Quality of Assets: Financial Integrity

“Changes in earnings can be sudden and violent, and changes in price–earnings ratios even more so. Changes in book value, on the other hand, by definition must be more gradual.” —Marty Whitman, The Aggressive Conservative Investor

Quality of Earnings and Assets

In his book Quality of Earnings Thornton L. O’Glove wrote “Long before I heard the term ‘quality of earnings’ I was aware that this was one of the keys to meaningful financial analysis.”

A second key to meaningful financial analysis is “quality of assets.” So how do we know if the assets are of high or low quality? Let’s see what Marty Whitman has to say about this subject.

Below, an excerpt from The Aggressive Conservative Investor (pp. 202-208) written by Marty Whitman et al.

AQ1

BOOK VALUE ANALYSIS AS A COMPETITIVE EDGE

Most people who trade common stocks (as opposed to those who hold common stocks) seem to be more interested in the near-term outlook than in anything else. They will not purchase a security if the near-term outlook seems bad or uncertain, regardless of the price at which it is selling. An investor who is able to take positions based on other factors increases his chances of finding outstanding long-term bargains, since there is a relative lack of competition in the market in which he is buying. Given that market values will be determined by future earnings, and given also that most investors rely primarily on the past earnings record of a company in predicting future earnings, a good past earnings record will probably be reflected in a high market price. However, although they may also be an indicator of good future earnings, large high-quality asset values will probably not be reflected in a high market price for the stock. Thus, by placing primary weight on present asset value rather than on past earnings, an investor should be able to realize higher appreciation potential and lower risk of loss in the long term.

The outside investor who purchases securities regardless of the immediate outlook will probably always be in a distinct minority among securities purchasers. Such an investor must be in a strong financial position. He must also be capable of curbing any tendencies toward greed in his investment: he cannot attempt to buy precisely at the bottom of the market or to maximize capital gains over short periods. Finally, he must be convinced that there are important values in the company whose stocks he holds that are not reflected in the market price and are not likely to be dissipated. Without such conviction, almost any investor can be expected to panic if the market price of the security he holds declines. It tends to be much easier for outsiders to gain some degree of conviction if a cornerstone of their analysis is the financial-integrity approach.

Changes in earnings can be sudden and violent, and changes in price–earnings ratios even more so. Changes in book value, on the other hand, by definition must be more gradual. A large, relatively unencumbered book value may be an anchor to windward, both for the company with honest and reasonably competent management and for the investor who holds its stock.

LIMITATIONS OF BOOK VALUE IN SECURITY ANALYSES

To repeat, we do not believe in acquiring securities solely on the basis of the earnings record of a company or on the outlook for its reported earnings. Neither do we think that an investment program based on acquiring securities simply because they are available at large discounts from book value would necessarily be well advised.

Availability at a large discount from book does give a first approximation that a security may be a bargain, or even that it may be attractive according to the financial-integrity approach. But this first approximation ought to be tempered by a more thorough analysis. In order for book value to be a good indicator of the wealth or future earning power of a going concern, other factors must be considered as well.

A company’s record of profitability is, of course, some indication that the book asset value actually reflects real operating wealth, in the sense of assets that provide the wherewithal for obtaining earnings. Earnings for the current and the three prior years may also be a potential source of liquidity if income taxes have been paid or tax liability has accrued on them. The investor should also consider such factors as the size of the company’s operational overhead and the incentives for control groups to work against the interests of the outside stockholders. Also, since book value is only an accounting figure, it cannot be more useful than accounting figures in general. In our view, the most important limitation of the usefulness of book value as an analytical tool is that in itself, it does not measure the quality of a company’s assets, which we believe tends to be significantly more important than the quantity of asset value. Unfortunately, quality is a less measurable and less precise concept than quantity, involving what is essentially a subjective judgment.

What do we mean by “quality of assets”? In short, financial integrity. We suggest that quality of assets is determined in a corporate situation by reference to three separate, but related, factors.

First, an asset or mix of assets has high-quality elements insofar as it approaches being owned free and clear of encumbrances. Conversely, the assets of debt-ridden companies tend to be of low quality. Note that though encumbrances that depress the quality of assets (such as long-term indebtedness) may be stated liabilities, they may also be off-balance-sheet items, some of which, of course, will be disclosed in footnotes to the company’s financial statements. These include such items as pension-plan liabilities, and such contingent liabilities as litigation and guaranties of the debts of others. Others may be disclosed elsewhere. For example, a railroad may be obligated to operate unprofitable commuter services, or a steel mill may be required to install antipollution equipment that does not generate revenue. Still other off-balance-sheet encumbrances may not be disclosed in any public document. A common example would be the need to substantially overhaul outdated plants and equipment in order for the business to remain competitive enough to survive. Unless an investor has know-how, and perhaps even know-who, he may be unable to find out that such encumbrances exist.

The second factor to consider in evaluating the quality of assets of a going concern is its operations. Does it have a mix of assets and liabilities that appears likely to produce high levels of operating earnings and cash flows? Good operations are the most important creator of high-quality assets and are likely to contribute to a company’s having a strong financial position. Lenders quite properly prefer to finance businesses whose operations are sound and who are likely to create the wherewithal for continuing debt service on a long-run basis. The most financially attractive going concerns are blue chips and near blue chips, such as IBM, General Motors, DuPont, Kraftco, and R. J. Reynolds.

The third factor the investor must consider is the nature of the assets themselves. An asset or mix of assets tends to have high quality when it appears to be salable at a price that can be estimated with a modicum of accuracy. In most going-concern situations, of course, no values can be assigned to specific assets as a practical matter, because they are useful only as a part of the operations of the company—as part of an overall mix. For example, although it is said that certain proved and readily recoverable domestic oil reserves have a present value of five dollars per barrel, it is not especially useful for a nonmanagement investor analyzing Exxon to value that company’s assets according to this formulation as long as the company is likely to remain a going-concern operation. Exxon’s domestic reserves in that instance are dedicated directly or indirectly to Exxon’s refinery and marketing operations; for practical purposes they have no five-dollar-per-barrel independent value. By contrast, if the same proved reserves were owned instead by, say, General American Oil, the five-dollar-per-barrel valuation would tend to be meaningful as long as there was a likelihood that General American would sell the reserves to others in bulk or in the normal course of business, or that General American would be acquired by others.

