Security Analysis Series: Introduction to Part VI

“Deconstructing the Balance Sheet” by Bruce Greenwald

Chapter Summary

  • The main value in Security Analysis comes from two concepts. First, the distinction between investment and speculation, investment demanding a “thorough analysis” and “safety of principal and a satisfactory return”. The second from a focus on the “intrinsic value” of a security, namely the discounted present value of the future cash flows. (pg 535).
  • Intrinsic value does not, and usually cannot, exist as a precise figure, but rather a range of value. It only needs to be valuable relative to market price, with a further divide between value and price bringing about a larger margin of safety. (pg 536).
  • P/E dominates modern discussion on valuation. Balance sheets are largely ignored by the popular investing community. (pg 537).
  • “Earnings on assets that are well in excess of a company’s cost of capital will be sustainable only under special circumstances.” Therefore, earnings must be supported by appropriate asset values; unsupported earnings tend to be temporary. (pg 538).
  • It also remains true that a balance sheet has less room for manipulation by management and accounting teams as compared to the income statement. (pg 539).
  • While Graham and Dodd hunted for bargain purchases that could be offered a large margin of safety by the supporting liquidation value of assets, they also understood management’s ability to dissipate the value of assets by continuing unprofitable operations. (pg 540).
    • “Net nets”, or a company selling at a price below liquidation value, is extremely rare today. (pg 541).
  • Replacement value of assets can be found far more easily than in Graham’s day considering the use of the internet, or contacting industry experts. (pg 542).
  • One must also consider the reasons that earning power exceeds asset values. For example, does the company hold irreplaceable “moats” to their business, protecting them from competition? How sustainable are these protections? (pg 544).
  • WorldCom serves as an excellent example of asset values that did not justify earnings. Over 85% of book value was made up of goodwill and other intangibles in 1997. Many expenses were being capitalized that were illogical. By 2001, the company was insolvent. (pg 546).

Chapter Thoughts and Analysis

  • While many true “net nets” with low risk can be found, the concept is still very applicable to modern investing. Understanding the current asset values and their liquidity can act as a floor to downside risk. If a company has cash assets/equivalents per share that make up, say 80% of price per share, an investor can take a position that is 80% protected by that cash asset.
  • I am unsure if the discussion on “moats” or protections from competition have an appropriate place in resource investing. It feels as though extractive companies are fairly removed from direct competitors, unlike companies in the consumer goods industries (Pepsi vs Coke, for example). What competitive protections can exist for two different gold miners that allow them to earn excess rents? The first thought that comes to mind is a limited tax burden/tax protections, but in theory, these should already be incorporated into cash flow calculations. Perhaps there is something to be said about having competitive advantage by having institutional partners that are ready and able to provide financing, cheapening cost of capital. But is this truly a lasting competitive advantage that will provide earnings in excess of asset values? I don’t think so. So overall, I would say competition in the resource industry is straightforward, with no monopolistic protections available to certain players.
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