I think it can be difficult to learn anything without actually living it. So handily Ennstone, my first purchase of a value stock using not much more than price to book, has fallen over into the abyss. This is good for a number of reasons, although of course not so good for the staff.
The collapse of Ennstone has helped me re-think my approach to value investing and most importantly helped me to clarify to myself what it means to me to invest at all.
Risk to Returns and Principle. I’m beginning to think that’s what it’s all about. For example, let’s say I have some money to invest, ignoring fees etc I could invest it in:
1. My matress – risk to principle of fire or theft, but no risk to income as there isn’t any.
2. A bank savings account – risk to principle is none as the government guarantees deposits, risk to the about 2-3% income is small and varies with interest rates.
3. Government bonds – no risk to principle and no risk to the about 4% income.
4. Corporate bonds – now here’s the first big risk to principle. If I give my money to a company where the assets don’t cover the debts then if the company goes bust I’ll only get back a fraction of my principle. In a worst case scenario I could get back nothing if assets are mostly intangible. The risk to income is if the company goes bust.
5. Company shares – Of course this can carry the greatest risk to both income and principle. A company can easily cancel income to shareholders, the dividend. You can also easily lose all you’re principle if the company goes bust since any fire sale of assets goes to bond holders first. Shareholders only get what, if anything, is left.
That fear of loosing the principle is where the net net or liquidation value approach to investing comes. If there’s enough assets to probably pay everyone back in the event the company fails then the risk to principle is as controlled as it can be for a shareholder. Unless of course you invest in large ‘moat’ companies that are unlikely to fail in your lifetime.
So my first investment rule, which I had been kind of using from a while back and which would have barred Ennstone from entry to my portfolio, is:
A company must be trading for less than the value of 100% of its current assets plus 0% of its fixed assets minus all debts, or 80% of it’s current assets plus 50% of it’s fixed assets minus all debts.
Both of those are reasonable estimates of the liquidation value of a company. Depending on the ratio of fixed to current assets sometimes one is higher than the other. If a company passes either test then I’m interested. However, a slight caveat is that I’ll also consider companies slightly above this level if the company is generating enough cash.
Once I think my principle is reasonably safe, I’ll look at the cash generated and returned to shareholders over the last 5 years. If the company returned 15% cash returns at the current price to shareholders and had cash flows greater than that (i.e. they weren’t paying out to shareholders more cash than they were making) then I’m interested. The 15% is a number I read that Mr Buffet was happy with, so if it’s good enough for him then it’s good enough for me.
So I end up with a company that has enough assets to privide me with some reasonable downside protection to my principle, and has historically returned 15% to shareholders over the last few years, my assumption being that the next 5 years will look something like the last few years. Without my crystal ball I cannot assume anything else.
At 15% returns most investors would love to own such a stock. The idea is that when confidence returns for this company then investors will pile in. Once Mr Market offers me a price such that I can buy more assets and earnings power elsewhere (perhaps if he offers double my purchase price) then I will sell. If no such offer arises then I’ll sit and hold hopefully getting my 15%. If I don’t even get that then I’ll sell out after 5 years and go panning for gold again.
This formula proved to be very restrictive, so I've adjusted it somewhat in a later post. However I do still look at past ROE if two companies are close in terms of assets and price.