5 posts tagged “corporations”
The proponents of LBOs, usually the managements involved and those who are paid fat fees to construct the deals, point out that shareholders benefit by getting to sell their stock at a substantial premium relative to what the stock would be worth if there was not an LBO offer. They also point to somewhat hazy theoretical benefits including (but not limited to) concepts that the nonpublic corporation will be more competitive and thereby benefit the economy as a whole. In addition, they contend that those who provide the financing (usually through junk bonds) are pro. vided higher interest rates than they could otherwise obtain.
Critics of LBOs contend the only true value is to those who construct the deals and the management that takes over the corporation, in that they are provided very large profits with relatively low risk. They maintain that the added debt burden to the corporation detracts from its financial stability, using the high default rate of junk bonds as proof. Their criticism also includes a couple of accusations: For one, the junk bondholders are not properly appraised of the risk involved. Also, when banks are involved in the financing, the taxpayers (because the bank's deposits are insured by the federal government) are subsidizing a process that does nothing except make a select few enormously rich and destabilize the overall economy, as the U.S. savings and loan debacle clearly attests.
Irrespective of the arguments, one aspect is clear. The managements who are buying the stock from stockholders (the owners) are, in effect, competitors thinking they are buying the stock cheap (at least relative to their risk). Otherwise, why would they want the stock all to themselves? Our main point is to demonstrate that the objectives of management and shareholders (for whom management presumably works) can often bedivergent and directly competitive.
Corporate Raiders
Corporate acquisitions can take one of two forms: friendly or hostile. In riendly arrangements, the buyer and the corporation to be acquired agree
on the terms involved and all proceeds (usually) rather smoothly. In hostile situations, the management of the corporation resists the buyer's actions. The buyer in such instances is usually termed a raider.
For a variety of reasons, including the possibility of loss of employment, managements do not like raiders. They want the raider to go away. To entice the raider to leave, they may offer incentives, such as buying the raider's stock in the corporation at a price significantly above the free market price, providing the raider high paying preferred stock/bonds, or any other enticement that leaves the raider with a profit sufficient enough for him to promise not to return. These payments are called Greenmail. In a greenmail arrangement corporate management has paid off the threatening party without the permission of shareholders (or owners). The shareholders have not even been given the choice as to whether they want to take the raider's presumed offer.
Thus, once again, corporate management and shareholder objectives can diverge and, in effect, place management and shareholders in direct competition.
Some raiders have perfected their activities to an art, getting paid off repeatedly without ever really making a serious attempt to takeover the "threatened" corporations. Other raiders have been known to buy stock in a corporation, then announce (or imply) that they might takeover the corporation at a price higher than the current market price. Speculators might rush in and push the stock higher. The raider then "changes his mind" and sells his stock into the buying demand (higher prices) created by the speculation. Such activities turn ethical stomachs. They are mentioned to reinforce the true nature of the market, which includes avoiding the assumption that corporations are automatically investors' friends.
Taking a Corporation Public
In taking a corporation public, instead of management buying stock from the public, it is selling its stock to the public. The sale may take the form of new stock issues, selling stock held previously taken private by means of LBOs, or simply large blocks of stock held by management in corporations already trading publically. Whatever the form, the implication is clear that management is selling because the price of the stock is too high. Again, the managements of corporations so involved have placed themselves in direct competition with other investors.
Avoiding competitive abuses from corporations entirely is not possible. Slimy types have been known to work their way to the top of some of the finest corporations. Once identified as the unethical types that these individuals almost always are, they can be avoided by staying away from the corporations with which they are involved. To reduce the possibility of being victimized by unscrupulous corporate managements, we confine investment interest to the issues that meet the selection criteria where shareholders concern plays an important role.
Corporations Role on Stock Market
Most of the investing public fail to view corporations as direct market participants. They usually assume that the relationship of a corporation to the trading of its stock is an arm's length situation. The corporation, they reason, is consumed by business activities, and the stock exchange is independently judging the relative merits of the corporation's activities.
