In the past few years, my investment strategy has evolved and is now best described as being dominated by an analysis of private market value. By "private market value," I mean the value that a potential buyer would assign to an entire company. It can manifest itself in takeovers, LBOs, and transactions completely outside of public markets in which a privately held company is purchased.
This approach essentially ignores technical analysis and does not attempt to determine whether the "market" is over- or under-priced (although, inevitably, more stocks will be attractive on a private market value basis in a down market). If you follow this approach, you will not necessarily be in tune with trends. On the other hand, an investor following this approach will discover that he or she often owns stocks that are also owned by certain notable value investors (e.g., Carl Icahn) and that "activist investors" often arise and try to get management to "unlock" the inherent value of the company through various restructuring plans. You also will tend to find many of the companies in your portfolio engaged in share repurchases - reflecting management's conviction that the stock is a bargain. Another phenomenon will likely be the discovery that a number of your holdings are subject to takeover or leveraged buyout activity. You will have to be patient because the price may take a long time to catch up to the value, but, in the long run, the strategy should work very well.
The problem is that assessing private market value can be hard work and requires a certain amount of judgment. It involves more than simply plugging numbers into a formula and printing out the result. For that very reason, I generally like to buy at a significant discount to value.
I am going to start in this article with the most straightforward situation. This is the situation in which the company is selling at a meaningful discount to the readily ascertainable value of its assets. These situations arise for a number of reasons; as noted above, they are much more prevalent at the bottom of the market and, in early 2009, looking for these opportunities was like shooting fish in a barrel. Let's first go through some basic steps in the analysis.
Enterprise Value versus Market Cap - One of the most important elements of private market value strategy is the focus on enterprise value rather than market cap. Market Cap is simply the number of outstanding shares times the share price; enterprise value is the market cap plus net debt or minus net cash. Most other metrics used by analysts (for example, price earnings ratios) are based on market cap. Enterprise Value is really more important because it tells a buyer what it will really cost to acquire the entire company. If the company has more cash than debt, then the buyer's net cost to acquire the company can be reduced by the balance sheet cash. On the other hand, if the company has net debt, the buyer must either pay the debt off or assume it, which increases the total cost of acquisition. Of course, the focus on Enterprise Value tends to favor companies with low or no debt and with lots of balance sheet cash. In the context of the recent credit crisis, this strategy has other reasons to recommend it.
Calculating Enterprise Value - While Market Cap is generally relatively easy to calculate (one must choose whether to use fully diluted or outstanding shares - I generally make that choice in favor of fully diluted shares), Enterprise Value is more difficult. First of all, cash must be calculated. I generally add up cash and short-term investments. I then look at long-term investments and, if they are reasonably liquid (e.g., long-term publicly traded bonds), I include them as well. I then examine accounts receivable. While I generally do not include accounts receivable, in some cases, the company finances its own receivables and essentially loans customers money to buy its products. If this appears to be the case, I generally calculate the amount by which accounts receivable exceeds accounts payable and credit this amount to cash as well. The reasoning is that the accounts receivable could likely be sold or financed to generate cash and the financing could be paid off as the receivables came in. A little more than a year ago, I applied this process to Dell Computer (DELL) and, in this article, identified it as undervalued and a possible takeover target on January 1, 2013, a few weeks before a takeover by Michael Dell was announced.
The debt side is more difficult. I generally include all debt (short and long term). I also try to calculate the value of preferred stock (based on liquidation preference or maturity value). If there are other large liabilities (e.g.,pensions), I try to determine whether to include them as well. In some cases, a calculation has to be made for "non-controlling interests." Many companies now consolidate the financials of variable interest entities (VIEs) and this can make the exercise very difficult. If the VIE liabilities are non-recourse to the main company, then I try to pull out all the liabilities and assets of the VIEs. If possible, I then try to calculate the net value of the company's interest in the VIE and include it on the asset side.
The result of this exercise is a calculation of the price an investor is paying for the business itself with cash and debt stripped out. Surprisingly, in some cases this turns out to be a negative number. A negative Enterprise Value is another way of saying a company is selling for less than net balance sheet cash. You could buy the entire company, reimburse yourself with the company's balance sheet cash, and, at the end of the day, own the company's operations as well as have extra cash in your checking account. I recently identified an example of this phenomenon in Firsthand Technology Value Fund (SVVC) in this article arguing that SVVC was trading "like a stolen laptop" - since I wrote the article, the stock has moved from $16.07 to $23.69.
