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Archive for the ‘Net Quick Stocks’ Category

The Kabuki narrative

Posted in About, Behavioral economics, Liquidation, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Stocks, tagged , , , , on February 12, 2010| 5 Comments »

Regular readers of Greenbackd know that I’m no fan of “the narrative,” which is the story an investor concocts to explain the various pieces of data the investor gathers about a potential investment. It’s something I’ve been thinking about a great deal recently as I grapple with the merits of an investment in Japanese net current asset value stocks. The two arguments for and against investing in such opportunities are as follows:

Fer it: Net current asset value stocks have performed remarkably well throughout the investing world and over time. In support of this argument I cite generally Graham’s experience, Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update paper, Testing Ben Graham’s Net Current Asset Value Strategy in London, a paper from the business school of the University of Salford in the UK, and, more specifically, Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values, James Montier’s Graham’’s net-nets: outdated or outstanding?, and Dylan Grice’s Are Japanese equities worth more dead than alive.

Agin it: Japan is a special case because it has weak shareholder rights and a culture that regards corporations as “social institutions with a duty to provide stable employment and consider the needs of employees and the community at large, not just shareholders.” In support of this argument I cite the recent experiences of activist investors in Japan, and Bildersee, Cheh and Zutshi’s The performance of Japanese common stocks in relation to their net current asset values (yes, it supports both sides of the argument). Further, the prospects for Japan’s economy are poor due to its large government debt and ageing population.

How to break the deadlock? Montier provides a roadmap in his excellent Behavioural Investing:

We appear to use stories to help us reach decisions. In the ‘rational’ view of the world we observe the evidence, we then weigh the evidence, and finally we come to our decision. Of course, in the rational view we all collect the evidence in a well-behaved unbiased fashion. … Usually we are prone to only look for the information that happens to agree with us (confirmatory bias), etc.

However, the real world of behaviour is a long way from the rational viewpoint, and not just in the realm of information gathering. The second stage of the rational decision is weighing the evidence. However, as the diagram below shows, a more commonly encountered approach is to construct a narrative to explain the evidence that has been gathered (the story model of thinking).

Hastie and Pennington (2000) are the leading advocates of the story view (also known as explanation-based decision-making). The central hypothesis of the explanation-based view is that the decision maker constructs a summary story of the evidence and then uses this story, rather than the original raw evidence, to make their final decision.

…

All too often investors are sucked into plausible sounding story. Indeed, underlying some of the most noted bubbles in history are kernels of truth.

As to the last point, arguably, the converse is also true. Investors have missed some great returns because the ugly stories about companies or markets were so compelling.

There are several points that are not contentious about an investment in Japan. The data suggests to me and to everyone else that there are a large number of net current asset value bargains available there. The contention is whether these net current asset value stocks will perform as they have in other countries, or whether they are destined to remain net current asset value bargains, the classic “value traps.” My own penchant for value investing, and quantitative value investing in particular, makes this a reasonably simple matter to resolve. I am going to invest in Japanese net current asset value stocks. Here are the bases for my reasoning:

  • I believe that value investing works. I believe that this is the case because it appeals to me as a matter of logic. I also believe that the data supports this position (see Ben Graham’s Net Current Asset Values: A Performance Update or Lakonishok, Shleifer, and Vishny’s Contrarian Investment, Extrapolation and Risk). Where a stock trades at a significant discount to its value, I am going to take a position.
  • I believe that Graham’s net current asset value works. In support of this proposition I cite the papers listed in the “Fer it” argument above.
  • I believe that simple quantitative models consistently outperform expert judgements. In support of this proposition generally I cite James Montier’s Painting By Numbers: An Ode To Quant. Where the data looks favorable to me, I am going to take a position, and I’m going to ignore the qualitative factors.
  • I believe that value is a good predictor of returns at a market level. In support I cite the Dimson, Marsh and Staunton research. I am not dissuaded from investing in a country simply because its growth prospects are low. Value is the signal predictor of returns.

The arguments militating against investing in Japan sound to me like the arguments militating against any investment in a NCAV stock, which is to say that they are arguments rooted in the narrative. I’ve never taken a position in a NCAV stock that had a good story attached to it. They have always looked ugly from an earnings or narrative perspective (otherwise, they’d be trading at a higher price). As far as I can tell, this situation is no different, other than the fact that it is in a different country and the country has economic problems (which I would ignore in the usual case anyway). While the research specific to NCAV stocks in Japan is not as compelling as I would like it to be, I always bear in mind the lessons of Taleb’s “naive empiricist,” which is to say that the data are useful only up to a point.

