Stocks and Bonds
Posted in Finance on December 2nd, 2008 by Sacha PeterI’ve gotten a few inquires whether I still think “now is a good time to buy”. I said earlier in an October 20 post “the worst is over”, but let me put some colour on this.
A friend of mine asked me “So what do you think about purchasing Nortel and Goldman Sachs? Buffett’s invested in Goldman, and Nortel is trading at {then, 58, now 75 pennies} a share, so cheap!”. As soon as I heard the word Nortel, I realized that this friend was a true Canadian – there are very few people I know that invested in stocks back in 2000 that weren’t in Nortel. The answer is still the same – “I don’t know much about Nortel or Goldman”.
What I do know about Goldman is that Buffett got a special deal and was able to hedge a lot of risk through warrants and also is getting a considerably higher yield than a common shareholder could receive otherwise. You can, however, receive an approximate 11.5% yield by investing in Goldman junior debt at this time and be further up the chain than Buffett.
What I know about Nortel is that their cumulative preferred shares are trading less than the common shares, which is a huge sign that you will never see a return on your investment in Nortel (note you have to account for the fact that the preferred shares’ par values are $25). If you must to buy into Nortel shares, I’d invest in the preferred shares instead of the common stock. But both are horrible choices.
Nortel debt, however, is trading at about 30 cents on the dollar. Their 2016 issue (with a coupon of 10.75%!) is at 27 cents on the dollar. It doesn’t take much math to figure out, not if, but when the market thinks Nortel is going bankrupt. At least with the bonds, you would be able to clip a few coupons of cash before you got some sort of equity settlement. The common shareholders and the preferred shareholders would lose everything.
Still, if you invested in the debt, you would end up with something at the end of the day (assuming the reformed company didn’t go bankrupt after like Air Canada!).
The rules of investing in companies in major economic downturns are the following:
1. Avoid common stock in companies that have meaningful amounts of debt, “meaningful” taking into account quantity and maturity of debt, measured against the industry and cash flow. For example, utility companies should be measured differently than pharmaceutical firms. Conversely, companies that are cash-rich are golden in such times – they saved the “acorns” for this day.
Leverage only works when things are going up and has the opposite effect when things are going down.
2. If exploring companies that have higher debt levels, consider investing in the debt rather than the equity.
3. In all cases, you should be able to answer “yes” to the question “Will people/businesses continue using this product/service the company is selling three years from now, and if these people/businesses were facing financial difficulties?”.
There is a lot of exchange traded debt out there which fits these rules. One security I mentioned earlier was senior debt in Sprint Capital (the US phone company). It’s senior debt is trading at about 50 cents on the dollar in the bond market, but the exchange traded security is trading at about 32 cents on the dollar.
Another security I have been watching but not taken any position on it is in Limited Brands, the retailing company (yes, the female apparel company that most notably owns Victoria’s Secret). The equity fails the debt test I outlined above, but their debt itself is interesting – their senior debt (6.95%, due 2033) trades at 36 cents on the dollar, while their exchange traded debt is at 39 cents on the dollar. (If you do the math and get a 39 cent price, that works out to a 17.8% current yield). One would think that even if the company went belly-up that you’d receive equity in a firm that’s worth more than $1.1 billion (that’s 2.9B total debt times 39 cents).
The reason for these disparities is liquidity concerns – the exchange traded debt is a lot less liquid than the equivalent debt.
I find it hard to understand those exchange traded debt charts – how do you know when the debt matures, or what the value at maturation will be?
The one huge disadvantage is that you REALLY have to do your research on these things since they’re all different – the key variables being the maturity date, the coupon, and how far up or down the precedence list the security is if the company goes into default. Of course there’s the usual concern of whether the company is fit to pay back the debt or not.
The variables to evaluating whether the company can service the debt is generally the same as equity, with the notable exception that you care much more about cash flow than net income, and you also don’t care about earnings per share – absolute amount of cash flow is more important.
Bond holders also cheer if the company raises capital through equity financing, and love it when they issue options in replacement of cash compensation.