What a RED day!

Feels like 2008 all over again.

S&P Downgraded … the USA ! I still don't get it, how can you downgrade a country that prints its own debt denominated currency, how can you downgrade a country that cannot go bankrupt. Buffett commented that it was not a wise move. (EDIT: see first comment below)

Ironically, after the downgrade, the yield on the US 10 year bonds decreased to a record low (the lower the yield on the bond, the higher its price and the lower the borrower finance costs) , "as investors flee to safety". Ironically, safety is no other than the downgraded US.

As I discussed here in the past, there is simply no alternative to the USA:

  • Europe is full of debt problems and social problems. Some of the EU members have very low work standards and very high tax evasion standards, and when facing economic problems, cannot print their own currency (Greece? PIGS countries?).
  • China is developing the biggest real estate bubble that was ever created, that dwarfs anything prior to it including the sub-prime crisis. Add to it the lack of transparency, communism and lack of rule of law, you get a country with a problematic future outlook.
  • South America's economies all went bankrupt a few times in the last decade or two and still show instability or economies that sometimes relying heavily on the Chinese.

There is no place to go but to the USA, even with AA+ grade. This is why the USA will emerge from this crisis, there is no other choice.

So today markets may look similar to 2008, but this time, things are different. I know you heard it a million times. "This time things are different". But I do not mean it the way you think I am:

This time, Banks are not as leveraged as before. Companies are not as leveraged. Spending has picked up. Housing and jobs have picked up. Economy is more transparent than before, less CDO's etc. Retail sales is up in July. Percentage of interest as part of the average american income is the lowest in years.

And… I am not the same. I have more experience. I have been there before. Once I was afraid, now I am much more educated and prudent. I see these declines as a gift, not as an obstacle.

Today I have consumed almost all of my cash in my portfolio, buying whatever I could lay a hand on. I am now with less than 4% cash, and I must retain some of it for current expenses so there is not more than 2-2.5% to invest. The downward trend may continue but stocks are already at good prices. 2008 and 2009 had taught me (along with Benjamin Graham's Security Analysis) that stocks that are considered "safe" lose much less on the way down than "less safe" stocks. This calls in for a shuffle in your holdings going down, as they reverse when going up. For instance, Intel lost 50% in 2009, but Marvell lost 75%. On the way up, Intel gained 80% while Marvell gained 350%. One who switched stocks in the right time, lost 50% on Intel but made 350% later on (total of 125% yield).

I did not sell a single stock yet, I was a net buyer. But I am about to run out of cash, so when push comes to shove it will be wise to sell "expensive" stocks and buy "low quality" stocks.

For instance, today I bought ETM at the price of 6.36$ per share. In the past, I bought this stock at 6.67, 5.8, 8.21, 9.00 at a total of over 6% of my portfolio and sold it at 11.09$ per share.

ETM is a radio stock. It owns and operates radio stations.
As radio transmitters equipment is very cheap, it has very low CAPEX. Most of its earnings goes to cover interest and create free cash flow.
As all media stocks, it has a lot of debt and they are returning it in an astonishing pace. At the end of 2007, it had 973 M$ in debt and notes, at the end of 2010, 3 years and a financial crisis later, it had only 650M$. They returned 323M$ in 3 years !
Interest expense on 2007 was 57M$, today it is only 22m$ due to lower interest rates and the fact that it returned over 30% of its debt. Today, its total debt is 625M$. Moreover, its EBITDA will be about 100M$ this year, this means about 4 times cover ratio on interest expense, a pretty conservative one.

Today it published 2nd Q report. Its results for FH 2011 are somewhat disappointing, showing about 15% decline in EBITDA and FCF due to lower efficiency (Management is changing a lot of things that cost the company money, they claim it is "one time expense", we'll see), but the company is very cheap as it is. It had 31.5M$ FCF for the first 6 months of the year, while in the radio business the first quarter is the worst. For the full year, it will probably do close to a 75M$. In the past it produced FCF as follows: 2006: 93.1M$, 2007: 91.7M$, 2008: 94.2M$, 2009: 70.4M$, 2010: 86.7M$. Looks pretty stable to me, considering it passed through the worst crisis in 100 years and that today it has even less debt than before.

