Klarman Distressed Investing - HBJ Publishing, Bank Failures, and Savings Banks

When a company files for bankruptcy, most investors run. When a bank announces catastrophic losses, portfolio managers dump everything and ask questions later. When a mutual thrift converts to public ownership during the worst real estate crisis in decades, nobody shows up to buy. These are exactly the situations where patient, disciplined investors make the most money.

Four investments, four different flavors of distressed and special situation investing. A publishing empire drowning in junk debt. A regional bank bleeding cash. A savings institution so conservatively run it was practically a vault. And a retail spin-off that institutions threw away like junk mail. Each one demonstrates that the best opportunities appear when everyone else is looking away.

Harcourt Brace Jovanovich – The Publisher That Fell Off a Cliff

Harcourt Brace Jovanovich was a publishing company, an insurance operation, and a theme park owner – all held together by junk bonds. In August 1989, its total market capitalization across all debt and equity was 4.6 billion dollars. The junk bonds traded above par. Wall Street loved it.

Then HBJ sold its theme parks to Anheuser-Busch for 1.1 billion dollars, about 1 billion after taxes. Analysts had expected 1.5 billion. The proceeds went to repay bank debt. Simple arithmetic says total capitalization should have dropped from 4.6 billion to 3.6 billion.

By January 1990, total market capitalization was 1 billion dollars. Not 3.6 billion. One billion. A two-thirds collapse in four months.

What happened? Perception shattered. HBJ had been “good junk” – a company where the credit rating was low but everyone felt comfortable. Once investors realized the company was seriously overleveraged, forced selling cascaded through every class of security. Bondholders who had to maintain investment-grade portfolios dumped everything. Panic fed more panic.

Here is the critical point: a price decline alone does not make something a bargain. You need an actual discount from what the business is worth. In HBJ’s case, the business was almost certainly worth between 1.4 and 1.7 billion dollars. Senior debt had about 800 million in face value. That left 600 to 900 million of value backing 950 million of subordinated debt.

Those subordinated bonds were trading at twenty-five cents on the dollar. Even under a pessimistic scenario – even if the business got worse – those bonds were extraordinarily attractive. And in actual bankruptcy, the picture would have improved further: interest payments to senior unsecured holders would stop, and the cash savings would accumulate mostly to the benefit of subordinated bondholders.

General Cinema Corporation later offered 1.5 billion to acquire HBJ, confirming the valuation. Subordinated bondholders received nearly fifty cents on the dollar – roughly a double from the purchase price.

The lesson is almost painfully simple. When mass psychology shifts from “good junk” to “toxic waste,” prices overshoot to the downside just as badly as they overshoot to the upside. Your job is to calculate what the pieces are actually worth, not what the crowd thinks they are worth today.

Bank of New England – The Long-Short That Cost Nothing

Bank of New England was a small regional bank that announced a large loss in January 1990. The subordinated bonds plunged from the 70s to 10-13. At the same time, the common stock traded around 3.50 dollars per share.

Think about the capital structure for a moment. BNE had roughly 700 million face amount of bonds outstanding, now trading at a total market value under 100 million. The common stock – which is junior to every bond in existence – had a market capitalization of approximately 250 million dollars.

This makes no sense. The equity, which gets wiped out first in any liquidation, was valued at more than two and a half times the bonds that sit above it in the capital structure. The bond market and the stock market were pricing the same company as if they existed on different planets.

The trade was elegant. Buy 1 million face value of subordinated bonds at 10.5 – that costs 105,000 dollars. Simultaneously short 30,000 shares of common stock at 3.50 – that generates 105,000 dollars in proceeds. Net cash outlay: zero.

Now work through the scenarios.

If BNE becomes insolvent – which it did in early 1991 – bondholders lose some or all of their investment, but the common stock goes to zero with certainty. The short position covers the bond loss. Plus you collected interest on the short sale proceeds and received two semiannual coupon payments from the bonds before default.

If BNE miraculously recovers, the bonds rally by a far greater percentage than the stock. If the stock triples to 10.50, the bonds would likely trade well above 30-40, which is the breakeven point. The long position wins by more than the short position loses.

If BNE does a financial restructuring – which was seriously considered – bondholders get offered a conversion to equity at a premium. The bonds benefit from the premium. The stock declines from dilution. Long position wins, short position wins. Both sides profit.

Every scenario either breaks even or makes money. And the whole thing was funded with zero cash. This is what happens when you stop thinking “buy stock, hope it goes up” and start thinking about relative value across the capital structure.

Jamaica Savings Bank – Buying a Vault at Half Price

Thrift conversions are one of those rare structural opportunities that produce bargains almost by design. When a mutual savings bank converts to stock ownership, a specific set of forces conspires to keep the price low.

First, these are tiny institutions. Institutional investors cannot or will not buy them. Second, the newly converted bank is prohibited from repurchasing its own shares for a full year after conversion. Third, the bank cannot be acquired for three years. Both restrictions suppress demand for shares at exactly the moment when supply is highest.

