http://blogs.reuters.com/rolfe-winkler/files/2009/10/einhorn-vic-2009-speech.pdf
The premium on January 2011 $1 put options (VVFMI) is $0.75. This leaves the buyer with a maximum gain of $0.25, which he will realize if CIT Group files for bankruptcy, and a total loss if the equity remains intact. Meanwhile, January 2010 $1 put options (CITMI) are trading at $0.55. The simultaneous purchase of CITMI and sale of VVFAI creates a nearly perfect hedge that should perform well under any possible scenario.
http://dealbreaker.com/images/thumbs/Pershing%20Square%20Q2%202009%20Investor%20Letter.pdf
The short position mentioned on page 7 is, I suspect, Alexandria Real Estate Equities.
The premium on Las Vegas Sands $10 January 2011 call options is $9.40, with an intrinsic value of only $6.70. It seems likely that the writer of covered calls will earn the $2.70 balance upon expiration, which would work out to a return of 37% ($2.70 / $7.30 debit).
Las Vegas Sands can raise low cost funds through the sale of initial public offerings for its Asian operations.
The general commercial gloom has sent many companies into insolvency, reorganization or liquidation. Where the main issue is poor capital structure instead of operating weakness, there appear to be opportunities for the enterprising investor. One example of this type is furnished by Six Flags Inc., the affairs of which are now undergoing Chapter 11 reorganization.
Earning power. Financial performance over the past four years is presented below:
|
|
2008 |
2007 |
2006 |
2005 |
| Revenue |
1,021.3 |
970.83 |
942.18 |
956.76 |
| Total Revenue |
1,021.3 |
970.83 |
942.18 |
956.76 |
|
|
|
|
|
|
| Cost of Revenue, Total |
86.46 |
81.47 |
79.99 |
83.2 |
| Gross Profit |
934.84 |
889.35 |
862.19 |
873.56 |
|
|
|
|
|
|
| Selling/General/Administrative Expenses, Total |
214.55 |
245.37 |
239.36 |
192.84 |
| Research & Development |
0.0 |
0.0 |
0.0 |
0.0 |
| Depreciation/Amortization |
139.61 |
137.91 |
131.5 |
127.66 |
| Unusual Expense (Income) |
17.69 |
39.24 |
27.06 |
33.21 |
| Other Operating Expenses, Total |
419.04 |
428.69 |
413.29 |
390.8 |
| Operating Income |
143.95 |
38.14 |
50.99 |
129.06 |
Minority interests contribute an additional $40 million to GAAP net income each year. While these undistributed earnings do not count as cash flow, they tend to be fully as beneficial to Six Flags as if they had been distributed. Altogether, the business has earned an average of $130.5 million annually over the past four years.
Debt to equity exchange. Outstanding senior indebtness is set forth below:
|
Description |
CUSIP |
Outstanding Par Val. |
Last Price |
| SIX.GJ 8.875% Senior Notes 2010 |
83001PAD1 |
$131.1 million |
$11.00 |
| SIX.GL 9.75% Senior Notes 2013 |
83001PAF6 |
$142.4 million |
$10.50 |
| SIX.GN 9.625% Senior Notes 2014 |
83001PAH2 |
$314.8 million |
$10.00 |
| SIX.GO 4.5% Senior Notes Convertible 2015 |
83001PAJ8 |
$280.0 million |
$11.50 |
| 12.25% Senior Notes Convertible 2016 |
? |
$400.0 million |
? |
The present Plan of Reorganization grants Avenue Capital 7 percent of the new equity of SFTP—a ridiculous arrangement trumped only by its former proposal of owning a majority of the new equity—and leaves all other senior unsecured noteholders with 1 percent.
Let us examine the investment prospects of the notes under these terms. Assuming that SFTP can maintain its present level of earnings while reducing capital expenditures by half, enterprise value is not much more than $4 billion. A 1 percent stake in this business ($40 million) is less than the aggregate market price of the 2010, 2013, 2014 and 2015 notes ($89.9 million). http://cxa.marketwatch.com/finra/BondCenter/AdvancedScreener.aspx
In the final analysis it must be remembered that Six Flag’s troubles are mainly financial. Its offerings have not lost their prestige, and the valuable goodwill built up by years of national advertising should be preserved unimpaired. However, instead of purchasing the senior unsecured notes I intend to wait for the issuance of new common stock.
Miscellaneous considerations. Net loss carryforwards of $1.8 billion are a substantial benefit to holders of new equity in SFTP.
