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Archive for the ‘Seth Klarman’ Category

In The value of Seth Klarman (free registration required), Absolute Return has a rare interview with the president and portfolio manager of the 28-year-old Baupost Group. In the interview, Klarman discusses several of Baupost’s positions over the last twelve months, including the fund’s stake in Facet Biotech, which I fumbled last year:

Around the same time the CIT deal was playing out, Klarman took a sizable stake in Facet Biotech—a small biotech company spun off in December 2008 from PDL BioPharma—for an average cost of $9 even though it had $17 per share in net cash at the time of the spinoff. “We liked the discount and pipeline of products,” Klarman recalls. “We knew that when small caps are spun off, they are frequently ignored and become cheap.”

Biogen Idec tried to acquire Facet in a hostile deal for $14.50 per share, raising the offer later to $17.50. When Facet allowed its largest shareholder, Biotech Value Fund, to buy up to 20% of the company, Baupost asked for identical terms, essentially becoming a poison pill. Baupost then told Facet it did not intend to tender its shares in the $17.50 per share offer. Eventually Biogen backed off, and Facet accepted a $27 per share offer from Abbott Laboratories.

Here Klarman discusses his strategy more broadly:

Value investors are typically thought of as stock investors, but Klarman says most of the time he prefers to buy bonds. Bonds are a senior security, offering more safety, and they have a catalyst built into them. Unlike equity, debt pays current principal and interest. If the issuer doesn’t make that timely payment, an investor can take action. “Catalysts can reduce your dependence on the level of the market or action of the market,” he explains. For example, defaults are specific incidents affecting the company regardless of what is going on in the overall market.

Over the past two years, Klarman’s preference for debt has been even more pronounced. After peaking at just $2 billion in June 2008, Baupost’s total equity assets shrank to around $1.2 billion from the fourth quarter of 2008 to the first half of 2009, before turning up slightly at year-end 2009 to nearly $1.6 billion. That puts equities at just a little more than 7% of total assets under management.

And his view on the market

The value pro is still looking at troubled companies, mortgage securities and select equities. But he is not buying much at the moment. Klarman says there are some opportunities in commercial real estate on the private side, but not as much as would be expected, given the depressed levels of the market. “That’s why we want to be patient,” he stresses.

Baupost is 30% in cash now, its long-time average. Klarman stresses that the cash position is residual—the result of a search for opportunity and not the result of a macro view. He says he can find great opportunities to buy at the same time he has a bearish view on the world. “We’re good at finding bargains, good at doing analysis,” he emphasizes. “We’re not good at calling short-term movements in the markets.”

And when the markets started to crumble in mid-May, he mostly stood pat, asserting that the 5% to 8% drop in prices did not unleash a torrent of bargains, mostly because of the market’s surge from its March 2009 bottom. “The market has gone up so much that, based on valuation, it is overvalued again to a meaningful degree where the expected returns logically from here can be as low as the low single digits or zero for the next several years,” he says.

Click here to see the remainder of the interview (free registration required).

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Following on from the Klarman sees another lost decade for stocks post, here are the full notes of Seth Klarman’s interview with Jason Zweig at the CFA Institutes Annual Conference (via ZeroHedge):

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Seth Klarman’s teachings, which I’ve covered on this site on several occasions (see, for example, Klarman on calculating liquidation value, on identifying catalysts, and on investing in liquidations), are always worth reading. In his most recent investor letter Klarman has provided a list of twenty investment lessons of 2008 (via the always superb Zero Hedge):

