In Chapter 5 titled “Classification of Securities” in his masterpiece “Security Analysis,” the author and my teacher Benjamin Graham rejected the conventional classification of securities into bonds, preferred stocks, and common stocks. Instead, he advised readers to focus not on titles but on economic substance of the security being examined. Graham suggested the following framework:
This is an incredibly useful framework for practical security analysis for it teaches you to focus on the underlying reality and not on legal claims and titles and names. For instance:
- When is a stock not a stock but more like a bond? Imagine a stock which pays a dividend of Rs 6 per share, and earns Rs 12 per share, but sells in the market at Rs 60. Imagine further that such a stock is capable of continuing to earn Rs 12 and pay Rs 6 as dividend indefinitely. Under these circumstances, can one not think of the dividend stream of Rs 6 per annum as if they were “bond coupons” on a perpetual bond. If so, what would be the value of this stream of “bond coupons?” Well, if the current rate of interest is 10% p.a., then a perpetuity of Rs 6 per annum is worth Rs 60 today. So the “stock” which sells at Rs 60 can be thought having a “bond component” embedded inside it which has a claim to only half the company’s earnings and yet it alone is worth the current stock price. In other words, using Graham’s framework, one can “see” the “hidden bond component” inside dividend paying stocks having high dividend covers.
- When is a bond not a bond but more like a stock? Imagine a convertible bond issued at 100 carries a coupon of 10% p.a. (the going rate of interest in India), to be redeemed at Rs 100 in 5 years but which is convertible at any time in its 5th year into 2 equity shares of the issuer. Imagine that 4 years in the life of the bond are over and now the stock sells at Rs 200. Since the conversion value of this bond is Rs 400 which is four times its face value, such a bond is a bond in name only. It will behave in the market like the stock of the company. According to Graham, such a convertible bond, should be treated like a stock and bought only after careful equity analysis.
I think its terribly important for fundamental investors to incorporate Graham’s framework while analyzing securities.
I find one class of securities under Graham’s framework as very interesting. These are Type II (A): Senior Securities of variable value type: Well-protected issues with profit possibilities. These are fixed income securities where there is a very good chance of earning an yield to maturity which is significantly higher than one offered by the promised coupon on the instrument. The example below will illustrate.
In July of 2008, Ankur, my colleague (who worked on this idea) and I started buying compulsorily redeemable preference shares (CRPS) of Sakuma Exports at about Rs 60 per share. This security issued by this commodity trader (risky business model), had features of Graham’s Type IIA: Well Protected Issues with Profit Possibilities. This wasn’t a plain vanilla high grade debt security. Had that been the case, it would have been classified as a Type I security.
Instead, this was a case of Type II A security because it was worthy of a high credit rating, so far as credit quality was concerned, and yet it was selling at an abnormally low price of Rs 60 levels in July 2008. The promised redemption price was Rs 100 in Feb 2011. In addition we were promised dividends of Rs 5 per share every year. If, and it was a big if, the company would honor its promise related to the CRPS, the yield to maturity was excellent.
How did we analyze the credit risk? It was easy. While this company was conducting a risky business of commodity trading, it had zero debt and had cash on its balance sheet in excess of the value of equity and CRPS combined. The total funds required for the promised redemption were already in possession of the company. We started buying.
Two subsequent events re-inforced our belief that the credit risk was negligible and that the market was wrong in pricing this instrument at such a low price. These were (1) the company’s decision to skip its dividend on common stock in order to “build reserves to redeem preference shares by 2011”; and (2) insider buying of CRPS by the promoters.
There is an apparent paradox in (1). When a company skips its dividend, markets assume the worst. While skipping dividends may be bad news for the minority owners of a firm, its good news for its lenders because every rupee not paid out as dividend is a rupee available for debt service.
Point (2) was terribly important to us because we asked this question: “Why would promoters buy the CRPS from the market if the company was going to default on redemption?”
Ankur and I felt that the insider buying was very solid confirmation of our investment thesis and we started buying aggressively. Indeed there were several days when the entire traded volume was shared between the buying being done by the promoters and us. See chart below which shows the price movement of the security over time.
We stopped buying at Rs 85 in December 2009. As per our expectations, the company never defaulted on the promised dividends and we collected three dividends of Rs 5 each, and one dividend of Rs 4.58 for the period 1 April 2010 to 28 February, 2011. This final dividend, along with the redemption money of Rs 100 per CRPS came in yesterday.
Since dividends are tax free in the hands of the investors, these should be grossed up in order to accurately calculate the pre-tax IRR earned on this operation, which, according to my calculations comes to 36% p.a – all from a fixed income security with profit possibilities mistreated by the market as if it was junk bond with a very high default risk.