Sunday, September 27, 2015

Value Investing: Yes,
Book Value: No


Two thoughts to begin this post:

1.  Value focused investing has produced good results for hundreds of years.

2.  The use of unadjusted book value found in the modern corporate accounting statements can mislead the value investor.

Investment See-Saw

With our need to label anything that moves, particularly in the stock market, during rising markets we often divide companies, stocks, and fund portfolios into either growth or value. With the power of computers to sort and mislead, many foolishly believe that there are some statistical divining rods that can separate growth from value. In truth almost every entity has alternating periods when it can be recognized as either growth or value.

The Perceived “Two Number” Screens

As a life long student of investing I have noted that growth investing is essentially time-focused arbitrage. The growth investor has reasons to believe that in a particular future the price of the shares of interest will be materially higher than today’s price. Growth investors are essentially forecasters. In a secular rising market (as experienced by US investors) the trend is their friend until it periodically disappoints.

Value investors see the future as a range of outcomes, only some of which are identifiable. Charlie Munger is the epitome of rational investing. He and his partner Warren Buffett have three baskets, In, Out, and Too Tough. Jason Zweig quotes Charlie invoking Confucius, who said that real knowledge is knowing the extent of one’s ignorance.”

Dangers of “Latest Published Book Value”

Far too many professional investors start their search with a screen of current prices compared with the latest published book value. I would suggest they are taking an easy and faulty crutch to find value. One of the many things drummed into me by Professor David Dodd of Graham and Dodd fame was never to accept the validity of a balance sheet as presented. Balance sheets then and now are important initial file instruments for the credit world. The initial bottom line for credit work is book value. This is a calculation derived from taking all the liabilities on the balance sheet from the total of all assets also shown. For investors in stocks and bonds priced way below par or maturity value, Dodd would term book value, unadjusted as “rubbish.” The good professor was not just a learned academic at Columbia University, he was also an investor and partner with Ben Graham* in a very successful investment partnership.

The Lessons Not Learned

On my recent trip to visit investment managers in London I came across at least two instances where they could have profited from Professor Dodd’s classes. In the first case a sizeable, successful group invested in closed-end discounts from the fund’s current net asset value (equivalent to book value for funds), large family dominated non-US financial entities, and other conglomerates. I have been an analyst of bear raids on US closed-end funds selling at significant discounts. These “operations” rarely work out in practice compared to what they should do in theory.

All published net asset values for funds are based on the closing price of the individual holdings on statement date. Market operators are well-conscious of important stated dates and may adjust their closing prices accordingly. If the fund has particular positions in somewhat illiquid stocks the price to liquidate the positions will likely be anything other than the last price in the NAV. Also the unwinding of the raided investment advisor’s management company can prove to be expensive in terms of settling leases and termination payments. Further, to force a liquidation of a closed-end fund an initial investment needs to be taken and it is at risk for the difference between the purchase price and the liquidation proceeds in the future when the market could move materially. At times, hedging this risk can be expensive. As faulty as raiding a closed-end is, the rest of this portfolio is at risk for using book value as an important measure.

I was one of the very few analysts who in the 1960s spent a great deal of time following multi-industry companies. These were soon called conglomerates, somewhat forgetting that General Electric and other industrial companies were producing products for a wide range of business customers. One of the reasons I was attracted to these companies is that there were many fewer analysts following them and thus they were not highly valued.

One of the sales pitches to convince institutional investors to buy these stocks was to show that there was a substantial discount from the value of each of the major parts of the conglomerates. It was a good sales approach, but I can not remember a single conglomerate that liquidated itself by selling off all of its parts. Yet this is the very same approach that was being used by this London manager. Further, as I knew a little bit about some of the financial operating holdings, I questioned whether book value was reflective of a liquidating value.

In one case, the financial operation was one of a handful of major players in a somewhat restricted market. I raised the question as to whether the local government would permit its sale to a foreign entity. Having recently visited this particular headquarters, I asked whether a very extensive art collection was in the book value calculation. (There is at least one important US group with a similar art collection.)  The conversation then pivoted to their treasures, we did not even get into the expected size of retention packages for key personnel or any guess as to the proportion of revenues that could be lost if the founding family was no longer involved.

On a second London visit, to one of the great names in the global financial world, we were going over its balance sheet and other financials. It was pointed out to me that the monetary value of the firm’s great name was not included. I raised the question whether or not they could get an external appraisal as to the value to the name, which my hosts never considered. As someone who has a globally recognized name in various financial communities, I am aware that a well-known name helps in getting the first introduction. But from that point on it is what one is presenting that will determine what is bought. Thus, the value of a name is a bit ephemeral, but I believe it still can be measured.

The interesting thing coming out of this type of exercise is that for internal purposes the value of the brand would have been added to its assets and perhaps materially. If that was the case, the return on assets and return on investment could well show that the present management was not really earning its keep.

What to do Now?

As we do not know which type of investing will do the best for any particular period, in our portfolio practice we own both growth and value focused mutual funds for our accounts. Over long periods of time the survivors of these two schools of investing produced similar results, but quite different in shorter periods. On a year-to-date basis in each market capitalization size category, value funds have underperformed growth funds. In a somewhat extreme example, through the 24th of September, the average Large-Cap Growth fund is barely down -0.36% as compared with the average Large-Cap Value fund falling -8.57% as measured by my old firm. As a long-term contrarian investor I note that the spread is unusually large and could prove to be attractive in the next cycle. 

* I was very honored when the New York Society of Security Analysts awarded me the Benjamin Graham Award, my old Professor might not have believed it.

Question of the Week: What measures do you use to find value?

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