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How not to invest in these inefficient monsters?

Jul 23, 2015

In this issue:
» Is Facebook really more valuable than General Electric?
» Promoters that have pledged full 100% of their shares
» ...and more!


00:00
I am sure you would have heard of things like frozen food, frozen river or for that matter even frozen shoulders. But have you heard of a frozen corporation? Well, at least I hadn't. Turns out this term was concocted by none other than the father of value investing, Benjamin Graham.

So, what exactly is a frozen corporation? If you are thinking along the lines that the term implies the freezing up of some of the key activities within a firm, then you are indeed on the right track. However, in this case, it is something more specific than that. What Graham meant by a frozen corporation was a firm whose charter prohibited it from ever paying out anything to its owners or ever being liquidated or sold.

Yes, you heard that right. So while the capital could go inside the firm, it cannot be taken out. Neither in the form of the sale of its assets or compensating its owners through things like dividends or buy backs.

As far as investing is concerned, this is indeed a very tricky situation. Tricky because without cash coming out or without its assets being sold, one can simply not perform a valuation exercise on the firm. So the answer to the question of what this enterprise is worth simply remains an enigma. And consequently, no investment can be made into the stock.

All of this may seem a bit stretched to you. And rightly so. After all there's no such thing as frozen corporation in today's day and age, at least to my knowledge. Quite surely, I haven't come across any such charters that render a particular firm frozen.

However, what about the proverbial wolf in sheep's clothing? In other words, a company that on the surface is like any other corporation but is no different than a frozen corporation when it comes to rewarding its shareholders.

And what if we tell you that arguably the most successful investing pair out there attributes its tremendous success to totally staying away from companies that either act as or are pretty close to being labelled frozen corporations?

Yes, that's correct. Both, Warren Buffett as well as Charlie Munger had unpleasant experiences early on in their careers that taught them a very important lesson.

And this is the lesson that Warren Buffett later on made his mission to sort of teach in business schools. He used to show records of two companies to students and mention how over a period as long as 30 years, one company turned out to be a way better investment than the other.

In fact, the company which lost the race was a pretty lousy one and came very close to being called a typical frozen corporation. The company was none other than the telecom giant AT&T which just kept issuing shares like crazy and throwing more capital into the business. The company grew no doubt but most of the growth came only be reinvesting enormous amounts of cash. And there was never any real cash to distribute to AT&T shareholders.

And there was this other company which simply spewed out more cash year after year. It never really needed to put a lot of cash back into the company unless they were making an acquisition of another equally cash rich company. And therefore, the people owning this company became really rich over time.

I think you got the difference between the two. While both the companies grew, AT&T had to suck in huge capital, in fact more than the business was capable of generating, to let growth happen. The other company on the other hand, grew without actually needing a lot of capital to be put back into the business.

Goes without saying that Buffett and Munger eventually became fans of the second kind of companies and made it their life's mission to find such stocks. And then all that was needed was to really back up the truck and invest in a big way if the stock fell in price and became attractively valued.

Therefore, it really pays to avoid stocks that have all the qualities of a frozen corporation. The spectacular track record that Buffett and Munger built over the years is a fantastic example of the same.

Have you ever been tricked into buying a stock that almost behaved like a frozen corporation? Let us know your comments or share your views in the Equitymaster Club.

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02:50
 Chart of the day
Guess who is scraping at the legacy of the great Thomas Edison these days. None other than Mark Zuckerberg. For just a few days back, the latter's company overtook engineering titan General Electric (GE) in terms of market value.

The Edison founded company GE traces its origins all the way back to 1892. That's a good 123 years of building the business. Zuckerberg's Facebook on the other hand is all of 10 years old, and traces its beginnings to a dorm room in Harvard. While GE rakes in annual revenues in the region of US$ 146 bn, for Facebook that number stands at US$ 13 bn.

The contrast is striking to say the least.

But not so much to investors it seems. They've bid up the market value of Facebook to stratospheric levels. So much so, that it is now ahead of many of the biggest names of corporate America. Are these investors letting their optimism run ahead of themselves?

Only time will tell.

Facebook now bigger than General Electric

03:50
Turning from the founders of American giants to the founders of Indian companies, a recent Livemint report throws some light on the state of affairs back home. The promoters of 41 BSE listed companies have pledged 100% of their shares as collateral to raise funds. The number of companies whose promoters have pledged over half their holdings stands at 359. A result perhaps of the sluggish economic environment that has tenaciously prevailed in the country since 2011.

So should you invest in a company whose promoters have pledged such a large part of their holdings? To some extent, it depends on what the promoters utilize the funds thus raised for. For example, if they have pledged shares to raise money for the very company whose shares they have pledged, it may not be an outright red flag. If not, then the use of the money must be carefully examined. However, in either case, the ideal scenario would be to avoid such companies. As more often than not, substantial pledging is a sign of stress on the finances of the promoters or the company.

04:45
The Indian stock markets were trading with volatility today with the benchmark indices crisscrossing the dotted line multiple times. At the time of writing, the BSE-Sensex was trading down by around 8 points. Gains were largely seen in consumer durables and auto stocks.

04:55
 Today's investing mantra
"We always keep enough cash around so I feel very comfortable and don't worry about sleeping at night. But it's not because I like cash as an investment. Cash is a bad investment over time. But you always want to have enough so that nobody else can determine your future essentially" - Warren Buffett.

This edition of The 5 Minute WrapUp is authored by Rahul Shah (Research Analyst).

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