By Steve Kiel of Arquitos Capital Management
Any value investor will tell you that focusing on the downside and ensuring a margin of safety is of paramount concern. Finding safety can be challenging, especially in an environment where market valuations are elevated. This is compounded by the fact that easy access to information has made it more difficult (though by no means impossible) to have a research edge. Additionally, idea generating screens based on quantitative metrics have become ubiquitous.
How do we differentiate ourselves? My goal is to find the pockets of the market where there are low risk returns. I look for hidden value. Sometimes this shows up in the numbers. Examples may be real estate carried on a company’s balance sheet at a carrying cost far below market value, or an overfunded pension plan, or an asset that is marked to market but on a fundamental basis is worth far more.
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Other times this hidden value is not quantitative. A company may have an unusually talented operator. There may be incentives in place that promote shareholder-friendly behavior. There may be an effective allocator involved that enforces financial discipline.
The advantage of examining the qualitative factors for idea sourcing is that this information typically doesn’t show up on screens. Analysts rely on quantitative screening far too much for idea generation. We can use this to our advantage by finding companies where the current numbers don’t reflect the value of the company. We want to find companies that don’t show up on screens today, but will show up on screens in the future.
I want to be clear that I’m not minimizing the importance of quantitative analysis, but it is just one part of the analysis that should be done. Specific to idea generation, access to information has made quantitative analysis easier, therefore increasing efficiency and reducing the chances of finding value. For example, I love net-nets, but the companies on net-net lists have been picked over very thoroughly. You can still occasionally find an interesting company on these lists, but it has become much more difficult both because of the current market environment and because of how easy it has become to access information. Essentially, there are both cyclical and structural issues working against finding significant mispricings through screens.
Applying Qualitative Analysis to Idea Generation
How does this relate to potential investments in companies with Net Operating Losses (NOLs)? Over the past few years this area of the market has been fertile ground for finding qualitative hidden value. The 2008-2009 crisis obviously generated a significant amount of losses for a large number of companies.
Within the S&P 500, earnings cumulatively dropped by 40% in 2008. The roughly 15% of S&P 500 companies that lost money that year generated more than $200 billion of losses. The result was that some companies came out of the crises with massive amounts of NOLs relative to the size of their operations or market caps. Some companies like Washington Mutual (currently $6 Billion of NOLs and now named WMI Holdings) and Fremont General (currently $934 million of NOLs and now named Real Industry) failed while still retaining either all or a significant amount of their NOL carryforwards.
Successors to these companies are in various stages of monetizing these NOLs thanks to the help of new allocators, operators, and activist investors.
A federal NOL can be used to offset taxable income and can be carried forward 20 years from the original loss, making it a valuable asset. When NOLs are large relative to the assets of the company, it is imperative that the company make efforts to protect this asset. The specific rules can be complex but, in general, IRS Section 382 severely limits the use of NOLs when an ownership change occurs. An ownership change is deemed to occur when any and all shareholders who own more than 5% of the outstanding common stock of a company collectively increase their stake more than 50% over a three year period.
Factset identified 171 companies since 2009 that adopted some sort of poison pill that referenced the need to protect the company’s NOLs. While there are bound to be other companies out there that do not have this protection, it is fair to say that the size of the investment opportunity in this type of asset is large enough to warrant examination and certainly large enough to support an investment strategy.
There must be specific circumstances involved to increase the odds of success. We are not interested in companies that have NOLs for their own sake. We are interested in NOL companies that have some combination of the following characteristics:
- A change in operations: This occurs often through the sale or liquidation of their current operations or a failing subsidiary. We are not interested in a company that is still carrying out the same operations they did to create the losses. This helps to eliminate companies whose losses come from purely cyclical downturns.
- The involvement of an effective capital allocator: The company may have been taken over by an activist, a new operator may have been put in place, or another strategic investor may have gotten involved. The point is that the new leaders understand the value of the NOLs and were attracted to the company for that very reason.
- The stock is trading at or near its net asset value: When determining whether to purchase an NOL shell, or an NOL company with limited operations, we prescribe no value to the NOLs in our valuation calculations. This protects our downside if the decision-maker at the company fails in their attempt to monetize the NOL asset.
- The NOLs are large relative to the market cap and long-dated: The reason why the current environment is unusually interesting for NOL companies is because of the 2008-2009 crisis. The 20 year carry-forward period gives NOL companies a long period of time to monetize the asset, increasing the opportunity to make creative acquisitions. The large NOLs that were created during this period have attracted experienced dealmakers such as KKR and Sam Zell, and others.
NOL Company Acquisition Incentives
The highest probability of gains in these types of companies is when a NOL company that has no or limited operations makes an astute acquisition. The company is incentivized to look for a particular type of prospective purchase. The focus on using the tax asset causes the acquirer to look for businesses that generate predictable taxable income. The acquirer is incentivized to lever up in a reasonable way in order to buy the largest company possible so they can burn as many of the NOLs as fast as they can. If they are successful purchasing a business with predictable cash flow, then the added debt is not as risky as it otherwise would be. Of course saving 35% per year also helps them pay down the debt much faster than a typical business. We’ll get into some other aspects of debt in the next section as well. The net effect is that debt in an NOL company is not as risky as the same amount of debt in a non-NOL company.
