Building Asset Value - what I look for when investing in companies

this is an interesting thought on how to get value. I am just starting out and am looking to develop a strategy along the lines of yours however am struggling to get away from the fact that earnings surely do matter more than you perhaps give them credit for.

I'm not saying in any way that you are incorrect but just trying to mull some thoughts over. If you have a loss making business as you say you do the reason that the book price is discounted is because losses over the following period will erode the book value and that is why that discount is there is the first place. Looking at one of your holdings French Connection they have a book value of £0.741 and as at end June 10 (from your current holdings list on your blog) you had a mid price of £0.395 so therefore you are getting a discount on this. I realise the price has gone up since this time but as you say this is not important for now as you are waiting to get the book value before selling. They are making losses of £0.093 per annum so if this stayed the same then in 3.7 years the book value will be £0.395 ie the price paid. So if all things remain the same then in 3.7 years you will be back where you started (although in real terms worse off as you could have been earning interest on the capital invested). So, as you rightly say you are waiting for something to happen in order that the price moves up to above BV. The strategy that you have put in place however only seems to ensure that you are getting a cheap price rather than a stock that is more likely to turn their earnings around and therefore head back above BV. In the end it comes back to the company's ability to turn their earnings around to drive the share price back above BV.

Surely it is better to have a company that has a zero book value but is making profits since those profits will raise the BV than one that is cheap but losing money?

Sorry if this has been a bit rambly but as I say I am just trying to crystalise by thoughts and compare different long term strategies.  Would love to hear your thoughts on this. thanks

lud0,

That is an interesting post.; some History can help us put this strategy in context.

UK Value Investor (UKVI) is following what is perhaps the first ever concrete investment philosophy, essentially the system devised by Benjamin Graham in the The Intelligent Investor. This is a system that has a considerable history and continues as per UKVI's results and those of Richard Beddard Thrifty Thirty to still have proven success, even in the UK context.

It is important however to appreciate some features of Graham's system:

1. It is a purely quantitative system and allows no space for qualitative decision making. For Graham, a decision had to have a numerical basis, anything else was deemed by Graham as too subjective and with good reason. Graham believed that an Investor is his own worst enemy, and the mechanical nature of the system is in part an attempt to combat human greed and over-reactivity to market swings. 
2. Graham uses a dated valuation concept. Living in the age of rail roads and industrial manufacturing Graham believed the ultimate value of a business to lie in it's TANGIBLE ASSETS, i.e those things you can touch. We now understand that the value of a business is only partially derived from its assets, and in fact what is far more important - if the business is considered as a going concern - is the cash flow of a business; as calculated by the DCF valuation method. With the DCF model you use the projected future cash flow (related but different to earnings) of a business to calculate its worth - in this sense assets are only of secondary importance. You pay more for a business that generates more cash, regardless of the assets at play - a system related to how the markets value businesses on earnings though with important differences.

Despite these limitations Benjamin is the father of investment philosophy, the very first to frame the concept of value, and a very successful investor in his own right and clearly a complex character who believed in so much more than just money making. However, it's important to note, that the world's most successful investor: Warren Buffet, a student of Graham, adapted Graham's insistence on value, but used discounted cash flow analysis as the main determinant of value as opposed to assets. So, yes you are right there are other more sophisticated ways of accounting for value, though book value (i.e tangible assets) is still one useful measure. 

Given the craziness of markets, the original Graham still works and looks set to continue doing so.

hey, thanks so much for the response - I was recommended to this site recently and have been very impressed so far with the help that is given on here.

I read a few books on Buffet's investing style a few years ago but never really had the funds to put in place what I learnt so promptly forgot it all. Time to dust them off and re-read them I think.

I think what you have said has made a lot of sense and I think that I need to read up on discounted cash flow as this should probably form the basis of any solid long term strategy. Do you have a good recommendation for a book that will point me in the right direction on this?

thanks again

In reply to lud0, post #3

It's worth having a look at this list of books from UKVI - http://www.stockopedia.co.uk/content/the-art-of-value-investing-15-investment-books-you-have-to-read-45364/

Some good ones in there.

In reply to hannibal, post #2

Hannibal,

I am sorry but must respond here. Both you and value investor have clearly not read Graham fully. The strategy value investor describes is, most certainly, NOT one Graham recommends.

Graham actually employed numerous strategies. It is a common misconception that looking purely at book value was one of them. It was not.

