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Picking Net-Nets: Don't Overfocus on the Balance Sheet
Posted by: Geoff Gannon (IP Logged)
Date: May 8, 2012 05:24PM
Someone who reads my articles asked me this question:
I am a regular reader of your writings and appreciate them immensely. My question is about valuing assets on the balance sheets of net-nets. Do you use the classic old Graham markdowns of 50% for inventory and 25% for receivables or do you customize your valuation more depending on the business (the extreme examples of having only one customer or inventory consisting of CRT TVs). To what extent do you tweak those percentages, if at all? Do you also, like Marty Whitman, go into the non-current assets if you suspect that they are more current than the strict accounting would say or is that a no-no? Would be fantastic to see an article on this subject.
So, first of all there are definitely no no-nos. If you find valuable land, etc., on a net-net you should take note of that fact.
Generally, I prefer that a high proportion of a net-net’s value comes in cash. I don’t like to see a lot of inventory. But, I’m willing to forgive a good business almost anything. Usually, a net-net isn’t a good business. But a terrible business with a lot of cash is not necessarily something I like better than a really good net-net with everything invested in inventory.
Once I know a stock is a net-net, I focus on the past income statements rather than the present balance sheet.
I worry less about net-nets as a liquidation measure than most people do. I think of something being a net-net as just a sign that it is very, very cheap.
I try to transition very quickly from focusing on the balance sheet to focusing on the business when dealing with net-nets. The reason for this is that I know it’s cheap on a balance sheet basis. It’s a net-net.
I don’t want to downplay the importance of analyzing balance sheets beyond what a computer screen can do. But the truth is that a human’s analysis of a balance sheet usually works best outside of net-nets.
Computers can analyze the balance sheets of net-nets just fine. So all you need is a screener.
Once you have a screener, most of your time analyzing net-nets should be spent looking at the business and proving to yourself that it isn’t in danger of going bust.
I spend more time looking at the balance sheet of something like DreamWorks Animation (DWA). For example, here is DWA’s film inventory:
In release, net of amortization: $326 million
Completed, not released: $14 million
In production: $558 million
In development: $30 million
Total: $929 million
There are also notes explaining that $17 million worth of the in release inventory belongs to live performances rather than films (DreamWorks has a musical based on Shrek, a How to Train Your Dragon arena show, etc.).
So that means released films account for around $309 million of DreamWorks’ book value. This is important because DreamWorks’ book value is just under $16 a share and the stock is trading at $17.20 a share as I write this.
In the case of DreamWorks, the way they account for their films and the stock price relative to book value is very important because these film assets account for a lot of DreamWorks’ value.
So a human can do important work by looking at the balance sheet, looking at the notes on film amortization, and then researching DreamWorks past releases and trying to figure out how – if at all – their economic value differs from their book value.
With some other companies, it is easy to see the company owns a lot of valuable assets – but it may not matter to the investment decision the way it does with DreamWorks.
A good example is Copart (CPRT). Copart owns thousands of acres of land around the U.S. Some of it is quite valuable. It’s carried on the balance sheet at $343 million. That number excludes buildings and improvements (which had an original cost of another $384 million).
Some of that land – for example, some of the earliest properties they still own in California – are worth much, much more than they are carried for.
But that fact actually isn’t that important. Why not?
Because Copart earns very high returns on its net tangible assets. We’re talking about probably 20% to 30% returns on tangible investment. You don’t normally earn 20% on land. So, the value of land is not very high outside of Copart’s operations relative to what it is worth inside Copart’s operations.
And, yes, the land is critical to Copart’s operations. They don’t necessarily have to own it – a major competitor leases almost all of its land – but they do have to control it.
Now, if something were ever to happen to Copart’s business where you had a long-term deterioration in the car salvage business that land might become very important to an analysis of Copart.
Let’s assume that tomorrow there is some high tech crash avoidance system. For example, cars are navigated remotely rather than being driven by someone inside the car.
Under those circumstances, Copart’s business would be forever changed. The volume of wrecks would decline. And Copart’s invested assets – like its big salvage yards – would become much less valuable inside Copart’s business.
That means the market value of the land would now be a lot higher relative to the value Copart could get from using the land to store cars. This would change the analysis entirely. And suddenly Copart’s balance sheet would be worth careful analysis.
While this sounds farfetched, it’s actually the kind of thing that happens at net-nets and other stocks that are valuable on a liquidation basis. They start by having assets invested in a business earning a decent return. Over time – sometimes many, many decades – the business stops earning a decent return. But the assets are still there.
Sometimes you have weirder situations. Sometimes the assets were never really earning a decent return.
Take Avalon Holdings (AWX). This is a company that is in two different businesses.
It has a golf course business that is not profitable but has a lot of assets. And then it has a waste management business that is profitable. But doesn’t have a lot of assets.
