The truth about asset investing

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Did you ever play the game of telephone when you were a kid?  The game where everyone sits in a line and passes a message along by whispering it to their neighbor.  It didn't matter how many kids were participating, after a few passes a message like "The Indians will win the World Series" would morph into "My aunt Tilda said the world is near us."  My feeling is that the modern value investing view of asset investing is something like the game of telephone.  Between what Benjamin Graham initially wrote in Security Analysis and what we're telling ourselves today something has been lost.

Asset based investing is commonly referred to as cigar butt investing where investors gamble that a depressed stock has 'one last puff'.  The idea is that down and out stocks selling for less than their asset value will sometimes experience what amounts to a dead cat bounce.  Investors are supposed to watch their basket of depressed stocks like a hawk and trade opportunistically to reap the gains.

I've read countless blog posts that describe a company who's assets are melting away like an ice cube  as a Graham-type value play.  The gross mis-characterization of Graham's asset plays has always bothered me.  I realize that Security Analysis is considered a classic text, which means that everyone is aware of it, but no one has read it.  In response to seeing this mis-characterization recently I went back to Security Analysis (6th edition) and re-read a few of the chapters on asset based investing.  I believe a lot could be learned by investors from just reading these few chapters.

Because I know most of my readers won't be reading Security Analysis I've decided to provide a few quotes that illustrate what asset investing should be.

First a definition of liquidation value:

"Liquidating Value.  By the liquidating value of an enterprise we mean the money that the owners could get out of it if they wanted to give it up.  They might sell all or part of it to some one else, on a going-concern basis.  Or else they might turn the various kinds of assets into cash, in piecemeal fashion, taking whatever time is needed to obtain the best realization from each." (p559)

A common complaint about stocks trading at a discount to their asset value is that they have poor earnings, don't cover their cost of capital.

"Common stocks in this category practically always have an unsatisfactory trend of earnings." (p564)

Graham discusses that stocks selling below NCAV have many potential catalysts that could result in value being unlocked including, general industry improvement, a change in operating policies, a sale or merger, complete liquidation, or a partial liquidation.

Finally Graham discusses that even though many of these types of stocks are cheap they need to be approached with caution:

"Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category [below NCAV].  He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above.  Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past.  The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so." (p568-569)

What can we learn from this?  A company's liquidation value is a rough approximation of what value might be realized if management either sold the company entirely or broke it apart.  Many companies that trade for less than their liquidation value are not great companies, if they were they wouldn't be selling that cheap.  Investors should prefer companies at less than NCAV where NCAV is at least stable, if not growing.  Preference should be given to companies that are growing both earnings and asset value.

Instead of speculating on last cigar puffs the texts from Security Analysis paint quite a different picture.  They show an investor carefully examining a stock like a business and making a purchase if the business is of at least average quality and selling at a reasonable discount.

I recognize that asset based investing isn't for everyone.  Some investors aren't comfortable investing like this.  That's perfectly fine, there isn't one correct way to invest.  But for those who have heard, or read about asset based investing I wanted to clarify some of the misconceptions surrounding it.

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  1. We always called it Chinese whispers....not sure if that's racist or not.

    I have to admit even though I read Security Analysis it is a pretty hard book to get through and can't remember much of it now. Always useful to go back and scan through books you haven't read for years, there's always something useful in there that you had forgotten.

    1. My first pass at Security Analysis was tough as well. I'm not even sure I got 20% of the book. I re-read it about four years later and everything made sense. Maybe it was a maturity thing, or just being familiar with the material, but it was MUCH better the second pass.

      I have gone back and re-read sections from time to time again, I learn something new each time.

  2. I don't really get the hate towards asset based investments. If you had to make a decision based on one financial statement it would have to be the balance sheet. It shows you the financial risk of the business as well as the past profitability (retained earnings).

