In Security Analysis - 1934 edition, BG (Benjamin Graham) talks about companies which are debt-free and their stock price is trading at very low multiples of CFO/Profit. His logic is : A Common Stock Representing the Entire Business Cannot Be Less Safe Than a Bond Having a Claim to Only a Part of Thereof.
BG gives example of a company called The American Laundry Machine to illustrate his point. For simplicity I will take a ficitious company A. Company A is debt free and earns Profit before tax of 100 crore annually(say 5 year average). Now suppose A goes to bank and asks for loan. The appraiser from bank will see the fundamentals of company and will conclude that A can support interest of 40-45 crores annually and if current interest rate is 10%, A can support loan of 400-450 crore easily for forseeable future. If industry of A is stable, without undergoing rapid changes and A has dominant position in the industry, it will add-on to comfort of bank in extending loan.
Now come to think of it. If a bank opens its credit line of 400-450 crores for A and in return expects the annual interest payment and can have claim on SOME PART OF "A" for return of loan, VALUE of whole of A must be lot more than 400-450 crore. So if A trades at market cap less than 400 crore, any investor buying shares of A is virtually getting the upside of equity claim and downside of a fixed claim of a bond. Investor can just buy the shares of A and wait for the market value to reach in a zone where he is not getting the benefit of fixed claim so that he can sell.
Will publish the modified post some time next week....
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Not sure.. but company will find it difficult to raise cash at 10%.. could be in the range of 12-15% in current scenario where banks are holding up.. if i take 13% rate and interest of 65 crores then the loan it can raise is 500 crores.
ReplyDeleteKudos Ashish! Very well written post...Just to add -
ReplyDelete1. Debt free companies are drivers of investment grade (IG) world. Usually these companies raise money by issuing commercial paper (I believe they could easily raise cash at tenth of market rate in same IG universe. Banks usually issue revolving credit facility for such companies which backs up the commercial paper issued by the company (in an event of default). The Facility is never drawn, given strong operating position of the Company...they have to pay only undrawn fees to Bank for the loan (Undrawn fees is 10% actual drawn fees).
2. Private placements is another means by which these firms raise cash for operations, Citibank is among the big players in private placements...the terms of transaction between lender and borrower is not usually disclosed. In this case as well company will end up raising capital at a rate lesser than actual market rate.
In above cases it becomes difficult for an investor to judge actual value of the scrip. I worked on such company in 2007 - Teradyne (TER) listed at NYSE.
However,nowadays Lenders always look to hedge the capital they lend to companies. In mature markets Loans are traded (LCDX is one example)...also CDS instrument is another entity that insures lender is never in loss. CDX and iTraxx are mature OTC markets where lenders take up position. CDS markets have risen at horrendous pace in last two years, in 2008 CDS markets were trading close to 70 Trillion USD which is 6 times of US GDP.
This ensures retail investors to trade in a pipe which is bounded from both ends with limited upside and downside...aribtrage opportunities become minimum.