The most important misconception is that anyone following Graham's theories can do so without considerable work. He emphasised repeatedly that if you are an "enterprising investor" (i.e. not sticking mainly to bonds with SOME blue chip investments - FC most certainly doesn't qualify) you need to study several years' annual reports of any company you are considering investing in, and analyse their performance in depth, taking account of adjustments that may distort key ratios. That also fits my own experience: there is no substitute for the hard graft of studying a company you plan to invest in in depth - though I'll freely admit that I may not be as rigorous with this as I ought to be! It is also a common misconception that Buffett doesn't do this but simply looks at a few key metrics: he most certainly does study the businesses he invests in considetable depth and is very shrewd at doing so.

Graham had no strategy based solely on book value. One of his strategies WAS to look for companies with a market cap below NET CURRENT ASSETS - not book value. It is most unusual to come across such cases... but worth exploring if you do. ;0)

Graham was well aware of the DCF methodology and discusses it in the Intelligent Investor. However, he rightly stresses that DCF models are highly dependent on assumptions about the future... and such assumptions are not particularly reliable. His key "value" concept was that of a "margin of safety", i.e. look for investments that a) remain viable; b) remain cheap even in future scenarios worse than you are expecting.

Cheers.

Mark

lud0,

The best book I have encountered - in terms of readability & practicality - that explains value investing from a DCF perspective is Joe Ponzio's 'F Wall Street'.

Don't be fooled by the vulgar title, Ponzio is a very sophisticated investor and has a gift for explaining this investment perspective in very simple no-nonsense language. The meat of the book are chapters 6 - 9, with the examples in chapter 9 priceless. Ponzio is unique in that he also considers the question of portfolio management, and the issue of when to sell a stock!!

He has a website @ www.fwallstreet.com, but this is really secondary to the book. You need to read the book first, to understand the companies he considers on his website.

-----------------------------------------------

Primer in Discounted Cash Flow Analysis.

DCF uses future cashflows to value a business, first you have to know what cash flow is: it is definatley not the same as 'net profit' or 'earnings' that the market uses!!! Ponzio and other sources explain how to calculate it, you might want to look at Warren Buffet's definition of "owner earnings" as a practical definition of cash-flow.

Say you accept that the value of a business is its cash flow, and you have calculated this; how do you assign value to this cash flow, giving that it is yet to occur? To put this in an other way, what is the value of £1000 a year from now? To answer that, lets think of the value of £1000 today.

£1000 today is worth its face value, plus if you had that £1000, you can also earn around 6% risk free using investment grade bonds or 3% with a savings account. So that £1000 in a years time would be worth £1060. So what then is the worth of £1000 received a year from now?

£1000 received in a years time is worth £1000 minus the risk free return you would have earned on that money. So £1000 in a years time is worth = £1000 - 6% = £960. £1000 received in 2 years is £1000 minus risk free return over two years = £1000 - 12.3% = £877 (12.3% being the compound interest rate over 2 years).

However we have so far only accounted for the opportunity cost of receiving money in the future, when investing in stocks there is risk, and you must account for this risk in your calculation. I could invest £1000 today and receive 6% annually risk free, for my investment in a business to be worth it, I must receive much more than 6% in order to justify the risk I am taking. Let say I demand a 10% premium for taking such risk, what then is the value of £1000 in a years time.

£1000 one year from now = £1000 - risk free return in 1 yr (AKA opportunity cost) + risk premium (compensation for taking risk) = 1000 - 6% + - 10% = 1000 - 16% = £840.

£1000 two year from now = £1000 - risk free return in 2 yr (AKA opportunity cost) + risk premium (compensation for taking risk) = 1000 - 12.3% + - 10% = 1000 - 23.3% = £777.77

If you notice the value of money in the future becomes smaller (tends towards 0) the longer we have to wait for that money - which makes sense, as the longer you have to wait the greater the opportunity cost. As such, virtually the entire value of the business lies in its cash flow for the next 20 - 25years.

So effectively using some very simple mathematics, we have a way of assigning a value to the future cash-flows of a business in any one year. So how do we use this to calculate the value of the business? Well you look at its accounts, analyze its likely cash-flow growth rate and then jot down projected cash flows for 10 - 20 years, discount each year of cashflows as shown above, and bingo you have a magical figure of what the business is worth - notice nowhere in this calculation have we even considered assets - for us they don't matter!!!!

In practice you use spreadsheets or online calculators to simplify the computation of DCF, and it is more of an art than science. The aim is not to calculate the exact value of a business, but rather to calculate the minimum value a business is worth.

