Continue from Part 2…….
The special importance that Graham and Dodd placed on balance sheet valuations remains on of their most important contributions to the idea of what constitutes s “though” analysis of intrinsic value. It is also, unfortunately, one of their most frequently overlooked contributions outside the relatively small community of value investors.
The reason that the balance sheet often ignored goes back to the times that produced Security Analysis. Back than, the economy and business were operating under severely depressed conditions. As a result, Graham and Dodd went to balance sheet to determine liquidation values or, as a proxy for these, current assets minus all liabilities. the logic behind this predisposition was compelling and conservation. if a company could be bought at a price well below its liquidation value, that it seem unambiguously to be a bargain. Earning could pick up because of either an improvements in a firm’s industry environment (competition eases or demands recovers) or better management. If the earning improvement produced a market value above liquidation value, all well and good. On the other hand, if such positive earnings developments failed to materialize and if this happened before the liquidation value of the firm was significantly damaged, then the company could be liquidation and the proceeds distributed to its shareholders. In either case, the shareholders who bought below liquidation value would earn a “satisfactory return” on their investments.
The only risk of which, Graham and Dodd were well aware, was that management continue to operate the firm unprofitably and, in the process, dissipate the value of the assets. This, they advocated their own version of shareholders activism as a necessary complement to this kind of investing. As they wrote,
The choice of a common stock is a single act; its ownership is a continuing process. Certainly there is just as much reason to exercise care and judgment in being stockholders as in becoming a stockholder. It is a notorious fact, however, that the typical American stockholder is the must docile and apathetic animal in captivity.
Taken as a whole, this approach was unimpeachable and, in its time, successful in practice. Since then the practice of buying below liquidation value has been undermined by two factor. First, the rapid rise in tax rates post-1940 has meant that strategies like this one, which have often involved realizing short-term gains over relatively short periods, have incurred high tax costs. Second, and more importantly, opportunities by stocks at price below liquidation value, which were abundant in the 1930s, have effectively disappeared in the long-term prosperity that has followed.
Relatively few industries in recent times have become economically nonviable and hence candidates for liquidation. This reality has been embodied in the general level of stock prices, with the result that Graham and Dodd’s much be loved “net nets” —— that is, companies selling below the value of their current assets less all liabilities—-are rare. And, net nets are available, their second requirement ——– namely, that management not be dissipating those assets at a rapid rate—— is seldom met.
However, the broader lessons that lead Graham and Dodd to focus on the balance sheet of firms continue to apply, with extensions that are much within the spirit of their original approach. First, it is now recognize that for economically viable firms, assets were out or become obsolete and have to be replaced. Thus, replacement value ——- the lowest possible cost of reproducing a firm’s net assets by the competitors who are best positioned to do it—— continues to serve the role that Graham and Dodd recognized.
If projected profit levels for a firm imply a return on assets well above the costs of capital, then competitors will be drawn in. That, in turn, will drive down profits and with them the value of the firm. Thus, earning power unsupported by assets values——- measured as reproduction values— will, absent special circumstances, always be at risk from erosion due to competition. Both “safety of principle” and the promise of “ a satisfactory return”, therefore, require that “through” investors support their earnings projections with a careful assessment of the replacement value of a firm’s assets. Investors who do this will have and advantages over those who do not, and they should outperform these less through investors in the long run.
What appears to have deterred Graham and Dodd from considering the replacement value of assets was the potential difficulty of calculating them. They choose the focus on the wealth of new financial information made available through the establishment of the Securities and Exchange Commission. With today’s computers, that information can be obtained and digested almost instantaneously. Moreover, industry reports and trade publications, many of them available online, provide a wealth of information on assets values that was inconceivable to Graham and Dodd.
For, example, the cost estimate of adding to existing reserves of oil and gas are widely available, at lest forU.S.companies. So are estimates of recoverable deposits. As a result, investors today can calculate the values of resource companies; holding with the precision that was unattainable in the authors’ time. Physical property and equipment can also be valued with a higher degree of accuracy. For real estate, assessors with access to extensive transactions data can quickly and cheaply estimate the cost of purchasing comparable properties.
Continue in Part 4…..