The Ability to Pay: Graham’s Great Distinction (One of Many)
“The difference between stupidity and genius is that genius has its limits.”
- Albert Einstein
I’ve often mentioned that during times of continued market highs, I spend an awful lot of time reading the value investment classics. This helps me keep my eye on the “value” ball and grounds me in my more natural condition of trading sloth and indolence. This week I started my 11th full read-through of Benjamin Graham and David Dodd’s classic “Security Analysis.” To be honest, this tome is a much greater slog than Graham’s “The Intelligent Investor”, but I highly recommend every investment manager and individual investor read it at least once. There seems to always be a diamond in each chapter that turns up through each reading.
Most investors tend to skim - or skip entirely - the sections on fixed income investing. This is unfortunate. These chapters have an enormous amount of insights that are transferrable between bonds and equities. To Graham and Dodd both types of assets are dependent upon price versus value first, and risk versus uncertainty second. Overpaying for a bond is as poor a decision as overpaying for a stock. Miscalculating risk is equally dangerous. So, I encourage everyone to roll up their sleeves, gird their intellectual loins, and do some additional reading. It will be well worth it in the long run of your investment education.
In reading Chapter 6, “The Selection of Fixed-Value Investments[1]”, investors get their first view of the now standard discussion of the rights of bondholders versus shareholders (hint: the former come first). Traditionally we think of an investor’s position in terms of ownership as bondholders, preferred shareholders, and shareholders respectively. We are also told to look at either a stock or bond investment as the purchase of a piece of a business. This is all very true. All too often investors (both individual and institutional) look at their purchase as a piece of paper or a digital number on a screen.
But in this chapter, we are told looking at your investment as a part of a business is really only half the equation. As Graham and Dodd point out, understanding the investment company’s ability to pay is equally - if not more important - than your placement in the rights to assets/profits hierarchy. They write:
“In the past the primary emphasis was laid upon the specific security, i.e. the character and supposed value of the property on which the bonds hold a lien. From our standpoint this consideration is quite secondary; the dominant element must be the strength and soundness of the obligor enterprise. There is here a clear-cut distinction between two points of view. On the one hand the bond is regarded as a claim against property; on the other hand, as a claim against a business.”
At Nintai Investments we think this is a tremendously important concept whether you are bond investor or stockholder. The old phrase “you can’t blood from a stone” applies as much to a turnip[2] as it does a cash flow negative investment holding. It doesn’t matter what your rights position is if the company has no ability to pay out – either in terms of cash flow or assets remaining on the balance sheet.
Why This Matters
It’s always best to look ahead and not fight the last war. The 2008-2009 Great Recession was (in part) caused by derivatives that blew up on company balance sheets with shocking speed and devastation. Just ask anybody who was invested in Washington Mutual (now part of J.P. Morgan). Another issue was the sudden elimination of access to short term debt. In this case, ask GE investors or anybody invested in business development corporations (BDCs). In some of these aforementioned instances, the investor found themselves owning a piece of a business – wherever they were on the rights continuum – that simply had no way of meeting their obligations. When Graham and Dodd wrote about “the dominant element must be the strength and soundness of the obligor enterprise”, they really weren’t kidding.
I would suggest there are three important lessons equity investors can take from this section.
There Will Always Be Future Rainy Days
No matter how rosy a picture management paints about the future, there will be inevitable downturns. Bad product launches, operational failures, or market downturns will inevitably place stress on your investment’s financial and competitive strength. In a recent call I listened to corporate management discuss the fact that revenue could decrease by 25% for the next five years and they could still pay the current dividend, fund current operations, and increase research and development without tapping their credit line. That’s what I call planning for a rainy day.
It’s Always Darkest Before It Goes Pitch Black
In 2008, I was participating on a conference call trying to get a better understanding of a company’s assets on the balance sheet. During the call the CEO announced they felt that while things were dark, they had reached a nadir in their financial distress. Over the next 6 months they wrote down an astounding additional 81% of total assets. Don’t let management fool you, things can always get worse when they don’t understand their very own assets. In this case, the company had no “strength or soundness” to meet their obligations.
The Future is Unknowable, But Cash Will Always Be King
It’s a fool’s errand to try to predict the directions of the markets. It would be quite a feat if someone had correctly predicted the length of the current bull market. One thing I’m comfortable predicting is that it will end. I haven’t the foggiest idea when, but I know it will end. When that time comes and confidence collapses, investors sell regardless of price/value, corporations will reduce spending across the board, and cash will be king. The ability to pay – so important to Graham & Dodd – will become a simple question of free cash generated and cash on the balance sheet.
Conclusions
Some writing is timeless. Graham and Dodd’s “Security Analysis” certainly falls in that category. The wisdom to be found in their writing can assist investors in both ascending as well as descending markets. More importantly, some suggestions by the writers apply to all types of securities whether they be bonds or stocks. The concept of buying a piece of a business is a great way to look at investing. Buying a piece of a business that can afford to pay its bills – regardless of market or economic conditions – is great value investing. The difference can make all the difference in your long-term returns.
As always, I look forward to your thoughts and comments.
[1] Benjamin Graham and David L. Dodd, “Security Analysis”, 6th Edition, McGraw Hill, 2009, pages 141-153
[2] Many people have different versions of this phrase. The original phrase seems to be “you can’t get blood from that wall” or “to go about to fetch blood out of a turnip” as used by Giovanni Torriano in an Italian/English translation manual. Why he chose a root vegetable is beyond the purview of this writer’s knowledge but might be worth a future article by a GuruFocus author. Investment knowledge can never be too esoteric.
