Analyzing Sears and Bonds

Yesterday we briefly compared the equity of Sears Holdings to its outstanding “junk” bonds and found that an investor with a short time horizon (say 2-3 years) may find comparable or superior value in the bonds when compared to its equity. To be clear, we don’t mean to suggest that Sears bonds are without risk. One only needs to look to Circuit City, or Linens n Things to see that today’s retail environment is increasingly difficult. And we are assured that more retailers will seek bankuptcy as they watch American consumers begin to cultivate the lost art of saving.

Today, we will take some time to evaluate the risk of Sears bonds in greater detail. Though sophisticated bond analysis tools abound (some more useless than others), relative simplicity will rule this day. Benjamin Graham, in his widely acclaimed The Intelligent Investor, highlights a variety of criteria relevant for bond analysis. First, and most important, is “the number of times that total interest charges have been covered by available earnings for some years in the past” (148). Either the analyst should concentrate on the average multiple of interest coverage over the past seven years, or she can use the multiple of interest coverage in the “poorest” year. Graham concludes that, before income taxes, a retailer must have—at minimum—produced average earnings at least five times the interest charges, or at least four times the earnings of the poorest year.

A second test for bonds is the size of the business. Third, the analyst should assess the ratio of the equity’s market price to the business’ total outstanding indebtedness. And lastly, the analyst should discern the values of the assets on the debtor’s balance sheet.

In the case of Sears Holdings, it appears that its debt does not pass Graham’s first test. According to Sears’ most recent press release, interest expense for the fiscal year ending Jan 31, 2009 was around $272 million. Yesterday, we found Sears average annual FCF to be 1.03 billion; the ratio then is 3.8, below Graham’s 5x threshold.

The second criterion is fine, and the third as well, with Sears’ equity priced in the market at 4.3 billion (as of 3/5/09), compared to 2.9 billion in total long term indebtedness. The fourth criterion is quite interesting in Sears’ case. Given its wealth of real estate assets, its valuable brands, and its ownership stake in Kmart, Lands’ End, and Sears Canada, the balance sheet far understates its true value. For example, Bruce Berkowitz, manager of the Fairholme Fund, conservatively values Sears’ real estate at $90 per share, a valuation he has made using tax records and fairly detailed site analysis. By itself, the value of Sears’ real estate, largely hidden from the balance sheet, should provide the debt holder with an additional margin of safety.

All told, the analyst can see where Sears’ perceived weakness lies—its earnings power in its current state appears too meager. Given its assets however, combined with its cash balance of 1.3 billion, and the 3.5 billion available on its line of credit, some of the risk diminishes.  Diminished enough at least for this investor to seek the proffered returns.

Disclosure: I, or persons whose accounts I manage, own debt of Sears Holdings at the time of this writing.

Buffett the Bondsman Revisited

Warren Buffett’s annual letter to shareholders arrived this past Saturday morning with the anticipated fanfare and has produced its usual industry of commentary. Ever since Berkshire’s 13-F became public (2/17/09), I have been thinking increasingly about whether current economic conditions should alter my investment strategy and return expectations. As we observed yesterday, Graham and Dodd seem to suggest that such changes are unnecessary, if our current holdings were acquired with reasonable expectations and a significant margin of safety. Yet, in Buffett’s letter, he discusses selling some equities (presumably purchased with the requisite margin of safety) in order to purchase fixed income securities:

“On the plus side last year, we made purchases totaling $14.5 billion in fixed-income securities issued by Wrigley, Goldman Sachs and General Electric. We very much like these commitments, which carry high current yields that, in themselves, make the investments more than satisfactory. But in each of these three purchases, we also acquired a substantial equity participation as a bonus. To fund these large purchases, I had to sell portions of some holdings that I would have preferred to keep (primarily Johnson & Johnson, Procter &Gamble and ConocoPhillips). However, I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits.”

Of these three equities, I am most familiar with JNJ, a favorite of many value investors (including Prem Watsa and John Hussman). Joe Ponzio at F Wall Street has analyzed JNJ and given it an intrinsic value (using a discounted cash flow analysis) of $83.10. With future cash flows discounted at 15% and a 25% margin of safety, Ponzio would be willing to purchase JNJ below $62.33.

Though personally I find this valuation a bit high, it does show that JNJ has a significant likelihood of returning the investor at least 15% per annum. For Buffett to sell JNJ for his fixed income securities, I would contend that he either sees greater return potential in them, or a greater margin of safety for a similar rate of return. The conclusion then presses upon me—a 15% return in equities may not be sufficient in this market. If that’s true, then perhaps the appropriate strategic response is to increase the discount rate in my DCF evaluations, and/or increase my desired margin of safety.

Of course, we can still find wide moat businesses whose current prices look like bargains even with these heightened standards, but the list is shorter. Ebay makes the new list, but likely not the Washington Post Company.

Lastly, Buffett’s moves have inspired me to look further up the capital structure. In the past decade, corporate bonds rarely looked attractive relative to the projected returns for their equity. Now, however, one can find a few better risk-adjusted returns in the corporate bond market. Tomorrow we’ll look at one potential opportunity by comparing the equity of Sears Holdings with its outstanding bonds.

Disclosure: I, or persons whose accounts I manage, own shares of Berkshire Hathaway, eBay, Fairfax Financial Holdings, and debt of Sears Holdings at the time of this writing.

