The 'Bookies' and The 'Booker' Awards

The ‘Bookies’ and The ‘Booker’ Awards (originally published in October 2008)

As usual our title does not reflect accurately, the contents of the article: this article is neither about gambling nor about books and certainly not about awards given to writers. It is about one of the oldest valuation methodologies, one that is not used commonly in these days of complex and catchy jargons but one which we believe when used in the current state of the markets, can be used as one of the investment themes in a portfolio. We are referring to the Book Value method of valuation (at-last some small connection to the title, after all!).

The American humorist, Will Rogers had it right when he said, "Only buy stocks that go up. If they aren't going to go up, don't buy them." For some (most?) investors this means “buy anything High" and “sell anything Low”. We, on the other hand, believe in buying “Value” stocks.
But what is “Value”? A Google search produces a variety of criteria that help to identify Value Stocks; the standard ones being low Price to Book Value*, low P/E ratio, high dividend yield etc. None of these themes, including low price to book value, may work in isolation (more on this later). Notwithstanding this, the idea behind looking at stocks with low book value is that it could provide a floor for a company's share price.

* In the simplest form, the book value of a company is its net worth. But actually it’s a bit more than this: Ben Graham , the father of value investing, took the view in his 1934 book, Security Analysis, that only Tangible assets (like Machinery, cash, receivables etc) should be taken to compute net worth and not intangible assets (eg. Brand value or goodwill). As per him, the intangibles could, in some situations, even be superior assets. However he preferred not to put a value to them while analyzing a company.

On the other hand, Graham’s best known disciple, Warren Buffett loves companies with valuable, and sometimes irreplaceable, goodwill. To Warren Buffett, it is this intangible good will that continually produces profits without the need to spend money on maintenance, upgrading or replacement. After all, what would you consider the important element of profits for Coca Cola: its name and recipe (intangibles), or the various factories (tangibles) that produce the drink? However, for reasons of ease and for the sake of conservatism, we have taken the Ben Graham definition for our purpose.

But how useful or relevant is the concept of Book Value?

There are strong views on both sides.

In one of our earlier blogs, we have written about Walter Schloss, who was amongst those who studied and worked under Ben Graham (in a famous 1984 speech titled the "The Superinvestor of Graham-and-Doddsville," Buffett proclaimed Schloss as one of the Superinvestors). Schloss, who never went to college and started out as a Wall Street runner in the 1930s, has lived through 17 recessions and innumerable stock market ups and downs. Started in late 1955, Walter J. Schloss Associates during its 47-year performance history generated in excess of 15% gross annualized returns for its partners, 50% more than the S&P 500. His investing method? He loves companies quoting well below book value. In his view, assets are more stable than earnings. The market ofcourse thinks differently and focuses on short term prospects. And this throws up opportunities. In Schloss’s long experience, a company whose shares can be bought at a significant discount to their book value has a great chance of either becoming profitable again, or being taken over by other companies. Both scenarios hold great prospect with regard to the stock price. Ofcourse this approach tends to take time and his usual holding period is 4 years. And Schloss has the patience to hold on. “Something will happen”, he likes to say.

Adding to this view, there was also a study conducted by 2 eminent American economists, Eugene Fama and Kenneth R. French, on the performance of low price to book value stocks. The study covered the period from 1963-1990 and included nearly all the stocks on the NYSE, AMEX and NASDAQ. The study found that the lowest book/price stocks outperformed the highest book/price stocks 21.4% to 8% AND had lower price risk as compared to the ‘growth’ stocks.

On the flip side, some researchers believe that stocks quoting below book value are risky because they are down-and-out and in danger of getting worse: in other words a “value trap”. There are still others who rightfully point out that book value is not a representative value since it may differ significantly from both market value and the replacement cost.

Amongst those who have spoken against the book value concept is Warren Buffett. As is well known, Buffett had acquired a textile business in the 1960s, which due to various reasons he eventually closed down in the 1980s and sold its assets by way of an auction. Referring to this transaction, Buffett wrote the following in his 1985 letter to the shareholders of Berkshire Hathway:

“Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole. Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery.

The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.

Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.”

So are we recommending a methodology that has been nixed by the Investment world’s superman? Well quite certainly like most others, this is not a methodology that can be implemented blindly or in complete isolation. In fact, in the bearish conditions that exist today, more than one theme can usually be used to describe a good stock. The Book value method, when used in combination with other factors, can be a useful defensive investment tool. And one that we have adopted amongst several others that we use to invest.

While looking at a stock quoting under book value, one thing that we do is to look for reasons as to why the market is offering the stock at a considerable discount and then consider whether those reasons are valid. This normally prunes down the list to just a handful.

We quote from some of the examples from the Indian market that we have invested in recently:
Eveready Industries: This company is India’s largest dry cell manufacturer having a dominant market share and products available at over 3MM retail outlets. It had fallen into bad times because the price of zinc, one of its main raw materials, rose around 4X between 2005 and 2007.

They tried to pass on some of the cost to the customers, but that led to a fall in volume especially in the lowest rung of their target segment which was price sensitive. Recently however, zinc (still one of the key raw materials for the company) like other commodities has been under pricing pressure and has fallen over 60% from its peak. The company has also undertaken measures to reduce debt and as of last quarter it had become profitable again. It is available at less than 50% of its book value.

Banking sector: The financial sector (despite the issues of high leverage, low return on assets and other ills) is one that becomes attractive when it starts trading at a discount to book value. The fact, that in these times when some of their international brethren are gasping for breath, they are not exactly everyone’s top picks only makes our job simpler. Additionally, India’s reserve requirements are one of the highest among major world economies, requiring banks to maintain 25% as SLR. If one believes, as we do, that given a scenario of lower oil and a good monsoon, the inflation is set to drop within the next few months, then so would the interest rates. This will make a direct impact on the value of the securities held by banks.

Despite the above argument, we need to look for financial institutions which are punished only because they happen to be, well, financial institutions. One company which is a pure play on interest rates where we have invested is PNB Gilts; a subsidiary of Punjab National Bank dealing only in Government Securities. This company is also available at around 50% of book value. Besides the interest rate related impact, an additional item which makes this interesting, is that PNB is looking to divest a part of its 74% stake in the company and has said clearly that they will not entertain a sale at below book. Failing a sale, they plan to merge this with the parent bank. Given the multiple likely catalysts, we feel that this is a good enough bet. In this we follow a quote made famous by Mohnish Pabrai: “Heads I win, tails I don’t lose much.”

Someone else we like to read and follow is Bruce Greenwald, Professor at the Columbia University and author of a book called Value Investing: From Graham to Buffett and Beyond. In an interview he mentioned some important considerations for value investing:

One, it is just inescapable that whenever someone sells a stock, somebody else is buying it; and whenever someone buys a stock, somebody else is selling it. And one of them is wrong. (In other words, we need to be certain about the ‘why’ of investing. And it can’t be that someone else is also buying). Two, have patience and discipline. Finally, Diversify.

Well, we do follow the above advices and believe that while we may not get the booker awards for our articles but our investments are likely to be a rewarding experience. We are willing to place our bets on that.