First and foremost, then, for an asset to have independent value from the point of view of the outside securities holder, it must be available for sale apart from the operations of the going concern. It must be something that is not so related to the going-concern operation, or if so dedicated, is separable from it in a manner that will not have an adverse impact on the operating-earnings power of the going concern.

Aside from this freedom from a going-concern encumbrance, there are certain other characteristics that tend to make assets more attractive to lenders, and thus of higher quality. Assets that are liquid and marketable tend to be more attractive to lenders than those that are not. Liquid assets include cash and equivalent marketable securities, including restricted securities with meaningful rights of registration, proved oil and gas reserves, cutting rights and timberlands, and various types of real property. In order to be marketable, the assets must have a value that is readily measurable. In the case of securities that are traded in organized markets, the market provides a measure of value. Other assets may have readily ascertainable values even though not so traded—as, for example, income-producing real estate.

If an asset is one that third-party lenders or guarantors (such as financial institutions and governments) are experienced in lending against, the standards they have developed for lending may also provide a measure of value, and the asset tends to be more valuable than it would otherwise be. Examples of such high-quality assets have included oil and gas, maritime vessels and certain types of real estate.

Flexibility and scarcity are factors that tend also to make an asset more valuable. Thus, multipurpose assets tend to be more valuable than single-purpose assets. Flexibility is especially important in the case of real estate: a factory useful for only one type of assembly-line production tends to be less attractive than, say, a downtown hotel that can be converted economically into efficiency apartments. Assets that are scarce, at least on a long-term basis (such as copper mines or domestic oil), may have special values all their own.

Certain assets that appear to have these characteristics may, of course, not have them because of legal impediments. For example, U.S. margin regulations make common stocks worse collateral than other assets that lack common stocks’ characteristics of liquidity, marketability, flexibility and measurability. Other assets may have special value because they can be used to create tax shelter. Because tax savings allow these assets to throw off more cash, tax-sheltered assets tend to be most attractive in the eyes of creditors. Thus, assets such as real estate, timberlands, to some extent oil and gas as well as other natural resources, and until recently, motion pictures have been outstanding examples of this.

These three factors—the amount of encumbrances, the operations and the nature of the assets themselves—tend to be interrelated and may be offsetting. Thus, a company that is less encumbered tends to be freer to invest in assets lacking high quality. The property and casualty insurance industry provides a good example of this: where an insurer’s capital and surplus are small relative to stated liabilities (and to premium income, which in turn tends to be related to the size of liabilities), that insurer will concentrate its investments in government and corporate debt instruments. Only as capital ratios improve relative to stated liabilities (and premium income) will insurers tend to invest a portion of their assets in such lower-quality instruments as equity securities, especially common stocks.

High-quality asset businesses tend to be far more attractive holdings at given prices—say, when the common stocks are selling at ten times earnings—than are comparable businesses with lower-quality asset values. This is so because such businesses have a tendency to be subject to certain dynamic developments. And frequently, the common stocks of businesses with high-quality assets may sell at lower price-earnings ratios than comparable businesses with lower-quality assets. This tends to happen when stock traders desire to pay premiums for aggressive managements, although companies with high-quality assets oftentimes are run by careful rather than aggressive managers.

High-quality assets are most commonly used to finance rapid growth, both in present product lines and into diversified areas—as in such large businesses as Philip Morris and W. R. Grace—or in emerging growth companies, such as Ups ’N Downs and Henry Pratt Company.

Surplus liquid assets not needed in a business (sometimes called surplus surplus) may be extracted from these companies. This was, for example, the basis of the takeovers in 1968 and 1969 of strongly capitalized insurers, such as Reliance Insurance and Great American Holding Company. At the time of takeover, the workouts for shareholders were more than twice what the shares had been selling at one year earlier.

A company’s high-quality assets may be used to finance the takeover of that company on a better price basis than would otherwise be available. An example of this—a case where a mouse swallowed an elephant—was the 1962 acquisition by Albermarle Paper Manufacturing Company, a small company, of the entire capital of the much larger and extremely well financed Ethyl Corporation. Albermarle not only swallowed the elephant, but also adopted its name.

When a company lacks encumbrances as measured against the amount of obligations it owes, the nature of its operations and/or its potential to sell or convert all or part of its assets to a more liquid or useful form, that company is deemed by us to have a strong financial position, one of the four main characteristics sought in an equity investment using the financial-integrity approach. Generally, it is our view that if a company has little or no outstanding obligations, it is in a strong financial position, unless operating losses seem to have some prospect of being so large that the company’s strength will be impaired.

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Modern Security Analysis: Net Asset Value (Part 10)

“…we try to invest in the common stocks of well-financed companies with readily ascertainable NAVs selling at discounts from such NAVs of at least 20 percent.” —Whitman & Diz, Modern Security Analysis

Chapter 6 – Net Asset Value: The Static and Dynamic Way

MSA1• The Graham and Dodd View on NAV
• The Financial Accounting View on NAV
• Our View on NAV
• The Usefulness of NAV in Security Analysis’
• The Importance of NAV Dynamics
• NAV as One Measure of Resources
• NAV as One Measure of Potential Liquidity
• Limitations of NAV in Security Analyses
• Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE
• Net Nets Redefined
OPMI Investing in Companies with Growing NAVs Summary

OPMI Investing in Companies with Growing NAVs Summary

Historically NAVs of reasonably managed companies with reasonably strong finances grow year by year, almost continuously. This can be seen in Table 6.10, which shows the changes in book values for the Standard & Poor’s 500 stock index during the 18 years ended December 31, 2012. The book values increased in 16 of the 18 years failing to do so only in 2002, an aftermath of the bursting of the dotcom bubble; and 2008, an aftermath of the onset of the Great Recession. During the 18 years period book value per share increased from 206 to 661, or at a rate of 6.7 percent per annum compounded before adding back dividends paid.