Jamaica Savings Bank converted from mutual to stock ownership in June 1990. The timing could not have been worse. America was in the middle of a devastating real estate downturn. Estimates for the total cost of the savings and loan bailout were reaching 500 billion dollars. Banks were being seized by regulators. Thrift stocks had cratered across the board.

But Jamaica Savings was not a typical thrift. Organized in 1866 in New York, it had total assets of 1.5 billion dollars and retained earnings of 197 million. Its tangible capital ratio was 13.5 percent – among the highest in the entire country. Two-thirds of its assets were in U.S. Treasury securities and cash equivalents. Only 30 percent was in loans, virtually all residential mortgages. This was not some reckless lender chasing yield. It was, for all practical purposes, a vault with a banking license.

Depositors were offered 16 million shares at 10 dollars each – just 47 percent of book value. A price-to-earnings multiple of ten. You were paying less than half of what the bank’s assets were actually worth, getting the entire business thrown in for free.

Consider the downside protection. Half the conversion proceeds – 80 million dollars – stayed at the holding company as excess capital. If that cash were used entirely to repurchase shares at two-thirds of book value, which itself represented a 40 percent premium to the IPO price, the company could have bought back a third of all outstanding shares. The pro forma book value per share would have jumped from 21.12 to 25 dollars.

Management bought a significant amount of stock in the IPO for themselves. When insiders put their own money in at the same price you are paying, alignment is as good as it gets.

The first trade in Jamaica Savings Bank shares took place at a 30 percent premium to the offering price. And the shares held that premium even when the broader market slumped later that year. Earnings grew as excess capital was deployed. Book value grew from earnings retention. And management executed an aggressive stock repurchase program that boosted both earnings and book value per share.

InterTAN – The Spin-Off Nobody Wanted

In late 1986, Tandy Corporation spun off its international retail operations as InterTAN. Book value was about 15 dollars per share. Net-net working capital after all debt was roughly 11 dollars per share. The Canadian and Australian operations were highly profitable.

But large operating losses in Europe masked everything. On an aggregate basis, InterTAN showed a small overall loss. Anyone who bothered to look at the individual geographic segments could see that Canada and Australia alone were worth considerably more than the 11 dollar stock price. But almost nobody looked.

The institutional selling was mechanical. A large fund managing a billion dollars might have owned a million Tandy shares at 40 dollars. After the spin-off, they received 200,000 InterTAN shares worth 2.2 million. That is an insignificant position. Either increase it to the standard 40 million position size – which would mean buying 45 percent of the entire company and triggering ownership restrictions – or sell it. Everyone sold.

No Wall Street coverage. No broker incentives. No analyst attention. Just waves of forced selling creating a temporary supply-demand imbalance.

Value investors who did the work accumulated large positions at attractive prices. By 1989, InterTAN had turned around the money-losing European operations. The same Wall Street analysts who had ignored the stock suddenly fell in love with it. Shares peaked at 62 dollars. From 11 to 62 – a return of nearly 500 percent.

The Patterns

All four investments share a common thread: the seller had non-economic reasons for selling. HBJ bondholders were forced out by credit quality mandates. Bank of New England’s stock and bond prices diverged because different investor pools did not talk to each other. Jamaica Savings Bank shares were suppressed by regulatory restrictions on buybacks and acquisitions. InterTAN was dumped because institutions could not hold a position that small.

In every case, the price was set by people who had to sell, not by people who wanted to sell. When you are buying from forced sellers, you are getting a structural discount that has nothing to do with business fundamentals.

The other pattern: each investment had a clearly identifiable floor. HBJ’s bonds had asset coverage even under pessimistic assumptions. Bank of New England’s long-short structure eliminated directional risk. Jamaica Savings Bank traded at half of book value for a bank with 13.5 percent capital ratios. InterTAN had net-net working capital backing the entire stock price.

Key Takeaways

Understand why the price is low before you decide if it is cheap. Price decline alone means nothing. HBJ bonds fell because the company was genuinely overleveraged – but the subordinated bonds had real asset coverage at twenty-five cents on the dollar. The reason for the decline matters less than the gap between price and value.

Capital structure is a weapon, not just accounting. The Bank of New England trade was possible only because someone looked at bonds and stocks simultaneously. Most investors live in one world or the other. The ones who see both can construct positions with zero cash outlay and positive expected value in every scenario.

Regulatory restrictions create predictable mispricings. Thrift conversions are cheap because buybacks are blocked for a year and acquisitions are blocked for three years. These are known constraints with known expiration dates. Jamaica Savings Bank was a fortress balance sheet selling at half of book value because of temporary structural suppression of demand.

When institutions are forced to sell, be the one buying. InterTAN went from 11 to 62 not because the business transformed overnight, but because the selling pressure was artificial and temporary. Once it stopped, the stock repriced to what it was always worth. The edge was not in analysis. It was in showing up when nobody else would.

Distressed investing is not about having a stronger stomach. It is about having a calculator and the discipline to use it when everyone around you is reaching for the exit.