The employee pension fund shows a deficit of approximately $50 million on December 31, 2008.
Hedging involves the simultaneous purchase of one security and sale of another, because the first is relatively cheaper than the second. Where the security bought sells lower than the one sold, there must be good reason for believing that the price of the two will come closer together,—and conversely for the opposite circumstance.
Oftentimes there are wide price differences between American Depository Receipts and their underlying stocks listed internationally. In fact, a simple relative value hedging method has produced returns of over 30% per annum:
http://www.bauer.uh.edu/rsusmel/Academic/ptadr.pdf
The Korea Exchange enforces strict listing requirements for all member companies, namely:
- Shareholders’ equity at least KRW 10 billion; or market capitalization at least KRW 20 billion
- Sales at least KRW 30 billion (USD 30 million) for the latest fiscal year
- Average annual sales for last three years at least KRW 20 billion (USD 20 million)
- ROE at least 5% for latest fiscal year; 10% for the last three fiscal years; or net income at least KRW 2.5 billion (USD 2.5 million) for latest fiscal year; KRW 5 billion (USD 5 million) for the last three fiscal years
Corporate earnings deficits in 2008 have set forth a round of de-listings accompanied by forced selling. It seems at least plausible that some of the effected stocks have been trading at levels which do not correspond with their intrinsic values. Companies de-listed during 2008 are presented here:
|
Corporation |
De-listing Date |
Reason |
| Woo Young |
Mar. 13 |
Bankruptcy |
| ModelLine |
Apr. 12 |
Impairment of capital |
| Securoty KOR |
Apr. 12 |
Impairment of capital |
| NTorino |
Apr. 12 |
Impairment of capital |
| Future Vision |
Apr. 12 |
Impairment of capital |
| UCIcols |
Apr. 17 |
Impairment of capital |
| CHUNG LAM |
Apr. 23 |
Failure to submit ann. report |
| Planet 82 |
Apr. 23 |
Net loss for 3 years consec |
| Hantel |
Apr. 23 |
Impairment of capital |
| Dongjak Cable & Comm |
Jul. 12 |
Fall of trading volume |
| BestFlow |
Aug. 25 |
Impairment of capital |
| Seraon |
Sep. 9 |
Impairment of capital |
| Ibxene |
Dec. 20 |
Bankruptcy |
| KOREA CEMENT |
Aug. 20 |
Fall under dissolution criteria |
Source: KRX
After de-listing from the Korea Exchange, stocks trade in the private over-the-counter market: http://www.pstock.co.kr/
http://www.jstock.com/
Before we review individual Korean securities, it may be well to consider briefly the economic factors involved. I will not attempt a comprehensive survey of a subject that has been investigated at such length, but I will confine myself to certain elements that are relevant to our goal. The four problems which concern the investor most immediately are: (1) the general price level, (2) corporate profits, (3) interest rates and (4) security price movements. Let us consider the historical record of each of these in turn.
1. General Price Level. The movements of producer and consumer prices from 1962 through 2008 are set forth below:
| (Avg. Annual Increase) | 1962-1969 | 1970-1979 | 1980-1989 | 1990-1999 | 2000-2008 |
| Producer Prices | 6.0% | 14.5% | 2.8% | 3.3% | 2.2% |
| Consumer Prices | 15.4% | 14.9% | 6.0% | 5.4% | 4.7% |
Source: Bank of Korea
Two distinct periods are evident from the data: first, the rapid inflation from 1962 to 1981—a normal concomitant of money supply expansion; and second, the more moderate advance beginning in 1982. These long-term price movements have imparted an inflationary bias to expectations. In fact inflation, continued at its current rate, would eat up more than half of the income now obtainable from high grade corporate bonds. The next question, naturally, is whether stocks can offset a loss of the Won’s purchasing power with advances in their dividends and prices. Experience has shown that businesses retain some of their earnings for later use, and this grants common stocks the compounding effect not present with bonds.
2. Corporate Profits. The last 50 years have been characterized by an extraordinarily rapid advance in the aggregate earnings of Korean businesses. But while the dollar amount earned is important in appraising performance, it is not the best measure of profitability. Dollar earnings should also be considered in relation to the amount of capital necessary to their production—or more specifically the equity required (from the stockholder’s perspective). The chart below sets forth various performance metrics of Korean enterprise from 2003-2008. There are obvious weaknesses in analyzing such short-term data, but the period encompasses nearly a full business cycle. It appears that Korean businesses are more profitable than average.