  1. Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
  2. When excesses such as lax lending standards become widespread and persist for some time, people are lulled into a false sense of security, creating an even more dangerous situation. In some cases, excesses migrate beyond regional or national borders, raising the ante for investors and governments. These excesses will eventually end, triggering a crisis at least in proportion to the degree of the excesses. Correlations between asset classes may be surprisingly high when leverage rapidly unwinds.
  3. Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell. Portfolio hedges must be in place before a crisis hits. One cannot reliably or affordably increase or replace hedges that are rolling off during a financial crisis.
  4. Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
  5. Do not trust financial market risk models. Reality is always too complex to be accurately modeled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioral science, not physical science.
  6. Do not accept principal risk while investing short-term cash: the greedy effort to earn a few extra basis points of yield inevitably leads to the incurrence of greater risk, which increases the likelihood of losses and severe illiquidity at precisely the moment when cash is needed to cover expenses, to meet commitments, or to make compelling long-term investments.
  7. The latest trade of a security creates a dangerous illusion that its market price approximates its true value. This mirage is especially dangerous during periods of market exuberance. The concept of “private market value” as an anchor to the proper valuation of a business can also be greatly skewed during ebullient times and should always be considered with a healthy degree of skepticism.
  8. A broad and flexible investment approach is essential during a crisis. Opportunities can be vast, ephemeral, and dispersed through various sectors and markets. Rigid silos can be an enormous disadvantage at such times.
  9. You must buy on the way down. There is far more volume on the way down than on the way back up, and far less competition among buyers. It is almost always better to be too early than too late, but you must be prepared for price markdowns on what you buy.
  10. Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather. Securitization is an area that almost perfectly fits this description; markets for securitized assets such as subprime mortgages completely collapsed in 2008 and have not fully recovered. Ironically, the government is eager to restore the securitization markets back to their pre-collapse stature.
  11. Ratings agencies are highly conflicted, unimaginative dupes. They are blissfully unaware of adverse selection and moral hazard. Investors should never trust them.
  12. Be sure that you are well compensated for illiquidity – especially illiquidity without control – because it can create particularly high opportunity costs.
  13. At equal returns, public investments are generally superior to private investments not only because they are more liquid but also because amidst distress, public markets are more likely than private ones to offer attractive opportunities to average down.
  14. Beware leverage in all its forms. Borrowers – individual, corporate, or government – should always match fund their liabilities against the duration of their assets. Borrowers must always remember that capital markets can be extremely fickle, and that it is never safe to assume a maturing loan can be rolled over. Even if you are unleveraged, the leverage employed by others can drive dramatic price and valuation swings; sudden unavailability of leverage in the economy may trigger an economic downturn.
  15. Many LBOs are man-made disasters. When the price paid is excessive, the equity portion of an LBO is really an out-of-the-money call option. Many fiduciaries placed large amounts of the capital under their stewardship into such options in 2006 and 2007.
  16. Financial stocks are particularly risky. Banking, in particular, is a highly lever- aged, extremely competitive, and challenging business. A major European bank recently announced the goal of achieving a 20% return on equity (ROE) within several years. Unfortunately, ROE is highly dependent on absolute yields, yield spreads, maintaining adequate loan loss reserves, and the amount of leverage used. What is the bank’s management to do if it cannot readily get to 20%? Leverage up? Hold riskier assets? Ignore the risk of loss? In some ways, for a major financial institution even to have a ROE goal is to court disaster.
  17. Having clients with a long-term orientation is crucial. Nothing else is as important to the success of an investment firm.
  18. When a government official says a problem has been “contained,” pay no attention.
  19. The government – the ultimate short- term-oriented player – cannot with- stand much pain in the economy or the financial markets. Bailouts and rescues are likely to occur, though not with sufficient predictability for investors to comfortably take advantage. The government will take enormous risks in such interventions, especially if the expenses can be conveniently deferred to the future. Some of the price-tag is in the form of back- stops and guarantees, whose cost is almost impossible to determine.
  20. Almost no one will accept responsibility for his or her role in precipitating a crisis: not leveraged speculators, not willfully blind leaders of financial institutions, and certainly not regulators, government officials, ratings agencies or politicians.

See also Klarman’s False Lessons of 2009.

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Dr. Roderick Wong has withdrawn his slate of director nominees for election at Facet Biotech Corporation’s (NASDAQ:FACT) 2009 annual meeting of stockholders. Wong’s withdrawal means that our investment thesis is gone, and we’re closing the position.

We opened the position at $9.13 and closed it at $8.96, which means we’re down 1.86% on an absolute basis. The S&P500 Index closed at 850.08 on the day we opened the position and closed yesterday at 919.53, which means we’re off 10% on a relative basis.

