So, this is the fourth and final part of this series! Endings of the series haven't really lived up to the expectations of the audience, as of late, but I hope this one will be different. In the first post, we talked about three different categories of securities - Fixed Value Investments, Senior Securities with Speculative Features, and Common Stocks. We've covered the last group of securities already, but now we'll get to the first two. Let's start with Fixed Value Investments.
Takeaway Number 01: The Selection of Fixed Value Investments: Corporate Bonds
Investments in fixed value senior securities involve issues where changes in market price can be said to hold only minor importance, at least the upside, of the investment. The investor's primary interest in such securities is that of creating a safe and reliable source of passive income. Therefore, it must be limited to high-grade securities only.
Bonds are essentially alone, issued against a fixed interest rate. The interest rate (or the "yield") is typically paid out once or twice a year in the form of a coupon and depends on the quality of the company and the "Time to Maturity" (in other words, when the loan is expected to be paid back). For instance, McDonald's recently released two new issues - maturing in 2026 and in 2034, and yielding 0.89% and 2.87% respectively, while Sanofi, a major drug manufacturer with a better credit rating than McDonald's, recently released an issue maturing in 2034 as well, but yielding only 1.23%. As stated in post number one, bonds have an unqualified right to fixed interest payments and an unqualified right to the repayment of the loan (or principal amount), but no other participation right in neither assets nor profits.
HERE ARE FOUR PRINCIPLES IN SELECTING FIXED VALUE BONDS :
1. Safety is measured by the company's ability to meet its obligations: When buying bonds for fixed value investments, all you should care about is earning power. Some people would argue that if a company goes bankrupt, bondholders have a priority to the assets, so it would make sense to consider those as well. But Benjamin Graham argues that the primary aim of the bond buyer must be to avoid trouble, and not to protect himself in the event of trouble.
2. Evaluate under depressive conditions: As security is of the highest importance when doing fixed value investing, it does make sense to measure earning power under difficult conditions. So today, you'd probably want to go back to the financial crisis to see how the company you're thinking about buying bonds from performed during 2008 to 2009.
3. Coupon rates cannot compensate for deficient safety: The investor cannot afford to expose himself to even a small risk of losing his principal at, say, $1,000, in return for an extra, say, $50 of income from coupons. The whole premise of fixed value investing is that you shouldn't have to rely on the insecurities of the future, because if you do, you must be able to gain as a reward for being right, as you would always be penalized for being wrong. And investing in bonds near par value doesn't give you that. They don't appreciate in value unless the interest rates experience a major change, and no matter what, they will still be worth the par value at maturity.
4. Use exclusion and specific quantitative tests: Instead of finding the bonds with the highest potential yields and then look for safety, one must do the reverse when investing for a fixed value. First, exclude all issues of questionable security. Use a minimum standard, then work yourself upwards regarding yields. When calculating the interest coverage for interest expenses, you must use all obligations that are equivalent to bond interest, and thus you may also need to include expenses such as rentals and guarantees. And yes, there are many other factors that could be considered to assure the safety of a corporate bond, outside of interest coverage and market cap to debts. But if you want to add extra safety, you might as well increase your minimum requirements on these two points instead of complicating things by adding additional statistics. Sometimes less is more.
As a side note, governmental backed debt is much easier for the individual investor to acquire than individual corporate bonds, and there are other alternatives to fixed value bonds as well, such as paying off your mortgage.
Takeaway Number 02: The Selection of Fixed Value Investments: Preferred Stocks
 |
| Photo by Ishant Mishra on Unsplash |
Preferred Stocks are very similar to bonds when they are bought as Fixed Value Investments. Typically, preferred stocks don't have a specific date when they mature though, but companies may choose to buy back the issues because of changes in interest rates. A major difference between bonds and preferred stocks though, is that preferred stocks don't have to be paid anything at all, unless the common shareholders receive something too. Benjamin Graham and David Dodd are therefore very skeptical to investments in preferred stocks, for fixed value purposes. "That the typically preferred -stock represents an unattractive form of an investment contract is hardly open to question. On the one hand, its principal value and income return are both limited. On the other hand, the owner has no fixed enforceable claim to payment of either principal or income."
The four guidelines mentioned previously for investing in bonds for a fixed value purposes, apply to preferred stocks too, but because of their lack of enforceable claims, the minimum standards must be erased to the following. Furthermore, the interest coverage ratio must include not only the payments on bonds but also that on preferred stocks.
In 1932, only 5% of the listed preferred stocks met the criteria. Benjamin Graham concludes that not only are preferred stocks of the fixed value type exceptional, but they must also be called anomalies or even mistakes, as they are preferred stocks that should have been issued as bonds. Because, whenever the business issuing the preferred stock derives a benefit from its right to withhold the dividend payments, the owner does not have a fixed value investment. And on the other hand, whenever the issue is of high grade and suspension of dividends are very unlikely, the issuer should have used bonds instead, as they are typically priced relatively higher.
