"I am a value investor." declared the octogenarian owner of a pawn shop, showcased in a recent episode of television series 'Pawn Stars'. The gentleman was contemplating giving out a loan against the security of an antique watch or buying it. But he wanted to make sure that the money he spent would be a lot less than the value of the watch. It was not the seriousness with which he declared himself to be a value investor that I found funny. But the fact that most lenders, corporate lenders to be more precise, do not think in this manner. I am not referring to the PSU banks who have lent to companies with poor cash flows. But to investors like you who invest in corporate bonds of listed companies.
Now, if you are a good lender, then you would want to make sure that the business to which you are lending money is worth a lot more than the loan. So even as a bond holder you would want to subscribe to bonds of companies that are AAA rated. In other words the cash flows of the company are sound enough to service your debt.
But when it comes to stocks, as an investor, you may end up ignoring a debt free company that is under valued, especially considering the potential of its cash flows.
Let me explain this to you with an example. Say the market capitalization of company A is less than Rs 500 crores. Since the company is debt free and has healthy cash flows it can easily raise Rs 500 crores via corporate bonds. So it can use its cash flows either to pay interest to bond holders or to pay dividends to equity shareholders. Now if the market continues to value the company below its debt servicing capacity, the management can easily sell the bonds, which can leave their equity ownership intact. Can they not? So the option for an investor is to subscribe to bonds of a company with healthy cash flows or to own a stake in it.
Here is the quote from Ben Graham's Intelligent Investor which describes what I have just explained:
"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 with all the chances of large income and principal appreciation inherent in an equity share."
Thus margin of safety is something that does not come just from low PE multiples. But the balance sheet and cash flows of the company can offer what is called 'debt capacity bargains'. And in such cases investors must evaluate if they would be better off as bond holder or value investor for such stocks.
The reason I am highlighting this is because we are living in times when investors are all focused on earnings per share (EPS) and its growth. In doing so they may be ignoring some interesting bargains offered by companies with solid balance sheets and strong cash flows.
By Tanushree Banerjee
Now, if you are a good lender, then you would want to make sure that the business to which you are lending money is worth a lot more than the loan. So even as a bond holder you would want to subscribe to bonds of companies that are AAA rated. In other words the cash flows of the company are sound enough to service your debt.
But when it comes to stocks, as an investor, you may end up ignoring a debt free company that is under valued, especially considering the potential of its cash flows.
Let me explain this to you with an example. Say the market capitalization of company A is less than Rs 500 crores. Since the company is debt free and has healthy cash flows it can easily raise Rs 500 crores via corporate bonds. So it can use its cash flows either to pay interest to bond holders or to pay dividends to equity shareholders. Now if the market continues to value the company below its debt servicing capacity, the management can easily sell the bonds, which can leave their equity ownership intact. Can they not? So the option for an investor is to subscribe to bonds of a company with healthy cash flows or to own a stake in it.
Here is the quote from Ben Graham's Intelligent Investor which describes what I have just explained:
"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 with all the chances of large income and principal appreciation inherent in an equity share."
Thus margin of safety is something that does not come just from low PE multiples. But the balance sheet and cash flows of the company can offer what is called 'debt capacity bargains'. And in such cases investors must evaluate if they would be better off as bond holder or value investor for such stocks.
The reason I am highlighting this is because we are living in times when investors are all focused on earnings per share (EPS) and its growth. In doing so they may be ignoring some interesting bargains offered by companies with solid balance sheets and strong cash flows.
By Tanushree Banerjee
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