This is not to say that I have any great conviction about Japan or Japanese net current asset value stocks. Far from it. I fully expect, as I always do when taking a position in any stock, to be wrong and have the situation follow the narrative. Fortunately, the decision is out of my hands. I’m going to follow my simple quantitative model – the Graham net current asset value strategy – and take some positions in Japanese net nets. The rest is for the goddess Fortuna.

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5 big Japanese Graham net nets

Posted in About, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Value Investment, tagged , , , , on February 10, 2010| 5 Comments »

In his Are Japanese equities worth more dead than alive?, SocGen’s Dylan Grice conducted some research into the performance of sub-liquidation value stocks in Japan since the mid 1990s. Grice’s findings are compelling:

My Factset backtest suggests such stocks trading below liquidation value have averaged a monthly return of 1.5% since the mid 1990s, compared to -0.2% for the Topix. There is no such thing as a toxic asset, only a toxic price. It may well be that these companies have no future, that they shouldn’t be valued as going concerns and that they are worth more dead than alive. If so, they are already trading at a value lower than would be fetched in a fire sale. But what if the outlook isn’t so gloomy? If these assets aren’t actually complete duds, we could be looking at some real bargains…

In the same article, Grice identifies five Graham net net stocks in Japan with market capitalizations bigger than $1B:

He argues that such stocks may offer value beyond the net current asset value:

The following chart shows the debt to shareholders equity ratios for each of the stocks highlighted as a liquidation candidate above, rebased so that the last year’s number equals 100. It’s clear that these companies have been aggressively delivering in the last decade.

Despite the “Japan has weak shareholder rights” cover story, management seems to be doing the right thing:

But as it happens, most of these companies have also been buying back stock too. So per share book values have been rising steadily throughout the appalling macro climate these companies have found themselves in. Contrary to what I expected to find, these companies that are currently priced at levels making liquidation seem the most profitable option have in fact been steadily creating shareholder wealth.

This is really extraordinary. The currency is a risk that I can’t quantify, but it warrants further investigation.

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Performance of Japanese sub-liquidation value stocks

Posted in About, Liquidation, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Stocks, tagged , , , on February 8, 2010| 2 Comments »

Following on from last week’s Japanese liquidation value: 1932 US redux post, I’ve been trying to determine whether the historical performance of Japanese sub-liquidation value stocks matches the experience in the US. The question arises because of the perception (rightly or not) that the weakness of shareholder rights in Japan means that net current asset value stocks there are destined to trade at a discount to net current asset value. I’m always a little chary of the “Japan has weak shareholder rights” narrative (or any narrative, for that matter). I’d rather look at the data. In this instance, unfortunately, the data are wanting.

In The performance of Japanese common stocks in relation to their net current asset values, a 1993 paper by Bildersee, Cheh and Zutshi, the authors analyzed the performance of Japanese net nets between 1975 and 1988. Here are their findings described in another paper:

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).

Not a great return, but obviously a difficult period through 1987 and not an exact facsimile of Graham’s strategy. An astute reader notes that “…the test period for that study is not the best. It includes Japan’s best analog to America’s Roaring Twenties. The Nikkei peaked on 12/29/89, and never recovered:”

Many of the “assets” on public companies’ books at that time were real estate bubble-related. At the peak in 1989, the aggregate market price for all private real estate in the city of Tokyo was purportedly greater than that of the entire state of California. You can see how the sudden runup in real estate during the bubble could cause asset-heavy companies to outperform the market.

So a better crucible for Japanese NCAVs might be the deflationary period, say beginning 1/1/90, which is more analogous to the US in 1932.

It would be interesting to see an update of the performance, but, as far as I am aware, none exists. To that end, I’ve undertaken a little research project of my own. I’ll publish the results tomorrow.

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Japanese liquidation value: 1932 US redux

Posted in About, Liquidation, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, tagged , , , , , on February 4, 2010| 14 Comments »

Zero Hedge has an article Uncovering Liquidation Value… In Japan? discussing SocGen’s Dylan Grice’s Are Japanese equities worth more dead than alive. The title is a nod to Benjamin Graham’s landmark 1932 Forbes article, Inflated Treasuries and Deflated Stockholders, where he discussed the large number of companies in the US then trading at a discount to liquidation value:

…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.

