Feeds:
Posts
Comments

Archive for the ‘Liquidation Value’ Category

Portfolio construction

Posted in About, Greenbackd, Greenbackd Portfolio, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Stocks, tagged , , on January 15, 2009| 2 Comments »

In our last post, we discussed our approach to long-term and fixed asset valuation. We concluded that, given our inability to actually value any given asset or class of assets, the best that we could do is fix a point at which we feel that we are more likely to be right than wrong about a stock’s value but would also have enough opportunities to invest. We argued that magic point for us in relation to property, plant and equipment is 50%, based on nothing more more than our limited experience. We acknowledge that this method will cause us to make many mistakes, so in this post we set out our method for protecting ourselves from those mistakes.

We try to protect ourselves from our mistakes in three ways:

  1. We try to buy at a substantial (i.e. more than 1/3) discount to our estimate of the written down value. Sometimes our valuation will be so wrong that the discount will be an illusion, and the real value will be well south of our estimate (maybe somewhere near Antarctica). In those instances, if the liquidation becomes a reality, we will lose money. In other instances, the real value will be higher than our estimate, and we will make money. Our hope is that the latter occurs more frequently than the former, but we are certain that the former will occur regularly.
  2. We try to buy a portfolio of these securities and we don’t concentrate too much of the portfolio in any one security. The more certain we are about a security, the larger the portion of the portfolio it will command. This means that net cash stocks that have ceased trading and are in liquidation or paying a special dividend take up a larger proportion of our portfolio than cash-burning industrials in liquidity crises with value wholly concentrated in property, plant and equipment (that said, at a big enough discount, they might take up a lot of the portfolio). This means that if any one stock, or even a handful of stocks, go to zero or thereabouts, they don’t destroy our entire stake and we can live to invest another day.
  3. We try to follow investors much smarter than we are. From our perspective, there’s no shame in riding on someone else’s coat-tails, especially when those coat-tails are on the back of someone smarter, better resourced and more experienced. This is one of the main reasons we only invest when we can see a Schedule 13D notice filed with the SEC (the other reason is that the 13D filing is the precursor to the catalytic event that removes the discount). Often, the 13D notice will set out the investor’s rationale for the investment, which may include their view on the stock’s valuation. While we always do our own research, we are comforted when we see other value-oriented investors in the stock, and we hope that experienced, professional, value investors are right more often than they are wrong (even though we know that they will also make mistakes).

The first method above attempts to limit the effect of an error in valuation on any given investment. We hope that if we’re wrong about the value, it’s only by a matter of degree, and we can salvage some value from the investment. The second limits the damage that a total, or near total, destruction of value in any one investment does to the portolio as a whole. The third is a check on our thought process. If we’re right about a situation, we’d expect to see investors smarter than we are already in the stock. If they’re not there, we’d have to look deep into the abyss before jumping in. We haven’t had to do that yet.

We hope that this better explains our approach to investment. Once again, we’re always keen to hear other points of view, or to have someone point out the obvious holes in the argument.

Read Full Post »

Valuing long-term and fixed assets

Posted in About, Greenbackd, Liquidation Value, Net Cash Stocks, Net Current Asset Value, Net Net Stocks, Net Quick Stocks, Net Quick Value, tagged , , , , , , on January 15, 2009| 14 Comments »

We’ve recently received several questions about our valuation methodology. Specifically, readers have asked why we include property, plant and equipment in our valuation, and why we only discount it by half, as opposed to a higher figure (two-thirds, four-fifths, one-hundred percent). They are concerned that by including property, plant and equipment in our assessment, or by failing to apply a sufficient discount to those assets, we are overstating the asset or liquidation value of the companies we cover and therefore overpaying for their stock. In this post, we better describe our approach to asset valuation. In the next post, we deal with our method for protecting ourselves from overpaying for stock.

