Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

The editor of www.csinvesting.wordpress.com has a library on special situation investing since asset based investing with a catalyst can be a fertile area for profits. Eventually the library will be available to all. Learning how to invest can be accomplished similarly to analyzing a company. Start at the top of the balance sheet and work down from there—simple to complex. Liquidations and net/nets can be a good place to start your development. www.csinvesting.wordpress.com will have more of a focus on business analysis and strategic logic, but I encourage readers to visit blogs and read books that go into more depth on asset-based investing. I hope these excerpts will encourage your interest to learn more.

Special Situation Investing
Security Analysis, 1951 edition (Pages 729 – 734) by Benjamin Graham Special situations are the happy hunting grounds for the simon-pure analyst who prefers to deal with the future in terms of specific, measurable developments rather than general anticipations. Warren Buffett in his early partnership letters (1957-1970) used the term “workouts” rather than special situations as he describes below:
“Workouts” - These are the securities with a timetable. They arise from corporate activity - sell-outs, mergers, reorganizations, spin-offs, etc. In this category we are not talking about rumors or "inside information" pertaining to such developments, but to publicly announced activities of this sort. We wait until we can read it in the paper. The risk pertains not primarily to general market behavior (although that is sometimes tied in to a degree), but instead to something upsetting the applecart so that the expected development does not materialize. Such killjoys could include anti-trust or other negative government action, stockholder disapproval, withholding of tax rulings, etc. The gross profits in many workouts appear quite small. A friend refers to this as getting the last nickel after the other fellow has made the first ninety-five cents. However, the predictability coupled with a short holding period produces quite decent annual rates of return. This category produces more steady absolute profits from year to year than generals do. In years of market decline, it piles up a big edge for us; during bull markets, it is a drag on performance. On a long term basis, I expect it to achieve the same sort of margin over the Dow attained by generals. As I have mentioned in the past, the division of our portfolio among the three categories is largely determined by the accident or availability. Therefore, in a minus year for the Dow, whether we are primarily in generals or workouts is largely a matter of luck, but it will have a great deal to do with our performance relative to the Dow. This is one or many reasons why a single year's performance is of minor importance and, good or bad, should never be taken too seriously. If there is any trend as our assets grow, I would expect it to be toward controls which heretofore have been our smallest category. I may be wrong in this expectation - a great deal depends, of course, on the future behavior of the market on which your guess is as good as mine (I have none). At this writing, we have a majority of our capital in generals, workouts rank second, and controls are third.

-Benjamin Graham under the pen name, Cogitator, wrote several articles for the Analyst’s Journal. The article below was published in the fourth quarter 1946 issue of the Analyst’s Journal.
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

The period 1939-1942 was a heyday for operators in special situations and undervalued securities. During these years the trend was unfavorable to those owning standard issues, and the brokerage business was on the quiet side. By contrast, many bargain industrial stocks scored substantial advances—especially since the early war years brought proportionately greater business improvement to the secondary companies than to the leaders. In addition, quite a number of railroad and utility reorganizations were taking shape, and developing good profits for those who had bought their issues at unpopular times and consequently at basement prices. By 1942 many in Wall Street had come to believe that the only real and dependable income was to be made in special situations. As usually happens, this generalization proved wide of the mark. In the ensuing four years there have been good profits in almost everything, and the spectacular returns have lately been shown in essentially speculative, as distinct from “special,” operations. But perhaps enough interest remains in the latter type of activity to warrant an article on the subject.

The Meaning of Special Situations
First, just what is meant by a “special situation”? Convention has not jelled sufficiently to permit a clear-cut and final definition. In the broader sense, a special situation is one in which a particular development is counted upon to yield a satisfactory profit in the security even though the general market does not advance. In the narrow sense, you do not have a real “special situation” unless the particular development is already under way. This distinction is readily apparent by reference to the wide fields of bankrupt corporations and preferred stocks with large back dividends. In the former case, “the particular development” would be reorganization; in the latter, it would be discharge of the arrears, usually by a recapitalization. Many practitioners will say that a company in trusteeship does not constitute a special situation until a reorganization plan has actually been submitted; similarly, there must be a definite plan on foot for taking care of dividend accumulations. Thus, American Woolen Preferred may have had interesting possibilities for years because of its very large back dividends, but it became a true special situation only when the buyer knew that a plan of repayment had been or was soon to be announced. There is a logical and important reason for favoring this narrower definition of a special situation. By doing so we are able to conceive of these commitments in terms of an expected annual return on the investment. As will be seen, such a calculation involves quite a number of estimates in each case, and thus the final figure bears little resemblance to the bond yields taken out of a basis book. Nevertheless, this technique is valuable as a guide to the operator in special situations, and it gives him an entirely different attitude toward his holdings than that of the trader, speculator or ordinary investor. In one respect, however, the calculation goes beyond the lore of the yield book. If we are willing to make the necessary assumptions, the attractiveness of any given special situation can be expressed as an indicated annual return in per cent with allowance for the risk factor. Here is a general formula:

Let G be the expected gain in points in the event of success; L be the expected loss in points in the event of failure;
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

C be the expected chance of success, expressed as a percentage; Y be the expected time of holding, in years; P be the current price of the security. Then Indicated annual return = GC – L(100% - C)/YP
We may take as a current example the Metropolitan West Side Elevated 5s selling at 23. It is proposed to sell the property to the City of Chicago on terms expected to yield in cash about 35 for the bonds. For illustrative purposes only (and without responsibility) let us assume (a) that if the plan fails the bonds will be worth 16; (b) that the chances of success are two out of three—i.e., 67% (c) that the holding period will average one year. Then by the formula: Indicated annual return = 12 x 67% - 7 x 33%/1 x 23 = 24.7% Note that the formula allows for the chance and the amount of possible loss. If only possible gain were considered, the indicated annual return would be 34.5%. (Sequel: The purchase was affected, and the bondholders have since received $33.5 in cash, retaining also “stubs” currently worth about $5.)

Classes of Special Situations
Let us turn now to a condensed description and discursion of the various types of special situations. These could be divided into two main categories: (I) (II) Security exchanges or distributions, Cash payouts.

Only in a rare case does a special situation, as we use the term, work itself out in a higher market without a cash of security distribution occurring somewhere in the picture. However, a more conventional classification may better serve our present purpose. Class A. Standard Arbitrages, Based on a Reorganization, Recapitalization or Merger Plan. In bankruptcy reorganizations, particularly those of railroads, the arbitrage has had a curious history in the past five years. In more than half of the cases the plans have been consummated and the expected profit realized—although almost always after a longer time lag than was originally anticipated. In the remainder the plans have been changed or dropped and the when-issued trades cancelled; or else such cancellation is now expected, chiefly as a result of the Wheeler Bill. Nevertheless, large profits were made by many arbitragers, even in the unsuccessful plans, because the old securities advanced greatly above the price they paid, in spite of the plan’s failure. Thus what was intended to be an old-fashioned arbitrage turned into a successful bond speculation.

