Masters Series: Equity Steak

Editor's note: It's a lesson in staying safe that every investor should remember: When it comes to the companies they invest in… common-stock shareholders don't really matter.

 

In today's Masters Series essay, adapted from the September 2007 issue of Extreme Value, editor Dan Ferris describes what kind of claim stockholders have on a company's earnings and assets. Once you understand where you stand… it will change the kinds of stocks you load into your portfolio…

 

 

Equity Steak
By Dan Ferris, editor, Extreme Value

 

Please don't take the following personally. I'm only making a point...

 

But let's face it... As an investor, you just aren't that important.

 

For starters, you're an outsider. Sure, the stock you buy means you own a piece of the company. But let's be realistic. You have no idea what's going on in its hallways, meeting rooms, and corner offices minute by minute, day by day. Management could be swinging from the chandeliers. (How do you know there aren't any chandeliers?)

 

Not only are you an outsider. You're passive, too. You get to vote your shares, but otherwise, management doesn't want to know and certainly doesn't really care what you think. In management's view, you, the shareholder, are best neither seen nor heard.

 

And while you may have the potential to vote with the majority, wielding whatever power you possess, you are the tiniest minority of all: the individual shareholder. You are a gnat on the windshield of the companies in your portfolio.

 

Putting a more technical face on it, the publicly traded common equity we typically discuss (and discuss and discuss...) represents a residual claim on earnings and assets.

 

Note the word residual, as in residue. You know what residue is. It's the stuff you have a bear of a time cleaning off the bottom of the pan. After you take the meat out and use the drippings and scrapings to make the sauce, there's a little bit of stuff stuck to the bottom.

 

That's the residue.

 

In other words, that's the equity. Not the meat, or the drippings, or the scrapings. The residue. The stuff nobody wants.

 

Well, if the equity is the residue, then what are the steak and the sauce? What comes before equity? The answer, it turns out, is "just about everything and everyone." The following list shows you the order of claims on a corporation's assets in the event of liquidation. Note the position of the common-equity holder. Now that's what I call residue.

 

1) Secured creditors get paid when pledged property is sold or refinanced, then
2) Unpaid wages, then
3) Taxes, then
4) Trade creditors, then
5) Unsecured debt holders, then
6) Subordinated unsecured debt holders, then
7) Preferred stockholders, and finally, after all these other claims are met,
8) Common stockholders get whatever is left.

 

You are eighth in a line of eight. Every common-equity holder should see this list, study it, and remember it forever. This list of priorities is why I've often been attracted to stocks with little or no debt and way too much cash or other high-quality liquid assets.

 

And claims on earnings are an even wispier notion than claims on assets. Before a corporation can pay common dividends – if it even wants to – it has to pay all of its interest payments and other expenses.

 

Makes you appreciate a world-class dividend payer like ExxonMobil that much more.

 

Once you start thinking about yourself as a subordinated unsecured creditor, you're really just making sure you'll get paid.

 

That's how a creditor thinks. We're not predicting earnings. We're not figuring out the next hot technology. We're not even worried about the business having some great competitive advantage. We're just looking at the business through the eyes of a subordinated unsecured creditor. That's how we get safety, and staying safe is how you keep yourself in a position to take advantage of the big gains that come.

 

If this were what you got every time you scraped the bottom of the pan, you'd be happy to let others eat the steak.

 

Good investing,

 

Dan Ferris

 

 

Editor's note: As Dan says… every month, he scours the market for companies with little debt and lots of cash. And when he finds them trading far below their true value, he highlights them for subscribers. To learn more about subscribing to Extreme Value, click here.