Yet corporations and the stock market are intertwined on both a theoretical and practical basis. It is widely presumed, and generally true, that the goals of the corporation's management and the stockholders are identical: to maximize the corporation's profitability and consequently to optimize the value of ownership (that is, the common stock). Corporationsare established because of money and the stock market is established because of money.
However, in some instances the objectives of management and stockholders conflict. In these cases, the corporation is both a direct market participant and a direct competitor.
The Dangers of New Issues
Such a conflict is clear, for example, when corporations offer new issues of stock during seller's markets.
The sale of common stock allows access to money without any guarantee it will be returned, and without having to make interest payments. In effect, it is a source of cheap capital. Many corporations, keenly aware of stock market activity, have a genuine desire that their stock command a high market price. The more people are willing to pay for the stock, the higher the (paper) valuation of the entire corporation and the more money available through the sale of new stock.
Thus, when the market is high and a euphoric atmosphere prevails, corporations (both new and established) will come to market to sell new issues of stock. In effect, they are taking advantage of the elevated stock pricing to generate more money through the sale of new stock than would be available if stock prices were lower. In other words, they are selling high—to the corporation's owners!
This type of corporate activity is usually a clear warning signal of impending decline. The corporations, by rushing to sell themselves through new stock issues, are effectively advertising that stock prices are too high. Yet few investors heed the warning. On a more elementary basis, the new corporate stock offerings are increasing the supply of stock and dissipating buying demand over a larger number of shares. Both factors add to a curtailment of price advance and a consequent lessening of buying demand, with the eventual result of supply outweighing demand, causingprices to decline.
Stock Splits
Corporations might also take advantage of high prices with stock splits. The effect of a stock split is simply to expand the number of outstanding shares. Although attractive to naive investors, the effect of a stock split is usually meaningless to the real value of the stock.
For example, let's say a corporation has 1000 shares outstanding and earns $4000. The earnings per share would be: $4 per share.
Now let's say there is a 2-for-1 stock split. The company exchanges two new shares for each old share. The per share earnings change to: $2 per share.
The end result is that the investor has twice as much of what is worth half as much. In other words, if the stock was worth $50 per share before the2-for-1 split, it would be worth $25 per share after the split with twice as much outstanding stock.
In the middle to late 1980s, the restructuring binge financed by junk bonds resulted in many previously superior corporations degenerating to bankruptcy. Despite past records of earnings predictability and growth, we usually delete corporations that have restructured with excessive debt because they are less likely to meet earnings projections.
Inordinately high compensation (in the form of salary or options) to senior management and/or their families and friends is another managerial practice that can disqualify a corporation from our list of issues suitable for investment consideration.
Many corporations have various classes of common stock. The most important differentiations among the classes are usually concerned with rights involving dividends and/or voting. The various classifications are usually distinguished alphabetically—Class A, Class B, and so on. Note that alphabetical positioning is not necessarily indicative of the merit of the class of stock. For example, Class A may be nonvoting and Class B voting.)
Of particular concern is the restriction of the voting right and/or preferential right to dividends to a class that is not available to the public. This characteristic is usually found when a family or other tightly knit group is able to sell the public the lower classes of stock. The public is, in effect, capitalizing the holders of the preferential stock and accepting disproportionate risk. Although such "class" issues are defended rather vigorously, those most vocal in the defense are those holding the preferential stock.
It is a general policy of ours to disqualify such stock issues, but not because of the voting right. As discussed in Chap. 1, the vote is relatively meaningless to the vast majority of stockholders. Our objection is to the basic attitude of the issuing corporation. The motivation demonstrated by any corporation selling "ownership" (via common stock) and then not allowing the stockholder even the gesture of a vote, carries the implication of pomposity at best and hypocrisy at worst. Neither of these traits is desirable in any form and the avoidance of such issues is prudent.
Family-held/publicly-traded situations are similar to those involving stock classes, except that all outstanding stock has voting privileges and equal rights to dividends. The majority of outstanding shares, however, remain under the control of one family. Thus, nonfamily stockholders are effectively as powerless as if their stock has no voting rights.