Our valuation methodology is closely based on Benjamin Graham’s approach, which he set out in Security Analysis and The Interpretation of Financial Statements. Like Graham, we have a strong preference for current assets, and, in particular, cash. As we mention on the About Greenbackd page, our favorite stocks are those backed by greenbacks, hence our name: Greenbackd. We love to find what Graham described as gold-dollars-with-strings-attached that can be purchased for 50 cents. We believe that there is value in long-term and fixed assets, although not necessarily the value at which those assets are carried in the financial statements. The appropriate discount for long-term and fixed assets is something with which we (and we suspect other Grahamite / asset / liquidation investors) struggle. We think it’s useful to consider Graham’s approach, which we’ve set out below:

Graham’s approach to valuing long-term and fixed assets

Graham’s preference was clearly for current assets, as this quote from Chapter XXIV of The Interpretation of Financial Statements: The Classic 1937 Edition demonstrates:

It is particularly interesting when the current assets make up a relatively large part of the total assets, and the liabilities ahead of the common are relatively small. This is true because the current assets usually suffer a much smaller loss in liquidation than do the fixed assets. In some cases of liquidation it happens that the fixed assets realize only about enough to make up the shrinkage in the current assets.

Hence the “net current asset value” of an industrial security is likely to constitute a rough measure of its liquidating value. It is found by taking the net current assets (or “working capital”) alone and deducting therefrom the full claims of all senior securities. When a stock is selling at much less than its net current asset value, this fact is always of interest, although it is by no means conclusive proof that the issue is undervalued.

Despite Graham’s cautionary tone above, he did not necessarily exclude long-term and fixed assets from his assessment of value. He did, however, heavily discount those assets (from Chapter XLIII of Security Analysis: The Classic 1934 Edition “Significance of the Current Asset Value”):

The value to be ascribed to the assets however, will vary according to their character. The following schedule indicates fairly well the relative dependability of various types of assets in liquidation.

liquidation-value-schedule2

Graham then set out an example valuation for White Motor Company:

In studying this computation it must be borne in mind that our object is not to determine the exact liquidating value of White Motor, but merely to form a rough idea of this liquidating value in order ascertain whether or not the shares are selling for less than the stockholders could actually take of the business. The latter question is answered very definitively in the affirmative. With a full allowance for possible error, there was no doubt at all that White Motor would liquidate for a great deal more than $8 per share or $5,200,000 for the company. The striking fact that the cash assets alone considerably exceed this figure, after deducting all liabilities, completely clinched the argument on this score.

white-motor-example1

Current-asset Value a Rough Measure of Liquidating Value. – The estimate values in liquidation as given for White Motor are somewhat lower in respect of inventories and somewhat higher as regards the fixed and miscellaneous assets than one might be inclined to adopt in other examples. We are allowing for the fact that motor-truck inventories are likely to be less salable than the average. On the other hand some of the assets listed as noncurrent, in particular the investment in White Motor Securities Corporation, would be likely to yield a larger proportion of their book values than the ordinary property account. It will be seen that White Motor’s estimated liquidating value (about $31 per share) is not far from the current-asset value ($34 per share). In the typical case it may be said that the noncurrent assets are likely to realize enough to make up most of the shrinkage suffered in the liquidation of the quick assets. Hence our first thesis, viz., that the current-asset value affords a rough measure of the liquidating value.

Greenbackd’s approach to valuing long-term and fixed assets

The first thing to note is that we’ve got no particular insight into any of the companies that we write about or the actual value of the companies’ assets. The valuations are based on the same generalized, unsophisticated, purely mathematical application of Graham’s formula. Further, if the actual value of an asset is objectively known or determinable, then we don’t know it and, in most cases, can’t determine it. That puts us at a disadvantage to those who do know the assets’ real value or can make that determination. Secondly, we can’t make the fine judgements about value that Graham has made in the White Motor example above. Perhaps it’s blindingly obvious that “motor-truck inventories are likely to be less salable than the average,” but we don’t know anything about motor-truck inventories or the average. It’s specific knowledge that we don’t have, which means that we are forced to mechanically apply the same discount to all assets of the same type.

