For the followers of the blog that keep track of new posts using the email subscription feature I have bad news. The email updates are powered by Google Feedburner, and Google has decided to put this product in maintenance mode which means that only core functionally will remain operational. As you might have guessed by now, email updates are not a core feature and somewhere next month Google will discontinue email subscriptions. If you want to keep track of new posts you can use the RSS-feed and subscribe in a tool like Feedly (I personally think this is a great way to keep track of various blogs), or follow me on Twitter (but easy to miss a link to a new post between all the other content that gets posted daily). Or you can just take the old fashioned route, and visit the alphavulture.com once in a while to see what’s new.
I suspect that many readers of this blog also follow the blog of Aswath Damodaran, and if they don’t, I would recommend doing so. Damodaran is a Professor of Finance at the Stern School of Business and he often posts how he would approach valuing high-profile stocks such as Tesla or Uber. It’s very unlikely I would ever be interested in investing one of those companies, but his valuation methodology is pretty solid and his posts are educational. I think having a good grasp on the fundamentals of valuing a company is very important, even when most of the time you revert to simple back of the napkin valuations using a P/E multiple (which I do).
However, I disagree strongly with his approach in his latest post about how to incorporate truncation risk in the valuation of Aramco. To quickly recap Damodaran point of view, a DCF valuation is only suitable for going concerns because you assume cash flows are continuing long-term and potentially indefinitely. Because of that you can’t properly model survival risk where a company might cease to exist after a certain point in time. In the case of Amerco it could be a possible regime change at some point in time to fundamentally change the value of the business going forward. But it’s also very relevant in startups that have a high probability of not making it past the first few years. His suggested solution is to value the company as a going concern in one scenario, value it with a regime change in a second scenario, put some probabilities on the two scenarios and call it a day.
I think there are two problems with his post:
- This approach doesn’t work well because it doesn’t fit reality
- A DCF is perfectly capable of incorporating truncation risk
The reason that this methodology is flawed is because it doesn’t incorporate the timing of the potential event. It matters a whole lot if the regime change is in the next year, or if it happens in 30 years time. So what does a 20% probability mean? Is that a 20% probability of regime change happening this year? the next 5 years? the next 50 years? And because that question isn’t answered, you also can’t really do a equity valuation in the regime change scenario. What he is doing I think is just taking the going concern equity valuation, and reducing it by 50% in the regime change scenario to account for higher taxes and royalties. That implicitly assumes that the regime change will happen on day one, which is of course highly unlikely and unrealistic.
A better model would be to assume that there is a small probability of a regime change every single year. That sounds complicated, but luckily, that’s exactly what we can model in a DCF by increasing the discount rate. If you would for example assume a 1% probability that there is a regime change in a given year you can simply increase your discount rate by 1%. It’s that easy! A one percent chance for 10 years in a row would imply a probability of regime change of 9.56% during that period and 39.5% during a 50 year period.
Note that by increasing the discount rate by one percent in case of a regime change we are assuming that the residual value is zero. If you think there is a 1% probability with 50% residual value we should increase the discount rate by just 0.5%. And a second small note, if you want to do things mathematically correct, you can’t simply add probabilities. In the example below you can see how that becomes especially relevant when probabilities become large.
If you want you can also easily change the model to customize probabilities of failure for each time period. Perhaps you have the view that there is in the next five years a higher chance of regime change, followed by a period of lower probabilities. But it’s probably more useful when thinking about a startup. The probability of failure is presumably very high in the first few years while lower in subsequent year.
Let’s imagine a project that will costs 10 million to start and 10 million more at the end of the first two years, and will produce 100 million at the end of year 3 and 4. In the first two years there is a 25% probability of failure. We could (and should!) model that as following:
Note that the discount rate is calculated by taking:
(1 + "equity risk") / (1 - "truncation risk") - 1 and the NPV factor is the factor of the previous year multiplied by
1 / (1 + "discount rate") of the current year. That way you carry a risk of total failure that you introduced in the early years forward for the calculations of the NPV of later years1.
The great thing about this model is that it matches actual reality. If you have a failure in the first year you don’t have to put more cash in the project, that’s why the net present value of the cash outlays at the end of year one and two are severely discounted. And of course, the same is true about the payoff in year 3 and 4 because there is a high probability that the project will never get to that point. If you would want to model this using Damodaran’s approach you would be in big trouble, because one single failure scenario can’t easily account for the fact that failure can occur at different times, and that the impact on the net present value depends on the timing.
Let me know in the comments if you found this post useful, otherwise I will be back to posting the occasional merger with a contingent value right ;). And of course, perhaps you want to point out that I’m completely wrong. It’s totally possible that I don’t know things better than someone who is a professor of Finance.
No intention to ever initiate a position in Aramco
1. A previous version of this post was using the wrong formula to calculate the discount factor and the combined discount rate. Thanks to a reader in the comments this has now been corrected.
