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Sweet spot to invest in capital intensive firms


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For some capital intensive firms (like Level 3 and Sandridge), the best place to invest may be in the high yield or convertible debt as most of the cash flow will accrue to these instruments before the common gets anything.  Sandridge has a convertible preferred which may be better than the common as you get a great yield and the opportunity for upside with the conversion feature.  I am invested in the common but in the future in this type of business I may take a hard look at debt/convertibles before I buy the common.  Was just wondering if others feel this way also.

 

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Look at the new equipment financing businesses; leasing, vendor financing, etc. The crisis forced most parent &/or shadow bankers to exit the market, hence it is very under served.

 

Know that these businesses are inherently unstable as LT assets end up being funded with ST debt; if they can't roll their ST debt they go under - even the GE Capitals of the world. They are marketing tools, & their primary business purpose is to move metal (ie product of the underlying manufacturer), not necessarily make money in their own right.

 

To be successful you need scale. The bigger you are the lower your Cost Of Funds, the more and earlier you see new deal flow, & the greater your ability to reject the probable duds. Over time, margins initially increase as financing is walked down the yield curve, then declines to zero as pricing is reduced to move more metal.

 

The early years of the business model favor rapid growth, funded with recurring equity financing's priced at growth multiples. The middle years favor a sale of the various financing platforms to other entities (sovereign wealth funds, banks, manufacturers, etc).

 

You also may want to keep in mind that the mindset in the early stage of the business is very different from that in the later stages.

 

SD

 

 

 

 

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For some capital intensive firms (like Level 3 and Sandridge), the best place to invest may be in the high yield or convertible debt as most of the cash flow will accrue to these instruments before the common gets anything.  Sandridge has a convertible preferred which may be better than the common as you get a great yield and the opportunity for upside with the conversion feature.  I am invested in the common but in the future in this type of business I may take a hard look at debt/convertibles before I buy the common.  Was just wondering if others feel this way also.

 

Packer

 

Your way of analyzing the entire capital structure of companies is very interesting.  Curious if you posted at all about the pricing of the capital structure of banks and financials in 2008-2010.  I am sure there were some discrepancies there and it seems like your investing style may have picked up on a few.

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For some capital intensive firms (like Level 3 and Sandridge), the best place to invest may be in the high yield or convertible debt as most of the cash flow will accrue to these instruments before the common gets anything.  Sandridge has a convertible preferred which may be better than the common as you get a great yield and the opportunity for upside with the conversion feature.  I am invested in the common but in the future in this type of business I may take a hard look at debt/convertibles before I buy the common.  Was just wondering if others feel this way also.

 

Packer

 

Your way of analyzing the entire capital structure of companies is very interesting.  Curious if you posted at all about the pricing of the capital structure of banks and financials in 2008-2010.  I am sure there were some discrepancies there and it seems like your investing style may have picked up on a few.

 

Packer, you're in good company.  This is the way Warren frequently invests when there is some risk a company might not survive.

 

jay21, That's how Warren invested in BAC as opposed to buying pure common stock as he did when the MOS was greater with WFC.

 

In retrospect, that extra protection may not have been necessary with the TBTF banks.  They weren't in Cpt. 11, but think of the worst of the TBTF banks a few years ago as if they were with the US as their trustee.  Hypothetically, the common could then be viewed as the fulcrum security on the bubble for survival after taking a haircut.

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Packer, I agree although I have limited experience in this area.  Having this in your toolbox seems like it would be especially useful since you specialize in high debt companies.

 

A good example of this working is LUTHP, it was a steal recently at 60 cents on the dollar, now back up to 88. A good example of it not working would be ATPGP.

 

For reference,

http://quantumonline.com/ - A list of all preferred, convertible preferred, etc.

http://screener.finance.yahoo.com/bonds.html - Screening for distressed bonds.

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For some capital intensive firms (like Level 3 and Sandridge), the best place to invest may be in the high yield or convertible debt as most of the cash flow will accrue to these instruments before the common gets anything.  Sandridge has a convertible preferred which may be better than the common as you get a great yield and the opportunity for upside with the conversion feature.  I am invested in the common but in the future in this type of business I may take a hard look at debt/convertibles before I buy the common.  Was just wondering if others feel this way also.

 

Packer

 

Your way of analyzing the entire capital structure of companies is very interesting.  Curious if you posted at all about the pricing of the capital structure of banks and financials in 2008-2010.  I am sure there were some discrepancies there and it seems like your investing style may have picked up on a few.

 

Packer, you're in good company.  This is the way Warren frequently invests when there is some risk a company might not survive.

 

jay21, That's how Warren invested in BAC as opposed to buying pure common stock as he did when the MOS was greater with WFC.

 

In retrospect, that extra protection may not have been necessary with the TBTF banks.  They weren't in Cpt. 11, but think of the worst of the TBTF banks a few years ago as if they were with the US as their trustee.  Hypothetically, the common could then be viewed as the fulcrum security on the bubble for survival after taking a haircut.

 

During the Q&A at either the 2009 or 2010 annual meeting Buffet and Munger said something to the tune of "If you like the bonds then your usually better of buying the stock". Does anyone remember or have a transcript of that? That might be a good addition to this conversation about when it makes sense to hold debt, convertible prefs, or stock.

 

I don't totally agree that the BAC/GS/GE deals are the same as buying convertibles. It it is better because you get the benefit of exposure through the warrants but you don't have to covert your principle to get it.

 

I think its very much a case by case basis which depends on what the price and features are of the convertibles.

 

During the crisis I bought Ford convertible prefs that had a $50 par with  %6.5 coupon from $2 up to $12 per share, the payment was in arrears a couple of quarters and I ended up getting the arrearage plus some regular payments for a while and then they called them in 2011. Much better option than the stock in retrospect. I can't claim that idea it was provided to me by a family member and I just started investing in stocks in late 2008 so it was just right place right time, rather than investing accumen. Wish I knew then what I know now, would have bought way more of those :)

 

Then looking recently at the CHK convertible prefs recently I would rather own the stock because I feel like the odds are good that they will trade much higher in the next couple of years and at that point the prefs might just start to reach the conversion point and I think the assets will hopefully provide a margin of safety to the common shareholder. So I guess that maybe that is the trick, if you feel the liquidation value has enough MOS then stay with the stock. If you are worried then buy the prefs, hopefully at nice discount.

 

 

 

 

 

 

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Thanks for that link (quantumonline.com). That looks like an excellent resource to delve into senior securities.

 

Yes that site is great, used it many times. Also you can pick up a Barron's if you want to browse over a list of securities and then go to quantum to see what the features and details are.

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I remember a quote from Françis Chou saying that when you see a company that is highly levered, debt is probably a better play than the common.

 

This has inspired me and I was tired of following Level 3, seeing that is was profitable on an operational point of view but was paying all their cash flow in interest. So I bought the bond and I'm  so far enjoying a 10% yield.

 

Also I figured that would Level 3 go bankrupt, the equity would get wiped out, but that the cash flow would probably be sufficient to allow a full recovery for a debt holder.

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Great essay by Andrew Redleaf:

http://www.whiteboxselectedresearch.com/wp-content/uploads/2012/09/WBA-Arithmetic-of-Equities-Final.pdf

 

Buying the bond and selling the stock has been the core day-to-day business of both our convert arb and credit funds for most of their history.

...

The trade of the present and perhaps the trade of the new decade is to sell the bond and buy the stock.

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