I have always believed that investors with an overly optimistic view of the world have an inherent disadvantage and can be predisposed to overpay for securities. While I do not advocate being a pessimist in general, there are advantages that clearly exist for investors who attempt to think of all the possible factors that could go wrong when evaluating an investment. The need for a healthy dose of “pessimism” is nowhere more urgent than when an investor is evaluating bargain basement stocks selling for under net current asset value.
“Killing The Company”
Bruce Berkowitz of the $6 billion Fairholme Fund was recently interviewed in the latest issue of Columbia University’s investment newsletter. Berkowitz is very bullish regarding the prospects for his portfolio in particular and opportunities for value investors in general. One could say that he is very optimistic regarding potential opportunities given current valuation levels. However, when analyzing potential investments, Berkowitz believes in trying to figure out how you could “kill the company” in question. What this exercise refers to is evaluating the factors that would be required to destroy or seriously impair the value of a company’s ability to create cash flow.
Berkowitz refers to the entire research process in terms of figuring out how to “kill the company”. Berkowitz states that he has his research staff begin by looking at businesses under stress where market prices have fallen precipitously. He then analyzes the nature of the cash flows of the business, how those cash flows might be allocated by management, and how the macroeconomic factors might come into play to impair the cash flows. When asked how he determines whether an analyst really understands a business, Berkowitz makes some interesting observations:
It is based on this process of trying to kill the business. Once a person has an idea, we then start whacking at it. We invert the concept. Instead of trying to prove a person’s idea, we try to kill it, and if we can’t kill it then the person is onto something. Whether it is my own idea or someone else’s idea, that is the process we go through. We will then talk to experts with 20 or 30 years of industry knowledge, and we will try to attack it from every way that we know how. After a period of time as we go through our checklist and we’ve been through all the ways that we can kill an institution, we decide that maybe we can make some money. Much of investing is about not losing just as much of life is about not dying. It is avoiding those places where you can die. That’s why I’m not a really big fan of parachuting.
Net Current Asset Value Stocks
Nowhere is the importance of trying to “kill the company” more clear than when one is evaluating a bargain basement security that appears to be trading at or below net current asset value (NCAV). I wrote about this general concept last month including the history of this approach first pioneered by Benjamin Graham. In recent months, a new crop of stocks selling at bargain basement valuations have appeared but one must figure out how to separate those that have been unfairly punished from companies that have management teams that will eventually destroy all shareholder value. Many cheap stocks are cheap for very good reasons.
I take a similar approach to Berkowitz when evaluating NCAV stocks for potential purchase. Here are a few rules that I follow:
My first rule is to recognize that not all current assets are equally safe or valuable. Cash and liquid short term investments are generally more valuable than inventories or trade receivables particularly if there are questions regarding the overall valuation of inventory on hand or the collectability of receivables. This is why some investors discount the value of inventories and receivables depending on how distressed the company appears to be.
Second, one must examine potential liabilities that are not necessarily reflected fully or at all on the financial statements. Many companies have long term lease obligations that are material in nature as well as employment contracts with key staff that could eat into a significant chunk of the cash on the balance sheet in the event of a liquidation.
Third, one must examine the intentions of management and the controlling shareholders to determine if the value on the balance sheet will be returned to shareholders in some productive manner. There is no point in identifying and purchasing a NCAV stock only to watch management and controlling shareholders continue operations that destroy shareholder value.
Of course, there are many other factors involved but I view the three items above to be the most critical.
The Best of Both Worlds
Normally the hunt for NCAV stocks involves looking at business after business operating in distressed industries and one is usually looking at liquidation plays. However, there are situations where NCAV stocks can be found that are valuable as going concerns while providing significant downside protection backed by the discount to NCAV. I recently examined a company selling under NCAV and attempted to “kill the company” following an approach similar to what Berkowitz described. I am not naming the company in question since I hope to purchase additional shares in the future (hopefully at even lower prices). However, I will describe a few aspects of this company that jumped out at me when I applied the “kill the company” analysis:
- Significant Cash Balance. The investment in question was available at less than 90% of Net Current Asset Value at the time of my initial purchase. While inventories and receivables accounted for a majority of the current assets on the balance sheet, cash alone accounted for 35% of the market value of the stock. The company has no long term debt.
- Resilient Operating Results. The company is in a cyclical industry and sales have been severely impacted over the past six months. The company was solidly profitable over the past five years. In the most recent quarter, sales dropped by more than fifty percent from prior year levels. In certain geographic markets, the damage was even worse. Still, despite the global meltdown, the company posted slightly positive earnings for the most recent quarter and had only a small negative cash flow from operations.
- Able and Honest Management. The management team in question has a strong track record built over a period of several years and successfully navigated the difficulties presented by the last recession earlier this decade. Executive compensation appears reasonable for the size of the company and there is no excessive use of stock options. Management has a very conservative approach to running the business and is keeping large amounts of cash on the balance sheet to weather the economic downturn.
When I evaluated this business, I could not find a way to “kill the company” short of entering another Great Depression. If we are currently at the equivalent of 1930 or 1931 in our economic cycle, the business will have significant difficulties over the coming years. However, any business that can suffer a decline in revenues of over fifty percent and has the discipline to restrain operating costs and take other steps to avoid hemorrhaging cash is unlikely to result in a permanent loss of capital for an investor purchasing shares at current valuations. I figure that if we are entering another Great Depression, I could well lose the value of my investment but if the economy recovers in 2010, the minimum result I should achieve is a double or triple when conservative multiples are applied against the company’s normalized earnings power.
Should Investors Consider the Macroeconomy?
Warren Buffett often says that he does not consider the overall macro economy when making investment decisions. I have to admit that I normally do consider the overall economy, at least in terms of my analysis of how to “kill the company”. Particularly in these tough economic times, one must be as certain as possible that an investment that appears to be cheap is not a value trap. By only swinging at pitches that appear to be able to weather a worst case scenario, downside risk can be minimized in the long run. Of course, in the short run, a cheap stock can get much cheaper. For those with confidence in their analysis, this merely presents a good opportunity to buy more shares. In fact, for the company I described in this post, I hope that the price will get much cheaper in the coming weeks and months.