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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.
Disclosure: I receive a small commission if you purchase anything through Amazon.com.