned $% #onald Tru"p8 a

prospective client of -anne%<

It is eas% for Wall Streeters to $e $ullish< A fe9 opti"istic assu"ptions 9ill

ena$le a reasona$le invest"ent case to $e "ade for practicall% an% stock or $ond<

The pro$le" is that 9ith so "uch attention $eing paid to the upside8 it is eas% to

lose sight of the risk<

7thers share Wall Street@s $ullish $ias< Investors naturall% prefer rising

securit% prices to falling ones8 profits to losses< It is "ore pleasant to conte"plate

upside potential than do9nside risk< 'o"panies too prefer to see their o9n shares

rise in priceF an increasing share price is vie9ed as a vote of confidence in

"anage"ent8 as a source of increase in the value of "anage"ent@s personal shares

and stock options8 and as a source of financial fle:i$ilit%8 facilitating a co"pan%@s

a$ilit% to raise additional e?uit% capital<

ven govern"ent regulators of the securities "arkets have a stake in the

"arkets@ $ullish $ias< 4ising "arkets are acco"panied $% investor confidence8 9hich

the regulators desire to "aintain< An% do9nturn8 according to the regulator%

"entalit%8 should $e orderl% and free of panic< =#isorderl% rising "arkets are of no

evident concern<>





*1 W6ERE MOST INESTORS ST5M7E

tors8 illustrated $% the uneven application of circuit $reakers8 "a% itself encourage

investors to purchase and hold overvalued securities<

,an% of the sa"e factors that contri$ute to a $ullish $ias can cause the

financial "arkets8 especiall% the stock "arket8 to $eco"e and re"ain overvalued<'orrecting a "arket overvaluation is "ore difficult than re"ed%ing an undervalued

condition< With an undervalued stock8 for e:a"ple8 a value investor can purchase

"ore and "ore shares until control is achieved or8 $etter still8 until the entire

co"pan% is o9ned at a $argain price< If the value assess"ent 9as accurate8 this is an

attractive outco"e for the investor< B% contrast8 overvalued "arkets are not easil%5

correctedF short5selling8 as "entioned earlier8 is not an effective antidote< In addition8

overvaluation is not al9a%s apparent to investors8 anal%sts8 or "anage"ents< Since

securit% prices reflect investors@ perception of realit% and not necessaril% realit% itself8

overvaluation "a% persist for a long ti"e<

F#nan(#al!Mar,et Innovat#ons Are Goo 8or

Wall Street 7ut 7a 8or Cl#ents

Invest"ent $ankers in Wall Street fir"s are constantl% creating ne9 t%pes of

securities to offer to custo"ers< 7ccasionall% such offerings $oth solve the financial

pro$le"s of issuers and "eet the needs of investors< In "ost cases8 ho9ever8 the%

address onl% the needs of Wall Street8 that is8 the generation of fees andco""issions<

6inancial inter"ediariesWall Street invest"ent $ankers and institutional

investorsstand to $enefit the "ost fro" financial5"arket innovations< Wall Street

earns fees and co""issions 9ith no riskF institutional investors "a% $e a$le to

attract "ore "one% to "anage $% creating ne9 vehicles to invest in the innovative

securities< If the first investors in a financial5"arket innovation e:perience good

results8 "ore



#he -ature of ,all !treet ,orks Against Investors .(

"one% 9ill $e raised and "ore securities 9ill $e issued8 generating additional

"anage"ent fees8 under9riting fees8 and co""issions< The $u% side and sell side in

effect $eco"e co5conspirators8 each having a vested interest in the continued

success of the innovation< An% long5ter" $enefit to the issuers or actual o9ners of

the ne9 securities is considera$l% less certain<

In the 1./s the financial "arkets 9ere flooded 9ith ne9 varieties of de$t and

derivative securities< -ust to na"e a fe98 an investor could $u% $onds that 9ere fi:ed

or floating rate8 #utch auction8 Dero5coupon8 pa%5in5kind or pa%5in5stock8 converti$le

into the issuers@ stock8 into so"eone else@s stock8 or into co""odities8 putta$le8

calla$le8 resetta$le8 e:tendi$le to a longer "aturit%8 e:changea$le into another

securit%8 or deno"inated in a foreign currenc% or "arket $asket of currencies< So"e

of these securities8 such as auction5rate preferred5stock and Dero5coupon ;unk $onds8

have $een discredited $% events< ,an% others8 like e:hi$its at a science fair8 "a%have achieved their original goals8 $ut al"ost no one reall% cared<

Investors "ust recogniDe that the earl% success of an innovation is not a

relia$le indicator of its ulti"ate "erit< Both $u%ers and sellers "ust $elieve that the%

9ill $enefit in the short run8 or the innovation 9ill not get off the dra9ing $oardF the

longer5ter" conse?uences of such innovations8 ho9ever8 "a% not have $een

considered carefull%< At the ti"e of issuance a ne9 t%pe of securit% 9ill appear to add

value in the sa"e 9a% that a ne9 consu"er product does< There is so"ethinglo9er

risk8 higher return8 greater li?uidit%8 an i"$edded put or call option to the holder or

issuer8 or so"e other 9rinklethat "akes it appear superior =ne9 and i"proved8 if

%ou 9ill> to an%thing that ca"e $efore< Although the $enefits are apparent fro" the

start8 it take longer for pro$le"s to surface< Neither cash5hungr% issuers nor greed%

investors necessaril% anal%De the perfor"ance of each financial5"arket innovation

under ever% conceiva$le econo"ic scenario< What appears to $e ne9 and i"proved

toda% "a% prove to $e fla9ed or even fallacious



*3 W6ERE MOST INESTORS ST5M7E

to"orro9<

Wall Street is never satisfied 9ith its success< If one deal is successfull%

co"pleted8 Wall Street sees this as a sure sign that still another deal can $e done< In

virtuall% all financial innovations and invest"ent fads8 Wall Street creates additionalsuppl% until it e?uals and then e:ceeds "arket de"and< The profit "otivation of Wall

Street fir"s and the intense co"petition a"ong the" render an% other outco"e

unlikel%<

The eventual "arket saturation of Wall Street fads coincides 9ith a cooling of

investor enthusias"< When a particular sector is in vogue8 success is a self5fulfilling

prophec%< As $u%ers $id up prices8 the% help to ;ustif% their original enthusias"<

When prices peak and start to decline8 ho9ever8 the do9n9ard "ove "ent can also

$eco"e self5fulfilling< Not onl% do $u%ers stop $u%ing8 the% actuall% $eco"e sellers8

aggravating the over suppl% pro$le" that "arks the peak of ever% fad<

IOs an "Os9 Innovat#ons #n the Mort/a/e

Se(ur#t#es Mar,et

7ne financial5"arket innovation of the "id51./s involved h%$rid "ortgage

securities kno9n as I7s =interest onl%> and !7s =principal onl%>< I7s and !7s 9ere

created $% separating pool of "ortgages into its t9o cash5flo9 co"ponents& interest

pa%"ents and principal repa%"ents<

A conventional "ortgage5$acked securit% fluctuates in value inversel% to

interest rates for t9o reasons< 6irst8 the value of a "ortgage declines as interest

rates rise $ecause8 as 9ith an% interest5$earing securit%8 it is 9orth less 9hen its

periodic cash flo9s are discounted at the ne98 higher rate< Second8 the e:pected life

of a "ortgage lengthens 9ith higher interest rates as optional prepa%"ents lessen8

so that the relativel% less attractive interest pa%"ents last for a longer ti"e<

The responses of separate I7s and !7s to interest rate changes are ver%

different fro" those of an intact "ortgage5$acked securit%<



#he -ature of ,all !treet ,orks Against Investors **

I7s8 interest pa%"ents stripped fro" a pool of "ortgages8 fluctuate in value for a

given change in interest rates in the opposite direction fro" conventional "ortgages<

The reason is8 if interest rates rise8 interest pa%"ents on an I7 9ill $e received for a

longer period< :perience sho9s that the present value of a larger nu"$er ofpa%"ents is "ore than that of a s"aller nu"$er of pa%"ents8 even at a so"e9hat

higher discount rate< Because of this counterfluctuation8 such "ortgage investors as

thrifts and insurance co"panies are attracted to I7s as a potential hedge against

changes in interest rates< The price of !7s8 conversel%8 "oves in the sa"e direction

as conventional "ortgages in response to interest rate changes $ut 9ith greater

volatilit%< Thus the% are potentiall% useful instru"ents for an%5art 9ishing to

speculate on interest rates<

Wall Street 9as a$le to earn su$stantial fees and trading prof5its $% creating

these h%$rid securities< The ?uestion8 as 9ith an% financial5"arket innovation8 is

9hether an%one else 9as $etter off. especiall% after allo9ing for the co""issions8

fees8 and dealer "arkups< The $u%ers8 fre?uentl% thrifts and insurance co"panies8

9ere $etting on their o9n a$ilit% to understand a

$rand ne9 securit%< The% needed to understand it $etter than other "arket

participants8 and at least as 9ell as Wall Street8 to avoid $eing e:ploited< The%

depended on the e"ergence of a sustained8 li?uid "arket for the securities the%

$ought< And the% 9ere i"plicitl% assu"ing that the t9o parts 9ere 9orth at least as

"uch as8 and perhaps "ore than8 the 9holeclearl% an

opti"istic assu"ption<

What if I7s or !7s failed to trade in a li?uid and orderl% "arket narro9

$idJasked spreadsE What if accurate and ti"el% infor"ation on these securities

ceased to $e availa$le on a continuing $asisE What if interest rate fluctuations

rendered each of these securities "ore volatile than e:pectedE Then holders 9ere in

trou$le8 for it is far easier to separate a "ortgage into t9o parts than it is to glue it

$ack together again< There 9as no assurance8 or even reason to think it likel%8 that

the holder of one piece 9ould $e interested in an% proposition "ade $% the holder of

the other piece to reco"$ine< It 9as8 in other 9ords8 possi$le







* W6ERE MOST INESTORS ST5M7E

invest"ent fads originate in real $usiness trends8 9hich deserve to $e reflected in

stock prices< The fad $eco"es dangerous8 ho9ever8 9hen share prices reach levels

that are not supported $% the conservativel% appraised values of the underl%ing

$usinesses<

Con(lus#on

Wall Street can $e a dangerous place for investors< 0ou have no choice $ut to do

$usiness there8 $ut %ou "ust al9a%s $e on %our guard< The standard $ehavior of

Wall Streeters is to pursue "a:i"iDation of self5interestF the orientation is usuall%

shoe ter"< This "ust $e ackno9ledged8 accepted8 and dealt 9ith< If %ou transact

$usiness 9ith Wall Street 9ith these caveats in "ind8 %ou can prosper< If %ou depend

on Wall Street to help %ou8 invest"ent success "a% re"ain elusive<

Notes

1< The onl% advantage of closed5end over open5end "utual funds is that closed5end

funds can $e "anaged 9ithout considerations

of li?uidit% needs since the% are not su$;ect to shareholder rede"ptions< This "inor

advantage does not offset the high up5front co""issions charged to initial

purchasers of closed5end fund shares<

2< If the last price fluctuation 9as up9ard8 the ne:t trade at the sa"e price is called aDero5plus tickF short5selling "a% rake place on a Dero5plus tick<

3< ,an% Wall Streeters have a different vie9 of short5selling< The% $elieve that short5

sellers are dangerous "anipulators of securities prices8 driving prices do9n for their

personal financial gain< This pre;udice against short5sellers is consistent 9ith Wall

Street@s interest in "aintaining high stock prices<

*< !rogra" trading is an ar$itrage activit% in 9hich the stocks in an inde: are

purchased and futures contracts on that inde: are sold8 or vice versa8 in either event

locking in a riskless profit



+

The Inst#tut#onal "er8orman(e2erb%9

The Cl#ent Is the oserro9ing pools of retire"ent and endo9"ent funds seeking sound invest"ent outlets

led to the "ost i"portant develop"ent in the invest"ent 9orld over the last three

decades& the ascendanc% of the institutional investor< Unfortunatel% institutional

investing has developed in 9a%s that are detri"ental to the returns generated on the

"one% under "anage"ent< The great "a;orit% of institutional investors are plagued

9ith a short5ter"8 relative5perfor"ance orientation and lack the long5ter"

perspective that retire"ent and endo9"ent funds deserve< /yriad rules and

restrictions8 often self5i"posed8 also i"pair the a$ilit% of institutional investors to

achieve good invest"ent result.

Several decades ago the financial "arkets 9ere do"inated $% individual

investors 9ho "ade their o9n invest"ent decisions8 invest"ent 9orld 9as then a

si"pler placeF stocks8 govern5



* W6ERE MOST INESTORS ST5M7E

"ent $onds8 and high5grade corporate $onds co"prised virtuall% the entire

invest"ent "enu< That 9orld 9as a cautious one8 as "e"ories of the 12 stock

"arket crash and the reat #epression that follo9ed 9ere slo9 to fade<

In the %ears after World War II8 ho9ever8 increasing pools of retire"entsavings in corporate pension funds created an opportunit% for professional "one%

"anagers to go into $usiness< Total funds under "anage"ent rose fro" 1/ $illion

in 1)/ to "ore than )// $illion in 1.8 to appro:i"atel% 2 trillion in 1./8 and

trillion in 1/< 7ver the sa"e fort% %ears8 the share of institutional o9nership in

all pu$licl% traded U<S< e?uit% securities increased fro" . to *) percent<1

Under the "plo%ee 4etire"ent Inco"e Securit% Act of 1* =4ISA>

institutional investors 9ere re?uired to act as fiduciaries for future retirees $%

achieving accepta$le invest"ent returns 9ith li"ited risk< Adoption of the prudent5

"an standard8 under 9hich pension funds 9ould onl% "ake invest"ents that a

Gprudent "anG 9ould "ake8 9as intended to ensure conservative "anage"ent< 7ver

ti"e8 ho9ever8 the modus operandi of institutional investors $egan to diverge fro"

9hat the statute intended< A 1 U<S< #epart"ent of (a$or ruling that the prudent5

"an standard applied to an entire portfolio rather than to the individual securities

9ithin it opened the door to portfolio5oriented invest"ent strategies that ignore risk

on an invest"ent5$%5invest"ent $asis< In addition8 a great "an% institutional

investors have $een s9ept into the short5ter" relative5perfor"ance der$%8 an

orientation inconsistent 9ith the prudent5"an test<

Toda% institutional investors do"inate the financial "arkets8 accounting for

roughl% three5fourths of stock e:change trading volu"e<2 All investors are affected $%

9hat the institutions do8 o9ing to the i"pact of their enor"ous financial clout on

securit% prices<G Understanding their $ehavior is helpful in understanding 9h% certain

securities are overvalued 9hile others are $argain priced and "a% ena$le investors

to identif% areas of potential opportunit%<



#he Institutional Performance Derby0 #he Client Is the 1oser =;

The Mone% Mana/ement 7us#ness

If the $ehavior of institutional investors 9eren@t so horrif%ing8 it "ight actuall% $e

hu"orous< Hundreds of $illions of other peoples hard5earned dollars are routinel%9hipped fro" invest"ent to invest"ent $ased on little or no in5depth research or

anal%sis< The prevalent "entalit% is consensus8 groupthink< Acting 9ith the cro9d

ensures an accepta$le "ediocrit%F acting independentl% runs the risk of unaccepta$le

underperfor"ance< Indeed8 the short5ter"8 relative5perfor"ance orientation of "an%

"one% "anagers has "ade Ginstitutional investorG a contradiction in ter"s<

Institutional investors are presu"a$l% "otivated $oth $% the ongoing

challenge of achieving good invest"ent results and $% the personal financial success

that accrues to participants in a profita$le "one% "anage"ent $usiness<

Unfortunatel% for invest"ent clients these o$;ectives fre?uentl% are at odds< ,ost

"one% "anagers are co"pensated8 not according to the results they achieve, $ut as

a percentage of the total assets under "anage"ent< The incentive is to e:pand

"anaged assets in order to generate "ore fees< 0et 9hile a "one% "anage"ent

$usiness t%picall% $eco"es "ore profita$le as assets under "anage"ent increase8

good invest"ent perfor"ance $eco"es increasingl% difficult< This conflict $et9een

the $est interests of the "one% "anager and that of the clients is t%picall% resolved

in the "anager@s favor<

The $usiness of "one% "anage"ent can $e highl% lucrative8 It re?uires ver%

little capital invest"ent8 9hile offering high co"pensation and the rapid develop"ent

of 9hat is effectivel% an annuit%< 7nce an invest"ent "anage"ent $usiness

$eco"es highl% profita$le8 it is likel% to re"ain that 9a% so long as clients do not

depart in large nu"$ers< In the "one% "anage"ent $usiness "anage"ent fees paid

$% ne9 clients constitute al"ost pure profit< Si"ilarl%8 lost fees resulting fro" client

departures affect profita$ilit% nearl% dollar for dollar8 since there are fe9 varia$le

costs to $e cut in order to offset lost revenues<



=1 W6ERE MOST INESTORS ST5M7E

The pressure to retain clients e:erts a stifling influence on institutional investors<

Since clients fre?uentl% replace the 9orst5perfor"ing "anagers =and since "one%

"anagers live in fear of this>8 "ost "anagers tr% to avoid standing apart fro" the

cro9d< Those 9ith onl% average results are considera$l% less likel% to lose accounts

than are the 9orst perfor"ers< The result is that "ost "one% "anagers consider

"ediocre perfor"ance accepta$le< Although unconventional decisions that prove

successful could generate superior invest"ent perfor"ance and result in client

additions8 the risk of "istakes8 9hich 9ould di"inish perfor"ance and possi$l% lead

to client departures8 is usuall% considered too high<

The Short!Term> Relat#ve!"er8orman(e 2erb%

(ike dogs chasing their o9n tails8 "ost institutional investors have $eco"e locked

into a short5ter"8 relative5perfor"ance der$%< 6und "anagers at one institution have

suffered the distraction of hourl% perfor"ance calculationsF nu"erous "anagers are

provided dail% co"parisons of their results 9ith those of "anagers at other fir"s<

6re?uent co"parative ranking can onl% reinforce a short5ter" invest"ent

perspective< It is understanda$l% difficult to "aintain a long5ter" vie9 9hen8 faced

9ith the penalties for poor short5ter" perfor"ance8 the long5ter" vie9 "a% 9ell $e

fro" the une"plo%"ent line<

The short5ter" orientation of "one% "anagers "a% $e e:acer$ated $% the

increasing popularit% of pension fund consultants< These consultants evaluate

nu"erous "one% "anagers8 co"pare their perfor"ances8 contrast their invest"ent

st%les8 and then "ake reco""endations to their clients< Because their

reco""endations can have a significant influence on the health of a "one%

"anage"ent $usiness8 the need to i"press pension fund consultants "a% add to the

short5ter" perfor"ance pressures on "one% "anagers<



#he Institutional Performance Derby0 #he Client Is the 1oser )2

What is a relative5perfor"ance orientationE 4elative perfor"ance involves "easuring

invest"ent results8 not against an a$solute standard8 $ut against $road stock "arket

indices8 such as the #o9 -ones Industrial Average or Standard K !oor@s )// Inde:8 or

against other investors@ results< ,ost institutional investors "easure their success orfailure in ter"s of relative perfor"ance< ,one% "anagers "otivated to outperfor"

an inde: or a peer group of "anagers "a% lose sight of 9hether their invest"ents

are attractive or even sensi$le in an a$solute sense<

Instead of $asing invest"ent decisions on independent and o$;ective anal%sis8

relative5perfor"ance5oriented investors reall% act as speculators< 4ather than "aking

sensi$le ;udg"ents a$out the attractiveness of specific stocks and $onds8 the% tr% to

guess 9hat others are going to do and then do it first< The pro$le" is that even as

one "anager is atte"pting to guess 9hat others "a% do8 others are doing the sa"e

thing< The task $eco"es increasingl% intricate& guess 9hat the other guessers "a%

guess< And so on<

Who is to $la"e for this short5ter" invest"ent focusE Is it the fault of

"anagers 9ho $elieve clients 9ant good short5ter" perfor"ance regardless of the

level of risk or the i"possi$ilit% of the taskE 7r is it the fault of clients 9ho8 in fact8 do

s9itch "one% "anagers 9ith so"e fre?uenc%E There is a"ple $la"e for $oth to

share<

There are no 9inners in the short5ter"8 relative5perfor"ance der$%<

Atte"pting to outperfor" the "arket in the short run is futile since near5ter" stock

and $ond price fluctuations are rando" and $ecause an e:traordinar% a"ount of

energ% and talent is alread% $eing applied to that o$;ective< The effort onl% distracts

a "one% "anager fro" finding and acting on sound longter" opportunities as he or

she channels resources into 9hat is essentiall% an un9inna$le ga"e< As a result8 the

clients e:perience "ediocre perfor"ance< The overall econo"% is also deprived8 as

funds are allocated to short5ter" trading rather than to long5ter" invest"ents< 7nl%

$rokers $enefit fro" the high level of activit%<



)3 W6ERE MOST INESTORS ST5M7E

Other "eo$le<s Mone% versus Your O-n

0ou pro$a$l% 9ould not choose to dine at a restaurant 9hose chef al9a%s ate

else9here< 0ou should $e no "ore satisfied 9ith a "one% "anager 9ho does not eat

his or her o9n cooking< It is 9orth noting that fe9 institutional "one% "anagersinvest their o9n "one% along 9ith their clients@ funds< The failure to do so frees these

"anagers to single"indedl% pursue their fir"s@8 rather than their clients@8 $est

interests<

cono"ist !aul 4osenstein54odan has pointed to the Gtre"$le factorG in

understanding hu"an "otivation< GIn the $uilding practices of ancient 4o"e8 9hen

scaffolding 9as re"oved fro" a co"pleted 4o"an arch8 the 4o"an engineer stood

$eneath< If the arch ca"e crashing do9n8 he 9as the first to kno9< Thus his concern

for the ?ualit% of the arch 9as intensel% personal8 and it is not surprising that so

"an% 4o"an arches have survived<G3

Wh% should investing $e an% differentE ,one% "anagers 9ho invested their

o9n assets in parallel 9ith clients 9ould ?uickl% a$andon their relative5perfor"ance

orientation< Intellectual honest% 9ould $e restored to the institutional invest"ent

process as the focus of professional investors 9ould shift fro" tr%ing to outguess

others to "a:i"iDing returns under reasona$le risk constraints< If "ore institutional

investors strove to achieve good a$solute rather than relative returns8 the stock

"arket 9ould $e less prone to overvaluation and "arket fads 9ould less likel% $e

carried to e:cess< Invest"ents 9ould onl% $e "ade 9hen the% presented a

co"pelling opportunit% and not si"pl% to keep up 9ith the herd<

Im$e#ments to Goo Inst#tut#onal Investment "er8orman(e

7ne "a;or o$stacle to good institutional invest"ent perfor"ance is a

shortage of ti"e< There is "ore infor"ation availa$le



#he Institutional Performance Derby0 #he Client Is the 1oser )*

a$out securities8 as 9ell as corporate and "acroecono"ics develop"ents8 than

an%one could reasona$l% digest< -ust sifting through the accu"ulating piles of annual

reports8 Wall Street research8 and financial periodicals could consu"e all of one@s

ti"e ever% da%< Thinking a$out and digesting all this "aterial8 of course8 9ould take

considera$l% longer<

An investor@s ti"e is re?uired $oth to "onitor current holdings and to

investigate potential ne9 invest"ents< Since "ost "one% "anagers are al9a%s

looking for additional assets to "anage8 ho9ever8 the% spend considera$le ti"e

"eeting 9ith prospective clients in addition to hand5holding current clientele< It is

ironic that all clients8 present and potential8 9ould pro$a$l% $e financiall% $etter off if

none of the" spent ti"e with the "one% "anagers8 $ut a free5rider pro$le" e:ists in

that each client feels ;ustified in re?uesting periodic "eetings<

No single "eeting places an intolera$le $urden on a "one% "anager@s ti"eFcu"ulativel%8 ho9ever8 the hours diverted to "arketing can take a toll on invest"ent

results<

Another difficult% plaguing institutional investors is a $ureaucratic decision5

"aking process< While "anaging "one% successfull% is not eas% for an%one8 "an%

institutional investors co"pound that difficult% 9ith a tendenc% to9ard confor"it%8

inertia8 and e:cessive diversification that results fro" group decision "aking<

An% institutional investor 9ith an innovative or contrarian invest"ent idea

goes out on a li"$< He or she assu"es a personal risk 9ithin the fir"8 9hich

co"pounds the invest"ent r#s,. The cost of $eing 9rong goes $e%ond the financial

loss to include the adverse "arketing i"plications as 9ell as the personal career

considerations< This helps e:plain 9h% institutional investors rarel% "ake

unconventional invest"ents< It also sho9s 9h% the% tend to hold onto full% priced or

overpriced invest"ents8 un9illing to reco""end sale unless a consensus 8or selling

has alread% e"erged< The "ultidi"ensional risk fro" holding too long is usuall% less

than the risk in selling too soon<

Selling is difficult for "one% "anagers for three additional



)) W6ERE MOST INESTORS ST5M7E

reasons< 6irst8 "an% invest"ents are illi?uid8 and disposing of institutional5siDed

positions depends on "ore than si"pl% the desire to do so< Second8 selling creates

additional 9ork as sale proceeds "ust $e reinvested in a su$se?uent purchase<

4etaining current holdings is "uch easier< With so "an% de"ands on their ti"e8"one% "anagers have little incentive to create additional 9ork for the"selves<

6inall%8 the Securities and :change 'o""ission =S'>8 the govern"ental agenc%

9ith regulator% responsi$ilit% for "utual funds8 regards portfolio turnover

unfavora$l%< ,utual fund "anagers thus have %et another reason to avoid selling<

,an% large institutional investors separate anal%tical responsi$ilities fro"

portfolio5"anage"ent duties8 9ith the portfolio "anagers senior to the anal%sts< The

portfolio "anagers usuall% function on a top5do9n $asis8 integrating $road5scale

"arket vie9s 9ith the anal%sts@ reco""endations to "ake particular invest"ent

decisions< This approach is conducive to "istakes since the people "aking the

decisions have not personall% anal%Ded the securities the% are $u%ing and selling<

,oreover8 the anal%sts 9ho do have direct kno9ledge of the underl%ing co"panies

"a% $e s9a%ed in their reco""endations $% an% apparent top5do9n $ias "anifested

$% the portfolio "anagers<

There is one other i"pedi"ent to good institutional invest"ent perfor"ance&

institutional portfolio "anagers are hu"an $eings< In addition to the influences of the

invest"ent $usiness8 "one% "anagers8 despite $eing professionals8 fre?uentl% fall

victi" to the sa"e forces that operate on individual investors& the greed% search for

?uick and eas% profits8 the co"fort of consensus8 the fear of falling prices8 and all the

others< The t9in $urdens of institutional $aggage and hu"an e"otion can $e difficult

to overco"e<

Im$l#(at#ons o8 "ort8ol#o S#?e

Institutional investors are caught in a vicious circle< The "ore "one% the%

"anage8 the "ore the% earn< Ho9ever8 there are



#he Institutional Performance Derby0 #he Client Is the 1oser )

disecono"ies of scale in the returns earned on increasingl% larrge su"s of "one%

under "anage"entF that is8 the return per dollar invested declines as total assets

increase< The principal reason is that good invest"ent ideas are in short suppl%<

,ost of the "a;or "one% "anage"ent fir"s consider onl% large5capitaliDationsecurities for invest"ent< These institutions cannot ;ustif% anal%Ding s"all and

"ediu"5siDed co"panies in 9hich onl% "odest a"ounts could ever $e invested< To

illustrate this point8 consider a "anager at a ver% large institution 9ho oversees a 1

$illion portfolio< To achieve reasona$le $ut not e:cessive diversification8 the "anager

"a% have a polic% of investing )/ "illion in each of t9ent% different stocks< To

avoid o9ning illi?uid positions8 invest"ents "ight $e li"ited to no "ore than )

percent of the outstanding shares of an% one co"pan%< In co"$ination these rules

i"pl% o9ning shares of co"panies 9ith a "ini"u" "arket capitaliDation of 1 $illion

each =) percent of 1 $illion is )/ "illion><

At the $eginning of 11 there 9ere onl% )) co"panies 9ith "arket capitaliDations

this large8 a fairl% s"all universe<

I refer to this t%pe of li"itation on institutional investors@ $ehavior as a self5

i"posed constraint< This one is not8 ho9ever8 a co"pletel% ar$itrar% rule adopted $%

"anagersF the siDe of the portfolio dictates such a restriction< Unfortunatel% for the

clients of large "one% "anagers8 like the one in this e:a"ple8 thousands of

co"panies are auto"aticall% e:cluded fro" invest"ent consideration regardless of

individual "erit<

Sel8!#m$ose Constra#nts on Inst#tut#onal Investors

,ost institutional investors are li"ited $% a nu"$er of other self5i"posed

constraints< In response to the prudent5"an standard and si"ilar rules of

accepta$ilit% "an% institutions have i"posed restrictions on their portfolios< So"e

esta$lish li"its on the cash co"ponent of a portfolio< 7thers "a% e:clude invest"ent

in stocks selling $elo9 five dollars a share8 securi5



) W6ERE MOST INESTORS ST5M7E

ties not listed on an e:change8 stocks and $onds of co"panies in financial distress or

$ankruptc%8 and stocks not currentl% pa%ing a dividend<

Rema#n Full% Investe at All T#mes The fle:i$ilit% of institutional investors is fre?uentl% li"ited $% a self5i"posed

re?uire"ent to $e full% invested at all ti"es< ,an% institutions interpret their task as

stock picking8 not "arket ti"ingF the% $elieve that their clients have "ade the

"arket5ti"ing decision and pa% the" to full% invest all funds under their

"anage"ent<

4e"aining full% invested at all ti"es certainl% si"plifies the invest"ent task<

The investor si"pl% chooses the $est availa$le invest"ents< 4elative attractiveness

$eco"es the onl% invest"ent %ardstickF no a$solute standard is to $e "et<

Unfortunatel% the i"portant criterion of invest"ent "erit is o$scured or lost 9hen

su$standard invest"ents are ac?uired solel% to re"ain full% invested< Such

invest"ents 9ill at $est generate "ediocre returnsF at 9orst the% entail $oth a high

opportunit% costforegoing the ne:t good opportunit% to investand the risk of

apprecia$le loss<

4e"aining full% invested at all ti"es is consistent 9ith a relative5perfor"ance

orientation< If one@s goal is to $eat the "arket =particularl% on a short5ter" $asis>

9ithout falling significantl% $ehind8 it "akes sense to re"ain 1// percent invested<

6unds that 9ould other9ise $e idle "ust $e invested in the "arket in order not to

underperfor"s the "arket<

A$solute5perfor"ance5oriented investors8 $% contrast8 9ill $u% onl% 9hen

invest"ents "eet a$solute standards of value< The% 9ill choose to $e full% invested

onl% 9hen availa$le opportunities are $oth sufficient in nu"$er and co"pelling in

attractiveness8 preferring to re"ain less than full% invested 9hen $oth conditions are

not "et< In investing8 there are ti"es 9hen the $est thing to do is nothing at all< 0et

institutional "one% "anagers are unlikel% to adopt this alternative unless "ost of

their co"petitors are si"ilarl% inclined<





) W6ERE MOST INESTORS ST5M7E

as intellectuall% insulting to clientsF it also e:acer$ates price "ove"ents in either

direction< ven so8 as depressed issues drop further in price8 attractive opportunities

"a% $e created for value investors<

!erhaps as a response to the difficulties of successfull% "anaging institutional

portfolios8 a nu"$er of professional investors have a$andoned funda"ental anal%sis

entirel%< 4ather than overco"ing the pro$le"s of professional "one% "anage"ent8

ho9ever8 the% have co"pounded the"< The re"ainder of this chapter descri$es their

activities<

The Abanonment o8 Funamental Investment

Anal%s#s b% Inst#tut#onal Investors

7ver the past several %ears there has $een an enor"ous increase in the a"ount of

"one% "anaged $% people 9ho kno9ingl% ignore the underl%ing funda"entals of the

invest"ents o9ned< Acade"ic notions8 such as the efficient5"arket h%pothesis and

the capital5asset5pricing "odel =three of 9hose "ost vociferous proponents received

the No$el !riDe for econo"ics in 1/>8 support these ne9 invest"ent strategies<

Inde:ing is the pri"ar% invest"ent outlet for investors 9ho $elieve in these ideas<

!ractices such as tactical asset allocation8 portfolio insurance8 and progra" trading

share to a greater or lesser e:tent the sa"e disregard for investing $ased on co"5pan%5$%5co"pan% funda"entals<

"ort8ol#o Insuran(e

,an% institutional investors are forever seeking to uncover a "agic for"ula

for invest"ent success< A successful for"ula 9ould greatl% si"plif% their livesF

investing 9ould $eco"e effortless8 "arketing 9ould $e a cinch8 and the% 9ould

al"ost






As i"practical as portfolio insurance is for an% one investor8 it $eco"es ?uite

dangerous 9hen large nu"$ers of investors engage in it< With too "an%

practitioners8 frantic selling of stock inde: futures $% portfolio insurers could drive

futures prices $elo9 the underl%ing stock prices8 "aking it profita$le for ar$itrageursto $u% the cheap futures and sell the underl%ing stocks< Such selling 9ould put

additional pressure on stock prices8 perhaps necessitating "ore futures sales $%

portfolio insurers< A vicious circle could ensue<

This is e:actl% 9hat happened on ,onda%8 7cto$er 18 1.< After a sharp

"arket decline the previous 9eek $illions and $illions of dollars@ 9orth of stock inde:

futures 9ere du"ped in relentless 9aves $% portfolio insurers< This selling drove the

futures as "uch as 1/ percent $elo9 stock prices8 creating an attractive opportunit%

for ar$itrageurs to $u% futures and sell stocks< This selling drove share prices even

lo9er8 triggering "ore sales of futures $% hapless portfolio insurers< The notion that

%ou could escape do9nside risk $% selling futures 9as discredited in a couple of

hours that da% !ortfolio insurance had lured people 9ho 9ere not co"forta$le 9ith

the risks of stocks into $u%ing and holding the"< An apparentl% conservative strateg%

designed to prevent loss pla%ed an i"portant role in the 9orst de$acle in recent

financial histor%<

Ta(t#(al Asset Allo(at#on

B% 1.8 9ith portfolio insurance discredited8 institutional investors returned

to their co"puters searching for ne9 for"ulas< No9 their goal 9as to find a clear

signal that 9ould indicate 9hether stocks or $onds 9ere the $etter $u%< Although the

search for this ans9er has preoccupied investors over the %ears8 it is unlikel% that a

co"puter could ever $e progra""ed to "ake 9hat is clearl% a ;udg"ent call< 0et

9hat 9ould have $een considered a crackpot sche"e if adopted $% an individual









3= W6ERE MOST INESTORS ST5M7E

transact< 0et even ver% large capitaliDation stocks have li"ited li?uidit% at a given

ti"e< 79ing to li"ited li?uidit%8 on the da% that a ne9 stock is added to an inde:8 it

often ;u"ps apprecia$l% in price as inde:ers rush to $u%< Nothing funda"ental has

changedF nothing "akes that stock 9orth "ore toda% than %esterda%< In effect8people are 9illing to pa% "ore for that stock ;ust $ecause it has $eco"e part of an

inde:<

B% 9a% of e:a"ple8 9hen Block$uster ntertain"ent 'orporation 9as added

to the Standard and !oor@s )// Inde: in earl% 118 its total "arket capitaliDation

increased in one da% $% over 1)) "illion8 or <1 percent8 $ecause so "an% fund

"anagers 9ere Go$ligedG to $u% it< Indeed8 arron$s has calculated that stocks added

to the Standard K !oor@s )// Inde: outperfor"ed the "arket $% al"ost * percent in

the first 9eek after their inclusion<

A related pro$le" e:ists 9hen su$stantial funds are co""itted to or

9ithdra9n fro" inde: funds specialiDing in s"all5capitaliDation stocks< =There are

no9 a nu"$er of such funds<> Such stocks usuall% have onl% li"ited li?uidit%8 and

even a s"all a"ount of $u%ing or selling activit% can greatl% influence the "arket

price< When s"all5capitaliDation5stock inde:ers receive "ore funds8 their $u%ing 9ill

push prices higherF 9hen the% e:perience rede"ptions8 their selling 9ill force prices

lo9er< B% unavoida$l% $u%ing high and selling lo98 s"all5stock inde:ers are al"ost

certain to underperfor" their inde:es<

7ther perverse effects of inde:ing are no9 e"erging 9ith increasing

fre?uenc%< When securities are o9ned onl% $ecause the% are part of an inde: and the

onl% stated goal of the o9ners is to "atch the "ove"ents of that inde:8 the portfolio

G"anagerG responsi$le for those securities has virtuall% no interest in influencing the

perfor"ance of the inde:< He or she is indifferent to 9hether the inde: rises or falls in

value8 other than to the e:tent that fees are $ased on total "anaged assets valued

at "arket prices<

This "eans that in a pro:% contest8 it "akes no real difference to the

"anager of an inde: fund 9hether the dissidents or the incu"$ent "anage"ent

9ins the fight8 even though the out5



#he Institutional Performance Derby0 #he Client Is the 1oser

co"e "a% "ake a significant financial difference to the clients of the inde:er< =B%

choosing inde:ing8 investors have i"plicitl% e:pressed the $elief that their vote in a

pro:% contest could "ake no predicta$le financial difference an%9a%<> Ironicall%8

even if inde:ers 9anted to vote in a direction that "a:i"iDed value8 the% 9ould havea$solutel% no idea 9hich 9a% that 9ould $e $ecause inde: fund "anagers t%picall%

have no funda"ental invest"ent kno9ledge a$out the stocks the% o9n<.

It is note9orth% that the $oo" in inde:ing has occurred during a $ull "arket<

Bet9een 1./ and 1/ the esti"ated a"ount of "one% "anaged in inde:ed

accounts increased fro" 1/ $illion to a$out 1/ $illion8 9ith / percent of that

a"ount inde:ed to Standard K !oor@s portfolios< An additional 1// $illion or "ore is

$elieved to $e Gcloset inde:ed8G that is8 to track8 if not e:actl% "atch8 the SK! )//

Inde:< According to arron$s" GNo little i"petus has $een supplied to this "elanchol%

trend $% the harsh fact that the SK! has laid 9aste to the perfor"ance of

conventional "anagers during the ighties8 particularl% in the past five %ears< 6or

e:a"ple8 the SK! has $eaten the average e?uit% "utual fund in the (ipper Anal%tical

Service8 Inc<8 surve% in 2* out of the past 31 ?uarters<G1/ The SK! )// Inde: has also

significantl% $ettered the $roadl% $ased Wilshire )/// Inde: since the second half of

1.38 outperfor"ing it in t9ent%5three out of t9ent%5nine ?uartersF during that period

the co"pound annual total return for the SK! )// Inde: 9as 12< percent co"pared

9ith 1/< percent for the Wilshire )/// Inde:<

I $elieve that inde:ing 9ill turn out to $e ;ust another Wall Street fad< When it

passes8 the prices of securities included in popular inde:es 9ill al"ost certainl%

decline relative to those that have $een e:cluded< ,ore significantl%8 as arron$s has

pointed out8 GA self5reinforcing feed$ack loop has $een created8 9here the success of

inde:ing has $olstered the perfor"ance of the inde: itself8 9hich8 in turn pro"otes

"ore inde:ing<GG When the "arket trend reverses8 "atching the "arket 9ill not

see" so attractive8 the selling 9ill then adversel% affect the perfor"ance of the

inde:ers and further e:acer$ate the rush for the e:its<





)2elus#ons o8 alue9

The M%ths an M#s(on(e$t#ons

o8 Bun, 7ons #n the 1':;s The ;unk5$ond $oo" 9ould not have occurred 9ithout the enthusiastic acceptance of

financial5"arket participants< The greed and possi$l% the ignorance of individual

investors8 the short5ter" orientation of institutional investors8 and the tendenc% of

Wall Street to "a:i"iDe its self5interest a$ove all ca"e together in the 1./s to allo9

a 2// $illion "arket to develop virtuall% fro" scratch< Although unproven over a

co"plete econo"ic c%cle8 ne9l% issued ;unk $onds 9ere hailed as a safe invest"ent

that provided a ver% attractive return to investors< B% 1/8 ho9ever8 the concept of

ne9l% issued ;unk $onds had $een e:posed as seriousl% fla9ed8 defaults reached

record levels8 and the prices of "an% issues plunged< ven so8 the ;unk5$ond "arket

staged a surprising recover% in earl% 11F "an% of the fla9s that had resulted in

tens of $illions of dollars of losses 9ere once again $eing ignored<

Historicall% "an% financial5"arket innovations have gained 9idespread

acceptance $efore $eing e:posed as ill conceived<

.



