"Avoiding where others go wrong is an important step in achieving investment success. In fact, it almost assures it."~ Seth Klarman (Trades, Portfolio)
Readers of my investment articles are well aware of my affinity for investing in businesses which trade at attractive discounts to their tangible book value (or in some cases a discount to hidden book values). Currently, such entities are almost as difficult to locate as a volunteer fry cook at a nudist colony. That said, at some point in the future, the market will correct and a litany of price to book values discounts will once again present themselves to the investing community. Most of these potential bargains will exhibit diminishing earnings yields in the form of a declining price to earnings ratio. At this point the trick will be for investors is to discern whether the equities are in terminal decline or whether their earnings yields and future cash flows will once again return to their former levels.
Most value investors subscribe to the notion that a stock is worth the value of its future cash flows--thank you Mr. Graham for that undeniable edict. So why would a value investor decide to focus upon the net worth of a business rather than upon the earnings power of the company. First of all, the net assets of a business are less susceptible to variation--as Walter Schloss pointed out--and secondly, the tangible assets of most businesses are instrumental in the generation of earnings. The latter notion is frequently lost upon investors who have been programmed to primarily focus upon earnings. After all, what good are a set of assets that do not result in significant earnings or cash flows? What good is owning a garage if it full of hula-hoops or a bar that serves very few customers?
The answer lies in the reality that most businesses are cyclical in nature and most investors fail to realize that basic fact of economics. Moreover, many investors fail to comprehend the notion that a company which owns a set of lightly depreciated assets is typically worth far more than a similar business which possesses a set of assets which are almost fully depreciated, particularly if the business with the worn out assets is trading at a substantially lower price to earnings multiple. Such investors disregard the reality that capital-intensive businesses have cycles of their own in terms of how much cash that they will generate in the future, since free cash flow cycles are largely a result of the quality of the tangible assets which they possess. The reason being is that impending maintenance capital expenditures will temporarily hamper future free cash flow. The notion is counter intuitive to most investors; however it is seldom lost among the company’s competitors who sometimes launch buy-out offers when the price to book value discount of a company becomes too steep.
Let me take this discussion of the importance of the balance sheet one step farther: current assets are an essential component of the liquidity of most businesses. The goal of a prospering business should be to fund its operations (and growth if it exits) from its cash flow from operations. Such entities have a built in margin of safety. Businesses with little equity and low current assets in relationship to current liabilities, often find themselves reliant upon short-term borrowing to fund day to day operations. In that regard, businesses with high price to book ratios (and/or low current ratios) are much riskier than businesses which trade at sizable price to book value discounts. Further, leverage which supports liquidity (short term borrowing) is particularly risky during periods of economic slowdowns. That observation applies in spades for financial institutions during such periods. The practice of borrowing short and lending long was one of fundamental conditions which led to financial crisis of 2008 and 2009 but that is a story for another day.
Of course Benjamin Graham recognized the importance of liquidity in businesses in establishing a margin of safety. Graham recommended that investors only purchase stocks which held current ratios (current assets divided by current liabilities) of at least two. Investors who choose to purchase equities which possess low current ratios had better be certain that the inventories of such businesses turnover rapidly and consistently and that accounts receivables are collected on a timely basis. The higher the current ratio (particularly if the current assets include a high percentage of cash), the greater the margin of safety for the business.
One final point, businesses which require revolvers to supplement day to day operations need to have assets as well as EBITDA to meet the covenants of the loan. Businesses with low price to book ratios typically have a better chance of securing favorable financing than high price to book businesses so long as they display sufficient EBITDA. Further, capital-intensive businesses generate higher depreciation expenses which are deducted from the EBITDA formula. On the down side, such companies find it significantly more difficult to grow earnings than businesses with low capital requirements, another reason for insisting on low price to book ratios when purchasing companies which require significant tangible assets to generate earnings.
Allow me to illustrate the aforementioned points by comparing the abbreviated balance sheets of two hypothetical businesses. Let’s say these companies are remodelling businesses, an industry which holds notoriously low barriers to entry and is highly cyclical in nature.