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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

This experience illustrates one pleasing aspect of the special situation operation, which is that if your deal works out you are sure to make profits, but if it doesn’t, you may still make a profit. The hazards of arbitraging increase as the general market level rises, because your chances of loss in the event of the plan’s failure become correspondingly greater. To this important extent many types of special situations are tied-in with general market conditions; but it is still true that in the average or representative case the result depends upon corporate and not on market price developments. Arbitrages in industrials generally grow out of mergers or recapitalizations and involve the sale of existing rather than when-issued securities. In the recent Raytheon-Submarine Signal merger, one could buy Submarine Signal and sell Raytheon on announcement at an indicated spread of about 18%. That arbitrage was successfully consummated within sixty days. Similarly, when the General Cable Recapitalization Plan was announced, one could buy a share of A stock at 52 and sell four shares of common for 59—A spread of about 13%--with consummation in 45 days. However, such operations have as a pre-requisite the ability to borrow the stock for the duration of the arbitrage. Under present conditions of no margin trading, cash borrowing is so difficult as to prevent many (though not all) of these deals. In the utility field, somewhat similar arbitrages have been available as a result of exchange offers made by holding companies for their preferred stocks. Recent examples are United Corporation and American Superpower. There are, of course, various hazards involved in all these arbitrages. They include possible rejection by stockholders; possible legal action by minority holders; possible disapproval by the S.E.C, etc. The experienced operator does not ignore these hazards, but attempts to measure them carefully in the particular circumstances of each case. It will be noted that the industrial, utility and rail arbitrages fall respectively into three distinct classed with regards to the time element. One might almost say that the first is usually a matter of weeks, the second of months, and the third of years. An exception to this rule was the United Light and Power arbitrage. Here one bought a share of old preferred and sold five shares of new common “when issued” against it, at an initial spread of about 10% net. Because of litigation that reached the Supreme Court, this utility recapitalization took fully two years between proposal and consummation. Though it yield the expected profit in dollars, the time element made the outcome far from brilliant. Class B. Cash Payout, in Recapitalization or Mergers. A recent example of this type is Central and Southwestern Utilities 2nd Preferred. Under a recapitalization and merger plan, presented to the SEC on Feb 5, 1946, the holders were given the option of taking the full redemption value in cash or the equivalent in new common stock at the syndicate offering price. The current redemption value was $220 per share, against the market price of 185. Thus the expected profit would be 19%, plus interest at about 3% per annum for the duration of the operation. The hurdles to be surmounted here in include: (a) SEC approval;
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

(b) Court approval.; (c) Ability to secure underwriting of new common stock at a specified minimum price; (d) Miscellaneous delays, most frequently caused by litigation. If the plan should fail, the buyer risks a fall in the price; but contrariwise in the typical preferred stock or bond pay-out, there is virtually no chance of getting more than the redemption value accorded under the plan. We must recognize here an inherent weakness in this type of operation. (Sequel: The plan was carried out, and the preferred holders who asked for cash received $233 in February 1947.) The experienced analyst knows that the chance of ultimate loss diminishes to the extent that the preferred stock is cushioned by the presence of a proportionately large common stock equity. Thus he should feel differently as regards Cities Service 1st Preferred selling at 132, with total claim of 181 (or 193 at call price) as compared with American Power and Light $6 Preferred selling at 117 with a total claim of 145 (or 160 at call price). The maximum indicated gain for Cities Service Preferred selling is 46%, against 37% for American P. and L. Preferred. The latter, however, has the advantage, first, of paying a current dividend ($44.50) and, second, of having an actual plan on file for paying off the issue. On the other side of the picture is the important fact that each dollar paid for Cities Service Preferred is now (October 5th) backed by $1.20 in market value of common stock; while each dollar paid American P. & L. Preferred is backed by only 20 cents of common stock. If continued weakness in the stock market should result in the definite postponement of the American P. & L. plan, the purchaser of Cities Service Preferred will undoubtedly fare the better of the two (Sequel: the pending plan for paying off the American Power & Light Preferred was withdrawn, and the $6 issue sold at 91 at the end of 1947.) Conversely, a plan was proposed and carried out for paying of the Cities Service Preferred issues. As a consequence the First Preferred was exchanged for bonds, making it worth $157 per share at the end of 1947.) Class C. Cash Payments on Sale or Liquidation. In most cases where a company sells out its business to another or merely liquidates its assets piecemeal, the ultimate amount received by the security holder exceeds the market price at the time the sale or liquidation is proposed. (This condition grows out of the nature of the price making factors in the security market; we do not have the space to discuss the reasons in detail.) In the case of a sale for cash on a going concern basis, the largest profits are most often to be made by those who buy before the negotiation are begun or completed. But even after the terms are announced, there is often an interesting spread to be realized if the sale is consummated. Quite a number of such sales have recently taken place in the textile-mill field. At this time the most recent example is a bid of $365 per share for stock of the Luther Mfg. Co., contingent on acceptance by not less than 95% of the stock. A week before the purchase offer was made public the stock was quoted at $150 bid. (Sequel: the purchase at $365 was consummated.) Most of these purchase offers, even though contingent on acceptance by a large majority, have become effective; and those which failed generally did so because a still higher bid was forthcoming from other quarters.
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

A vote to liquidate assets by piecemeal sale is rather infrequent, except that we have had a number of such liquidations of public utility holding companies under statutory pressure. In such cases the amount of cash to be realized for the assets, less the corporate liabilities and expenses, is subject to estimation and consequent error. Where estimates are made by management, they are customarily on the conservative side. In most instances, the market price at the time of the vote to liquidate proves to be appreciably less than the amount recovered. A protracted liquidation of this kind has been under way in Ogden Corp., showing a very good percentage profit for those who bought at an early stage. Brewster Corp. is an example in the industrial field. At this writing the tax liabilities of Brewster Corp. is an example in the industrial field. At this writing the tax liabilities of Brewster have not been determined. As against a state book value of 5 and a market price of about 4.25, the current “expert” estimate of ultimate realization ranges between 5.5 and 6. (Sequel: The stockholders have since received $5.75 per share in cash, and are expected to realize something additional.) Class D Litigated Matters. There are fairly numerous cases in which the value of a security depends largely on the outcome of litigation. This may involve a damage or subordination suit (e.g., International Hydro Electric, Inland Gas Co.); disputed income tax liability (e.g., Gold and Stock Telegraph, Pittsburgh Incline Plane); an appeal from a reorganization plan wiping out stock issues (e.g., St Louis Southwestern Ry., New Haven R.R.). In general, the market undervalues a litigated claim as an asset and overvalues it as a liability. Hence the students of these situations often have an opportunity to buy into them at less than their true value, to realize attractive profits—on the average—when the litigation is disposed of. Class E. Public Utility Breakups. These have been a very important group of special situations in recent years. They are an essentially temporary phenomenon in that they will pass out of the picture when compliance with Section 11 of the Public Utility Holding Company Act has been completed for the industry. Their unique feature is that the profit in them depends upon the principle that a holding company is worth more dead than alive—i.e., that it’s separate assets, net, will sell for more than the parent company securities. This has brought about the paradoxical situation that the stocks of holding companies bitterly fighting dissolution–presumably for the sake of their owners, the shareholders— have been depressed in price by this valiant battle and have advanced when they lost their fight. The technical quality which sets these situations apart from others is the fact that they usually depend upon an estimate or forecast of the market value of securities which are to be distributed and are not now traded in. In some cases there is a narrow market for existing minority shares, but it may not be too informing in relation to conditions after the majority shares come on the market. (An example of this is Philadelphia Co., which is the central factor in the valuation of standard Gas and Electric Preferred issues. The curb-market price for the 3.2% minority interest may or may not be representative of the value of the entire issue.)