Given that we’ve disclaimed any ability to actually value an asset or class of assets, why not adopt the lower to middle end of Graham’s valuation range for those assets? (Editors note: What a good suggestion. From here on in, we’re taking Graham’s advice. It’s simply because, in our experience, as idiosyncratic as it has been, an 80% discount to property, plant and equipment is too much in most instances. We think that 50% is a conservative estimate. In our limited experience, commercial and industrial real estate rarely seems to sell at much less than 15% below book value, and that’s in the recent collapse.) At first blush, specialist plant and equipment might appear to be worthless because the resale market is too small, but it can also be sold at a premium to its carrying value. For example, in the recent resources boom, we heard from an acquaintance in the mining industry that mining truck tires were so scarce as to sell in many instances at a higher price second hand than new. Apparently entire junked mining trucks were purchased in one country and shipped to another simply for the tires. Without that specialist knowledge of the mining industry, one might have ascribed a minimal value to an irreparable mining truck or a pile of used mining truck tires and missed the opportunity. What these examples demonstrate, in our opinion, is that the sale price for an asset to be sold out of liquidation is extremely difficult to judge until the actual sale, by which time it’s way too late to make an investment decision.

The best that we can do is fix a point at which we feel that we a more likely to be right than wrong about the value but will also have enough opportunities to invest to make the exercise worthwhile. For us, that point is roughly 20% 50% for property, plant and equipment. That 20% 50% is not based on anything more than (Edit: Graham’s formula, which has stood the test of time and should be applied in most cases unless one has a very good reason not to do so our limited experience, which is insufficient to be statistically significant for any industry or sector, geographical location or time in the investment cycle.) We always set out for our readers our estimate so that you can amend our valuation if you think it’s not conservative enough or just plain wrong (if you do make that amendment, we’d love to hear about it, so that we can adjust our valuation in light of a better reasoned valuation).

We hope that this sheds some light on our process. We’d love to hear your thoughts on the problems with our reasoning.

Read Full Post »

Catalysts: Share buy-backs

Posted in About, Catalysts, InFocus Corporation (NASDAQ:INFS), Liquidation Value, Net Net Stocks, Stocks, tagged , , , , , on December 15, 2008| 3 Comments »

A stock buy-back is a great way for a deeply undervalued company to quickly increase its per share value. After identifying an undervalued asset situation, we look through the company’s filings to see if it has any existing plans authorizing it to buy-back its stock. On the rare occasions when we do locate such plans, we are often struck by (a) how few shares the company is authorized to buy back and (b) how few of the shares the company has actually bought back. InFocus Corporation (NASDAQ:INFS), which we posted about on Friday, is a classic example of this phenomenon.

INFS is trading at a big discount to its liquidation value, it has heaps of cash on hand and no debt, all of which makes it a prime candidate to undertake a big buy-back. Given the substantial discount to its current asset backing, any shares bought back at these levels have a huge positive effect on its per share value. It has just initiated a buy-back plan to repurchase over a three-year period up to 4M shares out of 40.7M on issue. As of September 30, the company had repurchased only 50,000 shares at an average price of $1.53 per share. 50,000 shares is simply too little to have any meaningful impact on the company’s value. We’d argue that even 4M (less than 10% of the outstanding common stock) isn’t enough. Why? Let’s look at what happens if the company repurchases many more shares, say 50% of its issued stock.

In our last blog post, we argued that INFS had a liquidation value of around $1.15 per share, 70% higher than its Friday close of $0.67. The company has cash and equivalents of around $55M and no debt as the summary financials demonstrate (the “Carrying” column shows the assets as they are carried in the financial statements, and the “Liquidating” column shows our estimate of the value of the assets in a liquidation):

Before

before-infs-summary

After

If INFS was to repurchase 50% of its stock (20M of its 40.7M shares currently on issue) at $0.67, it would cost INFS only $13.4M, leaving it with nearly $42M in cash on hand:

after-infs-summaryAfter the buy back, INFS’s per share liquidating value increases from $1.15 to $1.61 (a 40% increase).

There are very few investment opportunities that so quickly increase a company’s per share value. Given that management should know the company’s value better than the value of any other investment opportunity, it is also the most assured way of increasing a company’s per share value. There is simply no better way for an undervalued company to invest its excess cash than in its own stock.

Read Full Post »

About liquidation value investing

Posted in About, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, tagged , , on December 1, 2008| 9 Comments »

Liquidation value investing is the purchase of securities at a discount to the value of the securities in a liquidation.