    I once relayed an asset based (NAV) investment thesis in some of the mini-Berkshires to an investment class in college only to have the professor berate me, who was a PHD mind you. The professor claimed that earnings were all that mattered (I'm pretty certain he did not know what Free Cash Flow was). He even went so far as to say I was illogical and that asset values were meaningless, which is ridiculous/ironic when considering he was heavy into technical analysis. In reality earnings/free cash flow are not necessarily good indicators of value for holding companies, E&P companies, real estate companies, and many more.

    There are a number of other extremely stupid things that the Professor said to us: Enron would have been impossible figure out ahead of time... Could have looked at their cash flow statements for 4 seconds and figured out that they weren't making any cash (again he did not know what Free Cash Flow was). But this is besides the point.

    The weirdest thing is explaining an investment thesis in a liquidation in which the company is already mostly in cash or 100% and is just waiting for escrow accounts to close or otherwise. Maybe its because there are uncertainties but in these situations where the range of value is so much higher than the entry point the uncertainty is somewhat meaningless if your low range of value is sufficient to make the investment.

    There are situations which I call "Mohnish Pabrai Situations" because of an example he posted in The Dhandho Investor for Stewart Enterprises. This involved a highly levered company engaged in funeral home services. They owned hundred of funeral homes across the U.S. and some internationally. The company hit the skids and traded extremely cheaply. Because Mohnish understood that the company could easily sell a decent amount of funeral homes and easily escape all of their financial troubles he made a handsome profit. The key to understanding this investment was not directly the earnings power but the asset value of the company. A current example of this would be Cincinnati Bell which was punished severely for poor earnings despite owning $1b worth of CyrusOne. These situations are basically an arbitrage of the inability of most investors to understand or care about asset values.

  3. I've been rereading Security Analysis because of posts by Nate and other bloggers on the stereotypical Buffett vs. Graham styles. What Graham writes about and what he does may be slightly different. Although it does appear that he did invest mostly in bargain issues his writing does include a vast array of types of value investing- Distressed Investing, Control Investing, Growth/Quality Investing, Asset Value Based, Risk Arbitrage/special situations (not very much Risk Arb in all versions).

    He does mention that Growth Investing and Distressed investing can be much more difficult to figure out and in many cases more dangerous than bargain hunting, which I think most people would agree with but he doesn't say that these are necessarily highly speculative endeavors.

    I think the important lesson is not that Growth/Quality Investing is inherently better than net net investing or vice versa but that you should try to recognize value in whatever form it takes.

    1. I agree, great summary. Graham even discusses EBITDA, cash flow and growth investing in his last edition of Security Analysis. There is some quackery (macro forecasting formulas) in there as well, so I take that edition with a large grain of salt.

  4. Nate, this is going to sound like a weird question, but here it goes: how do you get the energy/time to simultaneously work on your blog, newsletter, CompleteBankData, all while you hold a full time job and look after your young son? I ask because I'm wondering if there's some secret to being so productive. Personally, I'd love to have the energy and time to do half the things you're able to. Any tips?

    1. Not a strange question at all. To clarify, I have two sons, so yes, a lot of time!

      The best answer is I break apart my tasks and focus on one thing at a time. For example, I will research stocks certain days, write a blog post a different day, work on CompleteBankData yet on a different day etc. My job provides a lot of flexibility so I'm able to be around my family often, I'm not a slave to the office.

      If I had to give out a secret it would be this. Stay up late, and stay focused. As I've added more things to my plate I've also removed other items. I barely watch any TV, and I've cut out almost all mindless surfing.

      Things move in waves, at times I'm very busy with CompleteBankData, and other times I'm not and can focus on other things. As my brother likes to say "If the Tobik's are known for one thing it's for being intense."

      One last thing, I've found working out is extremely helpful. When I don't go running or biking I don't have any energy. It's strange that doing something that drains energy is recharging, but it's true. I take a break right before lunch and run during the week. It reduces stress, is enjoyable and is healthy.