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More on Liquidating Value from Benjamin Graham
Posted by: Grass Hopper (IP Logged)
Date: October 31, 2013 04:57PM
An earlier article that I wrote focused on what liquidation value is, and how to calculate it. This article will discuss some additional thoughts from Benjamin Graham on liquidating value.
Below (in italics) is an excerpt from the 1940 Second Edition of Security Analysis by Benjamin Graham and David Dodd. This excerpt addresses whether or not it makes sense to have common stocks selling below liquidation value, the attractiveness of common stocks in this category, how to discriminate between this category of common stocks, and how general market conditions may affect your decision to invest in stocks selling below liquidation value.
Logical Significance of This Phenomenon. – …When a common stock sells persistently below its liquidating value, then either the price is too low or the company should be liquidated…. The truth of the principle above stated should be self-evident. There can be no sound economic reason for a stock’s selling continuously below its liquidation value. If the company is not worth more as a going concern than in liquidation, it should be liquidated. If it is worth more as a going concern, then the stock should sell for more than its liquidating value. Hence, on either premise, a price below liquidating value is unjustifiable.
Attractiveness of Such Issues As Commitments
Common stocks in this category practically always have an unsatisfactory trend of earnings. If the profits had been increasing steadily, it is obvious that the shares would not sell at so low a price. The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid. It may not be denied that this does actually happen in individual cases. On the other hand, there is a much wider range of potential developments which may result in establishing a higher market price. These include the following:
1. The creation of an earning power commensurate with the company’s assets. This may result from:
a. General improvement in the industry
b. Favorable change in the company’s operating policies, with or without a change in management. These changes include more efficient methods, new products, abandonment of unprofitable lines, etc.
2. A sale or merger, because some other concern is able to utilize the resources to better advantage and hence can pay at least liquidating value for the assets.
3. Complete or partial liquidation.
Discrimination Required in Selecting Such Issues. – There is scarcely any doubt that common stocks selling well below liquidating value represent on the whole a class of undervalued securities. They have declined in price more severely than the actual conditions justify. This must mean that on the whole these stocks afford profitable opportunities for purchase. Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category. He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above. Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past. The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so.
Bargains of This Type. – Common stocks that (1) are selling below their liquid-asset value, (2) are apparently in no danger of dissipating these assets, and (3) have formerly shown a large earning power on the market price, may be said truthfully to constitute a class of investment bargains. They are indubitably worth considerably more than they are selling for, and there is a reasonably good chance that this greater worth will sooner or later reflect itself in the market price. At their low price these bargain stocks actually enjoy a high degree of safety, meaning by safety a relatively small risk of loss of principal.
It may be pointed out, however, that investment in such bargain issues needs to be carried on with some regard to general market conditions at the time. Strangely enough, this is a type of operation that fares best, relatively speaking, when price levels are neither extremely high nor extremely low. The purchase of “cheap stocks” when the market as a whole seems much higher than it should be, e.g., in 1929 or early 1937, will not work out well, because the ensuing decline is likely to bear almost as severely on these neglected or unappreciated issues as on the general list. On the other hand, when all stocks are very cheap – as in 1932 – there would seem to be fully as much reason to buy undervalued leading issues as to pick out less popular stocks, even though these may be selling at even lower prices by comparison.
From the above excerpt, we learn that a stock selling below liquidating value makes no sense. Either a company is worth more as a going concern than in liquidation (and thus should not be liquidated), or a company is worth more in liquidation than as a going concern (and thus should be liquidated). Either way, a company should sell for at least liquidation value. Thus, liquidation value should put a floor under a stock.
The next thing we learn is that stocks selling below liquidation value can be attractive investment opportunities. Since they are already priced for Armageddon, anything even remotely positive that happens can lead to a higher market price. Benjamin Graham provides just a few examples of positive developments that could lead to a higher price (e.g., higher earnings power due to a number of improvements, a sale/merger, or actual liquidation).
Mr. Graham cautions the reader that, even with stocks selling below liquidation value, discrimination is required. He suggests purchasing stocks that have a positive catalyst on the horizon, or good current earnings/dividends or a satisfactory earnings history. Importantly, an investor should avoid situations in which a company is rapidly losing current (i.e., liquid) assets – as this erodes liquidation value and margin of safety.
One last interesting insight that Benjamin Graham makes is that an investor needs to keep the general level of the market in mind when deciding whether or not to purchases these “bargain issues.” He explains that purchasing these bargain stocks works best when the market is neither too high nor too low (kind of like Goldilocks preferring the porridge that was “just right”). This is an interesting insight because most value investors carry on their operations without locking at the macro picture or general market levels. The refrain goes that we should be looking at companies one-by-one and forget about the general economic picture or stock market as a whole. Mr. Graham’s experience must indicate that market levels do matter when purchasing a diversified group of these bargain issues – so, we would be wise to heed his counsel.
By understanding additional key aspects of liquidation value, hopefully, we will improve our results in this area of investment (if we choose to pursue it).
Stocks Discussed: SPY, DJI, QQQ,