One of the things the increase in book value connotes is that for those companies that remained creditworthy, their borrowing capacity in 2012 was greater that it had been in earlier years. This comports with our thesis, both for corporations and governments, that in the aggregate debt is never repaid. Rather it is refinanced and expanded by economic entities that remain creditworthy.

MSA6_10

Book value in the aggregate seems to be a good surrogate for NAV, but they are not the same thing in our view. For many of the companies making up the S&P 500 Index, high book value for assets such as surplus automobile assembly plants or obsolescent steel mills represent overhead costs that are unlikely to ever contribute to operating earnings or cash flows (though as Section 1231 assets they may give the owner of the assets favorable income tax attributes). When we focus on NAV,we restrict ourselves to readily ascertainable NAVs of companies that are well financed. Determining what is readily ascertainable is not rocket science. Readily ascertainable asset values exist where corporate assets consists of cash, marketable securities, performing loans, income-producing real estate, and other income-producing assets such as infrastructure and many power generators such as hydroelectric facilities. Also included are intangible assets, which appear to have a ready market for sale such as assets under management (AUM) of mutual fund management companies.

In our analysis, we try to invest in the common stocks of well-financed companies with readily ascertainable NAVs selling at discounts from such NAVs of at least 20 percent. Further, we restrict such investments to companies that we believe, after thorough analysis, have good prospects to be able to grow those NAVs by not less than 10 percent per annum compounded over the next three to five years.

Obviously, the vast majority of companies in the S&P 500 Index would not qualify for inclusion in our list of recommended NAV common stocks. As Table 6.10 shows, the average common stock in the S&P 500 Index was selling at 2.2 times book value (and was probably not as well financed as our recommended common stocks). In contrast, we will not pay more than 0.8 times readily ascertainable NAV for our recommended issues.

At June 30, 2012, a list of recommended NAV common stocks would include the issues contained in Table 6.11.

MSA6_11

Assuming growth in NAV over the next three to five years of 10 percent per annum, including dividends, the probabilities of losing money over this long term don’t seem great. Wheelock offers a good example. Over the next three- and five-year periods, Wheelock’s December 31, 2011, NAV given a 10 percent annual growth would increase to $80.29 per share and $97.15 per share respectively. To have a market loss on Wheelock Common the NAV discount would have to become greater than 64 percent after three years and 70 percent after five years. This could happen but seems unlikely. Wheelock’s probabilities of growing earnings and cash flow over the next three to five years seem to be very good. If Wheelock is not to achieve the 10 percent growth bogey, it may well be because of increased capitalization rates being applied to income-producing real estate as part of the independent appraisals mandated by IFRS accounting. Incidentally, in the five years to December 31, 2011, the average annual growth in Wheelock’s NAV after adding back dividends was 20.4 percent.

Obviously not all the companies listed in Table 6.11 are going to achieve 10 percent compound annual growth over the next three to five years. We are just not that competent as analysts to be that accurate about so many predictions. However, it is interesting to see how the actual portfolio fared in the five years through 2011. Only three common stocks, which were selling at NAV discounts five years previously—Capital Southwest, Investor A/B, and Toyota Industries—failed to grow NAV by as much as 10 percent compounded and one, Toyota Industries, actually suffered a small decline in NAV. Marketwise, the price of two of the common stocks was up, and only Toyota Industries common stock market price declined, and that only by 5 percent or so. The one issue in Table 6.11 that suffered material price depression in the market after 2007 was Forest City common. Prior to the 2008–2009 meltdown, Forest City common was selling at a very large premium over NAV; it was also not well financed. Neither of these factors seems to exist for Forest City in 2012.

While investing in readily ascertainable NAVs at a discount may provide OPMIs with considerable downside protections over the long term, it seems to offer no protection against short-term market risk, that is, fluctuations in security prices. Further, while investing in readily ascertainable NAVs at a discount may be a good way to enjoy a reasonable absolute return, it in no way assures an OPMI that favorable relative returns will be achieved compared with other investment approaches. In addition since the approach does nothing to guard against near-term market risk, it probably is dangerous to finance an NAV portfolio largely with borrowed money. After all in our recommended approach we emphasize a factor—growth in NAV—that is almost completely ignored by most market participants.

Growth in NAV is the prime measure of investment results used in certain parts of the securities markets, such as investment companies. Berkshire Hathaway, Brookfield Asset Management and White Mountains Insurance. But growth in NAV never seems to be a factor for the vast majority of OPMIs who seem focused on the primacy of the income account, short-termism, and top-down analysis.

We think our approach is particularly useful for passive market participants who have long-term outlooks and needs, and who don’t finance largely with borrowings. Such investors include pension funds and individuals saving for retirement.

In following our approach, U.S. taxpayers might want to avoid those companies, which for U.S. tax purposes are deemed to be passive foreign investment companies (PFICs). PFIC taxes are onerous. Among other things U.S. taxpayers holding PFIC securities are subject to ordinary income taxes each year on unrealized appreciation. Such a tax has the three worst elements of a tax, to wit, the tax rate is at the optimum; the taxpayer has no control over when the tax comes due; and the event, unrealized appreciation, which gives rise to the tax does not give rise to the cash with which to pay the tax. In Table 6.11 only Investor A/B, Lai Sun Garment and Toyota Industries appear to be PFICs.

