Sunday, April 15, 2012

Value Trap by the Book


One of my functions for clients is developing the menus of 401k and 403b rosters of funds. Quite properly the sponsors of these programs wish to offer a relatively low-risk equity alternative along with presumably higher performing funds. Many institutional as well as individual investors also seek lowered perceived risk investments. Each of these potential investors gets attracted to funds that have ‘value’ in their name. As has been said often, “One should not judge a book by its cover.” The perception of value may be quite different from the reality.

Value definitions

There is no universally accepted definition of value. Most investors believe that within the rubric of ‘value’ there is some attention being paid to the risk of permanent loss of capital. The marketing and distribution forces within the money management industry often attempt to demonstrate that advisors focus on value by quoting the price/book value statistic. According to this logic, the lower price/book ratio is better. A ratio below 1 is meant to be a sign of a real bargain. I believe this may well be a trap.

What is book value?

This is not the place or the time to produce a treatise on double entry accounting principles. The term ‘book value’ has a specific accounting definition. An investor searching for value needs to understand that there are a number of links between the income statement and the balance sheet. One of the key concepts is that the income statement is required show all of the costs that should be charged against the current period’s revenues. This is fairly simple to do for the cost of labor and supplies consumed during the period. There is a problem however on how to allocate some of the capital that has been invested in longer-lived assets like buildings, acquired customer lists and patents. Accounting rules dictate how much should be charged to the current period. The remaining portions of these costs are capitalized and are found in various entries on the balance sheets. They are included in the so-called book value. (In its simplest terms, book value is calculated by deducting from the assets all liabilities divided by the number of shares currently outstanding to arrive at a book value per share number.) Currently, auditing requirements demand an annual review as to whether these assets are at least worth what they are stated on the balance sheets. If they are worth less, they are to be written down on the balance sheet and an impairment charge is to be made to the income statement. Under conventional accounting procedures there is no provision to writing assets up.

Sound security analysis and effective loan officer research techniques should include reviewing these assets on internal spreadsheets. These augmented financials could lead to a justifiably higher price for the stock, the company, and/or an increase in collateral value for loans. These upward adjustments to book value cannot be published by the company issuing the financial statements.

“The Market” knows

While appropriate adjustments to stated book value are not published, market prices often reflect these changes. Years ago a successful, wise trader told me that a stock is only worth what it is selling for at the moment, not some theoretical accounting value. On Friday two of America’s strongest banks reported their first quarter results. Some in the media called attention to the fact that Wells Fargo* was selling at 1.29 times its book value and JP Morgan* was selling at 0.91 times its book value. Remembering what my old trader said, the market was suggesting that it was deducting an impairment charge for the “fortress balance sheet bank” (JP Morgan), and not for the bank with the largest home mortgage business (Wells Fargo). Considering that a portion of the former’s good earnings came from reversals in its bad loan reserves, the market could be right.

* Please note in terms of disclosure that I personally owned shares along with many other financial service stocks in my personal portfolio. Neither stock is included currently in the private financial services fund that I manage. The comments in this blog should not be interpreted as a recommendation to buy or sell these securities.

The corporate finance view on ‘value’

Both Warren Buffett and I studied at the feet of Graham and Dodd at Columbia. He studied under Benjamin Graham and I was with Professor David Dodd. Both instructed us to reconstitute financial statements in order to determine at least liquidating value. Part of the exercise was to eliminate most, if not all inventory value; also to re-price the outstanding debt at its current market value among other adjustments. The genius of Mr. Buffett was to recognize the economic value of the “moat” around the company that protected the firm’s market share. In many of Berkshire Hathaway’s** acquisitions, I believe the size of the “moat” relative to the price was an important element in the final decision. In some cases, key personnel were very much part of Berkshire’s valuation of the “moat.” (I know in the purchase and sale of financial data products and companies, the customer relations experience was a critical factor that I used in valuing the various opportunities before me.) These and similar approaches are used by corporate finance groups to determine acquisition value.

** As noted in earlier blogs, I personally own shares in Berkshire Hathaway, as does the private financial services fund that I manage. The mention of this stock should not be construed as a recommendation to purchase.

My concept of ‘value’

I try to divide potential investments into two large buckets. The first is one that future events will cause the stock to raise. Often this may have to with new products, processes, sales strategies and competitors’ problems. In the other bucket are stocks that are selling substantially below their current liquidating value, or at a price that a reasonably smart strategic buyer would pay for the company.

How to apply in fund/manager selection?

Avoid those managers that emphasize the value of published price/book ratios. Work with managers that know enough and have enough good contacts within an industry to come up with an independent valuation. Due to the time to research available companies, the preferred managers typically have relatively low portfolio turnover rates. However, these managers must have a history of reacting to their own misjudgments and exiting from what looked like great values.

All long-term successful investors use trial and error techniques. Thus the success of any particular investment is far from guaranteed. The truly great investors recognize their errors and quickly move on, so some portfolio turnover is a good thing to see. The essence of value-focused investing is to reduce the chances of large avoidable losses.

How do you find and invest in good values?

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