Monday, June 27, 2011

Asset vs Earnings Managers

Value investors can spend a lot of time evaluating the quality of a company's management. We look at management's track record, and attempt to gauge the level of management's candor in providing information to shareholders.

But when it comes to companies that trade at large discounts to their net assets, is this exercise worthwhile? Thanks to our capitalist system, managers who are not getting the most out of company assets will often be replaced, a process which can often serve as the catalyst that helps a stock's price converge with its intrinsic value. By avoiding the companies with poorly performing managers, shareholders may be missing out on the potential for large gains.

Consider RCM Technologies (RCMT), a company we discussed about a couple of years ago as one that traded at a deep discount to its net assets despite a flexible cost structure and therefore a decent earnings outlook. Nevertheless, management's poor capital allocation decisions in the past and their seeming intentions to continue to "build empires" had me avoiding the company.

But those who were willing to take the plunge despite the management situation would be rewarded. The company subsequently received a buy-out offer at a price which is about twice that of what it was when it was brought up on the site. This is a classic case of getting rewarded for buying assets for less than they are worth.

For companies expected/required to generate above-average returns on capital, the management team is likely a very important factor in determining whether the investment makes sense. But perhaps we place too much emphasis on the management team when it comes to companies trading at large discounts to their assets. After all, management teams can be replaced, and shareholders can get rewarded in the process. On the other hand, buyouts are difficult to predict and may not occur with enough frequency to remove every poorly performing management in a timely manner.

The right decision is not always clear, but investors should keep in mind that the importance placed on the management team in weighing an investment decision may change according to the type of investment (e.g. an earnings play vs an asset play) being made.

Disclosure: None

2 comments:

Ankit Gupta said...

I believe that investing based on asset values is still inherently a play on earnings.

Where do assets derive their value from? It is only worth something if it can earn money from it. This is why I'd rather invest in a mining company rather than just buying gold and storing it for a thousand years. The company is actively doing something and creating value. Land, machinery, buildings, etc., are all similar - sitting somewhere, they are worthless, but put in use, they create value. To me, real estate is a play on future earnings potential. People say that you get something physical as protection, but what are you going to do if no one wants to rent it? Are you going to rip out the toilets and drywall and sell them to someone else?

If the assets are all in cash or cash-like situations, like A/R, short term investments, etc., then that is a different case, but for truly valuing property, I think it's important to know what the earnings potential is. Even if a property has value that is not in use, it will only have that value because others are able to put it to use. At some point, you are relying on earnings as a measure of value.

In the hands of the wrong person, those assets might not be maximized in value, as we've seen described in this post.

I think my only point here is that assets get their value from earnings or earnings potential and not some kind of special and mystical value that all real estate or other assets receive.

Anonymous said...

Ankit,

Agreed that assets get their value from earnings. But there's still a difference- when you buy an asset, the earning power that gives it its worth can come from many places. Not always, as in your example of a real estate which no one will ever rent, but often.

So if you own a hotel (without the real estate) and tourism disappears, so does your wealth. But not necessarily your landlord's, who can try renting the building to a school or a hospital or a group of ladies of negotiable affections.

The protection lies in the diversity of ways in which you can get money out of your asset.

Juan

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