For almost all OPMIs, it seems very hard to try to beat the market consistently by trying to beat the market. The activity is just too competitive. Rather it seems to us a more rational approach is to be value conscious rather than outlook conscious. Acquire the common stocks of well-capitalized companies at deep discounts from readily ascertainable NAVs. We feel comfortable insofar as at least 50 percent of a common stock portfolio consists of safe and cheap equities such as those listed in Table 6.11, that is, the company enjoys a super strong financial position; the common stock is priced at, at least a 20 percent discount from readily ascertainable NAV; disclosures are comprehensive; the common stock is traded in well regulated markets, and the prospects appear good that over the next three to seven years, NAV will grow by not less than 10 percent compounded annually after adding dividends.

Once acquired these securities could be held indefinitely unless the security becomes grossly overpriced; the business seems to have suffered a permanent impairment (e.g., using company cash for an injudicious acquisition); or for portfolio considerations, such as required redemptions of ownership interests.

While not on our radar screen, perhaps over the long term, one or more of our portfolio companies are to be subject to resource conversion activity. For example, if there were to be a change of control through a new party acquiring common stock, there seems a probability that OPMIs would realize a premium (maybe a substantial premium) over NAV. Given a strong financial position and a deep discount from NAV, many insiders would consider going private, including a leveraged buyout (LBO) at a premium over market but probably a discount from NAV.

SUMMARY

Net asset value or NAV, unlike reported accounting earnings, seems to play little or no role in influencing day-to-day stock market prices. This is probably the principal reason why nearly all writers about financial accounting and security analysis have denigrated the importance of NAV as a tool of valuation, emphasizing instead a primacy of earnings. In this chapter, we detail reasons why we think attention to NAV should be useful for creditors and investors. We believe that in almost all analysis outside of the day-to-day stock-trading environment, NAV is a highly useful tool of analysis for a variety of purposes, including as a comprehensive measure of the wealth-creation capability of a business, as an appraisal of companies and managements as operators, investors, and financiers and as one measure of the resources and liquidity available to a business. NAV analysis can be extremely useful. We offer examples where growth in NAV can be an almost assured source of profit or an absence of loss for the fundamental finance investor and how NAV analysis can be used to see whether market pricing is way ahead of corporate fundamentals. We redefine the concept of net nets and in doing so highlight the importance of understanding what accounting numbers mean rather than what they are. Finally, we offer the OPMI a primer on investing in companies with growing NAVs.

MSACoverDisclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Modern Security Analysis: Net Asset Value (Part 9)

“…the investor using a fundamental finance approach can obtain large margins of safety by restricting his purchases to issues selling at steep discounts from readily ascertainable NAVs from highly creditworthy issuers with good prospects for increasing NAV in the future at rates of 10 percent per annum or larger.” —Whitman & Diz, Moderns Security Analysis

Chapter 6 – Net Asset Value: The Static and Dynamic Way

MSA1• The Graham and Dodd View on NAV
• The Financial Accounting View on NAV
• Our View on NAV
• The Usefulness of NAV in Security Analysis’
• The Importance of NAV Dynamics
• NAV as One Measure of Resources
• NAV as One Measure of Potential Liquidity
• Limitations of NAV in Security Analyses
• Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE
Net Nets Redefined
• OPMI Investing in Companies with Growing NAVs Summary

Net Nets Redefined

Net asset values are readily ascertainable insofar as the specific assets consist of cash and equivalents; investments in marketable securities and performing loans; income producing real estate; land suitable for development; and intangibles such as mutual fund assets under management. Rarely (except for cash and equivalents) are these readily ascertainable asset values classified as current assets under Generally Accepted Accounting Principles (GAAP). Graham and Dodd describe net nets in the 1962 edition of Security Analysis on pages 561 and 562:

We feel on more solid ground in discussing these cases in which the market price or the computed value based on earnings and dividends is less than the net current assets applicable to the common stock. [The reader will recall that in this computation we deduct all obligations and preferred stock from the working capital to determine the balance for the common.] From long experience with this type of situation we can say that it is always interesting, and that the purchase of a diversified group of companies on this “bargain basis” is almost certain to result profitably within a reasonable period of time. One reason for calling such purchases bargain issues is that usually net current asset values may be considered a conservative measure of liquidation value. Thus as a practical matter such companies could be disposed of for not less than their working capital, if that capital is conservatively stated. It is a general rule that at least enough can be realized for the plant account and miscellaneous assets to offset any shrinkage sustained in the process of turning current assets into cash. [This rule would nearly always apply to a negotiated sale of the business to some reasonably interested buyer.] The working capital value behind a common stock can be readily computed. Consequently, by using this figure (i.e., net-net asset value) as the equivalent of “minimum liquidating value” we can discuss with some degree of confidence the actual relationship between the market price of a stock and the realizable value of the business.

Our definition of net nets is taken from Graham and Dodd’s Security Analysis, but with a few twists. Graham and Dodd relied on a GAAP classified balance sheet to define current assets in order to ascertain if a common stock was a net net. We use our own judgment rather than GAAP classification to define current assets in order to decide what is a liquid, that is, a current asset.

While Graham and Dodd seem to have invented the idea of net nets, we use that idea with a number of modifications based on our discussions earlier in this chapter.

