“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.
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.