Valuations Have Limits: Think Of The Bankruptcy Pecking Order

Valuations Have Limits: Think Of The Bankruptcy Pecking Order
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Valuations Have Limits by David Merkel, CFA of Aleph Blog

Every now and then, some will argue that there are no limits on valuations.  This tends to happen in bull markets.  We are getting that now.

This sentiment is sometimes due to ignorance, because bull markets encourage cheerleaders.  There are few who will oppose a bull market, though many who will talk about it after the bear market emerges, as if they had predicted it.

But there are limits on valuations.  Think of the bankruptcy pecking order.

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  • Government and lawyers get paid
  • General creditors get paid
  • Banks and secured bondholders get paid
  • Unsecured bondholders get paid
  • Preferred stockholders get paid
  • Common stockholders get paid

That is the way you should think about risk.  What are the odds that you do not get paid?  The higher the odds that you don’t get paid, the higher the yield you must receive.  Don’t own a stock unless you are likely to be earning significantly more then the preferred stock, much less debt instruments on the same company.

That is why I look at the value of various claims on a company.  It gives me data on where the stock should be valued.

I encourage all readers to think like businessmen about investments, because it leads to the best results.  Analyze where valuations are cheap, and where free cash flow is being productively deployed.

That is the way to think about investing.  Think like an intelligent businessman, and only buy companies that you would like to run.


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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.

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