Distressed Debt Investing's Book Recommendations: Equity Shorts

This past week, ValueWalk conducted an interview with Dr. Howard Schilit, author of Financial Shenanigans and founder of CFRA which used to be one of my favorite resources for independent research related to dubious accounting. Given the current state of the market (overbought), I thought I would take a few minutes and give my thoughts on each of the books that I have learned from in regards to equity shorts.

My favorite quote from the interview (on how to begin the process of detecting earnings quality issues):

Start with reading the actual financial statements (Balance Sheet, Statement of Income and Cash Flows) and accompanying footnotes for at least two periods and look for changes -- in account titles, accounting principles, estimates. After you have concluded your analysis and evaluation, then read the commentaries found in the MD&A, Letter from the President, other subjective reports by "friendly" sell-side analyst. Also, interview management when you have read all these documents and be alert when management is giving an evasive or untruthful answers.

Before I begin with the recommendations, I think there needs to be a quick point made. While I think that the majority of the accounting disclosure books can be used for shorts, they can also be used to determine if a management team is prudent and conservative. That being said, the books listed below have greatly increased my ability in shorting common e equities (as well as buying protection on a number of issuer).

Many of these books cover the same topics in nature (i.e. growth of sales versus growth of AR), but each presents ideas in a unique spin that I think all investors can learn greatly from. I personally have read each of these books below multiple times and recommend each of them highly. I will give a flavor with bullet points for each of them below:

The Art of Short Selling

• Recommended by Blue Ridge Capital's John Griffin to Columbia Business School Students
• The book title spells it out: The book is 100% devoted to short selling and the categories that go along with that: "Bubble Stocks", high growth companies with low returns on capital, companies that can't internally finance themselves
• Unlike the other books below, this book deals less with accounting disclosure and more with the short sale process that a long/short hedge fund might engage in (it is also less technical)
• If you had to read one of the books on the list, I would recommend this one

Financial Fine Print: Uncovering a Company's True Value

• Written by Michelle Leder, of Footnoted.com fame
  
• Very good introduction to basic financial statement analysis and understanding of corporate footnotes
• Michelle does an incredible job at providing a substantial amount of case studies throughout the book
• If you want a quick read to polish up your "accounting gimmicks" skills, I would recommend this one

Creative Cash Flow Reporting

• Of all books in this post, this one is BY FAR the most comprehensive
• That being said, this book is not for the faint of heart: It is HIGHLY technical and sometimes a very tough read. But, I promise you, you will learn more about "sustainable financial performance" and accounting disclosure than any other book on the list
• This book also does an incredible job at really digging into the cash flow statement and has helped me better understand a company's free cash flow potential
• If you think you are an expert in this detecting earnings mismanagement, and want to further sharpen your skills, I would recommend this book.

Financial Shenanigans: How to Detect Accounting Gimmicks & Fraud in Financial Reports

• To give you a sense of how much I enjoy this book: I own both the second and third editions, and have read them both multiple times
• Relies heavily on case studies with actual short recommendations from CFRA - I.E. The back their claims up with solid performance
• Very focused on accounting disclosure and management - depreciation rates, AR charge offs, etc
• I very much like Dr. Schilit's writing style which made the book a fairly quick read despite clocking in at ~300 pages
• If you want a deep dive into accounting mismanagement and want a read that is not too easy but not technical, I would recommend this book

Quality of Earnings

• In my opinion: The original book on accounting disclosures and mismanagement. If you have not read it yet, you are really missing something special
• This was the first book I read on "Quality of Earnings" - I have read it so many times that my copy is falling apart. I use it as a reference very often.
• Goes through the major ways a management team can manipulate earnings.
• Delves into some of the intangibles. For instance, there is a whole chapter on parsing a Chairman's Annual Letter that comes with the annual report. While the book heavily relies on number, it also shows you how to think about those numbers in a holistic way.
• For the best treatise on the quality of earnings, I would recommend this book.

Read more...

New Value Investing Blog

I am sure some of you have seen it, but if you have not, I have launched a new value investing blog, specifically targeting Walter Schloss, Irving Kahn, Warren Buffett, and others from the Graham-Newman Corporation. Enjoy!

Read more...

