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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