Tag Archives: Banks

Hybrid bonds and contingent convertibles

November 13, 2009 By in Convertibles, hybrid bonds/contingent convertibles, Investment firms, Preferred Stock, Vocabulary Tags: , , , , , Leave a comment

Investment banking “practical jokes”

Every upcycle, clever investment bankers devise exotic securities that they sell to gullible portfolio managers, who come to regret their purchase decision almost immediately.  They continue to rue their bull-market impulsiveness for the many months it takes them to find (if they can) some even more gullible person to sell them to.

One of my favorite issues of this type was a wildly oversubscribed issue made by Hong Kong property company New World Development in 1993, at the height of an emerging markets mania.  It was a zero-coupon bond, convertible into shares of a China subsidiary of New World that did not yet exist, except as a name on a certificate of incorporation.

The hybrid bond

This time around, a leading candidate for purchase blunder of the cycle is the hybrid bond, a type of security issued notably by financial institutions.

What made these securities hybrid?  They had terms of 40-60 years, or sometimes were perpetual, that is, principal was never returned–just like stocks.  Also, the interest payment could be reduced or eliminated without causing a default.

What made them bonds?  A good question. That’s what they were called on the front page of the prospectuses.  This naming made them eligible to be purchased by bond fund managers.  The inducement to purchase was a relatively high yield.  The instruments ranked below all other bonds, just above equities, in the pecking order in case of bankruptcy.

If bonds were food, I think the Food and Drug Administration would have been alerted to hybrids, just like it was when Aunt Jemima was selling “blueberry waffles” that had no blueberries in them.  In fact, some tax authorities or industry regulators do classify the hybrids as equity. But a couple of years ago, this was regarded as another beauty of the hybrids, because having regulators count them as equity bolstered the issuers’ capital ratios.

Fast-forward to the present

Lloyds Banking Group  of the UK has a bunch of these hybrids on its balance sheet.  It wants to swap them for a new type of securities, which it is calling contingent convertible bonds.

The idea is that under normal circumstances the securities will be bonds, paying interest and having a bond’s liquidation preference over equity.  But if Lloyds gets into trouble (again), the securities would convert automatically into equity, losing their bankruptcy advantage and presumably their income payment as well.  The trigger for conversion would be Lloyds’ tier 1 capital ratio falling below 5%.

Yes, this is kind of like having medical insurance that terminates if you get sick.  No, it’s not a joke.  On second thought, though, this could be a little more investment banking humor. Sometimes, it’s hard to tell.

I can’t imagine contingent convertibles finding any takers in an original issue, other than at the tippy-top of the business cycle.  But Lloyds and the EU are playing hardball with the conversion offer.   Unswapped hybrids are set to cease making interest payments after the swap period ends.

The offer situation isn’t as bad as it looks at first blush, however–it’s worse. Not taking it may be very difficult to do.  Depending on their current carrying value in portfolios, post-exchange, post-interest-elimination hybrids may have to be considered as further impaired and written down.   Also, it seems to me that any remaining hybrids have got to be much less liquid than they are now.  So they may be impossible to dispose of, thereby having to remain on the lists of holdings sent to clients for some time to come.

Moral to the story?

I’m not sure there is one.  If we consider hybrids and contingent converts as two parts to one story, the combo probably rockets to the top of my list of bull market follies.  My only other thought is that this is Liar’s Poker all over again.

An update from Nov. 22nd

Here’s the link.

Book Value (l)–general

November 6, 2009 By in Basic Concepts, book value, growth vs value Tags: , , , , , 3 Comments

I was reading an article a few days ago which asserted that emerging markets equities were overvalued because they were trading at an average of 2.3x book value vs. an average of 1.8x book for stocks in developed markets.

What does this mean?  Is the argument a reasonable one?

I’m going to cover this topic in two posts.  This one will outline what book value is and the sorts of circumstances where I think it’s useful.  In the second post, I’ll talk about situations where book value is more problematic as a value indicator.

What “book value” is

“Book value” is the value of the shareholders’ investment in a company as shown on the company’s official records, or “books”.

For reporting the condition of their client companies to stockholders,  accountants produce three basic records:

the balance sheet,

the income statement and

the cash flow statement.

Book value comes from the balance sheet.

The balance sheet has two sides.  The entries on each side add up to the same number,  or “balance” with each other. One side lists everything the company owns, from cash, to inventory and receivables, to plant and equipment.  The other has liabilities–loans, preferred stock, credit extended by suppliers and anything else the company owes to others–plus common shareholders’ equity.  Book value is what’s left after subtracting liabilities from assets. It’s another name for shareholders’ equity.

Why it’s useful

Book value is a very basic and traditional measure of value.  It functions in several ways:

1.  liquidation value.  If we assume that the accounting statements are accurate, book value per share is the amount that stockholders would receive if the company’s assets were sold in an orderly way, liability holders paid back, and the remainder distributed to owners.  A company whose stock trades at a steep discount to book value is, at least in theory, under threat of being taken over and liquidated, if its results can’t be improved by the new owners.