Post mortem

FACT was a new category of investment for us: special situations (see our post archive here). It was an activist play with a catalyst in the form of Dr. Roderick Wong’s nomination for the annual meeting of an alternative slate of directors, including well-known activist investor Robert. L. Chapman. The dissident slate called for a cash dividend of up to $15 per share and demanded the sale of the other non-cash assets, estimating they may be worth an additional $8 to $16 per share, which represented a substantial upside at FACT’s $9.13 closing price (equivalent to a market capitalization of $216.8M) at the time we opened the position. We estimated the liquidation value to be anywhere from nil to $259M or ~$10.85 per share and the net cash value from nil to $228M or $10.54 per share, so it wasn’t a typical liquidation play for us. The company was burning through its cash at a rapid rate, so the main risk to the investment was that the status quo was maintained. Although Wong et al held only 0.5% of FACT’s outstanding stock, we thought the presence of Bob Chapman and other noted activist and deep value investors on the register (Baupost Group holds ~18%) indicated a good chance of success for the dissidents.

The position started falling apart when Chapman and Broenniman withdrew their consents:

In March 2009, Facet Biotech Corporation (the “Company”) received a notice of intention to nominate five candidates for election to the Company’s five-person Board of Directors at the Company’s 2009 Annual Meeting of Stockholders (the “Annual Meeting”). Sent by Roderick Wong, the notice stated the intent to nominate Philip R. Broenniman, Robert L. Chapman, Jr., David Gale, Bradd Gold and Roderick Wong, for election to the Company’s Board of Directors. On April 30, 2009, Philip R. Broenniman and Robert L. Chapman, Jr. each separately notified the Company in writing that they were withdrawing their consent to being named as nominees for election to the Company’s Board of Directors at the Annual Meeting.

And the death knell was Wong withdrawing the entire slate:

RODERICK WONG WITHDRAWS DIRECTOR NOMINATIONS

Redwood City, Calif., May 4, 2009 — Facet Biotech Corporation (Nasdaq: FACT) and Roderick Wong, M.D., today jointly announced that based on productive discussions between Facet and Dr. Wong, Dr. Wong has withdrawn his slate of director nominees for election at Facet’s 2009 annual meeting of stockholders and will not present, recommend or move for the election of any of the nominees he had submitted for election.

Faheem Hasnain, president and chief executive officer of Facet, said, “We thank Dr. Wong for raising important concerns held by some of Facet’s stockholders and advocating for these stockholders. Our Board values his insights regarding the future of the company and we look forward to an ongoing constructive dialogue with Dr. Wong.”

Dr. Wong said “I am pleased to have brought this situation to an amicable conclusion. Our discussions have focused on issues that are critical to Facet’s success and I appreciate the time and attention that the company has devoted to our discussions.”

Wong gives no indication in the press release what, if any, concessions were made by FACT to bring the situation to an “amicable conclusion.” There were no reasons given for Chapman and Broenniman’s withdrawl either. It could be that, without Chapman and Broenniman, Wong felt he didn’t have the support to roll the board and so sought a face-saving resolution with the company. We don’t know, but we welcome speculation in the comments.

[Full Disclosure:  We do not have a holding in FACT. 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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Today we complete our series on Seth Klarman, the founder of The Baupost Group, a deep value-oriented private investment partnership that has generated an annual compound return of 20% over the past 25 years, and the author of an iconic book on value investing, Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor

Following on from our earlier posts, Seth Klarman on Liquidation Value, and Seth Klarman on Catalysts, we present Seth Klarman’s application of liquidation value investment principles to a specific case: the City Investment Liquidating Trust (from Chapter 10 Areas of Opportunity for Value Investors: Catalysts, Ineficiences, and Institutional Constraints):

Investing in Corporate Liquidations

Some troubled companies, lacking viable alternatives, voluntarily liquidate in order to preempt a total wipeout of shareholders’ investments. Other, more interesting corporate liquidations are motivated by tax considerations, persistent stock market undervaluation, or the desire to escape the grasp of a corporate raider. A company involved in only one profitable line of business would typically prefer selling out to liquidating because possible double taxation (taxes both at the corporate and shareholder level) would be avoided. A company operating in diverse business lines, however, might find a liquidation or breakup to be the value-maximizing alternative, particularly if the liquidation process triggers a loss that results in a tax refund. Some of the most attractive corporate liquidations in the past decade have involved the breakup of conglomerates and investment companies.

Most equity investors prefer (or are effectively required) to hold shares in ongoing businesses. Companies in liquidation are the antithesis of the type of investment they want to make. Even some risk arbitrageurs (who have been known to buy just about anything) avoid investing in liquidations, believing the process to be too uncertain or protracted. Indeed, investing in liquidations is sometimes disparagingly referred to as cigarbutt investing, whereby an investor picks up someone else’s discard with a few puffs left on it and smokes it. Needless to say, because other investors disparage and avoid them, corporate liquidations may be particularly attractive opportunities for value investors.