Asset Value - This article addresses situations in which asset value is subject to relatively easy calculation. Thus, I am not going to include analysis of typical operating businesses (that will come in future parts). Situations of easy to value assets are generally cases in which the company's assets are either publicly traded securities or debt instruments. In certain cases, real estate assets or commodity inventories can be evaluated with enough confidence to be sure that an attractive discount is present. In addition, some conglomerate companies own subsidiaries and it can be possible to value the subsidiaries with enough confidence to identify an attractive discount. Sometimes, a company owns a mix of assets - some of which are easy to value - and an examination of Enterprise Value and the easy to value assets reveals that the price being paid for the rest of the assets is likely very attractive.
Putting It All Together - I think that the best way to describe this process is to provide some examples. In 2009, I got very interested in Business Development Companies (BDCs). In many cases, the assets of BDCs are debt instruments with an ascertainable face value. Of course, the financial panic led to all sorts of refinancing problems for both the BDCs and their borrowers. Many BDCs were trading at large discounts to net asset value. I used the above methodology, which led me to prefer BDCs with little or no debt. One of my early favorites was TICC Capital (TICC), which had no debt at the time. I generally bought only if I could buy at a big discount to net asset value because I was aware that the assets could be written down due to collection problems. If you have two BDCs and each has $1 billion in loan assets, they each have 10 million outstanding shares and one of them has $500 million in debt while the other is debt free, they are actually quite different entities. If the BDC with the debt is trading at $30 a share with a market cap of $300 million, conventional analysis would suggest that you are getting net asset value of $500 million at a 40% discount. Using enterprise value instead reveals that the Enterprise Value is actually $800 million so that the discount applied to the total asset base is only 20%. This is the real "cushion" you have to absorb write-offs. On the other hand, the company with no debt may be trading at $70 a share which, on either an enterprise value basis or a market cap basis, provides a 30% discount to net asset value. Using the market cap method, the company with debt may appear "cheaper," but using the enterprise value method, it is clear that the discount is actually greater for the debt-free company.
In early 2009, many closed end bond funds traded at enormous discounts to net asset value. Again, it was important to analyze leverage to appreciate the full situation. There are some equity closed end funds now trading at large discounts to asset value but, in some cases, the fund is very small and the percentage expense ratio is too high. Two funds that I find attractive are First Opportunity Value Fund (OTCQB:FOFI) and Central Securities (CET); CET is well covered in this article. GSV Capital (GSVC) has, from time to time, traded at large discounts to net asset value. It has always had net cash so that the discount - on an enterprise value basis - is actually larger than market cap analysis would suggest as I pointed out in this article. Early in the century, some beaten down tech stocks traded for less than net balance sheet cash. In 2002, one of them was a small company with a failed business strategy and a shake up in its management and it was trading for well below net balance sheet cash. Its name was Apple (AAPL), trading in the $7 range with over $10 a share in net balance sheet cash - all you had to do is buy it for less than cash and wait for a liquidation. Do we all still believe in the efficient market hypothesis?
Even with debt, some companies are trading at large discounts to reasonably calculated asset value. The latent value of real estate often creates this situation. A striking example is Reading International (RDI) which is well described in this article by a knowledgeable author who has followed it closely.
Although some of its assets could be valued only with the exercise of some judgment, American Capital (ACAS) was very attractive when it was trading at $6.50 or less than 50% of net asset value as described in this article. It is trading at $14.86 now but I still consider it to be a strong buy because of a continuing substantial discount.
Right now this strategy should lead investors to watch closed end fund discounts. Certain mortgage REITs can be attractive on this basis, although the agency mortgage REITs have a great deal of leverage and so do not have large discounts on an enterprise value basis. Opportunities to take advantage of the discounts described in this article generally arise when there is an overreaction to bad news or a sell-off, which affects a broad range of stocks (some of which are babies that have been thrown out with the bath water). When there is a sharp pullback in the market, value investors should have a list of stocks and closed end funds they can track and use to identify attractive entry points. The current market offers fewer of these opportunities than we had in 2009, but opportunities still exist in the "cheap cash flow" arena, which I shall address in future parts of this series.