Graham and Doddsville -- Value Investing In The New Era Message Board

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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era

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To: Axel Gunderson who wrote (627)	8/13/1998 7:04:00 PM
From: Freedom Fighter	Read Replies (1) of 1722

>This isn't entirely satisfying. The problem is that GM can not know that going forward, they will be generating higher average cash earnings yield than the average interest yielded by the bonds. There is some level of leverage which might be considered optimal (or safe) and if GM is above that level, it would be prudent of them to pay down debt while cash earnings are high - for that is the only practical time for them to do so.< I agree completely here. I am certainly not expert enough to know what GM is going to be making on a normalized basis, but the industry has been known to have some very hard times. As I stated in the prior post, they are also more leveraged than they appear. I would be more comfortable as an owner if they would deleverge. According to finance models there is a point at which deleveraging, even if it doesn't help EPS as much as share buybacks, enhances value. Investors will pay a higher multiple of the lower EPS if the capital structure is more to their liking and less risky. Thus creating value even with lower EPS. I am not familiar enough with GM to make that call. That is one of the reasons I like Sbarro, bought Tootsie Roll back in early 97, and bought Reuters. All were in a position to leverage up and give all that cash plus the cash on balance sheet to owners. The higher leverage postion in these cases is actually value enhancing because the ROE goes up and free cash flow levels remain the same or rise at the new capital structure even though EPS goes down slightly. Because all three had no debt, I knew the companies would not be penalized by the market because of greater leverage. It was easily supported and represented no additional risk that would warrant a higher cost of capital (or risk premium). According to CAPM it actually lowers weighted average cost of capital. This is an area that I completely agree with when it comes to CAPM. Tootise Roll and Reuters eventually both made special dividend payments. (I sold Reuters at a profit when the scandal broke) I still hold TR. Sbarros is presently in a similar position and can enhance the valuation and distribute large sums of cash if management chooses to do so. Wayne

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