First, we are not interested in net nets unless the company is extremely well financed. A large quantity of current assets, especially if they consist of inventories, costs in excess of billings, or receivables from less than creditworthy customers, probably cannot help the common stock of a company that cannot meet its obligations to its creditors. Second, many current assets classified as current assets under GAAP are really fixed assets of the worst sort. Take department store merchandise inventories. If the department store is to be liquidated, merchandise inventories are indeed a current asset, convertible to cash within 12 months at prices that conceivably could be close to NAV, although much less than NAV may be realized if the merchandise is disposed of in a GOB (going out of business) sale. On the other hand, if the department store is a going concern, merchandise inventories are a fixed asset of the worst sort. The merchandise inventories have to be replaced, are hard to value, and are subject to mark-downs, obsolescence, shrinkage, seasonality, and mislocation. The Toyota Industries portfolio of marketable securities seems to be much more of a current asset than department store merchandise inventories even though, for GAAP or IFRS purposes, Toyota Industries’ marketable securities are not considered a current asset. Third, the Graham and Dodd formulation does not account for off-balance-sheet liabilities that may, or may not, be disclosed in footnotes, nor do Graham and Dodd take into account excessive expenses or losses. We capitalize such expenses or losses, and we add them to liabilities. Fourth, Graham and Dodd only seem to recognize partially that certain fixed assets, such as property, plant, and equipment, can sometimes create cash. For example, under Section 1231 of the U.S. Internal Revenue Code, the sale at a loss of such assets used in a trade or business, usually gives rise to an ordinary loss for income tax purposes. In that case, a corporation may be able to apply the loss first to reduce current year taxes and any excess loss might be used to get quickie cash refunds from the IRS with regard to taxes paid in the prior two years.

The identification of net nets does not appear to be that difficult. Cheung Kong Holdings, The Wharf Holdings, and Capital Southwest, discussed earlier in this chapter, are clear examples of Graham and Dodd net nets. The toughest problem by far, is to identify managements and control groups of these net nets who are both able and conscious of the interests of outside, passive, minority investors. This problem notwithstanding, the investor using a fundamental finance approach can obtain large margins of safety by restricting his purchases to issues selling at steep discounts from readily ascertainable NAVs from highly creditworthy issuers with good prospects for increasing NAV in the future at rates of 10 percent per annum or larger.

When all is said and done, however, we owe an enormous debt of gratitude to Graham and Dodd for introducing the concept of net nets.

MSACover

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Modern Security Analysis: Net Asset Value (Part 8)

“…in the hands of an astute management an overpriced common stock can be a most important asset.” —Whitman & Diz, Modern Security Analysis

Chapter 6 – Net Asset Value: The Static and Dynamic Way

MSA1• The Graham and Dodd View on NAV
• The Financial Accounting View on NAV
• Our View on NAV
• The Usefulness of NAV in Security Analysis’
• The Importance of NAV Dynamics
• NAV as One Measure of Resources
• NAV as One Measure of Potential Liquidity
• Limitations of NAV in Security Analyses
Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE
• Net Nets Redefined
• OPMI Investing in Companies with Growing NAVs Summary

Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE

When common stocks are selling at ultra-high premiums over book value, it is hard to acquire securities at reasonable P/E ratios. This can only be accomplished if the issuer enjoys unprecedently high returns on equity (ROE), say well in excess of 30 percent. In fact, most companies rarely achieve ROEs in excess of 25 percent most of the time. In our recommended list of common stocks in Table 6.11, the goal for the issuer, as measured by ROE is to achieve growth of 10 percent per year after adding back dividends, over a 3- to 7-year period.

The above can be demonstrated by a simple example. Assuming a market price of 6× book value, P/E ratios at various ROEs would be as follows:

MSA6_8

The 6× book value might be justifiable assuming that a company has such attractive access to capital markets that it could increase their number of shares outstanding by 31.5 percent via the issuance of new shares at 5.25× book either in an acquisition or a public offering. (This assumption is probably unrealistic for most companies most of the time.) In that instance book value would increase to $2.02 per share,[11] and EPS and P/E ratios would be as shown in Table 6.9 for various ROEs (forgetting the probabilities that the increased equity base might well precipitate a decline in ROE). This is part of our thesis that in the hands of an astute management an overpriced common stock can be a most important asset.

MSA6_9

 __________

[11] Since the new number of shares relative to the old number is 1.315, the proportion of old shares at a book value of $1 is 1/1.315 or 76 percent, while the proportion of new shares priced at $5.25 is 24 percent. The new book value per share is calculated as (0.76*$1+ 0.24*$5.25), or $2.02.

MSACoverDisclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Modern Security Analysis: Net Asset Value (Part 7)

“In value investing, asset allocation is driven more by price considerations and less by predicting outlooks.” Whitman & Diz, Modern Security Analysis

Chapter 6 – Net Asset Value: The Static and Dynamic Way

MSA1• The Graham and Dodd View on NAV
• The Financial Accounting View on NAV
• Our View on NAV
• The Usefulness of NAV in Security Analysis’
• The Importance of NAV Dynamics
• NAV as One Measure of Resources
• NAV as One Measure of Potential Liquidity
Limitations of NAV in Security Analyses
• Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE
• Net Nets Redefined
• OPMI Investing in Companies with Growing NAVs Summary

Limitations of NAV in Security Analyses

To repeat, we do not believe in acquiring securities solely on the basis of the earnings record of a company or on the outlook for its reported earnings. Neither do we think that an investment program based on acquiring securities simply because they are available at large discounts from NAV would necessarily be well advised. Availability at a large discount from book does give a first approximation that a security may be a bargain, or even that it may be attractive according to the fundamental finance approach. But this first approximation ought to be tempered by a more thorough analysis. In order for NAV to be a good indicator of the wealth or future earning power of a business, other factors must be considered as well.

A company’s record of profitability is, of course, some indication that the book asset value actually reflects real operating wealth, in the sense of assets that provide the wherewithal for obtaining earnings. Earnings for the current and the three prior years may also be a potential source of liquidity if income taxes have been paid or tax liability has accrued on them. The investor should also consider such factors as the size of the company’s operational overhead and the incentives for control groups to work against the interests of the outside stockholders. Also, since NAV is only an accounting figure, it cannot be more useful than accounting figures in general. In our view, the most important limitation of the usefulness of NAV as an analytical tool is that in itself, it does not measure the quality of a company’s assets, which we believe tends to be significantly more important than the quantity of asset value. Unfortunately, quality is a less measurable and less precise concept than quantity, involving what is essentially a subjective judgment.