3' W6ERE MOST INESTORS ST5M7E

What is uni?ue a$out ;unk $onds is the speed and "agnitude of their riseF their

strong and pernicious influence on other securities8 on financial "arkets8 and on the

$ehavior of $usinessesF and their continued popularit% in the face of large investor

losses< !erhaps "ost i"portant8 ;unk $onds gave an up9ard propulsion to $usinessvaluation8 as ti"e5tested anal%tical standards and trusted %ardsticks of value ca"e

to $e either overlooked $% investors or a$andoned for ne9 and unproven ones< This

chapter is intended as a cautionar% tale8 an illustration of ho9 seriousl% "isguided

investor thinking can $eco"e<

The ;unk5$ond de$acle 9as no great surprise< It had $een predicted pu$licl%

$% -a"es rant8 editor of Grant$s Interest 3ate 4bserver" (ouis (o9enstein8 author of

,hat$s ,rong with ,all !treet" Warren Buffett8 chair"an of Berkshire Hatha9a%8

Inc<8 and "e a"ong others< The ;unk5$ond "arket not onl% e:isted $ut actuall%

thrived in the face of continued criticis" and repeated 9arnings< The self5interest of

the participants in its perpetuation 9as so great8 ho9ever8 that the% used their

collective influence to effectivel% stave off for a nu"$er of %ears the gro9ing 9eight

of evidence against ;unk $onds<

A 7r#e8 6#stor% o8 the Bun,!7on Mar,et

To understand the ;unk5$ond "arket and its a"aDing gro9th in the 1./s8 one "ust

$egin 9ith ,ichael ,ilken8 its "aster"ind< In college and then at the Universit% of!enns%lvania@s Wharton School of Business in the earl% 1/s8 ,ilken studied the

9ork of acade"ician W< Braddock Hick"an< T9o decades earlier Hick"an had sho9n

that a 9ell5diversified8 lo95grade $ond portfolio could earn a greater rate of return

than a high5?ualit% $ond portfolioF in other 9ords8 the higher %ields on lo95rated

securities 9ould "ore than co"pensate for capital losses fro" an% defaults<1 This

opportunit% e:isted $ecause risk5averse investors shunned lo95grade $onds

regardless of potential return< Hence such $onds traded at depressed prices8 and lo9



#he /yths and /isconceptions of 5unk onds in the &6')s /

prices8 not high coupons8 9ere the driving force $ehind the attractive returns< As 9e

shall see8 the legiti"ate opportunit% in a virtual handful of distressed securities that

9ere overlooked $% others 9as carried to e:cess 9hen ,ilken e:trapolated fro" a

historical relationship to an entirel% ne9 t%pe of securit%<After graduating fro" the Wharton School8 ,ilken took a ;o$ at #re:el

6irestone8 9here he traded the $onds of Gfallen angels8G co"panies that had

deteriorated in credit ?ualit% to $elo9 invest"ent grade< According to legend8 ,ilken

co""uted fro" his ho"e outside !hiladelphia to his Wall Street office $% $us8

spending the hours en route reading corporate financial state"ents $% the di" light

of a "iner@s headla"p that he 9ore< He soon $eca"e one of the "ost kno9ledgea$le

and visi$lepeople on Wall Street in the high5%ield "arket<

The argu"ents in favor of high5%ield5$ond investing represented a radical

departure fro" the conventional 9isdo" of the earl% 1./s< In the after"ath of the

1*5) recession and $ear "arket8 investors 9ere generall% loathe to incur credit

risk< !assage of the "plo%ee 4etire"ent Inco"e and Securit% Act of 1* =4ISA>

led "an% institutions to adopt stringent fiduciar% standards that precluded risk

taking< ,ilken overca"e investor reluctance $% purportedl% de"onstrating that

invest"ent in lo95rated securities historicall% provided higher total returns than

could $e earned on invest"ent5grade securities<

The %ield on lo95rated $onds 9as o$viousl% high< The ne98 radical clai" 9as

that the risk 9as also lo9& losses fro" defaults 9ould $e "ore than offset $%

incre"ental %ield< This clai" of a lo9 default rate 9as central to the $ullish case for

;unk $ondsa case that co"es apart under even casual scrutin%<

6allen5angel $onds t%picall% are illi?uid8 and potential $u%ers are put off $%

the fear of $eing virtuall% locked into their invest"ents< Another prere?uisite to the

esta$lish"ent of a ne95issue ;unk5$ond "arket then 9as ,ilken@s pro"ise of

li?uidit%< ,ilken pro"ised $u%ers that he 9ould "ake a "arket in all of his deals8

ensuring li?uidit%< In the earl% da%s of the ne95issue ;unk5$ond "arket a great

a"ount of paper 9as traded $ack and



&1 W6ERE MOST INESTORS ST5M7E

forth a"ong a nu"$er of ,ilken disciples< This gave the appearance of li?uidit%8

9hich 9as8 in fact8 onl% as deep as ,ilken@s various pockets<

Before ,ichael ,ilken ca"e along8 the onl% ;unk $onds in e:istence 9ere a

fe9 $illion dollars@ face a"ount of fallen angels< Investors 9ere no "ore likel% to $u%

ne9l% issued ;unk $onds at par =the face value of a $ond8 the contractual a"ount of

the $ondholders@ clai"> than an offering of co""on stock in a $ankrupt issuer<

,ilken shaped financial histor% $% pioneering the issuance of ;unk $onds8 glossing

over the "a;or differences $et9een fallen angels and ne9 issues< This re?uired an

enor"ous leap of faith8 one 9hich ,ilken "ade and 9as a$le to persuade others to

"ake as 9ell<

Unfortunatel% ne9l% issued ;unk $onds 9ere not the lo95risk instru"ents that

$u%ers 9ere led to $elieve< The% have8 in fact8 ver% different risk and return

characteristics fro" fallen angels< Specificall%8 ne9l% issued ;unk $onds offer no"argin of safet% to investors< Trading around par value8 the% have ver% li"ited

appreciation potential8 $ut unlike high5grade $onds trading near par8 the% have

su$stantial do9nside risk< A fallen angel8 $% contrast8 trades considera$l% $elo9 par

and thus has less do9nside risk than ne9l% issued ;unk $onds of co"para$le credit

?ualit%< The other side of this coin is that $onds trading $elo9 par have "ore upside

price potential than $onds trading at par< If underl%ing credit ?ualit% i"proves or if

interest rates drop8 discount $onds have roo" for su$stantial appreciationF $onds

trading at par8 $% contrast8 are usuall% su$;ect to call prior to "aturit% and thus have

ver% li"ited upside potential< 7ther things $eing e?ual8 then8 ne9l% issued ;unk

$onds carr% greater risk of loss 9ith lo9er potential return than fallen angels8 an

i"portant distinction that ,ilken failed to "ake8 at least pu$licl%<

The Fla-s o8 the 2e8ault!Rate Cal(ulat#on

There 9as8 in fact8 no reasona$le $asis for ,ilken@s clai" that the default rate

of ;unk $onds issued in the late 1./s 9ould $e





&+ W6ERE MOST INESTORS ST5M7E

cash5pa% ;unk $onds "a% actuall% $e in trou$le long $efore the actual event of

default<

In the "id51./s several acade"ics produced studies concluding that ;unk

$onds 9ere attractive invest"ents< In earl% 1/8 even as the "arket 9as collapsing8

d Alt"an edited #he High 7ield Debt /arket" an antholog% of "ore than a doDen

recent articles "ostl% lauding ;unk5$ond issuance and invest"ent< Such up$eat

anal%ses8 so"eti"es financed $% the leading high5%ield under9riters8 failed to take

into account the serious fla9s in the default5rate calculation<

The default rate 9as offered $% under9riters8 approved $% acade"ics8 and

accepted $% investors as a pro:% for investor losses fro" ;unk $onds that 9ent $ad<

Not onl% 9as its calculation an e:ercise in science fiction8 it also ignored the fact that

defaults and investor losses are not the sa"e thing< A fallen angel that defaults8 for

e:a"ple8 has not so far to drop as a ;unk $ond trading at par< The default rate also

failed to incorporate the financial i"pact of voluntar% e:change offers and restruc5

turings in 9hich $ondholders accepted i"pair"ent of their clai"s 9ithout an actual

default having taken place<

The Bun,!7on Crusae

-unk $onds appeared to perfor" a sort of financial alche"%8 as (ouis (o9enstein has

o$served<3 79ners of the ;unk $onds issued $% the "an% co"panies 9hose interest

e:penses 9ere greater than their preta: profits 9ere a$le to clai" to have earned

interest inco"e in e:cess of the profits earned $% the underl%ing $usinesses< As long

as investors 9ere 9illing to purchase $onds on such ter"s8 there 9ere ne9

under9ritings to $e done< And as long as the %ield illusion 9as perpetuated8 investors

kept $u%ing the $onds<

The tre"endous gro9th of the "arket 9as acco"panied $% a $uildup of the

;unk5$ond infrastructure on Wall Street< If investors the"selves failed to discern the

attractiveness of ;unk





&= W6ERE MOST INESTORS ST5M7E

cient8 ad"inistrativel% $loated8 or even corrupt8 and in desperate need of ne9

"anagerial $lood< While there 9ere certainl% kernels of truth in this characteriDation

of corporate A"erica8 there 9as onl% scant consideration of 9hether the i"position of

a staggering de$t $urden 9as the $est re"ed% for this particular ail"ent< ,oreover8virtuall% no one noticed or cared that ;unk $onds 9ere no longer fulfilling their

for"er8 highl% pu$liciDed role of financing s"all co"panies<

It see"s incredi$le that an%one could get a9a% 9ith the portra%al of ;unk

$onds as a kind of financial aspirin good for 9hat ails %ou< Nevertheless8 ,ilken had

legions of lo%al follo9ers8 "an% of 9ho" he had helped "ake incredi$l% rich< ven

the $lue $loods of Wall Street like ,organ Stanle%8 6irst Boston8 and old"an Sachs8

once threatened $% ,ilken@s $urgeoning ;unk5$ond e"pire8 had $% the "id51./s

$uilt e:tensive ;unk5$ond under9riting8 "arketing8 and trading capa$ilities of their

o9n< Al$eit to a lesser degree than ,ilken8 the% too 9ere no9 $eneficiaries of the

$oo"ing ;unk5$ond "arket< The greatest iron% in the 9hole ;unk5$ond stor% "a% $e

that one of the $iggest financial s9indles of all ti"e8 ne9l% issued ;unk $onds8 had $%

the end of the 1./s co"e to en"esh ever% "a;or Wall Street fir" alongside #re:el

Burnha" (a"$ert< (ong after the de"ise of #re:el8 the rest of Wall Street 9ould $e

licking its ;unk5$ond5inflicted 9ounds8 a nagging re"inder of the 9idespread greed

that 9ouldn@t leave a shak% financial innovation to its po9er5hungr% founder<

Earl% Su((esses o8 Bun,!7on Investors e to

5nreal#st#( E0$e(tat#ons

Self5fulfilling prophesies contri$uted to the successful ;unk5$ond e:periences

of the earl% to "id51./s< The increasing availa$ilit% of nonrecourse ;unk5$ond de$t

=in 9hich the lender looks onl% to the $orro9ing entit% for pa%"ent> led to increasing

"ultiples $eing paid for corporate assets< This is $ecause



#he /yths and /isconceptions of 8unk onds in the &6')s

$u%ers ar"ed 9ith other people@s "one% developed a ske9ed vie9 of risk and return

co"pared 9ith that of $u%ers using their o9n "one% and 9ere therefore 9illing to

pa% higher and higher prices< Business valuations started to increase at the sa"e

ti"eF the econo"% 9as re$ounding fro" the 1.2 recession8 and interest rates 9ere

falling fro" their earl% 1./s peak< cono"ic gro9th $oosted operating results for

"an% ;unk5$ond issuersF declining interest rates allo9ed a nu"$er of issuers to

refinance on advantageous ter"s< ven $ad deals 9ere $ailed out $% a gro9ing

econo"% and higher $usiness valuations8 reinforcing the notion of a lo9 default rate<

arl% investors did 9ell8 e"$oldening othersF su$se?uent deals 9ere perfor"ed at

still higher "ultiples of earnings and cash flo9< #r !epper8 -ack5in5the5Bo:8 and 'olt

Industries8 Inc<8 for e:a"ple8 9ere each $ought and sold "ore than once at

successivel% higher prices<

,ost ;unk5$ond $u%ers and issuers 9ere pro$a$l% una9are that the% 9erei"plicitl% assu"ing a great deal a$out the ongoing health of the econo"% and the

;unk5$ond "arket< ,an% ;unk5$ond issuers8 for e:a"ple8 had raDor5thin or

none:istent interest coverage =ratio of preta: earnings to interest e:pense> and

insufficient cash flo9 to "eet upco"ing de$t5principal repa%"ents< Issuers and

investors alike assu"ed that cash flo9 9ould al9a%s gro9 and that upco"ing

"aturities could $e refinanced< If gro9th did not "aterialiDe or if credit proved

unavaila$le8 a financial restructuring or $ankruptc% filing 9ould result< High5%ield

$onds 9ere not purchased $% cautious investors8 ho9ever8 $ut $% opti"istic8 short5

ter"5oriented8 and gulli$le ones< It is not surprising that ;unk5$ond holders did not

e:pect an econo"ic do9nturn or credit contractionF if the% had8 the% 9ould not have

$ought ;unk $onds<

The pervasive opti"is" of investors led to a rela:ation of invest"ent

standards< A stud% $% Barrie Wig"ore8 a li"ited partner at old"an Sachs8 sho9ed

that the t%pical interest coverage ratio for ne9l% issued ;unk $onds declined

drasticall% $et9een 1./ and 1.. to the point 9here it fell $elo9 1</that is8

preta: earnings 9ere less than interest e:pense for the aver5







&' W6ERE MOST INESTORS ST5M7E

the rate paid on deposits< In the presence of deposit insurance8 the "arket could not

and did not i"pose discipline on the invest"ent $ehavior of thrift institutions< As long

as ;unk $onds did not default in large nu"$ers8 the thrifts that invested in the"

9ould achieve high reported returns that $elonged to the o9ners and to"anage"ent< If the $onds defaulted8 the 6S(I' 9ould $ear the losses<

The largest thrift o9ners of ;unk $onds'olu"$ia Savings and (oan

Association8 'enTrust Savings and (oan Association8 I"perial Savings and (oan

Association8 (incoln Savings and (oan Association8 and 6ar West 6inancial

'orporation9ere either insolvent or on the $rink of insolvenc% $% the end of 1/<

,ost of these institutions had gro9n rapidl% through $rokered deposits =deposits

raised 9ith the assistance of Wall Street> for the sole purpose of investing the

proceeds in ;unk $onds and other risk% assets< The legac% of thrift invest"ent in ;unk

$onds is that these invest"ents caused "a;or pro$le"s for institutions that

other9ise 9ould have $een $oth considera$l% s"aller and less trou$led<

Insuran(e Com$an#es

A nu"$er of insurance co"panies 9ere also caught up in a cost5of5funds s?ueeDe in

the earl% 1./s< To investors seeking high %ields the% $egan to offer guaranteed

invest"ent contracts =I's>8 9hose attraction 9as the reinvest"ent of interest at

contractual rates8 effectivel% eli"inating reinvest"ent risk<

When U<S< govern"ent $ond %ields 9ere dou$le digit8 insurers 9ere a$le to

offer attractive rates on I's 9hile taking on little or no credit risk< When interest

rates declined8 insurers continued to offer high I' %ields in order to avoid a runoff of

assets< To "aintain a positive %ield spread8 insurance co"panies 9ere forced to

reach for %ield8 and "an%8 like 6irst :ecutive 'orporation and 6irst 'apital Holdings

'orporation8 9ere lured into the ;unk5$ond "arket< Unfortunatel% a nu"$er of their

co"petitors felt co"pelled to $id for I' $usiness despite the risks of $eco"ing ;unk5

$ond investors the"selves< B% 1/ a nu"$er of leading insurance co"panies had to

take





:1 W6ERE MOST INESTORS ST5M7E

"itring historicall% unprecedented "ultiples to $e paid for $usinesses in the "id5late

1./s<

ero5coupon and !IC financing can act as corporate life support s%ste"s8

preserving patients 9ho are ter"inall% ill< Such issuers can have lia$ilities thate:ceed assets and $e una$le to "eet de$t5service o$ligations in cash %et re"ain in

$usiness8 giving an appearance of financial health< As Buffett has o$served8 GIf (#'

govern"ents had issued no de$t in the 1/s other than long5ter" Dero5coupon

o$ligations8 the% 9ould no9 have a spotless record as de$tors<G*

Historicall% investors in $onds have en;o%ed a presu"ption of solvenc%8

safet%8 and even seniorit%< An investor in a U<S< Treasur% $ill8 for e:a"ple8 or GDero5

coupon U<S< govern"ent $ondG =created s%ntheticall% 9hen a Wall Street fir" strips

the cash flo9s fro" a U<S< Treasur% $ond and sells each pa%"ent seriall%> can $e

confident that inco"e and principal 9ill $e paid at "aturit%< A ;unk Dero5coupon

$ond8 ho9ever8 is a ga"$leF no cash is paid until "aturit%8 at 9hich point it either

pa%s or defaults< ,an% $u%ers of Dero5coupon or !IC ;unk $onds 9ho $elieved that

the% 9ere locking in an attractive %ield to "aturit% turned out to have ga"$led and

lost< Indeed8 "ost ;unk Dero5coupon and !IC instru"ents "ore closel% rese"$led

options on a future i"prove"ent in $usiness results than fi:ed and secure clai"s

against the current value of a co"pan%< 'alling ;unk Dero5coupon and !IC securities

$onds didn@t give the" the sa"e risk and return characteristics as other $onds8 $ut it

did "ake the" easier to sell to investors<

Interest Rate Resets Wor, #n Onl% One 2#re(t#on

In the late 1./s interest rate resets $eca"e a co""on and 9idel% accepted feature

of ne9l% issued ;unk $onds< An interest rate reset is a pro"ise "ade $% an issuer to

ad;ust the coupon on a $ond at a specified future date in order to cause it< to trade at

a predeter"ined price8 usuall% par<) This reset feature8 "as?uerading as a sort of

financial guarantee8 is reall% a financial place$o< It appears to provide a "eaningful

assurance of capital



#he /yths and /isconceptions of 5unk onds in the &6')s .2

preservation $ut is virtuall% 9orthless< 'reated during an era 9hen al"ost an%one

could $orro9 a great deal of "one%8 the "isleading reset feature serves as a

re"inder that a pro"ise is onl% as good as the entit% that "akes it<

6or a $ond reset to 9ork properl%8 the underl%ing issuer "ust $e credit9orth%<!arado:icall%8 if the issuer is credit9orth%8 the reset feature is unnecessar% =other

than to ad;ust for apprecia$le interest rate "ove"ents in the econo"% or "inor

fluctuations in the issuer@s credit9orthiness>< There is no interest rate8 ho9ever8 that

9ill cause the $onds of a severel% distressed issuer to trade at parF no "atter ho9

"uch the interest coupon is raised8 the do9nside risk to prospective $u%ers holds

do9n the $ond@s "arket price< ,oreover8 the higher the rate at 9hich the coupon is

reset8 the 9orse off the issuer $eco"es8 as increased de$t5service re?uire"ents

e:acer$ate the financial distress<

Nu"erous ;unk5$ond resets failed in the late 1./s8 and onl% a fe9

succeeded< The $onds of ,a::a"8 Inc<8 9ere a near successF reset to trade at par8

the% failed to sell a$ove )8 despite ,a::a"@s strong $usiness results at the ti"e< An

issue of 1 percent Western Union 'orporation $onds 9as reset to a 1<2) percent

coupon at a ti"e 9hen Western Union alread% had one foot in the graveF the $ond

prices did not respond to the reset8 declining ?uickl% fro" the ./s to the */s and

then lo9er still< In 1. #re:el Burnha" (a"$ert 9as una$le to reset the $onds of

-i" Walter 'orporation8 9hich 9as then forced to file for $ankruptc%<

In a daring displa% of financial chutDpah8 Cohl$erg8 Cravis and 4o$erts =CC4>8 the

$u%er of 4-4 Na$isco8 Inc< =4-4>8 in 1.8 cra""ed do9n =distri$uted> ) $illion face

value of reset5ta$le !IC securities to for"er stockholders of that co"pan% as "erger

consideration< The perceived attractiveness of the reset feature "a% have allo9ed

CC4@s $id to prevail over co"peting offers8 although the entire reset "arket 9as far

less than the siDe of this issue alone and the record of previous reset atte"pts 9as

a$%s"al< The reset feature8 accepted $% $u%ers as an al"ost ironclad guarantee8

stirred enor"ous enthusias" for the 4-4 cra"5do9n paper< So"e of the de"and 9as

fro" investors



:+ W6ERE MOST INESTORS ST5M7E

9ho didn@t usuall% purchase ;unk $onds $ut 9ere attracted $% the apparent pro"ise

of GassuredG par value<

The "ost 9idel% ?uoted %ield on the 4-4 Na$isco $onds and preferred stock

9as not the conventional current %ield or %ield to "aturit% $ut the ne9l% coinedG%ield to reset<G Su$stantial su"s 9ere invested $ased on this unproven concept8 one

that 9ould 9ork onl% if 4-4 Na$isco 9ere financiall% health% and if the ;unk5$ond

"arket 9ere not in disarra%< As it turned out8 even after a last5ditch infusion of 1<)

$illion of ne9 e?uit% capital into 4-4 Na$isco8 the $onds failed to trade a$ove 3

percent of par at the date of the reset< It 9as onl% later8 after the co"pan%

co"pleted a "ore significant deleveraging8 that the "arket price of the $onds

reached par value<

An Anal%t#(al Error o8 Bun,!7on Investors

The rela:ation of invest"ent standards $% ;unk5$ond investors 9as acco"panied $%

the dangerous "isconception that the a"ount of de$t and e?uit% in a co"pan%@s

capital structure ;unior to one@s o9n invest"ent provided a degree of protection< It

9as as if the value of a $usiness e:isted on the lia$ilit% side rather than on the asset

side of its $alance sheet< Although it "a% $e superficiall% reassuring to kno9 that

there are investors in a co"pan% 9hose clai"s are su$ordinated to %our o9n8 this

infor"ation is of little8 if an%8 value in assessing the "erits of %our invest"ent<

At the ti"e of the 2) $illion 4-4 Na$isco leveraged $u%out8 Wall Street

anal%sts argued that the issuance of ) $illion 9orth of cra"5do9n de$t and

preferred stock i"proved the credit9orthiness of 4-4@s senior de$t< To illustrate the

fallac% of this argu"ent8 suppose CC4 had paid 12 rather than 1/ per share for

4-4 in the for" of an additional * $illion of cra"5do9n preferred stock< The senior

lenders 9ould have $een no $etter off 9ith this additional * $illion of $ook e?uit%

;unior to theirs< No "ore tangi$le assets 9ould have $elonged to the co"pan% than

$eforeF onl% the intangi$le asset called good9ill 9ould have $een increased via a

$ookkeeping entr%< ,oreover8 the i"proved de$t5to5e?uit% ratio 9ould have $een

irrelevant



#he /yths and /isconceptions of 5unk onds in the &6')s :)

to the safet% of the senior lenders< "phasis on the ;unior clai"s against a co"pan%

is a greater5fool argu"ent8 9herein one takes co"fort fro" the potentiall% foolish

actions of others rather than fro" the 9isdo" of one@s o9n<

A Fla-e 2e8#n#t#on o8 Cash Flo-> E7IT2A> eas to Overvaluat#on

Investors in pu$lic co"panies have historicall% evaluated the" on reported earnings<

B% contrast8 private $u%ers of entire co"panies have valued the" on free cash flo9<

In the latter half of the 1./s entire $usinesses 9ere $ought and sold al"ost as

readil% as securities8 and it 9as not unreasona$le for investors in securities to start

thinking "ore like $u%ers and sellers of entire $usinesses< There is8 of course8

nothing 9rong 9ith ree:a"ining an old anal%tical tool for continued validit% nor 9ith

replacing one that has $eco"e out"oded< Thus8 in a radical departure fro" thehistorical nor"8 "an% stock and ;unk5$ond $u%ers in the latter half of the 1./s

replaced earnings 9ith cash flo9 as the anal%tical "easure of value<

In their haste to anal%De free cash flo98 investors in the 1./s sought a si"ple

calculation8 a single nu"$er8 that 9ould ?uantif% a co"pan%@s cash5generating

a$ilit%< The cash5flo9 calculation the great "a;orit% of investors settled upon 9as

BIT#A =earnings $efore interest8 ta:es8 depreciation8 and a"ortiDation>< +irtuall% all

anal%ses of highl% leveraged fir"s relied on BIT#A as a principal deter"inant of

value8 so"eti"es as the onl% deter"inant< ven nonleveraged fir"s ca"e to $e ana5

l%Ded in this 9a% since virtuall% ever% co"pan% in the late 1./s 9as dee"ed a

potential takeover candidate< Unfortunatel% BIT#A 9as anal%ticall% fla9ed and

resulted in the chronic overvaluation of $usinesses<

Ho9 should cash flo9 $e "easuredE Before the ;unk5$ond era investors

looked at t9o co"ponents& after5ta: earnings8 that is8 the profit of a $usinessF plus

depreciation and a"ortiDation "inus capital e:penditures8 that is8 the net invest"ent

or disinvest"ent in the fi:ed assets of a $usiness< The availa$ilit% of large a"ounts of

nonrecourse financing changed things< Since



:= W6ERE MOST INESTORS ST5M7E

interest e:pense is ta: deducti$le8 preta:8 not after5ta:8 earnings are availa$le to pa%

interest on de$tF "one% that 9ould have gone to pa% ta:es goes instead to lenders<

A highl% leveraged co"pan% thus has "ore availa$le cash flo9 than the sa"e $usi5

ness utiliDing less leverage<Not9ithstanding8 BIT =earnings $efore interest and ta:es> is not necessaril%

all freel% availa$le cash< If interest e:pense consu"es all of BIT8 no inco"e ta:es

are o9ed< If interest e:pense is lo98 ho9ever8 ta:es consu"e an apprecia$le portion

of BIT< At the height of the ;unk5$ond $oo"8 co"panies could $orro9 an a"ount so

great that all of BIT =or "ore than all of BIT> 9as fre?uentl% re?uired for pa%ing

interest< In a less froth% lending environ"ent co"panies cannot $eco"e so highl%

leveraged at 9ill< BIT is therefore not a reasona$le appro:i"ation of cash flo9 for

the"< After5ta: inco"e plus that portion of BIT going to pa% interest e:pense is a

co"pan%@s true cash flo9 derived fro" the ongoing inco"e strea"<

'ash flo98 as "entioned8 also results fro" the e:cess of depreciation and

a"ortiDation e:penses over capital e:penditures< It is i"portant to understand 9h%

this is so< When a co"pan% $u%s a "achine8 it is re?uired under generall% accepted

accounting principles =AA!> to e:pense that "achine over its useful life8 a

procedure kno9n in accounting parlance as depreciation< #epreciation is a noncash

e:pense that reduces net reported profits $ut not cash< #epreciation allo9ances con5

tri$ute to cash $ut "ust eventuall% $e used to fund capital e:penditures that are

necessar% to replace 9orn5out plant and e?uip"ent< 'apital e:penditures are thus a

direct offset to depreciation allo9ancesF the for"er is as certain a use of cash as the

latter is a source< The ti"ing "a% differ& a co"pan% "a% invest heavil% in plant and

e?uip"ent at one point and after9ard generate depreciation allo9ances 9ell in

e:cess of current capital spending< Whenever the plant and e?uip"ent need to $e

replaced8 ho9ever8 cash "ust $e availa$le< If capital spending is less than

depreciation over a long period of ti"e8 a co"pan% is undergoing gradual li?uidation<

A"ortiDation of good9ill is also a noncash charge $ut8 con5



#he /yths and /isconceptions of 5unk onds in the &6')s .

versel%8 is "ore of an accounting fiction than a real $usiness e:pense< When a

co"pan% is purchased for "ore than its tangi$le $ook value8 accounting rules re?uire

the $u%er to create an intangi$le $alance5sheet asset kno9n as good9ill to "ake up

for the difference8 and then to a"ortiDe that good9ill over fort% %ears< A"ortiDation

of good9ill is thus a charge that does not necessaril% reflect a real decline in

econo"ic value and that likel% need not $e spent in the future to preserve the

$usiness< 'harges for good9ill a"ortiDation usuall% do represent free cash flo9<

It is not clear 9h% investors suddenl% ca"e to accept BIT#A as a "easure of

corporate cash flo9< BIT did not accuratel% "easure the cash flo9 fro" a co"pan%@s

ongoing inco"e strea"< Adding $ack 1// percent of depreciation and a"ortiDation to

arrive at BIT#A rendered it even less "eaningful< Those 9ho used BIT#A as a

cash5flo9 pro:%8 for e:a"ple8 either ignored capital e:penditures or assu"ed that

$usinesses 9ould not "ake an%8 perhaps $elieving that plant and e?uip"ent do not9ear out< In fact8 "an% leveraged takeovers of the 1./s forecast steadil% rising cash

flo9s resulting partl% fro" anticipated sharp reductions in capital e:penditures< 0et

the realit% is that if ade?uate capital e:penditures are not "ade8 a corporation is

e:tre"el% unlikel% to en;o% a steadil% increasing cash flo9 and 9ill instead al"ost

certainl% face declining results<

It is not eas% to deter"ine the re?uired level of capital e:penditures for a

given $usiness< Businesses invest in ph%sical plant and e?uip"ent for "an% reasons&

to re"ain in $usiness8 to co"pete8 to gro98 and to diversif%< :penditures to sta% in

$usiness and to co"pete are a$solutel% necessar%< 'apital e:penditures re?uired for

gro9th are i"portant $ut not usuall% essential8 9hile e:penditures "ade for

diversification are often not necessar% at all< Identif%ing the necessar% e:penditures

re?uires inti"ate kno9ledge of a co"pan%8 infor"ation t%picall% availa$le onl% to

insiders< Since detailed capital5spending infor"ation 9as not readil% availa$le to

investors8 perhaps the% si"pl% chose to disregard it<

So"e anal%sts and investors adopted the vie9 that it 9as not



:& W6ERE MOST INESTORS ST5M7E

necessar% to su$tract capital e:penditures fro" BIT#A $ecause all the capital

e:penditures of a $usiness could $e financed e:ternall% =through lease financing8

e?uip"ent trusts8 nonrecourse de$t8 etc<>< 7ne hundred percent of BIT#A 9ould

thus $e free preta: cash flo9 availa$le to service de$tF no "one% 9ould $e re?uiredfor reinvest"ent in the $usiness< This vie9 9as fla9ed8 of course< (easehold

i"prove"ents and parts of a "achine are not t%picall% financea$le for an% co"pan%<

'o"panies e:periencing financial distress8 "oreover8 9ill have li"ited access to

e:ternal financing for an% purpose< An over5leveraged co"pan% that has spent its

depreciation allo9ances on de$t service "a% $e una$le to replace 9orn5out plant and

e?uip"ent and eventuall% $e forced into $ankruptc% or li?uidation<

BIT#A "a% have $een used as a valuation tool $ecause no other valuation

"ethod could have ;ustified the high takeover prices prevalent at the ti"e< This

9ould $e a clear case of circular reasoning< Without high5priced takeovers there 9ere

no upfront invest"ent $anking fees8 no under9riting fees on ne9 ;unk5$ond issues8

and no "anage"ent fees on ;unk5$ond portfolios< This 9ould not $e the first ti"e on

Wall Street that the "eans 9ere adapted to ;ustif% an end< If a historicall% accepted

invest"ent %ardstick proves to $e overl% restrictive8 the path of least resistance is to

invent a ne9 standard<

E7IT2A Anal%s#s Obs(ures the 2#88eren(e bet-een Goo an 7a 7us#nesses

BIT#A8 in addition to $eing a fla9ed "easure of cash flo98 also "asks the

relative i"portance of the several co"ponents of corporate cash flo9< !reta:

earnings and depreciation allo9ance co"prise a co"pan%@s preta: cash flo9F

earnings are the return on the capital invested in a $usiness8 9hile depreciation is

essentiall% a return of the capital invested in a $usiness< To illustrate the confusion

caused $% BIT#A anal%sis8 consider the e:a"ple portra%ed in e:hi$it 1<



#he /yths and /isconceptions of 5unk onds in the &6')s ''9xhibit & Companies : and 7

In(ome Statement 8or 1''; @H #n m#ll#ons

Serv#(e Com$an% 4

Revenue H1;;Cash E0$enses :; 2e$re(#at#on an

Amort#?at#on JE7IT H*;E7IT2A H *;

Manu8a(tur#n/ Com$an% Y

Revenue H1;;Cash E0$enses :; 2e$re(#at#on an

Amort#?at#on *;E7IT H;E7IT2A H *;

Investors rel%ing on BIT#A as their onl% anal%tical tool 9ould value these t9o

$usinesses e?uall% At e?ual prices8 ho9ever8 "ost investors 9ould prefer to o9n

'o"pan% O8 9hich earns 2/ "illion8 rather than 'o"pan% 08 9hich earns nothing<

Although these $usinesses have identical BIT#A8 the% are clearl% not e?uall%

valua$le< 'o"pan% O could $e a service $usiness that o9ns no deprecia$le assets<

'o"pan% 0 could $e a "anufacturing $usiness in a co"petitive industr%< 'o"pan% 0

"ust $e prepared to reinvest its depreciation allo9ance =or possi$l% "ore8 due to

inflation> in order to replace its 9orn5out "achiner%< It has no free cash flo9 over

ti"e< 'o"pan% O8 $% contrast8 has no capital5spending re?uire"ents and thus has

su$stantial cu"ulative free cash flo9 over ti"e<

An%one 9ho purchased 'o"pan% 0 on a leveraged $asis 9ould $e in trou$le<

To the e:tent that an% of the annual 2/ "illion in BIT#A 9ere used to pa% cash

interest e:pense8 there 9ould $e a shortage of funds for capital spending 9hen plant

and e?uip"ent needed to $e replaced< 'o"pan% 0 9ould eventuall% go $ankrupt8

una$le $oth to service its de$t and "aintain its $usiness< 'o"pan% O8 $% contrast8

"ight $e an attractive $u%out candidate< The shift of investor focus fro"







'1 WH4 ,7ST IN+ST74S STU,B(

received $% e?uit% investors fro" ;unk5$ond5financed ac?uisitions returned to the stock

"arket8 $idding up the prices of shares in still independent co"panies< The "arket prices of

securities involved in ar$itrage transactions8 e:change offers8 and corporate reorganiDations

9ere all influenced $% the e:cessive valuations "ade possi$le $% the ;unk5$ond "arket< As a

result8 even those 9ho avoided o9ning ;unk $onds found it difficult to escape their influence

co"pletel%<

We "a% confidentl% e:pect that there 9ill $e ne9 invest"ent fads in the future< The%

too 9ill e:pand $e%ond the rational li"itations of the innovation< As surel% as this 9ill happen8

it is e?uall% certain that no $ells 9ill toll to announce the e:cess< Investors 9ho stud% the ;unk5

$ond de$acle "a% $e a$le to identif% these ne9 fads for 9hat the% are and avoid the"< And as

9e shall see in the chapters that follo98 avoiding losses is the "ost i"portant prere?uisite to

invest"ent success<

Notes

1< 'onnie Bruck8 The Predators !all =Ne9 0ork& !enguin8 1.>8 p< 2.<2< A "ore appropriate "ethod 9ould have $een to e:a"ine defaults or8 $etter still8 total

invest"ent returns for ;unk $onds grouped $% %ear of issuance8 9hich 9ould have eli"inated

the arith"etic fla9s in the custo"ar% default5rate calculation<

3< (ouis (o9enstein8 G(essons for Wall Street fro" ,ain Street8G "olu#$ia %aga&ine =7cto$er

1.>& 252<

*< Berkshire Hatha9a%8 Inc<8 annual report for 1.8 p< 1<

)< !ar is usuall% 18///8 $ut $ond prices are e:pressed as percentages of parF a $ond trading

at / is 9orth / percent of its 18/// par value8 or //<

< Anal%sts fre?uentl% co"pounded the error of using BIT#A as a pro:% for free cash flo9 $%

co"paring it 9ith cash interest e:pense rather than 9ith total interest e:pense in deter"ining

the cash flo9 coverage of interest< The ratio of the cash generated if a $usiness fails to

reinvest8 to onl% the interest that it "ust have pa% currentl%8 is not onl% "eaninglessF it

s"acks of deli$erate deception<



IIA A5E!INESTMENT

"6IOSO"6Y



=2e8#n#n/ Your Investment

GoalsWarren Buffett likes to sa% that the first rule of investing is G#on@t lose "one%8G and

the second rule is8 GNever forget the first rule<G I too $elieve that avoiding loss should

$e the pri"ar% goal of ever% investor< This does not "ean that investors should

never incur the risk of an% loss at all< 4ather Gdon@t lose "one%G "eans that over

several %ears an invest"ent portfolio should not $e e:posed to apprecia$le loss of

principal<

While no one 9ishes to incur losses8 %ou couldn@t prove it fro" an e:a"ination

of the $ehavior of "ost investors and speculators< The speculative urge that lies

9ithin "ost of us is strongF the prospect of a free lunch can $e co"pelling8 especiall%

9hen others have alread% see"ingl% partaken< It can $e hard to concentrate on

potential losses 9hile others are greedil% reaching for gains and %our $roker is on the

phone offering shares in the latest GhotG initial pu$lic offering< 0et the avoidance of

loss is the surest 9a% to ensure a profita$le outco"e<

A loss5avoidance strateg% is at odds 9ith recent conventional "arket 9isdo"<

Toda% "an% people $elieve that risk co"es8

3



') A A5E!INESTMENT "6IOSO"6Y

not fro" o9ning stocks8 $ut fro" not o9ning the"< Stocks as a group8 this line of

thinking goes8 9ill outperfor" $onds or cash e?uivalents over ti"e8 ;ust as the% have

in the past< Inde:ing is one "anifestation of this vie9< The tendenc% of "ost institu5

tional investors to $e full% invested at all ti"es is another< There is an ele"ent of truth to this notionF stocks do figure to outperfor"

$onds and cash over the %ears< Being ;unior in a co"pan%@s capital structure and

lacking contractual cash flo9s and "aturit% dates8 e?uities are inherentl% riskier than

de$t instru"ents< In a corporate li?uidation8 for e:a"ple8 the e?uit% onl% receives the

residual after all lia$ilities are satisfied< To persuade investors to venture into

e?uities rather than safer de$t instru"ents8 the% "ust $e enticed $% the prospect of

higher returns< Ho9ever8 as discussed at greater length in chapter 8 the actual risk

of a particular invest"ent cannot $e deter"ined fro" historical data< It depends on

the price paid< If enough investors $elieve the argu"ent that e?uities 9ill offer the

$est long5ter" returns8 the% "a% pour "one% into stocks8 $idding prices up to levels

at 9hich the% no longer offer the superior returns< The risk of loss ste""ing fro"

e?uit%@s place in the capital structure is e:acer$ated $% pa%ing a higher price<

Another co""on $elief is that risk avoidance is inco"pati$le 9ith invest"ent

success< This vie9 holds that high return is attaina$le onl% $% incurring high risk and

that long5ter" invest"ent success is attaina$le onl% $% seeking out and $earing8

rather than avoiding8 risk< Wh% do I $elieve8 conversel%8 that risk avoidance is the

single "ost i"portant ele"ent of an invest"ent progra"E If %ou had 18///8 9ould

%ou $e 9illing to 9ager it8 dou$le or nothing8 on a fair coin tossE !ro$a$l% not< Would

%ou risk %our entire net 9orth on such a ga"$leE 7f course not< Would %ou risk the

loss of8 sa%8 3/ percent of %our net 9orth for an e?uivalent gainE Not "an% people

9ould $ecause the loss of a su$stantial a"ount of "one% could i"pair their standard

of living 9hile a co"para$le gain "ight not i"prove it co""ensuratel%< If %ou are

one of the vast "a;orit% of investors 9ho are risk averse8 then loss avoidance "ust

$e the cornerstone of %our invest"ent philosoph%<



Defining 7our Investment Goals )reed%8 short5ter"5oriented investors "a% lose sight of a sound "athe"atical reasonfor avoiding loss& the effects of co"pounding even "oderate returns over "an%%ears are co"pelling8 if not do9nright "ind $oggling< Ta$le 1 sho9s the delightfuleffects of co"pounding even relativel% s"all a"ounts<

#able &

Com$oun alue o8 H1>;;; Investe at 2#88erent Rates o8 Return an 8or ar%#n/ 2urat#ons

Rate = vears 1; vears *; vears +; vears

3 H 1>++: H 1>&'1 H +>*;& H =>&)+

: 1>)3' *>1=' )>331 1;>;3+

1; 1>311 *>=') 3>&*& 1&>))'

1* 1>&3* +>1;3 '>3)3 *'>'3;

13 *>1;; )>)11 1'>)31 :=>:=;

*; *>):: 3>1'* +:>++: *+&>+&3

As the ta$le illustrates8 perseverance at even relativel% "odest rates of return is ofthe ut"ost i"portance in co"pounding %our net 9orth< A corollar% to the i"portance

of co"pounding is that it is ver% difficult to recover fro" even one large loss8 9hich

could literall% destro% all at once the $eneficial effects of "an% %ears of invest"ent

success< In other 9ords8 an investor is "ore likel% to do 9ell $% achieving

consistentl% good returns 9ith li"ited do9nside risk than $% achieving volatile and

so"eti"es even spectacular gains $ut 9ith considera$le risk of principal< An investor

9ho earns 1 percent annual returns over a decade8 for e:a"ple8 9ill8 perhaps

surprisingl%8 end up 9ith "ore "one% than an investor 9ho earns 2/ percent a %ear

for nine %ears and then loses 1) percent the tenth %ear<

There is an understanda$le8 al$eit unecono"ic8 appeal to the latter pattern of

returns8 ho9ever< The second investor 9ill outperfor" the for"er nine %ears out of

ten8 gaining considera$le ps%chic inco"e fro" this apparentl% superior perfor"ance<

If $oth investors are "one% "anage"ent professionals8 the latter





Defining 7our Investment Goals

9orker earns "ore the "ore he or she produces< An investor cannot decide to think

harder or put in overti"e in order to achieve a higher return< All an investor can do is

follo9 a consistentl% disciplined and rigorous approachF over ti"e the returns 9ill

co"e< Targeting invest"ent returns leads investors to focus on upside potential

rather than on do9nside risk< #epending on the level of securit% prices8 investors

"a% have to incur considera$le do9nside risk to have a chance of "eeting predeter5

"ined return o$;ectives< If Treasur% $ills %ield percent8 "ore cannot $e achieved

fro" o9ning the"< If thirt%5%ear govern"ent $onds %ield . percent8 it is possi$le8 for

a 9hile8 to achieve a 1) percent annual return through capital appreciation resulting

fro" a decline in interest rates< If the $onds are held to "aturit%8 ho9ever8 the return

9ill $e . percent<

Stocks do not have the fir" "athe"atical tether afforded $% the contractual

nature of the cash flo9s of a high5grade $ond< Stocks8 for e:a"ple8 have no "aturit%

date or price< ,oreover8 9hile the value of a stock is ulti"atel% tied to the

perfor"ance of the underl%ing $usiness8 the potential profit fro" o9ning a stock is

"uch "ore a"$iguous< Specificall%8 the o9ner of a stock does not receive the cash

flo9s fro" a $usinessF he or she profits fro" appreciation in the share price8

presu"a$l% as the "arket incorporates funda"ental $usiness develop"ents into

that price< Investors thus tend to predict their returns fro" investing in e?uities $%

predicting future stock prices< Since stock prices do not appreciate in a predicta$le

fashion $ut fluctuate unevenl% over ti"e8 al"ost an% forecast can $e "ade and

;ustified< It is thus possi$le to predict the achieve"ent of an% desired level of return

si"pl% $% fiddling 9ith one@s esti"ate of future share prices<

In the long run8 ho9ever8 stock prices are also tethered8 al$eit "ore loosel%

than $onds8 to the perfor"ance of the underl%ing $usinesses< If the prevailing stock

price is not 9arranted $% underl%ing value8 it 9ill eventuall% fall< Those 9ho $ought in

at a price that itself reflected overl% opti"istic assu"ptions 9ill incur losses<



. A +A(U5IN+ST,NT !HI(7S7!H0

4ather than targeting a desired rate of return8 even an e"inentl% reasona$le one8

investors should target risk< Treasur% $ills are the closest thing to a riskless

invest"entF hence the interest rate on Treasur% $ills is considered the risk5free rate<

Since investors al9a%s have the option of holding all of their "one% in T5$ills8invest"ents that involve risk should onl% $e "ade if the% hold the pro"ise of

considera$l% higher returns than those availa$le 9ithout risk< This does not e:press

an invest"ent preference for T5$illsF to the contrar%8 %ou 9ould rather $e full%

invested in superior alternatives< But alternatives 9ith so"e risk attached are

superior onl% if the return "ore than full% co"pensates for the risk<

,ost invest"ent approaches do not focus on loss avoidance or on an

assess"ent of the real risks of an invest"ent co"pared 9ith its return< 7nl% one that

I kno9 does& value investing< 'hapter descri$es value investingF chapter

ela$orates on three of its central underpinnings< Both chapters e:pand on the the"e

of loss avoidance and consider various "eans of achieving this o$;ective<



3alue Invest#n/9 The

Im$ortan(e o8 a Mar/#n o8 Sa8et%+alue investing is the discipline of $u%ing securities at a significant discount fro"

their current underl%ing values and holding the" until "ore of their value is realiDed<

The ele"ent of a $argain is the ke% to the process< In the language of value

investors8 this is referred to as $u%ing a dollar for fift% cents< +alue investing

co"$ines the conservative anal%sis of underl%ing value 9ith the re?uisite discipline

and patience to $u% onl% 9hen a sufficient discount fro" that value is availa$le< The

nu"$er of availa$le $argains varies8 and the gap $et9een the price and value of an%

given securit% can $e ver% narro9 or e:tre"el% 9ide< So"eti"es a value investor 9ill

revie9 in depth a great "an% potential invest"ents 9ithout finding a single one that

is sufficientl% attractive< Such persistence is necessar%8 ho9ever8 since value is often

9ell hidden<

The disciplined pursuit of $argains "akes value investing ver% "uch a risk5

averse approach< The greatest challenge for

''





Value Investing: The I#portance of a %argin of Safety 1/1

$allpla%ers8 si"pl% can@t distinguish a good pitch fro" a 9ild one< Both

undiscri"inating individuals and constrained institutional investors can take solace

fro" kno9ing that "ost "arket participants feel co"pelled to s9ing ;ust as

fre?uentl% as the% do<6or a value investor a pitch "ust not onl% $e in the strike Done8 it "ust $e in

his Gs9eet spot<G 4esults 9ill $e $est 9hen the investor is not pressured to invest

pre"aturel%< There "a% $e ti"es 9hen the investor does not lift the $at fro" his

shoulderF the cheapest securit% in an overvalued "arket "a% still $e overvalued< 0ou

