Trade in Groups

As was discussed last time, all too often investors handicap themselves by defaulting to the long-only equity investment strategy. While equity ownership is the best path to wealth in peaceful and stable capitalist societies, having a portfolio solely comprised of long stock positions is in reality minimal diversification; in cases where the broad markets suffer a broad and deep decline, odds are your portfolio will lose value as well. It might be some comfort that superior stock picking can provide for relative outperformance, (i.e., losing less than the average), you probably aren’t a mutual fund manager and thus can’t eat relative performance. By using risk management strategies to target absolute returns – that is, consistent positive gains – investors have a chance of making money regardless of what the major indices are doing.

Most of the financial media’s attention is focused on the equity markets, when the equity holders of a company are the last in line for payments in the capital structure. A quick overview: the capital structure of a company is simply how it is financed – through debt, equity (stock), or some hybrid of those. There are also many variations because debt and equity can have modifiers as to their payment rights – subordinated debt is paid after senior debt, for example, or preferred stock is paid before common stock. Here’s a simple outline of a hypothetical capital structure in order of right to payment, with the amounts of each at book value:

7% Senior Debt, $300 million

8.5% Subordinated Debt, $75 million

5% Cumulative Preferred Stock, $100 million

Common Stock, 2% Dividend, $400 million

A simple takeaway from this is that, in liquidation, the company would need to have assets valued at

($300mm + $75mm + $100mm = $475mm, not counting possible interest owed)

before the common stock holders would see anything. Another is that the company needs to generate

($300mm * 7% + $75mm * 8.5% + $100mm * 5% = $32.4 million)

in cash annually to pay obligations senior to the dividend on the common stock, only amounts above that may be distributed to regular stock holders. And because of the cumulative provision on the preferred stock, if the company misses a payment to its preferred holders, the amounts accumulate over time and must be repaid in full before the common stock holders can receive a dividend.

The most direct way to apply this to investing strategy is to buy the debt or preferred stock of a company. My largest personal position is in high yielding senior debt, and that has held up quite well in the last six months – but this does not mean buying up debt or preferred stock is the always the best choice. There were plenty of holders of preferred stock in Fannie Mae and Freddie Mac, and debt holders of Lehman, who now have investments worth pennies on the dollar.  

But to go a little bit deeper into using capital structure, one popular investment strategy used by many top hedge fund managers is searching for cheap options, often ones hidden (embedded) in a security. We’ve discussed why options are so valuable now – so how and where might they be available for less? Some companies issue convertible preferred stock or bonds, which have a fixed coupon payable before the common stock holders receive any dividend, in addition to having an embedded option that allows the holder of the convertible security to turn their stake into a certain number of shares of common stock.

Of course, it’s worth mentioning that convertible arbitrage – the practice of buying a convertible and short selling the underlying common stock – is classified as a “market-neutral” strategy, but it has actually been the worst performing hedge fund strategy of late. It should be emphasized that not every strategy should be used by every investor – you must be able to understand and manage the risks of your investments. Still, with the distress in the convertibles market so high, it that means there could be opportunities to lock in high yields while acquiring undervalued call options on good companies. Next, we’ll give a sample analysis of a convertible security.