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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

Improvements in the art of utility analysis, favored by the relative infrequency of unlooked for developments in the field, makes it possible to calculate fairly dependably what any operating company stock is likely to sell at under current market condition. Thus the hazard in exploiting these breakup situations grows largely out of the uncertain time element, with the attendant possibility of an unfavorable change in market conditions before the distributions are received. Class F. Miscellaneous Special Situations. This catch-all category includes everything we have not already classified. There is no point in trying to make our descriptions comprehensive since a good deal depends on one’s personal definition of “special situation.” We may suggest two additional varieties by way of example only. A peculiar one would be the rather major field of hedging operations-most characteristically the sale of a common stock against ownership of a convertible bond or preferred stock. (Here the securityexchange feature operates to protect against loss rather than to create the profit.) Another, more limited, would be the purchase of a guaranteed security on the expectation that it will later be made exchangeable into a bond on attractive terms, in order to save a heavy corporate income tax. (This occurred in the case of Delaware and Hudson and D. L &W. leased-line stocks.)

Conclusion
At the outset of this article we grouped special situations and undervalued securities together. The reader will have noticed that we do not consider these terms as synonymous—although it may be held that special situations constitute a major subdivision of undervalued securities. The essence of a special situation is an expected corporate (not market) development, within a time period estimable in the light of past experience. Thus here, as almost everywhere else in finance, wide experience is a major factor in lasting success; it must be supplemented by careful study of each situation and the possession of sound though somewhat specialized judgment. Special situations, as we define them appeal mightily to one class of temperament for the very reason that they leave other people cold. They lack industrial glamour, speculative dynamite, or more sober growth prospects. But they do afford the analyst an opportunity to deal with security values very much as the merchant deals with his inventory, calculating in advance his average profits and his average holding period. In this sense they occupy an interesting middle ground between security purchases for ordinary speculation or investment and security purchases for resale in syndicate or dealership operations. Editorial Comments: Special situations or workouts are happy hunting grounds for the entrepreneurial merchant analyst/investor who can find undervalued securities with a built-in catalyst of corporate action. A great special situations investor once said that good investors in special situations do so well that they grow their assets to the point that they can no longer take advantage of many of the opportunities offered in obscure, small workouts. Larger investors will move away from these opportunities, leaving the field open to new talent.
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

-Excerpts from Security Analysis on Wall Street by Jeffrey C. Hooke (Pages 384 to 385) Liquidations First you must determine if the company can remain as a going concern. If not, then a publicly held company is viewed as a liquidation candidate. It has poor prospects as an operating business and shows a history of losses. Investors appraise the business not as a going concern, but rather as a collection of assets better off in the hands of others. In performing a liquidation analysis, you examine the worth of each asset category in a quick selloff, aggregate these liquidation values, and subtract from this sum the estimated cost of closing the business and paying off its liabilities. If this calculation provides a positive number, such as $10 per share, you have established a ceiling purchase price. From this $10 must then be subtracted your time-adjusted rate of return requirement. Unless the business has substantial intangible assets such as well-respected brand-names, exclusive patents or quasi-monopoly operating rights, the first “back of the envelope” evaluation focuses on historical balance sheet data. For each balance sheet item, you determine an estimated range of “liquidated value” percentages, which are based on experiences for similar businesses. Later on, after further study, these percentages are adjusted to include the new information. Consider the hypothetical case of Siegel Corporation, a troubled manufacturer of construction materials, as presented in Exhibit 23-15 Siegel Corporation—Summary Liquidation Analysis (in millions except per share).
Historical Book Value Assets Cash Accounts receivable Inventory Totals Plant & Equipment Goodwill Liabilities and Stockholders’ Equity Short-term debt Other current liabilities Total Stockholders’ Estimated Liquidation Percentages Estimated Liquidation Values $ 10 28 20 58 40 0 $98 $ (15) (25) (40) (8) $(48) $ 50 Divided 5 $ 10

$

10 40 40 90 $100 20 $210 $ 15 25 40 170 $210

100% 70 50 40 0 100 100 Costs of shutdown Net Outflows Net Liquidation Value (98 – 48) = 50) Shares Outstanding Value per share

The $50 million liquidation value is far below Siegel’s stockholders’ equity of $170 million. This significant discount to book value is characteristic of most liquidation analysis and emphasizes an important point: Firms realize a better stock price when they are viewed as going concerns, whereby
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

their respective values are based on future earnings power rather than on tangible asset compositions. To prove this assertion, one need only look at the November 1997 pricing for the Dow Jones Industrials, which were then trading at 5x historical book value. Unless an analyst works for a firm that is considering a takeover of Siegel Corp., there is no way for him to unlock the liquidation value. Thus, his rate of return requirement must reflect not only the uncertainty of his liquidation estimates but also (1) Siegel’s burn rate and (2) the likelihood of its acquisition by a third party interested in unlocking those values. Assuming a 30% IRR requirement and a two-year holding period, the $10 liquidation value translates into a $6 investment price (i.e., $10/($1.30)^2 Security Analysis, Third Edition 1951 by Graham and Dodd. Chapter 38 pages 475 - 491: The Asset-Value in Common Stock Valuation Note that this chapter was written before 1951. The principles hold but the examples may seem strange such as companies trading at 3 – 4 x earnings. Earning-Power Value and Liquidating Value. In the legal approach to valuation and enterprise is usually considered to be worth at least as much as the net amount that could be realized by its sale or liquidation. The liquidating value is minimum value because, if worse comes to worst, a concern can be sold or liquidated. In other words, no business is worth less to its owners than they could realize from it by sale. For if a business could not earn enough to support the liquidating value, ordinary prudence would suggest that it be wound up or disposed of and that the sale value or liquidating value be turned over to its owners. On this point, the legal approach to valuation appears to diverge widely from the stock-market or practical approach. Stock prices do not reflect any presumption that liquidating value is minimum value. The reasoning of the market—i.e., of investors and speculators generally—is that liquidating value is of no practical importance in the typical case. For the typical company—whether prosperous or not—is not going to be liquidated. True, the liquidating value does sometimes become important when a non-prosperous company sells out or merges. But these occurrences are comparatively rare, and they are so unpredictable that they cannot justify paying more for a stock than it would be worth solely on a going concern basis without regard to its assets. The ignoring of realizable asset value by the stock market is perhaps the most clear-cut and striking element of difference between its approach to value and that of private business. Let us call this the “Wall Street approach” and the “Main Street approach.” On Main Street the idea that a business is worth much less than you could auction it off for would seem preposterous, but in Wall Street, people think of themselves as owning not a part of a business but shares of stock in a business. These shares may be valued, bought and sold on a basis that bears little relationship to a normal appraisal of the business entity on which they have their ownership claim. Net-Current-Asset Value as Liquidating Value
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

