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Fixed income investing

F

My blog and most of my posts refer to equity investments. I have once in a while posted on real estate. However fixed income investments are a fair percentage of my portfolio. The reason I don’t post much on fixed income investments is because there is not much I can do to generate extra returns in proportion to the time and effort I will have to spend on it.

The fixed income options available to me are

– Bank FD : this is almost a no brainer and the most passive form of investmtent. However I don’t chase returns blindly. I typically hold deposits in only the Top banks and avoid the second tier banks and co-operatives. The extra 1-2% return is not worth the risk. In addition, I tend to look at the capital adequacy ratio (CAR) and the NPA levels of the bank, before going ahead with the FD. The name or reputation of the bank alone is not sufficient. Typically the CAR levels of the bank should be above 8-9 % (TIER I) and NPA levels below 1-2 %.

– Company bonds : The next avenue for fixed income investing is company bonds. I have invested in company bonds and FD’s in the past when the interest rates were higher and it was possible for me to process the paperwork. However since 2000, partly due to the amount of paperwork involved then (there was no Demat for bonds) and due to the easy of investing in mutual funds , I stopped looking at company bonds and FD’s. Also due to the high profile failure of some of the companies and the losses incurred by the bondholders, I kind of lost interest in company FD’s and bonds. The key factors to look at when investing in such instruments is the interest coverage ratio ( PBIT/ Interest expense ) which should atleast be 4, Debt equity ratio for the company ( < 0.5 if possible) and debt rating by the rating agencies such as Crisil (invest in AAA or AA+ only).

– Mutual funds – fixed income: This is my favored avenue during a falling rate scenario and I tend to invest with well know mutual fund houses such as franklin templeton, DSP etc. At the time of investing in a debt mutual fund, I tend to look at the following factors
o Asset under management – avoid investing in funds with low level of asset as the expense ratios could be high.
o Fund expense – lower the better. Although the indian mutual fund industry typically gouges its customers and charges too high compared to the returns.
o Duration of fund – This is the average duration of the fund. A fund with longer duration will rise or fall more when interest rates change
o Fund rating – 80-90% of the fund holding should be in p1+ or AAA / AA+ securities.
o Long term performance of the fund versus the benchmark

– Mutual funds – floating rate funds : This is my favored approach in a rising rate scenario. In addition to all the factors for the fixed income mutual funds, I also tend to favor floaters with shorter duration.

– Post office : Nothing much to analyse in this option other than it was an attractive option a few years back when the Post office offered better rates than available in the market. Currently the 8-9% per annum for the 6 year duration is not attractive enough.

– FMP (fixed maturity plan) : I have just heard about it and have yet to understand about this investment option.

Finally in terms of tax effectiveness, debt based mutual funds are the most efficient as they are subject to long term tax rate after 1 year.

You can be a stock market genius – Recaps, stub stocks,warrants and options

Y

The final section of the book starts with recaps. Under a recap, a company may decide to buy back stock from the investor via cash, bond or through preferred stock. Thus the proptional ownership of the investor remains the same. However the company doing the recap is able to create value for the investor. For example, a company is trading at 200 Rs per share. The company earns 20 Rs per share (post-tax). The company returns Rs 150 to the shareholder by raising debt. Post the recap, the company has say Rs 15 of interest expense. As a result the post tax earnings are now are Rs 11 share (assuming 40% tax rate). Even if the company continues to sell at 8 times earning, the net gain for the shareholder is now Rs 38.

The stock after the recap is called as a stub and an investor can benefit from buying such stub stocks after the announcement of the recap. The reason for this is that the stub is a leveraged position on the stock. As the company has high amount of debt, the equity value is depressed due to high leverage. As the company pays off debt, the earnings grow rapidy. Also the multiple could expand at the same time due to reduction in the risk. As a result a small improvement in the debt level can result in a large improvement of the stock price.

Recaps are rare (and even rarer in the indian markets). As stubs via re-caps are rare, the same result can be achieved through LEAPS (Long term equity anticipation security). Leaps are a form of long term call options on the company. They are a leverage call on the medium to long term performance of the company. For sake of an example, lets assume that the stock price of company is Rs 88 / share. The company is highly leveraged and I feel that the company should do well in the next 1-2 years. I could (theortically speaking) buy a LEAP at 50 Rs/ share. If the company does well and the stock goes to 150 Rs/ share in two years, my gain would be 300%. The downside is that if the stock goes below the strike price, then I lose my money completely. LEAPS are thus a leveraged bet on the performance of a company. However, I think the indian market does not have LEAP securities yet.

Warrants provide an alternative route to put in a leveraged bet on the performance of the company. Warrants however have an advantage that their duration is much longer than options and LEAPS. The book has specific examples on recaps and all the other specific arbitrage options like spin-offs, arbitrage, and merger securities.

For all the previous posts on the book
Introduction
Bankruptcy and restructuring
Arbitrage and merger securities
Spin-offs

Company analysis worksheet and valuation template

C

I have received several requests for my company level valuation template. Instead of responding individually to each of the request, I am posting it in the ‘My analysis worksheet section’ (see here)

The company level analysis worksheet is still a work in progress and I will keep uploading updated versions in the future. I use this worksheet as I detailed it here in an earlier post, for a detailed analysis of a company once it has passed through the basic filters.

I am also uploading the worksheet which I created for gujarat gas limited in 2003 (see here). I have since then, bought and liquidated my holding. I will upload more of such worksheets in the future.

In addition, I am also posting a quantitative worksheet. This worksheet has some quantitative analysis of the relationship between PE, ROC and Competitive advantage period. It has a similar analysis of the relationship between FCF (free cash flow), ROE and depreciation (see here)

You can be a stock market genius – Bankruptcy and restructuring

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The next section of the book deals with how to profit from bankruptcy and restructuring. As in the other parts of the book, the author again emphasizes the point that an investor should ‘pick his spots’ within the bankruptcy arena.

It is rarely a good idea to purchase the stock in a company which has recently filed for bankruptcy. As the stock holders have the lowest claim when a company files for bankruptcy, usually they end up getting very little or almost nothing at the end of the bankruptcy proceedings.

One way to make money off bankruptcy is to invest in the debt securities of such a company which may be selling at 20-30 % of the face value. However this is a very specialized field which is best left to experts who specialize in this field.

The best way to profit from bankruptcy is to invest in the new common stock of the company which is issued after the completion of the bankruptcy proceedings. Since the stock is issued to the current creditors like banks or suppliers, they are rarely interested in holding the stock due to which there is a selling pressure after the new common stock is issued. This creates a situation similar to spinoffs. However it is critical that the investor analyses the company in detail before buying the common stock as random purchase of such stocks that have recently emerged from bankruptcy will rarely result in superior long term performance. There are several reasons for it. One reason is that most companies that have gone through bankruptcy were in diffcult or unattractive businesses to begin with and shedding debt obligations does not change the basic economics of the business ( think airlines). However if the investor does reasonable due diligence, then he would be able to find a few attractive opportunities which the underlying economics of the business is healthy.

The next area of opportunity is corporate re-structuring. If there is a major re-structuring of a company where a major division is spun off or if a losing business is sold off then such an event can create a profitable opportunity. After spinning off the weaker or money losing division, the resulting company is more profitable and focussed and may be given a higher multiple by the market. In addition the re-structuring can create a more focussed and efficient enterprise which may perform better in the future. Investing in the company after the re-structuring is over can be a profitable option.

Previous post on arbitrage
Previous post on spin-offs

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