Our Investment Philosophy
The publication of the Equity Strategies Fund 1989 Annual Report affords good opportunity to discuss with all shareholders the underlying investment principals: what we see as the potential and the problems with our investment programs. The discussion below is divided into four topics:
- Troubled Issues
- Mezzanine Securities
- Equity Securities
- Business Development Investments
A troubled issuer is a company which has either defaulted on money payments due creditors, or where there appears to be a high degree of probability that such a default will occur. If the Fund is going to invest in the securities of troubled issues, it has been and will be as a senior creditor, preferably a secured creditor. Fund investments in these credits in recent years have included Anglo Energy Secured Income Notes (now Nabors Industries), Johns-Manville Debentures, Mission Insurance Group Notes, LTV Steele Trade Claim, Public Service Company of New Hampshire Second Mortgages and Public Service Company of New Hampshire Third Mortgages.
This has been a fertile, relatively non-competitive investment field for the Fund where returns have probably averaged well over 20% per year compounded including situations (e.g. Mission Insurance Group) where the workout has proved to be difficult and time consuming. The relative non-competitiveness of the field arises, I think, out of the fact that our analysis focuses on different variables than almost everyone else’s. All credit analysis and most security analysis, e.g. Graham & Dodd, are concerned solely with how to avoid investing in credit instruments where there might be a money default. Our emphasis, on the other hand is on what will occur in the event there is a money default. Frankly, most analysts have neither the background nor the access to qualified professionals to be able to be effective in dealing with defaulted securities.
In general, the senior debt of troubled companies is of two types: issues which will participate in reorganization and issues which will not participate in reorganization. Judgements as to whether a troubled credit will or will not participate in a reorganization involve analysis by people relatively experienced in workouts. Issues which will not participate in a reorganization are true credit instruments which will remain pretty much as is after a reorganization (whether or not that reorganization occurs voluntarily or in Chapter 11), and which, even during a Chapter 11 reorganization, may never even miss an interest payment. The Fund tries to acquire such non-participating credits at current yields of 18% – 20% or better, and with yields to “an improved credit rating” of not less than 40% annually. Such non-participating investments by the Fund have included the LTV Trade Claim, Public Service Company of New Hampshire Second Mortgages, Public Service Company of New Hampshire Third Mortgage Industrial Revenue Bonds, and probably NACO Financial Notes. Non-participating credits of troubled issues remain a promising area for Fund Investments.
Credit instruments that are going to participate in the reorganization of troubled issues pose a different set of problems. The basic rule (and law) in reorganization is that a senior creditor participating in a reorganization is entitled to receive “Full Value” before anyone junior to the senior creditor receives anything at all, unless a requisite vote is obtained in a Chapter 11 case and, as a result of that vote, the class of senior creditors agrees to accept less than full value. Full value need not be paid in the same or similar credit instruments, but might be paid in all sorts of considerations ranging – in whole or in part – from cash, to other assets, to new debt instruments, to common stock and warrants. The U.S. Bankruptcy Code contemplates that Plans of Reorganization be consensual, i.e. negotiated between creditors and parties-in-interest. By and large, those negotiations determine whether or not an individual creditor will get full value, and in what form such value, whether full or less than full, is to be paid. Fund investments in these participating credits have included Anglo Energy secured Income Notes, Johns-Manville Debentures and Trade Claims, Mission Insurance Group Unsecured Notes, Petro-Lewis Secured Debentures and Public Service Company of New Hampshire 13 ¾% Third Mortgage.
If investments in these participating credits are going to work out well for an investment company, the investment company has to be in a position to ride the coattails of an activist. The very nature of consensual plans requires hard, active negotiating – and legal posturing – if a class of creditors is to receive a satisfactory value in a satisfactory form. Being active is a very expensive proposition, especially looking at the rates lawyers, investment bankers, and accountants charge nowadays. In my view, active investing is inappropriate for companies such as Equity Strategies which is a Registered Investment Company under the investment Company Act of 1940, as amended. This does, however, remain an attractive investment field for the Fund. Equity Strategies will continue to make investments as a senior creditor where it hopes to participate in reorganization. However, it will generally do so only as a coattail-rider of third party activists whom we believe are highly competent, and only when there can be no question but that the Fund is a passive investor.
