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

By Rohit Chauhan
In Arbitrage, Book review, Uncategorized
April 24, 2007
3 Min read
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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

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Company analysis worksheet and valuation template

By Rohit Chauhan
In Company analysis, Uncategorized
April 20, 2007
1 Min read
2 comments
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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)

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You can be a stock market genius – Bankruptcy and restructuring

By Rohit Chauhan
In Arbitrage, Book review, Uncategorized
April 19, 2007
3 Min read
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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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Why I avoid IPO’s

By Rohit Chauhan
In General thoughts
April 14, 2007
3 Min read
10 comments
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I have a very irrational reason (yes it is not a typo) for not investing in IPOs. My thinking is like this (A hypothetical tale)

I have a house and wish to sell it. Also I have a decent cash balance and I am no hurry to sell the house. I will sell the house if I can get a good price for it. Looking around I realise that my neighbour has just sold his house at a fantastic price. That tempts me into start looking for buyers and I approach a few brokers to test the market. The brokers are extremely bullish and tell me that this is a good time to sell and the market is hot !. I get all excited and invite a few brokers to come over and look at the house. A few brokers come over and have a look at the house. On inspecting the house, they notice a few problems in the house. The west side wall seems to be weak and roof needs repairing. They ask me to repair the roof and paint the walls so that the these ‘defects’ can be hidden. I go ahead and start the repairs and meanwhile the brokers are looking for buyers.

The broker meets the buyers and tells them that they have a great house on the market. The price for houses in that area have increased by 50% in the recent past and this house is a great deal. The buyer, all excited by the likely appreciation, comes over, looks at the house and agrees to buy it. A somewhat weak roof and wall goes un-noticed because the house is a great ‘investment’. Why bother checking!!

So the deal gets done and everyone is happy. I get a good price, the broker his commission and buyer gets the dream of price appreciation and hopes of profits in the future.

One year later, the RBI in all its wisdom raises the interest rates. The housing market starts slowing. Buyers are now more discerning. They are not buying to invest, but to stay. A house with a weak roof and wall is not a good place to stay. The buyer is finding it difficult to sell the house and has EMI to pay on top of that. Dejectedly he sells the house at a loss and resolves never to get sucked into such a scheme.

Ok, I am not an evil scheming guy 🙂

So now replace me with company, broker with merchant banker, buyer with investor and house with a company and you would get the point.

If I have only X no. of hours in a week to analyse stocks, why waste time looking for needles in an IPO haystack when I can find them more easily in the rest of the market (with full knowledge of all the problems and leaky roof !!)

 

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