To discuss this phenomenon more concretely, let us shift our attention from “liquidating value” to “current-asset value.” The analyst cannot calculate accurately the liquidating value of a given company, since it is ordinarily impossible to estimate what could actually be realized for its fixed assets and what the expenses of liquidation would be. But we do know as a practical matter that most companies could be disposed of for not less than the net working capital if the latter is conservatively stated. As a general rule, at least enough can be realized for the plant account and the miscellaneous assets to offset any shrinkage sustained in the process of turning the current assets into cash. (This rule would apply in nearly all cases to a negotiated sale of the business to some reasonably interested buyer.) The working-capital value behind a common stock can be readily computed. Consequently, by using this figure as the equivalent of “minimum liquidating value,” we can discuss with some degree of confidence the actual relationship between the market price of a stock and the realizable value of the business. The historical development of this relationship has been interesting. Before the 1920’s, common stocks selling under current-asset value were practically unknown. During the “new-era” market, when prime emphasis was placed on prospects to the exclusion of other factors, a few issues in depressed industries sold below their working capital. In the great depression of the early 1930’s this phenomenon became widespread. Our computations show that about 40% of all industrial companies on the New York Stock Exchange were quoted at some time in 1932 at less than their net current assets. Many issues actually sold for less than their net cash assets alone. Writing about this situation in 1932, we stated that the market prices as a whole seem to indicate that American business was “worth more dead than alive.” It seemed evident that the market had carried its pessimism much too far—to compensate no doubt for its reckless optimism of the 1920’s. In the appraisal of most (nonutility) common stocks their asset value is of minor importance. This is true whether we are considering the implied standards of the stock market itself, or accepted techniques of analysis or legal theories of valuation as they have developed in recent years. In the day-to-day prices of the stock markets, it is generally impossible to identify any influence exerted by asset values. This point may be illustrated by Table 115, which shows quite characteristic relationships between year-end price and year-end asset value in 1949 for a group of common stocks of steel companies. Table 115. Selected Data on Steel-Company Stocks (per share) Closing Book 1949 Price, Dec. value earnings 31, 1949 (S&P) Armco Bethlehem Inland Jones & Laughlin National Republic U.S. Steel Wheeling Youngstown 28.66 32 39 29.5 92.5 23.75 26.62 47.13 75.5 45.51 69.88 38.10 90.88 112.21 58.18 64.15 144.09 144.89 7.68 9.68 5.11 7.5 16.02 7.54 5.39 10.68 18.97 1949 dividend (including extras) 2.50 2.40 3.00 2.60 5.50 3.00 2.25 4.00 6.00 Year-end ratio of price to earnings 3.7x 3.3x 7.6x 3.9x 5.8x 3.1x 4.9x 4.4x 4.0x

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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

The possession of tangible assets does not appear to have been of any help to the companies in this list. On the contrary, Inland Steel, with the least assets per dollar of market price, sold at the highest multiplier of 1949 earnings, while Jones & Laughlin, with the most assets per dollar of price, sold at a somewhat lower multiplier of earnings than the group as a whole. There are several classes of exceptions to the general stock-market rule that asset values are of negligible importance. The outstanding exception is the public-utility field. Here the actual property investment plays a significant role in determining the earnings permitted under rate regulation, and thus earning-power value tends to remain reasonable close to asset value. In the large sector of financial companies the asset value remains a prominent element in the valuation of a commonstock issue. In fact the appraisal process is likely to start with the asset value as a point of departure and to add a premium or to subtract a discount there-from to reflect the many other elements of valuation. This statement applies fairly generally to banks, insurance companies, and investment funds, but only slightly, if at all, to finance or credit companies. In a less direct fashion the asset-value factor enters into market price in the case of companies with relatively small earnings and dividends and relatively large net current assets. While in such cases the market does not ordinarily pay close attention to the current-asset value of the shares, it is possible to trace some influence exerted by this factor. For example, it is comparatively rare for a stock to sell at less than, say, 40% of its indicated current-asset value, whereas no similar minimal relationship may be traced in the market between price and total-asset value including plant. Common-stock analysis as it is generally practiced in Wall Street and reflected in the published studies of individual issues adheres pretty closely to the canons of value apparently set up by the stock market itself. Thus we do not find any tendency in such studies to emphasize asset value generally, although the figure is often stated, and in some cases attention is called to the fact that the asset value is many times the market price. (The converse situation is practically never referred to.) It is only in the past twenty years that analysts have had to deal with a large number of stocks selling below their current-asset value. Their attitude toward this phenomenon has been tentative and uncertain. The fact that a stock is selling well below its liquidating value is usually pointed to as “interesting” but with the added caution that it cannot be relied upon as a guide to successful investment. In legal valuations ruling principles have changed substantially in the last generation. In earlier years the point of departure was always the tangible asset value-subject to modifications according to certain formulas which generally sought to determine how much should be added to the tangible investment to reflect the good-will. Today the standard legal valuation is what a willing buyer would pay a willing seller, if both were conversant with the facts and intelligent, and if neither was under any pressure to trade. (This is a private market transaction). It is assumed that the price agreed upon by this buyer and seller would be found mainly by capitalizing expected future earning power. Thus legal value has tended to identify itself with ordinary investment value as found by “experts.” This affords little recognition of the asset-value factor. However, in statutory appraisals of the shares of dissenting stockholders we frequently see the asset value used as a separate factor, to which either a certain percentage weight5 or some less definite notice accorded. Furthermore, there is a fairly well defined tendency to consider the liquidating value—for which current-asset value may be taken as a rough guide—as the lowest fair value of an enterprise for purposes of reorganization, taxation, and the appraisal of dissenting shares.
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