City Investing Liquidating Trust

In 1984 shareholders of City Investing Company voted to liquidate. The assets of this conglomerate were diverse, and the most valuable subsidiary, Home Insurance Company, was particularly difficult for investors to appraise. Efforts to sell Home Insurance failed, and it was instead spun off to City Investing shareholders. The remaining assets were put into a newly formed entity called City Investing Liquidating Trust, which became a wonderful investment opportunity.

Table 2

table-2-margin-of-safetyAs shown in table 2, City Investing Liquidating Trust was a hodgepodge of assets. Few investors had the inclination or stamina to evaluate these assets or the willingness to own them for the duration of a liquidation likely to take several years. Thus, while the units were ignored by most potential buyers, they sold in high volume at approximately $3, or substantially below underlying value.

The shares of City Investing Liquidating Trust traded initially at depressed levels for a number of additional reasons. Many investors in the liquidation of City Investing had been disappointed with the prices received for assets sold previously and with City’s apparent inability to sell Home Insurance and complete its liquidation. Consequently many disgruntled investors in City Investing quickly dumped the liquidating trust units to move on to other opportunities. Once the intended spinoff of Home Insurance was announced, many investors purchased City Investing shares as a way of establishing an investment in Home Insurance before it began trading on its own, buying in at what they perceived to be a bargain price. Most of these investors were not interested in the liquidating trust, and sold their units upon receipt of the Home Insurance spinoff. In addition, the per unit market price of City Investing Liquidating Trust was below the minimum price threshold of many institutional investors. Since City Investing Company had been widely held by institutional investors, those who hadn’t sold earlier became natural sellers of the liquidating trust due to the low market price. Finally, after the Home Insurance spinoff, City Investing Liquidating Trust was delisted from the New York Stock Exchange. Trading initially only in the over-the-counter pink-sheet market, the units had no ticker symbol. Quotes were unobtainable either on-line or in most newspapers. This prompted further selling while simultaneously discouraging potential buyers.

The calculation of City Investing Liquidating Trust’s underlying value in table 2 is deliberately conservative. An important component of the eventual liquidating proceeds, and something investors mostly overlooked (a hidden value), was that City’s investment in the stock of Pace Industries, Inc., was at the time almost certainly worth more than historical cost. Pace was a company formed by Kohlberg, Kravis and Roberts (KKR) to purchase the Rheem, Uarco, and World Color Press businesses of City Investing in a December 1984 leveraged buyout. This buyout was profitable and performing well nine months later when the City Investing Liquidating Trust was formed.

The businesses of Pace had been purchased by KKR from City Investing in a financial environment quite different from the one that existed in September 1985. The interest rate on U.S. government bonds had declined by several hundred basis points in the intervening nine months, and the major stock market indexes had spurted sharply higher. These changes had almost certainly increased the value of City’s equity interest in Pace. This increased the apparent value of City Investing Liquidating Trust units well above the $5.02 estimate, making them an even more attractive bargain.

As with any value investment, the greater the undervaluation, the greater the margin of safety to investors. Moreover, approximately half of City’s value was comprised of liquid assets and marketable securities, further reducing the risk of a serious decline in value. Investors could reduce risk even more if they chose by selling short publicly traded General Development Corporation (GDV) shares in an amount equal to the number of GDV shares underlying their investment in the trust in order to lock in the value of City’s GDV holdings.

As it turned out, City Investing Liquidating Trust made rapid progress in liquidating. GDV shares surged in price and were distributed directly to unitholders. Wood Brothers Homes was sold, various receivables were collected, and most lucrative of all, City Investing received large cash distributions when Pace Industries sold its Rheem and Uarco subsidiaries at a substantial gain. The Pace Group debentures were redeemed prior to maturity with proceeds from the same asset sales. Meanwhile a number of the trust’s contingent liabilities were extinguished at little or no cost. By 1991 investors who purchased City Investing Liquidating Trust at inception had received several liquidating distributions with a combined value of approximately nine dollars per unit, or three times the September 1985 market price, with much of the value received in the early years of the liquidation process.

That concludes our series on Seth Klarman.