Seth Klarman from 1992

We have covered Seth Klarman in depth on Distressed Debt Investing. Seth Klarman is the investor I really think I respect the most and try to learn as much as I can from him and his style of investing. Frankly, if I could work anywhere, I would work at Baupost (HINT HINT READERS FROM BAUPOST).

Yesterday, I talked to about the high yield credit market of 2010. I received a number of response of people agreeing and disagreeing with me. That being said, one reader sent me a fascinating article penned by Seth Klarman in 1992 in Forbes. If you replace some of the names and dates, it really sounds like he is talking about today's credit markets. Enjoy!

Don't be a yield pig. (seeking high current rates in investments)

Seth A. Klarman

Brief Summary: Some investors seek high yields with no thought of the risk. In today's stock market situation, it is better to use up some acquired capital funds than to risk major loss.

I HAVE THOROUGHLY reviewed the U.S. Constitution (and the Bill of Rights for good measure) and, contrary to popular belief, there is no mention of a right for savers to earn high rates of interest on government-guaranteed principal. Nevertheless, it comes as a terrible shock to a lot of people that some current short-term interest rates are only one-third of early 1980s levels. The correct response to this shock can be crucial to your financial health.

There is always a tension in the financial markets between greed and fear. During the 1980s investor greed frequently got the better of fear, with the result that yield-seeking investors, known among Wall Streeters as "yield pigs," were susceptible to any investment product that promised a high current rate of return, the associated risk notwithstanding. Naturally, Wall Street responded by introducing a variety of new instruments--junk bonds, option-income mutual funds, international money market funds, preferred equity return certificates (PERCS)--anything that promised high current yields to investors.

Unless they are deluding themselves, investors understand that to achieve incremental yield above that available from U.S. government securities (the "risk-free" rate), they must incur increasing levels of principal risk. There is no risk-free yield enhancement on Wall Street. The painful result: Higher risk investments often erose one's capital and produce lower returns--the worst of al investment worlds. Higher-returns-for-higher risks only applies on average and over time.

Investors must carefully examine alternative investments to assess when they are being adequately compensated for bearing risk and when they are not. When the yield differential between riskless and more risky securities is sufficiently large, ven a conservative investor might reasonably venture beyond U.S. government securities. Thus, for example, it made sense to buy the Federated Department Stores senior secured bonds, Harcourt Brace debentures and Manville preferred stock when panic hit the junk bond market in late 1990 and early 1991.

These days, however, I don't believe investors are being compensated sufficiently to venture beyond risk-free instruments. Yield spreads between government bonds and corporate credits have contracted sharply this year from levels a year ago. Some bonds of such highly leveraged issuers are Burlington Industries and Unisys now trade above par. A year ago the sold at substantial discounts from par.

Yield-starved investors also have been bidding up the bonds of such deeply troubled issuers as Chrysler, Stone Container and Marriott. The General Motors PERCS--a newly created instrument that only a yield pig could love--recently traded at a level so high that the common stock became a better buy no matter where GM common traded and no matter what action GM's board took on its dividend.

Some investors, desperate for better yield, have been reaching not for a new Wall Street product but for a very old one--common stocks. Finding the yield on cash unacceptably low, people who have invested conservatively for years are beginning to throw money into stocks, despite the obvious high valuation of the market, its historically low dividend yield and the serious economic downturn currently under way.

How many times have we heard in recent months that stocks have always outperformed bonds in the long run? Funny, but we never hear that argument at market bottoms.

In my view, it is only a matter of time before today's yield pigs are led to the slaughterhouse. The shares of good companeis and bad companies alike are vulnerable to sharp declines. Moreover, many junk bonds that have rallied will tumble again, and a number of today's investment-grade issues will be downgraded to junk status if the economy doesn't begin to recover soon.

What if you depend on a higher return on your money and can't live on the income from 4% interest rates? In that case, I would advise people to ignore conventional wisdom and consumer some principal for a while, if necessary, rather than to reach for yield and incur the risk of major capital loss.

Stick to short-term U.S. government securities, federally insured bank CDs, or money market funds that hold only U.S. government securities. Better to end the year with 98% of your principal intact than to risk your capital rooting around for incremental yield that is simply not attainable.

I would also counsel conservative income-oriented investors to get out of most stocks and bonds now, while the getting is good. Caution has not been a profitable investment tactic for a long time now. I strongly believe it is about to make a comeback.

Read more...

