I have recently been interested in some companies in the oil sector. To reach a better understanding on the dynamics and to get a good idea on how to value a distressed sector, I went back to "Security Analysis," the famous work by Graham and Dodd, which is considered by many the Bible of value investing.
I found a few extremely important comments regarding liquidating value, which I will comment upon:
"When a common stock sells persistently below its liquidating value, then either the price is too low or the company should be liquidated. Two corollaries may be deduced from this principle: Corollary I. Such a price should impel the stockholders to raise the question whether or not it is in their interest to continue the business. Corollary II. Such a price should impel the management to take all the proper steps to correct the obvious disparity between market quotation and intrinsic value, including a reconsideration of its own policies and a frank justification to the stockholders of its decision to continue the business."
"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."
Here is what many investors including Graham found attractive in these securities. Is there really a reason for companies to trade below liquidating value? As Graham mentions, there is no reason -- either the company should stop given the lack of results and then reach more value at the distribution, or it should get on the right track by making the right decisions and keep on a going concern basis, trading above liquidating value.
"There is a much wider range of potential results that may result in establishing a higher market price. 1) The creation of an earning power commensurate with the company's assets, resulting from a) General improvement in the industry or b) Favorable change in the company's operating policies. 2) A sale or merger and 3) Complete or partial liquidation."
"A company's balance sheet does not convey exact information as to its value in liquidation, but it does supply clues or hints that may prove useful. The first rule in calculating liquidating value is that the liabilities are real but the value of the assets must be questioned. This means that all true liabilities shown on the books must be deducted at their face amount. The value ascribed to the assets, however, will vary according to their character."
Now, what could be the catalysts? As Graham mentions, there are generally three ways in which the management can unlock the hidden value of the assets. In particular, I believe that the oil industry should benefit from the first one, which is the general improvement of the industry. Then we find a sale or merger, in which the buyer pays a premium over liquidating value and then, lastly, liquidation enters the scene.
"Security Analysis" provides several examples on how to adjust a balance sheet in order to get an estimate or range of values. These prove very useful and even though there is no specific method, the main guideline is that liabilities go at full value, while assets are adjusted using a range of discounts depending their particular nature.
I am applying this method to one specific security, Atwood Oceanics (ATW, Financial). After reviewing their business and statements, I think it is fair to say that its assets provide a nice margin of safety at current prices. Certainly, Graham and Dodd's work has been of great help in providing the guidelines on analyzing these (and nearly all) types of securities.