The rationale for such an investment is straight foward. In the 1934 edition of Security Analysis, Benjamin Graham argued that the phenomenon of a stock selling persistently below its liquidation value was “fundamentally illogical.” In Graham’s opinion, it meant:

  1. The stock was too cheap, and therefore offered an attractive opportunity for purchase and an attractive area for security analysis; and
  2. Management was pursuing a mistaken policy and should take corrective action, “if not voluntarily, then under pressure from the stockholders.”

Graham understood why these sort of stocks – also known as “net-net”, “net-quick” or “net current asset value” stocks – traded at a discount to liquidation value:

“Common stocks in this category almost always have an unsatisfactory trend of earnings.

…

The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will dissipated and the intrinsic value ultimately become less than the price paid.”

Graham responded to these objections that, while he could not deny that these outcomes occurred in individual cases:

“…there is a much wider range of potential developments which may result in establishing a higher market price.  These include the following:

  1. The creation of an earning power commensurate with the company’s assets.   This may result from: a. General improvement in the industry. b. Favorable change in the company’s operating policies, with or without a change in management.  These changes include more efficient methods, new products, abandonment of unprofitable lines, etc.
  2. A sale or merger, because some other concern is able to utilize the resources to better advantage and hence can pay at least liquidating value for the assets.
  3. Complete or partial liquidation.“

Graham cautioned that, while there was scarcely any doubt that common stocks selling well below liquidating value represent on the whole a class of undervalued securities, the discerning securities analyst should exercise as much discrimination as possible:

“He will lean towards those for which he sees a fairly imminent prospect of some one of the favorable developments listed above.  Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, e.g., satisfactory current earnings and dividends, or a high average earning power in the past.  The analyst will avoid issues which have been losing their quick assets at a rapid rate and show no definite signs of ceasing to do so.”

Why securities trade below liquidation value

In 1932 Graham had authored a series of three articles for Forbes, titled, Inflated Treasuries and Deflated Stockholders, Should Rich Corporations Return Stockholders’ Cash?, and Should Rich but Losing Corporations Be Liquidated? in which he discussed the phenomenon of companies trading below liquidation value.

In the first article, Inflated Treasuries and Deflated Stockholders, Graham wrote:

“…a great number of American businesses are quoted in the market for much less than their liquidating value; that in the best judgment of Wall Street, these businesses are worth more dead than alive. For most industrial companies should bring, in orderly liquidation, at least as much as their quick assets alone.”

The reasons for the selling, Graham argued, was primarily “due to fear rather than necessity,” but also because investors didn’t pay any attention to what a company owns – not even its cash.  He argued that value was associated exclusively with “earning power” and therefore “reported earnings – which might only be temporary or even deceptive – and in a complete eclipse of what had always been regarded as a vital factor in security values, namely the company’s working capital position.”
Graham proposed that investors should become not only “balance sheet conscious,” but “ownership conscious:”
“If they realized their rights as business owners, we would not have before us the insane spectacle of treasuries bloated with cash and their proprietors in a wild scramble to give away their interest on any terms they can get. Perhaps the corporation itself buys back the shares they throw on the market, and by a final touch of irony, we see the stockholders’ pitifully inadequate payment made to them with their own cash.“

In the final article, Should Rich but Losing Corporations Be Liquidated?, Graham explained the logic of an investment in a security trading at a discount to its liquidating value:

“If gold dollars without any strings attached could actually be purchased for 50 cents, plenty of publicity and plenty of buying power would quickly be marshaled to take advantage of the bargain. Corporate gold dollars are now available in quantity at 50 cents and less–but they do have strings attached. Although they belong to the stockholder, he doesn’t control them. He may have to sit back and watch them dwindle and disappear as operating losses take their toll. For that reason the public refuses to accept even the cash holdings of corporations at their face value.”
Graham then considered why investors should even contemplate liquidating values when companies were not going to liquidate, responding:
“The stockholders do not have it in their power to make a business profitable, but they do have it in their power to liquidate it. At bottom it is not a theoretical question at all; the issue is both very practical and very pressing.
…
In its simplest terms the question comes down to this: Are these managements wrong or is the market wrong? Are these low prices merely the product of unreasoning fear, or do they convey a stern warning to liquidate while there is yet time?”