Grice writes:

In the space of a generation, Japan has gone from the world economy’s thrusting up-and-coming superpower to its slowing silver-haired retiree. Accordingly, the Japanese market attracts a low valuation. The chart [below] shows FTSE Japan’s equity price to book ratio and enterprise price to book ratio, since equity P/B ratios alone can be distorted by leverage. Both metrics show Japan to be trading at a low premium to book compared to its recent history. So it’s certainly cheap. But does it offer value? The answer can be seen in the chart above, which shows corporate Japan’s RoEs and RoAs over recent decades to have averaged a mere 6.8% and 3.8% respectively. This is hardly the sort of earnings power which should command any premium over book value at all. Indeed, to my mind the question is one of how big a discount the market should trade at relative to book.

The fundamental problem in 1932 America, according to Graham, was that investors weren’t paying attention to the assets owned by the company, instead focussing exclusively on “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 themwith their own cash.

In his article, Grice makes a parallel argument about valuations based on earnings in Japan now:

Regular readers will know I favour a Residual Income approach to valuation. It’s not perfect, and it’s still a work in process, but anchoring estimates of intrinsic value on the earnings power of company assets (relative to a required rate of return, which I set at an exacting 10%) helps avoid value traps. Things don?t necessarily come up as offering value just because they’re on low multiples. The left chart below shows Japan’s ratio of Intrinsic Value to Price (IVP ratio, where a higher number indicates higher value) to be only 0.6, suggesting that in an absolute sense, Japan is intrinsically worth only about 60% of its current market value.

Grice arrives at the same conclusion about Japan as Graham did in 1932 about the US:

But here the tension between “going concern” valuation and “liquidation” valuation becomes important. Let’s just imagine the unimaginable for a second, and that my IVP ratios are correct. Japan currently trades on a P/B ratio of 1.5x, but if it is only worth 60% of that, its “fair value” P/B ratio (assuming we value it as a going concern) would be around 0.9x. Of course, that would only be true on average. Nearly all stocks would trade either above or below that level. And of those trading below, some would trade slightly below, others significantly below. And of those which traded significantly below, some might be expected to flirt with liquidation values which called into question whether or not the “going concern” valuation was appropriate. Indeed, this is exactly what is beginning to happen.

It seems that there are quite a few stocks trading at a discount to net current asset value in Japan:

Grice likes the net current asset value strategy in Japan (sort of):

Not only are these assets cheap but, unlike the overall market, they probably offer value as well. My Factset backtest suggests such stocks trading below liquidation value have averaged a monthly return of 1.5% since the mid 1990s, compared to -0.2% for the Topix. There is no such thing as a toxic asset, only a toxic price. It may well be that these companies have no future, that they shouldn’t be valued as going concerns and that they are worth more dead than alive. If so, they are already trading at a value lower than would be fetched in a fire sale. But what if the outlook isn’t so gloomy? If these assets aren’t actually complete duds, we could be looking at some real bargains…

…

So should we be filling our boots with companies trading below liquidation value? Not necessarily. But I would say the burden of proof has shifted. Why wouldn’t you want to own assets that have been generating shareholder wealth yet which trade at below their liquidation values?

It is interesting that this article echoes another SocGen article, this one a September 2008 report by James Montier called Graham’’s net-nets: outdated or outstanding? in which Montier looked at Graham sub-liquidation stocks globally. Of the 175 stocks identified around the world, Montier found that over half were in Japan.

Now all we have to do is figure out how to invest in Japan.

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October Net-Net follow-up

Posted in About, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Stocks, tagged on February 2, 2010| 1 Comment »

In October I introduced a “monthly” net-net watch list based on the GuruFocus Benjamin Graham Net Current Asset Value Screener (subscription required). I haven’t updated it on a monthly basis, so now it’s a quarterly net-net watch list.

July Net-Net Screen

I was prompted to introduce the October net-net watch list because of the performance of a watch list created on July 7, 2009 using the July 6, 2009 closing prices. The performance of the stocks in that first watch list to October 13 was nothing short of spectacular. Here is a screen grab (with some columns removed to fit the space below):

GuruFocus NCAV Screen

The average return to October across the nine stocks in the watch list was 45.5% against the return on the S&P500 of 20.05% over the same period, an outperformance of more than 25% in ~three months. Pretty impressive stuff.