In the succeeding pages we shall subject the asset-value elements to some independent scrutiny. First let us ask ourselves whether the almost universal attitude of ignoring asset value in the general or ordinary case is entirely sound. Second, let us consider the various kinds of special cases in which asset values admittedly play a more or less important part. Thirdly, we shall point out the little understood but vitally important ways in which asset value enters into the measurement of the success of an enterprise, thence into the testing of the accomplishment and competence of management, and finally into the area of stockholder-management relationships. The General Relationship between Asset Value and Investment Value. We started this chapter by stating flatly that asset values are ordinarily of minor importance in appraising the common stocks. Why is this so? The general answer is that a stockholder depends upon dividends for ultimate value; that dividends in turn are derived from earnings; but that earnings in their turn are not derived from earnings; but that earnings in their turn are not derived in any clear-cut or ascertainable way from the asset values. If 100 stocks are taken at random, no convincing relationship could be traced between their earnings and the equity per share. This viewpoint is thoroughly entrenched and undoubtedly too well grounded to be challenged as fallacious. But certain questions remain unanswered. Asset Value in Appraisal of Private Business …But we are fairly sure that the typical private business is valued first by relation to the net worth as shown in its balance sheet. If the earning power is large, an increment for good-will is clearly present. If the earning power is large, an increment for goodwill is clearly present. If the earning power is quite low or nonexistent, the fixed assets may be marked down by the valuer to their realizable values, just as inventories and receivables are regularly so market down in the annual audit. Why should net assets, either per books or as modified, be the controlling or at least the starting factor in the valuation of a private business, and be left almost entirely out of the reckoning when publicly traded shares are in question? Surely the mere presence of a quoted market should not properly change the basis of value. In logic, marketability is merely an added factor of value. A given stock under given circumstances should always be worth some percentage more if it has a quoted market than if it has not. But we must emphasize that, in practice, the conversion from a close corporation with unquoted shares to one with listed or over-the-counter securities is not a matter of simply to one with listed or over-thecounter securities is not a matter of simply assign a new element of value, but rather of changing the psychological attitude of the owners of its shares, and consequently changing also the criteria of value applied to it in the market lowest value their owners would set upon them—and be willing to sell them for—if they had no published quotations. The chief reason for this fact, undoubtedly, is that as long as a stock has no market its asset value retains importance in the minds of the owners; but soon after a market has been created, the asset value seems to lose all significance. Stated Asset Value Unreliable. In partial explanation of this seeming irrationality of finance we may mention three plausible reasons why asset values have been entitled to less weight in the case of publicly owned stocks than in private businesses. The first is that, historically, the stated asset value of active common stocks
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was often unreliable—or, more bluntly stated, falsified, the plant-account total included large but unrevealed amounts for intangibles or “water.” Since the figures supplied were meaningless, it was natural and sensible to ignore them. Asset Value Dependent on Earning Power. The second reason is that the typical publicly owned business has been of the kind in which the true worth of the physical assets is largely bound up with their earning power. The realizable value of the plant or machinery, in the absence of profitable operation, may be extremely low. When there is substantial debt and preferred stock outstanding, these low values plus the working capital would leave no residue whatever for the common stock. In the smaller private businesses the fixed assets may be more readily disposed of, and in a fair proportion of such concerns, the working capital makes up most of the book equity. Unavailability of the Assets. The third reason is that ownership of or in a private undertaking is generally identified with control of that business. (Minority shareholdings not part of a cohesive management or family group are the exception rather than the rule.) Thus the owners of the stock or partnership shares consider themselves as having direct access to the assets. Consequently, what the net assets are wor4th, plus possible good-will is more or less the same thing as what the business is possibly worth. The typical outside stockholder of a listed company has no practical access to his share of the net assets. The theoretical access which he has by moving jointly with his fellow stockholders appears to him to be an empty privilege and scarcely enters into his calculations. -Margin of Safety by Seth Klarman Chapter: The Art of Business Valuation Pages 131-133 The liquidation value of a business is a conservative assessment of its worth in which only tangible assets are considered and intangibles, such as going-concern value, are not. Accordingly, when a stock is selling at a discount to liquidation value per share, a near rock-bottom appraisal, it is frequently an attractive investment. A liquidation analysis is a theoretical exercise in valuation but not usually an actual approach to value realization. The assets of a company are typically worth more as part of a going concern than in liquidation, so liquidation value is generally a worst-case assessment. Even when an ongoing business is dismantled, many of its component parts are not actually liquidated but instead are sold intact as operating entities. Breakup value is one form of liquidation analysis; this involves determining the highest value of each component of a business, either as an ongoing enterprise or in liquidation. Most announced corporate liquidations are really breakups; ongoing business value is preserved whenever it exceeds liquidation value. . How should investors value assets in a liquidation analysis? An orderly liquidation over time is virtually certain to realize greater proceeds than a “fire sale,” but time is not always available to a company in liquidation. When a business is in financial distress, a quick liquidation (a fire sale)
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may maximize the estate value. In a fire sale the value of inventory, depending on its nature, must be discounted steeply below carrying value. Receivables should probably be significantly discounted as well; the nature of the business, the identity of the customer, the amount owed, and whether or not the business is in any way ongoing all influence the ultimate realization from each receivable. When no crisis is at hand, liquidation proceeds are usually maximized through a more orderly winding up of a business. In an orderly liquidation the values realized from disposing of current assets will more closely approximate stated book value. Cash, as in any liquidation analysis, is worth one hundred cents on the dollar. Investment securities should be valued at market prices, less estimated transaction costs in selling them. Accounts receivable are appraised at close to their face amount. The realizable value of inventories—tens of thousands of programmed computer diskettes, hundreds of thousands of purple sneakers, or millions of sticks of chewing gum—is not so easily determinable and may well be less than book value. The discount depends on whether the inventories consist of finished goods, work in process, or raw materials, and whether or not there is the risk of technological or fashion obsolescence. The value of the inventory in a supermarket does not fluctuate much, but the value of a warehouse full of computers certainly may. Obviously, a liquidation sale would yield less for inventory than would an orderly sale to regular customers. The liquidation value of a company’s fixed assets can be difficult to determine. The value of plant and equipment, for example, depends on its ability to generate cash flows, either in the current use or alternative uses. Some machines and facilities are multipurpose and widely owned; others may have value only to the present owner. The value of restaurant equipment, for example, is more readily determinable than the value of an aging steel mill. In approximating the liquidation value of a company, some value investors, emulating Benjamin Graham, calculate “net-net working capital” as a shortcut. Net working capital consists of current assets (cash, marketable securities, receivables, and inventories) less current liabilities (accounts, payable, notes, and taxes payable within one year.) Net-net working capital is defined as net working capital minus all long-term liabilities. Even when a company has little ongoing business value, investors who buy at a price below net-net working capital are protected by the approximate liquidation value of current assets alone. As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all its liabilities, and still distribute proceeds in excess of the market price to investors. Ongoing business losses (the cash “burn rate”) can, however, quickly erode net-net working capital. Investors must therefore always consider the state of a company’s current operations before buying. Investors should also consider any off-balance sheet or contingent liabilities that might be incurred in the course of an actual liquidation, such as plant closing and environmental laws. A corporate liquidation typically connotes business failure; but ironically, it may correspond with investment success. The reason is that the liquidation of underlying business value. Since value investors attempts to buy securities trading at a discount from the value of a business’s underlying assets, liquidation is one way for investors to realize profits. Liquidation is, in a sense, one of the few interfaces where the essence of the stock market is revealed. Are stocks pieces of paper to be endlessly traded back and forth, or are they proportional interests in underlying businesses? A liquidation settles this debate, distributing to owners of pieces
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of paper the actual cash proceeds resulting from the sale of corporate assets to the highest bidder. A liquidation settles this debate, distributing to owners of pieces of paper the actual cash proceeds resulting from the sale of corporate assets to the highest bidder. A liquidation thereby acts as a tether to reality for the stock market, forcing either undervalued or overvalued share prices to move into line with actual underlying value. End.

The following excerpts are to encourage you to thoroughly explore the following blogs to learn more about net/nets/liquidations and asset based investing. These blogs reference each other and can be a great learning tool for you. http://www.manualofideas.com/blog/ www.gannononinvesting.com

http://www.thirdavenuefunds.com/ta/shareholder-letters-mf.asp
Marty Whitman on value and corporate governance http://can-turtles-fly.blogspot.com/ www.greenbackd.com

March 3, 2010 by greenbackd The superb Manual of Ideas blog has an article by Ravi Nagarajan, Marty Whitman Reflects on Value Investing and Net-Nets, on legendary value investor Marty Whitman’s conversation with Columbia Professor Bruce Greenwald at the Columbia Investment Management Conference in New York. I have in the past discussed Marty Whitman’s adjustments to Graham’s net net formula, which I find endlessly useful. Whitman has some additional insights that I believe are particularly useful to net net investors: “Cheap is Not Sufficient” At several points in the discussion with Prof. Greenwald, Mr. Whitman came back to a central theme: It is not sufficient for a security to be “cheap”. It must also possess a margin of safety as demonstrated by a strong balance sheet and overall credit worthiness. In other words, there are many securities that may appear cheap statistically based on a number of common criteria investors use to judge “cheapness”. This might include current year earnings compared to the stock price, current year cash flow, and many others. However, if the business does not have a durable balance sheet, adverse situations that are either of the company’s own making or due to macroeconomic factors can determine the ultimate fate of the company. A durable balance sheet demonstrates the credit worthiness a business needs to manage through periodic adversity.
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Whitman also discusses an issue near and dear to my heart: good corporate governance, and, by implication, activism: One other point that Mr. Whitman made while discussing corporate governance also applies to many net-net situations. The true value of a company may never come out if there is no threat of a change in control. This obviously makes intuitive sense because the presence of a very cheap company alone will not result in realization of value unless management is willing to act in the interests of shareholders either by liquidating a business that has no future prospects but a very liquid balance sheet or taking steps to improve the business. Read the balance of the article at The Manual of Ideas blog.
Marty Whitman Reflects on Value Investing and Net-Nets