9ouldn@t 9ant to settle for an invest"ent offering a safe 1/ percent return if %ou

thought it ver% likel% that another offering an e?uall% safe 1) percent return 9ould

soon "aterialiDe<

An invest"ent must $e purchased at a discount fro" underl%ing 9orth< This

"akes it a good a$solute value< Being a good a$solute value alone8 ho9ever8 is not

sufficient for investors "ust choose onl% the $est a$solute values a"ong those that

are currentl% availa$le< A stock trading at one5half of its underl%ing value "a% $e

attractive8 $ut another trading at one5fourth of its 9orth is the $etter $argain< This

dual discipline co"pounds the difficult% of the invest"ent task for value investors

co"pared 9ith "ost others<

+alue investors continuall% co"pare potential ne9 invest"ents 9ith their

current holdings in order to ensure that the% o9n onl% the "ost undervalued

opportunities availa$le< Investors should never $e afraid to ree:a"ine current

holdings as ne9 opportunities appear8 even if that "eans realiDing losses on the sale

of current holdings< In other 9ords8 no invest"ent should $e considered sacred 9hen

a $etter one co"es along<

So"eti"es doDens of good pitches are thro9n consecutivel% to a value

investor< In panick% "arkets8 for e:a"ple8 the nu"$er of undervalued securities

increases and the degree of undervaluation also gro9s< In $uo%ant "arkets8 $%

contrast8 $oth the nu"$er of undervalued securities and their degree of

undervaluation declines< When attractive opportunities are plentiful8 value investors

are a$le to sift carefull% through all the



1;* A A5E!INESTMENT "6IOSO"6Y

$argains for the ones the% find "ost attractive< When attractive opportunities are

scarce8 ho9ever8 investors "ust e:hi$it great self5discipline in order to "aintain the

integrit% of the valuation process and li"it the price paid< A$ove all8 investors "ust

al9a%s avoid s9inging at $ad pitches<The Com$le0#t% an ar#ab#l#t% o8 7us#ness aluat#on

It 9ould $e a serious "istake to think that all the facts that descri$e a particular

invest"ent are or could $e kno9n< Not onl% "a% ?uestions re"ain unans9eredF all

the right ?uestions "a% not even have $een asked< ven if the present could so"e5

ho9 $e perfectl% understood8 "ost invest"ents are dependent on outco"es that

cannot $e accuratel% foreseen<

ven if ever%thing could $e kno9n a$out an invest"ent8 the co"plicating

realit% is that $usiness values are not carved in stone< Investing 9ould $e "uch

si"pler if $usiness values did re"ain constant 9hile stock prices revolved predicta$l%

around the" like the planets around the sun< If %ou cannot $e certain of value8 after

all8 then ho9 can %ou $e certain that %ou are $u%ing at a discountE The truth is that

%ou cannot<

There are "an% e:planations for volatilit% in $usiness value< The Gcredit

c%cle8G the periodic tightening and rela:ation of the availa$ilit% of credit8 is a "a;or

factor8 for e:a"ple8 $ecause it influences the cost and ter"s upon 9hich "one% can

$e $orro9ed< This in turn affects the "ultiples that $u%ers are 9illing to pa% for

$usinesses< Si"pl% put8 $u%ers 9ill 9illingl% pa% higher "ultiples if the% receive lo95

rate nonrecourse financing than the% 9ill in an unleveraged transaction<

Trends in inflation or deflation also cause $usiness values to fluctuate< That

said8 value investing can 9ork ver% 9ell in an inflationar% environ"ent< If for fift%

cents %ou $u% a dollar of value in the for" of an asset8 such as natural resource

properties or real estate8 9hich increases in value 9ith inflation8 a



Value Investing: The I#portance of a %argin of Safety 1/3fift%5cent invest"ent toda% can result in the realiDation of value apprecia$l% greaterthan one dollar< In an inflationar% environ"ent8 ho9ever8 investors "a% $eco"eso"e9hat careless< As long as assets are rising in value8 it 9ould appear attractive torela: one@s standards and purchase 1 of assetsP not for )/ cents8 $ut for / or ./cents =or perhaps even 1<1/>< Such la:it% could prove costl%8 ho9ever8 in the event

that inflation co"es to $e anticipated $% "ost investors8 9ho respond $% $idding upsecurit% prices< A su$se?uent slo9do9n in the rate of inflation could cause a pricedecline<

In a deflationar% environ"ent assets tend to decline in value< Bu%ing a dollar@s9orth of assets for fift% cents "a% not $e a $argain if the asset value is dropping<Historicall% investors have found attractive opportunities in co"panies 9ith su$stan5tial Ghidden assets8G such as an overfunded pension fund8 real estate carried on the$alance sheet $elo9 "arket value8 or a profita$le finance su$sidiar% that could $esold at a significant gain< A"idst a $road5$ased decline in $usiness and asset values8ho9ever8 so"e hidden assets $eco"e less valua$le and in so"e cases "a% $eco"ehidden lia$ilities< A decline in the stock "arket 9ill reduce the value of pension fundassetsF previousl% overfunded plans "a% $eco"e underfunded< 4eal estate8 carriedon co"panies@ $alance sheets at historical cost8 "a% no longer $e undervalued<7verlooked su$sidiaries that 9ere once hidden ;e9els "a% lose their luster<

The possi$ilit% of sustained decreases in $usiness value is a dagger at theheart of value investing =and is not a $arrel of laughs for other invest"entapproaches either>< +alue investors place great faith in the principle of assessingvalue and then $u%ing at a discount< If value is su$;ect to considera$le erosion8 thenho9 large a discount is sufficientE

Should investors 9orr% a$out the possi$ilit% that $usiness value "a% declineEA$solutel%< Should the% do an%thing a$out itE There are three responses that "ight$e effective< 6irst8 since investors cannot predict 9hen values 9ill rise or fall8valuation should al9a%s $e perfor"ed conservativel%8 giving considera$le 9eight to9orst5case li?uidation value as 9ell as to other



1;) A A5E!INESTMENT "6IOSO"6Y

"ethods< Second8 investors fearing deflation could de"and a greater than usual

discount $et9een price and underl%ing value in order to "ake ne9 invest"ents or to

hold current positions< This "eans that nor"all% selective investors 9ould pro$a$l%

let even "ore pitches than usual go $%< 6inall%8 the prospect of asset deflation placesa heightened i"portance on the ti"e fra"e of invest"ents and on the presence of a

catal%st for the realiDation of underl%ing value< In a deflationar% environ"ent8 if %ou

cannot tell 9hether or 9hen %ou 9ill realiDe underl%ing value8 %ou "a% not 9ant to

get involved at all< If underl%ing value is realiDed in the near5ter" directl% for the

$enefit of shareholders8 ho9ever8 the longer5ter" forces that could cause value to

di"inish $eco"e "oot<

The Im$ortan(e o8 a Mar/#n o8 Sa8et%

Ben;a"in raha" understood that an asset or $usiness 9orth 1 toda% could $e

9orth ) cents or 1<2) in the near future< He also understood that he "ight even $e

9rong a$out toda%@s value< Therefore raha" had no interest in pa%ing 1 for 1 of

value< There 9as no advantage in doing so8 and losses could result< raha" 9as onl%

interested in $u%ing at a su$stantial discount fro" underl%ing value< B% investing at a

discount8 he kne9 that he 9as unlikel% to e:perience losses< The discount provided a

"argin of safet%<

Because investing is as "uch an art as a science8 investors need a "argin of

safet%< A "argin of safet% is achieved 9hen securities are purchased at prices

sufficientl% $elo9 underl%ing value to allo9 for hu"an error8 $ad luck8 or e:tre"e

volatilit% in a co"ple:8 unpredicta$le8 and rapidl% changing 9orld< According to

raha"8 GThe "argin of safet% is al9a%s dependent on the price paid< 6or an%

securit%8 it 9ill $e large at one price8 s"all at so"e higher price8 none:istent at so"e

still higher price<G1

Buffett descri$ed the "argin of safet% concept in ter"s of tol5



;alue Investing0 #he Importance of a /argin of !afety 1;=

erances& GWhen %ou $uild a $ridge8 %ou insist it can carr% 3/8/// pounds8 $ut %ou

onl% drive 1/8///5pound trucks across it< And that sa"e principle 9orks in

investing<G2

What is the re?uisite "argin of safet% for an investorE The ans9er can var%fro" one investor to the ne:t< Ho9 "uch $ad luck are %ou 9illing and a$le to

tolerateE Ho9 "uch volatilit% in $usiness values can %ou a$sor$E What is %our

tolerance for errorE It co"es do9n to ho9 "uch %ou can afford to lose<

,ost investors do not seek a "argin of safet% in their holdings< Institutional

investors 9ho $u% stocks as pieces of paper to $e traded and 9ho re"ain full%

invested at all ti"es fail to achieve a "argin of safet%< reed% individual investors

9ho follo9 "arket trends and fads are in the sa"e $oat< The onl% "argin investors

9ho purchase Wall Street under9ritings or financial5"arket innovations usuall%

e:perience is a "argin of peril<

ven a"ong value investors there is ongoing disagree"ent concerning the

appropriate "argin of safet%< So"e highl% successful investors8 including Buffett8

have co"e increasingl% to recogniDe the value of intangi$le assets$roadcast

licenses or soft5drink for"ulas8 for e:a"ple9hich have a histor% of gro9ing in value

9ithout an% invest"ent $eing re?uired to "aintain the"< +irtuall% all cash flo9

generated is free cash flo9<

The pro$le" 9ith intangi$le assets8 I $elieve8 is that the% hold little or no

"argin of safet%< The "ost valua$le assets of #r !epperJSeven5Up8 Inc<8 $% 9a% of

e:a"ple8 are the for"ulas that give those soft drinks their distinctive flavors< It is

these intangi$le assets that cause #r !epperJSeven5Up8 Inc<8 to $e valued at a high

"ultiple of tangi$le $ook value< If so"ething goes 9rongtastes change or a

co"petitor "akes inroadsthe "argin of safet% is ?uite lo9<

Tangi$le assets8 $% contrast8 are "ore precisel% valued and therefore provide

investors 9ith greater protection fro" loss< Tangi$le assets usuall% have value in

alternate uses8 there$% providing a "argin of safet%< If a chain of retail stores

$eco"es unprofita$le8 for e:a"ple8 the inventories can $e li?uidated8



1;3 A A5E!INESTMENT "6IOSO"6Y

receiva$les collected8 leases transferred8 and real estate sold< If consu"ers lose their

taste for #r !epper8 $% contrast8 tangi$le assets 9ill not "eaningfull% cushion

investors@ losses<

Ho9 can investors $e certain of achieving a "argin of safet%E B% al9a%s$u%ing at a significant discount to underl%ing $usiness value and giving preference to

tangi$le assets over intangi$les< =This does not "ean that there are not e:cellent

invest"ent opportunities in $usinesses 9ith valua$le intangi$le assets<> B% replacing

current holdings as $etter $argains co"e along< B% selling 9hen the "arket price of

an% invest"ent co"es to reflect its underl%ing value and $% holding cash8 if

necessar%8 until other attractive invest"ents $eco"e availa$le<

Investors should pa% attention not onl% to whether $ut also to why current

holdings are undervalued< It is critical to kno9 9h% %ou have "ade an invest"ent

and to sell 9hen the reason for o9ning it no longer applies< (ook for invest"ents 9ith

catal%sts that "a% assist directl% in the realiDation of underl%ing value< ive

preference to co"panies having good "anage"ents 9ith a personal financial stake

in the $usiness< 6inall%8 diversif% %our holdings and hedge 9hen it is financiall%

attractive to do so< ach of these points is discussed in the chapters co"prising the

re"ainder of this $ook<

To appreciate the "argin of safet% concept8 consider the stock of rie

(acka9anna8 Inc<8 in late 1.8 9hen it 9as $acked $% nearl% 1*/ per share in cash

as 9ell as a siDa$le and 9ell5supported ta: refund clai" against the I4S< The stock

sold at prices as lo9 as 11/ per share8 a discount fro" the net cash per share even

e:clusive of the refund clai"< The do9nside risk appeared to $e Dero< The onl%

foreseea$le loss on the stock 9ould $e a te"porar% "arket5price decline8 a

develop"ent that 9ould "erel% render the shares a still $etter $u%< Ulti"atel% rie

(acka9anna 9on its ta: case< Through "id511 cu"ulative li?uidating distri$utions

of 1 per share had $een paid =11) 9as paid in 1..8 returning all of a $u%er@s

late 1. cost>8 and the stock still traded at appro:i"atel% . per share<

Si"ilarl% !u$lic Service 'o"pan% of Ne9 Ha"pshire =!SNH> 1. percent

second5"ortgage $onds traded in earl% 1. at a$out par value< Although for"all% in

$ankruptc% !SNH had



;alue Investing0 #he Importance of a /argin of !afety &)<

continued to pa% current interest on these $onds $ecause their principal a"ount 9as

covered "an% ti"es over $% the value of the utilit% assets securing the"< The

contractual "aturit% date of these $onds 9as -une 1.8 $ut investors 9ere

uncertain 9hether or not the% 9ould $e retired if the co"pan% 9ere then still in

'hapter 11< 7ther than the possi$ilit% of a near5dou$ling of interest rates8 there 9as

i""aterial do9nside risk other than fro" short5ter" price fluctuations< !SNH

ulti"atel% raised "one% to retire the $onds in Nove"$er 1.8 several "onths after

their contractual "aturit% date< Investors 9ere a$le to earn annualiDed returns of 1.

percent 9ith ver% lo9 risk due to the uncertain ti"ing of the $onds@ rede"ption<

!erhaps the $est recent e:a"ple of investing 9ith a "argin of safet% occurred

in the de$t securities of Te:aco8 Inc< In 1. Te:aco filed for $ankruptc% as a result

of uncertaint% surrounding a 1/ $illion legal verdict against it in favor of !ennDoil<

Although the value of Te:aco@s assets appeared to "ore than full% cover all of itslia$ilities even under a 9orst5case scenario8 in the i""ediate after"ath of Te:aco@s

'hapter 11 filing its stock and $onds plunged in price< As 9ith an% $ankruptc%8 "an%

investors 9ere suddenl% constrained fro" o9ning Te:aco securities< ven the

co"pan%@s pu$lic state"ent that $ondholders 9ould receive all principal and

postpetition as 9ell as prep5etition interest failed to $oost prices "uch<

The specific opportunit% in Te:aco securities 9as e:e"plified $% the Te:aco

11<.) percent de$entures due ,a% 181*< These $onds traded activel% at the /

level =the% traded flatF the price incorporated appro:i"atel% eighteen "onths of

accrued interest> in the 9ake of the 7cto$er 1. stock "arket crash< Assu"ing the

full pa%"ent of principal and interest upon e"ergence fro" 'hapter 118 these $onds

purchased at / 9ould provide annualiDed returns of **<1 percent8 2)<* percent8 and

1<) percent8 respectivel%8 assu"ing a one5%ear8 t9o5%ear8 and three5%ear holding

period fro" Nove"$er 18 1.< 'ould these $onds have declined further in priceE

'ertainl%8 $ut the% 9ould si"pl% have $eco"e a $etter $u%< Uncertaint% regarding

the ti"ing and e:act resolution of the $ankruptc% created an outstanding opportunit%

for value investors 9ho 9ere content



1;: A A5E!INESTMENT "6IOSO"6Y

9ith doing 9ell under an% scenario 9hile al9a%s having a considera$le "argin of

safet%<

alue Invest#n/ Sh#nes #n a 2e(l#n#n/ Mar,et

When the overall "arket is strong8 the rising tide lifts "ost ships< !rofita$le

invest"ents are eas% to co"e $%8 "istakes are not costl%8 and high risks see" to pa%

off8 "aking the" see" reasona$le in retrospect< As the sa%ing goes8 G0ou can@t tell

9ho@s s9i""ing naked till the tide goes out<G

A "arket do9nturn is the true test of an invest"ent philosoph%< Securities

that have perfor"ed 9ell in a strong "arket are usuall% those for 9hich investors

have had the highest e:pectations< When these e:pectations are not realiDed8 the

securities8 9hich t%picall% have no "argin of safet%8 can plu""et< Stocks that fit this

description are so"eti"es referred to as Gtorpedo stocks8G a ter" that descri$es the

disastrous effect o9ning the" can have on one@s invest"ent results< 'o"pa?

'o"puter 'orporation traded at 2 on ,arch 8 11< B% April 2* the shares had

fallen to 1 The ne:t da% the% plunged 6= points< Then on ,a% 1* the% plunged

13, points to close at 3< The ,arch share price had reflected investor

e:pectations of high earnings gro9th< When the co"pan% su$se?uentl% announced a

decline in first5?uarter earnings8 the stock 9as torpedoed<

The securities o9ned $% value investors are not $uo%ed $% such high

e:pectations< To the contrar%8 the% are usuall% unheralded or ;ust ignored< In

depressed financial "arkets8 it is said8 so"e securities are so out of favor that %ou

cannot give the" a9a%< So"e stocks sell $elo9 net 9orking capital per share8 and a

fe9 sell at less than net cash =cash on hand less all de$t> per shareF "an% stocks

trade at an unusuall% lo9 "ultiple of current earnings and cash flo9 and at a

significant discount to $ook value<

A nota$le feature of value investing is its strong perfor"ance in periods of

overall "arket decline< Whenever the financial "arkets fail to full% incorporate

funda"ental values into securi5



;alue Investing0 #he Importance of a /argin of !afety &)6

ties prices8 an investor@s "argin of safet% is high< Stock and $ond prices "a%

anticipate continued poor $usiness results8 %et securities priced to reflect those

depressed funda"entals "a% have little roo" to fall further< ,oreover8 securities

priced as if nothing could go right stand to $enefit fro" a change in perception< If

investors refocused on the strengths rather than on the difficulties8 higher securit%

prices 9ould result< When funda"entals do i"prove8 investors could $enefit $oth

fro" $etter results and fro" an increased "ultiple applied to the"<

In earl% 1. the shares of Telefonos de ,e:ico8 S<A<8 sold for prices as lo9 as

ten cents< The co"pan% 9as not doing $adl%8 and anal%sts 9ere forecasting for the

shares annual earnings of fifteen cents and a $ook value of appro:i"atel% sevent%5

five cents in 1..< Investors see"ed to focus onl% on the continual dilution of the

stock8 ste""ing fro" ?uarterl% <2) percent stock dividends and fro" the issuance

of shares to ne9 telephone su$scri$ers8 ostensi$l% to fund the re?uired capital out5la%s to install their phones< The "arket ignored virtuall% ever% criterion of value8

pricing the shares at e:tre"el% lo9 "ultiples of earnings and cash flo9 9hile

co"pletel% disregarding $ook value<

In earl% 11 Telefonos@s share price rose to over 3<2)< The shares8 out of

favor several %ears earlier8 $eca"e an institutional favorite< True8 so"e i"prove"ent

in operating results did contri$ute to this enor"ous price appreciation8 $ut the

pri"ar% e:planation 9as an increase in the "ultiple investors 9ere 9illing to pa%<

The higher "ultiple reflected a change in investor ps%cholog% "ore than an%

funda"ental develop"ents at the co"pan%<

alue Invest#n/ Is "re#(ate on the

E88#(#ent!Mar,et 6%$othes#s 7e#n/ Wron/

Investors should understand not onl% 9hat value investing is $ut also 9h% it is

a successful invest"ent philosoph%< At the ver% core of its success is the recurrent

"ispricing of securities



11; A A5E!INESTMENT "6IOSO"6Y

in the "arketplace< +alue investing is8 in effect8 predicated on the proposition that

the efficient5"arket h%pothesis is fre?uentl% 9rong< If8 on the one hand8 securities

can $eco"e undervalued or overvalued8 9hich I $elieve to $e incontrovert5i$l% true8

value investors 9ill thrive< If8 on the other hand8 all securities at so"e future date

$eco"e fairl% and efficientl% priced8 value investors 9ill have nothing to do< It is

i"portant8 then8 to consider 9hether or not the financial "arkets are efficient<

The efficient5"arket h%pothesis takes three for"s<3 The 9eak for" "aintains

that past stock prices provide no useful infor"ation on the future direction of stock

prices< In other 9ords8 technical anal%sis =anal%sis of past price fluctuations> cannot

help investors< The se"istrong for" sa%s that no pu$lished infor"ation 9ill help

investors to select undervalued securities since the "arket has alread% discounted all

pu$licl% availa$le infor"ation into securities prices< The strong for" "aintains that

there is no infor"ation8 pu$lic or private8 that 9ould $enefit investors< Thei"plication of $oth the se"i5strong and strong for"s is that funda"ental anal%sis is

useless< Investors "ight ;ust as 9ell select stocks at rando"<

7f the three for"s of the efficient5"arket h%pothesis8 I $elieve that onl% the

9eak for" is valid< Technical anal%sis is indeed a 9aste of ti"e<

As to the other for"s& %es8 the "arket does tend to incorporate ne9

infor"ation into pricessecurities prices are neither rando" nor do the% totall%

ignore availa$le infor"ation%et the "arket is far fro" efficient< There is si"pl% no

?uestion that investors appl%ing disciplined anal%sis can identif% inefficientl% priced

securities8 $u% and sell accordingl%8 and achieve superior returns< Specificall%8 $%

finding securities 9hose prices depart apprecia$l% fro" underl%ing value8 investors

can fre?uentl% achieve a$ove5average returns 9hile taking $elo95average risks<

The pricing of large5capitaliDation stocks tends to $e "ore efficient than that

of s"all5capitaliDation stocks8 distressed $onds8 and other less5popular invest"ent

fare< While hundreds of invest"ent anal%sts follo9 IB,8 fe98 if an%8 cover thousands



;alue Investing0 #he Importance of a /argin of !afety &&&

of s"all5capitaliDation stocks and o$scure ;unk $onds< Investors are "ore likel%8

therefore8 to find inefficientl% priced securities outside the Standard and !oor@s 1//

than 9ithin it< ven a"ong the "ost highl% capitaliDed issues8 ho9ever8 investors are

fre?uentl% $linded $% groupthink8 there$% creating pricing inefficiencies<

Is it reasona$le to e:pect that in the future so"e securities 9ill continue to $e

significantl% "ispriced fro" ti"e to ti"eE I $elieve it is< The elegance of the efficient5

"arket theor% is at odds 9ith the realit% of ho9 the financial "arkets operate<

An entire $ook could $e 9ritten on this su$;ect alone8 $ut one enlightening

article cleverl% re$uts the efficient5"arket theor% 9ith living8 $reathing refutations<

Buffett@s GThe Superinvestors of raha"5and5#oddsvilleG de"onstrates ho9 nine

value5invest"ent disciples of Ben;a"in raha"8 holding varied and independent

portfolios8 achieved pheno"enal invest"ent success over long periods<*

Buffett considers the possi$ilit% that the e:traordinar% perfor"ance of theseinvestors could so"eho9 $e a rando" event8 such as correctl% calling a se?uence of

coin tosses8 or that the value investors discussed in his article co"prise a $iased

sa"ple8 i"itating rather than e"ulating raha"@s invest"ent strateg%< Buffett

strongl% argues other9ise< His vie9 is that the onl% thing the "an% value investors

have in co""on is a philosoph% that dictates the purchase of securities at a discount

fro" underl%ing value< The e:istence of so "an% independent successes is

inconsistent 9ith the efficient5"arket theor%< If the "arkets 9ere efficient8 then ho9

could so "an% investors8 identifia$le $% Buffett %ears ago as sharing a co""on

philosoph% $ut having little overlap in their portfolios8 all have done so 9ellE Buffett@s

argu"ent has never8 to "% kno9ledge8 $een addressed $% the efficient5"arket

theoristsF the% evidentl% prefer to continue to prove in theor% 9hat is refuted in

realit%<

Wh% do stock prices tend to depart fro" underl%ing value8 there$% "aking the

financial "arkets inefficientE There are nu"erous reasons8 the "ost o$vious $eing

that securities prices are deter"ined in the short run $% suppl% and de"and< The



11* A A5E!INESTMENT "6IOSO"6Y

forces of suppl% and de"and do not necessaril% correlate 9ith value at an% given

ti"e< Also8 "an% $u%ers and sellers of securities are "otivated $% considerations

other than underl%ing value and "a% $e 9illing to $u% or sell at ver% different prices

than a value investor 9ould<If a stock is part of a "a;or "arket inde:8 for e:a"ple8 there 9ill $e de"and

fro" inde: funds to $u% it regardless of 9hether it is overpriced in relation to

underl%ing value< Si"ilarl%8 if a stock has recentl% risen on increasing volu"e8

technical anal%sts "ight consider it attractiveF $% definition8 underl%ing value 9ould

not $e a part of their calculations< If a co"pan% has e:hi$ited rapid recent gro9th8 it

"a% trade at a Ggro9thG "ultiple8 far higher than a value investor 9ould pa%<

'onversel%8 a co"pan% that recentl% reported disappointing results "ight $e du"ped

$% investors 9ho focused e:clusivel% on earnings8 depressing the price to a level

considera$l% $elo9 underl%ing value< An investor una$le to "eet a "argin call is in

no position to hold out for full valueF he or she is forced to sell at the prevailing

"arket price<

The $ehavior of institutional investors8 dictated $% constraints on their

$ehavior8 can so"eti"es cause stock prices to depart fro" underl%ing value<

Institutional selling of a lo95priced s"all5capitaliDation spinoff8 for e:a"ple8 can

cause a te"porar% suppl%5de"and i"$alance8 resulting in a securit% $eco"ing

undervalued< If a co"pan% fails to declare an e:pected dividend8 institutions

restricted to o9ning onl% dividend5pa%ing stocks "a% unload the shares< Bond funds

allo9ed to o9n onl% invest"ent5grade de$t 9ould du"p their holdings of an issue

i""ediatel% after it 9as do9ngraded $elo9 BBB $% the rating agencies< Such

pheno"ena as %ear5end ta: selling and ?uarterl% 9indo9 dressing can also cause

"arket inefficiencies8 as value considerations are su$ordinated to other factors<

Ben;a"in raha" and #avid #odd e:plained stock "ispric5ings this 9a%& GThe

"arket is not a 9eighing "achine8 on 9hich the value of each issue is recorded $% an

e:act and i"personal






underl%ing value8 for e:a"ple8 a "a;orit% of shareholders can force it to $eco"e

open5ended =9here$% shares can $e redee"ed at net asset value> or to li?uidate8

delivering underl%ing value directl% to shareholders< The open5ending or li?uidation of

a closed5end fund is one of the purest e:a"ples of value ar$itrage< The ar$itrage profit fro" purchasing the undervalued stock of an ongoing

$usiness can $e "ore difficult to realiDe< The degree of difficult% in a given instance

depends8 a"ong other things8 on the "agnitude of the gap $et9een price and value8

the e:tent to 9hich "anage"ent is entrenched8 the identit% and o9nership position

of the "a;or shareholders8 and the availa$ilit% of credit in the econo"% for corporate

takeover activit%<

7e-are o8 alue "reteners

G+alue investingG is one of the "ost overused and inconsistentl% applied ter"s in the

invest"ent $usiness< A $road range of strategies "ake use of value investing as a

pseudon%"< ,an% have little or nothing to do 9ith the philosoph% of investing

originall% espoused $% raha"< The "isuse of the value la$el accelerated in the "id5

1./s in the 9ake of increasing pu$licit% given to the long5ter" successes of true

value investors such as Buffett at Berkshire Hatha9a%8 Inc<8 ,ichael !rice and the

late ,a: (< Heine at ,utual Series 6und8 Inc<8 and Willia" 4uane and 4ichard 'unniff

at the Se?uoia 6und8 Inc<8 a"ong others< Their results attracted a great "an% Gvalue

pretenders8G invest"ent cha"eleons 9ho fre?uentl% change strategies in order to

attract funds to "anage<

These value pretenders are not true value investors8 disciplined craftspeople

9ho understand and accept the 9isdo" of the value approach< 4ather the% are

charlatans 9ho violate the conservative dictates of value investing8 using inflated

$usiness valuations8 overpa%ing for securities8 and failing to achieve a "argin of

safet% for their clients< These investors8 despite =or



;alue Investing0 #he Importance of a /argin of !afety 11)

perhaps as a direct result of> their i"prudence8 are a$le to achieve good invest"ent

results in ti"es of rising "arkets< #uring the latter half of the 1./s8 value

pretenders gained 9idespread acceptance8 earning high8 even spectacular8 returns<

,an% of the" $enefitted fro" the overstated private5"arket values that 9ereprevalent during those %earsF 9hen $usiness valuations returned to historical levels

in 1/8 ho9ever8 "ost value pretenders suffered su$stantial losses<

To so"e e:tent value8 like $eaut%8 is in the e%e of the $eholderF virtuall% an%

securit% "a% appear to $e a $argain to so"eone< It is hard to prove an overl%

opti"istic investor 9rong in the short run since value is not precisel% "easura$le and

since stocks can re"ain overvalued for a long ti"e< Accordingl%8 the $u%er of

virtuall% an% securit% can clai" to $e a value investor at least for a 9hile<

Ironicall%8 "an% true value investors fell into disfavor during the late 1./s<

As the% avoided participating in the full% valued and overvalued securities that the

value pretenders clai"ed to $e $argains8 "an% of the" te"poraril% underperfor"ed

the results achieved $% the value pretenders< The "ost conservative 9ere actuall%

criticiDed for their Ge:cessiveG caution8 prudence that proved 9ell founded in 1/<

ven toda% "an% of the value pretenders have not $een defrocked of their value5

investor "antle< There 9ere "an% articles in financial periodicals chronicling the poor

invest"ent results posted $% "an% so5called value investors in 1/< The top of the

list8 needless to sa%8 9as do"inated $% value pretenders<

Con(lus#on

+alue investing is si"ple to understand $ut difficult to i"ple"ent< +alue

investors are not supersophisticated anal%tical 9iDards 9ho create and appl%

intricate co"puter "odels to find attractive opportunities or assess underl%ing value<

The hard part is discipline8 patience8 and ;udg"ent< Investors need disci5



113 A A5E!INESTMENT "6IOSO"6Y

pline to avoid the "an% unattractive pitches that are thro9n8 patience to 9ait for the

right pitch8 and ;udg"ent to kno9 9hen it is ti"e to s9ing<

Notes

1. 7enam#n Graham> #he Intelligent Investor" )th e. @Ne- Yor,9 6ar$er Ro->1'&+> $. *:1.

*. Warren E. 7u88ett> DThe Su$er#nvestors o8 Graham!an!2osv#lle>D Hermes

@Columb#a 7us#ness S(hool ma/a?#ne @Fall 1':)9)!1=.

+. 7urton G. Mal,#el> A 3andom ,alk down ,all !treet" )th e. @Ne- Yor,9 W. W.

Norton> 1':=> $$. 1&)!&=.

). 7u88ett> $$.1)!1=.

=. 7enam#n Graham> 2av# . 2o> an S#ne% Cottle> !ecurity Analysis @Ne- Yor,9

M(Gra-!6#ll> 1'3*> $. )*.



&At the Root o8 a

alue!Investment "h#loso$h% There are three central ele"ents to a value5invest"ent philosoph%< 6irst8 value

investing is a $otto"5up strateg% entailing the identification of specific undervalued

invest"ent opportunities< Second8 value investing is a$solute5perfor"ance58 not

relative5perfor"ance oriented< 6inall%8 value investing is a risk5averse approachF

attention is paid as "uch to 9hat can go 9rong =risk> as to 9hat can go right

=return><

The Mer#ts o8 7ottom!5$ Invest#n/

In the discussion of institutional investing in chapter 38 it 9as noted that a great

"an% professional investors e"plo% a top5do9n approach< This involves "aking a

prediction a$out the future8 ascertaining its invest"ent i"plications8 and then acting

upon the"< This approach is difficult and risk%8 $eing vulnera$le to error at ever%

step< !ractitioners need to accuratel% fore5

11



11. A A5E!INESTMENT "6IOSO"6Y

cast "acroecono"ic conditions and then correctl% interpret their i"pact on various

sectors of the overall econo"% on particular industries8 and finall% on specific

co"panies< As if that 9ere not co"plicated enough8 it is also essential for top5do9n

investors to perfor" this e:ercise ?uickl% as 9ell as accuratel%8 or others "a% getthere first and8 through their $u%ing or selling8 cause prices to reflect the forecast

"acroecono"ic develop"ents8 there$% eli"inating the profit potential for

lateco"ers<

B% 9a% of e:a"ple8 a top5do9n investor "ust $e correct on the $ig picture

=e<g<8 are 9e entering an unprecedented era of 9orld peace and sta$ilit%E>8 correct in

dra9ing conclusions fro" that =e<g<8 is er"an reunification $ullish or $earish for

er"an interest rates and the value of the deutsche "ark>8 correct in appl%ing those

conclusions to attractive areas of invest"ent =e<g<8 $u% er"an $onds8 $u% the

stocks of U<S< co"panies 9ith "ultinational presence>8 correct in the specific

securities purchased =e<g<8 $u% the ten5%ear er"an govern"ent $ond8 $u% 'oca5

'ola>8 and8 finall%8 $e earl% in $u%ing these securities<

The top5do9n investor thus faces the daunting task of predicting the

unpredicta$le "ore accuratel% and faster than thousands of other $right people8 all

of the" tr%ing to do the sa"e thing< It is not clear 9hether top5do9n investing is a

greater5fool ga"e8 in 9hich %ou 9in onl% 9hen so"eone else overpa%s8 or a greater5

genius ga"e8 9inna$le at $est onl% $% those fe9 9ho regularl% possess superior

insight< In either case8 it is not an attractive ga"e for risk5averse investors<

There is no "argin of safet% in top5do9n investing< Top5do9n investors are

not $u%ing $ased on valueF the% are $u%ing $ased on a concept8 the"e8 or trend<

There is no defina$le li"it to the price the% should pa%8 since value is not part of their

purchase decision< It is not even clear 9hether top5do9n5oriented $u%ers are

investors or speculators< If the% $u% shares in $usinesses that the% trul% $elieve 9ill

do 9ell in the future8 the% are investing< If the% $u% 9hat the% $elieve others 9ill

soon $e $u%ing8 the% "a% actuall% $e speculating<

Another difficult% 9ith a top5do9n approach is gauging the level of e:pectations

alread% reflected in a co"pan%@s current



At the 3oot of a ;alue>Investment Philosophy 11

share price< If %ou e:pect a $usiness to gro9 1/ percent a %ear $ased on %our top5

do9n forecast and $u% its stock $etting on that gro9th8 %ou could lose "one% if the

"arket price reflects investor e:pectations of 1) percent gro9th $ut a lo9er rate is

achieved< The e:pectations of others "ust therefore $e considered as part of an%top5do9n invest"ent decision< =See the discussion of torpedo stocks in chapter <>

B% contrast8 value investing e"plo%s a $otto"5up strateg% $% 9hich individual

invest"ent opportunities are identified one at a ti"e through funda"ental anal%sis<

+alue investors search for $argains securit% $% securit%8 anal%Ding each situation on

its o9n "erits< An investor@s top5do9n vie9s are considered onl% insofar as the%

affect the valuation of securities<

!arado:icall% a $otto"5up strateg% is in "an% 9a%s si"pler to i"ple"ent

than a top5do9n one< While a top5do9n investor "ust "ake several accurate

predictions in a ro98 a $otto"5up investor is not in the forecasting $usiness at all<

The entire strateg% can $e concisel% descri$ed as G$u% a $argain and 9ait<G Investors

"ust learn to assess value in order to kno9 a $argain 9hen the% see one< Then the%

"ust e:hi$it the patience and discipline to 9ait until a $argain e"erges fro" their

searches and $u% it8 regardless of the prevailing direction of the "arket or their o9n

vie9s a$out the econo"% at large<

7ne significant and not necessaril% o$vious difference $et9een a $otto"5up

and top5do9n strateg% is the reason for "aintaining cash $alances at ti"es< Botto"5

up investors hold cash 9hen the% are una$le to find attractive invest"ent oppor5

tunities and put cash to 9ork 9hen such opportunities appear< A $otto"5up investor

chooses to $e full% invested onl% 9hen a diversified portfolio of attractive

invest"ents is availa$le< Top5do9n investors8 $% contrast8 "a% atte"pt to ti"e the

"arket8 so"ething $otto"5up investors do not do< ,arket ti"ing involves "aking a

;udg"ent a$out the overall "arket directionF 9hen top5do9n investors $elieve the

"arket 9ill decline8 the% sell stocks to hold cash8 a9aiting a "ore $ullish opinion<

Another difference $et9een the t9o approaches is that $otto"5up investors

are a$le to identif% si"pl% and precisel% 9hat



12/ A A5E!INESTMENT "6IOSO"6Y

the% are $etting on< The uncertainties the% face are li"ited& 9hat is the underl%ing

$usiness 9orthF 9ill that underl%ing value endure until shareholders can $enefit fro"

its realiDationF 9hat is the likelihood that the gap $et9een price and value 9ill

narro9F and8 given the current "arket price8 9hat is the potential risk and re9ardEBotto"5up investors can easil% deter"ine 9hen the original reason for "aking

an invest"ent ceases to $e valid< When the underl%ing value changes8 9hen

"anage"ent reveals itself to $e inco"petent or corrupt8 or 9hen the price

appreciates to "ore full% reflect underl%ing $usiness value8 a disciplined investor can

reevaluate the situation and8 if appropriate8 sell the invest"ent< Huge su"s have

$een lost $% investors 9ho have held on to securities after the reason for o9ning

the" is no longer valid< In investing it is never 9rong to change %our "ind< It is onl%

9rong to change %our "ind and do nothing a$out it<

Top5do9n investors8 $% contrast8 "a% find it difficult to kno9 9hen their $et is

no longer valid< If %ou invest $ased on a ;udg"ent that interest rates 9ill decline $ut

the% rise instead8 ho9 and 9hen do %ou decide that %ou 9ere 9rongE 0our $et "a%

eventuall% prove correct8 $ut then again it "a% not< Unlike ;udg"ents a$out value

that can easil% $e reaffir"ed8 the possi$le grounds for reversing an invest"ent

decision that 9as "ade $ased upon a top5do9n prediction of the future are si"pl%

not clear<

Ao$t an Absolute!"er8orman(e Or#entat#on

,ost institutional and "an% individual investors have adopted a relative5

perfor"ance orientation =as discussed in chapter 3>< The% invest 9ith the goal of

outperfor"ing either the "arket8 other investors8 or $oth and are apparentl%

indifferent as to 9hether the results achieved represent an a$solute gain or loss<

ood relative perfor"ance8 especiall% short5ter" relative per5






unlike an% other holding8 cash does not involve an% risk of incurring opportunit% cost

=losses fro" the ina$ilit% to take advantage of future $argains> since it does not drop

in value during "arket declines<

R#s, an ReturnWhile "ost other investors are preoccupied 9ith ho9 "uch "one% the% can "ake

and not at all 9ith ho9 "uch the% "a% lose8 value investors focus on risk as 9ell as

return< To the e:tent that "ost investors think a$out risk at all8 the% see" confused

a$out it< So"e insist that risk and return are always positivel% correlatedF the greater

the risk8 the greater the return< This is8 in fact8 a $asic tenet of the capital5asset5

pricing "odel taught in nearl% all $usiness schools8 %et it is not al9a%s true< 7thers

"istakenl% e?uate risk 9ith volatilit%8 e"phasiDing the GriskG of securit% price

fluctuations 9hile ignoring the risk of "aking overpriced8 ill5conceived8 or poorl%

"anaged invest"ents<

A positive correlation $et9een risk and return 9ould hold consistentl% onl% in

an efficient "arket< An% disparities 9ould $e i""ediatel% correctedF this is 9hat

9ould "ake the "arket efficient< In inefficient "arkets it is possi$le to find

invest"ents offering high returns 9ith lo9 risk< These arise 9hen infor"ation is not

9idel% availa$le8 9hen an invest"ent is particularl% co"plicated to anal%De8 or 9hen

investors $u% and sell for reasons unrelated to value< It is also co""onplace to

discover high5risk invest"ents offering lo9 returns< 7verpriced and therefore risk%

invest"ents are often availa$le $ecause the financial "arkets are $iased to9ard

overvaluation and $ecause it is difficult for "arket forces to correct an overvalued

condition if enough speculators persist in overpa%ing< Also8 unscrupulous operators

9ill al9a%s "ake overpriced invest"ents availa$le to an%one 9illing to $u%F the% are

not legall% re?uired to sell at a fair price<

Since the financial "arkets are inefficient a good deal of the




ti"e8 investors cannot si"pl% select a level of risk and $e confident that it 9ill $e

reflected in the acco"pan%ing returns< 4isk and return "ust instead $e assessed

independentl% for ever% invest"ent<

In point of fact8 greater risk does not guarantee greater return< To thecontrar%8 risk erodes return $% causing losses< It is onl% 9hen investors shun high5risk

invest"ents8 there$% depressing their prices8 that an incre"ental return can $e

earned 9hich "ore than full% co"pensates for the risk incurred< B% itself risk does

not create incre"ental returnF onl% price can acco"plish that<

The Nature o8 R#s,

The risk of an invest"ent is descri$ed $% $oth the pro$a$ilit% and the potential

a"ount of loss< The risk of an invest"ent the pro$a$ilit% of an adverse outco"eis

partl% inherent in its ver% nature< A dollar spent on $iotechnolog% research is a riskier

invest"ent than a dollar used to purchase utilit% e?uip"ent< The for"er has $oth a

greater pro$a$ilit% of loss and a greater percentage of the invest"ent at stake<

In the financial "arkets8 ho9ever8 the connection $et9een a "arketa$le

securit% and the underl%ing $usiness is not as clear5cut< 6or investors in a "arketa$le

securit% the gain or loss associated 9ith the various outco"es is not totall% inherent

in the underl%ing $usinessF it also depends on the price paid8 9hich is esta$lished $%

the "arketplace< The vie9 that risk is dependent on $oth the nature of invest"ents

and on their "arket price is ver% different fro" that descri$ed $% $eta =9hich is

considered in the ne:t section><

While securit% anal%sts atte"pt to deter"ine 9ith precision the risk and

return of invest"ents8 events alone acco"plish that< 6or "ost invest"ents the

a"ount of profit earned can $e kno9n onl% after "aturit% or sale< 7nl% for the safest

of invest"ents is return kno9a$le at the ti"e of purchase& a one5%ear




percent T5$ill returns percent at the end of one %ear< 6or riskier invest"ents the

outco"e "ust $e kno9n $efore the return can $e calculated< If %ou $u% one hundred

shares of 'hr%sler 'orporation8 for e:a"ple8 %our return depends al"ost entirel% on

the price at 9hich it is trading 9hen %ou sell< 7nl% then can the return $e calculated<Unlike return8 ho9ever8 risk is no "ore ?uantifia$le at the end of an

invest"ent than it 9as at its $eginning< 4isk si"pl% cannot $e descri$ed $% a single

nu"$er< Intuitivel% 9e understand that risk varies fro" invest"ent to invest"ent& a

govern"ent $ond is not as risk% as the stock of a high5technolog% co"pan%< But

invest"ents do not provide infor"ation a$out their risks the 9a% food packages

provide nutritional data<

4ather8 risk is a perception in each investor@s "ind that results fro" anal%sis

of the pro$a$ilit% and a"ount of potential loss fro" an invest"ent< If an e:plorator%

oil 9ell proves to $e a dr% hole8 it is called risk%< If a $ond defaults or a stock plunges

in price8 the% are called risk%< But if the 9ell is a gusher8 the $ond "atures on

schedule8 and the stock rallies strongl%8 can 9e sa% the% 9eren@t risk% 9hen the

invest"ent 9as "adeE Not at all< The point is8 in "ost cases no "ore is kno9n a$out

the risk of an invest"ent after it is concluded than 9as kno9n 9hen it 9as "ade<

There are onl% a fe9 things investors can do to counteract risk& diversif%

ade?uatel%8 hedge 9hen appropriate8 and invest 9ith a "argin of safet%< It is

precisel% $ecause 9e do not and cannot kno9 all the risks of an invest"ent that 9e

strive to invest at a discount< The $argain ele"ent helps to provide a cushion for

9hen things go 9rong<

For 7eta or Worse

,an% "arket participants $elieve that invest"ent risk is intrinsic to specific

securities8 as it is to activities like hang gliding and "ountain cli"$ing< Using "odern

financial the5



At the 3oot of a ;alue>Investment Philosophy 12)

or%8 acade"ics and "an% "arket professionals have atte"pted to ?uantif% this risk

9ith a single statistical "easure8 $eta< Beta co"pares a securit%@s or portfolio@s

historical price fluctuations 9ith those of the "arket as a 9hole< High5$eta stocks are

defined as those that tend to rise $% a higher percentage than the average stock in arising "arket and decline "ore than the average stock in a falling "arket< #ue to

their greater volatilit%8 high5$eta stocks are dee"ed to $e riskier than lo95$eta

stocks<

I find it preposterous that a single nu"$er reflecting past price fluctuations

could $e thought to co"pletel% descri$e the risk in a securit%< Beta vie9s risk solel%

fro" the perspective of "arket prices8 failing to take into consideration specific $usi5

ness funda"entals or econo"ic develop"ents< The price level is also ignored8 as if