Just one week ago I wrote that I initiated a position in Aratana Therapeutics (NASDAQ:PETX). At the time stock was trading was trading at roughly a 1.2% discount to the price Elanco Animal Health (NYSE:ELAN) was willing to pay, and a CVR with a max payout of $0.25/share was thrown in the mix for free. With Elanco now trading at $30.77/share and Aratana at $4.63/share the spread is a negative 1.6% and the CVR is implicitly valued at $0.07/share. My rough, and perhaps optimistic guess, of its value was around $0.10/share so there is little reason to keep my Aratana position. Unfortunately I decided to not hedge with short position of Elanco, so while the spread went in the right direction, I didn’t make any money. But that’s not a bad result for a week like this!
No position in Aratana Therapeutics anymore
A question that people regularly ask me is what kind of books, blogs and other resources I would recommend. To tackle this question once and for all I thought the best idea was to write one or more blog posts about it, starting with books that I would recommend reading. What books to recommend is an easy question in my opinion. There are really a ton of good books out there, and I don’t think it matters too much which ones you read. Start with some of the well known classics and it’s really hard to go wrong.
After reading enough books on, for example, value investing you will see the content becoming more and more repetitious. They first book you read you might think, “Wow, that’s genius buying stocks at a discount to NCAV” while in the 10th book you start thinking “Can’t this author tell me anything new?”. It’s not that the 10th book is a worse one, but at some point you know the drill. So I have to admit that these days I rarely read investing books anymore, so quite possibly I’m not the most qualified person to give reading tips. But since you have been asking I’ll try anyway! All the books in the lists below are books I have read personally. If you think I’m missing something great, let me know in the comments.
Investment basics, philosophy
If you are totally new to investing these are the kinds of books that I think should be helpful to understand what (intelligent) investing is, what kind of attitude you should have with regards to your investments, and what kinds of stocks could be profitable investments.
- The Intelligent Investor I think this timeless classic is a must have on the reading list, and a good one as a first book to read.
- Margin of Safety Only buy it if you run a successful hedge fund and want to showoff with the books on your bookshelf. For the rest of us, you should be able to find the pdf-version somewhere online.
- The Manual of Ideas A way more modern text that incorporates many of the ideas of the previous books and some new ones.
- Common Stocks and Uncommon Profits and Other Writings There is more under the sun than just buying dirt cheap stocks.
- Essays of Warren Buffet At some point in your investing life you will probably get bored by hearing for the millionth time the same Buffett quotes, but if you are new to investing these are a must read. Instead of buying the book you can also go for the value option, and read all of Buffets shareholder letters on berkshirehathaway.com.
Understanding psychology is extremely important if you want to make good decisions, yet at the same time it’s very hard to apply. There is a big difference between reading a book about psychology, and being able to avoid the many psychological pitfalls you read about. But reading these books is a good first step I think.
- Thinking Fast and Slow It’s not really an investment book, but a great book to understand the various heuristics and biases our brain has that can influence our decision making. An absolute must read in my opinion.
- Beyond Greed and Fear It’s the same topic, but this time a bit more tailored towards investing.
The border between books in this category and the investment basics category is arguably a bit vague, but these books are on average a bit more practical, maybe aiming at more specific subjects and heavy on examples and case studies.
- You Can Be a Stock Market Genius The title of the book is very cheesy, but this is really one of the best books ever written on special situations investing. Highly recommended!
- Security Analysis: Sixth Edition, Foreword by Warren Buffett Another classic that goes a bit more in-depth into the accounting and valuation. Don’t read this one as one of your first books though, probably a bit too tough and dry!
- Quality of Earnings Another text I highly recommend. Being able to spot weird things in financial statements is an invaluable skill.
- Financial Shenanigans A good addition to the book linked above.
Most investing books I read nowadays fall in this category. Individually you’re probably not going to learn a whole lot from each book, but most of these books contain interesting nuggets of wisdom, and perhaps more importantly, are just very good reads.
- Fooling Some of the People All of the Time Entertaining story of Einhorn’s fight against Allied Capital.
- Reminiscences of a Stock Operator Interesting story about trading and speculation in the early days of the stock market
- The Big Short One of the best stories about the 2008 financial crisis. The movie is surprisingly great as well. So if you are tired of reading, you can just watch it.
- When Genius Failed Good story about the spectacular failure of the Long Term Capital Management hedge fund.
- Red Notice Hedge fund manager turns into social justice warrior after the Russian state murders his lawyer. Book reads reads like thriller, something you don’t expect in the finance category. @Billbrowder is worth a follow on Twitter too.
All of the links in this post contain my Amazon affiliate code. If you buy something I will get a small percentage while you get the same price as always. Hopefully this post can make me rich!
If you are looking for an actionable idea you can quit right away, because the BIND Therapeutics stock has been cancelled months ago so there is nothing that can be bought or sold anymore. But if you like reading something about a bizarre situation you are at the right address here.