Takeaway Number 03: Senior Securities of Inadequate Safety
 |
| Photo by nappy from Pexels |
The previously mentioned bonds of Sanofi with a yield of 1.23% until maturing in 2034, is regarded as a safe investment by the market. Compare this to a bond from Bed Bath and Beyond, a retail store, which also matures in 2034 but yields 7.68% instead. The difference is quite major. Does this mean that there's a 6.45% free lunch? No, of course not. The market thinks about the bond of Bed Bath and Beyond as one of inadequate safety, and therefore, the yield is higher. Such speculative bonds and preferred stocks should be viewed from the common stock direction. The evaluation of the issuing company, before deciding to make a purchase, should be pretty much the same.
Furthermore, it's not enough that the coupon rate is higher than that of high-grade senior security, the security must also be priced at 70% of its par value or less. Why? Because, as previously mentioned, when you rely on insecurities of the future, there must be a reward for being right as you will always be penalized for being wrong. The reward, in this case, represents the possibility that the issue can appreciate almost 50% in value to be priced at par if the company does well. Also, beware! An investment in senior security of this speculative sort should never be made if it requires the assumption that the common stock is also priced too low at the time. Because if the investor is correct about his judgment of the common stock, it would be more profitable to buy the share instead of the speculative senior security, and if he's wrong, the price of the senior security will probably drop too. There is an exception to this rule, which we'll get to in the final takeaway.
Takeaway Number 04: Senior Securities with Speculative Privileges
Some senior securities come with speculative privileges, which makes it so that we no longer can classify them in the category of fixed-income investments.
THERE ARE PRIMARILY THREE DIFFERENT TYPES OF SECURITIES:
Convertibles: The owner of the security has the right to exchange his senior security for common stock on specific terms.
Participation: Not only does the owner have a right to interest payments, but he has the right to additional income too, usually in proportion to the dividends paid on the common stock.
Subscription: The holder of senior security of this sort has the right to purchase common stocks on predefined terms.
The Attractiveness of the Form of these securities cannot be overstated. They possess a combination of maximum safety and the possibility of unlimited appreciation in value at the same time. However, the investor in a security of this type must decide if he's buying because of the attractiveness from a fixed value investment perspective, or because of the speculative participation in the common stock. When investing from the fixed value investment perspective, Benjamin Graham argues that the terms of the agreement are more important than selecting the company with the common stock most likely to increase in value. Not because it has a higher impact, but because it can be dealt with more definitely.
THE TERMS SHOULD BE EVALUATED FROM THREE PERSPECTIVES:
The Extent of Profit-Sharing to Investment: The higher the better! For example, company A has bonds with a warrant (a subscription privilege) attached to them, stating that for every $10 in bonds, $20 in stocks can be bought. Company B has bonds that allow for the purchase of only $10 of common stock. Should the stocks of these companies appreciate in value, you want to be able to buy as much as possible, and therefore, the bond of company A is preferable to the bond of company B.
The Closeness to Realizable Profit: The closer, the better! For example, company A has bonds convertible into common stock at $10. The current price of the stock of the company is $9. Company B has bonds that are convertible at $10 too, but the current price of its stock is $8. Therefore, the bond of company A is preferable, as its stock must increase only about 11% before the convertible is profitable, while the stock of Company B must increase 25% for the privilege of its bond to be profitable.
The Duration of The Privilege: The longer, the better! Say that company A has bonds that can be converted for the next 20 years, while Company B has bonds that can only be converted for the next five. Everything is equal, you'd prefer the bond of company A, as in this situation, you have the option to wait much longer for the privilege to become profitable.
Takeaway Number 05: Switching
 |
| Image by Csaba Nagy from Pixabay |
Finally, we've actually found a situation in which a definite, mathematical conclusion can be arrived at in the field of security analysis. Here's an example from 1936, which Benjamin Graham gives in the book. Paramount Pictures corporation had issued a preferred share with $6 in a dividend that, at any time, was convertible into seven common shares. At a certain point, the preferred stock was selling at $113 against almost $16 for the common, so just the speculative privilege of the preferred share was worth $112 at the time. In addition, the preferred share had $12 in accumulated dividends, which had to be paid before the common stock could receive anything. Clearly, if the common stock was worth $16, the preferred share should be priced at no less than $124, so the owner of a common share in Paramount Pictures corporation should definitely have switched into the preferred one in this instance.
Such opportunities are rare, for sure, and they're probably even more uncommon these days than in Graham's time. But in times of turmoil, they may present themselves again. And who will profit from them? Only the Intelligent Investor and Rigorous Security Analyst.
Bonds of investment-grade can be found by insisting that minimum quantitative standards should be met under depressing circumstances. Preferred shares are inferior to bonds as fixed value investments, in their form, but you can still find such issues. You do it by increasing your quantitative threshold. Senior securities of inadequate safety should meet the same requirements as to when investing in common stocks, and in addition, they must be priced at least 30% lower than par. The attractiveness of senior securities with participation rights should primarily be evaluated from terms- perspective and the investor wants to see high-profit sharing to investment, a price close to a realizable profit, and a long duration. In times of market turmoil, mathematically demonstratable evidence sometimes presents itself which allows the investor to switch from one security to another one with confidence.
Even though I covered twenty takeaways in this series, there are many more in the actual book. Next up is Trading For a Living, by. Dr. Alex Elder. I hope to see you then!