How do you use this value to make investment decisions? Well it's simple. Having done a DCF analysis, you have a concrete objective measure of what a business is worth. Whenever a business is selling for a lot less than its DCF value you buy that business confident that you are buying a bargain, you then sell that business when it reaches its true DCF value pocketing the profit. As such you're using DCF in a similar manner to book value, however you're using a completely different metric which assumes that the value of a business lies in its ability to generate cash and not it's tangible assets.

To elaborate on my previous post, a book value of 1.5x market cap is just one of seven criteria, which must all be met for stocks that might be chosen by a "defensive investor" (Graham suggests more complex criteria for "enterprising investors"). The other six are:

1. Minimum size of enterprise (smallcaps are excluded for such investors)
2. Quick ratio > 2 AND long term debt < net current assets
3. Profitable for last 10 years (so lossmaking businesses are excluded)
4. 20 years of uninterrupted dividends
5. > 33% overall EPS growth over last 10 years (calculated by comparing average earnings over first 3 years of 10 year period, with average earnings over most recent period)
6. P/E < 15 based on last 3 years average earnings

Cheers,

Mark

In reply to marben100, post #5

Mark,
,
Fair comments.

Yes you are correct in specifics, both me and perhaps UKVI use book value and net current assets interchangeably when they are in reality different, and perhaps simplify Graham's thinking to one of his multiple strategies. However, the net current asset/networking capital can fairly be called Graham's key strategy, this was the money maker!!! It was how Graham, Schloss, other members of Graham and Doddsville and Buffet in his early years made their market-beating returns! That idea is synonymous with Graham!!!

As you mention, for the enterprising investor - which we assume is anybody taking the time to post & visit sites like this - he mentions three viable strategies:

1) Bargain purchases - those bought below net current assets or working capital. Not book value as your point out, a laxness in terminology, for which I apologize.

2.) Purchase of temporarily unpopular companies. Similar to the dog's of the Dow strategy.

3.) Mergers, liquidations and other arbritage situations

In generalities, however, I think my points stand. When I say, Graham's strategies are mechanical, this is not to say they require no work, but rather that this work is of a quantitative nature, you calculate values - which requires careful reading of reports- but it is ultimately these numbers which decide where your invest and not any qualatative factors about the business apart from what is implied in the numbers. Graham's sole question is is this business good value, not what are the long term prospects for this company or industry. I feel this point is irrefutable.

Yes, Graham understands an early version of DCF, but never applies it, as he considers it too subjective. While not the sole determinant of a decision, a key principle of Graham's was never to buy a business for too far above its book value (i believe he specifies a 1.5x limit), as such it is fair to say that he uses tangible assets both in this rule, and in the working capital strategy as a key metric of value!!!!!!

Buffet however, uses DCF as his key valuation metric!!!! This point is also irrefutable; he won't buy a business where he can not predict cash-flows, and in fact his first mistake as an investor which taught him the limits of Grahams methodology was the purchase of bargain issues (as defined above) but which where poor businesses. I.e stocks where numbers looked good from a Graham perspective, but from a qualitative perspective analysis of the underlying industry and its likely trajectory (all subjective) where doomed businesses. As such, Buffet's strategy evolved to use DCF and qualatative factors, so he'd buy businesses for 6 - 8 x book value, a complete NO NO for Graham.

Again, while DCF is a mechanical calculation, to calculate this properly takes work, and the projection of 10 to 20 years worth of cash-flow itself implies a deep familiarity with the businesses and factors effecting it's cashflows.

To support my points above here are some links to interview with Water Schloss, a Grahamitte who worked with Benjamin Graham in his partnerships:

• http://www.grahamanddoddsville.net/wordpress/Files/Gurus/Walter%20Schloss/Schloss-Sixty-Five-Years.pdf
• http://www.forbes.com/forbes/2008/0211/048.html
• http://www.scribd.com/doc/14241243/0471244724
• http://www.scribd.com/doc/14136584/Walter-Schloss-Barrons-1985

Of particular note:

 

Ben’s emphasis was on protecting his expectation of profit with minimum risk. If one wants to get hold of Moody’s Investment Manu- als for the 1947–1956 period, it is interesting to see Graham-Newman’s holdings. Many of them were small, practically unknown companies but they were cheap on the numbers. It is instructive to read their annual report for the year ended January 1946. It states that their gen- eral investment policies were twofold.