Reductions in the corporate income tax rate—from 25 percent in 2008, to 22 percent in 2009, to 20 percent in 2010—should increase business earnings on the whole.
3. Interest Rates. The comparative yields of Korean Treasury bonds, AA- corporate bonds and BBB- corporate bonds are shown below:
4. Security Prices. The Korean capital market has failed to grow at a rate commensurate with the real economy.
Source: KRX
Additional information can be found here: http://www.keia.org/economy.php
In order to avoid a bankruptcy filing CIT Group must (1) pay the full amount of principal and interest on its floating rate notes maturing August 17 or (2) receive 90% participation in a tender offer of the notes at 82.5 cents on the dollar. The most likely outcome is either out-of-court restructuring or Chapter 11 bankruptcy (unless there is some last-minute capital raise for paying off the notes in full). My examination of the company’s capitalization has revealed a complex security that should do well under the circumstances.
CIT equity units include a “purchase contract” that obliges the owner to buy a certain number of common shares for $25 per unit—similar to assessable stock—and a 1/40th interest in a 7.50% senior note with $1,000 principal amount. At current market prices (below $1 per common share), the buyer would experience a loss of approximately $24 per unit from the purchase contract, which would fully offset his purchase price and a large portion of the principal of the note. However, there is an important stipulation in the terms regarding bankruptcy or any such reorganization:
“In addition, the purchase contract and pledge agreement that governs the Corporate Units and Treasury Units provides that your obligations under the purchase contracts will be terminated without any further action upon the termination of the purchase contracts as a result of bankruptcy, insolvency or reorganization of CIT Group Inc.”
There is also the option of converting an equity unit (a.k.a. corporate unit) to a Treasury unit, which would substitute $25 principal of the notes with $25 principal of U.S. Treasury securities. To convert corporate units to Treasury units, the owner should contact his broker or CIT’s collateral agent. The comparative payoffs of each option are presented in the following table:
| Bankruptcy | No Bankruptcy | |
| Corporate Unit | Purchase Agreement / Senior Note | Purchase Agreement / Senior Note |
| +$4 | -$8 | |
| Treasury Unit | Purchase Agreement / Treasury | Purchase Agreement / Treasury |
| +$17 | -$8 |
According to Standard & Poor’s, two-thirds of the original issue was redeemed in 2008, leaving 8 million equity units outstanding. My profit estimate of $4 per corporate unit assumes a 50% recovery for the notes in bankruptcy, which is based on CIT’s present capital structure. In any event, the best option is to convert to Treasury units if possible.
Commercial paper
Deposits
Term debt
Non-recourse, secured borrowings
7.50% senior notes due 2015
Junior subordinated notes
Preferred stock
Common stock
An excerpt from the testimony of Jim Simons before the House Committee on Oversight and Government Reform:
Renaissance, an SEC-registered Investment Adviser since 1998, manages what are termed quantitative funds – funds whose trading is determined by mathematical formulas designed to predict market behavior. Individual trades are generated by computers, based on work continually developed by our researchers. Naturally, human beings carefully monitor the trade execution process, making sure that all parts of the system are behaving properly. We operate in only highly liquid, publicly listed securities, such as stocks, bonds, currencies, and commodities, and do this on exchanges throughout the world. This means, for example, that we do not trade in credit default swaps or collateralized debt obligations, neither.of which satisfies the above criteria. In the stock trading of our Medallion Fund, we hold balanced portfolios in each country, i.e., portfolios very close to being equally long and short. Our trading models tend to buy stocks that are recently out of favor and sell those recently in favor. Thus, to some extent, our actions have the effect of dampening extreme moves in either direction, and, as a result, reducing volatility in those stocks. An example of this contrarian tendency is the fact that during the six-week period ending this September, Medallion held long positions in many of the most troubled of the financial stocks, including Lehman Brothers and Washington Mutual. We of course lost money on those trades!
Renaissance manages three fund families: Medallion, RIEF and RIFF. The first is our flagship fund, which we have operated for twenty years with great success. In the early part of this decade, we determined that the fund had grown too large, and we began to return capital to investors who were not employees of the firm. That process was completed in 2005, and since then the fund has been almost entirely owned by the people who operate it – Renaissance employees. We charge ourselves fees because fund investment is not allocated in the same proportion as is employee compensation. For example, my share of Medallion is far greater than is my share of employee compensation. Thus, the fee mechanism moves income away from the largest owners of the firm to the rest of the employees. Nearly all of the income of the firm and its employees is based on the performance of Medallion, a fund whose investors are almost exclusively its managers.
