24 On Creditworthiness


Much emphasis is placed on general “debt levels” in the belief that the amounts borrowed by U.S. Federal, State and Local governments are way too excessive.  Indeed 74% of recent poll respondents stated that a high priority ought to be given to debt reduction by governments.

It is obvious that this almost universal emphasis on general debt levels is misplaced.  Rather the emphasis should be on the creditworthiness of borrowers, specifically what are the borrower’s abilities to access capital markets, if needed.

There are two things about borrowing that any rational analyst ought to keep in mind.  First, while individual debt instruments mature, aggregate debt for most borrowers almost never gets repaid from the borrower’s perspective.  Rather for most borrowing entities, debt is refinanced and expanded as the borrower becomes increasingly creditworthy.  Second, if a borrower is not creditworthy and can’t be made creditworthy, then sooner or later that borrower has to reorganize or liquidate.  Reorganization can encompass capital infusions, major asset sales or a recapitalization designed to reduce or extend cash service that the borrower has to pay out for interest, principal retirements and premiums.

Creditworthiness is a function of four factors for feasible borrowing entities – whether corporate or governmental:

  • Debt level
  • Terms of the Debt
  • How productive are the Use of Proceeds received from the borrowings
  • How liquid is the borrower

There seems to be a common belief that a government’s use of proceeds is always non-productive.  Insofar as this is true, it seems to be valid to concentrate attention on the debt level because large debt levels coupled with a lack of productive use of proceeds means that the government entity will not be, or remain, creditworthy.  However, there seems to be no evidence that all government expenditures are non-productive.  Indeed, in at least three historic areas, the federal government’s use of borrowed moneys was unbelievably productive, probably returning to society and the country benefits with a present value hundreds of times greater than the amounts spent.  These three areas which come to mind are as follows:

  1. The Homestead Act of 1862 which enabled and accelerated the rapid settlement of the U.S. West.
  2. The Serviceman’s Readjustment Act of 1944 (the GI Bill of Rights) which resulted in the U.S. obtaining a highly educated population and the world’s best university system.
  3. Research and Development expenditures by the U.S. military after World War II which, among other things, gave the U.S. and the world, the Internet and a highly efficient aviation industry.

The U.S. Government, and its agencies, are creditworthy and seem likely to remain creditworthy for the foreseeable future.  In contrast, many states and local governments, including Puerto Rico, a territory, are not creditworthy.  Sooner or later many of these entities will have to reorganize, i.e., restructure their debts to reduce or eliminate periodic cash burdens.

Reorganizing governments seems to be many times tougher than reorganizing corporations:

It may be hard for various Third Avenue Funds, managed by Third Avenue Management (TAM), to become involved with much troubled municipal debt unless prices are manifestly lower than they are for troubled corporate debt.  For this there are three general reasons:

  1. Chapter 9 may not be available to the defaulting debtor.
  2. It may be impossible to get rid of incompetent elected officials.
  3. It may be hard to issue equity to impaired pre-petition creditors to satisfy part, or all, of their claims.

Many governments including all 50 states and Puerto Rico are not eligible to reorganize under Chapter 9 of Title 11 (the Bankruptcy Code). Access to courts through Chapter 9 provides a structured setting in which the rules for reorganizations are spelled out for local governments and their agencies. Also, post-petition borrowings can be very attractive to lenders if the borrower has been granted Chapter 9 relief.

No municipality can seek Chapter 9 relief without the affirmative consent of the state in which the municipality is located. It seems as if in the vast majority of instances outside Title 11 no creditor in this country can ever be forced to give up his, her or its, rights to money payments without his, her or its consent. In a court proceeding (such as Chapter 11, 7 and 9 of Title 11) this right can be abrogated. Without the ability to coerce creditors to give up their rights to cash payments, huge hold-out problems exist markedly reducing the probabilities of achieving a successful Plan of Reorganization (POR). If Chapter 9 is available to a government or its agencies, individual creditors can be forced to accept a POR which entails the creditor giving up rights to contracted for money payments upon the affirmative vote for the POR by two-thirds in amount and 50% in number, of the votes cast by each impaired class. Alternatively, the reorganization can take place in Chapter 9 after a cram-down ordered by a court of competent jurisdiction, usually a Bankruptcy Court.