Whither the Economy?

Over the weekend, I was paging through Graham and Dodd’s Security Analysis (5th edition, authors Cottle, Murray, and Block), and thinking especially about discount rates and the margin of safety concept, particularly in light of recent macroeconomic events. It is not yet clear to me how much attention an investor should yield to macroeconomic changes and predictions. Investors often take solace in Warren Buffett’s seeming ambivalence to most macroeconomic data, recalling his many quips about being wholly uninterested in the federal funds rate policy for the upcoming year. Cottle, Murray, and Block touch on these issues in their ninth chapter, on “Qualitative and Quantitative Factors in Security Analysis and the Margin of Safety Concept.” Having laid out the sources of information that an analyst should use, the authors move to the more difficult question—how should the analyst use them?

The basic quandary is this: the analyst could gather nearly infinite information about a given investment, information which would presumably help her to better judge its value. Any constraints on time and attention seemingly hold the analyst back from giving her best judgment. Yet, such constraints are not undesirable, for not all information is essential for a reasonably full evaluation. The analyst must cultivate discernment and practical wisdom in order to know whether the information she has is essential and enough. As our authors observe, “the analyst must exercise a sense of proportion in deciding how deep to delve” (114).

But the specifics here are likely the most useful. An analyst may not need to assess patent protections, geographical advantages, or labor conditions, which may or may not endure. For a stable company, five year financial statements “will provide, if not a conclusive basis, at least a reasonably sound one for measuring the safety of the senior issues and the attractiveness of the common shares” (114).

The company’s “statistical exhibit” though is not enough. “Exceedingly important” are qualitative factors, which—while difficult to assess—require the analyst to examine the nature of the business, the character of management, and the trend of future earnings (115). Particularly pertinent is the business’ position in its industry, its industry’s relative prospects, litigation risk, potential regulatory changes, and social issues. Management represent the face of the business, and many even consider picking good management more important than picking a business in a promising industry. Yet, our authors warn, “little tangible information is available about management… [and] objective tests of managerial ability are few and rather unscientific” (121). Even more worrisome, “there is a strong tendency in the stock market to value the management factor twice,” for both the fact that earnings growth is so robust, and that this capable management produced it (121). Though qualitative factors may be overemphasized and lead to an undue emphasis on perceptions of quality (think of the “Nifty Fifty” and the slogan “Make sure of the quality and price will take care of itself”), researchers Clugh and Meador have concluded that the predictive process is based primarily on qualitative factors.

Thoughout their discussion here, our authors say little explicitly about macroeconomic concerns, in large part because of their emphasis on the presence of a margin of safety for any true investment. As they observe, “when the price is well below the indicated value of a secondary share, the investor has a margin of safety which can absorb unfavorable future developments and can permit a satisfactory ultimate result even though the company’s future performance may be far from brilliant” (504). Though the margin of safety may not guarantee favorable performance by itself, when coupled with sufficient diversification, the margin of safety concept can produce acceptable returns in a variety of macroeconomic environments.

Since an analyst’s time and attention are limited, Graham, Dodd, and Buffett concentrate their energies almost solely on understanding businesses, and in particular, on those aspects of the business which management can control—namely, costs, marketing, and pricing. This concentration, coupled with the margin of safety concept, should be sufficient to defend the investor from unforeseen changes in the broader economy and render detailed economic analysis less relevant to the analyst’s work.

Ebay’s Relative Value

Many value investors scoff at the use of relative valuation techniques. At some basic level, the concept of intrinsic value resists any broader concern for prevailing market values. The sharp investor values only this business—relative to its assets or earnings power—and doesn’t worry about what Mr. Market thinks of it and its competitors. And historical stock market valuations would seem to confirm the intuitions of the saavy value investor. Just look at the NASDAQ bubble—what help would it have been to compare the value of a business to its insanely overpriced competitors?

However, recent research suggests that relative value arbitrage does provide market-beating returns. In addition, both Benjamin Graham and Warren Buffett used relative valuation at various points in their investing careers (though one should note that Buffett gave it up relatively quickly). In fact, in the 1960s, Buffett would borrow shares to short from the Treasurer of Columbia, and when asked which shares he wanted, Buffett said “just give me any of them.”

Most simply, the key to relative valuation, and long-short pair trading, is to find two businesses whose prospects are highly correlated. The standard example is Ford and General Motors. For two highly correlated businesses that are priced differently, the assumption is that business correlation will eventually filter into the businesses’ prices, and the arbitrageur can capture this spread.

For Ebay, many point to Amazon as its most correlated competitor. Both generate a substantial portion of their revenue from internet commerce, via the fixed-price sale of a wide array of consumer goods. As of today (2/12/09), Ebay trades at 7.4x its 2008 free cash flow, 1.55x book value, and 5.16x net tangible asset value. Amazon, on the other hand, trades at 20.15x its 2008 FCF, 10.27x book value, and 12.27x its net tangible asset value.

The best aspect about a paired trade is that it gives the investor multiple ways of being right—not only when Ebay’s value increases, but also when Amazon’s decreases. With multiple ways of being right, a value disparity is likely to fade more quickly. And more quickly realizing returns boosts a portfolio’s internal rate of return. It’s hard not to like that.

Coming up next—Ebay’s “Problems”

Disclosure: I, or persons whose accounts I manage, own shares of Ebay at the time of this writing.