By Ravi Nagarajan Despite a snowstorm that caused the absence of several speakers, the Columbia Investment Management Conference in New York today included many interesting presentations and panel discussions. The highlight of the day was the conversation between Columbia Professor Bruce Greenwald and Martin Whitman, Founder and Portfolio Manager of Third Avenue Management. Mr. Whitman has a sixty year history in the investment management field and represents a distinguished voice of experience we can all learn from. This article includes several topics that were included in the discussion between Prof. Greenwald and Mr. Whitman but it is not a complete transcript and, unless otherwise noted, is based on the authors notes and recollection of the conversation rather than a presentation of direct quotes. The Evolution of a Value Investor Most investors who have arrived at a “value oriented” strategy moved toward the approach over a period of time. Many of us know the story of Warren Buffett reading every book on investing in the Omaha library but not reaching the conclusion that value investing represents the best strategy until reading Ben Graham’s The Intelligent Investor in 1950. A similar “evolution” was the case for Mr. Whitman who entered the business as a security analyst at Shearson, Hammil in 1950. For the first four years, Mr. Whitman focused on many of the traditional benchmarks that security analysts today still concentrate on such as earnings per share growth and predicting near term price movements. In 1955, Mr. Whitman read Between the Sheets by William J. Hudson which is a book (currently out of print) regarding the importance of paying particular attention to the balance sheet. This book combined with several real life examples at the time convinced Mr. Whitman that emphasizing balance sheet quality should be more heavily considered in the field of security analysis. Mr. Whitman also gained a great deal of experience working as a portfolio analyst for William Rosenwald starting in 1956. Experience in stockholder litigation and bankruptcy, fields that were shunned at the time, also provided important lessons regarding analyzing the capital structure of distressed firms.
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“Cheap is Not Sufficient” At several points in the discussion with Prof. Greenwald, Mr. Whitman came back to a central theme: It is not sufficient for a security to be “cheap”. It must also possess a margin of safety as demonstrated by a strong balance sheet and overall credit worthiness. In other words, there are many securities that may appear cheap statistically based on a number of common criteria investors use to judge “cheapness”. This might include current year earnings compared to the stock price, current year cash flow, and many others. However, if the business does not have a durable balance sheet, adverse situations that are either of the company’s own making or due to macroeconomic factors can determine the ultimate fate of the company. A durable balance sheet demonstrates the credit worthiness a business needs to manage through periodic adversity. A New Take on Graham’s “Net-Nets” Mr. Whitman believes that it is a “myth” that there are no “net-net” opportunities available in the market today. We discussed Graham’s concept of net-nets in a prior article and came up with some examples of such opportunities over the past year (for example, see the articles on Hurco and George Risk Industries). However, such opportunities are very rare and often exist only in the most thinly traded stocks and therefore are rarely actionable. Rather than adhering to Ben Graham’s original concept of “net-nets”, Mr. Whitman has made a few modifications. Instead of using current assets as the store of value, he looks at “readily ascertainable asset value” and tries to buy at a large discount to that value. Assets that can be readily convertible to cash may include high quality real estate, for example. In certain situations, assets such as real estate may be more valuable in a liquidation than inventories which are part of current assets but often highly impaired in distressed situations. One other point that Mr. Whitman made while discussing corporate governance also applies to many net-net situations. The true value of a company may never come out if there is no threat of a change in control. This obviously makes intuitive sense because the presence of a very cheap company alone will not result in realization of value unless management is willing to act in the interests of shareholders either by liquidating a business that has no future prospects but a very liquid balance sheet or taking steps to improve the business. When asked if the management of a typical public company is overpaid, Mr. Whitman said “you’d better believe it” due partly to the fact that most Boards of Directors are “a bunch of wimps, including me.” This serves as a reminder that there is one other characteristic that many value investors share: Humility and a willingness to admit errors. The author of this post is a private investor and writer focused on applying value investing techniques to find securities trading well below intrinsic business value. He is a Manual of Ideas contributor and editor of The Rational Walk.
Posted by manualofideas on February 27, 2010 08:41 AM | Permalink

Marty Whitman’s adjustments to Graham’s net net formula
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May 4, 2009 by greenbackd Long-term readers of Greenbackd might remember our initial struggle to apply the net net / liquidation formula described by Benjamin Graham in the 1934 Edition of Security Analysis in the context of modern accounting. Putting aside our attempt to include and tweak the discounts to PP&E (kind of like fixing the smile on the Mona Lisa), most embarrassing was our failure to factor into the valuation off-balance sheet liabilities and contractual obligations. The best thing that we can say about the whole sorry episode is that we got there in the end and we’ve been applying a more robust formulation for the last quarter. With that in mind, we thought it was particularly interesting to see the Financial Post’s article, Veteran tweaks Graham’s rule to find bargains (via Graham and Doddsville), which details the refinements legendary value investor Marty Whitman makes to Graham’s net-net formulation. According to the article, Whitman makes the following adjustments to Graham’s 90-year old formula:

Companies must be well-financed

First and foremost, companies must be well-financed in keeping with the core tenet of Third Avenue’s “safe and cheap” method of value investing. The goal is to own companies that are going concerns, not ones destined for liquidation. This difference is a crucial point of distinction between the focus of equity investors, who are often wiped out in liquidation, and bond investors, who have rights to the assets of a company in liquidation.

Whitman includes long-term assets that are easily liquidated

The second adjustment is to the assets themselves. Graham and Dodd focused exclusively on current assets when calculating liquidation value whereas Whitman includes long-term assets that are easily liquidated. For example, roughly one third of long-term assets of Toyota Industries Corp. are investment securities, including a 6% position in Toyota Motor Corp. (TM/TSX), says Ian Lapey, portfolio manager at Third Avenue and designated successor to Whitman on the Third Avenue Value Fund. These securities are therefore included in Third Avenue’s calculations of net-net. Closer to home, oil and gas producer Encana Corp. (ECA/ TSX) has proved reserves of oil and natural gas that are not included in current assets, says Lapey. “They are liquid in that there is a real market, current commodity prices notwithstanding, for highquality proved reserves of oil and gas.” Encana is a top holding in AIC Global Focused Fund, subadvised by Third Avenue and managed by Lapey.

Adjust for off-balance sheet liabilities
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The third adjustment is the inclusion of off-balance-sheet liabilities. Here, U. S. banks’ structured investment vehicles readily spring to mind.

Include some PP&E

The fourth and final adjustment to Graham and Dodd is the inclusion of “some property, plant and equipment” for their liquidated cash value and associated tax losses that often produce cash savings. Hong Kong real estate companies, such as top holding Henderson Land Development Co. Ltd. (0012/HK),are required to mark property values to market prices, so liquidation values are easily ascertained. “In most time periods, the market for fully leased office buildings is quite liquid,” says Lapey, justifying their inclusion in net-net calculations of these companies. The article also discusses one of Whitman’s current positions, Sycamore Networks Inc (NASDAQ:SCMR): Sycamore Networks Inc. (SCMR/NASDAQ) is the most compelling example of a net-net situation in the United States offered up by Lapey. The telecom equipment company has more cash — US$935-million in all — than the total value assessed to it by the market, in light of its US$800-million market capitalization and US$38-million in total liabilities. “We feel that there is value to their technology that is being recognized by some of the large telecom carriers,” says Lapey of Sycamore Networks, but he acknowledges its current weak earnings power. Lapey is also attracted to the one-third of outstanding share ownership by management because it presents an important alignment of their interests with those of Third Avenue, who are by and large passive investors. These large valuation discounts in the market are reassuring words for investors from the one of the finest practitioners of Graham and Dodd. “We are holding these companies trading at huge discounts,” says Lapey, “and if these companies were to sell assets or sell the whole companies we think the result would be a terrific return for our investment.” As we discussed in our review of our first quarter, we started Greenbackd in an effort to extend our understanding of asset-based valuation described by Graham. Over the last few quarters we have refined our process a great deal, and it’s pleasing to us that we already include the adjustments identified by Whitman. We believe that our analyses are now qualitatively more robust than when we started out and seeing Whitman’s adjustments gives us some confidence that we’re on the right track. http://greenbackd.com/2009/05/04/marty-whitmans-adjustments-to-grahams-net-net-formula/? replytocom=3212#respond
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1. [...] at the Columbia Investment Management Conference in New York. I have in the past discussed Marty Whitman’s adjustments to Graham’s net net formula, which I find endlessly useful. Whitman has some additional insights that I believe are [...]