2.  a shorthand way of assessing management’s capabilities. In combination with profit data, we can use book value  to calculate ratios like return on capital (annual profit/debt + book value) or return on equity (annual profit/book value).  Years and years of all the data needed for these calculations are available in databases, so companies can be screened and compared very easily.  Comparison can either be across a universe of stocks or for a single company over different periods of time.

If we assume that the specific assets a company owns don’t carry with them a unique advantage over competitors, then variations in return on capital across an industry are most likely due to differences in management quality.  If the analysis is confined to a single industry, the highest results can at least show what returns can be achieved by strong management–and therefore what improvements are possible among laggards.

3.  a guide to stock market valuation. Another way of looking at book value is that it’s what it would cost to reconstitute a given company by buying similar assets and taking on similar liabilities.  By this measure, a stock trading at a discount to book value should be cheap.  Conversely, a stock trading at a premium to book should be expensive.  One of the rules Benjamin Graham, the father of value investing in the US, used to use was that a stock was potentially attractive if it traded at below 2/3 of book value.

A corollary of #1 and #2 is that a company whose stock is trading at, say, 2x book because returns are very high is likely creating an artificially high pricing umbrella which will draw competitors to the industry, eventually undercutting the “expensive” firm’s profits.

Screening

Because you’re only looking a one simple variable, it’s possible to screen large numbers of companies in an instant, as well as to compare firms in different industries with one another.

Advocates would also argue (this is not a majority view, however) that there’s no chance of being seduced into buying overvalued stocks by smooth-talking managements with fancy powerpoint presentations.  You’re dealing with hard, cold facts–the numbers.

What you need to believe

The basic assumptions you make when using book value as a tool are:

1.  when a company buys long-lived assets like property, plant and equipment, or makes a long-term investment in another company, it basically gets its money’s worth–in other words, the purchase price recorded is a fair assessment of value,

2.  while there may be differences in the bells and whistles decorating a given factory or the manufacturing equipment located inside, these assets are functionally equivalent to superficially different assets competitors may hold–so a comparison of carrying values is legitimate,

3.  these assets have enduring value that, if it changes, does so only slowly–so carrying value doesn’t lose its relevance as time passes,

4.  the auditors are doing their job of ensuring that the company writes down the carrying value of worn-out or obsolete assets,

5.  something can and will happen with a company trading at a deep discount to book to force the stock price up so that the discount disappears- in other words, action will be taken by shareholders, the board of directors or outside activist investors, to achieve this result.

Under these assumptions, then, when you locate a company whose stock is trading at a big discount to book, you’re looking at a deeply undervalued–and very attractive–security.

One other thing.  The industry itself must be viable–no buggy whips or whale oil processing.  In today’s world, many book value-guided value investors avoid airlines for this reason.

The basic metaphor

The basic metaphor is a manufacturing one.  A company has valuable tools that it employs workers and managers to utilize.   Assets are seen as commodity-like.

Firms are seen as achieving a competitive advantage by having been able to obtain enough capital to buy its productive assets in appropriate size the first place, and by achieving economies of scale by operating them efficiently and reinvesting profits in their expansion.

Where it works

Since the idea behind using book value as an investment tool is industrial, it makes sense that it should generally work best for companies that produce goods, not services.

The concept is useful in evaluating a very wide range of companies, from general industrials to oil refiners or cement makers or shipyards (or ship owners), or office buildings–to name a few.  Anything with physical assets.

It applies especially well, I think, to manufacturers of semiconductors, computer components and other IT hardware.  How so?  The industry is very capital intensive.  The companies in question are all relatively young.  Their plant and equipment has been purchased in the recent past.  As a result, the playing field for comparison is level and the figures are probably highly accurate.  There’s little chance of making an apples-to-oranges comparison between brand new plant carried at full purchase price and perfectly adequate plant bought at lower prices twenty years ago and already partly depreciated.

Book value has also been the tool of choice for assessing financial companies, especially brokers and other trading companies.  Results using book over the past few years have, of course, been disastrous–Bear Stearns had reported book value of above $80 a share just as is was collapsing.

The idea was that it’s impossible to understand, transaction by transaction, what is going on inside any financial company.  But what they do is invest shareholder’s money.  The money they have to work with is book value.  What an investor can do, however, is calculate the return a company achieves on book value.  If a company consistently earns, say, 20% annually on book, I can pay up to 2x book value for the stock–getting me a 10% earnings yield.  If the return is a Goldman-like 25%, then I can pay 2.5x book

What happened to the financial industry was, I think, not so much an indictment of the use of book value as it was an indictment of managements and auditors who used dubious accounting tricks to present a grossly distorted picture of their firms.

What about intangibles?

It may be that a company gradually builds up a reputation for quality and service that allows it to charge premium prices for its goods.  This will presumably translate into higher profits and a stock price that substantially exceeds book.  Won’t a book value screen toss out a firm like this?