Credit Market Quite Possibly Insane

Last week, I said the high yield market was hot. Today I am saying the entire credit market is quite possible insane. Toro's Running of the Bulls has been one of my favorite investing blogs for a long time. He recently penned an incredible piece entitled: The Bond Market Has Lost It's Mind. As you can tell, I am less than original in the title of my post. That being said, I would like to provide some "on the ground" intelligence if you will of what I am talking about.

As anyone in the credit markets are well aware, the primary market is running hotter than I can ever remember (except maybe bank debt in 1Q 2007...go CLO machine go!). And this turned on a complete dime relative to where it was just 6 or 7 weeks ago. I cannot recall a high yield deal (or investment grade deal for that matter) that was not oversubscribed and didn't trade up at least 1 point on the break.

Allocations are disgusting. Seriously. Unless you are Oaktree, Pimco, Franklin, etc, you are getting a couple million bonds here and there. Last week on the Distressed Debt Investors Club Forum, I posted a new topic about the Borgata deal currently in the market. At that time it was being talked at 10.5% which I found attractive given the risks inherent in investing in a single site casino in Atlantic City.

So I get a Bloomberg early this morning saying pricing is coming 75 bps tighter on the 5 year and 50ish tighter on the 8 year. And then I hear from my sales coverage: There is $5 billion in the book for an $800M deal. I will probably get 1/10th or 1/20 of my initial commitment.

Deals are pricing just incredulously tight. Teck Resources was in the market today and got a 7 year deal done at a 160 spread versus the curve translating into an all in yield of 3.858%. That's a low BBB issuer folks whose bonds were trading at 40-50 (Yield of 14-16%) about a year ago....

Now, I understand the bullish arguments. Rates are going to stay low, and possibly go lower if deflation kicks in, corporate balance sheets are healthy, earnings are coming in higher than consensus, excess liquidity in the market, investors are reaching for yield...

From a Bloomberg Article this evening (on Bloomberg you get high yield news with the function HYLN :

Investors are putting cash into junk-bond mutual funds as money market funds from companies such as Federated Investors Inc. and JPMorgan Chase & Co. offer yields at or below 0.25 percent, according to data compiled by Bloomberg.

"The average retail customer can’t live on 1 percent and that’s the issue,” said Jon Budish, senior vice president of high yield at Jefferies & Co. in Short Hills, New Jersey. “Until the default rate changes or you get a lot of downgrades, or until the Fed says something different, high-yield seems pretty interesting.”

Now, I do not invest top down. I look at securities across the capital structure (bank debt, investment grade, high yield, equities, and distressed) and determine my downside risk and if I am being compensated for taking that risk (as defined as permanent loss of capital). And frankly, while the upside / downside was quite favorable in 1Q and 2Q 2009 and to a lesser extend in the back half of the year, now things are just ludicrous.

I would venture to guess that my "new issue hit rate" is less than 10% in 2010. And you know what? I look like an idiot. And when new issues are up 2-5 points, it is my experience these things feed on themselves. Flippers start piling in when they know deals are oversubscribed, complicating allocations, and effectively "window dressing" the analysis of the issuer at hand. Rinse, repeat, and oh yea, put me in for $50M of XYZ bond even though I'll probably only get $3 or 4 million but I can probably sell it at 102 and make an easy 80k-100k.

Surprisingly, a lot of distressed credits seems to be very much under performing the on-the run credit markets. At least it feels that way. According to JPM, YTD performance for CCC bonds is 10.3% and BB bonds is 8.4%. From a yield to worst perspective, we are way below the long term average, yet from a spread to worst perspective we are 20-30 bps wide of the long term average.

Given where coupons have been printing, duration is creeping higher and higher as more treasurers are doing 30 year deals at very low coupons. And given where rates are today, doesn't that scare anyone else other than me? The 30 year Teck bond has a duration of 14 (using round numbers). That means a 7 or 8 bps move in rate or spreads is equivalent to 1 point change in bond value. Am I the only one that thinks that at least one of those two will definitely be wider in the next 4 or 5 years? Let me know your thoughts.

Read more...

Quick Housekeeping Item

Some of you know this, but I started the Distressed Debt Investing group on Linked In. You can (and should) join it here: Join Distressed Debt Investing Linked In Group ... We have about 650 members and going forward I am going to make sure the discussion stays on point with distressed corporate debt as opposed to CRE.

Read more...