Wise men say only fools rush in...

2 of my best friends in SMU – Lohnuts and Xinhong, are great proponents of the value investing philosophy. These guys are awesome, and they are great friends with whom I enjoy having beers during my unhealthier days. However, being a contrarian at times (Singaporeans call this guai lan), I want to raise some concerns that equity value investors should be mindful of when presented with overwhelming value propositions in these volatile markets.

XH and LOH: Pardon the tongue in cheek title. I have absolute respect for you guys.

The Setting:

The US financial markets have been taking a beating, last week, there was the famous 7-7-7 drop in the Dow, S&P and NASDAQ. Today, we had the Dow plunging below 10,000 points for the first time in a long while. The S&P is now trading at 1,056, which is a far cry from the 1,400 mark that technical analysts were touting as an inflexion point back in May 2008 (basically they said the global markets will rocket if the S&P hits 1,400). Well, it did, sometime between May and June 2008 – but look at where we are now.

Value Investing in a Nutshell:

How do we make sense of these numbers? Is the drop in stock price reflective of a real and underlying loss in value of the company? Well, yes and no. Of course, when Enron got wiped out, it reflected true economic reality. Enron was a circus and it rightly paid its dues. However, there are many stocks with good management, sound business model, streamlined operations with loyal customers that have taken a pounding – and it does not quite make sense. Perhaps, the true value of the stock is much higher than the stock price, thus, we can actually get the stock at a discount. Discounts, are generally good stuff, just ask the girls. This is what we call value investing.

The whole idea seems pretty good, we buy the stocks now when they are cheap and years later, when the economy picks up and all’s fine and dandy, people will realize that these stocks have been undervalued – and we’ll be able to reap capital gains that will be the stuff of legends. Alternatively, if one’s a buy and hold investor, the returns you’ll be getting in terms of dividends or reinvestment in the firm will be superior to those who bought into the stock at a higher price. BOOYAH!

Before we get ahead of ourselves, however, we should always think back on the whole “Return on Capital” vs. “Return of Capital” issue. I always believed that if you want to play a game, you have got to understand the rules being observed. Otherwise, the risk isn’t in getting a required return on capital, but rather, getting your invested capital back. My whole assumption here is that many investors who are following the Ben Graham/Buffett value investing philosophy are looking at the US markets and squealing, “WOW, Company X is selling for below book. Oh, look, Company Y is selling at below enterprise and/or liquidation value! Don’t buy confirm loogi!”

Happy days? Not quite. Don’t rush to open up that investment account with options express just yet. And here’s why…

My case against jumping into US equities:

One thing that Finance101, Financial Accounting 101 and Company Law has taught us is that common equity only has residual claims on the assets of a company. That is, in the event the company is insolvent, they will be last in line to receive any “handouts” from the judicial manager or bankruptcy judge.

Think about this, Buffett's a great investor and his investment philosophy is rock solid. He even has an outstanding track record to prove it. The fact that he’s so actively investing now seems to suggest that there are indeed many value propositions out there. However, we MUST bear in mind that he operates on an entirely different scale to us mere mortals with shallow pockets.

He has the financial muscle to buy his way out of trouble, to provide loans and financing to companies facing short term liquidity problems and the bargaining power to drive for favorable deals in times of severe liquidity (ask Goldman). His recent investment in Goldman Sachs was not in common equity - he was invested in debt, along with a bunch of options. Alternatively, Buffett can just buy a controlling stake in which he can veto certain board decisions. This is really where we are unable to replicate his strategy.

I've been blogging about the tightening of credit markets in the US after years of cheap credit and crazy lending. I've also blogged about Chapter11 and the evolving landscape for distressed debt investing. In addition, I've shared some lessons I've learnt about how the tightening credit markets can spark off a vicious cycle of GDP contraction through decreased consumer spending, corporate investments and other issues like greater unemployment and so on and so forth.

In times like these, we have two problems. Firstly, even a very solid company with solid financials and operations might not be able to tide through a bad recession. (Granted there are such good companies around, but what makes you think others haven’t already found them? Especially in such desperate times?) At the end of the day, the company must make money. We are almost likely to see a recession as a result of this financial crisis. This recession will be a drain on the company’s resources, and assuming this company has been highly levered, it will face problems paying off its debts.

Before you know it, your company could be filing for a prepackaged chapter 11 (no need actual default event, as long as its foreseeable, the court will grant it) or a involuntary chapter 11 filing (where its forced to file.. duh) In the US, Chapter 11 laws are really nice.. for the corporates or senior debt holders. Sadly, it really does not do much for common equity shareholders, often marginalizing them.

In this morphing investment landscape, there has been a whole bunch of new hedgefunds and asset managers involved solely in distressed debt investing and restructuring and M&As. These are highly sophisticated investors who know what they are buying, and more importantly, what they are doing. Specifically, they are looking for that fulcrum security that will eventually give them equity control of the whole business. This will wipe out the existing common shareholders. Seems unfair? Oh well, that’s the law.

In this case, your investment might go down to zero. Sure, you can say some people can launch proxy fights and appeal to the courts spending tonnes in bringing in valuation experts and the whole shebang. However, the value investing philosophy doesn’t promote that you leave your fate in the hands of others right? If no one steps up to the “bully” all the small investors are pretty much screwed.

A counter argument to my point is that one can find nicely capitalized companies in such conditions. Look, my point isn’t that you can’t find such opportunities. In fact, I totally agree that good propositions are out there. But what happens if the price drops further and the stock gets on the radar of more aggressive investors? (I’ve always been chided for being a price watcher, but let me explain why this is important). These investors will almost always definitely swoop in and pick up the stock at a price that while at a premium to current market prices, could just serve to confirm your capital loss.

Just ask the dudes who invested in Merrill Lynch when it was at 50 bucks.. or 30 dollars for that matter. Or the dudes who invested in Countrywide Financial Corp. before it was bought over by Bank of America. Sure, they got BoA shares in exchange, but hey, cash is king man, you are getting something you never paid for in the first place! In fact, BoA, under the wise leadership of Ken Lewis probably thought that his shareprice was overvalued in the first place, and used stock freely in financing his acquisitions. (it really does happen like that!) Now that I put it this way, how does that sound to you?

Conclusion:

Always seek to understand the rules and try to identify the fat tail events that might wipe you out. Understand what are the odds of these events happening. If you are still convinced that your stock represents a good value proposition, by all means, go ahead and invest. After all, you certainly do not make money by sitting on the sidelines and not taking a position.

The biggest danger is when one is totally ignorant of the risks posed by a particular strategy. Being an equity investor exposes us to a lot of risk, and it will be foolish to rush in and ignore all the possible pitfalls in equity investing – especially when the investing climate has changed.

There’s never a free lunch. As much as value investing is appealing, there are shortcomings as well.