If you’re reading this column, I think it’s safe to assume that you recognise the name Ben Graham. The legendary American “value” investor was the hero of Warren Buffett and continues to exert an influence on today’s legions of professional investors.
But, in recent decades, there’s been a constant problem: how to apply Graham’s ideas about picking undervalued gems in a market where virtually everything is overpriced relative to balance sheet fundamentals.
As Graham’s disciple, US fund manager Walter Schloss, observed a few years back: “Ben had it easier than we did because there were a lot of cheap stocks around in his day.
I find it hard to believe that he would even be in the market today because the kind of things that he liked aren’t around.”
This tension is explained in an excellent academic review paper by Robert F. Bierig from Duke University. He explores how an investor goes about finding a share with a large margin of safety based on careful analysis of tangible book assets and other key measures. Download it at www.econ.duke.edu/dje/2000/bierig.PDF.
I mention this academic debate because, while the task of a value investor has become more difficult over the last few decades, the past year has presented some opportunities.
But, because I don’t have access to the army of researchers – and the contact book – available to the likes of Buffett, I tend to start with a numbers- driven approach and then do some digging around the underlying business model. My own yardsticks combine some of Graham’s thoughts with other observations.
In general, I like to pay 50p or 60p for £1 of relatively liquid assets. I like a company or fund where there’s been an event that has turned away investors. I also like the possibility of a future catalyst that will add to value. Finally, I like to invest in something where the underlying business is strong.
Unfortunately, I don’t find many stocks or funds that are even near to ticking all these boxes – which is why I concentrate on a top-down, asset allocation-led strategy.
But there are exceptions. In fact, this week, I’ve been putting more money into a real oddity: technically a listed hedge fund that invests its money in lending “growth” capital to small and mid-sized US companies.
This fund is called Psource Structured Finance and it has had a horrible year in share price terms. It chose to list in August 2007 – what timing – with an approach that was perfectly suited to buoyant markets. Via a US partner, it lends money to companies in the $1m-$50m market value range looking to do something big in an effort to grow. These companies could instead seek bank funding, but most US banks don’t appear very interested in lending “growth capital” to this sector.
In return for the cash that it advances, Psource takes a claim over an asset and then charges a chunky rate of interest. In addition, it asks for an equity kicker in the shape of convertibles or warrant shares.
So, in all, this growth capital costs a lot – probably between 15 and 25 per cent a year. It’s a model that works well in bull markets . . . which we’re not in.
To make matters worse, Psource was investing in US companies and its currency exposure was automatically hedged. But as sterling plummeted, that blew up and debt with Bank of Scotland shot up past the covenant. Hedge fund investors also dumped the stock. Psource looked doomed. Its shares crashed.
But I’ve done some digging around. The managers at Psource have renegotiated their debt, striking a deal that means that, by spring next year, they will have got debt down to 7.5 per cent of assets. They’ve also squeezed some cash out of the portfolio companies
and sold some shares in successful companies.
There’s a catalyst, too:
30 per cent of the value of the fund is now tied up in one potentially hugely successful company called Petro Algae. It has an interesting new energy idea involving huge ponds of algae producing biomass for feedstock and biodiesel. China is touted as a massive growth market. Shares in PetroAlgae on the over-the-counter (OTC) market in the US have shot up and I believe that Psource will want to take profits on the stake by spinning off the shares.
That leaves an underlying lending business that is actually going to plan. Net asset value (NAV) was up more than 3 per cent last month at $1.66, or roughly £1 a share against the share price of 46p – and NAV since launch is up 21 per cent. So it passes my “big discount to NAV” test.
Crucially, if the US economy does pick up, then demand for Psource’s hybrid debt capital will also increase. That should be good news for the fund managers who will try to narrow the discount to NAV and then issue new shares so they can raise new money to start lending again.
So, is this a low risk investment? Absolutely not. Psource’s bank debt may still go wrong, the core portfolio companies may hit trouble and PetroAlgae may crash if the Chinese walk away. But the discount is a margin of safety that makes me feel comfortable with the risk.