2. on August 13, 2009 at 12:30 am | Reply About liquidation value investing « Greenbackd [...] For more detail, see our posts Valuing long-term and fixed assets, Portfolio construction and Marty Whitman’s adjustments to Graham’s net net formula. The historical returns from investing in securities trading at a discount to liquidation [...] 3. on July 28, 2009 at 2:19 am | Reply Marty Whitman discusses Graham’s net-net formula « Greenbackd [...] net-net formula and his adjustments to it. We’ve previously covered those adjustments here, but we’ve added the video because we think it’s quite amazing to see the great man [...] 4. on June 1, 2009 at 1:16 am | Reply Greenbackd Portfolio Q2 Performance and Update « Greenbackd [...] even managing members of hedge funds, and by incorporating the observations of Marty Whitman (see Marty Whitman’s adjustments to Graham’s net net formula here) and Seth Klarman (our Seth Klarman series starts here), we have refined our process. We [...] 5. on May 6, 2009 at 7:18 pm | Reply David Thanks for the nod, Greenbackd. I really enjoy your blog… keep up the good work! http://www.thirdave.com/ta/documents/sl/shareholderletters-09Q1.pdf I also wrote about the letter on my blog if anyone is interested: http://can-turtles-fly.blogspot.com/2009/03/martin-whitman-1q2009-shareholder.html

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on May 4, 2009 at 9:55 pm | Reply greenbackd Thanks, Sivaram.

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6. on May 4, 2009 at 9:28 am | Reply widemoat Talking to Whitman’s approach, I agree that the last three adjustments are a necessity. I’m not sure about the first. If there is any ‘financing’ other than the cash of the balance sheet, then cash becomes a crucial concern for a liquidation analysis. I wouldn’t want any creditors ahead of me if an asset-rich, cash-poor company went into bankruptcy (supposedly GGP is an example, per Ackman). I’d like him to say more about this. --

Net Current Asset Value Stocks
By Ravi Nagarajan Published on March 14, 2009 at 11:46 am The concept of having a durable margin of safety for investments is critical in all market environments but even more important in the economic climate of early 2009. I do not know of many economists who accurately predicted the macroeconomic climate of the past year and there are virtually no stock market forecasters who predicted 50 percent declines in the major averages. I certainly did not anticipate the market carnage and I have no faith in my ability to know where the Dow or S&P 500 will be at this time next year. Rather than attempting to forecast the economy or the direction of the overall market, it makes sense to identify individual securities that trade at levels that provide a solid margin of safety. The silver lining of the market declines over the past year is that there are many more bargains available, but how can one separate stocks that have been legitimately hammered from those that might represent bargains? Graham’s NCAV Concept Benjamin Graham pioneered a technique that holds a great deal of promise in today’s market. Graham’s concept of identifying bargain issues, or Net-Current-Asset Value Stocks (NCAV), is as relevant today as when he wrote about it in The Intelligent Investor in 1949. Let’s take a look at this concept and how it might be applied today. The NCAV concept involves identifying companies that are trading at below the level of the current assets on the balance sheet less all liabilities. Current assets consist primarily of cash and cash equivalents, trade receivables, and inventories. These are assets that are either cash or convertible into cash within a relatively short timeframe (usually less than a year). From current assets, one subtracts all liabilities on the balance sheet, not just current liabilities. This value is then compared against the market valuation of the company. This approach involves a far more rigorous standard than merely looking for companies trading at less than book value. Book value can include all kinds of intangible assets, many of which may be impaired in some manner. This is far more true today than when Graham was using this technique. Goodwill and intangibles litter the balance sheets of most companies and determining impairments
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is subjective at best. Graham’s NCAV approach values intangibles at zero. In addition, land, property, plants, and equipment are not even considered in the NCAV approach. Limitations Graham always recommended that this approach should be used to select a diversified group of stocks selling at under net current asset value. Why is this recommended? There are many limitations and variables that could exist to make a single investment of this kind unprofitable. It is prudent to have a diversified list to mitigate the risk of any particular NCAV situation not working out as expected. Some of the major limitations include the following: Unprofitable Operations It is obvious that even a company that currently is trading for far less than NCAV could end up destroying shareholder value further if the company has a track record of unprofitable operations and negative cash flow. It makes sense to filter out companies that have a pattern of unprofitable results and lack a coherent strategy for the business. Concentrated Ownership Many NCAV stocks have concentrated ownership profiles in which one individual or a small group controls the company. In such scenarios, it may be difficult or impossible to unlock the value in the company if the agenda of the controlling parties differs from your interests. For example, if the owners of a NCAV stock are also on the payroll, it is always possible for excessive compensation practices to divert the value from shareholders to the owners via payroll. Therefore, examining whether the company has trustworthy management is important. Often investors examine 10K reports but fail to examine proxy statements detailing executive compensation practices. This can be a warning sign when examining any company, but is particularly important for NCAV scenarios. Small Market Capitalization and Trading Volume It is very rare to find a company trading at below NCAV that has a market capitalization much greater than $100M. Most NCAV stocks have been overlooked by institutions or are too small to have a material impact on the results of large money managers. While this creates a potential opportunity for enterprising individual investors, sometimes the market capitalization is so small that trading volume makes it difficult or impossible to accumulate a meaningful number of shares without moving the market price. This has happened to me in the past on relatively small positions. If you are dealing with a stock that has average daily trading volume of 5,000 shares and trades at $5/share, if you attempt to make an investment of $10,000, you are accounting for a very significant portion of that day’s volume. Suddenly, even a small investor is facing issues such as having to spread out purchases over many days to accumulate a meaningful position – a dilemma normally only impacting larger investors and institutions. Regardless of the limitations, today’s market environment has created opportunities in this area that did not exist a year ago. I plan to write more about NCAV stocks, although the limitations noted above will eliminate my ability to write about stocks until after I obtain a position. I will disclose any positions in discussions of individual securities.
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As individual investors, we can benefit from today’s easy access to information. Graham had to manually filter through stacks of S&P reports but we have the advantage of screening tools to narrow down the list. It is actually quite surprising that such opportunities exist at all, and another sign of general market inefficiency during periods of economic stress. Net Current Asset Value Stocks By Ravi Nagarajan Published on March 14, 2009 at 11:46 am The concept of having a durable margin of safety for investments is critical in all market environments but even more important in the economic climate of early 2009. I do not know of many economists who accurately predicted the macroeconomic climate of the past year and there are virtually no stock market forecasters who predicted 50 percent declines in the major averages. I certainly did not anticipate the market carnage and I have no faith in my ability to know where the Dow or S&P 500 will be at this time next year. Rather than attempting to forecast the economy or the direction of the overall market, it makes sense to identify individual securities that trade at levels that provide a solid margin of safety. The silver lining of the market declines over the past year is that there are many more bargains available, but how can one separate stocks that have been legitimately hammered from those that might represent bargains? Graham’s NCAV Concept Benjamin Graham pioneered a technique that holds a great deal of promise in today’s market. Graham’s concept of identifying bargain issues, or Net-Current-Asset Value Stocks (NCAV), is as relevant today as when he wrote about it in The Intelligent Investor in 1949. Let’s take a look at this concept and how it might be applied today. The NCAV concept involves identifying companies that are trading at below the level of the current assets on the balance sheet less all liabilities. Current assets consist primarily of cash and cash equivalents, trade receivables, and inventories. These are assets that are either cash or convertible into cash within a relatively short timeframe (usually less than a year). From current assets, one subtracts all liabilities on the balance sheet, not just current liabilities. This value is then compared against the market valuation of the company. This approach involves a far more rigorous standard than merely looking for companies trading at less than book value. Book value can include all kinds of intangible assets, many of which may be impaired in some manner. This is far more true today than when Graham was using this technique. Goodwill and intangibles litter the balance sheets of most companies and determining impairments is subjective at best. Graham’s NCAV approach values intangibles at zero. In addition, land, property, plants, and equipment are not even considered in the NCAV approach. Limitations