IB, selling at )/ dollars per share 9ould not $e a lo9er5risk invest"ent than the

sa"e IB, at 1// dollars per share< Beta fails to allo9 for the influence that investors

the"selves can e:ert on the riskiness of their holdings through such efforts as pro:%

contests8 shareholder resolutions8 co""unications 9ith "anage"ent8 or the ulti"ate

purchase of sufficient stock to gain corporate control and 9ith it direct access to

underl%ing value< Beta also assu"es that the upside potential and do9nside risk of

an% invest"ent are essentiall% e?ual8 $eing si"pl% a function of that invest"ent@s

volatilit% co"pared 9ith that of the "arket as a 9hole< This too is inconsistent 9ith

the 9orld as 9e kno9 it< The realit% is that past securit% price volatilit% does not

relia$l% predict future invest"ent perfor"ance =or even future volatilit%> and

therefore is a poor "easure of risk<

The Relevan(e o8 Tem$orar% "r#(e Flu(tuat#ons

In addition to the pro$a$ilit% of per"anent loss attached to an invest"ent8

there is also the possi$ilit% of interi" price fluctuations that are unrelated to

underl%ing value< =Beta fails to distin5




guish $et9een the t9o<> ,an% investors consider price fluctuations to $e a significant

risk& if the price goes do9n8 the invest"ent is seen as risk% regardless of the

funda"entals< But are te"porar% price fluctuations reall% a riskE Not in the 9a% that

per"anent value i"pair"ents are and then onl% for certain investors in specificsituations<

It is8 of course8 not al9a%s eas% for investors to distinguish te"porar% price

volatilit%8 related to the short5ter" forces of suppl% and de"and8 fro" price

"ove"ents related to $usiness funda"entals< The realit% "a% onl% $eco"e apparent

after the fact< While investors should o$viousl% tr% to avoid overpa%ing for

invest"ents or $u%ing into $usinesses that su$se?uentl% decline in value due to

deteriorating results8 it is not possi$le to avoid rando" short5ter" "arket volatilit%<

Indeed8 investors should e:pect prices to fluctuate and should not invest in securities

if the% cannot tolerate so"e volatilit%<

If %ou are $u%ing sound value at a discount8 do short5ter" price fluctuations

"atterE In the long run the% do not "atter "uchF value 9ill ulti"atel% $e reflected in

the price of a securit%< Indeed8 ironicall%8 the long5ter" invest"ent i"plication of

price fluctuations is in the opposite direction fro" the near5ter" "arket i"pact< 6or

e:a"ple8 short5ter" price declines actuall% enhance the returns of long5ter"

investors<1 There are8 ho9ever8 several eventualities in 9hich near5ter" price

fluctuations do "atter to investors< Securit% holders 9ho need to sell in a hurr% are at

the "erc% of "arket prices< The trick of successful investors is to sell 9hen the% 9ant

to8 not 9hen the% have to< Investors 9ho "a% need to sell should not o9n "arketa$le

securities other than U<S< Treasur% $ills<

Near5ter" securit% prices also "atter to investors in a trou$led co"pan%< If a

$usiness "ust raise additional capital in the near ter" to survive8 investors in its

securities "a% have their fate deter"ined8 at least in part8 $% the prevailing "arket

price of the co"pan%@s stock and $onds< ='hapter . contains a "ore co"plete

discussion of this effect8 kno9n as refle:ivit%<>

The third reason long5ter"5oriented investors are interested in short5ter"

price fluctuations is that ,r< ,arket can create




ver% attractive opportunities to $u% and sell< If %ou hold cash8 %ou are a$le to take

advantage of such opportunities< If %ou are full% invested 9hen the "arket declines8

%our portfolio 9ill likel% drop in value8 depriving %ou of the $enefits arising fro" the

opportunit% to $u% in at lo9er levels< This creates an opportunit% cost8 the necessit%to forego future opportunities that arise< If 9hat %ou hold is illi?uid or un"arketa$le8

the opportunit% cost increases furtherF the illi?uidit% precludes %our s9itching to

$etter $argains<

The "ost i"portant deter"inant of 9hether investors 9ill incur opportunit%

cost is 9hether or not part of their portfolios is held in cash< ,aintaining "oderate

cash $alances or o9ning securities that periodicall% thro9 off apprecia$le cash is

likel% to reduce the nu"$er of foregone opportunities< Investors can "anage portfolio

cash flo9 =defined as the cash flo9ing into a portfolio "inus outflo9s> $% giving

preference to so"e kinds of invest"ents over others< !ortfolio cash flo9 is greater

for securities of shorter duration =9eighted average life> than those of longer

duration< !ortfolio cash flo9 is also enhanced $% invest"ents 9ith catal%sts for the

partial or co"plete realiDation of underl%ing value =discussed at greater length in

chapter 1/>< ?uit% invest"ents in ongoing $usinesses t%picall% thro9 off onl%

"ini"al cash through the pa%"ent of dividends< The securities of co"panies in

$ankruptc% and li?uidation8 $% contrast8 can return considera$le li?uidit% to a

portfolio 9ithin a fe9 %ears of purchase< 4isk5ar$itrage invest"ents t%picall% have

ver% short lives8 usuall% turning $ack into cash8 li?uid securities8 or $oth in a "atter

of 9eeks or "onths< An added attraction of investing in risk5ar$itrage situations8

$ankruptcies8 and li?uidations is that not onl% is one@s initial invest"ent returned to

cash8 one@s profits are as 9ell<

Another 9a% to li"it opportunit% cost is through hedging< A hedge is an

invest"ent that is e:pected to "ove in a direction opposite that of another holding

so as to cushion an% price decline< If the hedge $eco"es valua$le8 it can $e sold8

providing funds to take advantage of ne9l% created opportunities< =Hedging is

discussed in greater depth in chapter 13<>v




Con(lus#on

The pri"ar% goal of value investors is to avoid losing "one%< Three ele"ents of a value5

invest"ent strateg% "ake achieve"ent of that goal possi$le< A $otto"5up approach8 searching

for lo95risk $argains one at a ti"e through funda"ental anal%sis8 is the surest 9a% I kno9 to

avoid losing "one%< An a$solute5perfor"ance orientation is consistent 9ith loss avoidanceF a

relative5perfor"ance orientation is not< 6inall%8 pa%ing careful attention to riskthe pro$a$ilit%

and a"ount of loss due to per"anent value i"pair"ents9ill help investors avoid losing

"one%< So long as generating portfolio cash inflo9 is not inconsistent 9ith earning accepta$le

returns8 investors can reduce the opportunit% cost resulting fro" interi" price declines even as

the% achieve their long5ter" invest"ent goals<

Notes

1< 'onsider the e:a"ple of a five5%ear 1/ percent $ond pa%ing interest se"iannuall%

9hich is purchased at par =1//>< Assu"ing that interest rates re"ain unchanged over the life

of the $ond8 interest coupons can also $e invested at 1/ percent8 resulting in an annual rate of

return of 1/ percent for that $ond< If i""ediatel% after the $ond is purchased8 interest rates

decline to ) percent8 the $ond 9ill initiall% rise to 121<.. fro" 1//< The $ond rises in price to

reflect the present value of 1/ percent interest coupons discounted at a ) percent interest rate

over five %ears< The $ond could $e sold for a profit of nearl% 22 percent< Ho9ever8 if the

investor decides to hold the $ond to "aturit%8 the annualiDed return 9ill $e onl% <1/ percent<

This is less than in the flat interest case $ecause the interest coupons are reinvested at )

percent8 not 1/ percent< #espite the potential short5ter" profit fro" a decline in interest rates8

the return to the investor 9ho holds on to the $onds is actuall% reduced< Si"ilarl%8 if interest

rates rise to 1) percent i""ediatel% after purchase8 the investor is faced 9ith a "arket

decline fro" par to .2<.*8 a 1 percent loss< The total return8 if he holds the $ond for ) %ears8

is increased8 ho9ever8 to 1/< percent as



At the 3oot of a ;alue>Investment Philosophy 1*'

coupons are reinvested at 1) percent< This e:a"ple de"onstrates ho9 the short5ter"

and long5ter" perspectives on an invest"ent can diverge< In a rising "arket8 "an% people feel

9ealth% due to unrealiDed capital gains8 $ut the% are likel% to $e 9orse off over the long run

than if securit% prices had re"ained lo9er and the returns to incre"ental invest"ent higher<



:

The Art o8 7us#ness aluat#on,an% investors insist on affi:ing e:act values to their invest"ents8 seeking precision

in an i"precise 9orld8 $ut $usiness value cannot $e precisel% deter"ined< 4eported

$ook value8 earnings8 and cash flo9 are8 after all8 onl% the $est guesses of

accountants 9ho follo9 a fairl% strict set of standards and practices designed "ore to

achieve confor"it% than to reflect econo"ic value< !ro;ected results are less precise

still< 0ou cannot appraise the value of %our ho"e to the nearest thousand dollars<

Wh% 9ould it $e an% easier to place a value on vast and co"ple: $usinessesE

Not onl% is $usiness value i"precisel% kno9a$le8 it also changes over ti"e8

fluctuating 9ith nu"erous "acroecono"ic8 "icroecono"ic8 and "arket5related

factors< So 9hile investors at an% given ti"e cannot deter"ine $usiness value 9ith

precision8 the% "ust nevertheless al"ost continuousl% reassess their esti"ates of

value in order to incorporate all kno9n factors that could influence their appraisal<

An% atte"pt to value $usinesses 9ith precision 9ill %ield values that are

precisel% inaccurate< The pro$le" is that it is

1+;



#he Art of usiness ;aluation 1+1eas% to confuse the capa$ilit% to "ake precise forecasts 9ith the a$ilit% to "ake

accurate ones< An%one 9ith a si"ple8 hand5held calculator can perfor" net present

value =N!+> and internal rate of return =I44> calculations< The N!+ calculation

provides a single5point value of an invest"ent $% discounting esti"ates of future

cash flo9 $ack to the present< I448 using assu"ptions 7f future cash flo9 and price

paid8 is a calculation of the rate of return on an invest"ent to as "an% deci"al

places as desired< The see"ing precision provided $% N!+ and I44 calculations can

give investors a false sense of certaint% for the% are reall% onl% as accurate as the

cash flo9 assu"ptions that 9ere used to derive the"<

The advent of the co"puteriDed spreadsheet has e:acer$ated this pro$le"8

creating the illusion of e:tensive and thoughtful anal%sis8 even for the "ost

haphaDard of efforts< T%picall%8 investors place a great deal of i"portance on the

output8 even though the% pa% little attention to the assu"ptions< Gar$age in8

gar$age outG is an apt description of the process<

N!+ and I44 are 9onderful at su""ariDing8 in a$solute and percentage ter"s8

respectivel%8 the returns for a given series of cash flo9s< When cash flo9s are

contractuall% deter"ined8 as in the case of a $ond8 and 9hen all pa%"ents are

received 9hen due8 I44 provides the precise rate of return to the investor 9hile N!+

descri$es the value of the invest"ent at a given discount rate< In the case of a $ond8

these calculations allo9 investors to ?uantif% their returns under one set of assu"p5

tions8 that is8 that contractual pa%"ents are received 9hen due< These tools8

ho9ever8 are of no use in deter"ining the likelihood that investors 9ill actuall%receive all contractual pa%"ents and8 in fact8 achieve the pro;ected returns<

A Ran/e o8 alue

Businesses8 unlike de$t instru"ents8 do not have contractual cash flo9s< As a

result8 the% cannot $e as precisel% valued as




$onds< Ben;a"in raha" kne9 ho9 hard it is to pinpoint the value of $usinesses and

thus of e?uit% securities that represent fractional o9nership of those $usinesses< In

!ecurity Analysis he and #avid #odd discussed the concept of a range of value&

The essential point is that securit% anal%sis does not seek to deter"inee:actl% 9hat is the intrinsic value of a given securit%< It needs onl% to

esta$lish that the value is ade?uatee<g<8 to protect a $ond or to ;ustif% a

stock purchaseor else that the value is considera$l% higher or considera$l%

lo9er than the "arket price< 6or such purposes an indefinite and appro:i"ate

"easure of the intrinsic value "a% $e sufficient<1

Indeed8 raha" fre?uentl% perfor"ed a calculation kno9n as net 9orking capital per

share8 a $ack5of5the5envelope esti"ate of a co"pan%@s li?uidation value< His use of

this rough appro:i"ation 9as a tacit ad"ission that he 9as often una$le to ascertain

a co"pan%@s value "ore precisel%<

To illustrate the difficult% of accurate $usiness valuation8 investors need onl%

consider the 9ide range of Wall Street esti"ates that t%picall% are offered 9henever

a co"pan% is put up for sale< In 1.8 for e:a"ple8 'a"peau 'orporation "arketed

Bloo"ingdales to prospective $u%ersF Harcourt Brace -ovanovich8 Inc<8 held an

auction of its Sea World su$sidiar%F and Hilton Hotels8 Inc<8 offered itself for sale< In

each case Wall Street@s value esti"ates ranged 9idel%8 9ith the highest esti"ate as

"uch as t9ice the lo9est figure< If e:pert anal%sts 9ith e:tensive infor"ation cannot

gauge the value of high5profile8 9ell5regarded $usinesses 9ith "ore certaint% than

this8 investors should not fool the"selves into $elieving the% are capa$le of greater

precision 9hen $u%ing "arketa$le securities $ased onl% on li"ited8 pu$licl% availa$le

infor"ation<

,arkets e:ist $ecause of differences of opinion a"ong investors< If securities

could $e valued precisel%8 there 9ould $e "an% fe9er differences of opinionF "arket

prices 9ould fluctuate less fre?uentl%8 and trading activit% 9ould di"inish< To fun5

da"entall% oriented investors8 the value of a securit% to the $u%er "ust $e greater

than the price paid8 and the value to the





1+) A A5E!INESTMENT "6IOSO"6Y

$usinesses using the "ultiples paid 9hen co"para$le $usinesses 9ere previousl%

$ought and sold in their entiret%<

The second "ethod of $usiness valuation anal%Des li?uidation value8 the

e:pected proceeds if a co"pan% 9ere to $e dis"antled and the assets sold off<

Breakup value8 one variant of li?uidation anal%sis8 considers each of the co"ponents

of a $usiness at its highest valuation8 9hether as part of a going concern or not<

The third "ethod of valuation8 stock "arket value8 is an esti"ate of the price

at 9hich a co"pan%8 or its su$sidiaries considered separatel%8 9ould trade in the

stock "arket< (ess relia$le than the other t9o8 this "ethod is onl% occasionall% useful

as a %ardstick of value<

ach of these "ethods of valuation has strengths and 9eaknesses< None of

the" provides accurate values all the ti"e< Unfortunatel% no $etter "ethods of

valuation e:ist< Investors have no choice $ut to consider the values generated $%each of the"F 9hen the% apprecia$l% diverge8 investors should generall% err on the

side of conservatis"<

"resent!alue Anal%s#s an the 2#88#(ult% o8

Fore(ast#n/ Future Cash Flo-

When future cash flo9s2 are reasona$l% predicta$le and an appropriate discount rate

can $e chosen8 N!+ anal%sis is one of the "ost accurate and precise "ethods of

valuation< Unfortunatel% future cash flo9s are usuall% uncertain8 often highl% so<,oreover8 the choice of a discount rate can $e so"e9hat ar$itrar%< These factors

together t%picall% "ake present5value anal%sis an i"precise and difficult task<

A perfect $usiness in ter"s of the si"plicit% of valuation 9ould $e an annuit%F

an annuit% generates an annual strea" of cash that either re"ains constant or gro9s

at a stead% rate ever% %ear< 4eal $usinesses8 even the $est ones8 are unfortunatel%

not annuities< 6e9 $usinesses occup% i"penetra$le "arket niches






fore alread% discounted in securities prices8 shortfalls 9ill disappoint investors and

result in share price declines< As Warren Buffett has said8 G6or the investor8 a too5

high purchase price for the stock of an e:cellent co"pan% can undo the effects of a

su$se?uent decade of favora$le $usiness develop"ents<G

)

Another difficult% 9ith investing $ased on gro9th is that 9hile investors tend

to oversi"plif% gro9th into a single nu"$er8 gro9th is8 in fact8 co"prised of

nu"erous "oving parts 9hich var% in their predicta$ilit%< 6or an% particular $usiness8

for e:a"ple8 earnings gro9th can ste" fro" increased unit sales related to

predicta$le increases in the general population8 to increased usage of a product $%

consu"ers8 to increased "arket share8 to greater penetration of a product into the

population8 or to price increases< Specificall%8 a $re9er "ight e:pect to sell "ore

$eer as the drinking5age population gro9s $ut 9ould aspire to selling "ore $eer per

capita as 9ell< Bud9eiser 9ould hope to increase "arket share relative to ,iller< The

$re9ing industr% "ight 9ish to convert 9hiske% drinkers into $eer drinkers or reach

the a$ste"ious seg"ent of the population 9ith a $rand of nonalcoholic $eer< 7ver

ti"e co"panies 9ould seek to increase price to the e:tent that it 9ould $e e:pected

to result in increased profits<

So"e of these sources of earnings gro9th are "ore predicta$le than others<

ro9th tied to population increases is considera$l% "ore certain than gro9th

ste""ing fro" changes in consu"er $ehavior8 such as the conversion of 9hiske%

drinkers to $eer< The reaction of custo"ers to price increases is al9a%s uncertain< 7n

the 9hole it is far easier to identif% the possi$le sources of gro9th for a $usiness than

to forecast ho9 "uch gro9th 9ill actuall% "aterialiDe and ho9 it 9ill affect profits<

An unresolva$le contradiction e:ists& to perfor" present5value anal%sis8 %ou

"ust predict the future8 %et the future is not relia$l% predicta$le< The "isera$le

failure in 1/ of highl% leveraged co"panies such as Southland 'orporation and

Interco8 Inc<8 to "eet their o9n allegedl% reasona$le pro;ections "ade ;ust a fe9

%ears earlierin $oth cases underperfor"ing






an investor indifferent $et9een present and future dollars< Investors 9ith a strong

preference for present over future consu"ption or 9ith a preference for the certaint%

of the present to the uncertaint% of the future 9ould use a high rate for discounting

their invest"ents< 7ther investors "a% $e "ore 9illing to take a chance on forecastsholding trueF the% 9ould appl% a lo9 discount rate8 one that "akes future cash flo9s

nearl% as valua$le as toda%@s<

There is no single correct discount rate for a set of future cash flo9s and no

precise 9a% to choose one< The appropriate discount rate for a particular invest"ent

depends not onl% on an investor@s preference for present over future consu"ption

$ut also on his or her o9n risk profile8 on the perceived risk of the invest"ent under

consideration8 and on the returns availa$le fro" alternative invest"ents<

Investors tend to oversi"plif%F the 9a% the% choose a discount rate is a good

e:a"ple of this< A great "an% investors routinel% use 1/ percent as an all5purpose

discount rate regardless of the nature of the invest"ent under consideration< Ten

percent is a nice round nu"$er8 eas% to re"e"$er and appl%8 $ut it is not al9a%s a

good choice<

The underl%ing risk of an invest"ent@s future cash flo9s "ust $e considered in

choosing the appropriate discount rate for that invest"ent< A short5ter"8 risk5free

invest"ent =if one e:ists> should $e discounted at the %ield availa$le on short5ter"

U<S< Treasur% securities8 9hich8 as stated earlier8 are considered a pro:% for the risk5

free interest rate< (o95grade $onds8 $% contrast8 are discounted $% the "arket at

rates of 12 to 1) percent or "ore8 reflecting investors@ uncertaint% that the

contractual cash flo9s 9ill $e paid<

It is essential that investors choose discount rates as conservativel% as the% forecast

future cash flo9s< #epending on the ti"ing and "agnitude of the cash flo9s8 even

"odest differences in the discount rate can have a considera$le i"pact on the

present5value calculation<

Business value is influenced $% changes in discount rates and therefore $%

fluctuations in interest rates< While it 9ould $e eas5



#he Art of usiness ;aluation 1+'

ier to deter"ine the value of invest"ents if interest rates and thus discount rates

9ere constant8 investors "ust accept the fact that the% do fluctuate and take 9hat

action the% can to "ini"iDe the effect of interest rate fluctuations on their portfolios<

Ho9 can investors kno9 the GcorrectG level of interest rates in choosing a

discount rateE I $elieve there is no GcorrectG level of rates< The% are 9hat the "arket

sa%s the% are8 and no one can predict 9here the% are headed< ,ostl% I give current8

risk5free interest rates the $enefit of the dou$t and assu"e that the% are correct<

(ike "an% other financial5"arket pheno"ena there is so"e c%clicall% to interest rate

fluctuations< High interest rates lead to changes in the econo"% that are precursors

to lo9er interest rates and vice versa< Cno9ing this does not help one "ake

particularl% accurate forecasts8 ho9ever8 for it is al"ost i"possi$le to envision the

econo"ic c%cle until after the fact<

At ti"es 9hen interest rates are unusuall% lo98 ho9ever8 investors are likel%to find ver% high "ultiples $eing applied to share prices< Investors 9ho pa% these

high "ultiples are dependent on interest rates re"aining lo98 $ut no one can $e

certain that the% 9ill< This "eans that 9hen interest rates are unusuall% lo98

investors should $e particularl% reluctant to co""it capital to long5ter" holdings

unless outstanding opportunities $eco"e availa$le8 9ith a preference for either

holding cash or investing in short5ter" holdings that ?uickl% return cash for possi$le

redeplo%"ent 9hen availa$le returns are "ore attractive<

Investors can appl% present5value anal%sis in one of t9o 9a%s< The% can

calculate the present5value of a $usiness and use it to place a value on its securities<

Alternativel%8 the% can calculate the present5value of the cash flo9s that securit%

holders 9ill receive& interest and principal pa%"ents in the case of $ondholders and

dividends and esti"ated future share prices in the case of stockholders<

'alculating the present value of contractual interest and principal pa%"ents is

the $est 9a% to value a $ond< Anal%sis of the underl%ing $usiness can then help to

esta$lish the pro$a$ilit% that those cash flo9s 9ill $e received< B% contrast8 anal%Ding

the cash flo9s of the underl%ing $usiness is the $est 9a% to





#he Art of usiness ;aluation 1*1

the sa"e8 $ut private5"arket value fails to distinguish a"ong the"< ,oreover8 the

"ultiples paid to ac?uire $usinesses var% over ti"eF valuations "a% have changed

since the "ost recent si"ilar transaction< 6inall%8 $u%ers of $usinesses do not neces5

saril% pa% reasona$le8 intelligent prices< The validit% of private5"arket value depends on the assu"ption that

$usinesspeople kno9 9hat the% are doing< In other 9ords8 9hen $usinesspeople

consistentl% pa% a certain "ultiple of revenues8 earnings8 or cash flo9 for a $usiness8

it is assu"ed that the% are doing so after having perfor"ed an insightful anal%sis of

the underl%ing econo"ics< 7ften the% have< After all8 if the prices paid 9ere routinel%

too high8 the eventual losses incurred 9ould infor" su$se?uent $u%ers 9ho 9ould

pa% less in the future< If the prices paid 9ere too lo98 the $u%ers 9ould earn high

returnsF seeing this8 others 9ould eventuall% $id prices up to levels 9here e:cess

profits could no longer $e achieved< Nevertheless8 the fact is that the prices paid $%

$u%ers of $usinesses can diverge fro" the underl%ing econo"ics of those $usinesses

for long stretches of ti"e<

In the latter half of the 1./s8 for e:a"ple8 the Gprivate5"arket valuesG that

investors ca"e to rel% on ceased to $e the prices that sophisticated8 prudent

$usinesspeople 9ould pa% for $usinesses< 6inanciers ar"ed 9ith the proceeds of

nonrecourse ;unk5$ond offerings and using al"ost none of their o9n "one% 9ere

"otivated $% a tre"endous ske9ing of their o9n risk and re9ard8 as 9ell as $%

enor"ous up5front fees8 to overpa% for corporate takeovers< Indeed8 investors@

assess"ent of private5"arket value in "an% cases $eca"e the price that a ;unk5

$ond5financed $u%er "ight pa%F investors failed to consider that those ac?uirers 9ere

starting to go $ankrupt $ecause the prices the% had paid 9ere e:cessive<

As the prices paid for $usinesses rose a$ove historic "ultiples of underl%ing

$usiness value8 traditional private5"arket $u%ers 9ere shut out of the "arket<

Television stations8 9hich had $een valued for "an% %ears at roughl% ten ti"es

preta: cash flo98 ca"e to sell at prices as high as thirteen to fifteen





#he Art of usiness ;aluation 1*3

rel%ing on the ;udg"ent of a $u%er of $usinesses8 9ho "a% or "a% not $e trul%

kno9ledgea$le and insightful8 can cause investors to $eco"e co"placent and to

neglect to perfor" their o9n independent valuations as a check< ,% personal rule is

that investors should value $usinesses $ased on 9hat the% the"selves8 not others89ould pa% to o9n the"< At "ost8 private5"arket value should $e used as one of

several inputs in the valuation process and not as the e:clusive final ar$iter of value<

#Lu#at#on alue

The li?uidation value of a $usiness is a conservative assess"ent of its 9orth in 9hich

onl% tangi$le assets are considered and intangi$les8 such as going5concern value8 are

not< Accordingl%8 9hen a stock is selling at a discount to li?uidation value per share8 a

near rock5$otto" appraisal8 it is fre?uentl% an attractive invest"ent<

A li?uidation anal%sis is a theoretical e:ercise in valuation $ut not usuall% an

actual approach to value realiDation< The assets of a co"pan% are t%picall% 9orth

"ore as part of a going concern than in li?uidation8 so li?uidation value is generall% a

9orst5case assess"ent< ven 9hen an ongoing $usiness is dis"antled8 "an% of its

co"ponent parts are not actuall% li?uidated $ut instead are sold intact as operating

entities< Breakup value is one for" of li?uidation anal%sisF this involves deter"ining

the highest value of each co"ponent of a $usiness8 either as an ongoing enterprise

or in li?uidation< ,ost announced corporate li?uidations are reall% $reakupsF ongoing

$usiness value is preserved 9henever it e:ceeds li?uidation value<

Ho9 should investors value assets in a li?uidation anal%sisE An orderl%

li?uidation over ti"e is virtuall% certain to realiDe greater proceeds than a Gfire sale8G

$ut ti"e is not al9a%s availa$le to a co"pan% in li?uidation< When a $usiness is in

financial distress8 a ?uick li?uidation =a fire sale> "a% "a:i"iDe the estate value< In a

fire sale the value of inventor%8 depending on



1)) A A5E!INESTMENT "6IOSO"6Y

its nature8 "ust $e discounted steepl% $elo9 carr%ing value< 4eceiva$les should

pro$a$l% $e significantl% discounted as 9ellF the nature of the $usiness8 the identit%

of the custo"er8 the a"ount o9ed8 and 9hether or not the $usiness is in an% 9a%

ongoing all influence the ulti"ate realiDation fro" each receiva$le<

When no crisis is at hand8 li?uidation proceeds are usuall% "a:i"iDed through

a "ore orderl% 9inding up of a $usiness< In an orderl% li?uidation the values realiDed

fro" disposing of current assets 9ill "ore closel% appro:i"ate stated $ook value<

'ash8 as in an% li?uidation anal%sis8 is 9orth one hundred cents on the dollar<

Invest"ent securities should $e valued at "arket prices8 less esti"ated transaction

costs in selling the"< Accounts receiva$le are appraised at close to their face

a"ount< The realiDa$le value of inventoriestens of thousands of progra""ed

co"puter diskettes8 hundreds of thousands of purple sneakers8 or "illions of sticks of

che9ing gu"is not so easil% deter"ina$le and "a% 9ell $e less than $ook value<

The discount depends on 9hether the inventories consist of finished goods8 9ork in

process8 or ra9 "aterials8 and 9hether or not there is the risk of technological or

fashion o$solescence< The value of the inventor% in a super"arket does not fluctuate

"uch8 $ut the value of a 9arehouse full of co"puters certainl% "a%< 7$viousl%8 a

li?uidation sale 9ould %ield less for inventor% than 9ould an orderl% sale to regular

custo"ers<

The li?uidation value of a co"pan%@s fi:ed assets can $e difficult to deter"ine<

The value of plant and e?uip"ent8 for e:a"ple8 depends on its a$ilit% to generate

cash flo9s8 either in the current use or in alternative uses< So"e "achines andfacilities are "ultipurpose and 9idel% o9nedF others "a% have value onl% to the

present o9ner< The value of restaurant e?uip"ent8 for e:a"ple8 is "ore readil%

deter"ina$le than the value of an aging steel "ill<

In appro:i"ating the li?uidation value of a co"pan%8 so"e value investors8

e"ulating Ben;a"in raha"8 calculate Gnet5net 9orking capitalG as a shortcut< Net

9orking capital consists of current assets =cash8 "arketa$le securities8 receiva$les8

and inventories> less current lia$ilities =accounts8 notes8 and ta:es pa%a$le 9ithin one

%ear<> Net5net 9orking capital is defined as



#he Art of usiness ;aluation 1*)

net 9orking capital "inus all long5ter" lia$ilities< ven 9hen a co"pan% has little

ongoing $usiness value8 investors 9ho $u% at a price $elo9 net5net 9orking capital

are protected $% the appro:i"ate li?uidation value of current assets alone< As long

as 9orking capital is not overstated and operations are not rapidl% consu"ing cash8 aco"pan% could li?uidate its assets8 e:tinguish all its lia$ilities8 and still distri$ute

proceeds in e:cess of the "arket price to investors< 7ngoing $usiness losses can8

ho9ever8 ?uickl% erode net5net 9orking capital< Investors "ust therefore al9a%s

consider the state of a co"pan%@s current operations $efore $u%ing< Investors should

also consider an% off5$alance sheet or contingent lia$ilities8 such as underfunded

pension plans8 as 9ell as an% lia$ilities that "ight $e incurred in the course of an

actual li?uidation8 such as plant closing and environ"ental la9s<

A corporate li?uidation t%picall% connotes $usiness failureF $ut ironicall%8 it

"a% correspond 9ith invest"ent success< The reason is that the li?uidation or

$reakup of a co"pan% is a catal%st for the realiDation of underl%ing $usiness value<

Since value investors atte"pt to $u% securities trading at a considera$le discount

fro" the value of a $usiness@s underl%ing assets8 a li?uidation is one 9a% for

investors to realiDe profits<

A li?uidation is8 in a sense8 one of the fe9 interfaces 9here the essence of the

stock "arket is revealed< Are stocks pieces of paper to $e endlessl% traded $ack and

forth8 or are the% proportional interests in underl%ing $usinessesE A li?uidation settles

this de$ate8 distri$uting to o9ners of pieces of paper the actual cash proceeds

resulting fro" the sale of corporate assets to the highest $idder< A li?uidation

there$% acts as a tether to realit% for the stock "arket8 forcing either undervalued or

overvalued share prices to "ove into line 9ith actual underl%ing value<

Sto(, Mar,et alue

7ccasionall% investors "ust rel% on the pu$lic e?uit% and de$t "arkets to

provide an appro:i"ation of the 9orth of a securit%< So"eti"es8 as in the case of a

closed5end "utual fund8 this is the




onl% relevant valuation "ethod< 7ther ti"es8 especiall% if the ti"e fra"e in 9hich the

value "ust $e realiDed is short8 the stock "arket "ethod "a% $e the $est of several

poor alternatives<

'onsider the valuation of an invest"ent co"pan%< In "id51/ the Schaefer+alue Trust8 Inc<8 a closed5end "utual fund8 scheduled a vote of its shareholders to

consider li?uidation< The "ost relevant "easure of the li?uidation value of Schaefer

9as its stock "arket value8 the value that its holdings 9ould $ring 9hen sold at once

in the stock "arket< No other valuation "ethod 9ould have $een appropriate<

Stock "arket value applies in other situations as 9ell< In atte"pting to value a

co"pan%@s interest in an unrelated su$sidiar% or ;oint venture8 for e:a"ple8 investors

9ould certainl% consider the discounted anticipated future cash flo9 strea" =net

present value>8 the valuation of co"para$le $usinesses in transactions =private5

"arket value>8 and the value of tangi$le assets net of lia$ilities =li?uidation value><

Investors 9ould also $enefit fro" considering stock "arket value8 the valuation of

co"para$le $usinesses in the stock "arket< While the stock "arket@s vote8 especiall%

over the long run8 is not necessaril% accurate8 it does provide an appro:i"ate near5

ter" appraisal of value<

I kno9 9hat %ou "ust $e thinking< If the prices at 9hich stocks trade in the

"arket is a reasona$le appro:i"ation of their value8 then isn@t this an ad"ission that

the stock "arket is efficient8 the antithesis of one of the $asic tenets of value invest5

ingE ,% ans9er is decidedl% no< The stock "arket valuation of co"para$le

$usinesses is $ut one of several valuation tools and provides a %ardstick of 9hat a

securit%8 if not a $usiness8 "ight $ring if sold to"orro9<

Stock "arket value has its shortco"ings as a valuation tool< 0ou 9ould not

use stock "arket value to appraise each of the co"panies in an industr%< It 9ould $e

circular reasoning to o$serve that since ne9spaper co"panies tend to trade in the

"arket at8 sa%8 eight ti"es preta: cash flo98 that is 9hat the% "ust $e 9orth<

Cno9ing the stock "arket@s appraisal for the





1*. A A5E!INESTMENT "6IOSO"6Y

The Re8le0#ve Relat#onsh#$ 7et-een Mar,et "r#(e

an 5nerl%#n/ alue

A co"plicating factor in securities anal%sis is the refle:ive or reciprocal relationship

$et9een securit% prices and the values of the underl%ing $usinesses< In #he Alchemy

of 2inance eorge Soros stated8 G6unda"ental anal%sis seeks to esta$lish ho9

underl%ing values are reflected in stock prices8 9hereas the theor% of refle:ivit%

sho9s ho9 stock prices can influence underl%ing values<G In other 9ords8 Soros@s

theor% of refle:ivit% "akes the point that its stock price can at ti"es significantl%

influence the value of a $usiness< Investors "ust not lose sight of this possi$ilit%<

,ost $usinesses can e:ist indefinitel% 9ithout concern for the prices of their

securities as long as the% have ade?uate capital< When additional capital is needed8

ho9ever8 the level of securit% prices can "ean the difference $et9een prosperit%8

"ere via$ilit%8 and $ankruptc%< If8 for e:a"ple8 an undercapitaliDed $ank has a high

stock price8 it can issue "ore shares and $eco"e ade?uatel% capitaliDed8 a for" of

self5fulfilling prophec%< The stock "arket sa%s there is no pro$le"8 so there is no

pro$le"< In earl% 118 for e:a"ple8 'iticorp stock traded in the teens and the

co"pan% 9as a$le to find $u%ers for ne9l% issued securities< If its stock price had

$een in the lo9 single digits8 ho9ever8 it 9ould have $een una$le to raise additional

e?uit% capital8 9hich could have resulted in its eventual failure< This is another8 al$eit

negative for" of self5fulfilling prophec%8 9here$% the financial "arkets@ perception of

the via$ilit% of a $usiness influences the outco"e<

The sa"e holds true for a highl% leveraged co"pan% 9ith an upco"ing de$t

"aturit%< If the "arket dee"s a co"pan% credit9orth%8 as it did ,arriott 'orporation

in earl% 118 the co"pan% 9ill $e a$le to refinance and fulfill the prophec%< If the

"arket votes thu"$s do9n on the credit8 ho9ever8 as it did 9ith ,ortgage and

4ealt% Trust in 1/8 that prophec% 9ill also $e fulfilled since the co"pan% 9ill then

fail to "eet its o$ligations<





1)/ A A5E!INESTMENT "6IOSO"6Y

"arket prices 9as 9orth onl% fifteen cents per "erson share =9hich itself traded

around */>< Needless to sa%8 "an% holders of "erson ?uickl% sold their trivial sco

holdings<

What 9as sco 9orth at the ti"e of spinoffE Was it undervalued in the"arketplace8 and if so8 9h%E Was it an attractive value5invest"ent opportunit%E The

9a% to ans9er these ?uestions is to evaluate sco using each of the "ethods that

value investors e"plo%<

To $egin 9ith8 sco is a su$stantial co"pan%8 having appro:i"atel% )//

"illion in annual sales and si: thousand e"plo%ees8 9ho occup% 3<2 "illion s?uare

feet of space8 1< "illion of 9hich are o9ned $% the co"pan%< sco@s onl% recent

gro9th has co"e fro" its ac?uisition of HaDeltine 'orporation in late 1. for 1/

"illion =over 1) per sco share>< A "a;or consideration leading to the spinoff 9as

that sco@s after5ta: profits had declined fro" 3<3 "illion in 1.) =actual> to <

"illion =pro for"a8 to reflect ad;ust"ents related to the spinoff> in 1. after .<2

"illion of nonrecurring charges and to a loss of )<2 "illion =pro for"a> in 1/ after

13<. "illion of nonrecurring charges< The co"pan% 9as spun off 9ith a conservative

capitaliDation8 having onl% *) "illion in de$t co"pared 9ith al"ost )// "illion in

e?uit%< Tangi$le $ook value e:ceeded 2) per share8 and net5net 9orking capital8

current assets less all lia$ilities8 e:ceeded 1) per share<

T9o ?uestions regarding sco@s future 9orried investors< 7ne 9as 9hether the

sharp recent drop in profita$ilit%8 related to "one%5losing defense contracts the

co"pan% had taken on8 9ould reverse< The second concerned the outco"e of t9o

pending contract disputes $et9een sco and the U<S< govern"entF an adverse

outco"e could have cost sco tens of "illions of dollars in cash and forced it to

report siDa$le losses< These uncertainties caused "erson to spin off8 not shares of

co""on stock8 $ut co""on stock trust receipts held in escro9 in order to ensure

that sco 9ould "eet its o$ligation to inde"nif% "erson for certain custo"er5

contract guarantees<

The first step in valuing sco in 7cto$er 1/ 9as to tr% to understand its

$usiness results& earnings and cash flo9< sco@s



#he Art of usiness ;aluation 1)1

future earnings 9ere particularl% difficult to forecast8 especiall% $ecause in each of

the preceding t9o %ears the co"pan% had taken significant nonrecurring charges< An

anal%st at Bear Stearns esti"ated $reak5even earnings for fiscal %ear 11< This

esti"ate 9as after the deduction of a ne9l% instituted charge of <* "illion8 pa%a$le$% sco to "erson each %ear fro" 11 to 1)8 for guaranteeing outstanding

defense contracts< Although this charge 9ould have the effect of reducing reported

earnings for five %ears8 it 9as not a true $usiness e:pense $ut rather "ore of an

e:traordinar% ite"<

Another ongoing depressant to earnings 9as sco@s appro:i"atel% ) "illion

per %ear charge for nondeducti$le good9ill a"ortiDation resulting fro" the HaDeltine

ac?uisition< Since good9ill is a noncash e:pense8 free cash flo9 fro" this source

alone 9as ) "illion8 or fort%5five cents per share<

In order to value sco using N!+ anal%sis8 investors 9ould need to forecast

sco@s likel% future cash flo9s< ood9ill a"ortiDation of fort%5five cents a %ear8 as

stated8 9as free cash< Beginning in 1 there 9ould $e an additional fort%5five cents

of after5ta: earnings per %ear as the <* "illion guarant% fee ended< Investors 9ould

have to "ake so"e assu"ptions regarding future earnings< 7ne reasona$le

assu"ption8 perhaps the "ost likel% case8 9as that earnings8 currentl% Dero8 9ould

graduall% increase over ti"e< Unprofita$le contracts 9ould eventuall% $e co"pleted8

and interest 9ould $e earned on accu"ulated cash flo9< An alternative possi$ilit%

9as that results 9ould re"ain at current depressed levels indefinitel%<

In addition to predicting future earnings8 investors 9ould also need to

esti"ate sco@s future cash invest"ent or disinvest"ent in its $usiness in order to

assess its cash flo9< #epreciation in recent %ears had appro:i"ated capital spending8

for e:a"ple8 and assu"ing it 9ould do so in the future see"ed a conservative

assu"ption< Also8 9orking capital tied up in currentl% unprofita$le contracts 9ould

eventuall% $e freed for other corporate uses8 $ut the ti"ing of this 9as uncertain<

Were sco@s 9orking capital5to5sales ratio8 currentl% $loated8 to "ove into line 9ith

that of co"para$le defense elec5



1)2 A A5E!INESTMENT "6IOSO"6Y

tronics fir"s8 roughl% ./ "illion in additional cash 9ould $eco"e availa$le< To

ensure conservatis"8 ho9ever8 I chose to pro;ect no free cash flo9 fro" this source<

What 9as sco 9orth if it never did $etter than its current depressed level of

resultsE 'ash flo9 9ould e?ual fort%5five cents per share for five %ears and ninet%cents thereafter 9hen the guarant% pa%"ents to "erson had ceased< The present

value of these cash flo9s is )<. and *</ per share8 calculated at 12 percent and

1) percent discount rates8 respectivel%8 9hich the"selves reflect considera$le

uncertaint%< If cash flo9 proved to $e higher8 the value 9ould8 of course8 $e greater<

What if sco "anaged to increase its free cash flo9 $% ;ust 2<2 "illion a

%ear8 or t9ent% cents per share8 for the ne:t ten %ears8 after 9hich it leveled offE The

present value of these flo9s at 12 percent and 1) percent discount rates is 1*<

and 1/<.38 respectivel%< #epending on the assu"ptions8 then8 the net present value

per share of sco is conservativel% calculated at *</ and less pessi"isticall% at

1*< per share8 clearl% a 9ide range $ut in either case 9ell a$ove the 3 stock

price and in no case "aking highl% opti"istic assu"ptions<

Investors in sco 9ould certainl% 9ant to consider alternative scenarios for

future operating results< 7$viousl% there 9as so"e chance that the co"pan% 9ould

lose one or "ore of its contract disputes 9ith the U<S< govern"ent< There 9as so"e

possi$ilit% that a 9idel% anticipated reduction in national defense spending 9ould

cause the co"pan% to lose profita$le contracts or fail to receive ne9 ones< There 9as

a chance that the ne9l% independent co"pan%8 s"aller than "ost of its co"petitors8

9ould face difficulties in tr%ing to operate apart fro" "erson<

Alternativel%8 there 9as so"e prospect that sco 9ould either 9in $oth of its

contract disputes outright or settle 9ith the govern"ent on accepta$le ter"s<

Indeed8 the ne9 top "anage"ent 9ould likel% 9ish to start afresh8 putting past

difficulties $ehind the"< =The disputes 9ere8 in fact8 tentativel% settled 9ithin "onths

of the spinoff on ter"s favora$le to sco<> 6urther8 ne9 "anage"ent e:pressed its

intention to "a:i"iDe



#he Art of usiness ;aluation 1)3

cash flo9 rather than salesF ne9 contracts 9ould $e accepted on the $asis of lo95risk

profita$ilit% rather than prestige or the desire to achieve revenue gro9th< Thus it 9as

not unreasona$le to think that earnings 9ould gro9 over ti"e as unprofita$le

contracts 9ere concluded and profita$le contracts added<Investors 9ould 9ant to consider other valuation "ethods in addition to N!+<

The private5"arket value "ethod8 ho9ever8 9as not applica$le in the case of sco

$ecause there had $een fe9 recent $usiness transactions involving siDa$le defense

co"panies< ven if there had $een8 sco@s pending contract disputes 9ould put a

da"per on an%one@s enthusias" to $u% all of sco e:cept at an e:tre"e $argain

price< Indeed sco had $een put up for sale prior to spinoff8 and no $u%ers e"erged

at prices accepta$le to "erson<

'onversel% "erson had onl% four %ears earlier paid 1/ "illion for

HaDeltine8 9hich co"prised onl% a fraction of sco@s $usiness at the ti"e of spinoff<

At a takeover "ultiple even close to that of the HaDeltine transaction8 all of sco

9ould $e 9orth "an% ti"es its prevailing stock "arket price8 9ith HaDeltine alone

9orth 1) per sco share<

A li?uidation anal%sis 9as also not particularl% applica$leF defense co"panies

cannot $e easil% li?uidated< The assets have fe9 alternate uses8 and inventor% and

receiva$le valuations are realiDa$le onl% for an ongoing defense concern< sco could