In recent years, Renaissance started two new funds aimed at outside investors: the Renaissance Institutional Equities Fund (RIEF) and the Renaissance Institutional Futures Fund (RIFF). The first is net long one dollar of U.S.-traded stocks for each dollar of equity in the fund and is designed to be a lower-volatility and higher-return substitute for an index fund, The second is a slow trading fund, investing in commodities, currencies, bonds, and stock indices, and is designed to deliver an attractive return at relatively low volatility. RIEF has done a fine job during its three years plus of existence. RIFF, started 13 months ago, did well during its first nine months but has been challenged by the turbulence of this fall, during which its returns were disappointing. Both of these funds, designed for institutional investors, are lightly leveraged and charge fees less than half of those charged by mainstrearn hedge funds. These institutional funds are a new business for Renaissance, and while their financial contribution to the firm has been exceptionally modest, we have high hopes for the long term.
Tax law provisions and the operating losses at several corporations have set forth a peculiar round of rights offering. According to Section 382 of the Internal Revenue Code, a company cannot realize the full amount of its deferred tax asset if there is a “change of control” of the business, defined as ownership of more than 4.95% of the common shares outstanding. (This is intended to prevent the seizure of tax credits by corporate raiders, and hence the rule does not apply to shareholders with greater than 4.95% ownership at present.) Several large corporations have issued contingent rights to shareholders that are only exercisable if a change of control occurs—similar to the “poison pills” used to dilute hostile bidders. There is a great deal of variation in the terms, but typically rightsholders can earn 100% by participating in the offering.
The most important stipulation in the deal terms is whether (1) rights are issued as new securities or (2) they are evidenced by ownership of the common stock prior to issuance. Obviously the former would hold more value to the speculator or arbitrageur; and the latter would give the common stockholder more reason to keep his shares. My strategy involves the purchase of common shares shortly before the record date (to receive rights) and the sale of a corresponding number of near term, deep-in-the-money call options. The objective is to pocket a free right, without any exposure to fluctuations of the stock and without any expense beyond brokerage fees.
There is an element of reflexivity which may prevent the rights from being worth anything—institutional investors may avoid purchasing large stakes of the common because they do not wish to be diluted. I think that in particular cases this risk is outweighed by the minimal expense and attractive terms of the rights.
Below is an excerpt from the rights offering document of Toll Brothers:
U P D A T E
On July 31, tender offer participants received Citigroup common shares in exchange for their preferred shares.
T H E S I S
The public has been well informed by various media channels about Citigroup’s upcoming recapitalization. Naturally it seems that everyone and his brother-in-law is participating, as the spread in practice—0.5 percent via put options—is much narrower than it is theoretically—15.5 percent. I believe that the best procedure is to sell a corresponding number of naked January 2011 call options, $5 strike against the preferred shares purchased. This would be tantamount to purchasing the common at $1.90, with the attenuating disadvantage of limiting profits beyond $5.40.
Michael Price commented on Citigroup in a recent Bloomberg interview: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=atDqUlby7VOk
By October of last year it was apparent that the securities market had become dislocated. In addition to redemption-related selling by hedge funds and mutual funds, prime brokers had begun to liquidate client accounts that held insufficient margin. The EMH premise that market participants buy and sell assets solely on the basis of economic value seemed invalid for the moment.
One of the most peculiar opportunities I discovered was a classical arbitrage in the shares and warrants of Foster Wheeler. On days that FWLT advanced considerably, FWLTW would sometimes have an ask price 5% lower than its intrinsic value, which was immediately realizable from the warrant conversion terms. This was my first discovery of a true market inefficiency—substantial in that the return was both riskless and immediate.
Soon I conceived the idea of creating a private forum to discuss similar arbitrage opportunities. I appreciate the input of everyone who has participated.
"All great economists are tall. There are two exceptions: John Kenneth Galbraith and Milton Friedman." —George Stigler
In connection with my securities work I have begun to study the South Korean economy in some detail. I have also applied myself diligently to reading the financial reports of various local issuers. (By far the most valuable resource is a manual I received after graduating last year—that for some reason I neglected until recently.) On the basis of these studies I have drafted a short analysis of Korea to be published in several sections: (1) general economic achievements and prospects, (2) the money market, (3) the bond market and stock market, (4) corporate governance and (5) the Capital Market Consolidation Act.