What do we mean by quality of assets? We suggest that quality of assets is determined in a corporate situation by reference to three separate, but related, factors:

1. Assets owned free and clear of encumbrances
2. Quality of operations
3. Nature of assets themselves

An asset or mix of assets has high-quality elements insofar as it approaches being owned free and clear of encumbrances. Conversely, the assets of debt-ridden companies tend to be of low quality. Note that though encumbrances that depress the quality of assets (such as long-term indebtedness) may be stated liabilities, they may also be off-balance-sheet items, some of which, of course, will be disclosed in footnotes to the company’s financial statements. These include such items as pension plan liabilities, and such contingent liabilities as litigation and guaranties of the debts of others.

MSA_E1

Other encumbrances may be disclosed elsewhere. For example, a steel mill may be required to install antipollution equipment that does not generate revenue. Still other off-balance-sheet encumbrances may not be disclosed in any public document. A common example would be the need to substantially overhaul outdated plants and equipment in order for the business to remain competitive enough to survive. Unless an investor has know-how, and perhaps even know-who, he may be unable to find out that such encumbrances exist.

The second factor to consider in evaluating the quality of assets of a going concern is its operations. Does it have a mix of assets and liabilities that appears likely to produce high levels of operating earnings and cash flows? Good operations are an important creator of high-quality assets and are likely to contribute to a company’s having a strong financial position. Lenders quite properly prefer to finance businesses whose operations are sound and who are likely to create the wherewithal for continuing debt service on a long-run basis.

The third factor the investor must consider is the nature of the assets themselves. An asset or mix of assets tends to have high quality when it appears to be salable at a price that can be estimated with a modicum of accuracy. In many strict going concern situations, no separate values may be assigned to specific assets as a practical matter, because they may be useful only as a part of the operations of the company. A microchip manufacturing plant may be very valuable to the operations of a business but may have little or no value as a separate asset for sale. On the other hand, proved reserves belonging to an exploration and production company can be valued with a modicum of effort and do have value outside of the going concern either through a sale to a third party, monetization through entering into volumetric production payment agreements, or used as collateral in secured borrowing.

First and foremost, then, for an asset to have independent value from the point of view of the outside securities holder, it must be available for sale apart from the operations of the going concern. It must be something that is not so related to the going concern operation, or if so dedicated, is separable from it in a manner that will not have an adverse impact on the operating earnings power of the going concern.

Aside from this freedom from a going concern encumbrance, there are certain other characteristics that tend to make assets more attractive to lenders, and thus of higher quality. Assets that are liquid and marketable tend to be more attractive to lenders than those that are not. Liquid assets include cash and equivalent marketable securities, including restricted securities with meaningful rights of registration, proved oil and gas reserves, cutting rights and timberlands, and various types of real property. In order to be marketable, the assets must have a value that is readily measurable. In the case of securities that are traded in organized markets, the market provides a measure of value. Other assets may have readily ascertainable values even though not so traded—as, for example, income-producing real estate.

If an asset is one that third-party lenders or guarantors (such as financial institutions and governments) are experienced in lending against, the standards they have developed for lending may also provide a measure of value, and the asset tends to be more valuable than it would otherwise be. Examples of such high-quality assets have included oil and gas, maritime vessels and certain types of real estate.

Flexibility and scarcity are factors that tend also to make an asset more valuable. Thus, multipurpose assets tend to be more valuable than single-purpose assets. Flexibility is especially important in the case of real estate: A factory useful for only one type of assembly line production tends to be less attractive than, say, a downtown hotel that can be converted economically into efficiency apartments. Assets that are scarce, at least on a long-term basis (such as copper mines or domestic oil), may have special values all their own.

Certain assets that appear to have these characteristics may, of course, not have them because of legal impediments. For example, U.S. margin regulations make publicly traded common stocks worse collateral than other assets that lack common stocks’ characteristics of liquidity, marketability, flexibility, and measurability. Other assets may have special value because they can be used to create tax shelter. Because tax savings allow these assets to throw off more cash, tax-sheltered assets tend to be most attractive in the eyes of creditors. Thus, assets such as real estate, timberlands, to some extent oil and gas as well as other natural resources, have been outstanding examples of this.

These three factors—the amount of encumbrances, the operations, and the nature of the assets themselves—tend to be interrelated and may be off- setting. Thus, a company that is less encumbered tends to be freer to invest in assets lacking high quality. The property and casualty insurance industry provides a good example of this: Where an insurer’s capital and surplus are small relative to stated liabilities (and to premium income, which in turn tends to be related to the size of liabilities), that insurer will concentrate its investments in government and investment-grade corporate debt instruments. Only as capital ratios improve relative to stated liabilities (and premium income) will insurers tend to invest a portion of their assets in such lower-quality instruments as equity securities, especially common stocks.

High-quality asset businesses tend to be far more attractive holdings at given prices—say, when the common stocks are selling at ten times earnings—than are comparable businesses with lower-quality asset values. This is so because such businesses have a tendency to be subject to certain dynamic developments. And frequently the common stocks of businesses with high-quality assets may sell at lower P/E ratios than comparable businesses with lower-quality assets. This tends to happen when stock traders desire to pay premiums for aggressive managements, although companies with high-quality assets oftentimes are run by careful rather than aggressive managers.

High-quality assets are most commonly used to finance rapid growth, both in present product lines and into diversified areas—as, for example, in the case in 2012 for Brookfield Asset Management or Cheung Kong Holdings.

Surplus liquid assets not needed in a business (sometimes called surplus surplus [10]) may be extracted from these companies. This was, for example, the basis of the takeovers in 1968 and 1969 of strongly capitalized insurers, such as Reliance Insurance and Great American Holding Company. At the time of takeover, the workouts for shareholders were more than twice what the shares had been selling at one year earlier.