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Following on from our earlier post, Seth Klarman on Liquidation Value, we present the second post in our series on Klarman’s Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor.

As we discussed in our first post, Klarman is the founder of The Baupost Group, a deep value-oriented private investment partnership that has generated an annual compound return of 20% over the past 25 years. Klarman detailed his investment process in the iconic Margin of Safety. The book is required reading for all value investors, but is long out-of-print and notoriously difficult to obtain.

In today’s extract, drawn from Chapter 10 Areas of Opportunity for Value Investors: Catalysts, Ineficiences, and Institutional Constraints, Klarman discusses the importance of the catalyst in the investment process:

Once a security is purchased at a discount from underlying value, shareholders can benefit immediately if the stock price rises to better reflect underlying value or if an event occurs that causes that value to be realized by shareholders. Such an event eliminates investors’ dependence on market forces for investment profits. By precipitating the realization of underlying value, moreover, such an event considerably enhances investors’ margin of safety. I refer to such events as catalysts.

Some catalysts for the realization of underlying value exist at the discretion of a company’s management and board of directors. The decision to sell out or liquidate, for example, is made internally. Other catalysts are external and often relate to the voting control of a company’s stock. Control of the majority of a company’s stock typically allows the holder to elect the majority of the board of directors. Thus accumulation of stock leading to voting control, or simply management’s fear that this might happen, could lead to steps being taken by a company that cause its share price to more fully reflect underlying value.

Catalysts vary in their potency. The orderly sale or liquidation of a business leads to total value realization. Corporate spinoffs, share buybacks, recapitalizations, and major asset sales usually bring about only partial value realization.

Value investors are always on the lookout for catalysts. While buying assets at a discount from underlying value is the defining characteristic of value investing, the partial or total realization of underlying value through a catalyst is an important means of generating profits. Furthermore, the presence of a catalyst serves to reduce risk. If the gap between price and underlying value is likely to be closed quickly, the probability of losing money due to market fluctuations or adverse business developments is reduced. In the absence of a catalyst, however, underlying value could erode; conversely, the gap between price and value could widen with the vagaries of the market. Owning securities with catalysts for value realization is therefore an important way for investors to reduce the risk within their portfolios, augmenting the margin of safety achieved by investing at a discount from underlying value.

Catalysts that bring about total value realization are, of course, optimal. Nevertheless, catalysts for partial value realization serve two important purposes. First, they do help to realize underlying value, sometimes by placing it directly into the hands of shareholders such as through a recapitalization or spinoff and other times by reducing the discount between price and underlying value, such as through a share buyback. Second, a company that takes action resulting in the partial realization of underlying value for shareholders serves notice that management is shareholder oriented and may pursue additional value-realization strategies in the future. Over the years, for example, investors in Teledyne have repeatedly benefitted from timely share repurchases and spinoffs.

Tomorrow we present the final installment in the series, Seth Klarman on Investing in Corporate Liquidations.

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Seth Klarman, the founder of The Baupost Group, an exceptionally well-performed, deep value-oriented private investment partnership, is known for seeking idiosyncratic investments. The Baupost Group’s returns bear out his unusual strategy: Over the past 25 years, The Baupost Group has generated an annual compound return of 20% and is ranked 49th in Alpha’s hedge fund rankings.

Klarman detailed his investment process in Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor, an iconic book on value investing that is required reading for all value investors. Published in 1991, the book is long out-of-print and famously difficult to obtain. According to a 2006 Business Week article, The $700 Used Book: Why all the buzz about Seth Klarman’s out-of-print investing classic?:

The 249-page book is especially hot among those seeking jobs with value-oriented investment firms. “You win serious points for talking Klarman,” says a newly minted MBA who got his hands on a copy prior to a late-round interview with a top mutual fund firm. “It’s pretty much assumed that you’ve read Graham and Dodd and Warren Buffett.” (Benjamin Graham and David Dodd’s 1934 work, Security Analysis, is a seminal book on value investing, while Buffett’s annual letters to shareholders are considered gospel.) “The book belongs in the category of Buffett and Graham,” says Oakmark Funds manager Bill Nygren, a collector of stock market tomes.

In the book, Klarman carefully explains the rationale for an investment strategy grounded in the value school. He also discusses at some length several sources for value investment opportunities. Why is the book germane to Greenbackd’s ongoing discussion of liquidation value investment? One source of investment opportunity identified by Klarman is stocks trading below liquidation value.