Mezzanine securities, under our definition, are instruments which based on our purchase price show promise of giving the Fund an annual pre-tax cash return, or zero-coupon return of in excess of 20%, and where there does not appear to be large risks of either a money default or of a contemplated transaction including liquidations, not closing. In the event of a money default, mezzanine securities have to accept a junior position. Under our definition, any junior security can be a mezzanine security as long as it has reasonably well defined contractual terms and/or reasonably well defined workout terms. Fund investments in mezzanine securities have defined workout terms. Fund investments in mezzanine securities have included Adobe Resources Preferred Stocks, Empire Gas Subordinated Debentures, First Pennsylvania Corp. Common Stocks, National Loan Bank Common Stock, Royal Palm Beach Colony, L.P., Texas American Energy Subordinated Debentures; Vyquest, Inc. Subordinated Debentures and Weatherford International, Inc. Preferred Stock. While Equity Strategies appears to have done satisfactorily investing in mezzanine securities, it is unlikely that such investments are ever going to become a large part of the Fund’s portfolio even if many issues become available at ultra-attractive prices. It is just too unsettling swimming in the mezzanine swamp, as contrasted with either being a senior creditor, a holder of high grade equities, or an investor involved with business development. The basic problem with mezzanine investing is that each issuer tends to have specific weaknesses and if something does go wrong, it frequently is hard to protect the Fund’s investment position.
Equity securities are issues which have residual rights and are, in effect, ownership interests in going concerns. With only the most minor exceptions, all Fund investments in equity securities have the following characteristics:
- The Company has an extremely strong financial position.
- The Company appears to be reasonably well (or at least honestly) managed.
- There is a plethora of documentary information about the Company which is available to us and is understood by us.
- The equity security is available for purchase by us at a price which we believe represents a substantial discount from what the Company is worth as a private business.
Equity security investments have included the common stock of Adobe Resources, Capital Southwest Corp., Digital Communications Associates, Exxon, Ford, GATX Corporation, various genetic engineering companies, Kentucky Central Life Insurance Company, Liberty Homes, Penn Central and Perini Corp.
In our type of equity investing, there are two separate areas that one can look to: performance and value. In performance investing we not only follow the four criteria listed above but, in addition, look for a catalyst – a hostile take-over, friendly merger, restructuring – that will cause the common stocks (or its equivalent) to appreciate in the relatively near term. In value investing only an attractive price is sought; there does not have to be a catalyst.
By and large, Equity Strategies, insofar as it is an equity investor, is a value investor not a performance investor. I am not against performance investing but it tends to be a lot harder to do successfully than value investing. This is due, in great part, to the fact that most equity investors are looking for catalysts. If you want to be a successful performance investor, most of the time you have to be prepared to pay up, i.e. pay higher prices than that at which comparable values may be available. This tends to be hard for us to do.
Value Investing has its problems. The biggest single one seems to be that the companies invested in frequently are run by conservative, deeply entrenched managements and control groups who care a lot less than Equity Strategies shareholders do about when good stock market price performance will occur. Even given this, I believe that a portfolio of well selected value equities ought to earn reasonably satisfactory returns and ought to entail reasonably small investment risks.
The more I am around value equity investing, the more convinced I become that bargain purchases are created at least as much by past prosperity for companies (which does not get reflected in the market price for a company’s common stock) as they are by bear market. Regardless of the level of markets, good analysts ought to be able to uncover pretty good value most of the time.
One final word about equity investing by Equity Strategies. We are bottom-up investors not top down and the Fund also is a “good enough” investor, not a profit maximizer. Put simply, we analyze companies and individual securities, not markets and economies. If we think the internals for a company and its securities are good enough to meet our hurdle rates – a pre-tax return of 30% or better without meaningful investment risk; we ignore market risk completely. For example, we do not hesitate to buy Kentucky Central Life Common at 12, even though somebody’s technical approach to the market indicates that the common stock might sell down to 7 or 8. We worry about being wrong about the Kentucky Central Life business and about what the real value of the Kentucky Central subsidiaries might be; we do not worry about how the Kentucky Central Life Common Stock will perform. We assume – usually correctly – that if we are right about the Kentucky Central Life business, the market will catch up sooner or later. Market timing is a luxury we cannot afford. Business analysis is tough enough without overlaying it with market analysis; something we feel usually is not less than 99.44% mumbo-jumbo.
Business Development Investments
Business development investing entails funding a company either directly or indirectly through exchanging debt for common stock with the result that the company becomes strongly capitalized, and Equity Strategies becomes a holder of a significant percentage of that company’s equity. To date, Equity Strategies has invested in two business development situations: Nabors Industries and KCP Holding. If Vyquest reorganizes, it too will become a business development investment.
The risk reward ratio for Equity Strategies can be quite good in business development investing, but most of the investments seem to involve a high “beta”, that is big risk potential, big reward potential.