Let us not forget that 2012 is an election year in which radio revenue climbs substantially. Last time elections were at 2008. In 2008, even though the economy was crashing, ETM showed an INCREASE in FCF ! I can't wait for 2012…..

Now for the cherry: The company trades for… 240M$ ! This means 3.2 multiple on free cash flow (FCF)!. If one day it will stop returning debt and just distribute a dividend, the yield on the stock will be 33% in this year. 33%! The company is simply dirt cheap. Even if FCF will turn only 60M$, even lower than 2009, the worst year in decades, This still gives the company a multiple of 4. I hope it will continue to decline so I can pick up more in lower prices…
The downside is that management can do stupid things like buying other companies in a hostile takeover in a ridiculous price, or issuing stock (at depressed prices) for the merger.

There are more DIRT CHEAP stocks, like GSL. Since 2009 I made 440% on GSL, buying at 1.58$ per share, 1.18$, and selling at 7.02$. Unfortunately, total investment was only a small amount of about 2%. These 2% delivered about 8% of my yield in 2010. Amazing ha? GSL has its revenue contracted for the next 7 years in average. 7 years !!

I will issue a write-up about these stocks in the coming days.

At these times it is SUPER important to sell your expensive stocks and go for the cheaper stocks with lower multiples, that are of course stable and can swim through a difficult crisis, like ETM for instance.

And – don't panic ! Smile !! I smiled all day thinking of the great opportunities I was given in the last 2 trading days. If the decline continues, I will buy more. I thought I will never do 400% like I did on GSL again, but it seems I will be getting this opportunity once more.
This may give me a chance to repeat the overwhelming yields achieved in 2009, that much more than offset losses in 2008.

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  • I read this piece on the web:

    "In a CNBC interview, Warren Buffett says there is no question that the United States’ debt is AAA, and “if anything, it may change my opinion on S&P”. He justifies his claim by saying that the U.S. debt is good because we can print money. Following his logic and given his apparent lack of faith in S&P, the following countries should also be rated AAA, since they have the ability to print money as well: Argentina (rated B), Brazil (rated BBB+), China (rated AA-), Iceland (rated BBB-), India (rated BBB-), Japan (rated AA-), Russia (rated BBB+), or even Venezuela (rated BB-)."

    This was my reply:

    "Sorry, but you are DEAD wrong.

    The countries you mentioned have their debt in *other currency* than their own. So they can print money but they cannot repay their debt with it.

    Argentina uses Pesos, but its debt is in US dollars. It can print as many Pesos as it wishes, its debt will still be CONSTANT in US dollars and the Argentinian government can do exactly NOTHING to lower the debt.

    The US is the only country that has all of its debt in US dollar, the "home" currency, thus is able to control its external (and internal) debt.

    See for instance – Argentina entire external debt is in… US Dollars !

    Till those countries can print US dollars, they will repay their debt in other currencies than their own and as such they do not deserve perfect AAA rating.

  • Roy

    "Argentina uses Pesos, but its debt is in US dollars."

    So if the USA will inflate its way out of its debt it will assist other countries in achieving it as well. Right? That would be interesting…

  • Probably yes, as it will cause the dollar to weaken against all other currencies.
    But it will also cause inflation in the indebted countries.
    Imagine Israel. Israel has a debt in US dollars. Imagine that this debt shrinks by half because of dollar devaluation. This frees more money into the economy that can cause, aside to other many good things, inflation.

  • hey assaf,

    I've just read ETM'S report.
    what do you think about the chance of them hitting their covenants? they're pretty close.

  • Hi Shlomi.

