All value investors are familiar with the fact that stocks that trade at discounts to their net current assets tend to outperform the market. However, companies have substantial leeway when it comes to creating their financial statements, which can make it difficult for investors scanning financial statement data to identify stocks trading at such discounts.
For example, consider L.S. Starrett (SCX, Financial), manufacturer of a range of industrial and consumer products. The company trades for $60 million, and also shows net current assets of $60 million. From this standpoint, the company does appear cheap, but without further information it does not meet the requirement of having a large margin of safety.
However, careful reading of the company's notes to its financial statements reveals that it accounts for some of its inventory using LIFO accounting (FIFO, on the other hand, is used by the vast majority of companies). As a result, inventory is understated (compared to FIFO) by over $30 million! This is no rounding error, as $30 million is half of this company's market cap!
FIFO accounting likely more accurately reflects the actual value of inventory, and is therefore probably the more useful measure for investors looking to value companies by their balance sheets. LIFO accounting tends to make accounting profits lower in comparison to FIFO accounting, and is therefore employed by companies to reduce the amount of taxes owing.
After making this adjustment, L.S. Starrett goes from being just another cheap company, to a net current asset stock! Unfortunately, a quick scan of the company's financial statements would reveal none of this, requiring the investor to dig deep to uncover this situation.
By the way, L.S. Starrett is far from the only stock in such a situation. A few months ago, we saw that A.M. Castle (CAS) also had these properties, and as such could have been had at a significant discount to its net current assets. The stock subsequently appreciated in price and now sits on the Value In Action page.
Disclosure: Author has a long position in shares of SCX
Saj Karsan
http://www.barelkarsan.com
Saj Karsan
http://www.barelkarsan.com
