A few weeks ago I purchased common shares in Rait Financial Trust (RAS). I had looked at the 10-year free cash flow and figured that with an average $1.44 of free cash flow per share, alongside an average stock price of about $6 over the past five years, I didn’t need to read any public filings since the $2 price tag stock price would eventually correct itself.
The only effort I exercised was a quick Google search where I learned that the company was founded in 1997. From that, I rashly deduced that management must be capable since it survived the Great Crash of 2007. I happily called my broker and ordered 500 shares at-what-I-thought-to-be-a no-brainer-price of $2.
That was a mistake. When I finally leafed through the operating financials, I saw these were the financial records of a company no longer in existence.
The company had moved from the business of real estate ownership and management in the interest of becoming a leaner, focused company (“disposition of non-core assets” was the business lingo). It had sold the bulk of its commercial real estate last year and plans to get rid of the property management business this year. Rait will be originating commercial real estate loans to middle market clients solely.
As I was trying to put into numbers the change in business strategy, I came across a second surprise. Rait Financial has funded its operations over the years by issuing preferred stock, which the company carried on its books at par. But since these preferred issues had a liquidation preference of $25, I added them as a liability.
The adjustment added about $233 million to the company’s outstanding liabilities, or an additional $2.55 per share. When I purchased the stock for $2 in July of this year, I thought I had bought $2.29 of tangible book value per share. Yet after the adjustment, I purchased the stock at an outrageous premium!
While I reflected over my rash, idiotic decision, the stock price had halved. At first, prior to reading the public filings carefully, I saw the drop in price to be a fastidious opportunity to reduce my cost basis by purchasing additional common shares (perhaps, the word “opportunity” should be replaced with “excuse”).
While I eventually did not increase my position, I intend to keep the position in Rait Financial as a self-reminder of what happens when I am careless about a stock purchase. Three observations can be gleaned from this story. I will leave you to conclude on the possible lessons learned.
First, the balance sheet an accountant prepares does not always reflect an economic reality. Ask the head of any household and he or she will tell you that savings for the children’s education is an unrecorded liability. So are retirement savings. While the personal net worth statement the accountant prepares each year may hide these obligation, they are real.
Similarly, while the accounting convention is to record preferred shares at par, even when they have a liquidation preference, these should be added as liabilities, especially from the perspective of the common stock shareholder.
Second, the past is not necessarily a road map to the future. Even worse, as my case should demonstrate to you, it may give a false sense of security. Let us count the assumptions I made based on the past: (1) Since Rait Financial navigated through the turbulent times of 2007, I thought it could do so in the future (this assumption was faulty since the majority of management is relatively new). (2) With three lines of business, real estate ownership, property management and loans origination, I was certain there were sufficient, diversified streams of income. This also proved to be untrue, given management’s desire to become a lender.
Three, it is tough to sell at a loss. My experience is that selling a position that lost 10% is equally frustrating as selling a position that lost 50% of its price. It is much easier and comforting to find reasons why a losing position should be held.
Here are few: management may eventually reduce G&A enough to return to profitability; the company could become a main player in commercial real estate loans origination; or perhaps someone out there will purchase Rait’s operations at a rich premium. Finally, if you think it is hard to sell a position at loss, just imagine how hard it is to write about it.
Epilogue: As with any controversial, risky position, there are opposing views. There are still those who view the common shares of Rait Financial to be of investable value (to state the obvious, yours truly is not one of them).
Norman Roberts calls the company a cockroach, which he defines as a company that is favorable to the preferred shareholder at the expense of the common stock holder. Sam Lin has countered that opinion. In “Rait Financial: Forgive the Past and Buy for 50% upside,” he scrutinizes the securitization portfolio and concludes that there is plenty of upside.