Lets say Company A is up for sale at 100,000 dollars and has averaged 50,000 dollars in pretax earnings for the last ten years. Suppose Company B is asking the same sale price but has only generated an average of 25,000 dollars in pretax profits in the trailing ten years. If these two businesses traded on a public exchange most investors would undoubtably prefer the former company without regard to the value of the assets Company B, since the pretax earnings yield in substantially higher for Company A. But is Company A really the better choice?
| Company A |
| Current Assets Cash =$5,000 Total Current Assets=25,000 |
| Long Term Assets Goodwill=50,000 + 20,000=70,000 |
| Current Liabilities 20,000 |
| Long Term Liabilities 0 |
| Total Equity 50,000 |
| Tangible Equity 0 |
| Company B |
| Current Assets Cash=20,000 Total CurrentAssets=60,000 |
| Long Term Assets Tangible=150,000 |
| Current Liabilities 10,000 |
| Long Term Liabilities 0 |
| Total Equity 200,000 |
| Tangible Equity 200,000 |
An examination of the balance sheets of the two mythical companies provides some clarity:
-Neither business carries any long term debt and holds long term assets. Company A carries $20,000 on the balance sheet for Plant and Equipment which has been 90% depreciated. Company B shows 150,000 for Plant and Equipment of which 10% is depreciated (the depreciation percentage is not included in the abbreviated balance sheet).
-Company A was purchased at some point and carries 50,000 of goodwill on the balance sheet. It shows total equity $50,000 on its balance sheet.
-Company B has equity of $200,000 all of which is tangible.
-Company A has $25,000 of current assets and $20,000 of current liabilities, reflecting a current ratio of 1.25.
-Company B has $60,000 of current assets and $10,000 of current liabilities, reflecting a current ratio of 6.00.
-Company A has a price to book value of 2x but it has zero tangible book value.
-Company B has a tangible price to book value of .5x.
When quizzed about the superior profitability, the owner of Company A proclaims: 1) They generate high margins due to the employment of skilled salesman which they train themselves 2) They excel at lead generation, and 3) They travel farther to do business which eliminates competition.
Company B generates greater sales but has a significantly lower operating margin; although the EBITDA margins for Company B are not nearly as lopsided since the business records much higher depreciation expense. These depreciation expenses include: newer trucks, more extensive ownership of equipment (Company A rents much of its equipment), and a much larger warehouse which holds a significant amount of frequently used inventory.
A review of the 10-year financial records of the two businesses reveals that earnings fluctuate significantly and both companies had two years when they recorded negative earnings.
The advantages of purchasing Company B appear to be immense in terms of its net assets, yet the overall earnings history of Company A belies that assumption. Moreover, the return on equity would seem to indicate that Company A is much more efficient at producing profits.
In reality, the higher profits and returns of Company A are being achieved by the assumption of risk which is not apparent to the casual observer. First of all, the business could quickly encounter a liquidity crisis should it sales suddenly weaken, if the company would encounter a production delay or if some of its customers were slow in paying their bills.
Further, the business is operating with minimal assets which make it susceptible to increased rental prices for equipment, commodity inflation since it stocks no inventory, as well as significant replacement and repair charges as its nearly worn out equipment begins to break down. Since both businesses operate in a highly cyclical environment the risk is magnified. The risk is further exacerbated by the fact that neither business possesses a durable competitive advantage in an industry which holds few barriers to entry.
Taking everything into consideration, Company B represents a much superior purchase with a significant margin of safety, while Company A represents a high risk proposition even though it shows a vastly superior 10-year earnings history in addition to a much higher ROE.
In the real world, Company B would never be offered for 100,000 dollars but Company A might. However, in the world of stocks similar companies are offered for sale on a routine basis. The only difference is that investors are offered small pieces of the business in the form of shares rather the option of purchasing the entire company.
In my judgement the vast majority of investors would opt for Company A based upon its superior earnings metrics and superior ROE. In reality those investors would be making an extremely risky investment which would likely result in a significant loss of capital as the business price dropped to a level which more closely resembled the replacement value of its assets.. On the other hand, Company B would likely appreciate to a value much closer to the replacement value of its assets. If that level was not achieved, a knowledgeable competitor would likely take advantage of the discount and make a buyout offer on the company. Of course one must first ascertain that the industry in which the business exists will remain viable going forward.
That in a nutshell is why Walter Schloss averaged 20% compound annual returns by focusing on price to book discounts and waiting them out. He simply chose the contrarian play with the greater asset value. In doing so he minimized his losses and let the upside take care of itself.