This is the sort of situation where I would pay a lot of attention to the balance sheet. You aren’t really double counting in a stock like this. The assets are not producing the earnings. They could be separated from the business.
Unfortunately, this is a controlled company. And not a good activist target.
But you will find situations like Gyrodyne (GYRO) and Syms (SYMSQ) where at some point the company’s entire value really depended on its balance sheet.
Obviously when looking at things like real estate you don’t go by what it says on the balance sheet. You try to find a note on depreciation that breaks out land, buildings, etc. And gives information about how the company depreciates its property.
And – of course – you look at the “Properties” item in the 10-K. In the U.S., you then use the information you’ve gathered to check county land records and things like that for more information about the property.
Generally, you want to:
· Find out when the company bought the property
· Locate the property on a map
· Know what the property is used for
· Know what price per square foot / price per acre the property is carried at
· Find the tax information for the property (including what it is appraised at)
· Talk to someone who knows more about the local area than you do
Exactly what kind of investigating you do depends on what kind of property you are looking at. For example, if you’re looking at timberland or commercial property you want to keep in mind the tremendous difference in economic value based on exactly what kind of property you are dealing with.
What can it be used for? And where is it located?
This is a lot of work. And usually you want some hint that you are looking at an interesting asset situation.
What kind of hint are you looking for?
Stocks trading at or below book value – not counting goodwill – are the easiest to understand. Whether we are talking about DreamWorks or Avalon Holdings or Duckwall ALCO (DUCK) or J.W. Mays (MAYS), if a stock is trading around book value your next step is to figure out how book value is calculated.
The reason a company trading below book value is interesting has to do with accounting. In the U.S., you don’t mark up the book value of land and many other potentially valuable assets just because you have evidence – like an appraisal, comparable sale, etc. – that the market value is now higher than your original cost.
So, there will be situations where knowing how a company accounts for its assets and knowing the stock trades for less than book value can help direct you to companies selling for less than they are worth.
DreamWorks is a movie studio. So it is using a rather subjective estimate of the ultimate revenue a movie will produce. It is then amortizing the cost of the movie as revenue comes in to the company in proportion to the percentage of revenue this represents relative to expected total revenue the movie will produce.
For very old movies, it’s actually a little different. And for flops it’s different. DreamWorks can write off flops. And it can’t expect the ultimate revenue for a movie to be higher to the extent such revenue comes more than 10 years after the film’s release.
In other words, DreamWorks has to fully amortize a movie within 10 years and disregard the value an 11-year-old movie might have.
This is explained in a note to the company’s 10-K. It is very important for Ben Graham-type investors to read all these notes carefully – but especially the notes on depreciation and amortization:
Once a film, television special/series or live performance is released, capitalized productions costs are amortized and participations and residual costs are accrued on an individual title basis in the proportion that the revenue during the period for each title (“Current Revenue”) bears to the estimated remaining total revenue to be recognized from all sources for each title (“Ultimate Revenue”). The amount of film and other inventory costs that is amortized each period will depend on the ratio of Current Revenue to Ultimate Revenue for each film, television special/series or live performance for such period. The Company makes certain estimates and judgments of Ultimate Revenue to be recognized for each title based on information received from its distributor or its operating partners, as well as its knowledge of the industry. Ultimate Revenue does not include estimates of revenue that will be earned beyond 10 years of a film’s initial theatrical release date.
Meanwhile, for a stock like Mays, they actually list all the properties operated by the company.
Other than simply finding a stock trading for book value, here is another hint that a company might have a higher liquidation value than you think:
· (Tangible Book Value/Price) * (Accumulated Depreciation/Tangible Book Value) is very high.
This is a big hint. It means the company’s book value is low relative to the original cost of the assets it has on the balance sheet.
Also – and this is more important than you might think – it means the company is more likely to be rapidly depreciating its assets.
There’s a huge difference between old companies with high accumulated depreciation that trade below book value and young companies with very low accumulated depreciation.
Not all book value bargains are equal.
You want to find stocks with:
· Retained earnings
· Accumulated depreciation
· Property bought a long time ago
· Conservative accounting
You want to avoid companies that trade below book value simply because they once raised more money from the public than their stock is now trading for.
Finally, you want some evidence that valuable assets can be separated from the operating business without posing some sort of existential crisis.
Usually, the worst book value bargains to invest in are companies where all of the assets are being put to poor use in the operating business. If there is little prospect of these assets being disgorged, you’re basically betting on the business.
To be fair, a lot of net-nets and book value bargains work out fine precisely because the return on the assets invested in the business rises over time. These are basically stocks you bet on when times are terrible. You then wait for others to exit the industry, for the cycle to enter an upswing, etc.