Unlike corporate reorganizations, for sovereigns such as municipalities the period of exclusivity lasts forever (Corporations have exclusivity for 210 days after a Chapter 11 filing). Elected government officials most probably can’t be removed from office as a result of bankruptcy proceedings.

The ultimate goal of a reorganization is to make the debtor feasible (i.e., creditworthy) within the context of maximizing present values for creditors up to the amount of the creditors’ claims in accordance with a rule of absolute priority where no creditors of a class are given preference over other members of the same class, (forgetting certain priorities written into the Bankruptcy Code).

In corporate reorganizations, it is relatively common to issue ownership interests to impaired pre-petition creditors in satisfaction of the present value of their claims. Such equity interests might satisfy some or all of a creditor class’s claims. In issuing cash, or new debt which requires cash payments sooner or later, as part of a POR, the debtor has a harder time becoming feasible than if ownership interests were issued in, say, common stock which does not pay a dividend. In the vast majority of governmental reorganizations, it seems not possible to satisfy any portion of creditors’ claims by issuing ownership interests either in the form of equity interests or the direct distribution of assets.

The Role of Net Asset Values for Certain TAM Portfolio Companies
Many common stocks in various Third Avenue Portfolios: e.g., Brookfield Asset Management, Dundee Corp. Exor, Henderson Land, Investor A/B, Lai Fung Holdings, Lai Sun Garment, Pargesa, Toyota Industries, Wheelock & Company and a goodly proportion of the issues held by Third Avenue Real Estate Value Fund; are selling at discounts from readily ascertainable Net Asset Values (NAV) of anywhere from 25% to 75%. These are the common stocks of companies which are well-financed and which have had good to excellent records of growth. In contrast to these discounts, the Dow Jones Industrial Average (DJIA) at January 31, 2014, was selling at 2.79 times book value. In other words, certain TAM Portfolio companies can be acquired at, say, 25¢ to 75¢ for each $1.00 of corporate net assets most of which are accounted for under International Financial Reporting Standard (IFRS),while comparable DJIA assets cost $2.79 for each $1.00 of corporate net assets most of which are accounted for under Generally Accepted Accounting Principles (GAAP). This discrepancy makes no economic sense except that the discounts have always existed for the securities named at the start of this paragraph and no catalysts such as changes in control or going private, appear to exist for those companies.

The quality of net assets of the TAM portfolio companies appears to be significantly better than the quality of the net assets of the DJIA portfolio companies. Also NAV, or book values, seem to be significantly more important in analyzing the TAM portfolio companies and their securities than is the case for the DJIA portfolio companies. There are a number of reasons for this superior quality factor:

The TAM portfolio companies appear to be more strongly financed than the DJIA portfolio companies.

The reported NAV’s in accounting statements for TAM portfolio companies which are domiciled outside the United States are mostly more realistically stated than are the NAVs for DJIA portfolio companies. Non-US companies which are publicly traded use IFRS in reporting publicly while US companies rely on GAAP. Insofar as portfolio companies own income-producing real estate (as many TAM portfolio companies do), the real estate accounted for under IFRS is carried at an appraised value based on appraisals by independent appraisal firms; under GAAP income producing real estate is carried at depreciated historic cost less impairments.

The assets of TAM portfolio companies are probably more liquid and probably more easily measurable than is the case for the DJIA portfolio companies. A large portion of the TAM portfolio companies’ assets consist of income producing real estate, performing loans, Assets Under Management (“AUM”), and marketable securities; assets, that by and large, are measurable, separable and salable. In contrast, most DJIA assets have almost all their value tied-up as an integral, and inseparable, part of going concern operations.