A company’s high-quality assets may be used to finance the takeover of that company on a better price basis than would otherwise be available. An example of this—a case where a mouse swallowed an elephant—was the 1962 acquisition by Albermarle Paper Manufacturing Company, a small company, of the entire capital of the much larger and extremely well financed Ethyl Corporation. Albermarle not only swallowed the elephant, but also adopted its name.

When a company lacks encumbrances as measured against the amount of obligations it owes, the nature of its operations and/or its potential to sell or convert all or part of its assets to a more liquid or useful form, that company is deemed by us to have a strong financial position, one of the four main characteristics sought in an equity investment using the safe and cheap approach. Generally, it is our view that if a company has little or no outstanding obligations, it is in a strong financial position, unless operating losses seem to have some prospect of being so large that the company’s strength will be impaired.

Value investors, by definition, are conscious of the relationship of securities prices to corporate fundamentals. In value investing, asset allocation is driven more by price considerations and less by predicting outlooks.
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[10] Surplus surplus is a name we think, but are not sure, was invented by the New York State superintendent of insurance around 1969.

MSACover

Disclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Modern Security Analysis: Net Asset Value (Part 6)

“I have always been much better at asking questions than knowing what the answers were.” Bill James

Chapter 6 – Net Asset Value: The Static and Dynamic Way

MSA1• The Graham and Dodd View on NAV
• The Financial Accounting View on NAV
• Our View on NAV
• The Usefulness of NAV in Security Analysis’
• The Importance of NAV Dynamics
• NAV as One Measure of Resources
• NAV as One Measure of Potential Liquidity
• Limitations of NAV in Security Analyses
• Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE
• Net Nets Redefined
• OPMI Investing in Companies with Growing NAVs Summary

NAV AS ONE MEASURE OF POTENTIAL LIQUIDITY

Liquidity is a qualitative characteristic of assets, and as such is discussed later in this chapter. Conventional strict going concern analysis focuses on balance sheet liquidity by relating current assets—especially cash, marketable securities, and other assets readily convertible into cash—to liabilities. Such analysis is appropriate only in the strict going concern case. However, in the real world of resource conversion and the tax carryback provisions of the U.S. Internal Revenue Code, large quantities of brick and mortar assets are frequently the raw material out of which a great degree of liquidity is created.

With variations to allow for differences between financial accounting and income tax accounting, the book-carrying basis for assets is often close to the tax cost-carrying basis for those assets. If so and if certain other conditions prevail: namely, that a profitable business has been a taxpayer at relatively high tax rates, and the company’s assets that are used in operations decline materially in value, then opportunities exist to use tax carrybacks to create cash benefits for the company and/or the stockholders of a company that sells its assets, and for a buying entity and its stockholders.

Under the U.S. Internal Revenue Code, in many situations where a company sells to an unrelated party assets used in the trade or business (whether they are current or fixed, from an accounting point of view) for less than the tax basis of those assets, the selling company will have realized a loss for tax purposes subject to offsets, namely, possible tax recapture of investment tax credits and accelerated depreciation. This loss after offsets is usually treated under Section 1231 of the Internal Revenue Code as an ordinary loss, even though the assets are considered capital assets. With an ordinary loss, the company can then obtain a quickie refund under the tax loss carryback provisions of the Internal Revenue Code. A quickie refund results in a cash payment to the company, within 45 days after the end of the tax year, up to the income taxes paid for the current year and the two immediately preceding years. During the 2008–2009 meltdown the tax loss carryover provisions were extended to five years so that previously profitable companies that suffered huge losses in 2008–2009 (e.g., homebuilders) could get massive cash refunds from the Internal Revenue Service.

This tax loss carryback feature is especially useful when a profitable business is available for acquisition at a price well below net asset value as shown on the tax records. In that case, the Internal Revenue Service will probably provide a substantial amount of the cash needed to finance the acquisition.

Examples of such transactions abound. They include the purchase of Cletrac by White Motors; of American Viscose by FMC; of New York Trap Rock by Lazard Freres and Lone Star Cement; and the 1975 sale by Indian Head of its textile operations to Hanson Trust. Budd Manufacturing bought Continental Diamond Fiber assets in the late 1950s, and Fiber used the tax carryover to finance the expansion of the one small operation that Budd did not buy. That small operation became Haveg Industries, which was eventually valued at over $50 million when it merged into Hercules.

The mechanics of such a tax loss carryback transaction can be best explained by a relatively simple example that assumes there are no recapture offsets.

EXAMPLE

Assume that the common stock of Target Company, which has a NAV for financial statement and tax purposes of $44, is selling at $15, or 7 1⁄2 times earnings. Target has earned an average of $4 per share before taxes ($2 per share after taxes, based on a 50 percent tax rate) for the last four years. The company’s assets include $3 cash per share, and Target is virtually debt free.

Let’s say that Acquirer Company, which has had no prior relationship to Target, purchases after negotiations all of Target’s assets except its cash, and also assumes all of Target’s liabilities by paying to Target $23 cash per share. In order to accomplish this, Acquirer is able to borrow $18 of the cash per share from an insurance company.

Supposing that Target incurs $1 per share expense for this transaction and its subsequent liquidation, Target’s workout value for the common stockholders will be $31 per share. This is shown in Table 6.5. Target’s assets available for liquidation consist of $23 per share in cash received from Acquirer on the sale of its assets, plus $3 per share of Target’s own cash, plus an extra $2 per share of current-year income due to tax savings, plus a two-year NOL carryback plus current year’s taxes that generates refunds of prior income taxes paid of $2 per share per year for a total of $6 per share, minus $1 per share for deal expenses. The $31 per share distributed in liquidation to Target shareholders amounts to a 107 percent premium over the then market price of $15.

MSA6_5

From the buying entity’s point of view, Acquirer was able to purchase the Target business at a price to it of $31, using only $5 of its own resources. The rest of the purchase price was other people’s money$18 borrowed from an insurance company and $6 obtained from the tax refunds.