For those who don’t know anything about the story, a little bit of background information. BIND Therapeutics filed for chapter 11 bankruptcy protection in early 2016. It managed to sell its assets to Pfizer for enough money to pay back all creditors with some money left over for equity holders. So far all pretty straightforward, but the liquidation plan came with an interesting twist. The company picked a sort of random date (August 30, 2016) as the record date of which shareholders would be eligible to receive all future liquidation distributions. As a result the stock became basically worthless after that date, but since the stock continued to be traded for some time it offered shareholders a nice way to profit twice. I sold my position for something like $0.30/share which was a substantial windfall since I estimated liquidation distributions to be roughly $1.20/share while I bought the stock around $1.00/share.
Part of the reason that the stock continued trading at an elevated level was probably the involvement of a fund that apparently bought approximately one million shares after the record date. They have been, and still are involved in litigation, against the trustee (and FINRA as well I believe) trying to change the liquidation plan/the record date for future liquidation payments. So far they have been unsuccessful, but they haven’t given up yet. Their latest move is an attempt to convert the liquidation from chapter 11 to chapter 7, presumably to make it possible to work around the the record date confirmed in the chapter 11 plan.
Equity distribution form
While this is already weird, it got even weirder this year. After paying an initial liquidation distribution last year the trustee sent a letter to shareholders that they would be required to fill out an equity distribution form and a form W8/W9 in 180 days in order to be eligible for future distributions. This piece of paperwork proved a bit tricky to complete. You needed to provide the signed tax form to your broker, and your broker needed to sign-off on the number of shares you owned on the record date. A process like this has a lot of points where things can go wrong. Your broker might not notify you of the requirement to do the paperwork, is unable or unwilling to do the paperwork, or things simply get lost in the mail.
As a result shareholders owning 75.05% of the company provided tax forms and equity certification forms. This means that a relative large part of the shareholder base isn’t getting any money from future distributions, either because of their own inattention or the inability of their broker to process the form. Based on some unhappy shareholder letters in the docket not all brokers were willing to do this. Luckily for me Interactive Brokers proved to be quite capable in handeling this weird situation. As a result the second liquidation payment contains a nice windfall profit for those who did manage to do all the paperwork. The first liquidation payment of approximately $8.0 million resulted in a distribution of~$0.38/share while the second liquidation payment of $8.0 million resulted in a distribution of ~$0.51/share.
As an added twist, because the payment wasn’t made to all shareholders it couldn’t be processed by the Depository Trust Company (DTC) and instead shareholders got a paper check. In the Netherlands checks haven’t been used in decades, and this was the first time ever in my life to receive one, but luckily my bank is able to handle them for a nice fee… It also creates a nice tax headache for those owning the stock in for example an IRA account since you are effectively doing a withdrawal from your account.
What about short sellers
Directly distribution money to shareholders while bypassing the depository raises an interesting question: how the hell do you handle this if people have lend out shares and other people have sold stock short. I think it’s mostly a theoretical question. As far as I know I didn’t lend out any shares on the record date, and I got the full payment per share. There are no issues for me. But imagine how messy it would be there would be a lot of people short. A potential scenario:
- I own 100 shares.
- I lend them out to a short seller
- He sells them to person X.
So how to deal with this situation? If I would claim ownership of 100 shares, and person X would claim ownership of 100 shares the liquidation trust is going to pay money to the same shares twice. If I couldn’t claim ownership of the shares, but only person X (I think this is the most correct implementation) I wouldn’t be able to fill out the equity distribution form. Maybe person X doesn’t fill out the equity distribution form. So there is no payment to X, and the short seller could claim that there should also be no payment to me. But lets say that I owned another 100 shares that I did successfully fill out the paperwork on. Now it’s clear that I got a certain payment per share. The short seller is supposed to pay me whatever I would have gotten on the shares if I would not have lend them out. So he would be on the hook for the $0.51/share payment. But how would that money get to my account? I know I got the payment, but it’s a paper check. My broker doesn’t know how much if any money I got and the same goes for the depository. And even if they would know, can they fix it on an account by account basis?
If this is not yet messy enough, if I would have owned all the shares and done the paperwork the distribution/share would have been a little bit lower for everybody (still assuming X didn’t do the paperwork). So maybe the short seller shouldn’t pay the full $0.51/share? Or what about the case when the short seller closed his brokerage account in the time between the cancellation of the stock and this liquidation payment. Is his broker then on the hook for it?
If anyone has anything intelligent about this to say I’m interested. Did you lend out any shares? Did you get paid on these shares? Someone who has been short this stock on the record date? Lending out shares to short sellers is supposed to be sort of risk-less. But I’m pretty sure the process breaks down in this obscure case. My guess is that either some people lend out a few shares, and simply didn’t get paid on those, or the trustee paid twice (or more) for some shares “screwing” everybody else by a tiny amount.
No position in BINDQ, yet still have the right to remain all future liquidation payments