$e valued8 ho9ever8 on the $asis of a gradual li?uidation8 9here$% e:isting contracts

9ould $e allo9ed to run to co"pletion and no ne9 $usiness 9ould $e sought< The

value in such a scenario is uncertain8 $ut it is hard to i"agine the proceeds realiDed

over ti"e $eing less than the net5net 9orking capital of 1) per share<

Stock "arket value is another useful %ardstick8 especiall% for gauging 9here a

spinoff ne9 to the "arket "ight reasona$l% $e e:pected to trade< This "ethod 9ould

not deter"ine over5 or undervaluation8 $ut si"pl% relative valuation co"pared 9ith

other defense5electronics co"panies< In this case sco see"ed to trade as if its

$usiness 9ere located on a different planet< At 3 per share8 the stock sold for onl%

12 percent of tangi$le $ook



1)* A A5E!INESTMENT "6IOSO"6Y

value8 a staggeringl% lo9 level for a via$le co"pan% 9ith positive cash flo9 and little

de$t< Indeed8 the shares could rise *// percent fro" that level and still $e $elo9 half

of tangi$le $ook value< 7f course8 other defense co"pan% shares 9ere also

depressed at the ti"e8 9ith "ost of the" trading at onl% four to si: ti"es earningsFanother recent defense spinoff8 Alliant Techs%ste"s8 traded at onl% t9o ti"es

esti"ated earnings< Ho9ever8 "ost co"para$le fir"s 9ere trading at $et9een /

and 1// percent of $ook value and had historicall% traded considera$l% a$ove that<

Although sco 9as less profita$le than "ost other defense co"panies8 it 9as selling

for onl% three ti"es earnings if $oth good9ill a"ortiDation and the <* "illion

special charge 9ere ignored< The e:tre"el% lo9 valuation see"ed to "ore than full%

discount sco@s current shortco"ings as a $usiness<

It is difficult8 if not i"possi$le8 to deter"ine precisel% 9hat sco stock 9as

9orth< It is far si"pler to deter"ine that it 9as 9orth considera$l% "ore than the

"arket price< With the shares selling for 38 %et having 2) per share of tangi$le

$ook value and little de$t8 investors@ "argin of safet% 9as high<

sco appeared to $e 9orth easil% t9ice its 3 "arket price8 a level that 9as

onl% si: ti"es ad;usted earnings8 */ percent of net5net 9orking capital8 and less than

2) percent of tangi$le $ook value< Was it 9orth 1/ per shareE !ro$a$l%8 either on

the $asis of N!+ using "ildl% opti"istic assu"ptions or on a gradual li?uidation $asis<

The nice thing a$out sco at 3 per share is that one didn@t have to kno9

e:actl% 9hat it 9as 9orth< The price reflected disasterF an% other outco"e see"ed

certain to %ield a higher price< A siDa$le loss on the disputed contracts 9as the 9orst5

case scenario8 $ut even that 9as pro$a$l% alread% reflected in the lo9 share price<

,anage"ent certainl% $elieved that these disputes could $e favora$l% resolved<

According to pu$lic filings8 shortl% after the spinoff the chair"an of sco@s $oard

purchased shares on the open "arket for his personal account< B% earl% 11 selling

pressure related to the spinoff su$sided8 defense stocks rallied8 and sco rose to over

. per share<



#he Art of usiness ;aluation 1))

Convent#onal aluat#on Yarst#(,s9

Earn#n/s> 7oo, alue> an 2#v#en Y#el

arnings and arnings ro9th

We are near the end of a chapter on $usiness valuation8 and there has $een virtuall%

no "ention of earnings8 $ook value8 or dividend %ield< Both earnings and $ook value

have a place in securities anal%sis $ut "ust $e used 9ith caution and as part of a

"ore co"prehensive valuation effort<

arnings per share has historicall% $een the valuation %ardstick "ost

co""onl% used $% investors< Unfortunatel%8 as 9e shall see8 it is an i"precise

"easure8 su$;ect to "anipulation and accounting vagaries< It does not atte"pt to

"easure the cash generated or used $% a $usiness< And as 9ith an% prediction of the

future8 earnings are nearl% i"possi$le to forecast<

'orporate "anage"ents are generall% a9are that "an% investors focus on

gro9th in reported earnings8 and a nu"$er of the" gentl% "assage reported

earnings to create a consistent up9ard trend< A fe9 particularl% unscrupulous

"anage"ents pla% accounting ga"es to turn deteriorating results into i"proving

ones8 losses into profits8 and s"all profits into large ones<

ven 9ithout "anipulation8 anal%sis of reported earnings can "islead

investors as to the real profita$ilit% of a $usiness< enerall% accepted accounting

practices =AA!> "a% re?uire actions that do not reflect $usiness realit%< B% 9a% of

e:a"ple8 a"ortiDation of good9ill8 a noncash charge re?uired under AA!8 can

artificiall% depress reported earningsF an anal%sis of cash flo9 9ould $etter capture

the true econo"ics of a $usiness< B% contrast8 nonrecurring gains can $oost earnings

to unsustaina$le levels8 and should $e ignored $% investors<1/

,ost i"portant8 9hether investors use earnings or cash flo9 in their valuation

anal%sis8 it is i"portant to re"e"$er that the nu"$ers are not an end in the"selves<

4ather the% are a "eans to understanding 9hat is reall% happening in a co"pan%<



1) A A5E!INESTMENT "6IOSO"6Y

7oo, alue

What so"ething cost in the past is not necessaril% a good "easure of its value toda%<

Book value is the historical accounting of shareholders@ e?uit%8 the residual after

lia$ilities are su$tracted fro" assets< So"eti"es historical $ook value =carr%ingvalue> provides an accurate "easure of current value8 $ut often it is 9a% off the

"ark< 'urrent assets8 such as receiva$les and inventories8 for e:a"ple8 are usuall%

9orth close to carr%ing value8 although certain t%pes of inventor% are su$;ect to rapid

o$solescence< !lant and e?uip"ent8 ho9ever8 "a% $e out"oded or o$solete and

therefore 9orth considera$l% less than carr%ing value< Alternativel%8 a co"pan% 9ith

full% depreciated plant and e?uip"ent or a histor% of 9rite5offs "a% have carr%ing

value considera$l% $elo9 real econo"ic value<

Inflation8 technological change8 and regulation8 a"ong other factors8 can

affect the value of assets in 9a%s that historical cost accounting cannot capture< 4eal

estate purchased decades ago8 for e:a"ple8 and carried on a co"pan%@s $ooks at

historical cost "a% $e 9orth considera$l% "ore< The cost of $uilding a ne9 oil

refiner% toda% "a% $e "ade prohi$itivel% e:pensive $% environ"ental legislation8

endo9ing older facilities 9ith a scarcit% value< Aging integrated steel facilities8 $%

contrast8 "a% $e technologicall% out"oded co"pared 9ith ne9l% $uilt "ini"ills< As a

result8 their $ook value "a% $e significantl% overstated<

4eported $ook value can also $e affected $% "anage"ent actions< Write5offs

of "one%5losing operations are so"e9hat ar$itrar% %et can have a large i"pact on

reported $ook value< Share issuance and repurchases can also affect $ook value<

,an% co"panies in the 1./s8 for e:a"ple8 perfor"ed recapitaliDations8 9here$%

"one% 9as $orro9ed and distri$uted to shareholders as an e:traordinar% dividend<

This served to greatl% reduce the $ook value of these co"panies8 so"eti"es $elo9

Dero< ven the choice of accounting "ethod for "ergerspurchase or pooling of

interestscan affect reported $ook value<



#he Art of usiness ;aluation 1)

To $e useful8 an anal%tical tool "ust $e consistent in its valuations< 0et8 as a result of

accounting rules and discretionar% "anage"ent actions8 t9o co"panies 9ith

identical tangi$le assets and lia$ilities could have ver% different reported $ook

values< This renders $ook value not terri$l% useful as a valuation %ardstick< As 9ith

earnings8 $ook value provides li"ited infor"ation to investors and should onl% $e

considered as one co"ponent of a "ore thorough and co"plete anal%sis<

2#v#en Y#el

Wh% is "% discussion of dividend %ield so shortE Although at one ti"e a "easure of a

$usiness@s prosperit%8 it has $eco"e a relic& stocks should si"pl% not $e $ought on

the $asis of their dividend %ield< Too often struggling co"panies sport high dividend

%ields8 not $ecause the dividends have $een increased8 $ut $ecause the share prices

have fallen< 6earing that the stock price 9ill drop further if the dividend is cut8

"anage"ents "aintain the pa%out8 9eakening the co"pan% even "ore< Investors$u%ing such stocks for their ostensi$l% high %ields "a% not $e receiving good value<

7n the contrar%8 the% "a% $e the victi"s of a pathetic "anipulation< The high

dividend paid $% such co"panies is not a return on invested capital $ut rather a

return of capital that represents the li?uidation of the underl%ing $usiness< This

"anipulation 9as 9idel% used $% "one%5center $anks through "ost of the 1./s and

had the =desired> effect of propping up their share prices<

Con(lus#on

Business valuation is a co"ple: process %ielding i"precise and uncertain

results< ,an% $usinesses are so diverse or difficult to understand that the% si"pl%

cannot $e valued< So"e investors 9illingl% vo%age into the unkno9n and $u% into

such $usinesses8 i"patient 9ith the discipline re?uired $% value investing< Investors

"ust re"e"$er that the% need not s9ing at ever%



1=: A A5E!INESTMENT "6IOSO"6Y

pitch to do 9ell over ti"eF indeed8 selectivit% undou$tedl% i"proves an investor@s

results< 6or ever% $usiness that cannot $e valued8 there are "an% others that can<

Investors 9ho confine the"selves to 9hat the% kno98 as difficult as that "a% $e8

have a considera$le advantage over ever%one else<

Notes

1. 7enam#n Graham an 2av# . 2o> #n Charles 2. Ell#s an Bames R. ert#n> es.>

Classics0 An Investor$s Anthology @6ome-oo> 111.9 2o- Bones!Ir-#n> 1':'> $. =;.

*. Some #nvestors value bus#nesses b% #s(ount#n/ earn#n/s rather than (ash 8lo-.

For some bus#nesses> su(h as ban,s an thr#8ts> earn#n/s a$$ro0#mate (ash 8lo-

an ma% be use #nstea. In most (ases> ho-ever> (ash 8lo- #s the a$$ro$r#ate

valuat#on %arst#(,. The (al(ulat#on o8 (ash 8lo- #s #s(usse at len/th #n (ha$ter ).

+. Mana/ements not onl% res$on to un(erta#nt% the% somet#mes enhan(e #t b%

ta,#n/ un$re#(table or #ll!(ons#ere a(t#ons.

). See W#ll#am A. Sahlman @6arvar Grauate S(hool o8 7us#ness Am#n#strat#on

Case Stu%> Bune 1'';> DA Caut#onar% Tale about 2#s(ounte Cash Flo- Anal%s#s>D

8or a su$erb #s(uss#on o8 the #88#(ult#es o8 /enerat#n/ use8ul valuat#ons 8rom #s!

(ounte (ash 8lo- anal%s#s.

=. 7er,sh#re 6atha-a%> In(.> annual re$ort 8or 1':*> $. =.

3. There #s (ons#erable a(aem#( ebate (on(ern#n/ -hether short!term or lon/!

term #nterest rates shoul be a$$l#e. M% v#e- #s to mat(h the t#m#n/ o8 the (ash

8lo-s to the matur#t% o8 the 5.S. Treasur% se(ur#t%.

&. Geor/e Soros> #he Alchemy of 2inance @Ne- Yor,9 S#mon S(huster> 1':&> $.

=1.

:. A #s(uss#on o8 the o$$ortun#t% 8or #nvestors #n (or$orate s$#no88s (an be 8oun #n

(ha$ter 1;.

< 6a the same 8lo- o8 (ash 8rom Es(o to Emerson been stru(ture as an

#nterest!bear#n/ note $a%able> 8or e0am$le> the same H&.) m#ll#on annual $a%ment

-oul have ha less than hal8 the #m$a(t on re$orte earn#n/s. In that (ase> mu(h

o8 the H&.) m#ll#on $a%ment -oul have re$resente re$a%ment o8 $r#n(#$al> -h#(h

#s not an e0$ense.



#he Art of usiness ;aluation 1)

1;. While cash flo9 is less distorted $% accounting ?uirks than earnings8 it too

can $e "anipulated if a co"pan% is so inclined< 'ash flo9 can $e te"poraril%

increased8 for e:a"ple8 $% a reduction in capital spendingF ho9ever8 this eventuall%

leads to deterioration of the $usiness<



IllT6E A5E!INESTMENT

"ROCESS



'Investment Resear(h9 The

Challen/e o8 F#n#n/

Attra(t#ve InvestmentsWhile kno9ing ho9 to value $usinesses is essential for invest"ent success8 the first

and perhaps "ost i"portant step in the invest"ent process is kno9ing 9here to look

for opportunities< Investors are in the $usiness of processing infor"ation8 $ut 9hile

stud%ing the current financial state"ents of the thousands of pu$licl% held

co"panies8 the "onthl%8 9eekl%8 and even dail% research reports of hundreds of Wall

Street anal%sts8 and the "arket $ehavior of scores of stocks and $onds8 the% 9ill

spend virtuall% all their ti"e revie9ing fairl% priced securities that are of no special

interest<

ood invest"ent ideas are rare and valua$le things8 9hich "ust $e ferreted

out assiduousl%< The% do not fl% in over the transo" or "aterialiDe out of thin air<

Investors cannot assu"e that good ideas 9ill co"e effortlessl% fro" scanning the

reco""endations of Wall Street anal%sts8 no "atter ho9 highl% regarded8 or fro"

punching up co"puters8 no "atter ho9 clev5

131



12 T6E A5E!INESTMENT "ROCESS

erl% progra""ed8 although $oth can so"eti"es indicate interesting places to hunt<

Upon occasion attractive opportunities are so nu"erous that the onl% li"iting

factor is the availa$ilit% of funds to investF t%picall% the nu"$er of attractive

opportunities is "uch "ore li"ited< B% identif%ing 9here the "ost attractiveopportunities are likel% to arise $efore starting one@s ?uest for the e:citing handful of

specific invest"ents8 investors can spare the"selves an often fruitless surve% of the

hu"dru" "a;orit% of availa$le invest"ents<

+alue investing enco"passes a nu"$er of specialiDed invest"ent niches that

can $e divided into three categories& securities selling at a discount to $reakup or

li?uidation value8 rate5of5return situations8 and asset5conversion opportunities< Where

to look for opportunities varies fro" one of these categories to the ne:t<

'o"puter5screening techni?ues8 for e:a"ple8 can $e helpful in identif%ing

stocks of the first categor%& those selling at a discount fro" li?uidation value<

Because data$ases can $e out of date or inaccurate8 ho9ever8 it is essential that

investors verif% that the co"puter output is correct<

4isk ar$itrage and co"ple: securities co"prise a second categor% of

attractive value invest"ents 9ith kno9n e:it prices and appro:i"ate ti"e fra"es8

9hich8 taken together8 ena$le investors to calculate e:pected rates of return at the

ti"e the invest"ents are "ade< ,ergers8 tender offers8 and other risk5ar$itrage

transactions are 9idel% reported in the dail% financial pressthe ,all !treet 5ournal

and the $usiness section of the -ew 7ork #imesas 9ell as in specialiDed

ne9sletters and periodicals< (ocating infor"ation on co"ple: securities is "ore

difficult8 $ut as the% often co"e into e:istence as $%products of risk ar$itrage

transactions8 investors 9ho follo9 the latter "a% $eco"e a9are of the for"er<

6inanciall% distressed and $ankrupt securities8 corporate recapitaliDations8 and

e:change offers all fall into the categor% of asset conversions8 in 9hich investors@

e:isting holdings are e:changed for one or "ore ne9 securities< #istressed and

$ankrupt $usinesses are often identified in the financial pressF specialiDed

pu$lications and research services also provide



#he Challenge of 2inding Attractive Investments 13

infor"ation on such co"panies and their securities< 6unda"ental infor"ation on

trou$led co"panies can $e gleaned fro" pu$lished financial state"ents and in the

case of $ankruptcies8 fro" court docu"ents< !rice ?uotations "a% onl% $e availa$le

fro" dealers since "an% of these securities are not listed on an% e:change<'orporate recapitaliDations and e:change offers can usuall% $e identified fro" a close

reading of the dail% financial press< !u$licl% availa$le filings 9ith the Securities and

:change 'o""ission =S'> provide e:tensive detail on these e:traordinar%

corporate transactions<

,an% undervalued securities do not fall into an% of these specialiDed

categories and are $est identified through old5fashioned hard 9ork8 %et there are

9idel% availa$le "eans of i"proving the likelihood of finding "ispriced securities<

(ooking at stocks on the ,all !treet 5ournal$s leading percentage5decline and ne95

lo9 lists8 for e:a"ple8 occasionall% turns up an out5of5favor invest"ent idea<

Si"ilarl%8 9hen a co"pan% eli"inates its dividend8 its shares often fall to undul%

depressed levels< 7f course8 all co"panies of re?uisite siDe produce annual and

?uarterl% reports8 9hich the% 9ill send upon re?uest< 6ilings of a co"pan%@s annual

and ?uarterl% financial state"ents on 6or"s 1/C and 1/Q8 respectivel%8 are availa$le

fro" the S' and often fro" the reporting co"pan% as 9ell<

So"eti"es an attractive invest"ent niche e"erges in 9hich nu"erous

opportunities develop over ti"e< 7ne such area has $een the large nu"$er of thrift

institutions that have converted fro" "utual to stock o9nership =see chapter 11><

Investors should consider anal%Ding all co"panies 9ithin such a categor% in order to

identif% those that are undervalued< SpecialiDed ne9sletters and industr% periodicals

can $e e:cellent sources of infor"ation on such niche opportunities<

Mar,et Ine88#(#en(#es an Inst#tut#onal Constra#nts

The research task does not end 9ith the discover% of an apparent $argain< It

is incu"$ent on investors to tr% to find out 9h%



1* T6E A5E!INESTMENT "ROCESS

the $argain has $eco"e availa$le< If in 1/ %ou 9ere looking for an ordinar%8 four5

$edroo" colonial ho"e on a ?uarter acre in the Boston su$ur$s8 %ou should have

$een prepared to pa% at least 3//8///< If %ou learned of one availa$le for 1)/8///8

%our first reaction 9ould not have $een8 GWhat a great $argainRG $ut8 GWhat@s 9rong9ith itEG

The sa"e health% skepticis" applies to the stock "arket< A $argain should $e

inspected and reinspected for possi$le fla9s< Irrational or indifferent selling alone

"a% have "ade it cheap8 $ut there "a% $e "ore funda"ental reasons for the

depressed price< !erhaps there are contingent lia$ilities or pending litigation that %ou

are una9are of< ,a%$e a co"petitor is preparing to introduce a superior product<

When the reason for the undervaluation can $e clearl% identified8 it $eco"es

an even $etter invest"ent $ecause the outco"e is "ore predicta$le< B% 9a% of

e:a"ple8 the legal constraint that prevents so"e institutional investors fro"

purchasing lo95priced spinoffs =see chapter 1/> is one possi$le e:planation for

undervaluation< Such reasons give investors so"e co"fort that the price is not

depressed for an undisclosed funda"ental $usiness reason<

7ther institutional constraints can also create opportunities for value

investors< 6or e:a"ple8 "an% institutional investors $eco"e "a;or sellers of

securities involved in risk5ar$itrage transactions on the grounds that their "ission is

to invest in ongoing $usinesses8 not speculate on takeovers< The resultant selling

pressure can depress prices8 increasing the returns availa$le to ar$itrage investors<

Institutional investors are co""onl% un9illing to $u% or hold lo95priced

securities< Since an% co"pan% can e:ercise a degree of control over its share price

through splitting or reverse5splitting its outstanding shares8 the financial rationale for

this constraint is hard to understand< Wh% 9ould a co"pan%@s shares $e a good $u%

at 1) a share $ut not at 3 after a five5for5one stock split or vice versaE

,an% attractive invest"ent opportunities result fro" "arket inefficiencies8

that is8 areas of the securit% "arkets in 9hich



#he Challenge of 2inding Attractive Investments 1)

infor"ation is not full% disse"inated or in 9hich suppl% and de"and are te"poraril%

out of $alance< Al"ost no one on Wall Street8 for e:a"ple8 follo9s8 let alone

reco""ends8 s"all co"panies 9hose shares are closel% held and infre?uentl%

tradedF there are at "ost a handful of "arket "akers in such stocks< #epending onthe nu"$er of shareholders8 such co"panies "a% not even $e re?uired $% the S' to

file ?uarterl% or annual reports< 7$scurit% and a ver% thin "arket can cause stocks to

sell at depressed levels<

0ear5end ta: selling also creates "arket inefficiencies< The Internal 4evenue

'ode "akes it attractive for investors to realiDe capital losses $efore the end of each

%ear< Selling driven $% the calendar rather than $% invest"ent funda"entals

fre?uentl% causes stocks that declined significantl% during the %ear to decline still

further< This generates opportunities for value investors<

alue Invest#n/ an Contrar#an Th#n,#n/

+alue investing $% its ver% nature is contrarian< 7ut5of5favor securities "a% $e

undervaluedF popular securities al"ost never are< What the herd is $u%ing is8 $%

definition8 in favor< Securities in favor have alread% $een $id up in price on the $asis

of opti"istic e:pectations and are unlikel% to represent good value that has $een

overlooked<

If value is not likel% to e:ist in 9hat the herd is $u%ing8 9here "a% it e:istE In

9hat the% are selling8 una9are of8 or ignoring< When the herd is selling a securit%8 the

"arket price "a% fall 9ell $e%ond reason< Ignored8 o$scure8 or ne9l% created

securities "a% si"ilarl% $e or $eco"e undervalued<

Investors "a% find it difficult to act as contrarians for the% can never $e

certain 9hether or 9hen the% 9ill $e proven correct< Since the% are acting against

the cro9d8 contrarians are al"ost al9a%s initiall% 9rong and likel% for a ti"e to suffer

paper losses< B% contrast8 "e"$ers of the herd are nearl%




al9a%s right for a period< Not onl% are contrarians initiall% 9rong8 the% "a% $e 9rong

"ore often and for longer periods than others $ecause "arket trends can continue

long past an% li"its 9arranted $% underl%ing value<

Holding a contrar% opinion is not al9a%s useful to investors8 ho9ever< When9idel% held opinions have no influence on the issue at hand8 nothing is gained $%

s9i""ing against the tide< It is al9a%s the consensus that the sun 9ill rise to"orro98

$ut this vie9 does not influence the outco"e< B% contrast8 9hen "a;orit% opinion

does affect the outco"e or the odds8 contrar% opinion can $e put to use< When the

herd rushes into ho"e health5care stocks8 $idding up prices and there$% lo9ering

availa$le returns8 the "a;orit% has altered the riskJre9ard ratio8 allo9ing contrarians

to $et against the cro9d 9ith the odds ske9ed in their favor< When investors in 1.3

either ignored or panned the stock of Na$isco8 causing it to trade at a discount to

other food co"panies8 the riskJre9ard ratio $eca"e "ore favora$le8 creating a

$u%ing opportunit% for contrarians<

6o- Mu(h Resear(h an Anal%s#s Are Su88#(#ent

So"e investors insist on tr%ing to o$tain perfect kno9ledge a$out their i"pending

invest"ents8 researching co"panies until the% think the% kno9 ever%thing there is to

kno9 a$out the"< The% stud% the industr% and the co"petition8 contact for"er

e"plo%ees8 industr% consultants8 and anal%sts8 and $eco"e personall% ac?uainted

9ith top "anage"ent< The% anal%De financial state"ents for the past decade and

stock price trends for even longer< This diligence is ad"ira$le8 $ut it has t9o

shortco"ings< 6irst8 no "atter ho9 "uch research is perfor"ed8 so"e infor"ation

al9a%s re"ains elusiveF investors have to learn to live 9ith less than co"plete

infor"ation< Second8 even if an investor could kno9 all the facts a$out an

invest"ent8 he or she 9ould not necessaril% profit<

This is not to sa% that funda"ental anal%sis is not useful< It certainl% is< But

infor"ation generall% follo9s the 9ell5kno9n





13: T6E A5E!INESTMENT "ROCESS

avoiding situations in 9hich infor"ation is difficult to o$tain< 0et high uncertaint% is

fre?uentl% acco"panied $% lo9 prices< B% the ti"e the uncertaint% is resolved8 prices

are likel% to have risen< Investors fre?uentl% $enefit fro" "aking invest"ent

decisions 9ith less than perfect kno9ledge and are 9ell re9arded for $earing the risk

of uncertaint%< The ti"e other investors spend delving into the last unans9ered

detail "a% cost the" the chance to $u% in at prices so lo9 that the% offer a "argin of

safet% despite the inco"plete infor"ation<

Ins#er 7u%#n/ an Mana/ement Sto(, O$t#ons Can S#/nal

O$$ortun#t%

In their search for co"plete infor"ation on $usinesses8 investors often overlook one

ver% i"portant clue< In "ost instances no one understands a $usiness and its

prospects $etter than the "anage"ent< Therefore investors should $e encouraged

9hen corporate insiders invest their o9n "one% alongside that of shareholders $%

purchasing stock in the open "arket< It is often said on Wall Street that there are

"an% reasons 9h% an insider "ight sell a stock =need for cash to pa% ta:es8

e:penses8 etc<>8 $ut there is onl% one reason for $u%ing< Investors can track insider

$u%ing and selling in an% of several specialiDed pu$lications8 such as ;ickers !tock

3esearch*

The "otivation of corporate "anage"ent can $e a ver% i"portant force in

deter"ining the outco"e of an invest"ent< So"e co"panies provide incentives for

their "anage"ents 9ith stock5option plans and related vehicles< Usuall% these plans

give "anage"ent the specific incentive to do 9hat the% can to $oost the co"pan%@s

share price<

While "anage"ent does not control a co"pan%@s stock price8 it can greatl%

influence the gap $et9een share price and underl%ing value and over ti"e can have

a significant influence on value itself< If the "anage"ent of a co"pan% 9ere

co"pensated $ased on revenues8 total assets8 or even net inco"e8 it





1/ T6E A5E!INESTMENT "ROCESS

The trou$led de$t "arket8 for e:a"ple8 is event driven< Takeovers8 e:change offers8

and open5"arket $ond repurchases are fairl% routine< What is pu$lic kno9ledge8 and

9hat is notE If %ou sell $onds $ack to a co"pan%8 9hich then retires the"8 is

kno9ledge of that trade inside infor"ationE #oes it "atter ho9 "an% $onds 9ere

sold or 9hen the trade occurredE If this constitutes inside infor"ation8 in 9hat 9a%

does it restrict %ouE If %ou are a large $ondholder and the issuer contacts %ou to dis5

cuss an e:change offer8 in 9hat 9a% can that $e construed as inside infor"ationE

When does inside infor"ation $eco"e sufficientl% old to no longer $e

protectedE When do internal financial pro;ections $eco"e outdatedE When do

a$orted "erger plans cease to $e secretE

There are no fir" ans9ers to these ?uestions< Investors "ust $end over

$ack9ard to sta% 9ithin the la98 of course8 $ut it 9ould $e far easier if the la9 9ere

"ore clearl% enunciated< Since it is not8 la9 a$iding investors "ust err on the side ofignorance8 investing 9ith less infor"ation than those 9ho are not so ethical< When

investors are unsure 9hether the% have crossed the line8 the% 9ould $e 9ell advised

to ask their sources and perhaps their attorne%s as 9ell $efore "aking an% trades<

Con(lus#on

Invest"ent research is the process of reducing large piles of infor"ation to

"anagea$le ones8 distilling the invest"ent 9heat fro" the chaff< There is8 needless

to sa%8 a lot of chaff and ver% little 9heat< The research process itself8 like the factor%

of a "anufacturing co"pan%8 produces no profits< The profits "aterialiDe later8 often

"uch later8 9hen the undervaluation identified during the research process is first

translated into portfolio decisions and then eventuall% recogniDed $% the "arket< In

fact8 often there is no i""ediate $u%ing opportunit%F toda%@s research "a% $e

advance preparation for to"orro9@s opportu5



#he Challenge of 2inding Attractive Investments 11

nities< In an% event8 ;ust as a superior sales force cannot succeed if the factor% does

not produce ?ualit% goods8 an invest"ent progra" 9ill not long succeed if high5

?ualit% research is not perfor"ed on a continuing $asis<

Notes1. Charles 2. Ell#s an Bames R. ert#n> es.> Classics0 An Investor$s

Anthology @6ome-oo> 111.9 2o- Bones!Ir-#n> 1':'> $. =1+.



1;Areas o8 O$$ortun#t% 8or alue

Investors9 Catal%sts> Mar,et

Ine88#(#en(#es> an Inst#tut#onal

Constra#nts The attraction of so"e value invest"ents is si"ple and straightfor9ard& ongoing8

profita$le8 and gro9ing $usinesses 9ith share prices considera$l% $elo9

conservativel% appraised underl%ing value< 7rdinaril%8 ho9ever8 the si"pler theanal%sis and steeper the discount8 the "ore o$vious the $argain $eco"es to other

investors< The securities of high5return $usinesses therefore reach co"pelling levels

of undervaluation onl% infre?uentl%< Usuall% investors have to 9ork harder and dig

deeper to find undervalued opportunities8 either $% ferreting out hidden value or $%

co"prehending a co"ple: situation<

7nce a securit% is purchased at a discount fro" underl%ing value8

shareholders can $enefit i""ediatel% if the stock price

12



Areas of 4pportunity for ;alue Investors 13

rises to $etter reflect underl%ing value or if an event occurs that causes that value to

$e realiDed $% shareholders< Such an event eli"inates investors@ dependence on

"arket forces for invest"ent profits< B% precipitating the realiDation of underl%ing

value8 "oreover8 such an event considera$l% enhances investors@ "argin of safet%< Irefer to such events as catal%sts<

So"e catal%sts for the realiDation of underl%ing value e:ist at the discretion of

a co"pan%@s "anage"ent and $oard of directors< The decision to sell out or

li?uidate8 for e:a"ple8 is "ade internall%< 7ther catal%sts are e:ternal and often

relate to the voting control of a co"pan%@s stock< 'ontrol of the "a;orit% of a

co"pan%@s stock t%picall% allo9s the holder to elect the "a;orit% of the $oard of

directors< Thus accu"ulation of stock leading to voting control8 or si"pl%

"anage"ent@s fear that this "ight happen8 could lead to steps $eing taken $% a

co"pan% that cause its share price to "ore full% reflect underl%ing value<

'atal%sts var% in their potenc%< The orderl% sale or li?uidation of a $usiness

leads to total value realiDation< 'orporate spinoffs8 share $u%$acks8 recapitaliDations8

and "a;or asset sales usuall% $ring a$out onl% partial value realiDation<

The e"ergence of a co"pan% fro" $ankruptc% serves as a catal%st for

creditors< Holders of senior de$t securities8 for e:a"ple8 t%picall% receive cash8 de$t

instru"ents8 andJor e?uit% securities in the reorganiDed entit% in satisfaction of their

clai"s< The total "arket value of these distri$utions is likel% to $e higher than the

"arket value of the $ankrupt de$tF securities in the reorganiDed co"pan% 9ill

t%picall% $e "ore li?uid and avoid "ost of the stig"a and uncertaint% of $ankruptc%

and thus trade at higher "ultiples< ,oreover8 co""ittees of creditors 9ill have

participated in deter"ining the capital structure of the reorganiDed fir"8 seeking to

create a structure that "a:i"iDes "arket value<

+alue investors are al9a%s on the lookout for catal%sts< While $u%ing assets at

a discount fro" underl%ing value is the defining characteristic of value investing8 the

partial or total realiDa5




tion of underl%ing value through a catal%st is an i"portant "eans of generating

profits< 6urther"ore8 the presence of a catal%st serves to reduce risk< If the gap

$et9een price and underl%ing value is likel% to $e closed ?uickl%8 the pro$a$ilit% of

losing "one% due to "arket fluctuations or adverse $usiness develop"ents isreduced< In the a$sence of a catal%st8 ho9ever8 underl%ing value could erodeF

conversel%8 the gap $et9een price and value could 9iden 9ith the vagaries of the

"arket< 79ning securities 9ith catal%sts for value realiDation is therefore an

i"portant 9a% for investors to reduce the risk 9ithin their portfolios8 aug"enting the

"argin of safet% achieved $% investing at a discount fro" underl%ing value<

'atal%sts that $ring a$out total value realiDation are8 of course8 opti"al<

Nevertheless8 catal%sts for partial value realiDation serve t9o i"portant purposes<

6irst8 the% do help to realiDe underl%ing value8 so"eti"es $% placing it directl% into

the hands of shareholders such as through a recapitaliDation or spinoff and other

ti"es $% reducing the discount $et9een price and underl%ing value8 such as through

a share $u%$ack< Second8 a co"pan% that takes action resulting in the partial real5

iDation of underl%ing value for shareholders serves notice that "anage"ent is

shareholder oriented and "a% pursue additional value5realiDation strategies in the

future< 7ver the %ears8 for e:a"ple8 investors in Teled%ne have repeatedl% $enefitted

fro" ti"el% share repurchases and spinoffs<

Invest#n/ #n Cor$orate #Lu#at#ons

So"e trou$led co"panies8 lacking via$le alternatives8 voluntaril% li?uidate in

order to pree"pt a total 9ipeout of shareholders@ invest"ents< 7ther8 "ore

interesting corporate li?uidations are "otivated $% ta: considerations8 persistent

stock "arket undervaluation8 or the desire to escape the grasp of a corporate



Areas of 4pportunity for ;alue Investors 1)

raider< A co"pan% involved in onl% one profita$le line of $usiness 9ould t%picall%

prefer selling out to li?uidating $ecause possi$le dou$le ta:ation =ta:es $oth at the

corporate and shareholder level> 9ould $e avoided< A co"pan% operating in diverse

$usiness lines8 ho9ever8 "ight find a li?uidation or $reakup to $e the value5"a:i"iDing alternative8 particularl% if the li?uidation process triggers a loss that

results in a ta: refund< So"e of the "ost attractive corporate li?uidations in the past

decade have involved the $reakup of conglo"erates and invest"ent co"panies<

,ost e?uit% investors prefer =or are effectivel% re?uired> to hold shares in

ongoing $usinesses< 'o"panies in li?uidation are the antithesis of the t%pe of

invest"ent the% 9ant to "ake< ven so"e risk ar$itrageurs =9ho have $een kno9n

to $u% ;ust a$out an%thing> avoid investing in li?uidations8 $elieving the process to $e

too uncertain or protracted< Indeed8 investing in li?uidations is so"eti"es

disparagingl% referred to as cigar5$utt investing8 9here$% an investor picks up

so"eone else@s discard 9ith a fe9 puffs left on it and s"okes it< Needless to sa%8

$ecause other investors disparage and avoid the"8 corporate li?uidations "a% $e

particularl% attractive opportunities for value investors<

C#t% Invest#n/ #Lu#at#n/ Trust

In 1.* shareholders of 'it% Investing 'o"pan% voted to li?uidate< The assets

of this conglo"erate 9ere diverse8 and the "ost valua$le su$sidiar%8 Ho"e

Insurance 'o"pan%8 9as particularl% difficult for investors to appraise< fforts to sell

Ho"e Insurance failed8 and it 9as instead spun off to 'it% Investing shareholders<

The re"aining assets 9ere put into a ne9l% for"ed entit% called 'it% Investing

(i?uidating Trust8 9hich $eca"e a 9onderful invest"ent opportunit%<




#able (Assets o8 C#t% Invest#n/ #Lu#at#n/ Trust at Its In(e$t#on> Se$tember *=>1':=

Assets Est#mate value @H #n m#ll#ons 2er#vat#on o8 value

H' m#ll#on (ash H '.; (ash value

General 2evelo$ment Cor$.

(ommon sto(, an -arrants

)3.; mar,et $r#(e

&.+ m#ll#on shares "a(e

Inustr#es

+3.= (ost

H== m#ll#on ebentures "a(e

Grou$ 6ol#n/s

);.; est#mate net$resent value

H1& m#ll#on subor#nate ebt

@Woo 7rothers 6omes

'.; est#mate

H1: m#ll#on 7ra?#l#an

re(e#vables @H1; m#ll#on

re(e#ve to ate not (ounte#n (ash

1*.; est#mate

H1= m#ll#on m#s(ellaneous

notes an mort/a/es

1;.; est#mate

H11 m#ll#on m#s(ellaneous

#nvestments

3.; est#mate

H+= m#ll#on est#mate 8eeral

#n(ome ta0es re(overable

+1.; net $resent value

total assets H1''.=less ,no-n l#ab#l#t#es ).;net assets H1'=.=or H =.;* $er un#t>e0(lus#ve o8 m#s(ellaneous (ont#n/ent l#ab#l#t#es

As sho9n in ta$le 28 'it% Investing (i?uidating Trust 9as a hodgepodge of

assets< 6e9 investors had the inclination or sta"ina to evaluate these assets or the

9illingness to o9n the" for the duration of a li?uidation likel% to take several %ears<

Thus8 9hile the units 9ere ignored $% "ost potential $u%ers8 the% sold in high volu"e

at appro:i"atel% 38 or su$stantiall% $elo9 underl%ing value<

The shares of 'it% Investing (i?uidating Trust traded initiall% at depressed

levels for a nu"$er of additional reasons< ,an% investors in the li?uidation of 'it%

Investing had $een disap5




pointed 9ith the prices received for assets sold previousl% and 9ith 'it%@s apparent

ina$ilit% to sell Ho"e Insurance and co"plete its li?uidation< 'onse?uentl% "an%

disgruntled investors in 'it% Investing ?uickl% du"ped the li?uidating trust units to

"ove on to other opportunities< 7nce the intended spinoff of Ho"e Insurance 9as

announced8 "an% investors purchased 'it% Investing shares as a 9a% of esta$lishing

an invest"ent in Ho"e Insurance $efore it $egan trading on its o9n8 $u%ing in at

9hat the% perceived to $e a $argain price< ,ost of these investors 9ere not

interested in the li?uidating trust8 and sold their units upon receipt of the Ho"e

Insurance spinoff< In addition8 the per unit "arket price of 'it% Investing (i?uidating

Trust 9as $elo9 the "ini"u" price threshold of "an% institutional investors< Since

'it% Investing 'o"pan% had $een 9idel% held $% institutional investors8 those 9ho

hadn@t sold earlier $eca"e natural sellers of the li?uidating trust due to the lo9

"arket price< 6inall%8 after the Ho"e Insurance spinoff8 'it% Investing (i?uidating Trust 9as delisted fro" the Ne9 0ork Stock :change< Trading initiall% onl% in the

over5the5counter pink5sheet "arket8 the units had no ticker s%"$ol< Quotes 9ere

uno$taina$le either on5line or in "ost ne9spapers< This pro"pted further selling

9hile si"ultaneousl% discouraging potential $u%ers<

The calculation of 'it% Investing (i?uidating Trust@s underl%ing value in ta$le 2

is deli$eratel% conservative< An i"portant co"ponent of the eventual li?uidating

proceeds8 and so"ething investors "ostl% overlooked =a hidden value>8 9as that

'it%@s invest"ent in the stock of !ace Industries8 Inc<8 9as at the ti"e al"ost

certainl% 9orth "ore than historical cost< !ace 9as a co"pan% for"ed $% Cohl$erg8

Cravis and 4o$erts =CC4> to purchase the 4hee"8 Uarco8 and World 'olor !ress

$usinesses of 'it% Investing in a #ece"$er 1.* leveraged $u%out< This $u%out 9as

profita$le and perfor"ing 9ell nine "onths later 9hen the 'it% Investing (i?uidating

Trust 9as for"ed<

The $usinesses of !ace had $een purchased $% CC4 fro" 'it% Investing in a

financial environ"ent ?uite different fro" the one that e:isted in Septe"$er 1.)<

The interest rate on U<S< govern"ent $onds had declined $% several hundred $asis



1. T6E A5E!INESTMENT "ROCESS

points in the intervening nine "onths8 and the "a;or stock "arket inde:es had

spurted sharpl% higher< These changes had al"ost certainl% increased the value of

'it%@s e?uit% interest in !ace< This increased the apparent value of 'it% Investing

(i?uidating Trust units 9ell a$ove the )</2 esti"ate8 "aking the" an even "oreattractive $argain<

As 9ith an% value invest"ent8 the greater the undervaluation8 the greater the

"argin of safet% to investors< ,oreover8 appro:i"atel% half of 'it%@s value 9as

co"prised of li?uid assets and "arketa$le securities8 further reducing the risk of a

serious decline in value< Investors could reduce risk even "ore if the% chose $%

selling short pu$licl% traded eneral #evelop"ent 'orporation =#+> shares in an

a"ount e?ual to the nu"$er of #+ shares underl%ing their invest"ent in the trust

in order to lock in the value of 'it%@s #+ holdings<

As it turned out8 'it% Investing (i?uidating Trust "ade rapid progress in

li?uidating< #+ shares surged in price and 9ere distri$uted directl% to unitholders<

Wood Brothers Ho"es 9as sold8 various receiva$les 9ere collected8 and "ost

lucrative of all8 'it% Investing received large cash distri$utions 9hen !ace Industries

sold its !diee" and Uarco su$sidiaries at a su$stantial gain< The !ace roup

de$entures 9ere redee"ed prior to "aturit% 9ith proceeds fro" the sa"e asset

sales< ,ean9hile a nu"$er of the trust@s contingent lia$ilities 9ere e:tinguished at

little or no cost< B% 11 investors 9ho purchased 'it% Investing (i?uidating Trust at

inception had received several li?uidating distri$utions 9ith a co"$ined value of

appro:i"atel% nine dollars per unit8 or three ti"es the Septe"$er 1.) "arket price8

9ith "uch of the value received in the earl% %ears of the li?uidation process<

Invest#n/ #n Com$le0 Se(ur#t#es

I define co"ple: securities as those 9ith unusual contractual cash flo9

characteristics< Unlike $onds8 9hich provide a con5




stant cash strea" to investors8 a co"ple: securit% t%picall% distri$utes cash

according to so"e contingent event8 such as the future achieve"ent of a specified

level of earnings8 the price of a particular co""odit%8 or the value of specified

assets< 7ften $rought into e:istence as a result of "ergers or reorganiDations8 theirinherent co"ple:it% falls outside the invest"ent para"eters and scope of "ost

investors< Indeed8 9hile so"e co"ple: securities are stocks or $onds8 "an% of the"

are neither< As a result of their o$scurit% and uni?ueness8 co"ple: securities "a%

offer to value investors unusuall% attractive returns for a given level of risk<

'o"ple: securities have e:isted throughout "odern financial histor%< In the

13/s8 for e:a"ple8 railroad $ankruptcies often resulted in the creation of inco"e

$onds8 9hich paid interest onl% if the issuer attained certain levels of inco"e< In 1).

the ,issouri5Cansas5Te:as 4ailroad 'o"pan% =,CT> reorganiDed and issued

participation certificates 9hose onl% entitle"ent to "onetar% $enefit consisted of the

right to have pa%"ents "ade into a sinking fund for their retire"ent< Such pa%"ents

9ere re?uired to $e "ade onl% after accu"ulated earnings reached a specified level

as defined in the indenture< The certificates traded for %ears in the illi?uid pink sheet

"arket at ver% lo9 prices8 partl% as a result of investor neglect< In 1.) ,CT 9as

"erged into the ,issouri !acific 4ailroad 'o"pan%8 and the certificates 9ere the

target of a tender offer at several ti"es the "arket price prevailing earlier that %ear<

As another e:a"ple of a co"ple: securit%8 9hen Bank5A"erica 'orporation

ac?uired Seafirst 'orporation in 1.38 a series of preferred stock 9as issued as

partial consideration to Seafirst shareholders< The dividend 9as fi:ed for five %ears

and then 9ould fluctuate $ased on prevailing "arket conditions< The rede"ption

price could also $e reset8 $ased on the value of certain pro$le" loans in Seafirst@s

portfolio< In effect8 if losses e:ceeded )// "illion on a specified 1<2 $illion pool of

trou$led loans8 the preferred stock 9ith a 2) original par value 9ould likel% $e

retired $% BankA"erica at onl% 2 per share< Since fe9 investors understood ho9 to

value such an at%pical



1./ T6E A5E!INESTMENT "ROCESS

securit%8 fro" ti"e to ti"e its price dropped to levels that 9ere attractive even on a