Consummation of this transaction and the subsequent liquidation would result in Target’s stockholders receiving a substantial premium over the market value of their shares. If Target wants to liquidate, it can do so by distributing $31 in cash to its stockholders. This liquidation would have no tax consequences to Target itself, provided that under Section 337 of the Internal Revenue Code a liquidation was substantially consummated within 12 months after the adoption of a plan of liquidation. Rather, the liquidation would be a taxable event for the stockholders: Each stockholder would have a capital gain or capital loss, depending on the cost basis each had for his common stockholdings. Target, however, need not necessarily liquidate. If management wanted to continue in business, Target might become an investment trust,a or it might be able to buy certain other businesses. Target did not necessarily have to sell all its assets to Acquirer. It could, for example, have retained one operation and offset taxes on profits from that operation against the loss carry forward created by the sale of assets.

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[a] Target’s becoming an investment trust is a principal component of a form of transaction that has come to be known as the most common type of leveraged buyout. In this type of leveraged buyout, three elements are present. First, assets are purchased at, or below (hopefully below, so that tax refunds may be obtained), their tax cost basis, so that no tax liabilities are created regardless of how low the cost basis for common stock held by principal stockholders may be. Second, the acquiring company hires the operating management of Target, giving them attractive long-term contracts, to run the business represented by the assets the acquiring company has purchased. Third, Target converts into an open-end investment trust, that is, a mutual fund, whose investments are restricted to tax-free securities issued by city and state governments. Target then offers to redeem shares at net asset value ($31 per share in Table 6.5), at which time most public shareholders redeem and principal stockholders do not. The principal stockholders then control a mutual fund which has invested in tax-free obligations and which flows through without taxation all interest received to the remaining shareholders of Target. In effect, then, principal shareholders have converted their active business interests into a portfolio of tax-exempt securities without incurring any income tax liabilities even though their cost basis for their common stock holdings may be zero or close to zero.

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On a pro forma basis, Acquirer’s equity bought Target’s net assets at around three times earnings, based on Acquirer’s equity investment of $5, although Target’s P/E ratio as an independent company was 7.5×. Table 6.6 shows a condensed pro forma balance sheet for Acquirer, based on the acquisition of Target’s net assets. Acquirer, if it were a public company, might also benefit because its purchase of Target’s net assets at a price below NAV enables it to report higher earnings on the operations than Target had. This result is due to one factor: because Acquirer’s cost basis for the assets is lower than Target’s.

MSA6_6Table 6.7 illustrates a condensed income account for Acquirer, based on its having the same operating earnings before depreciation from Target’s assets that Target had actually experienced in the prior four years.

MSA6_7

MSACoverDisclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.

Modern Security Analysis: Net Asset Value (Part 5)

“Changes in earnings can be sudden and violent, and changes in price-earnings ratios even more so. Changes in NAV, on the other hand, by definition are almost always more gradual.” —Whitman & Diz, Modern Security Analysis

The Net Asset Value Way

Below is an excerpt (emphasis added) of chapter six in Modern Security Analysis: Understanding Wall Street Fundamentals, written by Marty Whitman and Fernando Diz.

This post is split up in a few pieces (too much text to make it all into one… and you should not stress, so it shouldn’t be a problem I think), each one covering one or two of the sub-topics in the chapter (see contents below).

Enjoy and please feel to share your own thoughts in the comment section. All the Best, Value Invest!

Chapter 6 – Net Asset Value: The Static and Dynamic Way

MSA1• The Graham and Dodd View on NAV
• The Financial Accounting View on NAV
• Our View on NAV
• The Usefulness of NAV in Security Analysis’
• The Importance of NAV Dynamics
NAV as One Measure of Resources
• NAV as One Measure of Potential Liquidity
• Limitations of NAV in Security Analyses
• Large Premiums over Book Value Always Mean High P/E Ratios: It Depends on ROE
• Net Nets Redefined
• OPMI Investing in Companies with Growing NAVs Summary

NAV AS ONE MEASURE OF RESOURCES

Even where the past earnings record of a company is a superior indicator of future earning power, we know of no instance in which it has been the sole indicator. The amount of resources a management has available to create future earnings remains an essential indicator of future earning power. And one measure of available resources is NAV.

This approach is more commonly used in the context of corporate takeovers (such as mergers and acquisitions) than it is in the context of passive investing by OPMIs. Corporate buyers tend to be acutely conscious of how they plan to use the resources over which they gain control in order to maximize earning power. OPMIs, on the other hand, are not in a position to alter the way a corporation’s resources are used, and understandably are thus less likely to use this resource conversion approach in forecasting future earnings. It does not follow from this, however, that an OPMI should or can safely ignore NAV in analyzing a corporate situation. If only because corporate acquirers are using NAV analysis in this fashion, the OPMI may be able to reap a substantial benefit from adopting this kind of approach.

NAV as a measure of resources is also crucial in any kind of return on investment (ROI) or return on equity (ROE) analysis. [9] ROI and ROE analyses are important tools in forecasting future earnings.

MSA7

Many analysts recognize the importance of ROI and ROE analyses and place considerable emphasis on them while disclaiming the importance of NAV. But you cannot calculate a return on investment unless you know the amount of the investment; nor can you know the amount of the investment unless you know the amount of the net worth. Inasmuch as NAV measures common stock equity, which is a component of net worth, it must necessarily figure in this calculation.

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[9] Return on investment is usually defined as net income as a percentage of net worth and funded debt. Return on equity is usually defined as net income as a percentage of capital stock and surplus; sometimes when preferred stocks are outstanding, ROE is defined as net income as a percentage of net worth (with the net worth account including preferred stock, common stock and surplus).

MSACoverDisclosure: I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company or individual mentioned in this article. I have no positions in any stocks mentioned.