Such circumstances, although quite common, are not an automatic reason to disqualify the stock issue from investment consideration. Almost all publicly traded corporations will eventually fall under the control of a few individuals whether or not they personally control the majority of outstanding stock.
Family-controlled corporations must, however, be closely monitored to isolate those instances in which management is passing from one generation to the next.
Managerial ability is not a genetic trait. Quite often, when the second and/or successive generations become dominant, the intelligence and drive that initially allowed the corporation to prosper tend to lessen. Another potential problem is sibling rivalry, which can result in effective stagnation of corporate growth.
In summary, the basic intent of our criteria is to select corporations that are stable and predictable. We want to minimize "surprise" from fundamental corporate events. By doing so, the process of actual market participation becomes greatly simplified because attention can be focused on intrinsic market mechanisms (timing and the other aspects of trading that are most affected by internal market structure).
Also important is the fact that our filtering process is a search for the quality of two elements: the corporation's business and its record in conducting that business, as well as the individual managers directing the corporation.
In our method of stock selection, we first determine which specific stocks warrant investment consideration. Qualification for consideration does not necessarily translate into actual investment. Consideration is only the first step. The actual implementation of purchase and sell decisions depends on a number of other factors which will be described after we have determined the general group of stocks we want to utilize. The qualification process is a filtering technique, through which thousands of different stocks are condensed down to a manageable number. This is not a hypothetical process. It is the actual method we use, and it is the basis from which our extraordinary high degree of accurate price forecasting was developed.
While very logical, the stock selection procedure is possibly too lengthy for the average investor. Do not be alarmed. After explaining the long method, we will describe a greatly simplified approach that is easy and quick, and that approximates the results of the longer method. The following lengthy explanation, however, is necessary for an understanding of the logic of the selection process.
The Criteria
The following qualifications are considered mandatory for the stock of any corporation to be of sufficient quality to warrant possible inclusion in our market strategy.
1. Earnings Predictability.
If you are involved in a serious hunt for a dangerous prey, your primary concern is the reliability and working condition of your weapon. Our weapon is common stock, and its specific selection is a serious (core) concern. The probability of error must be minimized to help assure survival.
Earnings are generally the most important factor in the value of a corporation. It was also mentioned that earnings generally are not easily predicted. Some corporations, however have demonstrated a consistent record of earnings predictability. Because of the existence of such corporations there is no need to rely on corporations whose earnings are less predictable.
As a rule, we consider the earnings predictability factor acceptable if the corporation has managed to meet earnings projections ±15 percent during each of the previous seven years. Disqualifying corporations that have not demonstrated a satisfactory past predictability as to earnings helps to eliminate fundamental surprises, as well as about 80 percent of all common stocks.
2. Earnings Growth.
Predictable earnings does not mean acceptable earnings. Because of the availability of corporations with demonstrated patterns of earnings growth, it is only logical to direct investment toward these issues.
The reason for this criterion is deeper than psychological reassurance. Corporations with demonstrated earnings growth get wider publicitywithin the investment community, and consequently they are considered for investment by a larger number of investors, both individual and institutional. It is from other investors that profits are taken. The greaterthe number and different types of investors involved, the easier the task of prey identification.
Keep in mind, however, that past earnings growth in itself is not enough. Future earnings projections must also indicate a pattern of growth. Themarket is most influenced by anticipation of the future. Limiting investment to corporations with both earnings predictability and earningsgrowth concentrates attention on quality, which can (but won't necessarily) help in supporting market price.
This earnings growth criterion generally halves the number of issues that were able to survive the test for earnings predictability.
- In an attempt to eliminate the effect of extrinsic factors, our Master List criteria stress predictability and quality. We are not part of corporate management. We cannot make corporate decisions. The fundamental activities of the corporation are not within our direct control.