9orst5case $asis<

Another e:a"ple of a co"ple: securit% 9as the contingent5value rights issued

to ,arion (a$oratories8 Inc<8 shareholders $% #o9 'he"ical 'o"pan% as part of theco"$ination of ,arion 9ith #o9@s ,errell #o9 !har"aceuticals8 Inc<8 su$sidiar% in

#ece"$er 1.< T9o or three %ears after then5issuance =at #o9@s option> these

separatel% trada$le rights 9ould $e redee"ed for cash if ,arion stock failed to reach

designated levels< Specificall%8 the rights entitled holders to the difference on

Septe"$er 3/8 118 $et9een *)< and the average ,arion share price $et9een

-une 1 and Septe"$er 1.8118 up to a "a:i"u" of 1)< per right< In effect8

these 9ere put options on ,arion stock 9hich had a ceiling on their value< #o9

'he"ical o9ned roughl% percent of ,arion ,errell #o98 Inc<F the pu$lic o9ned the

re"aining 2 "illion shares8 as 9ell as a si"ilar nu"$er of contingent5value rights<

The highl% unusual nature of these securities ensured ver% li"ited de"and fro"

institutional and individual investors and increased the likelihood that the% 9ould at

ti"es $eco"e undervalued co"pared 9ith other pu$licl% traded options<

Not all co"ple: securities are 9orth9hile invest"ents< The% "a% $e

overpriced or too difficult to evaluate< Nevertheless this area fre?uentl% is fertile

ground for $argain hunting $% value investors<

Invest#n/ #n R#/hts O88er#n/s

4ights offerings are "ore esoteric than "an% other invest"ents and for this reason

"a% occasionall% $e of interest to value investors< So"e rights offerings present

attractive $argains8 $ut "an% are full% priced or even overpriced< Investors "a% find

this an interesting area to e:a"ine $ut as usual "ust do their ho"e9ork<

Unlike a t%pical under9ritten share offering8 9here $u%ing



Areas of 4pportunity for ;alue Investors 1.1

b% ne9 investors dilutes the percentage interest of current shareholders8 in a rights

offering shareholders are given the opportunit% to preserve their proportional interest

in the issuer b% su$scri$ing for additional shares< Those 9ho su$scri$e retain the

sa"e percentage interest in the $usiness $ut have "ore of their "one% at stake<Investors 9ho fail to e:ercise their rights often leave "one% on the ta$le8 creating an

opportunit% for alert value investors<

4ights offerings can effectivel% co"pel current shareholders to put up "ore

"one% in order to avoid considera$le dilution of their invest"ents< B% 9a% of

e:a"ple8 assu"e O0 is a closed5end "utual fund 9ith one "illion shares

outstanding8 9hich trade at a price e?ual to the fund@s net asset value of 2)<

6urther assu"e that O08 seeking to raise an additional 1) "illion to take

advantage of "arket opportunities8 issues ever% holder a nontransfera$le right to

$u% another O0 share for S1)< If all holders su$scri$e8 then i""ediatel% after the

rights offering O0 9ill have t9o "illion shares outstanding and */ "illion of total

assets8 or 2/ per share< If holders of )/8/// shares do not e:ercise their rights8

9hile holders of )/8/// shares do8 the 18)/8/// shares outstanding after the rights

offering 9ill have a net asset value of 2/<13< The investors 9ho su$scri$ed 9ill have

an average cost of 2/ per share8 9hile those 9ho did not 9ill have an average cost

of 2)< Since nonsu$scri$ers 9ill suffer an i""ediate loss of al"ost 2/ percent of

their underl%ing value8 all holders have a po9erful incentive to

Fsu$scri$e<

So"e rights offerings give holders the opportunit% to oversu$scri$e $e%ond their o9n

proportional interest for shares that others do not $u%< In the case of O08 investors

9ho chose to oversu$scri$e for the )/8/// shares left unsold at the original offering

could have "ade a ?uick 2)/8/// $u%ing those shares at 1) and pro"ptl% selling

the" at the pro for"a net asset value of 2/<

'o"panies occasionall% e"plo% a rights offering to effectuate the initial pu$lic

offering of shares in a su$sidiar%< In 1.*8 for e:a"ple8 'onsolidated 7il and as8

Inc<8 utiliDed a rights offer5



1.2 T6E A5E!INESTMENT "ROCESS

ing to $ring its !rinceville #evelop"ent 'orporation su$sidiar% pu$lic< 'onsolidated

9as an overleveraged energ% co"pan% that o9ned so"e attractive Ha9aiian real

estate properties8 9hich 9ere held $% its !rinceville su$sidiar%< To separate the

Ha9aiian properties fro" the rest of the $usiness 9hile preserving the value of thoseproperties in shareholders@ hands8 'onsolidated conducted a rights offering< Under its

ter"s shareholders of 'onsolidated 9ere offered the right to purchase one share of

!rinceville for each share of 'onsolidated the% o9ned< The initial offering price8 3<2)

per share8 9as ar$itrar%8 according to the prospectus8 and considera$l% $elo9

'onsolidated@s cost $asis in !rinceville<

When the rights started to trade8 little infor"ation had $een released $%

'onsolidated 7il and as concerning !rinceville< The prospectus 9as apparentl% not

%et pu$licl% availa$le< In the a$sence of pu$licl% availa$le infor"ation8 so"e rights

traded for as little as 1J32 and 1J* of a dollar per right< Alert investors 9illing to

"ake an educated guess 9ere a$le to earn an enor"ous profit on this o$scure rights

offeringF upon co"pletion of the offering8 the "arket price of !rinceville ?uickl% rose

a$ove ) per share< 4ights that traded as lo9 as 1 1J2 cents rose in price to nearl%

2 onl% a fe9 9eeks later<

Invest#n/ #n R#s, Arb#tra/e

4isk ar$itrage is a highl% specialiDed area of value investing< Ar$itrage8 as noted

earlier8 is a riskless transaction that generates profits fro" te"porar% pricing

inefficiencies $et9een "arkets< 4isk ar$itrage8 ho9ever8 involves investing in far5

fro"5riskless takeover transactions< Spinoffs8 li?uidations8 and corporate

restructurings8 9hich are so"eti"es referred to as long5ter" ar$itrage8 also fall into

this categor%<

4isk ar$itrage differs fro" the purchase of t%pical securities in that gain or

loss depends "uch "ore on the successful co"pletion of a $usiness transaction than

on funda"ental develop5



Areas of 4pportunity for ;alue Investors 1.3

"ents at the underl%ing co"pan%< The principal deter"inant of investors@ return is

the spread $et9een the price paid $% the investor and the a"ount to $e received if

the transaction is successfull% co"pleted< The do9nside risk if the transaction fails to

$e co"pleted is usuall% that the securit% 9ill return to its previous trading level89hich is t%picall% 9ell $elo9 the takeover price<

The ?uick pace and high stakes of takeover investing have attracted "an%

individual investors and speculators as 9ell as professional risk ar$itrageurs< It is "%

vie9 that those ar$itrageurs 9ith the largest portfolios possess an advantage that

s"aller investors cannot easil% overco"e< #ue to the siDe of their holdings8 the

largest ar$itrageurs can afford to e"plo% the $est la9%ers8 consultants8 and other

advisors to ac?uire infor"ation 9ith a $readth8 depth8 and ti"eliness unavaila$le to

other investors< As 9e have learned fro" recent cri"inal indict"ents8 so"e have

even en;o%ed access to inside infor"ation8 although their infor"ational edge 9as

great even 9ithout circu"venting the la9<

The infor"ational advantage of the largest risk ar$itrageurs is not so

co"pelling in situations such as long5ter" li?uidations8 spinoffs8 and large friendl%

tender offers< In the largest friendl% corporate takeovers8 for e:a"ple8 the

professional risk5ar$itrage co""unit% depletes its purchasing po9er relativel%

?uickl%8 leaving an unusuall% attractive spread for other investors< A careful and

selective s"aller investor "a% $e a$le to profita$l% e:ploit such an opportunit%<

At ti"es of high investor uncertaint%8 risk5ar$itrage5related securities "a%

$eco"e unusuall% attractive< The #ece"$er 1. takeover of Becor Western Inc< $%

B5 Holdings8 Inc<8 fit this description< In -une 1. Becor sold its aerospace $usiness

for 1/<3 "illion cash< This left the co"pan% 9ith 1.) "illion in cash =over 11 per

share> and onl% 3/ "illion in de$t< The co"pan% also operated an unprofita$le $ut

asset5rich "ining5"achiner% $usiness under the Buc%rus5rie na"e<

The offer $% B5 Holdings to $u% Becor Western 9as the last in a series of

offers $% several suitors< The ter"s of this pro5



1.* T6E A5E!INESTMENT "ROCESS

posed "erger called for Becor holders to receive either 1 per share in cash or a

package of the follo9ing&

3 principal a"ount of 12<) percent one5%ear senior notes in B5 HoldingsF

1/ principal a"ount of 12<) percent fifteen5%ear senior de$entures in B5HoldingsF

/<2 shares preferred stock in B5 Holdings8 li?uidation preference 2)F and

/< 9arrants to $u% co""on stock in B5 Holdings at </1 per share<

A "a:i"u" of )<) percent of Becor shares 9ere eligi$le to receive the cash

consideration< Assu"ing that all stockholders elected to receive cash for as "an%

shares as possi$le8 each 9ould receive per share of Becor o9ned&

8) cash

182) principal a"ount one5%ear notes *<2) principal a"ount fifteen5%ear

de$entures </.) shares preferred stock <2)) 9arrants

The cash option 9as al"ost certain to $e 9orth "ore than the package of

securities< Thus the total value of the consideration to holders 9ho elected cash 9as

greater than for those 9ho did not< Nevertheless8 a s"all proportion of Becor holders

failed to choose the cash alternative8 increasing the value to $e received $% the vast

"a;orit% of holders 9ho did<

What "ade Becor particularl% attractive to investors 9as that in the after"ath of the

1. stock "arket crash8 the shares fell in price to $elo9 1/< Investors could thus

purchase Becor stock for less than the underl%ing cash on the co"pan%@s $ooks8 and

for an a"ount appro:i"atel% e?ual to the cash that 9ould $e distri$uted upon

consu""ation of the "erger8 9hich 9as e:pected either in #ece"$er 1. or

-anuar% 1..<

The shares 9ere a real $argain at 1/8 9hether or not the



Areas of 4pportunity for ;alue Investors 1.)

"erger occurred< The total value of the "erger consideration 9as certainl% greater

than the 1/ stock pricethe cash co"ponent alone 9as nearl% 1/< ,oreover8 there

9as nearl% enough cash on the $ooks of B5 Holdings pro for"a for the "erger to

retire the one5%ear notes< These appeared to $e 9orth close to par value< Based onthe "arket price of co"para$le securities8 the fifteen5%ear de$entures see"ed likel%

to trade at a "ini"u" of )/ percent of face value and perhaps significantl% higher<

The preferred stock 9as "ore difficult to evaluate8 $ut 2) percent of its li?uidation

preference see"ed conservative co"pared 9ith other preferred issues< The 9arrants

9ere virtuall% i"possi$le to value< ven assu"ing the% 9ould trade at negligi$le

prices8 ho9ever8 the total value of the "erger consideration appeared to $e at least

1* per share<

Better still8 the do9nside risk to investors 9as "ini"al< The $ook value of

Becor 9as 12 per share8 nearl% all of it in cash< There 9ere several siDa$le holders of

Becor stock8 a fact that increased the likelihood that underl%ing value 9ould $e real5

iDed in so"e fashion< ven if the "erger 9ere re;ected $% shareholders8 a corporate

li?uidation appeared likel% to %ield si"ilar value< At prices of 12 or $elo98 investors

faced little do9nside risk and the prospect of an apprecia$le and pro"pt return< As it

turned out8 the "erger consideration 9as 9orth a$out 1*<2) at "arket prices< Becor

shares had declined in the 9ake of a $road "arket rout to a level $elo9 underl%ing

value8 creating an opportunit% for value investors<

The C%(les o8 Investment Fash#on9

The R#s,!Arb#tra/e C%(le

,an% participants in specialiDed areas of investing such as $ankruptc% and

risk ar$itrage have e:perienced inferior results in recent %ears< 7ne reason is the

proliferation of investors in these areas< In a sense8 there is a c%cle of invest5



1:3 T6E A5E!INESTMENT "ROCESS

"ent results attendant on an% invest"ent philosoph% or "arket niche due to the

relative popularit% or lack of popularit% of that approach at a particular ti"e<

When an area of invest"ent such as risk ar$itrage or $ankruptc% investing

$eco"es popular8 "ore "one% flo9s to specialists in the area< The increased $u%ing

$ids up prices8 increasing the short5ter" returns of investors and to so"e e:tent

creating a self5fulfilling prophec%< This attracts still "ore investors8 $idding prices up

further< While the influ: of funds helps to generate strong invest"ent results for the

earliest investors8 the resultant higher prices serve to reduce future returns<

Ulti"atel% the good invest"ent perfor"ance8 9hich 9as generated largel% $%

those 9ho participated in the area $efore it $eca"e popular8 ends and a period of

"ediocre or poor results ensues< As poor perfor"ance continues8 those 9ho rushed

into the area $eco"e disillusioned< 'lients 9ithdra9 funds as ?uickl% as the% added

the" a fe9 %ears earlier< The rede"ptions force invest"ent "anagers to raise cash

$% reducing invest"ent positions< This selling pressure causes prices to drop8

e:acer$ating the poor invest"ent perfor"ance< ventuall% "uch of the Ghot "one%G

leaves the area8 allo9ing the s"aller nu"$er of re"aining investors to e:ploit

e:isting opportunities as 9ell as the ne9l% created $argains resulting fro" the forced

selling< The stage is set for another up5c%cle<

4isk ar$itrage has undergone such a c%cle during the past several %ears< In

the earl% 1./s there 9ere onl% a fe9 doDen risk ar$itrageurs8 each of 9ho"

"anaged relativel% s"all pools of capital< Their repeated successes received

considera$le pu$licit%8 and a nu"$er of ne9 ar$itrage $outi?ues 9ere esta$lished< The increased co"petition did not i""ediatel% destro% the invest"ent returns fro"

risk ar$itrageF the suppl% of such invest"ents increased at the sa"e ti"e8 due to a

si"ultaneous acceleration in corporate takeover activit%<

B% the late 1./s "an% ne9 participants had entered risk ar$itrage<

4elativel% unsophisticated individual investors and corporations had $eco"e

significant pla%ers< The% tended to







Areas of 4pportunity for ;alue Investors 1.

"ent often receives stock options $ased on initial trading pricesF until these options

are8 in fact8 granted8 there is an incentive to hold the share price do9n< 'onse?uentl%

a nu"$er of spinoff co"panies "ake little or no effort to have the share price reflect

underl%ing value< The "anage"ent of co"panies 9ith depressed share prices 9ould

usuall% fear a hostile takeover at a lo9 price8 ho9ever Gshark5repellent8G anti5

takeover provisions inserted into the corporate $%la9s of "an% spinoffs8 serve to

protect "anage"ent fro" corporate predators<

Another reason that spinoffs "a% $e $argain priced is that there is t%picall% a

t9o5 or three5"onth lag $efore infor"ation on the" reaches co"puter data$ases< A

spinoff could represent the $est $argain in the 9orld during its first da%s of trading8

$ut no co"puter5dependent investors 9ould kno9 a$out it<

Shares of spinoffs t%picall% do not fit 9ithin institutional constraints and

conse?uentl% are ?uickl% sold $% institutional investors< 'onsider8 for e:a"ple8 thespinoff of InterTAN8 Inc<8 $% Tand% 'orporation in late 1.< InterTAN had a $ook

value of a$out 1) per share8 net5net 9orking capital after all de$t of roughl% 11 per

share8 and highl% profita$le 'anadian and Australian retailing operations< (arge

operating losses in urope ca"ouflaged this profita$ilit% and caused a s"all overall

loss< It 9as clear to an%one 9ho looked $ehind the aggregate losses to the separate

geographic divisions that the 'anadian and Australian operations alone 9ere 9orth

considera$l% "ore than the price of 11 per share at 9hich InterTAN stock 9as

trading<

An institutional investor "anaging 1 $illion "ight hold t9ent%5five securit%

positions 9orth appro:i"atel% */ "illion each< Such an investor "ight have o9ned

one "illion Tand% shares trading at */< He or she 9ould have received a spinoff of

2//8/// InterTAN shares having a "arket value of 2<2 "illion< A 2<2 "illion

position is insignificant to this investorF either the stake in InterTAN 9ill $e increased

to the average position siDe of */ "illion8 or it 9ill $e sold< Selling the shares is the

path of least resistance8 since the t%pical institutional investor pro$a$l% kno9s little

and cares even less a$out




InterTAN< ven if that investor 9anted to8 though8 it is unlikel% that he or she could

accu"ulate */ "illion 9orth of InterTAN stock8 since that 9ould a"ount to *)

percent of the co"pan% at prevailing "arket prices =and that al"ost certainl% 9ould

violate a different constraint a$out o9nership and control<> Needless to sa%8 the great"a;orit% of Tand%@s institutional shareholders si"pl% du"ped their InterTAN shares<

InterTAN received no Wall Street pu$licit%8 and $rokers had no particular incentive to

dru" up interest in the stock< As a result8 9aves of institutional selling created a

te"porar% suppl%5and5de"and i"$alance8 and nu"erous value investors 9ere a$le

to accu"ulate large InterTAN positions at attractive prices< B% 1. the co"pan%

had turned its "one%5losing operations around8 Wall Street anal%sts 9ho had once

ignored the stock had suddenl% fallen in love 9ith it8 and investors no longer 9orried

a$out 9hat could go 9rong8 focusing instead on 9hat "ight go right< The shares

peaked that %ear at 2 <

7pportunities can so"eti"es arise not in the spinoff $ut in the parent5

co"pan% shares< As an e:a"ple8 at the end of 1.. Burlington Northern8 Inc< =BNI>8

9hich o9ned a "a;or railroad and a natural resources co"pan%8 spun off its

invest"ent in Burlington 4esources8 Inc< =B4>8 to shareholders< A nu"$er of unusual

"arket forces 9ere at 9ork at the ti"e that created an invest"ent opportunit% in the

ongoing parent co"pan%8 BNI< What happened is this& "an% investors held BNI

pri"aril% $ecause of its o9nership of B48 9hich represented a$out t9o5thirds of the

dollar value of the co"$ined co"pan%< A nu"$er of these investors apparentl% sold

BNI $efore the spinoff 9as co"pleted and $ought the ne9l% for"ed B48 causing BNI

to decline in price relative to B4< This created an opportunit% for other investors to

$u% BNI stock pre5spinoff and sell B4 stock short in order to lock in a cost of

appro:i"atel% 1 per share for the ne9l% separated railroad $usiness< Since the

railroad 9as e:pected $% anal%sts to earn 3<)/ per share and pa% a 1<2/ annual

dividend8 esta$lishing an invest"ent in the railroad at 1 appeared to $e an

attractive opportunit% co"pared




9ith $oth a$solute %ardsticks of value and 9ith the prices of shares in co"para$le

co"panies< B% 1/ the shares had appro:i"atel% dou$led fro" the 1.. level<

Con(lus#on

This chapter has identified a nu"$er of niches 9here value investors so"eti"es findattractive opportunities< It is $% no "eans an e:haustive list and is not "eant to $e<

4ather it sho9s ho9 securities in a variet% of "arket sectors can $eco"e inefficientl%

priced8 creating potential $argains for those 9illing to hunt for the"<

The ne:t t9o chapters offer in5depth e:a"ples of t9o areas of opportunit% for

value investors< 'hapter 11 e:a"ines the conversion of thrifts fro" "utual to stock

o9nership and sho9s ho9 the arith"etic of this ver% unusual transaction creates

fre?uent opportunities for value investors< 'hapter 12 e:plores the opportunities for

investors in financiall% distressed and $ankrupt securities< These chapters $oth

ela$orate on the the"e of this one& that attractive opportunities to purchase

undervalued invest"ents arise 9ith so"e fre?uenc% in a nu"$er of areas and that

these opportunities can $e identified and e:ploited $% value investors<



11Invest#n/ #n Thr#8t Convers#ons

,utual thrift institutions 9ere first for"ed in this countr% in the "id5nineteenthcentur% and toda% nu"$er in the thousands< The "utual for" of o9nership gave

depositors co"fort that the% 9ould $e fairl% treated since8 in theor%8 the% o9ned the

institutions< Since 1.3 the conversion of hundreds of "utual thrift institutions to

stock o9nership has created nu"erous opportunities for value investors< Negative

pu$licit% coupled 9ith the econo"ics of thrift conversions served to undul% depress

the share prices of "an% thrifts<

Before deregulation in the late 1/s the thrift industr% 9as "anaged8

according to the old ;oke8 $% the 3553 principle& take in deposits at 3 percent8 lend

the" out at percent8 and $e on the golf course $% 3 o@clock< A thrift e:ecutive@s life

9as si"ple8 fairl% re"unerative8 and of high status in the co""unit%< Before

deregulation forced their hands8 fe9 thrift e:ecutives 9ere 9illing to face the

uncertainties of a "utual5to5stock conversion<

B% the 1./s8 ho9ever8 "uch of the thrift industr% 9as he"orrhaging "one%<

6inancial deregulation had adversel% i"pacted

1'*



Investing in #hrift Conversions 13

"ost thrifts in that the interest rates paid on deposit lia$ilities 9ere suddenl% allo9ed

to fluctuate 9ith "arket interest rates8 9hile "ost thrift assets8 in the for" of ho"e

"ortgage loans8 $ore fi:ed interest rates< 6or "an% thrifts8 the cost of funds soon

rose a$ove the %ield on their assets8 resulting in a negative interest rate spread< The arn5St< er"ain Act of 1.2 per"itted thrifts to engage in ne98

increasingl% risk% lending and investing activities8 ulti"atel% resulting in hundreds of

$illions of dollars in losses8 9hich rendered nu"erous thrifts insolvent< #espite a

proliferation in the earl% 1./s of accounting gi""ickr% designed to prop up the net

9orth of trou$led institutions8 "an% thrifts desperatel% needed additional capital to

survive< ,one%5losing thrifts 9ere generall% una$le to raise ne9 funds8 and those

that 9ere "utuall% o9ned re"ained "utuall% o9ned< 7nl% profita$le and ade?uatel%

capitaliDed thrifts 9ere in a position to sell shares $% converting to stock o9nership8

and "an% of the" atte"pted to do so<

In a t%pical initial pu$lic offering =I!7> all preoffering shares are o9ned $%

insiders8 9ho t%picall% $ought in earlier at a s"all fraction of the offering price< To

illustrate the diluting effect of a t%pical under9riting8 if insiders have $ought one "il5

lion shares of O0 at 1 per share and the pu$lic is su$se?uentl% offered one "illion

ne9l% issued shares at 11 each8 there 9ill then $e t9o "illion shares outstanding

9ith total proceeds to the co"pan% of 12 "illion =ignoring under9riting costs>< The

pro for"a $ook value of the co"pan%@s stock is per share< The pu$lic@s invest"ent

has $een diluted $% ) per "are =*) percent of the purchase price>8 9hile the

insiders have gained a 9indfall of the sa"e ) per share<

Thrift conversions 9ork differentl%< A thrift institution 9ith a net 9orth of 1/

"illion "ight issue one "illion shares of stock at )1/ per share< Again ignoring costs

of the offering8 the proceeds of 1/ "illion are added to the institution@s pree:isting

net 9orth8 resulting in pro for"a shareholders@ e?uit% of 2/ "illion< Since the one

"illion shares sold on the I!7 are the




onl% shares outstanding8 pro for"a net 9orth is 2/ per share< The pree:isting net

9orth of the institution ;oins the investors@ o9n funds8 resulting i""ediatel% in a net

9orth per share greater than the investors@ o9n contri$ution<

The "echanics of a "utual5to5stock conversion are fairl% si"ple< #epositors ina converting thrift have a pree"ptive right to purchase shares< ,anage"ent is

t%picall% granted the right to purchase shares alongside depositors< 4e"aining

shares are offered to the general pu$lic8 9ith preference so"eti"es given to

custo"ers or to an%one living in the thrift@s geographic area<

So long as the thrift has positive $usiness value $efore the conversion8 the

arith"etic of a thrift conversion is highl% favora$le to investors< Unlike an% other t%pe

of initial pu$lic offering8 in a thrift conversion there are no prior shareholdersF all of

the shares in the institution that 9ill $e outstanding after the offering are issued and

sold on the conversion< The conversion proceeds are added to the pree:isting capital

of the institution8 9hich is indirectl% handed to the ne9 shareholders 9ithout cost to

the"< In a real sense8 investors in a thrift conversion are $u%ing their o9n "one% and

getting the pree:isting capital in the thrift for free<

There is another uni?ue aspect to thrift conversions< Unlike "an% I!7s8 in

9hich insiders 9ho $ought at ver% lo9 prices sell so"e of their shares at the ti"e of

the offering8 in a thrift conversion insiders virtuall% al9a%s $u% shares alongside the

pu$lic and at the sa"e price< Thrift conversions are the onl% invest"ent in 9hich

$oth the volu"e and price of insider $u%ing is full% disclosed ahead of ti"e and in

9hich the pu$lic has the opportunit% to ;oin the insiders on e?ual ter"s<

The t9in attractions of $u%ing on e?ual ter"s 9ith insiders and the favora$le

arith"etic of a thrift conversion "ake for a co"pelling invest"ent opportunit% as

long as the preconver5sion thrift has a positive value< ,an% thrifts8 of course8 are

9orth less than their stated $ook value8 and so"e are insolvent< 6unds raised on the

conversion of such institutions 9ould pa% to resolve pree:isting pro$le"s rather than

add to pree:isting value<



Investing in #hrift Conversions 1)

Wh% 9ere thrift stocks so depressed in the 1./sE The sell side of Wall Street has

historicall% e"plo%ed fe9 thrift anal%sts8 and the $u% side even fe9er< The handful of

sell5side anal%sts on dut% t%picall% follo9ed onl% the ten or t9ent% largest pu$lic

thrifts8 pri"aril% those $ased in 'alifornia and Ne9 0ork< No "a;or Wall Street house9as a$le to get a handle on all of the "an% hundreds of converted thrifts8 and fe9

institutional investors even "ade the effort< As a result8 shares in ne9 thrift

conversions 9ere fre?uentl% issued at an apprecia$le discount to the valuation

"ultiples of other pu$licl% traded thrifts in order to get investors to notice and $u%

the"<

7f course8 funda"ental invest"ent anal%sis applies to thrifts as it 9ould to

other $usinesses< Thrifts incurring high risks8 such as e:panding into e:otic areas of

lending or venturing far fro" ho"e8 should si"pl% $e avoided as unanal%Da$le<

Thrifts speculating in ne9fangled instru"ents such as ;unk $onds or co"ple:

"ortgage securities =those $ased on interest or principal onl%8 for e:a"ple> should

$e shunned for the sa"e reason< A si"ple rule applies& if %ou don@t ?uickl%

co"prehend 9hat a co"pan% is doing8 then "anage"ent pro$a$l% doesn@t either<

This initial test li"its investors to lo95risk thrifts< This does not "ean that investors

could not profit fro" investing in risk% institutions $ut rather that the potential return

is not usuall% ;ustified $% the risk and uncertaint%< 79ing to the high degree of

financial leverage involved in thrifts8 there can $e no "argin of safet% fro" investing

in the shares of thinl% capitaliDed financial institutions that o9n esoteric or risk%

assets<

While all $usinesses should $e valued conservativel%8 conservatis" is even

"ore i"portant in the case of highl% leveraged financial institutions 9here operating

risks are "agnified $% the capital structure< In evaluating such thrifts8 $ook value is

usuall% a lo9 esti"ate of private5"arket valueF "ost thrift takeovers occur at a

pre"iu" to $ook value< Investors should ad;ust $ook value up9ard8 ho9ever8 to

reflect understated assets8 such as appreciated invest"ent securities8 $elo95"arket

leases8 real estate carried $elo9 current 9orth8 and the value of a sta$le8 lo95cost

deposit $ase< Si"ilarl% $ook value should $e




ad;usted do9n9ard to reflect $alance sheet intangi$les8 $ad loans8 and invest"ents

9orth less than cost<

As part of the funda"ental anal%sis of a thrift8 its earnings should $e ad;usted

for such nonrecurring ite"s as securities gains and losses8 real estate gains andlosses8 $ranch sales8 real estate develop"ent profits8 and accounting changes<

Qualit% of earnings is e:tre"el% i"portant since earnings derived fro" the recurring

spread $et9een interest earned on loans and interest paid on deposits are far "ore

valua$le than nonrecurring gains or volatile inco"e fro" loan origination fees< Thrifts

9ith lo9 overhead costs are prefera$le to high5cost institutions $oth $ecause the%

are "ore profita$le and $ecause the% en;o% greater fle:i$ilit% in ti"es of narro9

interest rate spreads<

Although thrift conversions are attractive8 the% are not a sure thing< While "an% of

the thrift conversions of the 1./s ulti"atel% proved re9arding to investors8 there

9as never certaint% a$out the outco"e< There are "an% risks in an% thrift

invest"ent8 including asset ?ualit%8 interest rate volatilit%8 "anage"ent discretion8

and the unpredicta$le actions of co"petitors< Investors8 as al9a%s8 "ust anal%De

each potential thrift conversion invest"ent not as an instance of an often attractive

"arket niche $ut individuall% on its "erits<

Bama#(a Sav#n/s 7an,

In -une 1/ -a"aica Savings Bank converted fro" "utual to stock o9nership

through a ne9l% for"ed holding co"pan%8 -SB 6inancial =-SB>< It is i"portant to recall

the "acroecono"ic conte:t of this share offering< At the ti"e of the -SB conversion8

the United States had e:perienced a nation9ide real estate do9nturn< sti"ates of

the total cost of the thrift industr% $ailout 9ere reaching as high as )// $illion<

(ending standards had $een tightened for real estate $orro9ers in al"ost all regions<

,ost thrift and $ank stocks had declined sharpl% in price8 and "an% trou$led

institutions had $een seiDed $% federal regula5



Investing in #hrift Conversions 1

tors< A"idst these circu"stances -SB "ade the i"pro$a$le atte"pt to convert to

pu$lic o9nership<

-SB 9as not a t%pical thrift< 7rganiDed in 1. in Ne9 0ork8 it had on

#ece"$er 3181.8 total assets of 1<) $illion and retained earnings of 1<1"illion8 a ratio of tangi$le capital to total assets of 13<) percent prior to conversion<

This 9as a"ong the highest ratios in the countr%< T9o5thirds of the assets of -SB 9ere

held in U<S< Treasur% and other federal agencies@ securities or cash e?uivalents8 9hile

onl% 3/ percent 9as in loans8 virtuall% all residential "ortgages< -SB 9as in a class $%

itself& li?uid8 9ell capitaliDed8 and 9ithout "aterial $usiness risk<

#epositors in -SB 9ere offered the opportunit% of $u%ing 1 "illion shares at

1/ each< The econo"ics of a thrift conversion are such that even 9ith -SB@s o$vious

"erits8 the shares 9ere offered to investors at onl% * percent of $ook value and a

pro for"a priceJearnings "ultiple of ten ti"es< The gloo"% real estate environ"ent

and the depressed "arket for thrift stocks no dou$t contri$uted to the lo9 initial

offering price<

As an invest"ent -SB 9as e:tre"el% lo9 risk in ever% respect< The credit risk 9as

"ini"al8 the high capital ratio reflected lo9 financial leverage8 and the stock sold

9ell $elo9 -SB@s tangi$le $ook value8 a %ardstick of its underl%ing 9orth<

7ne interesting 9a% to evaluate the risk of investing in -SB 9as to consider

that half the proceeds fro" the stock conversion8 or ./ "illion8 9ere to $e retained

at the holding co"pan%< This cash represented e:cess capital that could $e used to

repurchase -SB shares su$se?uent to the pu$lic offering< If the cash had $een used in

its entiret% to repurchase -SB shares at t9o5thirds of $ook value =a */ percent

pre"iu" to the I!7 price>8 the co"pan% could have repurchased one5third of the

shares of -SB that had ;ust $een issued<

While "ost shareholders "ight have chosen not to sell at that price8 the effect

of such a progra" 9ould al"ost certainl% have $een to raise the price of -SB shares<

In fact8 the pro for"a $ook value per share8 ad;usted to reflect this h%pothetical

repurchase8 9ould have increased fro" 21<12 to 2)<//8 an 1. percent increase<

This illustrates the opportunit% to investors of o9ning





1*Invest#n/ #n F#nan(#all%

2#stresse an

7an,ru$t Se(ur#t#esAs 9e have learned fro" the histor% of the ;unk5$ond "arket8 investors have

traditionall% attached a stig"a to the securities of financiall% distressed co"panies8

perceiving the" as highl% risk% and therefore i"prudent< 6inanciall% distressed and

$ankrupt securities are anal%ticall% co"ple: and often illi?uid< The reorganiDation

process is $oth tedious and highl% uncertain< Identif%ing attractive opportunities

re?uires painstaking anal%sisF investors "a% evaluate doDens of situations to uncover

a single 9orth9hile opportunit%<

Although the nu"$er of varia$les is high in an% t%pe of investing8 the issues

that "ust $e considered 9hen investing in the securities of financiall% distressed or

$ankrupt co"panies are greater in nu"$er and in co"ple:it%< In addition to co"par5

ing price to value as one 9ould for an% invest"ent8 investors in financiall% distressed

securities "ust consider8 a"ong other things8 the effect of financial distress on

$usiness resultsF the

1



2// T6E A5E!INESTMENT "ROCESS

availa$ilit% of cash to "eet upco"ing de$t5service re?uire"entsF and likel%

restructuring alternatives8 including a detailed understanding of the different classes

of securities and financial clai"s outstanding and 9ho o9ns the"< Si"ilarl%8

investors in $ankrupt securities "ust develop a thorough understanding of the

reorganiDation process in general as 9ell as the specifics of each situation $eing

anal%Ded<

Because "ost investors are una$le to anal%De these securities and un9illing

to invest in the"8 the securities of financiall% distressed and $ankrupt co"panies can

provide attractive value5invest"ent opportunities< Unlike ne9l% issued ;unk $onds8

these securities sell considera$l% $elo9 par value 9here the riskJre9ard ratio can $e

attractive for kno9ledgea$le and patient investors<

F#nan(#all% 2#stresse an 7an,ru$t 7us#nesses'o"panies get into financial trou$le for at least one of three reasons& operating

pro$le"s8 legal pro$le"s8 andJor financial pro$le"s< A serious $usiness deterioration

can cause continuing operating losses and ulti"atel% financial distress< Unusuall%

severe legal pro$le"s8 such as those that plagued -ohns ,anville8 Te:aco8 and A< H<

4o$ins8 caused tre"endous financial uncertaint% for these co"panies8 leading the"

ulti"atel% to seek $ankruptc% court protection< 6inancial distress so"eti"es results

al"ost entirel% fro" the $urdens of e:cessive de$tF "an% of the ;unk5$ond issuers of

the 1./s shared this e:perience<

6inancial distress is t%picall% characteriDed $% a shortfall of cash to "eet

operating needs and scheduled de$t5service o$ligations< When a co"pan% runs short

of cash8 its near5ter" lia$ilities8 such as co""ercial paper or $ank de$t8 "a% not $e

refinancea$le at "aturit%< Suppliers8 fearing that the% "a% not $e paid8 curtail or

cease ship"ents or de"and cash on deliver%8 e:acer$ating the de$tor@s 9oes<

'usto"ers dependent on an



Investing in 2inancially Distressed and ankrupt !ecurities 2/1

ongoing $usiness relationship "a% stop $u%ing< "plo%ees "a% a$andon ship for

"ore secure or less stressful ;o$s<

Since the effect of financial distress on $usiness results can var% fro"

co"pan% to co"pan%8 investors "ust e:ercise considera$le caution in anal%Ding

distressed securities< The operations of capital5intensive $usinesses are8 over the

long run8 relativel% i""une fro" financial distress8 9hile those that depend on pu$lic

trust8 like financial institutions8 or on i"age8 like retailers8 "a% $e da"aged

irreversi$l%< 6or so"e $usinesses the decline in operating results is li"ited to the

period of financial distress< After a successful e:change offer8 an in;ection of fresh

capital8 or a $ankruptc% reorganiDation8 these $usinesses recover to their historic

levels of profita$ilit%< 7thers8 ho9ever8 re"ain shado9s of their for"er selves<

The capital structure of a $usiness also affects the degree to 9hich operations

are i"pacted $% financial distress< 6or de$tors 9ith "ost or all of their o$ligations ata holding co"pan% one or "ore levels re"oved fro" the co"pan%@s pri"ar% assets8

the i"pact of financial distress can $e "ini"al< 7verleveraged holding co"panies8

for e:a"ple8 can file for $ankruptc% protection 9hile their via$le su$sidiaries

continue to operate uni"pairedF Te:aco entered $ankruptc% 9hile "ost ofits

su$sidiaries did not file for court protection< 'o"panies that incur de$t at the

operating5su$sidiar% level "a% face greater dislocations<

The popular "edia i"age of a $ankrupt co"pan% is a rusting hulk of a factor%

vie9ed fro" $e%ond a padlocked gate< Although this is so"eti"es the unfortunate

realit%8 far "ore often the $ankrupt enterprise continues in $usiness under court

protection fro" its creditors< Indeed8 9hile there "a% $e a need to re$uild da"aged

relationships8 a co"pan% that files for $ankruptc% has usuall% reached rock $otto"

and in "an% cases soon $egins to recover< As soon as ne9 lenders can $e assured of

their senior creditor position8 de$tor5in5possession financing $eco"es availa$le8

providing cash to "eet pa%roll8 to restock depleted inventories8 and to give

confidence $oth to custo"ers and suppliers< Since postpetition suppliers to the

de$tor have a



2/2 T6E A5E!INESTMENT "ROCESS

senior clai" to unsecured prepetition creditors8 "ost suppliers rene9 ship"ents< As

restocked inventories and increased confidence sti"ulate $usiness and as deferred

"aintenance and dela%ed capital e:penditures are undertaken8 results "a% $egin to

i"prove< 'ash usuall% starts to $uild =for a nu"$er of reasons to $e discussed later><When necessar%8 ne9 "anage"ent can $e attracted $% the prospect of a sta$le and

i"proving $usiness situation and $% the lure of lo95priced stock or options in the

reorganiDed co"pan%< While 'hapter 11 is not a panacea8 $ankruptc% can provide a

sheltered opportunit% for so"e trou$led $usinesses to return to financial health<

Issuer Res$onses to F#nan(#al 2#stress

There are three principal alternatives for an issuer of de$t securities that encounters

financial distress& continue to pa% principal and interest 9hen due8 offer to e:change

ne9 securities for securities currentl% outstanding8 or default and file for $ankruptc%<

A potential investor in distressed securities "ust consider each of these three

possi$le scenarios $efore co""itting capital<

6inanciall% trou$led co"panies can tr% to survive outside $ankruptc% $%

resorting to cost cutting8 asset sales8 or an infusion of outside capital< Such efforts

can $e successful8 depending on the precise cause of the de$tor@s 9oes< Short5ter"

palliatives8 ho9ever8 can contri$ute to the erosion of long5ter" $usiness value<

fforts to conserve cash $% cutting $ack inventor%8 stretching out accounts pa%a$le8

or reducing salaries8 for e:a"ple8 can get a $usiness through a short5ter" crisis8 $ut

in the long run so"e of these "easures "a% hurt relationships 9ith custo"ers8

suppliers8 and e"plo%ees and result in a di"inution of $usiness value<

A second option for a co"pan% is to "ake an e:change offer to replace

outstanding de$t and8 9here relevant8 preferred stock 9ith ne9 securities< The

possi$ilit% of an e:change offer adds a







Investing in 2inancially Distressed and ankrupt !ecurities 2/)

overleveraged co"panies in order to e:pedite the reorganiDation process8 avoid the

high ad"inistrative costs of a traditional 'hapter 11 filing8 and circu"vent the free5

rider pro$le"<

If "easures to keep the patient alive prove unsuccessful8 the third option is to file forcourt protection under 'hapter 11 of the federal $ankruptc% code and atte"pt to

reorganiDe the de$tor 9ith a "ore via$le capital structure< This is t%picall% a t

resort8 ho9ever8 for there is still considera$le stig"a attached to $ankruptc%<

The Im$l#(at#ons o8 a 7an,ru$t(% F#l#n/

6iling for $ankruptc% halts efforts $% creditors =lenders> to collect repa%"ent fro" the

de$tor =$orro9er>< !a%"ent of principal and interest other than that due on full%

secured de$t is suspended< !a%"ents to trade creditors and even e"plo%ees are

9ithheld< The different classes of creditorssecured8 senior8 and ;unior lenders8 trade

creditors8 e"plo%ees8 and others9ill $e dealt 9ith in a plan or so"eti"es

co"peting plans of reorganiDation proposed and supported $% either the de$tor

andJor $% a "a;or creditor group or groups< As stated previousl%8 to $e confir"ed a

plan "ust $e approved $% the $ankruptc% ;udge as 9ell as $% a "a;orit% in nu"$er

and t9o5thirds in dollar a"ount of each class of creditors<

The interests of a $ankrupt de$tor and its creditors can and fre?uentl% do

diverge considera$l%< The de$tor8 seeking to e"erge fro" $ankruptc% as strong as

possi$le8 "a% atte"pt to "a:i"iDe postreorganiDation cash and "ini"iDe

postreorganiDation de$t< Si"ilarl% the de$tor "a% tr% to "aintain high levels of

capital spending during the 'hapter 11 process in order to ensure a via$le $usiness

after reorganiDation< B% contrast8 creditors 9ill generall% prefer to "a:i"iDe cash

distri$utions to the"selves< The% "a% oppose 9hat the% consider to $e e:cessive

capital e:penditures $% the de$tor during the reorganiDation process8 preferring a

cash $uildup that 9ill su$se?uentl%




$e distri$uted to the"< These conflicting interests 9ill $e resolved during the

negotiation of a plan of reorganiDation and finall% $% the $ankruptc% court<

A co"pan% "a% use a $ankruptc% filing to void leases and e:ecutor%

contracts such as long5ter" suppl% arrange"ents< In the past even la$or agree"entshave $een ter"inated under $ankruptc%< The 1. $ankruptc% of 6ood 6air Stores

resulted in a nu"$er of voided store leases8 the present value of 9hich $eca"e

clai"s against the de$tor< The 1.) $ankruptc% of Wheeling !itts$urgh Steel resulted

in the re;ection of e:isting iron ore5 and coal5purchase contracts8 9hich 9ere

su$se?uentl% renegotiated at lo9er pricesF suppliers such as 'leveland5'liffs and

Hanna ,ining $eca"e su$stantial clai"ants in $ankruptc%< Although this could no

longer $e done toda%8 in 1.3 'ontinental Airlines used a $ankruptc% filing to void its

la$or agree"ent8 effectivel% replacing a unioniDed 9ork force 9ith nonunion la$or<

79ing to a de$tor@s a$ilit% to re;ect contracts of nearl% all t%pes8 a $ankrupt

co"pan% is fre?uentl% in a position to $eco"e a lo95cost co"petitor in its industr%

upon reorganiDation< Unprofita$le8 high5cost facilities are closed or sold8 a$ove5

"arket lease costs are reduced to "arket levels8 and a co"pan%@s overstated assets

are t%picall% 9ritten do9n on its $ooks to fair5"arket value8 there$% reducing future

depreciation charges< The $ankruptc% process can so"eti"es serve as a salutar%

catharsis8 allo9ing trou$led fir"s the opportunit% to i"prove their $usiness

operations<

6or several reasons $ankrupt co"panies tend to $uild up su$stantial cash

$alances< 'osts "a% $e reduced either through contract re;ections or through

ordinar% cost5cutting efforts8 resulting in increased cash flo9< ,ore of a co"pan%@s

free cash flo9 is retained as interest pa%"ents on unsecured de$t are suspended and

co""on and preferred dividend pa%"ents are halted< ,an% $ankrupt fir"s have

su$stantial net operating loss =N7(> carr%5for9ards8 resulting fro" prior ta: losses or

fro" 9rite5offs incurred during $ankruptc%F these N7(s offset ta:es currentl% due8

also aug"enting cash< 'apital spending8 in par5



Investing in 2inancially Distressed and ankrupt !ecurities 2/

ticular spending on unrelated diversification and on ne9 or risk% activities8 is

curtailed< Unrelated8 unprofita$le8 or other9ise ill5fitting $usinesses "a% $e divested8

again resulting in cash $uildup< Since cash is not availa$le for distri$ution until a plan

of reorganiDation is approved and consu""ated8 cash 9ill gro9 fro" co"poundinterest earned on e:isting cash $alances and fro" interest on interest< All this has

led to 9hat one leading $ankruptc% advisor has ter"ed the "one%5"arket theor% of

$ankruptc%& if enough cash $uilds up8 it can si"plif% the process of devising a plan of

reorganiDation that is accepta$le to all parties $ecause there are no differences of

opinion concerning the value of cash and $ecause "ore creditors can $e paid in full<