Here is the performance NCAV screen updated to today:

While a 16.38% return over ~6 months is a good return, given that the watch list was up 45.5% to October, the last quarter was, to say the least, a little disappointing. It’s also underperformed the S&P500 by 5.12%.

October Net-Net Screen

The stocks in the October watch list are set out below (again, with a column removed to fit the space below):

GuruFocus NCAV Screen 2009 10 13

Here’s the performance of the October crop to yesterday’s close:

36.85% is a fantastic return for a quarter, more so given that the S&P500’s return was so anaemic at 1.21%. It was obviously helped by the performance of NLST, up more than 428% for the period. If we remove NLST from the portfolio, the portfolio return drops to 10.7%, which is still a good return, but nowhere near as impressive.

February Net-Net Screen

I have captured the February screen which I’ll track over the coming months. If you want to see complete list online in real time, go to GuruFocus Benjamin Graham Net Current Asset Value Screener (subscription required).

[Full Disclosure:  I have a holding in FORD and TSRI. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

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Montier on net nets: A simple quantitative value strategy

Posted in About, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Stocks, tagged , , , , on January 21, 2010| 10 Comments »

Continuing the quantitative value investment theme I’ve been trying to develop over the last week or so, I present my definition of a simple quantitative value strategy: net nets. James Montier, author of the essay Painting By Numbers: An Ode To Quant, which I use as the justification for simple quantitative investing, authored an article in September 2008 specifically dealing with net nets as a global investment strategy: Graham’’s net-nets: outdated or outstanding? (Edit: It seems this link no longer works as SG obliterates any article ever written by Montier). Quelle surprise, Montier found that buying net-nets is a viable and profitable strategy:

Testing such a deep value approach reveals that it would have been a highly profitable strategy. Over the period 1985-2007, buying a global basket of net-nets would have generated a return of over 35% p.a. versus an equally weighted universe return of 17% p.a.

An annual return of 35% over 23 years would put you in elite company indeed, so Montier’s methodology is worthy of closer inspection. Unfortunately he doesn’t discuss his methodology in any detail, other than to say as follows:

I decided to test the performance of buying net-nets on a global basis. I used a sample of developed markets over the period 1985 onwards, all returns were in dollar terms.

It may have been a strategy similar to the annual rebalancing methodology discussed in Oppenheimer’s Ben Graham’s Net Current Asset Values: A Performance Update. That paper demonstrates a purely mechanical annual rebalancing of stocks meeting Graham’s net current asset value criterion generated a mean return between 1970 and 1983  of “29.4% per year versus 11.5% per year for the NYSE-AMEX Index.” It doesn’t really matter exactly how Montier generated his return. Whether he bought each net net as it became a net net or simply purchased a basket on a regular basis (monthly, quarterly, annually, whatever), it’s sufficient to know that he was testing the holding of a basket of net nets throughout the period 1985 to 2007.

Montier’s findings are as follows:

  • The net-nets portfolio contains a median universe of 65 stocks per year.
  • There is a small cap bias to the portfolio. The median market cap of a net-net is US$21m.
  • At the time of writing (September 2008), Montier found around 175 net-nets globally. Over half were in Japan.
  • If we define total business failure as stocks that drop more than 90% in a year, then the net-nets portfolio sees about 5% of its constituents witnessing such an event. In the broad market only around 2% of stocks suffer such an outcome.
  • The overall portfolio suffered only three down years in our sample, compared to six for the overall market.

Several of Montier’s findings are particularly interesting to me. At an individual company level, a net net is more likely to suffer a permanent loss of capital than the average stock:

If we define a permanent loss of capital as a decline of 90% or more in a single year, then we see 5% of the net-nets selections suffering such a fate, compared with 2% in the broader market.

Here’s the chart:

This is interesting given that NCAV is often used as a proxy for liquidation value.

Very few companies turn out to have an ultimate value less than the working capital alone, although scattered instances may be found.