1.To purchase securities at prices less than their intrinsic value as determined by careful analysis with particular emphasis on the purchase of securities at less than their liquidating value [i.e book value].

2.To engage in arbitrage and hedging operations"

Also

Ben had been hurt by the Depression, so he wanted to invest inthings that would protect him on the downside. The best way to do this was to lay out rules which, if followed, would reduce his chance of loss

A good example of this was the day I happened to be in his office at Graham-Newman when he received a telephone call that they had bought 50 percent of Government Employees Insurance Co. (now GEICO). He turned to me and said, “Walter, if this purchase doesn’t work out, we can always liquidate it and get our money back.” [I.e by buying at or below book value, you where protected against loss]

The fact that GEICO worked out better than his wildest dreams wasn’t what he was looking for. As the saying goes, a stock well bought is half sold. I think Ben was an expert in that area.

This telling example above, shows just how central book value was to Graham as a valuation metric!

& Schloss's rule 3 of 16 Golden rules for investing:

Use book value as a starting point to try and establish the value of the enterprise. Be sure that debt does not equal 100% of the equity.

In reply to hannibal, post #9

Hi hannibal,

Firstly, whilst I'm sure you're aware, some less experienced readers may not be clear that NCA & book value are very different things. Passing the NCA test is much tougher than simply looking for a discount to book value.

Secondly, I don't think the quotes you've referenced support your statement that Graham made most of his money using this metric alone.

To purchase securities at prices less than their intrinsic value as determined by careful analysis with particular emphasis on the purchase of securities at less than their liquidating value [i.e book value].

 

Whilst there may have been an emphasis on book value, the key point is "less than intrinsic value". Studying Graham's books ("The Intelligent Investor" and "Security Analysis")  you will find that his definition of "intrinsic value" is much more sophisticated than most casual observers and some commentators seem to think. "Security Analysis" in particular is a 700 page tome, addressing precisely the topic of how to determine "intrinsic value". That is the core point abouve value investing, as practiced by Graham & Buffet: it is based on a thorough analysis of what a business (or other instrument*)  is worth, taking an extremely conservative view and being highly sceptical about growth in future earnings.

Many people will be surprised to learn that arbitrage & hedging operations (which Buffett also employs) were an important part of Graham's operation.

Note also that in the quote about GEICO, Graham's statement was true because a) he had a controlling interest in the company [not something the private investor usually has!]; b) his assessment was that the business could be liquidated to achieve a larger sum than he had paid for it - again much stronger than a good ratio or "book value" to market cap.

*Buffet, Graham & co also made considerable gains investing in "distressed assets", such as bonds & warrants, that other investors thought were worthless in times of crisis, but for which they determined that the chances of achieving a return as events played out were good.

Finally, I would observe that we live in a time when Graham & Buffet's value-based strategies really can be used to good effect. Some of my most successful investments over the last two years have been companies whose market cap. was no higher than net liquid assets: Encore Oil (LON:EO.) when trading at no more than cash value; Niger Uranium Ltd (LON:URU) ; Emerging Metals (LON:EML)  and Polo Resources Ltd (LON:POL) all trading at a substantial discount to their NTAV.

Best,

Mark

Hi hannibal,

Graham's strategies are mechanical, this is not to say they require no work, but rather that this work is of a quantitative nature, you calculate values - which requires careful reading of reports- but it is ultimately these numbers which decide where your invest and not any qualatative factors about the business apart from what is implied in the numbers. Graham's sole question is is this business good value, not what are the long term prospects for this company or industry. I feel this point is irrefutable.

...well, I'm going to refute it!

Graham's approach most certainly was not mechanical - but he was prepared to make big bets where a business was transparently undervalued on asset metrics and he could control that business.

In both "The Intelligent Investor" and "Security Analysis" he devotes chapters to matters such as the relationship between investors and a business's management.

Finally, "The Intelligent Investor" specifically warns AGAINST mechanical strategies. The commentary by Jason Zweig specifically citing the strategy suggested by Motley Fool USA ("Foolish Four") as an illustration of such strategies not working, as well as funds operated by O'Shaughnessy following the principle of "What Works on Wall Street".

Graham's own definiton of an investment operation, as opposed to a speculative one, is:

An investment operation is one which, upon thorough analysis promises safety of principal

and an adequate return.

[my bold]

Graham stresses repeatedly that there is no shortcut to analysing a business in depth (and the rest of his book explains just how such analysis may done and factors that need to be considered).