How to determine a company’s liquidation value

In Security Analysis, Graham wrote that, in determining the liquidation value, the current-asset value generally provides a rough indication:

“A company’s balance sheet does not convey exact information as to its value in liquidation, but it does supply clues or hints which may prove useful.  The first rule in calculating liquidating value is that the liabilities are real but the assets are of questionable value.  This means that all true liabilities shown on the books must be deducted at their face amount.  The value to be ascribed to the assets however, will vary according to their character.“

Graham then provided the following guide for determining the value of various types of assets in a liquidation:

  • Cash assets (including securities at market) – 100%
  • Receivables (less usual reserves) – between 75% to 90% with an average of 80%.  Graham noted that retail installment accounts should be valued for liquidation at a lower rate, between 30% to 60% with an average of about 50%
  • Inventories (at lower or cost or market) – between 50% to 75% with an average of 66.6%
  • Fixed and miscellaneous assets (real estate, buildings, machinery, equipment, nonmarketable investments, intangibles etc) – between 1% to 50% with an approximate average of 15%.
For more detail, see our posts Valuing long-term and fixed assets, Portfolio construction and Marty Whitman’s adjustments to Graham’s net net formula. We also have a series of articles extracted from Seth Klarman’s Margin of Safety, Seth Klarman on Liquidation Value, Seth Klarman on Catalysts and Seth Klarman on Investing in Corporate Liquidations.

Historical returns from investing at a discount to liquidation value

In 1992 Tweedy Browne, an undervalued asset investor established in 1920, produced a report What has worked in investing. The report described a number of academic studies of investment styles that have produced high rates of return, including an article in the November-December 1986 issue of Financial Analysts Journal called “Ben Graham’s Net Current Asset Values: A Performance Update”.  The article described a study undertaken by Henry Oppenheimer, an Associate Professor of Finance at the State University of New York at Binghamton, in which he examined the investment results of stocks selling at or below 66% of net current asset value during the 13-year period from December 31, 1970 through December 31, 1983:

“The study assumed that all stocks meeting the investment criterion were purchased on December 31 of each year, held for one year, and replaced on December 31 of the subsequent year by stocks meeting the same criterion on that date.  To create the annual net current asset portfolios, Oppenheimer screened the entire Standard & Poor’s Security Owners Guide.  The entire 13-year study sample size was 645 net current asset selections from the New York Stock Exchange, the American Stock Exchange and the over-the-counter securities market.  The minimum December 31 sample was 18 companies and the maximum December 31 sample was 89 companies.

The mean return from net current asset stocks for the 13-year period was 29.4% per year versus 11.5% per year for the NYSE-AMEX Index.  One million dollars invested in the net current asset portfolio on December 31, 1970 would have increased to $25,497,300 by December 31, 1983.  By comparison,$1,000,000 invested in the NYSE-AMEX Index would have increased to $3,729,600 on December 31,1983.  The net current asset portfolio’s exceptional performance over the entire 13 years was not consistent over smaller subsets of time within the 13-year period.  For the three-year period, December31, 1970 through December 31, 1973, which represents 23% of the 13-year study period, the mean annual return from the net current asset portfolio was .6% per year as compared to 4.6% per year for the NYSE-AMEX Index.

The study also examined the investment results from the net current asset companies which operated at a loss (about one-third of the entire sample of firms) as compared to the investment results of the net current asset companies which operated profitably.  The firms operating at a loss had slightly higher investment returns than the firms with positive earnings:  31.3% per year for the unprofitable companies versus 28.9% per year for the profitable companies.

Further research by Tweedy, Browne has indicated that companies satisfying the net current asset criterion have not only enjoyed superior common stock performance over time but also often have been priced at significant discounts to “real world” estimates of the specific value that stockholders would probably receive in an actual sale or liquidation of the entire corporation.  Net current asset value ascribes no value to a company’s real estate and equipment, nor is any going concern value ascribed to prospective earning power from a company’s sales base.  When liquidation value appraisals are made, the estimated “haircut” on accounts receivable and inventory is often recouped or exceeded by the estimated value of a company’s real estate and equipment.  It is not uncommon to see informed investors, such as a company’s own officers and directors or other corporations, accumulate the shares of a company priced in the stock market at less than 66% of net current asset value.  The company itself is frequently a buyer of its own shares.