There is nothing wrong with this.
But it’s very different from finding valuable assets that the business doesn’t need to keep running the operation.
How does this apply to net-nets?
Net-nets are stocks selling for less than their cash, receivables and inventory minus total liabilities.
Cash is surplus capital. It’s not invested. Inventory and receivables are invested. There are many bad businesses that have very little cash and trade as net-nets simply because they have a lot of receivables and inventory and they earn, say, 6% a year on these tangible invested assets.
That’s not so great. If almost all of their tangible invested assets are receivables and inventory, the truth is that such a company perhaps should trade for right around its net current asset value.
But even a company that can sometimes earn 10% on its investment may be an unattractive net-net if it sometimes manages to lose quite a bit of money.
In general, I encourage people to start by focusing on those net-nets that have very few losses in their recent past.
As an example, there are about 100 net-nets today.
About eight of these net-nets have 10 straight years of profits. Those are the ones I’d look at first. Because receivables and inventory invested in a business with 10 straight years of profits – or more – are often being put to better use than they would be in liquidation.
An asset should be appraised according to its best use. So, if you can find receivables and inventory that cover all of your purchase price – and you can find them in a stock that has 10 years or more of profits – you are in pretty good shape.
The problem is that these stocks are illiquid. I don’t know of any net-net in the U.S. that has a market cap over $30 million and ten straight years of profits. Most of the consistently profitable net-nets are in the less than $30 million market cap group.
A huge net-net like Ingram Micro (IM) with nine out of ten years of profits in the last decade is pretty unusual. And Ingram operates on a razor-thin margin. It usually makes about one cent in profit for every dollar of sales.
Ingram is far from an unattractive net-net. Right now, the majority of net-nets are either losing money this year or lost money last year.
I think there are only about 20 net-nets right now with three straight years of profits. So net-nets are usually companies without real earnings.
My advice is to only focus on a net-net’s balance sheet when performing the net-net screen. As soon as you know something is a net-net, pivot away from a balance sheet analysis and toward a business analysis.
I know this sounds counter intuitive. But it works just fine.
If you just collected the top 5 net-nets with the longest streak of positive earnings each year, you’d be pretty happy by the fourth year when you’d collected 20 of these things.
And more importantly – you’d have fewer total catastrophes. Especially in the long term. I always encourage people to think of net-net investing as being a bit longer term than they expect – more like two to four years than two to four months.
Well, if you focus on net-nets with a streak of positive earnings you are more likely to end up with a basket of net-nets that you can afford to hold for longer. Some of these stocks can underperform badly for a year (or two).
But, honestly, you will have more success investing in net-nets – and you’ll probably stick with net-net investing longer – if you start with the idea that you are trying to find the five or so highest quality net-nets you can find (each year) by analyzing the business rather than the balance sheet. By focusing on the income statement. And especially by looking at the long-term record.
One final point, I mention picking the best net-nets each year more as an illustration than as a guide as to what will work at all times. It won’t. In a really bad bear market, there will actually be dozens of decent net-nets.
And in a really frothy stock market even the five or so best net-nets in terms of past record will only have a few consecutive years of profits.
If you read GuruFocus’ Ben Graham: Net-Net Newsletter – you’ve already seen most of the net-nets with long records of profitability. They are my favorite kind to pick.
So, while it’s important to pay attention to the balance sheet – you don’t gain a lot by focusing on something you already know. Don’t worry too much about how cheap a net-net is.
By definition, a net-net is cheap. So focus on how good it is.
It’s often better to try to find the highest quality super cheap stock than to worry about finding the absolute cheapest stock.
This is kind of like my example of how finding a stock with:
· An above average dividend yield AND
· A below average price-to-book ratio AND
· A below average price-to-earnings ratio
Is probably better than finding the stock with the absolute highest dividend yield or the absolute lowest price-to-book ratio or the absolute lowest price-to-earnings ratio.
A stock that is better than average on all three criteria may actually be just as good – or better – than a stock that scores the best on one criteria but fails on the others.
You know a stock you find through a net-net screen is cheap. So I try to focus on safety and quality rather than spending any more time on the balance sheet.
Honestly, there is much less discussion of the balance sheet in the Ben Graham: Net-Net Newsletter than you’d expect.
Check out the Ben Graham: Net-Net Newsletter
Stocks Discussed: DWA, CPRT, AWX, GYRO, DUCK, MAYS, IM,
Re Picking Net-Nets Don t Overfocus on the Balance Sheet
Posted by: Munger200 (IP Logged)
Date: May 13, 2012 10:03AM
Instead of investing in net net's I think it's better to be purchasing stock in excellent businesses at good/reasonable prices.
Stocks Discussed: DWA, CPRT, AWX, GYRO, DUCK, MAYS, IM,