“The difference between stupidity and genius is that genius has its limits.”
- Albert Einstein
I’ve often mentioned that during times of continued market highs, I spend an awful lot of time reading the value investment classics. This helps me keep my eye on the “value” ball and grounds me in my more natural condition of trading sloth and indolence. This week I started my 11th full read-through of Benjamin Graham and David Dodd’s classic “Security Analysis.” To be honest, this tome is a much greater slog than Graham’s “The Intelligent Investor”, but I highly recommend every investment manager and individual investor read it at least once. There seems to always be a diamond in each chapter that turns up through each reading.
Most investors tend to skim - or skip entirely - the sections on fixed income investing. This is unfortunate. These chapters have an enormous amount of insights that are transferrable between bonds and equities. To Graham and Dodd both types of assets are dependent upon price versus value first, and risk versus uncertainty second. Overpaying for a bond is as poor a decision as overpaying for a stock. Miscalculating risk is equally dangerous. So, I encourage everyone to roll up their sleeves, gird their intellectual loins, and do some additional reading. It will be well worth it in the long run of your investment education.
In reading Chapter 6, “The Selection of Fixed-Value Investments[1]”, investors get their first view of the now standard discussion of the rights of bondholders versus shareholders (hint: the former come first). Traditionally we think of an investor’s position in terms of ownership as bondholders, preferred shareholders, and shareholders respectively. We are also told to look at either a stock or bond investment as the purchase of a piece of a business. This is all very true. All too often investors (both individual and institutional) look at their purchase as a piece of paper or a digital number on a screen.
But in this chapter, we are told looking at your investment as a part of a business is really only half the equation. As Graham and Dodd point out, understanding the investment company’s ability to pay is equally - if not more important - than your placement in the rights to assets/profits hierarchy. They write:
“In the past the primary emphasis was laid upon the specific security, i.e. the character and supposed value of the property on which the bonds hold a lien. From our standpoint this consideration is quite secondary; the dominant element must be the strength and soundness of the obligor enterprise. There is here a clear-cut distinction between two points of view. On the one hand the bond is regarded as a claim against property; on the other hand, as a claim against a business.”
At Nintai Investments we think this is a tremendously important concept whether you are bond investor or stockholder. The old phrase “you can’t blood from a stone” applies as much to a turnip[2] as it does a cash flow negative investment holding. It doesn’t matter what your rights position is if the company has no ability to pay out – either in terms of cash flow or assets remaining on the balance sheet.
Why This Matters
It’s always best to look ahead and not fight the last war. The 2008-2009 Great Recession was (in part) caused by derivatives that blew up on company balance sheets with shocking speed and devastation. Just ask anybody who was invested in Washington Mutual (now part of J.P. Morgan). Another issue was the sudden elimination of access to short term debt. In this case, ask GE investors or anybody invested in business development corporations (BDCs). In some of these aforementioned instances, the investor found themselves owning a piece of a business – wherever they were on the rights continuum – that simply had no way of meeting their obligations. When Graham and Dodd wrote about “the dominant element must be the strength and soundness of the obligor enterprise”, they really weren’t kidding.
I would suggest there are three important lessons equity investors can take from this section.
There Will Always Be Future Rainy Days
No matter how rosy a picture management paints about the future, there will be inevitable downturns. Bad product launches, operational failures, or market downturns will inevitably place stress on your investment’s financial and competitive strength. In a recent call I listened to corporate management discuss the fact that revenue could decrease by 25% for the next five years and they could still pay the current dividend, fund current operations, and increase research and development without tapping their credit line. That’s what I call planning for a rainy day.
It’s Always Darkest Before It Goes Pitch Black
In 2008, I was participating on a conference call trying to get a better understanding of a company’s assets on the balance sheet. During the call the CEO announced they felt that while things were dark, they had reached a nadir in their financial distress. Over the next 6 months they wrote down an astounding additional 81% of total assets. Don’t let management fool you, things can always get worse when they don’t understand their very own assets. In this case, the company had no “strength or soundness” to meet their obligations.
The Future is Unknowable, But Cash Will Always Be King
It’s a fool’s errand to try to predict the directions of the markets. It would be quite a feat if someone had correctly predicted the length of the current bull market. One thing I’m comfortable predicting is that it will end. I haven’t the foggiest idea when, but I know it will end. When that time comes and confidence collapses, investors sell regardless of price/value, corporations will reduce spending across the board, and cash will be king. The ability to pay – so important to Graham & Dodd – will become a simple question of free cash generated and cash on the balance sheet.
Conclusions
Some writing is timeless. Graham and Dodd’s “Security Analysis” certainly falls in that category. The wisdom to be found in their writing can assist investors in both ascending as well as descending markets. More importantly, some suggestions by the writers apply to all types of securities whether they be bonds or stocks. The concept of buying a piece of a business is a great way to look at investing. Buying a piece of a business that can afford to pay its bills – regardless of market or economic conditions – is great value investing. The difference can make all the difference in your long-term returns.
As always, I look forward to your thoughts and comments.
[1] Benjamin Graham and David L. Dodd, “Security Analysis”, 6th Edition, McGraw Hill, 2009, pages 141-153
[2] Many people have different versions of this phrase. The original phrase seems to be “you can’t get blood from that wall” or “to go about to fetch blood out of a turnip” as used by Giovanni Torriano in an Italian/English translation manual. Why he chose a root vegetable is beyond the purview of this writer’s knowledge but might be worth a future article by a GuruFocus author. Investment knowledge can never be too esoteric.
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