Peter - nice work, and I see your point.
Let me respond this way. Take this to a theoretical level.
You have a business with the following financials:
EBITDA of 20
Debt of 150
This is a business that analysis says is worth 6 times EBITDA. Now I ask, what should the equity trade at?
In the most simplistic theoretical sense, the answer would be zero. After all, if the business is worth 6 times EBITDA, then the equity would appear to be worth negative 30.
Now let's take it to the next step. Clearly that reasoning is wrong. If somebody were to give you that equity for free, you would take it, no? Think about that. So obviously it has value. What is that value? In a sense it is a form of option value. What if you had to pay a penny for it? $100? $10,000? $1,000,000? $100,000,000? Somewhere in that range you sense its too cheap and somewhere too expensive. If its anywhere close, you take a pass.
I have learned that with very low priced stocks with a lot of debt this option value takes over the analysis. I don't like debt ordinarily, but sometimes I like a lot of debt if the equity is almost free. The most relevant question is "is the company going bankrupt" near-term, which is a completely different form of analysis with a completely different set of questions. This is a form of what Graham called "intelligent speculation" - he covered this in some detail in the first edition of Security Analysis if my memory is correct. You could call this gambling, but its all about the odds.
With a speculation like I'm describing in theory, there is a chance of losing virtually all of your investment. And there is a chance of doubling or quadrupling your investment in a short time. What are the probabilities of each is the model I employ here, not the traditional value model. And if you do lose all of your investment it does not mean you were wrong. I know I'm going to get blasted for that, but consider Warren Buffett writing supercat insurance. If he takes a $10 billion loss next year on a California earthquake, does that mean he was wrong to write the policy? Buffett and Munger have often portrayed investing as an actuarial model, just like insurance. Bill Miller has also stressed the need for value investors to think probabilisticly.
I am not going to discuss Lanier any more on this thread (unless of course I find some new information that makes me sell - or if I get a quadruple next week and can gloat) - I find it a fascinating situation, but I would not want to open the door to any outside hypster with a penny stock idea and destroy this thread. That's why I'm trying to take the opportunity to broaden this into a theoretical discussion outside the box of traditional value investing.
This isn't "margin of safety" investing unless you are thinking in a diversified portfolio sense. Graham's investment thesis was based on a diversified portfolio - stock XYZ might make no sense to invest 100% of your money in unless you're a gambler, but if you can find 30 XYZs investing in all of them becomes a very conservative investment strategy with "satisfactory" upside. I would never invest more than 3% of a portfolio in something like Lanier, probably less than that. If it works I'll wish I invested more, but I understand the risk and I understand what "20/20 hindsight" means. |