We do have some control over intrinsic factors, those that determine stock price change because of market structure. As market participants, we must compete and (hopefully) profit within this inner world. By attempting to confine interest to corporations with demonstrated predictability, we have some assurance that matters beyond our control will not catch us unexpectedly. We can therefore concentrate attention on those aspects over which (by our actual buying and selling) we do have some control, including discretion as to whether we will even participate. As functioning professionals, we exist in the market, not within the corporations whose stock we are using to acquire profit.
The result of this reasoning is that we are involved with stocks whose prices are more a function of the market than a function of some particular corporate event that may (or may not) occur. Since corporations have been selected on a basis of both earnings predictability and earnings growth, the unexpected has been minimized. Price changes of the stock, therefore, will be more affected by overall changes in the market than by events within the corporations themselves. Consequently, the benefits associated with market timing become more easily attained.
4. As the investor may perceive, by limiting our interest to the Master List, we are shifting the entire investing situation to our favor. The variables that concern us most are those involved with internal market structure. Since we have a reasonable understanding of the earnings and dividend traits of our stocks, we can easily evaluate them as reasonable or unreasonable relative to market price.
As a result, we can do two things. First, we can make a disciplined determination as to which individual stocks appear relatively over- or underpriced, thereby allowing us to concentrate on the undervalued stocks as buying possibilities and the overvalued stocks as potential selling possibilities. Second, by determining if the entire list is overpriced or underpriced, we can develop a method of market timing. Both facets (relative positions within the list and the relative position of the list as a whole) are interrelated. The combination of the two (Chap. 9) forms the basis of Drach Market Research as being able to predict price change with an accuracy of 95+ percent for specific common stocks over many years and in a wide variety of market conditions.
The value of confining interest to stocks appearing on the Master List, therefore, goes far beyond the rather simplistic criteria used in the List's construction. We not only have concentrated attention on specific potential investments, but have taken an important step in constructing a method of market timing. The timing aspects are not limited to common stocks. They can be applied to a variety of investment types including closed-end funds.
Condensing the List
The more stocks there are on the list, the higher the probability of success, simply because of the greater number of individual stocks from which selections can be made. However, the list can be substantially reduced without any significant loss of accuracy. For those who desire to work with fewer stocks, the elimination of specific issues depends on individual investor's circumstance.
For U.S. investors, Canadian issues may hold disadvantages because of the added taxation on dividends and potentially added costs/risks associated with currency exchange.
If you do not work closely with over-the-counter stocks, the sometimes excessive spreads, the possibility of double charging (commissions plus markups/markdowns), the lack of accounting for order priority, and other factors can make this market less desirable than listed stocks.
This leaves the New York and American Stock Exchange issues. From these, the process of elimination becomes one of personal preference. If you do not like the name of a corporation, never heard of it, dislike an industry, then go ahead and scratch it. Throw darts. Let the kids decide. It is a matter of whim because the criteria used in developing the list are such that it mathematically makes little difference in the long term which stocks are selected.
Only two things must result after this condensation.
- The list should contain a minimum of 20 issues.
- The list should not be altered except to more issues from the Master List. No subtractions should be made unless they have been deleted from the original Master List. To do otherwise injects after-the-fact emotion, which can seriously detract from the probability of success and effectively destroys objectivity.
Whether you choose to follow all stocks or the minimum, the most important aspect is clear recognition that this is now your market. The principles and methods can be employed with the stocks selected.
Expanding the List
Some investors might feel that condensing the entire market to under 100 individual stocks is overly restrictive. Others might feel that the list should be altered to more closely duplicate the specific stocks comprising popular averages.
The statistical fact is that, in our method, the addition of issues that fail to meet the fundamental quality standards results in a net loss of accuracy as to both the percentage of individual positions including profitably and annualized return.
Changes in the List
Although additions and deletions to the Master List are rather infrequent, over time the list does change. Takeovers, buyouts, mergers, and the loss of fundamental quality reduce the number of acceptable issues, while the list can expand via corporations establishing the characteristics required by our criteria.