Two points:

1.  You can use the trading history of this sort of company’s stock vs. book value to judge when it it may be time to buy during a downturn or to sell during an upturn.  The idea would be that the stock has never in the past traded below .9x book in recession, so when it hits that level in a downturn it’s pretty safe to buy.  or that it peaks at 3x book in an upturn.

2.  If you’re worried about this, you’re not  a value investor–who are the primary users of book value as a tool.  Value investors argue that the real money, and the low-risk money is going to be made by finding the laggard company in the same industry that’s trading at a deep discount to book.  When the board of directors or activist investors force a change of management in that company, and when the new management works the company’s assets harder, the profits will soar (at least to the industry average and maybe beyond) and the stock will skyrocket.  That’s where you should be looking.

That’s it for today.  My second post will talk about situations where one has to be careful about using book value.

Citigroup’s deferred taxes–what Mike Mayo is saying

November 3, 2009 By in Banks, deferred taxes, Industry Analysis, Vocabulary Tags: , , , , , Leave a comment

The Wall Street Journal reported on Friday that long-time Wall Street bank analyst Mike Mayo told clients in a conference call he expects Citigroup will write off $10 billion in deferred tax assets in December.

Who is Mike Mayo?

He’s an experienced, well-respected sell-side bank analyst.  I don’t think I’ve ever met Mr. Mayo, who now works for French broker Calyon, but I’ve known and used his research for years.  We may even have worked for the same firm for a brief period.

Mr. Mayo periodically draws the ire of bank managements–with not always positive career consequences for himself–for his research findings.  His conclusions, which I think have generally proven to be correct, at times call attention to previously unnoticed company missteps.  Or they may just not be sufficiently bullish to suit company managements that regard analysts as extensions of their public relations efforts, rather than independent researchers.

To understand what he’s saying about Citigroup now,  you have to know some thing about what deferred taxes are.

Deferred taxes

Publicly listed companies keep several sets of books.  Among them are the tax books they use in reporting to the Internal Revenue Service and financial reporting books they use in reporting to shareholders.  Taxable income is typically lower in the reports to the IRS than in those to shareholders.  Deferred taxes are a way of reconciling the two sets of books.

An example:

Let’s say a company has a pre-tax loss of $1 million, and has used up its ability to receive a refund from the government for taxes paid in prior years.  For the IRS, this result is reported as an after-tax loss of $1 million.  The company is able to carry forward this loss, however, and use it to offset future years’ taxable income.  Rules vary from country to country.

In its financial reporting, the company will record a pre-tax loss of $1 million, just like it will for the IRS.  But, in contrast to the IRS filings, it will also record–as a reduction of the current loss–the value of future tax benefits that this loss potentially gives the company.  In this case, let’s say that’s $350,000.  Under financial accounting rules, then, the company will report a net loss of $650,000 to shareholders and record the $350,000 on the balance sheet.

If the company makes $1 million pre-tax next year,

1.  it will record the $1 million in taxable income in its IRS filing, but subtract the $1 million tax loss carryforward and pay $0.

2.  To shareholders, it will report $1 million in pretax income, subtract $350,000 in deferred taxes from that (and remove the balance sheet entry) and report $650,000 in aftertax profit.

Notice that the overall result in both cases is zero. The effect of deferred tax accounting is to make a loss-making company’s results look better in the loss-making years, at the expense of making future profits look worse.

One exception

In order to use deferred tax accounting, a company–and its accountants–have to be convinced that the firm will be able to make enough future profit to actually use the tax loss carryforwards it is taking credit for on the financial reporting books.

In particular, if a company’s fortunes deteriorate after having used deferred taxes to minimize current losses, and it finds it won’t be able to earn enough to actually employ them, it has to write them off.

Finally, to Citigroup

Citigroup had a little over $44 billion in deferred tax liabilities on its books at the end of last year.  According to Mr. Mayo, the company will write off $10 billion of them at yearend.

Typically, a firm’s auditors compel the company to make a writedown like this.  And, unlike Mr. Mayo, accountants are, in my experience, concerned enough about the egos of a client’s top management that they will not do so unless there is overwhelming evidence supporting their conclusion.

So what Mr. Mayo’s statement, if correct, implies to me is that:

1.  the auditors now realize that Citigroup will be significantly less profitable in the future than they had thought less than a year ago,

2.  past earnings have been inadvertently overstated by $10 billion, and

3.  the burden of proof has shifted, away from thinking that the other $34 billion is a conservative number, to worrying about that, too.

Normally, writedown of deferred taxes is an ominous sign for a stock.  And $10 billion is about a tenth of Citigroup’s market cap.  It’s unclear to me in this case, however, whether the writedown Mr. Mayo talked about is an industry phenomenon or something specific to Citigroup.

It also isn’t clear to me even how one could figure out the possibility of such a writedown for a complex multinational business like Citigroup.  My best guess is that this relates to some (unknown to me) legal or regulatory change in the UK, where US firms domiciled much of their activity in toxic assets.

Stay tuned.