Friday, June 22, 2012

Something Else Important From the EMH-Busting Paper

This is another gem from the paper we just wrote about, "Low Risk Stocks Outperform within All Observable Markets of the World"

"In considering the costs of raising internal capital, managers should employ state-of-the-art inductive technology (supplemented with their own information) to forecast the expected returns to their firm’s menu of prospective securities and portfolios of their securities. Forecasts of the expected returns to these securities, and portfolios of securities, should be based on statistical models that explain and forecast the behavior of stock market prices. In financing, managers should determine the least-expensive portfolio of securities that can be issued. As long as the firm’s assets are over or undervalued by the market, management should be able to create financing portfolios that are overvalued."
Another way of describing something I have long advocated: firms should arbitrage their own capital structures. It's amazing that so many firms are either indifferent to their capital structures (net nets) or actively mismanage them (poorly timed buybacks).

Any company that isn't issuing as much long term, low rate debt as possible right now is mismanaging its capital structure. Why aren't the oil majors issuing 4% long term paper and buying up E&P companies like CHK selling for less than half of NAV?

There's a short list of people and firms that have been really arbitraging their own capital structures. The two classic examples that come to mind are James Ling / LTV and Henry Singleton / Teledyne. Singleton famously bought back a huge portion of outstanding Teledyne stock during the early 70s bear market, reducing outstanding shares by 64% in four years. [Singleton was also a fantastic manager, emphasizing that all capital projects needed to have high returns on assets and equity in order to be approved.] Similarly, Ling was good about issuing securities that were overvalued and buying or trading new securities for what was undervalued.

When Teledyne stock was expensive, Singleton used it to make accretive acquisitions. This is something I thought that Netflix should have done back when its stock was insanely overpriced. As I wrote last year, the rents from the streaming entertainment business are going to go to the content owners. The smart play would have been to sell stock and acquire content, either by buying libraries or by generating new content.I'll bet that during the height of the NFLX mania, they could have bought film libraries with stock and their multiples would have expanded. With their peak market cap of $15 billion they could have easily absorbed DreamWorks and LGF, for example.

The latest own-firm capital structure arbitrage idea is David Einhorn's Greenlight Opportunistic Use of Preferreds (GO-UP) strategy. The idea would be to issue prefs at low yields and use the funds to buy back stock trading at low multiples. These could unlock value by converting low multiple net income into low yielding (high multiple) preferred stock.

Chesapeake Energy and Aubrey McClendon are pursuing the same essential strategy as the GO-UP arbitrage, by the way. As the company describes it, they like to raise capital through VPPs, royalty trusts, and asset level preferred stock transactions because they
"recognize the world is 'short yield' and [want to] provide various investment opportunities to yield-hungry investors who are willing to pay more for select assets than core E&P investors are willing to do."
In other words, investors will buy an MLP that owns midstream assets at a 5% yield, but they would never value them that highly as part of an E&P.So, the arbitrage opportunity exists because it takes advantage of an irrational investor preference for fixed coupons.

Is the preference for fixed coupons really that irrational? I think it might be "quasi-rational" in that investors have no confidence that managements will return earnings to them anymore, primarily because of a lack of capital allocation discipline.

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