Montier believes this may provide a clue as to why the net net strategy continues to work:

This relatively poor performance may hint at an explanation as to why investors shy away from net-nets. If investors look at the performance of the individual stocks in their portfolio rather than the portfolio itself (known as ‘narrow-framing’), then they will see big losses more often than if they follow a broad market strategy. We know that people are generally loss averse, so they tend to feel losses far more than gains. This asymmetric response coupled with narrow framing means that investors in the net-nets strategy need to overcome several behavioural biases.

Paradoxically, it seems that what is true at the individual company level is not true at an aggregate level. The net net strategy has fewer down years than the market:

If one were to frame more broadly and look at the portfolio performance overall, the picture is much brighter. The net-net strategy only generated losses in three years in the entire sample we backtested. In contrast, the overall market witnessed some six years of negative returns.

Here’s the chart:

And it seems that the net net strategy is a reasonable contrary indicator. When the market is up, fewer can be found, and when the market is down, they seem to be available in abundance:

The main drawback to the net net strategy is its limited application. Stocks tend to be small and illiquid, which puts a limit on the amount of capital that can be safely run using it. That aside, it seems like a good way to get started in a small fund or with a individual account. Montier concludes:

…In various ways practically all these bargain issues turned out to be profitable and the average annual return proved much more remunerative than most other investments.

Good old Benjamin Graham. What a guy.

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®.

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Introducing the Monthly Net-Net Watchlist

Posted in About, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Quarterly Net-Net Watchlist, Stocks, tagged , , , , on October 13, 2009| 4 Comments »

We’ve recently been using the GuruFocus Benjamin Graham Net Current Asset Value Screener (subscription required) to generate regular watchlists of net net stocks. The GuruFocus NCAV screen has some superb functionality that makes it possible to create the watchlist from the screen and then track the performance of those stocks. We created our first watchlist on July 7 of this year using the July 6 closing prices. The performance of the stocks in that first watchlist over the last quarter has been nothing short of spectacular. Here is a screen grab (with some columns removed to fit the space below):

GuruFocus NCAV Screen

We know the market’s been somewhat frothy recently, but those returns are still notable. The average return to date across the nine stocks in the watchlist is 45.5% against the return on the S&P500 of 20.05% over the same period, an outperformance of more than 25% in ~three months. We’ve decided to run another screen today and we’ll track the return of that watchlist over the coming months. The stocks in the watchlist are set out below (again, with a column removed to fit the space below):

GuruFocus NCAV Screen 2009 10 13

We’ve done no research on these firms beyond running the screen. If you plan on buying anything in this screen, at the absolute minimum we recommend that you do some research to determine whether they are currently net net stocks and not just caught in the screen because of out-of-date filings. We’ll compare the performance of the stocks against the S&P500, which closed yesterday at 1,076.18.

[Full Disclosure:  We have a holding in FORD. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

Benjamin Graham Net Current Asset Value Screener

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Sub-liquidation value ten baggers

Posted in About, Greenbackd, Liquidation, Liquidation Value, Net Current Asset Value, Net Quick Stocks, tagged , , , , , on August 5, 2009| 12 Comments »

Bespoke Investment Group (via The Reformed Broker) has a list of the biggest gainers for 2009. It should come as no surprise to regular readers of Greenbackd that a number of the stocks are former sub-liquidation value plays (most of which we missed):

Little ten baggersWe opened a position in VNDA and got a great return. We lost our nerve with BGP and missed out on a great return. We completely ignored ATSG, DTSG, SMRT, RFMD, PIR and CHUX although all appeared on our NCAV screen at some stage earlier this year. A little more evidence that diamonds can be found if you dig through enough trash.

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Marty Whitman discusses Graham’s net-net formula

Posted in About, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Stocks, tagged , , , , on July 28, 2009| Leave a Comment »

In the following video, legendary value investor Marty Whitman discusses Benjamin Graham’s net-net formula and his adjustments to it. We’ve previously covered those adjustments here, but we’ve added the video because we think it’s quite amazing to see the great man explaining his rationale for making them. The highlight, from our perspective, is this gem:

We do net-nets based more on common sense. As, for example, you have an asset – a Class A office building – financed with recourse finance, fully tenanted by credit-worthy tenants; That, for accounting purposes, is classified as a fixed asset, but, given such a building, you pick up the telephone and sell it, and really it’s more current than K-Mart’s inventories, for example, which is classified as a current asset. 