Common characteristics associated with stocks selling at less than 66% of net current asset value are low price/earnings ratios, low price/sales ratios and low prices in relation to “normal” earnings; i.e., what the company would earn if it earned the average return on equity for a given industry or the average neti ncome margin on sales for such industry.  Current earnings are often depressed in relation to prior earnings.  The stock price has often declined significantly from prior price levels, causing a shrinkage in a company’s market capitalization.”

Other studies

In Testing Ben Graham’s Net Current Asset Value Strategy in London (Word format), a paper from the business school of the University of Salford in the UK, the strategy was applied to stocks listed on the London Stock Exchange in the period 1980 to 2005.  The paper found that stocks selected using the strategy:

“…substantially outperform the stock market over holding periods of up to five years. The average 60-month buy-and-hold raw return is 254 percent with equal weighting within the NCAV/MV portfolio and 216 percent with value weighting, which are much higher than market indices of only 137 percent and 108 percent. One million pounds invested in a series of NCAV/MV (equal weighted) portfolios starting on 1st July 1981 would have increased to £432 million by June 2005 based on the typical NCAV/MV returns over the study period. By comparison £1,000,000 invested in the entire UK main market would have increased to £34 million by end of June 2005.

For almost all post-formation lengths, and regardless of within portfolio weighting, the NCAV/MV portfolio outperforms either equal weighted or value weighted market indices with high statistical significance. Market-adjusted returns rise to 117 percent and 146 percent after five years if the stocks are equally weighted; and 78 percent and 108 percent after five years if the stocks are value weighted.”

The University of Salford paper is also useful because it discusses other studies and Benjamin Graham’s own results:

“Graham used the NCAV/MV criterion extensively in the operations of the Graham-Newman Corporation and report that shares selected on the basis of the NCAV/MV rule earn, on average, about 20 percent per year over the 30-year period to 1956 (Graham and Chatman (1996)). More recently, Oppenheimer (1986) tested returns of NCAV/MV portfolios with returns on both the NYSE-AMEX value-weighted index and the small-firm index from 1971 through 1983. He found that returns are rank-ordered: securities with the smallest purchase price as a percentage of NCAV show the largest returns. Over the 13-year period, the Graham criteria NCAV/MV portfolios on average outperformed the NYSE-AMEX index by 1.46 percent per month (19 percent per year) after adjusting for risk. When compared to the small-firm index, these portfolios earned an excess return of 0.67% per month (8 percent per year).  In the first study outside of the USA, Bildersee, Cheh and Zutshi (1993)’s paper focuses on the Japanese market from 1975 to 1988.  In order to maintain a sample large enough for cross-sectional analysis, Graham’s criterion was relaxed so that firms are required to merely have an NCAV/MV ratio greater than zero. They found the mean market-adjusted return of the aggregate portfolio is around 1 percent per month (13 percent per year).”

At Greenbackd, we believe that Graham’s rationale, along with the results of the studies, present a compelling argument for investing in these stocks. We spend our days trying to uncover as many of these stocks as we can. What we dig up, we review and post it to the website. Our latest review should be right here.

Buy my book The Acquirer’s Multiple: How the Billionaire Contrarians of Deep Value Beat the Market from on Kindle, paperback, and Audible.

Here’s your book for the fall if you’re on global Wall Street. Tobias Carlisle has hit a home run deep over left field. It’s an incredibly smart, dense, 213 pages on how to not lose money in the market. It’s your Autumn smart read. –Tom Keene, Bloomberg’s Editor-At-Large, Bloomberg Surveillance, September 9, 2014.

Click here if you’d like to read more on The Acquirer’s Multiple, or connect with me on Twitter, LinkedIn or Facebook. Check out the best deep value stocks in the largest 1000 names for free on the deep value stock screener at The Acquirer’s Multiple®.

 

Read Full Post »

« Newer Posts