Value Investing Forum

mals said:

Well written.

I have had similar thoughts about investing in small caps where I cannot be as certain about management's capital allocation choices.

 

Re diversification, there is one other element – if a company is reasonably diversified, then

  – I think management will be more willing to make decisions that are somewhat bold and worry less about unnecessary hedging

  – Banks would be more willing to issue lower cost debt where needed

So in theory what you are saying holds true for an investor, but in practice there are perhaps other benefits to reasonable diversification.

Risk of course is that mgmt is driven by the wrong reasons because the line is thin and determined by judgement.

 

 

Banks would be more willing to issue lower cost debt where needed

Agreed – so debt holders don't have the same level of upside potential to compensate for large amounts of risk, and so it seems like if you want access to debt, you need some level of diversification. IE, typically if you need financing that requires a 13% return, you will turn to the equity markets and not debt markets. The debt markets want something a bit more secure. 

I think management will be more willing to make decisions that are somewhat bold and worry less about unnecessary hedging

Are you thinking in terms of from keeping the financial statements in line? So if they have only 1 line of business and they make a bold move of some kind, it affects the income statement entirely. If they have 4 lines of business and make a bold move with any 1 of them, then the other 3 still resemble a normal scenario and keep it from becoming too weird.

I wonder if this represents a conflict of interest between debt holders/management and equity holders. From management's perspective, the diversification helps keep their jobs, affords them flexibility with big moves in the business, and let's them worry less about hedging. From bond holder's perspectives, not being exposed to any 1 very specific line of business' risk will help them protect their downside risk because they can rely on other sources of income to cover debt repayments. Equity holders though… they would probably prefer less diversification at the company level, because "pure plays" can be easier to understand and analyze and they can easily diversify by purchasing other stocks. 

That said, there is a possibility that stock holders would like diversification to the extent that it helps with capital allocation. If you only have 1 source of revenue, any extra capital is either allocated to it, or set aside in the bank, or issued as a dividend. If management doesn't have a significant stake in the business, they will be more likely to invest the extra cash into the business even if it isn't necessarily the best choice. This means that if you have multiple lines of business, they might be more likely to compare performance of each and allocate it to the one that will produce the greatest returns.

In addition, tax concerns could offer a large benefit to diversification. Typically, a corporation has to earn money, get taxed on it, then distribute it through dividends to shareholders, who are then also taxed. Getting cash to the shareholder and then to other investment opportunities is pretty darn inefficient. A diversified company can shift the resources without issuing a dividend and saving a layer of taxes, which means that you end up with a significant amount more of capital available for investment purposes. To this extent, stock holders may like diversification as well.

Post edited 4:38 am – December 18, 2011 by ankitgu

I hope this is posted in the right category. It is a continuation of the comments here: http://www.oldschoolvalue.com/…../#comments

The 2 topics discussed of interest to me are capital allocation and diversification. The third of size is my own for discussion of investments based on size of AUM.

1) Capital Allocation

GRVY has a ton of money just sitting in the bank account. Unless it is used for something, what good does money in the bank account really do? What does it accomplish? 

You can look at their annual statement and see that this isn't something new, they've been slowly building up a large cash reserve for a very long time. What are they saving it for? Is there a purchase they want to make or is it simply to ensure that even in a bad situation, they can pay management's salaries? Building a war chest is very reasonable, but it seems to me like they're out of places to put the money to use and so now it's actually useless in their control.

Further, if they use it in R&D as their way of allocating capital, it will actually show the company operating at a loss. Right now, a part of the investment thesis is that they're at or above cash flow break even and so it doesn't "lose money." Should they invest, the income statement and statement of cash flows will show a loss. What happens to the thesis  at that point? We won't really know the outcome of that R&D for quite a while, because if those projects take time like this new game has taken, it'll be another 5-7 year long bet that management is making.

If they use it to buy a company, what happens to our investment thesis? We won't have a "net net" any longer to invest in, we'll own stock in a pure operating business that we are counting on staying profitable if we ever want to see a cash return on the investment.

2) Diversification

Diversification is not inherently good simply for the sake of diversification… it comes at a cost, the question is if it's worth it. Think about a situation where it helps the profitability. Imagine if you wrote an earthquake insurance policy on a $100 home in Indiana and a $100 home on the coast of California. If you only insure 1 state, then an earthquake in that state would mean a $100 loss. You have to keep $100 aside for that entire policy. If company A insures California, and company B insures Indiana, and they both keep $100 in the bank to pay out losses, then that's a societal total of $200 kept aside for losses. Now, if you have a scientific reason that shows you that you will only have an earthquake in 1 state in a given year, then you could combine both companies, and only keep $100 total aside, because you know that only 1 of those homes could have an earthquake in the given year, not both. If you earn $1 on each policy, then your return on capital is 1% if each company insures a different state. If a single company diversifies over 2 states, then the combined $2 of insurance earnings is earned on a total of $100 of capital, which means that you earn a 2% return. In this case, diversification resulted in greater earnings.

