As I stated in the blog yesterday, this talk by Prof. Sanjay Bakshi throws up multiple value investing themes. One other theme is ‘Debt Capacity Bargains’.
This theme was originally propounded by Benjamin Graham in ‘Security Analysis’. He didn’t call it a Debt Capacity Bargain. Rather, he called it ‘The rule of minimum valuation’. The ‘rule of minimum valuation’ states that –
“An equity share representing the entire business cannot be less safe and less valuable than a bond having a claim to only a part thereof.”
He explained this rule with the help of an example (American Laundry Machinery). An excerpt –
“The purpose of this analysis is to show that at $7 per share for American Laundry Machinery stock in early 1933- equivalent to only $4,300,000 for the entire business- the purchaser was getting as much safety of principal as would be required of a good bond, and in addition he was obtaining all the profit opportunities attaching to common stock ownership.
Our contention is that if American Laundry Machinery had happened to have outstanding a $4,500,000 bond issue, this issue would have been considered adequately secured by the standards of fixed-value investment.
There would have been no question about the continuance of interest payments, in view of the powerful cash position revealed by balance sheet. Nor could the investor fail to be impressed by the fact that the net current assets alone were nearly five times the amount of the bond issue.
If a $4,500,000 bond issue of American Laundry Machinery would have been safe, then the purchase of the entire company for $4,300,000 would also have been safe. For a bondholder can enjoy no right or protection which the full owner of the business, without bonds ahead of him, does not also enjoy. Stated somewhat fancifully, the owner (stockholder) can write out his own bonds, if he pleases, and give them to himself.”
To get a more layman understanding of this debt capacity bargain/minimum valuation, we take the help of ‘The Intelligent Investor’ where Graham states –
“There are instances where an equity share may be considered sound because it enjoys a margin of safety as large as that of a good bond. This will occur, for example, when a company has outstanding only equity shares that under depression conditions are selling for less than the amount of the bonds that could safely be issued against its property and earning power. In such instances the investor can obtain the margin of safety associated with a bond, plus all the chances of larger income and principal appreciation inherent in an equity share.”
All this Graham-gyaan is fine, but what does it mean in really really layman term? (the basic logic is – hidden inside every stock of a debt-free company is a high-grade bond which can easily be valued).
Let’s break it down further, into discrete steps for clearer understanding –
Search for debt-free companies which have displayed stable earning power in the past and are expected to continue to do the same in the future.
Average the past earning power, say for the past 5 years (Approaches differ here. You can either use EBIT or Buffett’s Owner’s Earnings (Cash flow from Operations – Capex +/- Changes in Working Capital) Both will result in different results though. Safer to go the Buffet way!)
Use a desired interest coverage ratio of 3x-5x (Prof. Sanjay Bakshi recommends 3x for highly stable businesses, 5x for cyclical businesses). I use 5x for all, just to be extremely safe.
We can use steps 2 and 3 to find out what is the interest expense that the company can service (EBIT/Interest coverage ratio or Owner’s Earnings/Interest coverage ratio)
Divide the interest expense arrived at in Step 4. into the current interest rate to determine debt-capacity of the company; SBI’s AAA bonds were issued recently at 9.5%. Let us be conservative and take an interest rate of 12.5% (a 15% would be even more conservative)
Compare this debt-capacity with the current market cap, and if the Market Cap is less than Debt-Capacity, we can consider buying the stock.
I have seen another approach (I can’t recollect where) where the author follows the steps below in addition to the steps above –
7. The value of equity would be 75% of this debt capacity.
8. Add back the value of cash on the balance sheet.
9. Add the debt capacity, equity value obtained in Step 7 and add cash on the balance sheet. This would be the enterprise value of the company. If this Enterprise value is less than Market cap, we can consider buying the stock.
(I would personally stop at Step 6, although in my analysis, I have hardly found any company which does not fulfill Step 6, but fulfills Step 9.)
Note: This approach works beautifully in bear (more likely, severe bear markets) than any bull market. We might find shady companies fulfilling the criteria above in a bull market.
Let us look at what companies fulfill this criteria in the current market (I consider the valuations of the current market are on the higher side; you can call it a bull market/dead cat bounce in a bear market or whatever!)
Of the three, Suditi Industries looks slightly better. But then again, as I said, in times of valuations like these, it is difficult to find debt capacity bargains. File this methodology away for bear markets. Diligently followed, it can make money.
Your thoughts on this methodology?