I recently covered a very profitable short position. Had I done so six months earlier, it would have been substantially more profitable, but a 400% rise in the interim took back part of my gains. I covered for good reason: The company sold off a portion of its equity and managed to raise nearly $100 million. This money will keep it in business substantially longer than would have otherwise been the case. The terms of the deal were pretty bad for shareholders -- the company sold off a chunk of its business at a substantial discount to the market price for its shares.
Mixed feelings
I ought to be happy that I've closed out a profitable position, but I'm not. This company has destroyed shareholder capital from the moment it came into existence and would not have survived had it not been able to tap the public markets again and again for funding. The fair value that I placed on this stock was zero before the financing, and it's still zero. But this latest capital infusion offers a renewed lease on life, creating the illusion of hope for shareholders and pushing the collapse into the future.
There is of course an alternate possibility: The market's valuation of this company isn't wrong, and mine is. But how does one value a business that has minimal competitive advantage, has run shareholder deficits from the beginning, has no real competitive advantage, and operates in a commodity business with ever-falling barriers of entry (now close to $300 million)? There's one word for it: hope. And hope is something we could use a heck of a lot less of these days when it comes to stocks.
It's been detailed over and over how the leaders in the latest stock market rise are generally profitless, low-quality, extremely risky companies. Meanwhile, the charts of higher-quality firms like Microsoft
What's in your wallet?
Managements employ any number of methods to raise capital to fund growth. As a rule, my favorite is for them to reinvest money generated from cash flow. Costco
Other companies use debt. The telecommunications sector is the worst-case scenario here, but corporate debt is nothing new, and used in moderation for growth (rather than for operations), it's a good thing. They don't call it leverage for nothing.
The third route is to sell equity; that's when a company dilutes existing shareholders by offering additional shares either on the market or to private buyers. All else being equal, it's generally more expensive than debt, because there's no tax advantage. And when a company's shares are priced in cents rather than in dollars, the money it can raise through equity is very small -- not enough to help stave off bankruptcy in many cases.
We could run down the rabbit trail of discussing some of the more exotic forms of financing, but those are the basic three. The method a company chooses depends on what is cheapest and most available at the time. When businesses are on the ropes, they don't have retained earnings to tap, and lenders either won't take the risk or make it expensive with onerous covenants. Want to solve the "illegal naked shorting" problem, for example? Easy, have the SEC ban floorless convertible debentures, the only kind of financing available to companies that really ought to be dead.
Debt's not free
Neither is equity. This is as it should be. One of the beautiful things about capitalism is its ability to self-police. Dead weight gets thrown overboard. People who make bad investment decisions get what they deserve -- eventually. Adam Smith noted in The Wealth of Nations that ill-conceived or badly executed projects cost not only those who have invested time or money into them but are also a "diminution in what would otherwise have been the productive funds of the society."
That is to say it's the running up and down of the stock market that is the problem, though each additional dollar of market cap added to speculative stocks marks an increase in risk to investors. The problem is that companies that really ought to be dead are given a new lease on life by virtue of a suddenly overpriced stock they can sell in secondary offerings.
Why does this matter? Remember, we have just gone through the most spectacular speculative bubble in history, fueled by easy credit and a fantastic expansion of the U.S. money supply. Telecommunications alone floated $600 billion in debt from 1996 to 2000 to lay cable and launch satellites that will be useless for decades, if they're ever used at all.
Excess capacity is not the issue. Fiber in the ground is not much different from, say, gold in the ground in every way except for one: No capital investment was used bury the gold in the earth. Gold can sit fallow for eons at little cost to anyone. Fiber laid in the ground in 1996 that isn't used until 2026 has been incurring debt service costs the entire time. It's not the excess of fiber, it's the excess of investment, much of it ill-conceived and destined for failure.
The cost of opportunity
And money that goes to service debt could be spent elsewhere. The trajectory of our stock market in 2001 and 2002 was actually healthy. Companies that had no purpose other than to destroy capital were on the brink of extinction by the hundreds. Then, all of a sudden, some little girl someplace got a pony (funded by cheap debt courtesy of Alan Greenspan), setting off some massive worldwide equity rebound, and "voila!" These businesses have a new lease on life.
The problem is that the only thing worse for a company than strong competition is weak competition. Management desperate to raise cash to make its next debt payment doesn't care about profits, it only cares about meeting that "nut." Given such short-term considerations, if it has the choice of pricing its goods at a net margin of 5% with some chance of not generating enough cash, and pricing at -5% and generating higher sales, it tends to price the goods too low -- destroying its own capital, and that of its competitors, which either have to compete on price or to forego sales.
Our economy will truly recover faster if the companies that have no long-term chance of survival are removed from the economic pool sooner rather than later. Now that the equity markets are wide open once again, it's going to take that much longer to churn the tanks. And while I'd love to be excited about the rebound of equities over the last year, I can't help but feel that pain delayed will be that much more severe.
Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann's not burying stuff in the back yard -- yet. In fact, he firmly believes that there are fine stocks available in any market, they just aren't where everyone else is looking for them. He owns shares of Costco. The Motley Fool is investors writing for other investors.
