"Most look at earnings and earnings potential. Well I can't get into that game" — Walter Schloss
If Walter Schloss did not focus on earnings or attempt to assess the earnings power value (EPV) of a business, what methodology did he use to ascertain the underlying value of a company? Mr. Schloss focused on the assets of a business to estimate the intrinsic value of a company. More specifically, Schloss sought out companies which were trading at substantial discounts to their tangible book value, a figure he considered much less susceptible to rapid change than the earnings of a company.
As Schloss proved, a patient investor can expect to dramatically outperform the average returns of the S&P by focusing upon the value of the assets which a company possesses. Of course that statement assumes that the balance sheet investor must also be able to discern whether the company is a viable ongoing concern. Certainly Mr. Schloss was also adept at selecting businesses which would be able to survive.
Bruce Greenwald points out that an investor must apply two different sets of criteria when evaluating the intrinsic value of a company's assets. The first valuation is a liquidation figure which is appropriate for estimating the intrinsic value of a business which has no viable future. The second is a replacement cost figure which is appropriate for valuing a business which is likely to survive.
The subject of today's article is a discussion of the methods involved in establishing the intrinsic asset value of a stock using liquidation value. I will conclude the discussion with a deep "value" purchase I made over a decade ago. The investment was largely based upon a perceived forced sale due to the liquidity issues of the company.
Dying Companies and Liquidation Value
Establishing liquidation value for stock is generally applicable when an investor is assessing whether a business exists in a dying economic sector is a potential buying opportunity. It should be noted that the investor is not likely to reap any gains from such a purchase unless the assets of the company are fully or at least partially liquidated and redistributed to shareholders. In such a case, accurately assessing whether the management is likely to act in the best interests of its shareholders is paramount. See the later section on Fairchild, for a discussion of a partial liquidation which resulted in no redistribution to the shareholders
The reason that companies in dying industries need to be priced at liquidation value rather than replacement value is based upon the assumption that no sensible entrepreneur would be interested in recreating or assimilating assets in such a sector. It is a lesson that Warren Buffett learned the hard way when he purchased the Berkshire Mills at a large discount to their tangible assets.
At the time that Buffett purchased Berkshire Hathaway (BRK.A)(BRK.B), the U.S. textile industry was in secular decline. U.S. manufacturers were unable to compete against overseas competitors who enjoyed an extensive competitive advantage in the form of cheap labor. The writing was on the wall; however, Buffett overlooked that inevitability when he purchased the Berkshire Hathaway business. Instead he focused upon the outstanding management which Berkshire possessed and relied upon an overstated intrinsic value which he calculated based upon the tangible assets which the company held.
Had Buffett calculated the liquidation value of Berkshire Hathaway, assuming that the business held little in the way of future cash flows, his estimation of intrinsic value would have been much lower. Buffett has stated on numerous occasions that buying Berkshire Hathaway was his worst investment and the experience prompted his famous quote: "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact."
Assessing reasonably accurate figures for liquidation value is frequently problematic, particularly when it comes to evaluating the fixed assets of a business. For example, how would one go about assessing the liquidation value of the Berkshire Mills buildings, land, plants and equipment? Such analysis is extremely complicated and relies upon intimate knowledge such as the value of the property location as well as the suitability of the property to adapt to an alternative industry.
For the purposes of this brief article I am going to suggest that investors focus upon current assets alone if they are interested in pursuing a liquidation play. It is a process which was advocated by Benjamin Graham when he asked the question of whether a business was worth more dead than alive during the early 1930s.
Graham suggested that the net current assets of a stock (current assets less total liabilities) roughly approximated the liquidation value of most businesses. Obviously only cash and certain short-term investments would be fully recoverable; however, Graham felt that the shortfall would generally be covered by the sale of a company's fixed assets.
Greenwald rightfully points out the hierarchy of current assets in terms of their liquidation value. Noting that cash and investments are generally the best current asset and should be figured at 100%, while accounts receivable are the next best and inventory is generally the least valuable.
It is common for investors to assign around an 85% value on accounts receivable and a 50% value for total inventory. Of course as Greenwald notes the quality of accounts receivable varies and the recovery price of finished inventory versus raw inventory can be directly a function of a particular business. In reality, some inventory such as raw commodities might be worth in excess of cost which was listed on the books, while finished goods such as outdated shirts could be virtually worthless.
Clearly, investors should put much more credence in liquidation plays which have significant cash or cash equivalents listed in their current assets. Secondly they should check the reserves for accounts receivable as well as examining their average age. Lastly, an investor should put considerably more stock in companies which have high levels of raw materials in their inventories and they should always check to see if the inventory is valued at LIFO or FIFO. FIFO inventory prices are much more accurate in assessing the value of raw inventory, particularly in businesses which utilize volatile commodities such as copper or sugar in their manufacturing process.
The main problem with investing in liquidation plays in dying industries is twofold:
1) How long will the liquidation take to unfold and how much value will be left by the time the sale is completed?
2) Will management redistribute the capital created by the liquidation of assets in the dying sector or decide to utilize the capital to reinvent the company?