The Investment Attra(t#ons o8 7an,ru$t(%

Investing in $ankrupt securities differs fro" investing in co"panies operating

nor"all%< An o$vious difference is that in a solvent co"pan%8 an investor can $e

relativel% certain of 9hat $elongs to 9ho"< In a $ankruptc% the treat"ent of valid

clai"s is precisel% 9hat is to $e decided in court& the disposition of the assets is to $e

deter"ined $% the o9ners of the lia$ilities 9ho8 along 9ith the e?uit% o9ners8 9ill

receive the assets either directl% or "ore t%picall% in the for" of ne9l% issued

securities of the reorganiDed de$tor<

As "entioned in chapter 1/8 one attractive feature of $ankruptc% investing is

that the reorganiDation process can serve as a catal%st for realiDing underl%ing value<

An undervalued stock "a% re"ain cheap forever and an attractive $ond "a% have to

$e held until a distant "aturit% date to pa% off8 $ut a $ankrupt co"pan% 9ill t%picall%

reorganiDe 9ithin t9o or three %ears of filing under 'hapter 11< Upon e"ergence

fro" $ankruptc%8 the fir"@s creditors t%picall% e:change their clai"s for so"e

co"$ination of cash8 ne9 de$t securities8 and e?uit% in the reorganiDed de$tor<



2/. T6E A5E!INESTMENT "ROCESS

"ergence fro" 'hapter 11 also serves as a li?uef%ing event for clai"holders<

79ners of s"all8 illi?uid trade clai"s or large a"ounts of $ank de$t 9ill e:perience a

su$stantial enhance"ent in the li?uidit% of their holdings< ,a:i"u" li?uidit% 9ould

co"e fro" an all5cash distri$ution8 $ut even de$t or e?uit% securities 9ould likel%provide holders "ore li?uidit% than clai"s against a $ankrupt de$tor<

An additional attraction of $ankruptc% investing is that $ankrupt de$t

securities8 particularl% senior securities8 are not ver% sensitive to fluctuations in the

stock or $ond "arket< Bankrupt securities tend to $ehave so"e9hat like risk5

ar$itrage invest"entsF the% fluctuate in price "ore 9ith the progress of the

reorganiDation than 9ith the overall "arket<

The Three Sta/es o8 7an,ru$t(% Invest#n/

,ichael !rice of ,utual Series 6und8 Inc<8 speaks of three stages of $ankruptc%< The

first stage8 i""ediatel% after the 'hapter 11 filing8 is the ti"e of greatest uncertaint%

$ut perhaps also of greatest opportunit% for investors< The de$tor@s financial situation

is in tur"oil8 financial state"ents "a% $e late or unavaila$le8 off5$alance5sheet

lia$ilities are not i""ediatel% evident8 and the underl%ing $usiness "a% not have

sta$iliDed< In addition the "arket for the de$tor@s securities is in disarra%8 9ith "an%

holders forced to sell their holdings regardless of price<

The second stage of $ankruptc%8 involving the negotiation of a plan of

reorganiDation8 $egins an%9here fro" a fe9 "onths to several %ears after filing< B%

then anal%sts 9ill have pored over the de$tor@s $usiness and financial situation< ,uch

"ore is kno9n a$out the de$tor8 and securit% prices 9ill incorporate the availa$le

infor"ation< 'onsidera$le uncertaint% re"ains8 ho9ever8 a$out the eventual plan of

reorganiDation< The treat"ent of various classes of creditors is still to $e resolved<

The third and final stage of $ankruptc% occurs $et9een the finaliDation of a

reorganiDation plan and the de$tor@s e"ergence



Investing in 2inancially Distressed and ankrupt !ecurities 2/

fro" $ankruptc%< Unless the plan is contested8 is re;ected $% one or "ore classes of

creditors8 or falls through $ecause a ke% condition is not "et8 this stage usuall% takes

three "onths to one %ear< Although the ti"e fra"e and legal process are less

certain8 the last stage "ost closel% rese"$les a risk5ar$itrage invest"ent<

ach stage of $ankruptc% affords different opportunities to the investor< The

$est $argains appear a"idst the uncertaint% and high risk of the first stage< The

lo9est $ut "ost predicta$le returns are availa$le in the third stage8 after the

reorganiDation plan $eco"es pu$licl% availa$le<

R#s,s o8 Invest#n/ #n F#nan(#all% 2#stresse an

7an,ru$t Se(ur#t#es

Investing in financiall% distressed and $ankrupt securities re?uires patience to 9ait

for the right situation and the right securit% at the right price and discipline to adhere

to value5investing criteria< When properl% i"ple"ented8 trou$led5co"pan% investing

"a% entail less risk than traditional investing8 %et offer significantl% higher returns<

When $adl% done8 the results of investing in distressed and $ankrupt securities can

$e disastrousF ;unior securities8 for e:a"ple8 can $e co"pletel% 9iped out< The

"arket for distressed and $ankrupt securities is illi?uid8 and traders can take

advantage of unsophisticated investors< Quoted prices "a% $ear little relationship to

actual trading levels8 and an uninfor"ed $u%er can significantl% overpa%< In a "arket

9here "ost $u%ers are highl% sophisticated8 caution is the order of the da% for the

ordinar% investor<

,an% things can go 9rong 9ith $ankruptc% invest"ents< 6or one thing8 the

rate of return is highl% dependent on ti"ing< In $ankruptc% unsecured $ut Gfull%

coveredG clai"s =clai"s that 9ill receive one hundred cents on the dollar upon

reorganiDation are kno9n as full% covered> in essence $eco"e Dero5coupon $ondsF

9ith par received at the end of the reorganiDation pro5




cess8 the rate of return to $u%ers depends on the duration of the $ankruptc%< An

investor 9ho anticipates a long $ankruptc% 9ould naturall% pa% less than a "ore

opti"istic investor if he or she is to achieve the sa"e rate of return<

The risk of investing in financiall% distressed and $ankrupt securities varies9ith the specifics of each situation< At the riskiest end of the spectru" are highl%

co"petitive or fashion5oriented $usinesses dependent on a li"ited nu"$er of their

ke% personnel and o9ning fe9 tangi$le assetsF co"panies that sell custo"iDed or

user5specific productsF and financial co"panies that are particularl% dependent on

investor and custo"er confidence< :a"ples include A"es #epart"ent Stores in the

fiercel% co"petitive discount store "arket and Integrated 4esources8 a highl%

leveraged financial5services co"pan%<

At the lo95risk end of the spectru" are overleveraged capital5intensive

de$tors8 possi$l% having "onopol% or near5"onopol% positions in their industries8 and

$usinesses producing ho"ogeneous or undifferentiated products< (o95risk

$ankruptcies also do not have pu$lic5polic% legal issues to $e resolved< The secured

$onds of !u$lic Service 'o"pan% of Ne9 Ha"pshire8 an electric utilit%8 or of -ones K

(aughlin Steel8 a su$sidiar% of (T+ 'orporation8 a "a;or integrated steel producer8

are located at the lo95risk end of the spectru"<

Investors should $e 9ar% of purchasing or holding the fi:ed5inco"e securities

of rapidl% deteriorating $usinesses< It is eas% to look at the apparent asset protection

of a $ond 9hile ignoring earnings or cash flo9 pro$le"s< When a $usiness loses cash

fro" operations even $efore interest e:pense8 it 9ill often e:perience accelerating

losses8 especiall% if it is highl% leveraged< If a turnaround does not co"e ?uickl%8 it

"a% not co"e at all<

Although no investor can ignore price8 investors in distressed or $ankrupt

securities "ust "ake price a pri"ar% focus< Both casual o$servers and so"e full5ti"e

acade"ics tend to think of the financial "arkets as efficient and continuous8 9ith

prices deter"ined $% underl%ing $usiness develop"ents< B% contrast8 the "arket for

a distressed or $ankrupt $ond "a% consist of onl% a fe9 $u%ers and sellers and

so"eti"es onl% the "arket5



Investing in 2inancially Distressed and ankrupt !ecurities 211

"akers the"selves< In an illi?uid "arket the price at 9hich a securit% transaction

takes place is deter"ined not so "uch $% invest"ent funda"entals as $% the trading

savv% of the participants< In the illi?uid "arket for distressed and $ankrupt $onds8

$eing a s"art trader "a% so"eti"es $e "ore i"portant than $eing a s"art anal%st<

The F#nan(#all% 2#stresse an 7an,ru$t Se(ur#t%

Invest#n/ "ro(ess

Investors in financiall% distressed and $ankrupt securities "ust concentrate on the

corporate $alance sheet< (ike kno9ing the opposing lineups at a $ase$all ga"e8

understanding the a"ounts and priorities of a co"pan%@s lia$ilities can tell investors

a great deal not onl% a$out ho9 the various securit% holders are likel% to $e treated

$ut also ho9 the financial distress is likel% to $e resolved<

The first step is to value the assets of the de$tor< 7nce the siDe of the pie is

kno9n8 it is possi$le to consider ho9 it "a% $e divided< To facilitate this process8 an

investor "ust divide the de$tor@s assets into t9o parts& the assets of the ongoing

$usinessF and the assets availa$le for distri$ution to creditors upon reorganiDation8

such as e:cess cash8 assets held for sale8 and invest"ent securities< Investors in A,

International8 Inc<8 senior clai"s received su$stantial a"ounts of A,@s e:cess cash

upon reorganiDationF investors in Braniff Airlines@ first $ankruptc% in 1.3 received

li?uidating trust certificates $acked $% a direct interest in aircraft assets<In valuing an ongoing $usiness operating in 'hapter 118 investors should

e"plo% each of the valuation "ethodologies descri$ed in chapter .< In "an%

instances the investor is in the difficult position of anal%Ding a "oving target since

the $usiness of the de$tor is unsta$le8 if not in tur"oil< It is essential that investors

take into account an% inco"e state"ent and cash flo9 distortions caused $% the

'hapter 11 process itself< Interest




earned on e:cess cash that $uilds up during $ankruptc%8 for e:a"ple8 9ill not $e a

source of inco"e for the reorganiDed co"pan%< Si"ilarl%8 interest e:pense on

reinstated de$t8 9hich does not accrue during $ankruptc%8 9ill once again accrue<

Then8 again8 the high invest"ent $anking8 legal8 and ad"inistrative costs of a

'hapter 11 proceeding8 often cu"ulativel% totaling several percent or "ore of the

value of the de$tor@s estate8 9ill cease upon e"ergence fro" $ankruptc%< Bankrupt

co"panies "a% even intentionall% Guglif%G their financial state"ents =for e:a"ple8 $%

e:pensing rather than capitaliDing certain e:penses or $% $uilding e:cessive $alance

sheet reserves> in order to "ini"iDe the assets apparentl% availa$le for distri$ution

to creditors< This value is ulti"atel% revealed after reorganiDation8 $ut $% then

insiders have picked up cheap stock or options<

Anal%sis of the assets and lia$ilities of financiall% distressed or $ankrupt

co"panies "ust e:tend $e%ond the $alance sheet ho9ever< 7ff5$alance5sheet assets"a% include real estate carried $elo9 current value8 an overfunded pension plan8

patents o9ned8 and the like< 7ff5$alance5sheet lia$ilities "a% include underfunded

pension plans8 Internal 4evenue Service8 nviron"ental !rotection Agenc%8 !ension

Benefit uarant% 'orporation =!B'>8 and other govern"ental clai"s8 and clai"s

resulting fro" re;ected e:ecutor% contracts and leases< In recent steel industr%

$ankruptcies8 for e:a"ple8 Wheeling !itts$urgh Steel and (T+ 'orporation

transferred their underfunded pension plans to the !B'8 resulting in a $ankruptc%

clai" $% the !B' against Wheeling and protracted litigation $et9een the !B' and

(T+<

7nce a de$tor@s assets have $een valued8 investors should turn their attention

to the lia$ilit% side of the $alance sheet< The lia$ilities of a $ankrupt co"pan% are

$est evaluated in descending order of seniorit%< Secured de$t should $e evaluated

first< If the value of the securit% interest is deter"ined8 9hether through negotiation

or a valuation proceeding8 to $e e?ual to or greater than the a"ount of clai"8 the

clai" is said to $e full%




secured or oversecured< An oversecured clai" entitles the holder to postpetition

accrued interest =interest that 9ould have accrued during the $ankruptc%

proceeding> to the e:tent of the a"ount of oversecurit%< If secured de$t is

deter"ined to $e less than full% secured8 holders 9ill t%picall% receive value e?ual tothe e:tent of their securit% plus a senior $ut unsecured clai" against the de$tor for

the a"ount of the undersecurit%<

There "a% $e so"e invest"ent opportunities in distressed securities at ever%

rank in the de$t hierarch%< 4isk5averse investors 9ill generall% prefer to hold senior

securitiesF the potential return fro" senior securities is fre?uentl% less than that

availa$le fro" ;unior clai"s8 $ut the risk is also "uch lo9er< Senior securities are first

in priorit%8 and unless the% are full% or al"ost full% repaid8 ;unior classes are unlikel%

to receive significant value<

G6ulcru" securitiesGthe class of securities partl% $ut not full% covered $% asset

valuecan also $e attractive invest"ents at the right price8 ranking "id9a% on the

risk spectru"< 6ulcru" securities $enefit "ost directl% fro" value increases and

like9ise are "ost directl% i"paired $% an% value di"inution<

Investing in ;unior securities can provide spectacular returns $ut can also

prove disastrous< These securities often serve as out5of5the5"one% options

effectivel%8 $etson an i"prove"ent in operating results or an increase in value<

The co""on stock of $ankrupt co"panies fre?uentl% trades considera$l% a$ove its

reorganiDation value8 9hich is often close to Dero< While there "a% $e an occasional

ho"e run8 as a rule investors should avoid the co""on stock of $ankrupt entities at

virtuall% an% priceF the risks are great and the returns ver% uncertain<

Unsophisticated investors have lost a great deal of "one% $u%ing the overpriced

co""on stock of $ankrupt co"panies8 even after the unfavora$le ter"s of the

reorganiDation plan have $een 9idel% disse"inated<

It is 9orth re"e"$ering that restructurings and $ankruptc% reorganiDations

are negotiated processes< Negotiations can $e affected $% the relative $argaining

strengths and 9eaknesses of




the different classes of creditors8 the skills of the negotiators8 and the dollar a"ounts

at stake<

B% 9a% of e:a"ple8 4on (a$o9 headed an investor group that $ought up "ost

of Wheeling !itts$urgh Steel@s $ank de$t and dictated a reorganiDation plan that lefthi" in control of the reorganiDed co"pan%< A $locking positionone5third of the

outstanding a"ount of de$tin a s"all8 closel% held de$t issue "a% ena$le that

class to o$tain $etter treat"ent than si"ilar $ut "ore 9idel% held de$t issues< The

holder of a $locking position in even the "ost ;unior $ankrupt securit%8 $ecause of his

or her a$ilit% to dela% the de$tor@s e"ergence fro" $ankruptc%8 "a% gain far $etter

treat"ent for his or her class than allo9ed $% an% allocation "ade strictl% according

to priorit% ranking< A $locking position is said to have Ghold5upG value in t9o senses&

the o9ner can hold up =dela%> the $ankruptc% process as 9ell as hold up =ro$> other

classes of creditors8 e:tracting nuisance value fro" 9hat "ight other9ise $e a nearl%

9orthless clai"<

67B Falls 8rom Gra(e9 An O$$ortun#t% #n

F#nan(#all% 2#stresse Se(ur#t#es

The nature of opportunities that can e:ist in the "arket for distressed

securities is 9ell e:e"plified $% the fall fro" grace of Harcourt Brace -ovanovich8 Inc<

=HB->< HB- 9as once a favorite of ;unk5$ond investors and as recentl% as August 1.

had a total "arket capitaliDation of de$t and e?uit% securities of *< $illion< Its ;unk

$onds traded a$ove par value< At the ti"e HB- operated a 9ell5kno9n pu$lishing

$usiness8 an insurance co"pan%8 and the"e parksF the parks 9ere up for sale< In

Septe"$er 1. HB- announced the sale of the the"e parks to Anheuser5Busch for

1<1 $illion =1</ $illion net of ta:es>8 a disappointing nu"$er to Wall Street anal%sts

9ho had e:pected 1<) $illion< Bank de$t 9as repaid 9ith the after5ta: proceeds<

(ogicall% the total capitaliDation should have declined fro" *< $illion to 3< $illion<

Instead8 on -anuar% 318 1/8 the total



Investing in 2inancially Distressed and ankrupt !ecurities 21)

"arket capitaliDation 9as onl% 1 $illion8 a decline of "ore than t9o5thirds fro" the

i"plied capitaliDation onl% four "onths earlier< The "agnitude of this decline can $e

e:plained onl% in the conte:t of the shattering of investors@ perceptions of Harcourt

as Ggood ;unk<G 7nce it $eca"e apparent that the co"pan% 9as seriousl%overleveraged8 9idespread selling took place8 and securit% prices plunged<

!rice decline alone does not "ake a securit% a $argainF an apprecia$le

discount fro" underl%ing value is also re?uired< In the case of HB- the su$ordinated

$onds 9ere no9 an attractive $argain8 for in -anuar% 1/ the $usiness 9as al"ost

certainl% 9orth $et9een 1<* and 1< $illion and possi$l% even "ore< =This valuation

9as $orne out $% the 1<) $illion takeover offer "ade $% eneral 'ine"a 'orporation

a %ear laterF the su$ordinated $onds 9ere to receive nearl% fift% cents on the dollar<>

The face value of senior de$t 9as onl% a$out .// "illion8 leaving $et9een //

"illion and // "illion of value against )/ "illion of su$ordinated de$t< Trading

at t9ent%5five cents on the dollar8 this de$t 9as e:traordinaril% attractive even under

a pessi"istic valuation scenario and even if $usiness results 9orsened< In fact8 in

$ankruptc% the value of these su$ordinated $onds 9ould ulti"atel% have $een

enhanced $ecause interest pa%"ents to senior unsecured de$t holders 9ould $e

haltedF an% cash savings 9ould accu"ulate "ostl% to the $enefit of the su$ordinated

$onds<1

2#stresse 7ons ersus O$t#m#st#( Sto(,9

Intermar,et Arb#tra/e #n 7an, o8

Ne- En/lan Se(ur#t#es

,an% ti"es securit% prices in the stock "arket 9ill $e inconsistent 9ith those

in the $ond "arket8 as if investors in one "arket do not co""unicate 9ith those in

another< 6inancial distress created such an opportunit% in the de$t and e?uit%

securities of the Bank of Ne9 ngland 'orporation =BN>< A large loss




announced in -anuar% 1/ caused the su$ordinated $onds of BN to plunge to 1/ to

13 fro" levels in the /s< At the sa"e ti"e the co""on stock of the Bank of Ne9

ngland traded at appro:i"atel% 3<)/ per share<

7verall BN had roughl% // "illion face a"ount of senior and su$ordinatedde$entures outstanding 9ith a total "arket value of less than 1// "illion< The

co""on stock8 9hich 9as8 of course8 ;unior to the holding co"pan% $onds8 had a

total "arket capitaliDation of appro:i"atel% 2)/ "illion<

7pportunistic investors $ought the BN $onds and sold BN co""on stock

short to lock in an apparent valuation disparit%< Specificall%8 investors could purchase

the $onds at 1/ to 13 and sell short co""on stock in e?ual dollar a"ounts< A $u%er

of 1 "illion face a"ount of su$ordinated $onds at 1/ 'A =for 1/)8///> could sell

short 3/8/// shares of co""on stock at 3<)/ for e?uivalent net proceeds<

!erfor"ing these si"ultaneous transactions appeared to $e a lo95risk strateg% under

an% conceiva$le scenario<

If BN $eca"e insolvent =as happened in earl% 11>8 for e:a"ple8

$ondholders 9ould at 9orst lose their invest"ent and "ight possi$l% achieve so"e

recover%F the co""on stock 9ould certainl% $e rendered 9orthless< The loss on the

$onds 9ould at least $e offset $% the gain on the short sale of co""on stock< In

addition8 investors 9ould earn interest on the short5sale proceeds and "ight receive

one or "ore interest pa%"ents fro" BN =t9o se"iannual coupons8 as it turned out><

If BN survived8 the $onds see"ed likel% to rall% $% a greater percentage than

the co""on stock< If the co""on stock tripled to 1/<)/ a"idst a surprising

recover%8 for e:a"ple8 the $onds see"ed likel% to trade 9ell a$ove the 3/ to */ level

that $ondholders 9ould need to $reak even< Again8 investors 9ould also $enefit fro"

interest pa%"ents received on the $onds as 9ell as interest earned on the short

credit $alance<

Another possi$le scenario 9as a financial restructuring8 9here$% BN 9ould

offer $ondholders the opportunit% to convert into e?uit%< This alternative8 9hich 9as

seriousl% consid5




ered $% the $ank $ut ulti"atel% proved to $e un9orka$le8 9ould have $een highl%

favora$le for those 9ho 9ere long $onds and short stock< The $onds 9ould have

$enefitted fro" the pre"iu" a$ove "arket that the co"pan% 9ould have had to

offer to induce holders to e:change8 9hile the co""on stock 9ould likel% havedeclined due to the dilution and selling pressure resulting fro" the issuance of large

a"ounts of co""on stock to $ondholders<

Con(lus#on

Investing in $ankrupt and financiall% distressed securities is a sophisticated8 highl%

specialiDed activit%< ach situation offers its o9n anal%tical challenges8 risks8 and

opportunities< A relative handful of savv%8 hard5nosed8 and e:perienced practitioners

co"pete for the availa$le opportunities< #ue to the stig"a of $ankruptc%8 the

uncertain outco"es of financial distress8 and the anal%tical co"ple:it% involved8 onl%

a s"all nu"$er of investors 9ill $u% or even hold these securities< In fact8 invest"ent

opportunities in this area result largel% fro" the unecono"ic $ehavior of other

investors< When such an area $eco"es popular8 as it did in earl% 118 investors

"ust "ake sure to avoid overpa%ing<

!erhaps ,ichael ,ilken 9as not craD%8 "erel% greed%8 9hen he e:trapolated

the invest"ent opportunit% in financiall% distressed and $ankrupt securities to ne9l%

issued securities that he under9rote< It is certainl% ironic that "an% of %esterda%@s

;unk5$ond "anagers and anal%sts have $eco"e toda%@s financiall% distressed and

$ankrupt pla%ers<

This chapter onl% touches on so"e of the reasons 9h% financiall% distressed

and $ankrupt securities "a% $e attractive to investors< It is certainl% not a pri"er on

ho9 to successfull% invest in these securities8 and I do not e:pect readers to i""e5

diatel% $eco"e successful $ankruptc% investors< ,% "ain point





1+"ort8ol#o Mana/ement an

Tra#n/

No $ook on investing 9ould $e co"plete 9ithout a discussion of trading and portfolio

"anage"ent< Tradingthe process of $u%ing and selling securitiescan have a

significant i"pact on one@s invest"ent results< ood trading decisions can so"eti"es

add to an invest"ent@s profita$ilit% and other ti"es can "ean the difference $et9een

e:ecuting a transaction and failing to do so< !ortfolio "anage"ent enco"passes

trading activit% as 9ell as the regular revie9 of one@s holdings< In addition8 an

investor@s portfolio "anage"ent responsi$ilities include "aintaining appropriate

diversification8 "aking hedging decisions8 and "anaging portfolio cash flo9 and

li?uidit%<

All investors "ust co"e to ter"s 9ith the relentless continuit% of the

invest"ent process< Although specific invest"ents have a $eginning and an end8

portfolio "anage"ent goes on forever< Unlike "an% areas of endeavor8 there is no

near5annuit% of profita$le $usiness8 no $acklog of upco"ing invest"ent returns<

HeinD ketchup 9ill have a reasona$l% predicta$le volu"e of sales %ear in and %ear

out< In a sense8 its profits of

*1'



**; T6E A5E!INESTMENT "ROCESS

to"orro9 9ere partiall% earned %esterda% 9hen its franchise 9as esta$lished<

Investors in "arketa$le securities 9ill not have predicta$le annual results8 ho9ever8

even if the% possess shares representing fractional o9nership of the sa"e co"pan%<

,oreover8 attractive returns earned $% HeinD "a% not correlate 9ith the returns

achieved $% investors in HeinDF the price paid for the stock8 and not ;ust $usiness

results8 deter"ines their return<

The Im$ortan(e o8 #Lu##t% #n Mana/#n/ an

Investment "ort8ol#o

Since no investor is infalli$le and no invest"ent is perfect8 there is considera$le "erit

in $eing a$le to change one@s "ind< If an investor purchases a li?uid stock such as

IB, $ecause he thinks that a ne9 product 9ill $e successful or $ecause he e:pects

the ne:t ?uarter@s results to $e strong8 he can change his "ind $% selling the stock at

an% ti"e $efore the anticipated event8 pro$a$l% 9ith "inor financial conse?uences<

An investor 9ho $u%s a nontransfera$le li"ited partnership interest or stock in a non5

pu$lic co"pan%8 $% contrast8 is una$le to change his "ind at an% priceF he is

effectivel% <locked in< When investors do not de"and co"pensation for $earing

illi?uidit%8 the% al"ost al9a%s co"e to regret it<

,ost of the ti"e li?uidit% is not of great i"portance in "anaging a long5ter"5

oriented invest"ent portfolio< 6e9 investors re?uire a co"pletel% li?uid portfolio that

could $e turned rapidl% into cash< Ho9ever8 une:pected li?uidit% needs do occur<Because the opportunit% cost of illi?uidit% is high8 no invest"ent portfolio should $e

co"pletel% illi?uid either< ,ost portfolios should "aintain a $alance8 opting for

greater illi?uidit% 9hen the "arket co"pensates investors 9ell for $earing it<

A "itigating factor in the tradeoff $et9een return and li?uidit% is duration<

While %ou "ust al9a%s $e 9ell paid to sacrifice li?uidit%8 the re?uired co"pensation

depends on ho9 long %ou



Portfolio /anagement and #rading 221

9ill $e illi?uid< Ten or t9ent% %ears of illi?uidit% is far riskier than one or t9o "onthsF

in effect8 the short duration of an invest"ent itself serves as a source of li?uidit%<

Investors "aking venture5capital invest"ents8 for e:a"ple8 "ust $e e:ceptionall%

9ell co"pensated to offset the high pro$a$ilit% of loss8 the large proportion of theinvest"ent that is at risk =losses are often co"plete 9ipeouts>8 and the illi?uidit%

e:perienced for the duration of the invest"ent< The cost of illi?uidit% is ver% high in

such situations8 rendering venture capitalists virtuall% una$le to change their "inds

and "aking it difficult for the" to cash in even 9hen the $usinesses the% invested in

are successful<

(i?uidit% can $e illusor%< As (ouis (o9enstein has stated8 GIn the stock "arket8

there is li?uidit% for the individual $ut not for the 9hole co""unit%< The distri$uta$le

profits of a co"pan% are the onl% re9ards for the co""unit%<G1 In other 9ords8 9hile

an% one investor can achieve li?uidit% $% selling to another investor8 all investors

taken together can onl% $e "ade li?uid $% generall% unpredicta$le e:ternal events

such as takeover $ids and corporate5share repurchases< :cept for such

e:traordinar% transactions8 there "ust $e a $u%er for ever% seller of a securit%<

In ti"es of general "arket sta$ilit% the li?uidit% of a securit% or class of

securities can appear high< In truth li?uidit% is closel% correlated 9ith invest"ent

fashion< #uring a "arket panic the li?uidit% that see"ed "iles 9ide in the course of

an ups9ing "a% turn out onl% to have $een inches deep< So"e securities that traded

in high volu"e 9hen the% 9ere in favor "a% hardl% trade at all 9hen the% go out of

vogue<

When %our portfolio is co"pletel% in cash8 there is no risk of loss< There is

also8 ho9ever8 no possi$ilit% of earning a high return< The tension $et9een earning a

high return8 on the one hand8 and avoiding risk8 on the other8 can run high< The

appropriate $alance $et9een illi?uidit% and li?uidit%8 $et9een seeking return and

li"iting risk8 is never eas% to deter"ine<

Investing is in so"e 9a%s an endless process of "anaging li?uidit%< T%picall%

an investor $egins 9ith li?uidit%8 that is8 9ith cash that he or she is looking to put to

9ork< This initial li?uidit% is converted into less li?uid invest"ents in order to




earn an incre"ental return< As invest"ents co"e to fruition8 li?uidit% is restored<

Then the process $egins ane9<

This portfolio li?uidit% c%cle serves t9o i"portant purposes< 6irst8 as discussed in

chapter .8 portfolio cash flo9the cash flo9ing into a portfoliocan reduce aninvestor@s opportunit% costs< Second8 the periodic li?uidation of parts of a portfolio

has a cathartic effect< 6or the "an% investors 9ho prefer to re"ain full% invested at

all ti"es8 it is eas% to $eco"e co"placent8 sinking or s9i""ing 9ith current

holdings< G#ead 9oodG can accu"ulate and $e neglected 9hile losses $uild< B%

contrast8 9hen the securities in a portfolio fre?uentl% turn into cash8 the investor is

constantl% challenged to put that cash to 9ork8 seeking out the $est values availa$le<

Reu(#n/ "ort8ol#o R#s,

The challenge of successfull% "anaging an invest"ent portfolio goes $e%ond "aking

a series of good individual invest"ent decisions< !ortfolio "anage"ent re?uires

pa%ing attention to the portfolio as a 9hole8 taking into account diversification8

possi$le hedging strategies8 and the "anage"ent of portfolio cash flo9< In effect8

9hile individual invest"ent decisions should take risk into account8 portfolio

"anage"ent is a further "eans of risk reduction for investors<

Appropriate #iversification

ven relativel% safe invest"ents entail so"e pro$a$ilit%8 ho9ever s"all8 of do9nside

risk< The deleterious effects of such i"pro$a$le events can $est $e "itigated through

prudent diversification< The nu"$er of securities that should $e o9ned to reduce

portfolio risk to an accepta$le level is not greatF as fe9 as ten to fifteen different

holdings usuall% suffice<

#iversification for its o9n sake is not sensi$le< This is the inde: fund

"entalit%& if %ou can@t $eat the "arket8 $e the "arket< Advocates of e:tre"e

diversification9hich I think of as






gold futures< A portfolio of i"port5 or e:port5sensitive stocks could $e partiall%

hedged through appropriate transactions in the foreign e:change "arkets<

It is not al9a%s s"art to hedge< When the availa$le return is sufficient8 for

e:a"ple8 investors should $e 9illing to incur risk and re"ain unhedged< Hedges can$e e:pensive to $u% and ti"e5consu"ing to "aintain8 and overpa%ing for a hedge is

as poor an idea as overpa%ing for an invest"ent< When the cost is reasona$le8

ho9ever8 a hedging strateg% "a% allo9 investors to take advantage of an

opportunit% that other9ise 9ould $e e:cessivel% risk%< In the $est of all 9orlds8 an

invest"ent that has valua$le hedging properties "a% also $e an attractive

invest"ent on its o9n "erits<

B% 9a% of e:a"ple8 fro" "id51.. to earl% 1/ the -apanese stock "arket

rose repeatedl% to record high levels< The "arket@s valuation appeared e:cessive $%

U<S< valuation criteria8 $ut in -apan the vie9 that the stock "arket 9as indirectl%

controlled $% the govern"ent and 9ould not necessaril% $e constrained $%

underl%ing funda"entals 9as 9idel% held< -apanese financial institutions8 9hich had

$eco"e accusto"ed to receiving large and gro9ing annual inflo9s of funds for

invest"ent8 9ere so confident that the "arket 9ould continue to rise that the% 9ere

9illing to sell -apanese stock "arket puts =options to sell> at ver% lo9 prices< To the"

sale of the puts generated i""ediate inco"eF since in their vie9 the "arket 9as

al"ost certainl% headed higher8 the puts the% sold 9ould e:pire 9orthless< If the

"arket should te"poraril% dip8 the% 9ere confident that the shares $eing put $ack to

the" 9ould easil% $e paid for out of the "assive cash inflo9s the% had co"e to

e:pect<

Wall Street $rokerage fir"s acted as inter"ediaries8 originating these put

options in -apan and selling the" in private transactions to U<S< investors<2 These

ine:pensive puts 9ere in theor% an attractive8 if i"precise8 hedge for an% stock

portfolio< Since the -apanese stock "arket 9as considera$l% overvalued co"pared

9ith the U<S< "arket8 investors in U<S< e?uities could hedge the risk of a decline in

their do"estic holdings through the purchase of -apanese stock "arket puts< These

puts 9ere












tage of "arket dips to increase one@s holdings8 a user of this techni?ue acts as if the

"arket kno9s the "erits of a particular invest"ent $etter than he or she does<

(i?uidit% considerations are also i"portant in the decision to sell< 6or "an%

securities the depth of the "arket as 9ell as the ?uoted price is an i"portantconsideration< 0ou cannot sell8 after all8 in the a$sence of a 9illing $u%erF the likel%

presence of a $u%er "ust therefore $e a factor in the decision to sell< As the

president of a s"all fir" specialiDing in trading illi?uid over5the5counter =pink5sheet>

stocks once told "e& G0ou have to feed the $irdies 9hen the% are hungr%<G

If selling still see"s difficult for investors 9ho follo9 a value5invest"ent

philosoph%8 I offer the follo9ing rhetorical ?uestions& If %ou haven@t $ought $ased

upon underl%ing value8 ho9 do %ou decide 9hen to sellE If %ou are speculating in

securities trading a$ove underl%ing value8 9hen do %ou take a profit or cut %our

lossesE #o %ou have an% guide other than Gho9 the% are acting8G 9hich is reall% no

guide at allE

5se a 7ro,er to Whom You Are Im$ortant

Whether $u%ing or selling8 there are distinct advantages to finding and doing

$usiness 9ith long5ter"5oriented stock$rokers 9ho recogniDe that it is in their

interest to $uild and "aintain "utuall% $eneficial relationships 9ith clients< If

custo"ers feel that their $est interests are $eing served and that $rokerage

co""issions are a secondar% consideration8 long5ter" relationships are likel% to

ensue< B% contrast8 $rokers 9ho charge e:or$itant co""issions or routinel%

reco""end trades designed "ore to generate co""issions than invest"ent profits

9ill eventuall% lose custo"ers< The challenge is to find one or "ore $rokers 9ith

9ho" %ou feel co"forta$le<

An appropriate $roker 9ill possess a $alance of e:perience and desire8 a

co""it"ent to the invest"ent $usiness8 and a 9illingness to sacrifice i""ediate

co""issions for the sake of




long5ter" relationships< 0ou 9ant a $roker 9ith sufficient clout 9ithin his or her fir"

to provide %ou 9ith access to anal%sts and traders8 one 9ith e:perience to handle

%our account properl% and to kno9 9hen to call %ou and 9hen not to 9aste %our

ti"e< 0ou don@t 9ant a totall% ine:perienced $roker 9ho is learning at %our e:pense8

a co"placent $roker satisfied 9ith "ediocre results8 or one so successful that %our

account is relativel% uni"portant< ,ichael !rice and Bill 4uane 9ould have no

pro$le" capturing the undivided attention of an% $rokerF the% 9ould $e ver%

i"portant clients for an%one< 7ther investors "ust 9ork harder to find one or "ore

$rokers to 9ho" the% 9ill $e i"portant clients< 7ne possi$ilit% is to develop a

relationship 9ith a fairl% %oung $ut capa$le $roker to 9ho" %our account is currentl%

ver% i"portant and one 9ho 9ill gain i"portance and clout 9ithin the fir" over ti"e<

Con(lus#on This chapter has identified a nu"$er of issues that investors should consider in

"anaging their portfolios< While individual personalities and goals can influence one@s

trading and portfolio "anage"ent techni?ues to so"e degree8 sound $u%ing and

selling strategies8 appropriate diversification8 and prudent hedging are of i"portance

to all investors< 7f course8 good portfolio "anage"ent and trading are of no use

9hen pursuing an inappropriate invest"ent philosoph%F the% are of "a:i"u" value

9hen e"plo%ed in con;unction 9ith a value5invest"ent approach<

Notes

1< (ouis (o9enstein8 ,hat$s ,rong with ,all !treet =4eading8 ,ass<& Addison5

Wesle%8 1..>8 p< *3<




2< At ti"es Wall Street also acted as principal in the sale of -apanese stock "arket

put options8 rel%ing on option5pricing "odels to esta$lish correct values for the puts

the% 9rote and on Gd%na"ic hedging strategiesG to protect the" fro" loss< #%na"ic

hedging operates ver% "uch like portfolio insurance8 re?uiring the sale of increasing?uantities of futures contracts as "arket prices decline<

3< Ta: considerations "a% $e an additional factor in the decision to sell<



1)Investment Alternat#ves

8or the In#v#ual InvestorIf this $ook 9ere a fair% tale8 perhaps it 9ould have a happier ending< The

unfortunate fact is that the individual investor has fe98 if an%8 attractive invest"ent

alternatives< Investing8 it should $e clear $% no98 is a full5ti"e ;o$< iven the vast

a"ount of infor"ation availa$le for revie9 and anal%sis and the co"ple:it% of the

invest"ent task8 a part5ti"e or sporadic effort $% an individual investor has little

chance of achieving long5ter" success< It is not necessar%8 or even desira$le8 to $e a

professional investor8 $ut a significant8 ongoing co""it"ent of ti"e is a prere?uisite<

Individuals 9ho cannot devote su$stantial ti"e to their o9n invest"ent activities

have three alternatives& "utual funds8 discretionar% stock$rokers8 or "one%

"anagers<

232







Investment Alternatives for the Individual Investor 23)

the validit% of their invest"ent approaches =do the% "ake senseE> and their integrit%

=do the% do 9hat is pro"ised8 and is it in %our $est interestE><

Ho9 do %ou $egin to evaluate stock$rokers and "one% "anagersE There are

several i"portant areas of in?uir%8 and one or "ore personal intervie9s area$solutel% essential< There is no $etter place to $egin one@s investigation than 9ith

personal ethics< #o the% Geat ho"e cookingG"anaging their o9n "one% in parallel

9ith their clients@E I can think of no "ore i"portant test of the integrit% of a "anager

and the likelihood of invest"ent success than his or her o9n confidence in the

approach pursued on $ehalf of clients< It is interesting to note that fe98 if an%8 ;unk5

$ond "anagers invested their o9n "one% in ;unk $onds< In other 9ords8 the% ate out<

Another area of in?uir% concerns the fair treat"ent of clients< Are all clients

treated e?uall%E If not8 9h% not8 and in 9hat 9a%sE Are transactions perfor"ed for all

clients conte"poraneousl%E If not8 9hat "ethod is used to ensure fairnessE

A third area of interest concerns the likelihood of achieving good invest"ent

results< Specificall%8 does the $roker or "one% "anager oversee a reasona$l% siDed

portfolio8 or have the assets under "anage"ent gro9n e:ceedingl% largeE 7ne 9a%

to ;udge is to e:a"ine the "anager@s track record since the assets under his or her

control reached appro:i"atel% the current level< Investors can also e:a"ine the

records of other "anagers to deter"ine in general ho9 increased siDe affects

perfor"ance< In "% e:perience8 large increases in assets under "anage"ent

adversel% affect returns< The precise a"ount that can $e "anaged successfull%

depends on the specific invest"ent strateg% e"plo%ed as 9ell as the skills of the

"anager under consideration<

A fourth area of in?uir% concerns the invest"ent philosoph% of the "anager<

#oes the $roker or "one% "anager have an intelligent strateg% that is likel% to result

in long5ter" invest"ent successE =7$viousl% in "% vie98 a value5invest"ent strateg%

9ould $e opti"al<> #oes he or she 9orr% a$out a$solute




returns8 a$out 9hat can go 9rong8 or is he or she caught up in the relative5

perfor"ance ga"eE Are ar$itrar% constraints and sill% rules8 such as re"aining full%

invested at all ti"es8 a$sentE

Evaluat#n/ Investment Results

The decision to e"plo% an invest"ent professional should onl% $e "ade after a

thorough anal%sis of the past invest"ent perfor"ance of the individual or

organiDation under consideration< So"e ?uestions are o$vious& Ho9 long a track

record is thereE Was it achieved over one or "ore "arket and econo"ic c%clesE Was

it achieved $% the sa"e person 9ho 9ill "anage %our "one%8 and does it represent

the co"plete results of this "anager@s entire invest"ent career or onl% the results

achieved during so"e favora$le periodE =ver%one8 of course8 9ill $e a$le to e:tract

so"e period of good perfor"ance even fro" a length% record of "ediocrit%<> #id this

"anager invest conservativel% in do9n "arkets8 or did clients lose "one%E Were the

results fairl% stead% over ti"e8 or 9ere the% volatileE Was the record the result of one

or t9o spectacular successes or of nu"erous "oderate 9innersE If this "anager@s

record turns "ediocre after one or t9o spectacular successes are e:cluded8 is there a

sound reason to e:pect "ore ho"e runs in the futureE Is this "anager still follo9ing

the sa"e strateg% that 9as e"plo%ed to achievehis or her past successesE

7$viousl% a "anager 9ho has achieved dis"al long5ter" results is not

so"eone to hire to "anage %our "one%< Nevertheless8 %ou 9ould not necessaril%

hire the $est5perfor"ing "anager for a recent period either< 4eturns "ust al9a%s $e

e:a"ined in the conte:t of risk< 'onsider asking 9hether the "anager 9as full%

invested at all ti"es or even "ore than 1// percent invested through the use of

$orro9ed "one%< =(everage is neither necessar% nor appropriate for "ost investors<>



Investment Alternatives for the Individual Investor 23

'ontrari9ise8 if the "anager achieved good results despite having held su$stantial

a"ounts of cash and cash e?uivalents8 this could indicate a lo95risk approach< Were

the invest"ents in the underl%ing portfolio the"selves particularl% risk%8 such as the

shares of highl% leveraged co"paniesE 'onversel%8 did the "anager reduce portfoliorisk through diversification or hedging or $% investing in senior securitiesE

When %ou get right do9n to it8 it is si"ple to co"pare "anagers $% their

invest"ent returns< As discussed in chapter 8 it is far "ore difficulti"possi$le

e:cept in retrospectto evaluate the risks that "anagers incurred to achieve their

results<

Invest"ent returns for a $rief period are8 of course8 affected $% luck< The la9s

of pro$a$ilit% tell us that al"ost an%one can achieve pheno"enal success over an%

given "easure"ent period< It is the task of those evaluating a "one% "anager to

ascertain ho9 "uch of their past success is due to luck and ho9 "uch to skill<

,an% investors "istakenl% choose their "one% "anagers the sa"e 9a% the%

pick horses at the race track< The% see 9ho has perfor"ed 9ell latel% and $et on

the"< It is helpful to recogniDe that there are c%cles of invest"ent fashionF different

invest"ent approaches go into and out of favor8 coincident 9ith recent fluctuations in

the results o$tained $% practitioners< If a "anager 9ith a good long5ter" record has

a poor recent one8 he or she "a% $e specialiDing in an area that is te"poraril% out of

favor< If so8 the returns achieved could regress to their long5ter" "ean as the c%cle

turns over ti"eF several poor %ears could certainl% $e follo9ed $% several strong

ones<

6inall%8 one of the "ost i"portant "atters for an investor to consider is

personal co"pati$ilit% 9ith a "anager< If personal rapport 9ith a financial

professional is lacking8 the relationship 9ill not last< Si"ilarl%8 if there is not a level of

co"fort 9ith the particular invest"ent approach8 the choice of "anager is a poor

one< A conservative investor "a% not feel co"forta$le 9ith a professional short5seller

no "atter ho9 favora$le the resultsF $% contrast8 an aggressive investor "a% not $e

co"pati$le 9ith a "anager 9ho $u%s securities and holds the"<



*+: T6E A5E!INESTMENT "ROCESS

7nce a "one% "anager has $een hired8 clients "ust "onitor his or her

$ehavior and results on an ongoing $asis< The issues that 9ere addressed in hiring a

"anager are the sa"e ones to consider after %ou have hired one<

Con(lus#on

7nce %ou choose to venture $e%ond U<S< Treasur% $ills8 9hatever %ou do 9ith %our

"one% carries so"e risk< #on@t think %ou can avoid "aking a choiceF inertia is also a

decision< It took a long ti"e to accu"ulate 9hatever 9ealth %ou haveF %our financial

9ell5$eing is definitel% not so"ething to trifle 9ith< 6or this reason8 I reco""end that

%ou adopt a value5invest"ent philosoph% and either find an invest"ent professional

9ith a record of value5invest"ent success or co""it the re?uisite ti"e and attention

to investing on %our o9n<

Notes

1. Close!en 8uns shoul never be $ur(hase on the #n#t#al $ubl#( o88er#n/

@as #s(usse #n (ha$ter +. 6o-ever> there ma% be an o$$ortun#t% to #nvest #n

(lose!en mutual 8uns at an a$$re(#able #s(ount to net asset value a8ter the%

have been #ssue an trae 8or a -h#le. I8 the 8un mana/er #s (a$able an the 8ee

stru(ture #s 8a#r> a (lose!en 8un sell#n/ at least 1; $er(ent belo- unerl%#n/ net

asset value ma% be attra(t#ve.