IMO Graham would turn in his grave if people misinterpreted his teachings into some idea that there is a simple mechanical route to riches.

He is not averse to the DCF methodology and IMO it is an important tool in the investor's armoury but one must be aware of the fundamental weakness that a DCF valuation is highly sensitive to assumptions about future cashflows. Except in the case of a bond or similar instrument such cashflows are highly uncertain.

Mark

Without wishing to immerse myself in the detail of this thread, I would note that NONE of these approaches would ever lead one to invest in oil E&P companies in which the value of the company's assets is not shown on the balance sheet.

This would arbitrarily exclude some of the best E&P companies, which have very low finding costs, thanks to the oil and gas properties that are the company's main assets being shown in the balance sheet as the capitalised sum of total exploration expenses. So, for example, a company that has an extremely good/lucky run of drilling - and therefore spends and capitalises a relatively small sum of money as assets in their balance sheet - will appear to have assets that are worth less than those of a very unsuccessful E&P company that has spend vast amounts on finding very little!

As Mark knows well, the E&P business is one that makes perfect investment sense if one makes realistic estimates of a company's Net Asset Value, based on what the actual oil and gas on their properties is estimated to be worth on the open market.....but it makes absolutely no sense at all to look at book values.

This quirk is, of course, pretty specific to the E&P sector - but those who are using investment metrics that are derived from the accounts should at least be aware of a set of opportunities in the E&P sector that their metrics won't correctly evaluate!

ee

In reply to lud0, post #1

Hi lud0

I think a key phrase in your first point is "more likely to turn their earnings around". I think, at least for me, it's very difficult to see what is going to happen ex-ante. So I don't even try. I've updated my profile here of a better description of what I'm trying to do. Basically it's quite closely related to the kind of back-testing that is done in academic papers where they just select the smallest, lowest price/book companies and rebalance each year. It's not quite like that but it's certainly closer to that than the more mainstream detailed analysis done by marben100. I'm not saying one way is better than another, it's just a strategy that I like and have the time and inclination to follow.

Actually I have started to look at integrating the F-score into new purchases as this metric may have some ability to indicate which companies are nearer turning around, but I have yet to use it in anger and as with all aspects of investing you can't really see if it has any merit until a lengthy period of time has passed.

As for whether it's better to have a company that has zero book value and is making profits, I'd say yes it may well be better. But, there are an infinite number of ways to approach investing and I like to stick to one method so that I can fine tune it over time. Investing based on earnings is of course totally valid, it's just that I don't do it at the moment. Perhaps in time I might, but only if my current method turns out to be a very bad idea.

In reply to emptyend, post #12

Hi ee,

Without wishing to immerse myself in the detail of this thread, I would note that NONE of these approaches would ever lead one to invest in oil E&P companies in which the value of the company's assets is not shown on the balance sheet.

I don't believe that's correct (at least in the case of Graham & Buffett's approaches). They most certainly would consider the value of assets that don't appear on balance sheets. However, where I would concur with hannibal is that I believe that Graham in particular would be extremely cautious about valuing assets on a DCF basis, based on future assumptions about the POO.

So, IMO he would consider such assets - but he'd want them at a very big discount to NAV! (or would value them using a very low future oil price assumption when determining "intrinsic value" and to be confident that the company wouldn't have much difficulty in financing their development*).

It is a complete misunderstanding that Graham's approach was based purely on examination of balance sheets, which many commentators wrongly assert. Rather, his approach was based on the "margin of safety" concept: that he wanted investments that, in the long run, were highly unlikely to destroy capital invested in them, pretty much regardless of short-term market conditions. The balance sheet is a good starting point but Graham recognised that one must go beyond that in analysing a business.

Regards,

Mark

*Based on those criteria, I think he would find Soco an interesting investment possibility, as a) it is well financed; b) Soco's "intrinsic value" is less sensitive to POO assumpitons than most comparable companies; c) there is substantial upside possibility but only limited downside, on a medium term view. That fits the core criteria of offering "safety of principal" and "an adequate return".

Just in case anyone's interested, Graham & Dodd's "Security Analysis" can be downloaded easily and fast at http://avaxhome.ws/ebooks/0071603131.html , and a related book I don't know at http://avaxhome.ws/ebooks/economics_finances/A_Modern_Approach_to_Graham_and_Dodd_Investing.html

I've successfully downloaded the former from that link recently.  Numerous other interesting investment books are available on Avax, eg for value investors http://avaxhome.ws/ebooks/economics_finances/0684813505.html