Wednesday, November 09, 2005

Trading on the Equity

“In a speculatively capitalized enterprise, the common stock holders benefit—or have the possibility of benefiting—at the expense of the senior security holders. The common stockholder is operating with little of his own money & with a great deal of the senior security-holder’s money; as between him & them it is a case of “heads I win, tails you lose.” This strategic position of the common stockholder with relatively small commitment is an extreme form of what is called “Trading on the Equity.” Using another expression, he may be said to have a “cheap call” on the future profits of the enterprise.”—Benjamin Graham.

A “Cheap call” on the future earnings. How?
I will use a hypothetical example to illustrate Graham’s assertion. Consider a steel company “Cyclical Business Inc” with the following financial statement numbers (I have for the sake of simplicity used only the numbers which are important in this case)

Debt

$75 m at 8%

Equity

$25 m

OPM

12%

No of shares

1 m


Scenario A
: Bad year of a typical cyclical business.
Scenario B: Good year of a typical cyclical business.

$ m

A

B

% Increase

Sales

100

200

100

EBIT

12

24


Interest

6

6


PBT

6

18

200

EPS

$ 6

$18


P/E

2

3


Market price

12

54

350


What is relevant in above table is the sensitivity of the EPS as compared to sales growth and the prospective markets returns. Having said that I would like to clarify that the sensitivity holds even on the downside (ie) if earnings drop we can expect that the drop in market price will be more as compared to drop in the sales. So it is all about where you catch the pendulum when it is swinging.

Leveraged Buyouts (LBO):
Apart from the advantages of speculative capitalization structure and sensitivity of EPS, LBO comes with an added advantage. Will use pie charts to illustrate,

(Table below represent the capital structure of a LBO company at the start of the buyout and after a few years)


While buying

After reducing debt

Equity

$ 10m

$ 10m

Debt

$ 90m

$ 40m




EBITDA

$ 20m

$ 20m

EBITDA * 5 (Value)

$100m

$100m

Market Value of equity

$10m

$20m

The advantage:
Generally it is the free cash flow from operations or sale of non productive assets that is used in paying off the debt. Thus we can probably expect that the EBITDA is atleast same even when the debt is down to $40m. Suppose we can sell out the company at the same multiple of EBITDA at which we got into it then our profit is atleast 100% (non-annualized)

LBO & Leveraged Arbitration:
We can apply the concept discussed above in increasing our return substantially from arbitration opportunities. Again will use a simplified example:

Expected return from arbitration

20 %

You have (equity)

$ 100

You can borrow (900% of your equity)

$ 900 @ 10% (say)

Total Profit after interest on leverage

$ 110

Return on your Equity

110 %

I am not saying that whenever an arbitration opportunity comes up we should borrow money and play the game, rather, only when the odds make it sensible enough to do so.

Conclusion:
A conservative capital structure is a must for a good business, I used to think, but when it comes to making a good investment “Price changes everything”. In other words,

“Safety does not reside in titles, or forms, or legal rights, but in the values behind the security issue”—Benjamin Graham.


7 Comments:

Anonymous day trading said...

Hello arpitranka, been looking for the latest info on futures trading systems and found Trading on the Equity. Though not exactly what I was searching for, it did get my attention. Interesting post, thanks for a great read.

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Anonymous futures brokers said...

Well done on a nice blog arpitranka. I was searching for information on commodity futures and came across your post Trading on the Equity - not quite what I was looking for related to commodity futures but very interesting all the same!

Well, Christmas is over and we're all getting ready for the new year and there aren't many trading days left. Although I'm still trying to grapple with where the dollar's headed next year. My feeling is that it's going to be much the same as this - all over the place, but possibly on the ascendant over the year, mainly due the instability in the Eurozone. And as for stocks, I think the safest thing is to stick to trading the indices. There's still too much downward pressure.

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