Glossar%Absolute!$er8orman(e or#entat#onthe tenen(% to evaluate #nvestment results b%

measur#n/ one<s #nvestment $er8orman(e a/a#nst an absolute stanar su(h as the

r#s,!8ree rate o8 return

Annu#t%a stream o8 (ash #n $er$etu#t%

Arb#tra/ethe $ra(t#(e o8 #nvest#n/ #n r#s,!8ree transa(t#ons to ta,e avanta/e o8

$r#(#n/ #s(re$an(#es bet-een mar,ets @see r#s, arb#tra/e

Arb#tra/eur#nvestor #n r#s,!arb#tra/e transa(t#ons

As,e $r#(e @o88erthe $r#(e at -h#(h a se(ur#t% #s o88ere 8or sale @see b# $r#(e

Assetsometh#n/ o-ne b% a bus#ness or #n#v#ual

Avera/e o-nto bu% more o8 a se(ur#t% 8or less than one<s earl#er $ur(hase

$r#(e@s> result#n/ #n a reu(t#on o8 the avera/e (ost

7alan(e sheeta((ount#n/ statement o8 a (om$an%<s assets> l#ab#l#t#es> an net

-orth7an,ru$t(%a le/al state -here#n a ebtor @borro-er #s tem$orar#l% $rote(te

8rom (re#tors @leners uner Cha$ter 11 o8 the 8eeral ban,ru$t(% (oe>

(om$an#es ma% (ont#nue to o$erate @see Cha$ter 11> 7ear mar,etan env#ronment

(hara(ter#?e b% /enerall% e(l#n#n/ share $r#(es @see bull mar,et

7etaa stat#st#(al measure use b% some a(aem#(s an mar,et $ro8ess#onals to

Luant#8% #nvestment r#s, b% (om$ar#n/ a se(ur#t%<s or

*+'



2*/ GOSSARY

$ort8ol#o<s h#stor#(al $r#(e $er8orman(e -#th that o8 the mar,et as a -hole

7# $r#(ethe $r#(e a $otent#al bu%er #s -#ll#n/ to $a% 8or a se(ur#t% @see as,e

$r#(e

7lo(,#n/ $os#t#onthe o-nersh#$ o8 a su88#(#ent $er(enta/e o8 a (lass o8 se(ur#t#es

to $revent unes#rable a(t#ons 8rom o((urr#n/ @a (re#tor o-n#n/ one!th#r or more

o8 a (lass o8 ban,ru$t ebt se(ur#t#es #s able to Dblo(,D a$$roval o8 a $lan o8

reor/an#?at#on not to h#s or her l#,#n/

7ona se(ur#t% re$resent#n/ a loan to a bus#ness or /overnment ent#t%

7oo, valuethe h#stor#(al a((ount#n/ o8 shareholers< eLu#t% th#s #s> #n e88e(t> the

res#ual a8ter l#ab#l#t#es are subtra(te 8rom assets

7ottom!u$ #nvest#n/strate/% #nvolv#n/ the #ent#8#(at#on o8 s$e(#8#( unervalue

#nvestment o$$ortun#t#es one at a t#me throu/h 8unamental anal%s#s

7rea,u$ valuethe e0$e(te $ro(ees #8 the assets o8 a (om$an% -ere sol to the

h#/hest b#er> -hether as a /o#n/ (on(ern or not @see l#Lu#at#on value

7ull mar,etan env#ronment (hara(ter#?e b% /enerall% r#s#n/ share $r#(es @see

bear mar,et

Callable bona bon that ma% be ret#re b% the #ssuer at a s$e(#8#e $r#(e $r#or to

#ts (ontra(tual matur#t% @see $uttable bon

Call o$t#ona (ontra(t enabl#n/ the o-ner to $ur(hase a se(ur#t% at a 8#0e $r#(e on

a $art#(ular ate @see $ut o$t#on

Cash 8lo-the (ash /a#n or loss e0$er#en(e b% a bus#ness ur#n/ a $art#(ular

$er#o o8 o$erat#ons

Cash!$a% se(ur#t#esse(ur#t#es reLu#re to ma,e #nterest or #v#en $a%ments #n

(ash @see non!(ash!$a% se(ur#t#esCatal%stan #nternall% or e0ternall% #nst#/ate (or$orate event that results #n

se(ur#t% holers real#?#n/ some or all o8 a (om$an%<s unerl%#n/ value

Cha$ter 11a se(t#on o8 the 8eeral ban,ru$t(% (oe -hereb% a ebtor #s

reor/an#?e as a /o#n/ (on(ern rather than l#Lu#ate @see ban,ru$t(%

Close!en mutual 8unmutual 8un hav#n/ a 8#0e number o8 outstan#n/ shares

that trae base on su$$l% an eman at $r#(es not ne(essar#l% eLual to

unerl%#n/ net asset value @see o$en!en mutual 8un

Collateral#?e bon obl#/at#on @C7O#vers#8#e #nvestment $ools o8 un,

bons that #ssue the#r o-n se(ur#t#es> usuall% #n several



Glossary 2*1

tranches8 each of 9hich has risk and return characteristics that differ fro" those of

the underl%ing ;unk $onds the"selves

'o""ercial papershort5ter" loans fro" institutional investors to $usinesses

'o""issiona charge for transacting in securities'o"ple: securitiessecurities 9ith unusual cash flo9 characteristics

'ontingent5value rightstrada$le rights that are redee"a$le for cash if a stock fails

to reach specified price levels

'onverti$le ar$itragear$itrage transactions designed to take advantage of price

discrepancies $et9een converti$le securities and the securities into 9hich the% are

converti$le

'onverti$le $onds$onds that can $e e:changed for co""on stock or other assets

of a co"pan% at a specified price

'ouponthe specified interest pa%"ent on a $ond e:pressed as a percentage

'overed5call 9ritingthe practice of purchasing co""on stocks and then selling call

options against the"

'ra"5do9n securit%securit% distri$uted in a "erger transaction8 not sold $% an

under9riter

'redit c%clethe e$$ and flo9 in the availa$ilit% of credit

#e$tor5in5possession financingloan to a $ankrupt co"pan% operating in 'hapter 11

#e$t5to5e?uit% ratiothe ratio of a co"pan%@s outstanding de$t to the $ook value of

its e?uit%F a "easure of a co"pan%@s financial leverage

#efaultthe status of a co"pan% that fails to "ake an interest or principal pa%"ent

on a de$t securit% on the re?uired date

#efault rate of ;unk $ondscalculated $% "an% ;unk5$ond5"arket participants as the

dollar volu"e of ;unk5$ond defaults occurring in a particular %ear divided $% the total

volu"e of ;unk $onds outstanding

#epreciationan accounting procedure $% 9hich long5lived assets are capitaliDed

and then e:pensed over ti"e

#iscount ratethe rate of interest that 9ould "ake an investor indifferent $et9een

present and future dollars

#iversificationo9nership of "an% rather than a s"all nu"$er of securitiesF the goal

of diversification is to li"it the risk of co"pan%5specific events on one@s portfolio as a

9hole

#ividendcash distri$uted $% a co"pan% to its shareholders out of after5ta:

earnings



2*2 GOSSARY

Earn#n/s be8ore #nterest> ta0es> e$re(#at#on> an amort#?at#on @E7IT2Aa

nonsens#(al number thou/ht b% some #nvestors to re$resent the (ash 8lo- o8 a

bus#ness

Earn#n/s $er sharea (om$an%<s a8ter!ta0 earn#n/s #v#e b% the total number o8

shares outstan#n/

E88#(#ent!mar,et h%$othes#ss$e(ulat#ve not#on that all #n8ormat#on about se(ur#t#es

#s #ssem#nate an be(omes 8ull% re8le(te #n se(ur#t% $r#(es #nstantaneousl%

Em$lo%ee Ret#rement In(ome Se(ur#t% A(t o8 1'&) @ERISAle/#slat#on that reLu#res

#nst#tut#onal #nvestors to a(t as 8#u(#ar#es 8or 8uture ret#rees b% ao$t#n/ the

D$ruent!man stanarD @see $ruent!man stanar

ELu#t% DstubsDlo-!$r#(e> h#/hl% levera/e sto(,s> o8ten result#n/ 8rom a

(or$orate re(a$#tal#?at#on @see re(a$#tal#?at#on

E0(han/e o88eran o88er mae b% a (om$an% to #ts se(ur#t% holers to e0(han/e

ne-> less!onerous se(ur#t#es 8or those outstan#n/

DFallen an/elsDbons o8 (om$an#es that have eter#orate beneath #nvestment

/rae #n (re#t Lual#t%

F#nan(#al #stressthe (on#t#on o8 a bus#ness e0$er#en(#n/ a short8all o8 (ash to

meet o$erat#n/ nees an s(heule ebt!serv#(e reLu#rements

Fr#enl% ta,eover(or$orate a(Lu#s#t#on #n -h#(h the bu%er an seller both su$$ort

the transa(t#on enthus#ast#(all%

Ful(rum se(ur#t#esthe (lass o8 se(ur#t#es -hose str#(t $r#or#t% ban,ru$t(% (la#m #s

most #mme#atel% a88e(te b% (han/es #n the ebtor<s value

Full $os#t#ono-nersh#$ o8 as mu(h o8 a /#ven se(ur#t% as an #nvestor #s -#ll#n/ to

holFunamental anal%s#sanal%?#n/ se(ur#t#es base on the o$erat#n/ $er8orman(e

@8unamentals o8 the unerl%#n/ bus#ness

G#nn#e Mae @GNMA$ool o8 mort/a/es #nsure b% the Government Nat#onal

Mort/a/e Asso(#at#on> a 5.S. /overnment a/en(%

Go#n/ lon/bu%#n/ a se(ur#t% @see short!sell#n/ Goo-#ll amort#?at#onthe

/raual e0$ens#n/ o8 the #ntan/#ble asset ,no-n as /oo-#ll> -h#(h (omes #nto

e0#sten(e -hen a (om$an% #s $ur(hase 8or more than #ts tan/#ble boo, value



Glossary 2*3

Guarantee!#nvestment (ontra(t @GICan #nsuran(e!(om$an%!s$onsore

#nvestment $rou(t that automat#(all% re#nvests #nterest at a (ontra(tual rate

6e/ean #nvestment that> b% a$$re(#at#n/ @e$re(#at#n/ #nversel% to another> has

the e88e(t o8 (ush#on#n/ $r#(e (han/es #n the latter

6ol#n/ (om$an%a (or$orate stru(ture #n -h#(h one (om$an% @the hol#n/

(om$an% #s the o-ner o8 another

6ol!u$ valuebene8#ts a((ru#n/ to $art#(#$ants #n a (lass o8 se(ur#t#es -ho are able

to e0tra(t (ons#erable nu#san(e value 8rom the holers o8 other (lasses o8

se(ur#t#es

Ill#Lu# se(ur#t%a se(ur#t% that traes #n8reLuentl%> usuall% -#th a lar/e s$rea

bet-een the b# an as,e $r#(es @see l#Lu# se(ur#t%

In(ome statementa((ount#n/ statement (al(ulat#n/ a (om$an%<s $ro8#t or loss

Ine0#n/the $ra(t#(e o8 bu%#n/ all the (om$onents o8 a mar,et #ne0> su(h as the

Stanar an "oor<s =;; #ne0> #n $ro$ort#on to the -e#/ht#n/s o8 that #ne0 an

then $ass#vel% hol#n/ them

In#t#al $ubl#( o88er#n/ @I"Ouner-r#t#n/ o8 a sto(, be#n/ o88ere to the $ubl#( 8or

the 8#rst t#me

Ins#e #n8ormat#on#n8ormat#on unava#lable to the $ubl#(> u$on -h#(h #t #s #lle/al to

base transa(t#ons

Inst#tut#onal #nvestorsmone% mana/ers> $ens#on 8un mana/ers> an mana/ers o8

mutual 8uns

Intan/#ble assetan asset -#thout $h%s#(al $resen(e e0am$les #n(lue #ntelle(tual

$ro$ert% r#/hts @$atents or /o#n/!(on(ern value @/oo-#ll

Interest$a%ment 8or the use o8 borro-e mone%Interest!(overa/e rat#othe rat#o o8 $reta0 earn#n/s to #nterest e0$ense

Interest!onl% mort/a/e se(ur#t% @IO#nterest $a%ments str#$$e 8rom a $ool o8

mort/a/es -h#(h> 8or a /#ven (han/e #n #nterest rates> 8lu(tuates #n value #nversel%

to (onvent#onal mort/a/es @see $r#n(#$al!onl% mort/a/e se(ur#t%

Interest rate reseta $rom#se mae b% an #ssuer to aust the (ou$on on a bon at

a s$e(#8#e 8uture ate #n orer to (ause #t to trae at a $reeterm#ne $r#(e

Internal rate o8 return @IRR(al(ulat#on o8 the rate o8 return o8 an



2** GOSSARY

invest"ent that assu"es reinvest"ent of cash flo9s at the sa"e rate of return theinvest"ent itself offersInvest"entan asset purchased to provide a returnF invest"ents8 in contrast tospeculations8 eventuall% generate cash flo9 for the $enefit of the o9ners =seespeculation>Invest"ent $ankingprofession involving raising capital for co"panies as 9ell asunder9riting and trading securities8 arranging for the purchase and sale of entireco"panies8 providing financial advice8 and opining on the fairness of specifictransactionsInvest"ent gradefi:ed inco"e securit% rated BBB or higher

-unk $ondfi:ed5inco"e securit% rated $elo9 invest"ent grade

(everaged $u%out =(B7>ac?uisition of a $usiness $% an investor group rel%ingheavil% on de$t financing(ia$ilit%a de$t or other o$ligation to pa%(i?uidating distri$utioncash or securities distri$uted to shareholders $% a co"pan%in the process of li?uidation(i?uidating trustan entit% esta$lished to co"plete a corporate li?uidation(i?uidation valuethe e:pected proceeds if the assets of a co"pan% 9ere sold off8$ut not as part of an ongoing enterprise(i?uidit%having a"ple cash on hand(i?uid securit%a securit% that trades fre?uentl% and 9ithin a narro9 spread$et9een the $id and asked prices,aking a "arketacting as a securities dealer $% si"ultaneousl% $idding for andoffering a securit%,argin of safet%investing at considera$le discounts fro" underl%ing value8 anindividual provides hi"self or herself roo" for i"precision8 $ad luck8 or anal%ticalerror =i<e<8 a G"argin of safet%G> 9hile avoiding siDa$le losses,arket pricethe price of the "ost recent transaction in a co"pan%@s pu$licl% tradedstock or $onds,aturit%the date on 9hich the face value of a de$t securit% is due and pa%a$le

,erchant $ankingan activit% 9here$% Wall Street fir"s co""it their o9n

capital 9hile acting as principal in invest"ent5$anking transactions



Glossary 2*)

,ergera co"$ination of t9o corporations into one

,utual funda pooled invest"ent portfolio "anaged $% professional investors

Net asset value =NA+>the per share value of a "utual fund calculated $% dividing

the total "arket value of assets $% the nu"$er of shares outstandingNet5net 9orking capitalnet 9orking capital less all long5ter" lia$ilities

Net operating5loss carr%for9ard =N7(>the carr%for9ard of past losses for ta:

purposes8 ena$ling a co"pan% to shield future inco"e fro" ta:ation

Net present value =N!+>calculation of the value of an invest"ent $% discounting

future esti"ates of cash flo9 $ack to the present

Non5cash5pa% securitiessecurities per"itted to pa% interest or dividends in kind or

at a later date rather than in cash as due =see cash5pa% securities8 pa%5in5kind8 and

Dero5coupon $ond>

Nonrecoursethe lender looks onl% to the $orro9ing entit% for pa%"ent

7pen5end "utual fund"utual fund offering to issue or redee" shares at a price

e?ual to underl%ing net asset value

7pportunit% costthe loss represented $% forgone opportunities

7ptionthe right to $u% =call> or sell =put> specified ite"s at specified prices $%

specified dates

7ver5the5counter =7T'>the "arket for stocks not listed on a securities e:change

=e<g<8 Ne9 0ork8 A"erican8 !hiladelphia8 Boston8 !acific8 Toronto>

!arthe face a"ount of a $ondF the contractual a"ount of the $ondholder@s clai"

!a%5in5kind =!IC>a securit% pa%ing interest or dividends in kind rather than in cash

!lan of reorganiDationthe ter"s under 9hich a co"pan% e:pects to e"erge fro"

'hapter 11 $ankruptc%

!ortfolio cash flo9the cash flo9ing into a portfolio net of outflo9s

!ortfolio insurancea strateg% involving the periodic sale of stock5inde:

futures designed to eli"inate do9nside risk in a portfolio at a "inor up5front cost



2* GOSSARY

!ostpsetition interestinterest accruing fro" the date of a $ankruptc% filing for9ard

!referred stockan e?uit% securit% senior in priorit% to co""on stock 9ith a

specified entitle"ent to dividend pa%"ents

!repackaged $ankruptc%a techni?ue 9here$% each class of creditors in a$ankruptc% agree on a plan of reorganiDation prior to the $ankruptc% filing

!repetition interestinterest accruing fro" the "ost recent coupon pa%"ent up to

the date of a $ankruptc% filing

!riceJearnings =!J> ratio"arket price of a stock divided $% the annualiDed earnings

per share

!rice5to5$ook5value ratio"arket price of a stock divided $% $ook value per share

!rincipalthe face a"ount or par value of a de$t securit%

!rincipal5onl% "ortgage securit% =!7>principal pa%"ents stripped fro" a pool of

"ortgages 9hich8 in response to changes in interest rates8 fluctuate in value in the

sa"e direction as conventional "ortgages $ut 9ith greater volatilit%

!rivate5"arket valuethe price that a sophisticated $usinessperson 9ould $e likel%

to pa% for a $usiness $ased on the valuation "ultiples paid on si"ilar transactions

!ro for"a financial infor"ationearnings and $ook value ad;usted to reflect a recent

or proposed "erger8 recapitaliDation8 tender offer8 or other e:traordinar% transaction

!ro:% contesta fight for corporate control through the solicitation of pro:ies or the

election of directors

!rudent5"an standardthe o$ligation under 4ISA to restrict one@s invest"ents to

those a GprudentG =conservative> person 9ould "ake =see "plo%ee 4etire"ent

Inco"e Securit% Act of 1* =4ISA>

!ut optiona contract ena$ling the purchaser to sell a securit% at a fi:ed price on a

particular date

!utta$le $ond$ond 9ith e"$edded put features allo9ing holders to sell the $onds

$ack to the issuer at a specified price and ti"e =see calla$le $ond>

4ecapitaliDationfinancial restructuring of a co"pan% 9here$% the co"pan% $orro9s

against its assets and distri$utes the proceeds to shareholders

4elative5perfor"ance orientationthe tendenc% to evaluate invest5



Glossary 2*

ment results b% (om$ar#n/ one<s #nvestment $er8orman(e -#th that o8 the mar,et as

a -hole

Return$otent#al /a#n

R#/hts o88er#n/a 8#nan(#n/ te(hn#Lue -hereb% a (om$an% #ssues to #ts

shareholers the $reem$t#ve r#/ht to $ur(hase ne- sto(, @or bons #n the (om$an%

or o((as#onall% #n a subs##ar% (om$an%

R#s,amount an $robab#l#t% o8 $otent#al loss

R#s, arb#tra/ea s$e(#al#?e area #nvolv#n/ #nvestment #n 8ar!8rom!r#s,!8ree

ta,eovers as -ell as s$#no88s> l#Lu#at#ons> an other e0traor#nar% (or$orate

transa(t#ons

Se(ure ebtebt ba(,e b% a se(ur#t% #nterest #n s$e(#8#( assets

Se(ur#t%a mar,etable $#e(e o8 $a$er re$resent#n/ the 8ra(t#onal o-nersh#$ o8 a

bus#ness or loan to a bus#ness or /overnment ent#t%

Sel8!teneran o88er b% a (om$an% to re$ur(hase #ts o-n se(ur#t#es

Sen#or!ebt se(ur#t%se(ur#t% -#th the h#/hest $r#or#t% #n the h#erar(h% o8 a

(om$an%<s (a$#tal stru(ture

Sens#t#v#t% anal%s#sa metho o8 as(erta#n#n/ the sens#t#v#t% o8 bus#ness value to

small (han/es #n the assum$t#ons mae b% #nvestors

Share bu%ba(,s(or$orate sto(, re$ur(hases <

Shareholer<s @o-ner<s eLu#t%the res#ual a8ter l#ab#l#t#es are subtra(te 8rom

assets

Short!sell#n/the sale o8 a borro-e se(ur#t% @see /o#n/ lon/

Short!term relat#ve!$er8orman(e erb%man#8estat#on o8 the tenen(% b%

#nst#tut#onal #nvestors to measure #nvestment results> not a/a#nst an absolutestanar> but a/a#nst broa sto(, mar,et #n#(es result#n/ #n an o8ten s$e(ulat#ve

or#entat#on

S#n,#n/ 8unobl#/at#on o8 a (om$an% to $er#o#(all% ret#re $art o8 a bon #ssue

$r#or to matur#t%

S$e(ulat#onan asset hav#n/ no unerl%#n/ e(onom#(s an thro-#n/ o88 no (ash

8lo- to the bene8#t o8 #ts o-ner @see #nvestment

S$#no88the #str#but#on o8 the shares o8 a subs##ar% (om$an% to the shareholers

o8 the $arent (om$an%

Sto(,a mar,etable $#e(e o8 $a$er re$resent#n/ the 8ra(t#onal o-nersh#$ o8 an

unerl%#n/ bus#ness

Sto(, #ne0 8utures(ontra(ts 8or the 8uture el#ver% o8 a mar,et bas,et o8 sto(,s

Sto(, mar,et $ro0%est#mate o8 the $r#(e at -h#(h a (om$an%> or #ts





Glossary 2*+olu"ethe nu"$er of shares tradedWindo9 dressingthe practice of "aking a portfolio look good for ?uarterl% reportingpurposesWorking capitalcurrent assets "inus current lia$ilities Writing call optionssellingcall options on securities o9ned

0ieldreturn calculated over a specific periodero5coupon $onda $ond that accrues interest until "aturit% rather than

pa%ing it in cash





*=1Ine0Absolute "er8orman(e> ))>1;:!11;

A. 6. Robb#ns> 1';

Alchemy of 2inance" #he @Soros> 1+3

All#ant Te(hs%stems> 1)*

Altman> E> 3;

AM Internat#onal> In(.> *;1

Amort#?at#on9 /oo-#ll> &+>1)*

Arb#tra/e9 value> 1;1!1;*. !ee also r#s,9 arb#tra/e transa(t#ons

Assets9 (onvers#ons> 1=*!1=+ h#en> bus#ness valuat#on> '1 tan/#ble> '+> 1+) ut#l#t%> '=

valuat#on> 1))

Au(t#on!$re8erre sto(,> *' Avera/#n/ o-n> *1&

7an, Amer#(a Cor$orat#on> 13' 7an, o8 Ne- En/lan> +*> *;=!*;& 7an,ru$t(%9 e0(han/e

o88ers> 1'+!') 8ull% (overe (la#ms> 1'' #m$l#(at#ons o8 8#l#n/> 1'=!'& #nvestment attra(t#ons>

1'&!': me#a #ma/e> 1'1 net o$erat#n/ loss (arr%!8or-ars> 1'3 o$$ortun#t% 8or #nvestors>

13+ reor/an#?at#on an> 1'&> *;* stav#n/ o88> 1'+ three sta/es o8 #nvest#n/> 1':!''

7an,ru$t se(ur#t#es9 asset (onvers#ons as> 1=*!1=+ #nvest#n/ #n> 1:'!*;: r#s,> 1''!*;1. See

also F#nan(#all% #stresse se(ur#t#es.

7ar/a#ns9 value #nvest#n/> :&!::

7arron<s> )'>=+

7e(or Wester> In(. 1&+!&=

7ehav#or o8 #nvestors> 0v##

7!E 6ol#n/s> In(. 1&+

7er,sh#re 6atha-a%> In(.> 0#v> =3> 1;*

7lo(,buster Enterta#nment Cor$orat#on> =*

7ons> 2ut(h au(t#on bons> *' 8allen an/el bons> 1)>=&!=: 8#ve!%ear 1; $er(ent bons>

113nl> 8#0e!rate bons> *' 8loat#n/!rate bons> *' l#Lu##t%> =& lo-!rate bons> %#el on>

=& no 8#rst (ou$on bons> =' $a%!#n!,#n bons> *' $a%!#n!sto(, bons> *' sto(,s>

(om$ar#son> :1 valuat#on> 1*& ?ero!(ou$on bons> *'> 3&!3:. See also Bun, bons 5. S.

Treasur% bons

7oo, value9 bus#ness valuat#on> 1))!)=

2)1



*=* MARGIN OF SAFETY

7ottom!u$ #nvest#n/> 1;=!1;: 7ran#88> In(.> ='>*;1 7ro,ers> *1'!**;

7u88et> Warren9 #ne0#n/> =1 un, bons> =3> 3: mar/#n o8 sa8et% (on(e$t> '*!'+ rules o8

#nvest#n/> :1 sto(, $ur(hase $r#(e> 1*) value #nvest#n/> 0#v> ::> 1;1> 1;* ?ero!(ou$on

8#nan(#n/> 3: 7ull#sh b#as o8 Wall Street> *=!*: 7url#n/ton Northern> In(.> 1:; 7url#n/ton

Resour(es> In(.> 1:; 7us#ness valuat#on9 boo, value> 1))!)= (ash 8lo- 8ore(ast#n/> 1**!*=

(ho#(e o8 methos> 1+= (onvent#onal %arst#(,s> 1)+!)= (urrent assets> 1)) ebt matur#t%>

1+3 #s(ount rate (ho#(e> 1*=!*: #v#en %#el> 1)= earn#n/s an earn#n/s /ro-th> 1)+

E(so Ele(tron#(s Cor$orat#on> 1+&!)*> 1)3n' /enerall% a((e$te a((ount#n/ $r#n(#$les> 1)+

h#en assets> '1 #nternal rate o8 return (al(ulat#ons> 11:!1'> l#Lu#at#on value> 1**> 1+1!++>

1+=> 1)1 methos> 1*1!**> 1+= net -or,#n/ (a$#tal> 1+* nonre(ourse ebt> 1+; $r#vate!

mar,et value> 1*:!+1> 1)1 ran/e o8 value> 11'!*1 re8le0#v#t%> 1+3!+& sto(, mar,et value>

1**> 1++!+= 1)1!)* var#ab#l#t% o8> ';!'* -r#teo88s> 1))

Ca$#tal e0$en#tures> &) Ca$#tal /a#ns an losses> &3>11&nl DCa$t#al Mar,et M%o$#a>D 3 Cash

8lo-9 a((ount#n/ Lu#r,s> 1)&nl; bus#nesses> 11'!*; (ontrast bet-een sto(,s an bons>

:= earn#n/s be8ore #nterest> ta0es> e$re(#at#on> an amort#?at#on> &* #nst#tut#onal

#nvest#n/> )= net $resent value an 8ore(ast#n/> 1**!*= $ort8ol#o> 11= s$e(ulat#on an> )

Catal%sts9 value real#?at#on> 13+!3) Cha$ter 11. See 7an,ru$t(%

DC#r(u#t brea,ers>D *& C#t#(or$> 1+3

C#t% Investment #Lu#at#n/ Trust> 13=!3:

Clevelan!Cl#88s> 1'3

Close!en mutual 8uns> **!*)> +)nl> 1+)>1&&>**+>**:nl

Co(a!Cola> 1*>++>1*+

Collateral#?e un, bon obl#/at#ons> &3

Colle(t#bles9 #nvestment #n> :!'

Comm#ss#ons> *;!*1

Com$aL Com$uter Cor$orat#on> '3

Com$le0 se(ur#t#es> 1=*>13:!&;

Com$uter!s(reen#n/9 #nvestment resear(h an> 1=*

Consol#ate O#l an Gas> In(.> 1&1!&*

Cont#nental A#rl#nes> +*>1'3 Contrar#an th#n,#n/> 1==!=3 Cre#t> 3=!3&>'; Cunn#88> R#(har> 0v##>

1;* C%(les o8 #nvestment 8ash#on> 1&=!&&

2e(l#n#n/ mar,et> '3!'& 2e8ault!rate (al(ulat#on> =:!3; 2e8lat#on9 bus#ness valuat#on> ';!'*

2e$re(#at#on9 (ash 8lo-> &* 2#s(ount> '*>11)>1*=!*:>1)3n*>13+ 2#stresse se(ur#t#es. See

F#nan(#all%

#stresse se(ur#t#es 2#vers#8#(at#on> *1*!1+>**& 2#v#ens> 1*&!*:>1)= 2o> 2av#> 0#v>

''>1*; 2o- Chem#(al Com$an%> 1&; 2o- Bones Inustr#al Avera/e> *&>

+'

2re0el 7urnham ambert> 3*> 3' 2re0el F#restone> =& 2r "e$$er> 3+>'+!') 2ut(h au(t#on

bons> *'

Earn#n/s be8ore #nterest> ta0es> e$re(#at#on> an amort#?at#on> &1!&3> &:n3

E88#(#ent mar,et h%$othes#s> '&!1;* Emerson Ele(tr#( Com$an%> 1+&!)*> 1)3n'





2)* MARGIN OF SAFETY

un, bons> )= levera/e bu%outs> )= l#m#tat#ons> )+!)3 mana/ement 8ees> +& mone%

mana/ement> +&!+: mutual 8un or/an#?at#ons> **+ narro- (ate/or#?at#on> )= $ort8ol#o s#?e>

#m$l#(at#ons o8> )*!)+ ret#rement 8uns> += short!term> relat#ve $er8orman(e erb%> +:!+'

s$#no88s> 1&' ta(t#(al asset allo(at#on> ):!=; value #nvest#n/> :: -#no- ress#n/> )=!)3

Insuran(e (om$an#es> 33!3&Interest onl% mort/a/e se(ur#t#es> +;!+*

Interest rates> 3:!&;> 113!11&nl> 1*&> 13&!3:

Internal rate o8 return (al(ulat#ons> 11:!1'

Internal Revenue Coe> 1==

Internal Revenue Serv#(e> *;*

InterTAN> In(.> 1&'!:;

Investment resear(h9 1=1!31 amount o8 resear(h> 1=3!=: #ns#e #n8ormat#on> 1='!3; #ns#er

bu%#n/> 1=:!='

Investment su((ess> '!1+ la(, o8> 1+!1)

Investors9 behav#or> 0v##> emot#onal 8a(tors o8 #nvest#n/> '!1;> 1+!1)> 1: /ree> 1+!13

#nvestment 8ormulas> sear(h> 1+!13 s$e(ulat#on> +!1: stumbl#n/ blo(,s o8> +!&: su((ess> '!1+ Wall Street an> 1'!+) D%#el $#/s>D 1)!13

Bama#(a Sav#n/s 7an,s> 1:3!:: Banne% Mont/omer% S(ott> In(.> *3 Ba$anese sto(, mar,et> *1)!

1=>**1n* B#m Walter Cor$orat#on> 3' Bohns Manv#lle> 1'; Bones au/hl#n Steel> 1='> *;; Bun,

bons9 anal%t#(al errors o8 #nvestors> &;!&1 ba(,/roun> 0#v!0v## bu%ers o8 3)!3& (a$#tal

losses> &3 (olla$se o8 mar,et> && (ollateral#?e obl#/at#ons> &3 e8ault!rate (al(ulat#on>

8la-s o8>

=:!3;> &:n* earn#n/s be8ore #nterest> ta0es> e$re(#at#on an amort#?at#on> &1!&3

e0$e(tat#ons> earl% su((ess an> 31!3) 8#nan(#all% #stresse (om$an#es> 1:'!'; /ree an>

1)>1=> && DGresham<s a- o8 Bun, 7ons>D 3) /ro-th o8 mar,et> 3;!3* /uarantee

#nvestment (ontra(ts> 33 h#/h!%#el bon mutual 8uns> 3)!3= h#stor% o8 mar,et> =3!=: #nsol!

vent ban,s as $ur(hasers> 33 #nst#tut#onal #nvest#n/> )= #nsuran(e (om$an#es as $ur(hasers>33!3& #nterest rate resets> 3:!&; #nvestment stanars> rela0at#on o8> 3&!&) less evelo$e

(ountr% borro-ers> =' m#s(on(e$t#ons> ==!&: $a%!#n!,#n se(ur#t#es> 3&!3: $r#vate!mar,et

value> 1+; ta,eovers 8#nan(e b%> *) thr#8ts> $ur(hases b%> 3=!33 Ton,a (or$orat#on> 1*1

value #nvest#n/> 1;;> D%#el $#/s>D &3 ?ero!(ou$on bons> *'>3&!3:

Kohlber/> Krav#s an Roberts> 3'> 13&

abo-> Ron> *;)

#ab#l#t#es9 h#en> '1

#Lu#at#on> 1**> 1+1!++> 1+=> 1)1>

13)!3:>1&* #Lu##t%> =&> *1;!1*>*1' oss avo#an(e> :1!:= o-enste#n> ou#s>

11>=1>=3>3;>*11 T (or$orat#on> *;*

Mana/ement sto(, o$t#ons> 1=:!=' Mar/#n o8 sa8et%> #m$ortan(e o8> :&!1;)Mar#on aborator#es> In(.> 1&; Mar#on Merrell 2o-> In(.> 1&; Mathemat#(s9 loss avo#an(e an>

:+>:= Ma00am> In(. 3' Mer(hant ban,#n/> 1'!*1



Index 2))

M#l,en> M#(hael> =3!=:>31> *;&

M#ssour#!Kansas!Te0as Ra#lroa Com$an%> 13'

Mone% mana/ement> +&!+:> **)!*3

Mort/a/e loans> 1:+

Mort/a/e Realt% an Trust> 1+3Mort/a/es> +;!+*

Mr. Mar,et> '!1+>1:>11)!1=

Mutual 8uns9 (lose!en 8uns> **!*)> +)nl> 1+)> **+> **:nl h#/h!%#el bon mutual 8uns>

3)!3= #n#v#ual #nvestors> **+!*) o$en!en 8uns> **+ o$t#on!#n(ome> 1=!13

Mutual Ser#es Funs> In(.> 1;* 1': **)

Mutual Shares Cor$orat#on> 00

Nab#s(o> 3'!&;>1=3 NA. See Net asset value Net asset value> 3!&> *+!*)>**+ Net!net -or,#n/

(a$#tal> 1+*!++>1&' Net o$erat#n/ loss (arr%8or-ars> 1'3

Net $resent value> 1*1> 1*=!*:> 1+=>

1+'>1)1 Net -or,#n/ (a$#tal> 1+* -ew 7ork #imes" #he" 1=* No 8#rst (ou$on bons> ='

Nonre(ourse ebt> 1+; N". See Net $resent valueO#l $r#(es> *+

O$en!en mutual 8uns> **+ O$$ortun#t#es 8or #nvestors9 13*!:1 ban,ru$t(%> 13+ (om$le0

se(ur#t#es> 13:!&; (%(les> 1&=!&& l#Lu#at#ons> 13)!3:> 1&* reor/an#?at#ons> 13+ 1&* r#/hts

o88er#n/s> 1&;!&* r#s, arb#tra/e> 1&*!&& s$#no88s> 13&> 1&*> 1&&!:1 thr#8t (onvers#ons> 1:*!::

O$t#on!#n(ome mutual 8uns> 1=!13

"a(e Inustr#es> In(.> 13&!3: "an#(> :'>*13>*1&

"aul> 2av# .> : "a%!#n!,#n bons> *' "a%!#n!,#n se(ur#t#es9 un, bons> 3&!3:

"a%!#n!sto(, bons> *' "enn?o#l> '=

"ens#on 7ene8#t Guarant% Cor$orat#on> *;* "ens#on 8uns9 over8une> '1 "E rat#o. See "r#(e!

to!earn#n/s rat#o "ort8ol#o #nsuran(e> )3!): "ort8ol#o mana/ement9 avera/#n/ o-n> *1&

bro,ers> *1'!*; #vers#8#(at#on> *1*!1+ he/#n/> *1+!1= l#Lu##t% an> *1;!*1* $an#(> *13r#s, reu(t#on> *1*!1= sta%#n/ #n tou(h -#th mar,et> *13!1& tra#n/ an> *;'!**1 "ort8ol#o

s#?e> )*!)+ "re$a%ments9 mort/a/es> +; "resent!value anal%s#s. See Net $resent value

D"reteners>D value #nvest#n/> 1;*!1;+

"r#(e> M#(hael> 00 1;*>1':

"r#(es9 avera/#n/ o-n> *1& #sasters an> 1* o#l $r#(es> *+ sto(, m#s$r#(#n/> '' su$$l% an

eman an> 1* value #nvest#n/> 11+!1=. See also Flu(tuat#ons #n $r#(e o8 sto(, an se(ur#t#es

"r#n(ev#lle 2evelo$ment Cor$orat#on> 1&*

"r#n(#$al onl% mort/a/e se(ur#t#es> +;!+*

"r#soner<s 2#lemma> 1') "r#vate!mar,et value9 1*:!+1> 1)1

thr#8t (onvers#ons> 1:= "ro/ram tra#n/> +)n) "ubl#( Serv#(e Com$an% o8 Ne-

6am$sh#re> ')!'=> *;;Real estate9 valuat#on> 1)) Re(a$#tal#?at#ons9 asset (onvers#ons>

as> 1=*!=+ Re8le0#v#t%9 bus#ness valuat#on> 1+3!

1+&



2) MARGIN OF SAFETY

Relat#ve!$er8oman(e> +:!+'> 1;:!1;'> **+

Rena#ssan(e Investment Mana/ement> In(.> )'

Reor/an#?at#ons> 13+>1&*>1'&>*;*

Ret#rement 8uns> +=>'1

Return!r#s, relat#onsh#$> 11;!11>**3Rheem> 13&!3:

R#/hts o88er#n/s> 1&;!&*

R#s,9 avers#t%> #m$l#(at#ons o8> 00 arb#tra/e transa(t#ons> 1=*> 1=)> 1&*!&& avo#an(e

strate/%> :1!:*> :)> :&!:: ban,ru$t se(ur#t#es> 1''!*;1 7eta an> 11*!1+ 8#nan(#all%

#stresse se(ur#t#es> 1''!*;1 nature o8> 111!1* $ort8ol#o mana/ement> reu(t#on o8 r#s,>

*1*!1= $otent#al> 8o(us on #nstea> := 5. S. Government se(ur#t#es> r#s,!8ree #nvestment> 1=

value #nvest#n/> :&!:: volat#l#t% an> 11; See also Return!r#s, relat#onsh#$

RBR Nab#s(o> In(. 3'!&;

Ro88man> Marv#n> *3

Rosenste#n!Roan> "aul> );

Ruane> W#ll#am> 0v##> 1;*Salomon 7rothers> :

S(hae8er alue Trust> In(. 1+)

SEC. See Se(ur#t#es an E0(han/e Comm#ss#on

Se(ur#t#es9 (om$le0 se(ur#t#es> 1=* 8ul(rum se(ur#t#es> *;+ h%br# mort/a/e se(ur#t#es> +;

#nnovat#ons #n mar,et> +;!+* #nterest onl% mort/a/e se(ur#t#es> +;!+* un#or se(ur#t#es> *;+

$a%!#n!,#n se(ur#t#es> 3&!3: $r#n(#$al onl% mort/a/e se(ur#t#es> +;!+* $ur(hase o8> *1&

resale o8> *1 sale o8> *1:!1' **1n* sen#or se(ur#t#es> **&. See also 7an,ru$t se(ur#t#es

Flu(tuat#ons #n $r#(e o8 sto(, an se(ur#t#es 5. S. /overnment se(ur#t#es

Se(ur#t#es an E0(han/e Comm#ss#on> )*>1=+>1==

Se(ur#t% Anal%s#s @Graham an

2o> 0#v> 1*; Sen#or se(ur#t#es> **& SeLuo#a Fun> In(.> 0v##> 1;*> **) Short!sell#n/> +)n+Short!term #nvestors> +:!+'>:+ Soros> Geor/e> 1+3 S$a#n Fun> In(.> 3!& S$e(ulat#on> +!1:

S$#no88s9 Es(o Ele(tron#(s Cor$orat#on> 1+&!)* #nst#tut#onal sell#n/> ': o$$ortun#t#es 8or

#nvestors> 13&>1&*>1&&!:1

Stanar "oor<s 1;; Ine0> 1;;

Stanar "oor<s =;; Ine0> +'> =;> =*>=+> *1+

Stanars o8 #nvestment> rela0at#on o8> 3&!&)Sto(,9 au(t#on!rate $re8erre sto(,> *'> bons> (om$ar#son> :1 (ash 8lo-> := #re(t sto(,o-nersh#$> **+ /ro-th mult#$le> ': lar/e!(a$#tal#?at#on sto(,> 1;; m#s$r#(!#n/> '' mutual!to!sto(, (onver s#ons> 1:) o$t#m#st#( sto(, vs. #stresse bons> *;=!*;& $a%!#n!sto(, bons>*' value #nvest#n/> '&!':Sto(,bro,ers9 *= evaluat#on o8> **)!*3Sto(, mar,et9 bus#ness valuat#on> 1**> 1++!+=> 1)1!)* #ne88#(#en(#es> 1=+!== Ba$anese sto(,mar,et> *1)!1=> **1n*Sto(, mar,et (rash9 1'*'> +3 1':&> 0v###> 1&>*&>):>'=Sto$!loss orers> *1:DSu$er#nvestors o8 Graham!an!2osv#lle> TheD @7u88ett> 1;1Su$$l% an eman9 $r#(es an> 1*Ta(t#(al asset allo(at#on> ):!=;Ta,eovers> *)>1*'!1+;>1&+>1&&Tan% Cor$orat#on> 1&'!:;

Ta0at#on9 ban,ru$t(%> 1'3 earn#n/s be8ore #nterest> ta0es> e$re(#at#on anamort#?at#on> &)!&= sale o8 se(ur#t#es> **1n* sto(, mar,et



Index 2)

#ne88#(#en(#es an> 1== -r#teo88s> 1))

T!b#lls. See 5. S. Treasur% b#lls Tele8onos e Me0#(o> S. A.> '& Te0a(o> In(.> '=>1'; Thr#8t

(onvers#ons> 3=!33>1:*!:: Ton,a Cor$orat#on> 1*1 To$!o-n #nvest#n/> 1;3!1;: Tra#n/9

avera/#n/ o-n> *1&> bro,ers> *1'!*; #m$ortan(e o8> *1=!13 $ort8ol#o mana/ement an> *;'!

**1 sell#n/> *1:!1'> **1n* Trens. See Fas

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Margin of Safety Seth Klarman

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