Case Study: Fairchild
Sometimes an asset play can take on the characteristics of a replacement value play as well as the characteristics of a liquidation play. On occasion, certain companies sell assets to provide sufficient capital for the firm to avoid bankruptcy without selling the company outright. In such cases the company sells some but not all of its assets in order to survive as a ongoing entity. If shareholders ultimately receive their piece of the sale as they would in a standard buyout, they are likely to profit handsomely. On the other hand, if management fails to promptly redistribute the excess capital to shareholders then investors are generally better served to exit the stock abruptly.
Take the case of the now-bankrupt aviation parts company Fairchild, former ticker symbol (FA). Fairchild was a stock which caught my eye over a decade ago when I was paying attention to stocks with extremely low price to book ratios which were owned by Mario Gabelli.
Fairchild had two principle assets in the form of an aircraft fasteners business and a Long Island mall which was almost fully rented, cash flow positive, and possessed an understated value on the company's balance sheet. The company was being encumbered by its extremely high debt burden and a temporary slow down in the aircraft cycle precipitated by 9-11. The company's interest coverage was becoming a major concern although its assets were extremely understated by any elementary liquidation or replacement value assessment.
By the fiscal year end in June 1, 2002, Fairchild was selling for slightly over two dollars a share but still had over nine dollars a share in book value. The problem was that the company was carrying over $400 million in debt which represented nearly twice its equity.
Fairchild was 27% owned by its highly overpaid chairman and CEO Jeffrey Steiner, who had raised the ire of Gabelli in regard to his excessive compensation. In 2001 Steiner was paid $2.8 million (excluding stock options) compensation which was less than the $5.7 million he earned the previous year and the $13.2 million in fiscal 1999. http://www.nytimes.com/2001/11/06/business/fairchild-shareholder-fights-pay-plan.html?ref=fairchildcorporation
I had begun buying Fairchild in 2001 and as the year wore on and the stock continued to drop, I noticed that an aging director had purchased a large block of stock well over the market price, at least according to insider purchases section of Yahoo Finance. The large insider purchase coupled with the rapidly increasing discount to book value convinced me to buy a much larger stake in Fairchild. I simply did not believe that Steiner would allow his compensation and his 27% stake in Fairchild to evaporate via bankruptcy. Bear in mind that Mr. Steiner was once compared to Carl Icahn in an article by the New York Times. http://www.nytimes.com/1989/05/21/business/globe-trotting-takeover-artist-jeffrey-j-steiner-transforming-nuts-bolts-into.html?pagewanted=all&src=pm
In retrospect I now realize that I had purchased an excessive amount of Fairchild stock based largely upon speculation that Mr. Steiner would concoct a profitable deal before the company become insolvent. The purchases were based more upon Steiner's past reputation than tangible fact but sometimes "the blind hog finds his acorn."
In the midsummer of 2002 one morning shortly after I awoke, I turned on CNBC. Scrolling across the bottom of the screen was the announcement that Alcoa was going to buy Fairchild's fastener division in an all cash deal which amounted to $657 million. http://www.nytimes.com/2002/07/18/business/company-news-alcoa-paying-657-million-for-fairchild-unit.html?ref=fairchildcorporation The deal also provided for large yearly bonus payments to Fairchild, based upon fastener sales in subsequent years.
The price of FA was scrolling across the bottom of CNBC at over six dollars a share on a stock that could have purchased the prior day for slightly over two dollars a share; still that price seemed hardly enough considering the magnitude of the deal.
You see prior to the sale of the fasteners division to Alcoa, FA had roughly $435 million in debt and just slightly over 25 million shares outstanding. I surmised that the company could pay down the entire debt load and still have nearly nine dollars in distributable cash. Additionally, the company would still own the Farmingdale shopping mall (which later sold for 95 million in 2006) and collect the residual checks from Alcoa (AA) which would run into tens of millions of dollars. If the rest of the business was worthless, I assumed the company was still worth in excess of the nine dollars in cash per share which would result from the Alcoa purchase.
To make a long story short, the market was correct and I would have been much better served to immediately sell my entire position at well over six dollars per share when the news broke. It dawned on me a few days later that shareholders were never going to get paid and I sold out my entire position in the mid-five dollar per share range. Subsequently the price dropped steadily, month after month, year after year until its ultimate bankruptcy and Steiner's death in 2008.
Steiner and Fairchild were later sued by the shareholders and eventually offered a pittance of a dollar or two a share to take the company private shortly before Steiner's death. Of course they wanted more and the bankruptcy eventually sealed their fate.
I should have felt lucky I sold my entire lot of shares at a tidy profit so many years earlier. After all, it resulted in my largest capital gain to that point in my investing career. However, that point was lost on the fact that I felt so short-changed for uncovering such an under-priced value.
It never dawned on me until years later that profits to be made in common stocks are largely dependent upon the goodwill of management and their board of directors. I also determined that I did not wish to invest in companies where the chairman was also the CEO, particularly if he drew exorbitant compensation.
If a greedy management team puts their interests above that of the shareholders and refuses to redistribute capital fairly, then its does not matter whether the intrinsic value of the stock is 1 dollar or 100 dollars. If one foolishly enters into such a situation, all that matters is the current price of the stock, and one had better sell shortly after any good news appears. At least I got that part correct.
Unwittingly, I had benefited by becoming a successful speculator, although my idea was cloaked purely in asset-based value theory. At least I was not alone: Mario Gabelli also misjudged the situation and he hung on to his stock much longer than I did.
"Most look at earnings and earnings potential. Well I can't get into that game" — Walter Schloss