Sunday, May 15, 2011

The Aggressive Conservative Investor: Chapter 12

Martin Whitman founded Third Avenue Value Fund some twenty years ago. Over that time period, the fund has beaten the returns of the S&P 500 by several points annually. In The Aggressive Conservative Investor, Whitman collaborates with Martin Shubik to discuss a concept that they call "safe and cheap" investing.

This chapter is about the value and limitations of a company's net asset value. Also known as book value, net asset value doesn't get a lot of respect in most market circles, as most analysts focus on earnings. Outside of the market, however, book value is often used as an important variable in determining a business' worth. Investors would do well to put as much emphasis on this number as they do on a company's earnings.

For one thing, a company's earnings and its book value are correlated because a company generates earnings from its resources. The authors also show how companies trading at high (or low) P/E ratios tend to also be trading at high (or low) P/B ratios. This relationship is obviously not perfect, but the point the authors make is that earnings change rather quickly, which can result in a dramatic change to a stock price, whereas by its nature a company's book value usually changes very slowly, and can therefore often be a better guide to a company's intrinsic value.

In judging a company's worth, investors should consider the quality of a company's book value. In the authors' opinions, there are three items to consider when evaluating the quality of a company's assets. First, the investor should understand to what extent the assets are free of encumbrances. Assets have maintenance requirements, may incur legal liabilities, and could have debt taken out on them for example.

Secondly, investors should consider how useful the mix of assets are in producing earnings and cash flow in the future. Good operations create high-quality assets and are likely to contribute to a company's strong financial position.

Finally, the nature of the assets must be considered. Are the assets liquid and such that they can be sold quickly for their carrying values? Are the assets flexible, such that if the company has no use for it, they would be of use to another business? Can the asset be separated from the going-concern without affecting operations?

Though book value is important, the authors note that this measure does have limitations. For one thing, it's an accounting number, so its usefulness is subject to the limitations of accounting. Furthermore, while it's the quality of the assets that is most important, the book value only produces a quantitative number. Lastly, a company's book value is useless on its own, as it must be compared to other objective and subjective information about the company.

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