The Price Earnings Ratios (PE) for the TAM portfolio companies are manifestly lower than is the case for the DJIA portfolio companies. Indeed, several of the TAM portfolio companies’ which report under IFRS standards, sport PE ratios of 2 to 3 times reported earnings. PE ratios are integrally related to NAV’s and are a function of Return on Equity (ROE). The TAM portfolios, of course, have much higher equity values per dollar of market value than do the DJIA portfolio issues. The ROE’s for the TAM portfolio companies appears to be comparable to the ROE’s for the DJIA portfolio companies. Thus, the TAM portfolio common stocks are characterized by relatively modest PE ratios.

There are problems with an NAV emphasis, in general, and with the TAM portfolios, in particular.

Discounts from NAV, and NAV itself, are pretty much ignored by most market participants, including even disciples of Graham & Dodd (G&D). G&D were believers in the primacy of the income account, even though they did not ignore NAV completely.

There is a tendency for the managements of well-financed companies such as those in the TAM portfolio to be relatively oblivious to the needs and desires of outside minority shareholders. In a way this is understandable since managements, which often own little or no common stock, run companies that need little or no access to capital markets. Historically, this has been a special problem for many well-financed Japanese companies whose common stocks were selling at material discounts from NAV. TAM tries to avoid investing where these types of managements exist. In the TAM portfolios, managements and/or insiders are substantial shareholders.

In this era of ultra-low interest rates, companies with strong financial positions are sacrificing ROE for the safety and opportunism inherent in having a strong financial position. TAM is very prejudiced in favor of opportunistic managements such as those heading Brookfield Asset Management and Wheelock & Company, both of which subsequent to the 2008 economic crisis were able to acquire companies or assets on highly attractive bases.

There is little or no attraction in focusing on NAV for going concerns lacking catalysts if the market participant has a short run goal; i.e., where short-term market performance is the most important consideration. I believe that a vast majority of market participants are short–run oriented.

One major problem with the TAM portfolio is that there appears to be little possibility that there will be changes of control or going-private, two courses of action that could result in immediate, and substantial, market price appreciation for a common stock. Rather in the TAM portfolio, one has to rely on the continued growth of NAVs in an environment where discounts don’t widen materially over a longer term period.

However, for virtually all TAM portfolio companies, at least 80% of the time in at least 80% of the cases, NAV seems likely to be larger in each reporting period than it was in the prior period. Historically this has been the case, at least since the end of World War II. While this fact alone does not guaranty good market performance for a TAM portfolio, it at least seems to have promise of putting the odds in TAM’s favor where the common stock was acquired at a meaningful discount from NAV.

Having served on an audit committee, as a Director of an NYSE company audited by a member firm of the Big 4, I think a comment about how reliable and protective of minority stockholders I think US audit statements are, appropriate. This is important when investing in companies where financial statements are important for an analysis something that is always the case in credit analysis and also is the case both for TAM portfolio companies and DJIA portfolio companies. (Financial statements are less important when analyzing the common stocks of high tech start-ups or natural resource companies seeking or exploiting new discoveries). Auditors tend to be ultra-strict and conservative when certifying audited financial statements. The auditors will insist that material matters be disclosed by management; and that disclosures be complete and comprehensive within the modifying convention of conservatism. Audits can be relied on by market participants to be comprehensive, reliable and essential tools for most analyses. It seems remote, to me at any rate, that the US companies in which TAM invests, will be subject to all the problems several years back that existed in connection with the Enron financial statements. The last thing a Big 4 Audit firm seems to want is accountant’s liability arising out of stockholder class actions or Securities and Exchange Commission proceedings. The last thing TAM portfolio managers and analysts want to do is invest in the common stocks of companies whose financial statements are incomprehensible, or almost so.


Dear Fellow Shareholders... Copyright © 2016 by Martin J. Whitman. All Rights Reserved.

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