NOL companies are also incentivized to find, or in some cases start, businesses that require low capex. Cyclical businesses are not ideal. For investors like Arquitos Capital, it is much easier to value these types of businesses than ones that are otherwise heavily dependent on outside variables. This operational predictability offers us the opportunity to buy more stock in a company post-acquisition if shares are significantly mispriced. We love predictability of operations and volatility in stock market prices.
Incentives for Ongoing Operations
As new investors and operators take over, the incentive is to utilize as much of the tax asset as possible by maximizing taxable income. For a NOL company that has changed their operations by selling a money-losing subsidiary or otherwise changing their source of revenue, management is highly incentivized to first cut costs as much as possible. Additional revenue is nice, but the unpredictable returns that may come from capital expenditures makes expansion a secondary endeavor. The most successful NOL companies aggressively tackled expenses to maximize cash flow. The sad fact is that most companies are at least somewhat bloated. Investors benefit from management recognizing this.
For NOL companies that have recently acquired a new business, the cost-cutting can be even more significant. The new operators can take a fresh look at the operational needs of the acquisition and right-size the business as needed. If the acquisition was particularly shrewd, then there should be opportunities for streamlining.
After the cost-cutting is done, the incentive to maximize taxable income encourages effective capital allocation in the operations. I’m constantly surprised at how often operators make disastrous allocation decisions, whether for an acquisition or for reinvestment in the current business. Carl Icahn has discussed variations of the Empty Suit problem, but corporate bureaucracy, employment protection pressures, and general corporate cultures also contribute to poor capital allocation decisions.
The decision-making process at many companies is simply flawed. There are typically incentives for employees to justify, rather than analyze, a potential acquisition or internal investment after the boss has already decided it should occur. I’m skeptical of internal models for acquisitions or internal investments. Accountability is not what it should be. Companies rarely look back to see if reality matched their projections at the time of their investment decision. These problems are reduced when dealing with capital investment within NOL companies. The NOLs incentivize the board and management to focus on returns and encourages them to be disciplined in their decisions.
Additional Funding Benefits
We touched on funding already, but it’s worthwhile to look at other ways that debt can be safer in an NOL company than other companies. In many cases the activist investor who took over the company would like to put more money to work than they are allowed to due to the Section 382 change of control rules. This encourages the new investor to provide debt in the form of convertibles. If the investor owns a large piece of the equity, it is in their best interest to provide this funding at below market rates in order to maximize the taxable income to shield. Will there be dilution in the future? Yes, but this structure can still be more beneficial to current investors. This incentive to provide cheap debt exists for traditional debt as well. If provided by equity investors, debt is also more likely to be covenant-light. It helps when the goal of debtholder is the same as our goal, to maximize the value of the equity.
Because of the change of control limitations, it is common for at least some of the funding to come from rights offerings. This gives investors like Arquitos Capital the opportunity to purchase additional shares at a discount to the current value even after taking dilution into account. It gets very interesting for investors when the company had been a shell where the NOLs were large relative to the assets. In that case, there are often a high amount of legacy shareholders that either have not been following what is now happening with the company or do not understand the value. This means that oversubscriptions for the rights offering are likely to be larger than usual, sometimes significantly larger, because the legacy shareholders either ignore the offering or choose not to participate. Their rights then go into the pool for the oversubscription. This is a tremendous opportunity for smart investors to lower their cost basis by participating in the rights offering as well as the oversubscription.
Considering the Effect of NOLs is Timeless
I should note that this concept is not new. An astute investor, John Woods, pointed out to me that the impetus for Warren Buffett selling off the operating business and liquidating Dempster Mill in 1963 was because the company’s tax loss carryforwards had been exhausted. Given the 52% corporate tax rate at the time (as well as having excess liquid funds in the company), Buffett determined that it would not make sense to continue the company in its present form. Because of the managerial leadership by Harry Bottle and the gains made by the marketable securities in which Buffett invested, the company burned through their NOLs faster than anticipated.
How we Value NOLs
The traditional way to value NOLs is to make a guess as to how much of them can be used before they expire, apply the corporate tax rate, and then attempt to determine their net present value. This exercise is only mildly interesting to me.
The reason why I haven’t discussed this quantitative part is that each of those three steps involves assumptions that may or may not be realized. One, we don’t know 10 to 20 years ahead of time how much taxable income a company will generate. Two, we don’t know if the corporate tax rate will be the same during that period. Three, what discount rate should we apply?
As Keynes has said, it is better to be roughly right than precisely wrong. The last thing we want is to fool ourselves into thinking that the NOLs a company owns are worth a precise price at the current time. This is why I do not take into account the value of the NOLs when determining whether to buy an NOL company. I’m much more interested in the qualitative factors involved than the quantitative factors.
The purpose of this report is to make the point that the value of the NOLs are not in the NOLs themselves. The value is in the incentives that the NOLs create.
Value investors should want hidden value. They should want to partner with effective capital allocators. They should want balance sheet protection. They should want predictable cash flow. They should want operators to be heavily focused on right-sizing expenses. They should want a company to make fair assessments of the returns they’ll get from capital investments. They should want creative funding and lower risk on the debt side.
For all of these reasons, investing in NOL companies with this strategy paradoxically provides both downside protection and the opportunity for asymmetric gains. This is a niche strategy, but the asset type is currently large enough to support an investment strategy focusing on the characteristics I’ve laid out in this report.