Diversification for the sake of keeping the company alive during ups and downs … is bad for the shareholder, while good for the management. For management, it means the risk of their jobs decreases because even if 1 fails, they will be needed for all the others. It also means that they oversee more and can demand a greater salary, which is an expense the shareholders take on. There is a conflict of interest. Diversification for the benefit of management is bad for shareholders, because the shareholder does not need it.

If you want diversification, instead of buying $100 of GRVY, buy $50 and then spend the other $50 on a stock with a company to get yourself the diversification you want. Why make the company diversify when it's much easier for you to look out into the investment landscape of 1,000 choices and pick something that looks attractive?

Back to the insurance example: Company A and Company B again. Company A realizes the benefits we discussed earlier and sets out to purchase B. 

Pre-acquisition financial details of A & B:

1. Insurance profits: $1

2. Total Assets: $100

3. Total net profit: $1

Post acquisition financial details of A (B as owned by A):

1. Insurance profits: $2

2. Total assets: $100

3. Total net profit: $2

Let's assume that they can borrow capital at 5% interest. If Company B wants $1000 to be purchased, then this is what the combination would look like:

1. Insurance profits: $2

2. Total Assets: $1100 ($100 to cover any loss, $1000 recorded as purchase price for the company)

3. Financing costs: $50 ($1000 * .05)

4. Total net profit: -$48

If Company B wants $5 to be purchased….

1. Insurance profits: $2

2. Total Assets: $105 ($100 for losses, $5 recorded as purchase price for the company)

3. Financing costs: $0.25

4. Total net profit: $1.75

In one case, the net profit went up, and in the other, it went down. If you issue stock instead of taking on debt to make an acquisition happen, then you need to adjust the total net profit to be on a per share basis.

At some price, diversifying is bad because as you can see, the insurance company should not pay $1000 for the company. Determining this price in real life takes some analysis and is very critical to good capital allocation. They shouldn't diversify simply to diversify, there has to be a financial reason behind it.

Let's stick to a simple example and think about GRVY. Let's say that gaming companies will sell for 10x earnings. If GRVY, without diversification, can earn $1/share in 10 years, then it will sell for $10. Let's say they have 2 options:

Option 1: They retire half off their stock and end up with $2/share of earnings in 10 years, then it will sell for $20.

Option 2: They use their money to diversify the business, and it goes really well, but results in $1.25/share of earnings in 10 years. It will sell for $12.50.

Right now, the stock hypothetically trades at $2/share. Option 1 results in 25% annualized returns while option 2 results in 18% annualized returns. In this example, if management finds a project that returns over 25%/year, they should invest in it, otherwise they should buy back stock.

Which option do you go with? Diversification has a price. Your company's stock price has a very large impact on this decision, because by not buying it back, you are saying that your projects will have a greater return, and with GRVY so low, that's a really bold and arrogant bet. They are priced for liquidation and so the return needed for a project to be the best capital allocation decision is ridiculously high.

3) Size Matters

With a stock where I'm truly valuing it for the net assets per share after all liabilities, I think the size of my positions matters more than in other scenarios. If the company has a lot of cash that it is sitting on, but chooses to not distribute it, I will only be able to realize it in a few ways, including:

A. Buy the entire company – make an offer for the entire company. If it's worth $10M to me, offer $8-9M, quickly liquidate all the accounts, and move on.

B. Buy enough (probably a negotiated transaction with other holders) to elect people to the board who will help liquidate assets that the company does not need or provide value from.

To this extent, even though 2 otherwise identical investors could have the same thesis and buying price, one may be speculating and one may be making a value investment. If you just buy a fraction of the company with the same thesis, you are counting on someone to liquidate, buy back stock, etc. If not, you are counting on the stock markets to bail you out. To this extent, having a larger sum is better than a smaller sum because it gives you flexibility to make offers for companies like GRVY.

In summary, I think Buffett says this with a very good reason: "The best time to sell is never."

If we've done our homework and have made a proper purchase, we simply don't need the markets to ever bail us out by buying the stock we own, because the value will be realized through other methods like a dividend, the company repurchasing it, etc.

This post is why I believe that GRVY's management is not making proper decisions at the moment. In hindsight, 5 years from now, it could look very different because for all I know, they've got an acquisition coming up or a project that they need all of the money for. Realistically, I would say that with the stock price where it's at, the odds of them doing the right thing are slim, however there is still a chance. My view on investing has been changing and so I like cheap stuff, but if the value simply cannot be realized because someone else (someone irrational) is in control, then it isn't really cheap to me. I think identifying a cheap company might be easier in a good company where management understands capital allocation, even if we pay a little more when looking at the standard ratios like P/E, P/B, etc.