Klarman’s attitude to liquidation value investment closely accords with our own, and so we’ve reproduced below the relevant portion of Chapter 8 The Art of Business Valuation in Margin of Safety, in which he provides the basis for making such investments and outlines his approach to assessing liquidation value:

Liquidation Value

The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles, such as going-concern value, are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment.

A liquidation analysis is a theoretical exercise in valuation but not usually an actual approach to value realization. The assets of a company are typically worth more as part of an going concern than in liquidation, so liquidation value is generally a worst-case assessment. Even when an ongoing business is dismantled, many of its component parts are not actually liquidated but instead are sold intact as operating entities. Breakup value is one form of liquidation analysis, this involves determining the highest value of each component of a business, either as an ongoing enterprise or in liquidation. Most announced corporate liquidations are really breakups; ongoing business value is preserved whenever it exceeds liquidation value.

How should investors value assets in a liquidation analysis? An orderly liquidation over time is virtually certain to realize greater proceeds than a “fire sale,” but time is not always available to a company in liquidation. When a business is in financial distress, a quick liquidation (a fire sale) may maximize the estate value. In a fire sale the value of inventory, depending on its nature, must be discounted steeply below carrying value. Receivables should probably be significantly discounted as well; the nature of the business, the identity of the customer, the amount owed, and whether or not the business is in any way ongoing all influence the ultimate realization from each receivable.

When no crisis is at hand, liquidation proceeds are usually maximized through a more orderly winding up of a business. In an orderly liquidation the values realized from disposing of current assets will more closely approximate stated book value. Cash, as in any liquidation analysis, is worth one hundred cents on the dollar. Investment securities should be valued at market prices, less estimated transaction costs in selling them. Accounts receivable are appraised at close to their face amount. The realizable value of inventories – tens of thousands of programmed computer diskettes hundreds of thousands of purple slippers, or millions of sticks of chewing gum – is not so easily determinable and may well be less than book value. The discount depends on whether the inventories consist of finished goods, work in process, or raw materials, and whether or not there is the risk of technological or fashion obsolescence. The value of inventory in a supermarket does not fluctuate much, but the value of a warehouse full of computers certainly may. Obviously a liquidation sale would yield less for inventory than would an orderly sale to regular customers.

The liquidation value of a company’s fixed assets can be difficult to determine. The value of plant and equipment, for example, depends on its ability to generate cash flows, either in the current use or in alternative uses. Some machines and facilities are multipurpose and widely owned; others may have value only to the present owner. The value of restaurant equipment, for example, is more readily determinable than the value of an aging steel mill.

In approximating the liquidation value of a company, some value investors, emulating Benjamin Graham, calculate “net-net working capital” as a shortcut. Net working capital consists of current assets (cash, marketable securities, receivables, and inventories) less current liabilities (accounts, notes, and taxes payable within one year.) Net-net working capital is defined as net working capital minus all long-term liabilities. even when a company has little ongoing business value, investors who buy at a price below net-net working capital are protected by the approximate liquidation value of current assets alone. As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all liabilities, and still distribute proceeds in excess of the market price to investors. Ongoing business losses can, however, quickly erode net-net working capital. Investors must therefore always consider the state of a company’s current operations before buying. Investors should also consider any off-balance sheet or contingent liabilities that might be incurred in the course of an actual liquidation, such as plant closing and environmental laws.

A corporate liquidation typically connotes business failure; but ironically, it may correspond with investment success. The reason is that the liquidation or breakup of a company is a catalyst for the realization of the underlying business value. Since value investors attempt to buy securities trading at a considerable discount from the value of a business’s underlying assets, a liquidation is one way for investors to realize profits.

A liquidation is, in a sense, one of the few interfaces where the essence of the stock market is revealed. Are stocks pieces of paper to be endlessly traded back and forth, or are they proportional interests in underlying businesses? A liquidation settles this debate, distributing to owners of pieces of paper the actual cash proceeds resulting from the sale of corporate assets to the highest bidder. A liquidation thereby acts as a tether to reality for the stock market, forcing either undervalued or overvalued share prices to move into line with actual underlying value.

We’ll continue our discussion on Seth Klarman and his approach to liquidation value investment later this week.

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

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