    The Consolidated Leverage Ratio is 5.7 now and it is allowed to be 6.5. It will decline over the next 2 quarters by 0.25 points each, down to 6.0 at January 2012.

    So currently, even with weak operating results due to all of their "one time expeses" they still deliver 5.7.
    It is almost 15% margin.

    by Jan 2012 they may return 50M$ more, so the spread will be wider, and lets not forget 2012 is election year, that can provide increase op cash flow and decreased debt.

  • Further more, I like this facility. It makes them repay debt as fast as they can and prevents them from doing stupid things like a takeover or a merger.
    Their stepped interest rate will also prevent them from taking on more debt.

    So basically the bank forces them to pay down their debt, for at least one more year, which only makes this investment more appealing for me, as it prevents mistakes from management side.

  • Mark

    Hi Asaf,
    I really like your blog(:
    I have some comments for your investment strategy – Why your decide to invest at company if you dont belive at her management?(So basically the bank forces them to pay down their debt, for at lease one more year, which only makes this investment more appealing for me, as it prevents mistakes from management side).
    If you remember Warren Buffet invest only at companies with briliant managment and ETM managemnt looks prety bad.(based on your words)
    I want to remind you that he invested at American Express and Coca Cola not only because of those stock good price but mainly based on managment estimation.

  • Hi Mark.
    Warren started to invest in high quality companies only late in his career, when he had a very large capital base.
    If you read "The Snowball", or "The making of an american capitalist" or know a little about his history in the partnerships era you would see that he bought what he called "cigar butts" or companies that are bad but still too cheap. Buffett started to think about quality only when he had too much money to buy small companies such as this one and after he met Charlie Munger. This is one of these plays.

    As one man says – "One man's garbage is another's treasure".

    I take the fact that the bank ties management hands as reduced risk that attracts me even more to this investment. It is very easy to value this company and as you can see, unfortunately, it jumps 12% today, which means that I will not be able to increase my position. 🙁 Hopefully it will decline in the close future.

  • Mark

    Hi Asaf,
    I hope you right, but i realy see some big problems with this company
    At those days this company cost 240Mil with a debt of 625mil. It pays realy small interest of 3% which could rise due to the Amiracas credit downgrade.
    Company shows approximaly 70 Mil operating profit.
    Based on the above facts it means that it will take at least 10 years only to return the debt.
    I saw some other problematic issues
    1)every time company reduce it debt it apply for additional loans,
    2)Company with such high level of debt and it raised company Expenses it is realy not good indicator for shareholders.
    3)Company priced for less than 2$ two years ago and for this price i would like to buy it.

  • The interest they are paying is more like over 4%, not 3%, I did not check but this what I remember.
    I dont care about their credit being downgraded. Even if interest rate they are paying will double they are cheap.
    In this company you should not look on operating profit but on operating cash flow. operating cash flow is around 80M$ and in a good year (like next year) it can be even 100M$.
    First of all nobody said they need to repay their entire debt. Most companies have permanent debt on their balance sheet. They need to repay it down to a reasonable level, and they are doing it.
    I would feel comfortable with 400 or 350M$ debt, or 3-4X cash flow, this can be reached in 3-4 years.
    Second, these are very bad times for the American economy. Even in these times the cash flow of this company remains strong. In case the economy will pick up, their operating cash flow can reach 150 or even over 200M$ easily. Per year. And they won't need a cent to invest in equipment.
    1) I don't understand this sentence. Overall debt in the last 3 years has decreased over 250M$, it speaks for itself. In the first half alone it has decreased 25-26M$. Maybe what you see is that they repay 25M and take 10M$ loan? this is called rolling debt… When looking on NET debt it has decreased. They are focused on returning debt.
    2) Correct, but as long as it is temporary I am willing to take the risk
    3) Yes, at 6.36$ it is a good buy no more than that. But at 2$ it is a killer buy. It is money on the floor. You can expect to buy companies at this price only once in a very long time.