one big thing.” Archilochus (7th century BC)
Over the centuries, many have dwelled upon this observation on foxes and hedgehogs by the Greek poet, Archilochus. As he didn’t write much more on the subject, we can only infer his meaning. The fox, blessed with cleverness, knows a thousand ways to stalk his prey. Yet, somehow, the much duller hedgehog survives in abundance. Disadvantaged in a battle of wits, a hedgehog knows one big thing – no fox wants a mouthful of quills.
The field of investing is populated by a variety of hedgehogs and foxes. The foxes know all about next quarter’s earnings projections, about product trends and developments, and they know who is buying or selling which company, and why. The hedgehogs of investing, while they generally perform due diligence of some sort, tend to rely on one basic insight – investments acquired at low prices tend to result in superior returns.
The life of the investing hedgehog, also known as a value investor, sounds simple. But there is a catch. What constitutes a low price? This is a critical question.
In recent times, identifying a low priced business has meant finding a stable or growing company which is priced to offer a relatively high current earnings yield. As a screen, one would start with something simple like P/E ratios or EV/EBITDA and inspect good candidates in greater detail. The deep value player may have sought out companies with temporarily depressed earnings resulting from a transitory crisis, but in effect he was looking for the same thing.
From the market depths of 1982 until the heights of 2007, such high yielding investments generally benefited from a triple play. The low-rated business, if carefully selected, got marked up on par with other comparable companies. At the same time earnings tended to be higher than expected due to a buoyant economy. And, as a bonus, the markets got used to the good news and continued to expand trading multiples.
Some things have changed of late. I would argue that the most interesting days for yield investing may be behind us, possibly for several years. Perhaps more interesting to the contemporary hedgehog investor are business assets that trade substantially below cost. Book value is a useful flag in this regard, but the best simple identifier may well be the little used metric Enterprise Value-to-Assets.
One of the most important reasons to start screening on assets, is that earnings just aren’t what they used to be. In the long run, every cost may be variable, but most businesses today are somewhat behind the curve. Revenue is coming in below expectations while costs such as debt-service, rent and salaries are showing themselves to be rather stubbornly fixed. If we are in a deep protracted recession, similar to what Japan experienced in the wake of its 1989-90 bubble burst, then we may find ourselves continually disappointed by earnings. Assets, on the other hand, tend to be more enduring. And while cash burn can whittle down even our estimate of value on the margin, assets are generally a more stable basis on which to anchor an understanding of corporate worth.
The second reason to look at assets is because, frankly, the crowd around the businesses which are still generating solid cash flows appears a little too big and much too enthusiastic. Consumer staples players like Wal-Mart, McDonald’s and Shoppers Drug Mart have continued in profitability through the downturn and remain trading in line with recent normal multiples of 13-17X earnings. There are no “Sell” reports written on Wal-Mart. However, measured by assets, the go-to consumer names look a little expensive. EV/Assets for these companies is in the range of 1.5 to 3.0X.
Just as a point of comparison, in my May 11 post, one of the highlighted companies was Cray Computer, whose claim to fame is making the fastest computer in the world. Cray has some issues, not the least of which has been a lack of steady profits. However, in early May, Cray was trading at 0.15X EV/Assets. Capital invested in Wal-Mart assets might throw off higher returns, but 10X higher? I wonder.
EV/Assets is also a more inclusive way of looking at investing in a company from a capital structure point of view. By adding debt to market cap and netting out cash, we are really using the market value of the company’s capital as our numerator. Levered or unlevered, are the assets priced below replacement cost? If bankruptcy looks to be a high possibility and we are afraid to hold the equity, we at least have a measure that addresses the value of the total capital structure and helps us think about whether buying the debt at face value is an attractive proposition.
Like any ratio, EV/Assets is not perfect. For one thing, it would be handier if we were able to add the market-priced debt to market priced equity. (Mr.Bloomberg, please do something about this!) Asset value also needs some serious qualifying. Intangible assets have a nasty habit of evaporating, while fixed assets can turn out to be stranded worse than a beached whale at low tide. Deficiencies acknowledged, but this ratio may be the best measure of price available to us in today’s market.
Every Hedgehog’s Dream
As a final, but not unimportant consideration, EV/Assets may be of some use to investors in times of extraordinary inflation. I’m not really talking about 9% inflation here, but more in the order of the big numbers that we have seen before in Argentina, Mexico, Russia and Germany at various times, that were the result of systemic financial stress. In these crisis moments, profits could just disappear across the board and asset ratios will be our best guide.
Now, despite all the hyperbole about government debt of late, I doubt that we will see hyper-inflation in the G-7 soon. This recession just hasn’t been as deep as the recessions preceding those other crises were. Even if it does happen, I expect that owning precious metals might prove to be a better holding going into such a crisis than any stock or bond. However, from the climax of such a crisis, and we will be very aware of the climax should it arrive, EV/Assets might just be a very useful number to be on top of. Good businesses going begging at pennies on inflation-adjusted assets? Every hedgehog’s dream might one day arrive. There’s no harm in being mentally prepared.