Value investors can deploy different strategies in choosing stocks to invest in. While some focus mainly on balance sheet for asset protection, others concentrate on the future potential growth and earnings power of a particular business for big long-term returns.
Net-Net Plays Have Been Working Well
Benjamin Graham, the father of value investing, focused his methods mainly on book value. He has the strategy called “net-net” investing. A stock is considered a “net-net” when it is trading below the net liquidation value, roughly calculated by current assets minus total liabilities. With this method, Ben Graham cared solely about the strength of the balance sheet. He still made money if the company went bankrupt. However, the company, which is classified a net-net, often has unprofitable operations. Thus, Benjamin Graham advised us to diversify by investing in around 30 stocks. Walter Schloss, a student of Benjamin Graham has strictly followed the balance sheet value investing method with incredible success. He has returned around 21% per year for 47 years, just by investing in cheap stocks with significant asset protection. He commented that by focusing on asset protection, we had three things in our favor: (1) earnings might turn around which drive stock up significantly, (2) someone would come in and acquire the whole company, and (3) the company began to repurchase its own stock.
The Shift from Net-Nets to Great Businesses
The most successful investor of all time, Warren Buffett (Trades, Portfolio), started out also by focusing on asset protection, buying cheap but ugly stocks. However, with the significant influence of his long-time friend Charlie Munger (Trades, Portfolio), Warren Buffett (Trades, Portfolio) has gradually shifted to much better businesses. He said: “It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price.”
Gradually, he recognized the difference between the book value and the fair value of the company, agreeing to pay much higher price for great businesses. For him, book value was only an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings, while intrinsic value was an economic concept, estimating future cash flow discounted to the present value. Book value is what has been put in, whereas business value is what could be taken out from the business.
In the 1987 Berkshire Hathaway (BRK.A)(BRK.B) letter to shareholders, he explained that a corporation’s book value and business value were nearly unrelated in many cases. He gave out two examples of LTV and Baldwin-United. LTV and Balwin-United had two audited book value of $652 million and $397 million, respectively, before they went bankrupt. In contrast, Belridge Oil, with only $177 million in book value, were acquired by Shell in 1979 for as much as $3.6 billion. Warren Buffett (Trades, Portfolio) purchased one of its most favorite stocks, Coca-Cola (NYSE:KO), in 1988 at as much as 14.5x P/E and 4.8x P/B. Recently, he poured more than $10 billion to purchase IBM shares, valued at more than 9x its book value.
Indeed, what Warren Buffett (Trades, Portfolio) focuses on is the potential earnings power of any corporations. Actually, Benjamin Graham also recognized the importance of business earnings power. He mentioned that the book value or liquidating value only plays a meaningful role in valuing financial corporations such as banks and insurance companies. He wrote: “In the great majority of instances the attractiveness or the success of an investment will be found to depend on the earning power behind it.”
In conclusion, the balance sheet is the starting point for investors to select safe and sound stocks. However, what really counts is the earnings power of any business. Investors should balance between the facts of the past and the possibilities of the future regarding earnings capacity of a company to determine the attractiveness of a certain common stock.
Disclosure: Long IBM