 Enjoy the rest of his wit below:

 

 

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Marty Whitman’s adjustments to Graham’s net net formula

Posted in About, Greenbackd, Liquidation Value, Net Current Asset Value, Net Quick Stocks, Net Quick Value, Stocks, tagged , , , , , , on May 4, 2009| 11 Comments »

Long-term readers of Greenbackd might remember our initial struggle to apply the net net / liquidation formula described by Benjamin Graham in the 1934 Edition of Security Analysis in the context of modern accounting. Putting aside our attempt to include and tweak the discounts to PP&E (kind of like fixing the smile on the Mona Lisa), most embarassing was our failure to factor into the valuation off-balance sheet liabilities and contractual obligations. The best thing that we can say about the whole sorry episode is that we got there in the end and we’ve been applying a more robust formulation for the last quarter. With that in mind, we thought it was particularly interesting to see the Financial Post’s article, Veteran tweaks Graham’s rule to find bargains (via Graham and Doddsville), which details the refinements legendary value investor Marty Whitman makes to Graham’s net-net formulation.

According to the article, Whitman makes the following adjustments to Graham’s 90-year old formula:

  • Companies must be well-financed

First and foremost, companies must be well-financed in keeping with the core tenet of Third Avenue’s “safe and cheap” method of value investing.

The goal is to own companies that are going concerns, not ones destined for liquidation. This difference is a crucial point of distinction between the focus of equity investors, who are often wiped out in liquidation, and bond investors, who have rights to the assets of a company in liquidation.

  • Whitman includes long-term assets that are easily liquidated

The second adjustment is to the assets themselves. Graham and Dodd focused exclusively on current assets when calculating liquidation value whereas Whitman includes long-term assets that are easily liquidated.

For example, roughly one third of long-term assets of Toyota Industries Corp. are investment securities, including a 6% position in Toyota Motor Corp. (TM/TSX), says Ian Lapey, portfolio manager at Third Avenue and designated successor to Whitman on the Third Avenue Value Fund.

These securities are therefore included in Third Avenue’s calculations of net-net.

Closer to home, oil and gas producer Encana Corp. (ECA/ TSX) has proved reserves of oil and natural gas that are not included in current assets, says Lapey.

“They are liquid in that there is a real market, current commodity prices notwithstanding, for high-quality proved reserves of oil and gas.” Encana is a top holding in AIC Global Focused Fund, sub-advised by Third Avenue and managed by Lapey.

  • Adjust for off-balance sheet liabilities

The third adjustment is the inclusion of off-balance-sheet liabilities. Here, U. S. banks’ structured investment vehicles readily spring to mind.

  • Include some PP&E

The fourth and final adjustment to Graham and Dodd is the inclusion of “some property, plant and equipment” for their liquidated cash value and associated tax losses that often produce cash savings.

Hong Kong real estate companies, such as top holding Henderson Land Development Co. Ltd. (0012/HK),are required to mark property values to market prices, so liquidation values are easily ascertained.

“In most time periods, the market for fully leased office buildings is quite liquid,” says Lapey, justifying their inclusion in net-net calculations of these companies.

The article also discusses one of Whitman’s current positions, Sycamore Networks Inc (NASDAQ:SCMR):

Sycamore Networks Inc. (SCMR/NASDAQ) is the most compelling example of a net-net situation in the United States offered up by Lapey.

The telecom equipment company has more cash — US$935-million in all — than the total value assessed to it by the market, in light of its US$800-million market capitalization and US$38-million in total liabilities.

“We feel that there is value to their technology that is being recognized by some of the large telecom carriers,” says Lapey of Sycamore Networks, but he acknowledges its current weak earnings power. Lapey is also attracted to the one-third of outstanding share ownership by management because it presents an important alignment of their interests with those of Third Avenue, who are by and large passive investors.

These large valuation discounts in the market are reassuring words for investors from the one of the finest practitioners of Graham and Dodd.

“We are holding these companies trading at huge discounts,” says Lapey, “and if these companies were to sell assets or sell the whole companies we think the result would be a terrific return for our investment.”

As we discussed in our review of our first quarter, we started Greenbackd in an effort to extend our understanding of asset-based valuation described by Graham. Over the last few quarters we have refined our process a great deal, and it’s pleasing to us that we already include the adjustments identified by Whitman. We believe that our analyses are now qualitatively more robust than when we started out and seeing Whitman’s adjustments gives us some confidence that we’re on the right track.

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