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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

Graham always recommended that this approach should be used to select a diversified group of stocks selling at under net current asset value. Why is this recommended? There are many limitations and variables that could exist to make a single investment of this kind unprofitable. It is prudent to have a diversified list to mitigate the risk of any particular NCAV situation not working out as expected. Some of the major limitations include the following: Unprofitable Operations It is obvious that even a company that currently is trading for far less than NCAV could end up destroying shareholder value further if the company has a track record of unprofitable operations and negative cash flow. It makes sense to filter out companies that have a pattern of unprofitable results and lack a coherent strategy for the business. Concentrated Ownership Many NCAV stocks have concentrated ownership profiles in which one individual or a small group controls the company. In such scenarios, it may be difficult or impossible to unlock the value in the company if the agenda of the controlling parties differs from your interests. For example, if the owners of a NCAV stock are also on the payroll, it is always possible for excessive compensation practices to divert the value from shareholders to the owners via payroll. Therefore, examining whether the company has trustworthy management is important. Often investors examine 10K reports but fail to examine proxy statements detailing executive compensation practices. This can be a warning sign when examining any company, but is particularly important for NCAV scenarios. Small Market Capitalization and Trading Volume It is very rare to find a company trading at below NCAV that has a market capitalization much greater than $100M. Most NCAV stocks have been overlooked by institutions or are too small to have a material impact on the results of large money managers. While this creates a potential opportunity for enterprising individual investors, sometimes the market capitalization is so small that trading volume makes it difficult or impossible to accumulate a meaningful number of shares without moving the market price. This has happened to me in the past on relatively small positions. If you are dealing with a stock that has average daily trading volume of 5,000 shares and trades at $5/share, if you attempt to make an investment of $10,000, you are accounting for a very significant portion of that day’s volume. Suddenly, even a small investor is facing issues such as having to spread out purchases over many days to accumulate a meaningful position – a dilemma normally only impacting larger investors and institutions. Regardless of the limitations, today’s market environment has created opportunities in this area that did not exist a year ago. I plan to write more about NCAV stocks, although the limitations noted above will eliminate my ability to write about stocks until after I obtain a position. I will disclose any positions in discussions of individual securities. As individual investors, we can benefit from today’s easy access to information. Graham had to manually filter through stacks of S&P reports but we have the advantage of screening tools to narrow down the list. It is actually quite surprising that such opportunities exist at all, and another
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

sign of general market inefficiency during periods of economic stress. -George Risk from Rational Investor
George Risk Industries: A Potential Bargain With Limited Downside Risk

By Ravi Nagarajan Published on January 21, 2010 at 5:18 pm In a recent lecture on value investing, Columbia Business School Professor Bruce Greenwald perfectly captured the essence of what value investors are looking for in the following quote: “You are looking for things that are ugly, cheap, boring, out of fashion, small and obscure, or otherwise on the other side of the existing finance industry mania. If it’s on the recommended list of one of the big retail brokerages, my advice to you is to watch out.”

Few publicly traded companies are more obscure than George Risk Industries, a small Nebraska manufacturer of security alarm products. With a market capitalization of $21 million and very low trading volume, the company is far too small to attract attention on Wall Street. Background George Risk designs, manufactures, and sells a variety of products with nearly 90% of revenue in the last fiscal year coming from security alarm related products. While the company claims to compete well based on price, product design, and quality, George Risk has also built competitive advantages by specializing in small custom orders that larger competitors often decline. The security products range from burglar alarms, pool alarms, and advanced sensors to detect incursions in unusual places such as skylights. George Risk has been solidly profitable over the past decade although business has slowed considerably since demand for the company’s products are highly correlated to activity in residential construction. The fact that the company has managed to remain profitable in this environment is a positive sign and an indication of good management, a competitive moat, or a combination of these factors. Management The company was founded by George Risk and has been run by President and CEO Ken Risk for the past two decades since the death of his father in 1989. Mr. Risk owns a majority interest in the company with 56.8% of shares outstanding. The presence of a CEO with a controlling interest in a company is often a mixed bag. While minority shareholders have limited influence, the CEO’s incentives are theoretically aligned with maximizing shareholder wealth (of course, provided that
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

he does not pay himself unreasonable compensation). In the case of George Risk, management appears to have reasonable policies on executive compensation and non-executive Directors were only paid $150 each in the last fiscal year. However, allocation of free cash flow has been questionable as we discuss below. Classic Graham Situation From a valuation standpoint, George Risk Industries is a classic Graham net current asset value situation with NCAV (current assets minus all liabilities) of $4.93 per share as of 10/31/2009 compared to a current market quote of $4.25. What makes the company particularly interesting is the fact that management has chosen to retain a significant portion of earnings over the past decade and invest the proceeds in marketable securities. As of 10/31/2009, the company had $4.28/share of cash and marketable securities on the balance sheet. Investments and securities accounted for $19.1 million as of October 31. Excess Cash and Investments In order to properly value George Risk, it is necessary to determine how much excess capital is on the balance sheet. With a current ratio of 38.6 and no long term debt, the company is significantly overcapitalized. A current ratio of 2 or more is normally considered adequate for an industrial business. However, taking a conservative approach would make sense in light of current economic conditions in the housing industry. Let us assume that George Risk requires a current ratio of 10 to safely navigate the recession. This would imply the presence of approximately $19 million of excess investments and securities which represents $3.73/share of value. Valuation of Business George Risk has a strong operating record over the past decade. Prior to the recession, operating margins averaged close to 25%. Earnings per share averaged $0.43 per share for the ten year period ending on April 30, 2008 (which in fact could be an understated indication of the business earning power due to cumulative losses in investments that have depressed net income). Since the recession began, sales have declined significantly and margins have been compressed. Earnings per share came in at $0.10 for fiscal 2009 (ending 4/30/2009) and $0.09 for the first half of fiscal 2010 (ending 10/31/2009). The company has remained profitable and is still generating free cash flow. While the quote on George Risk shares has varied quite a bit over the past decade, it was not unusual for the market to assign a price-earnings ratio of 10 or more prior to the recession. This type of valuation does not seem unreasonable given the strong track record of the company and healthy profit margins. Assuming that George Risk can earn $0.30 by the 2012 to 2014 time frame, the value of the business should be in the neighborhood of $3.00 per share. Discounting a $3.00 in 2012 to today’s present value at approximately 10% would result in a business valuation of around $2.50. Intrinsic Value = Excess Cash & Investments + Valuation of Business The combination of the excess cash and marketable securities on the balance sheet, which we have estimated at $3.73 per share, plus the valuation of the ongoing business of $2.50 results in an
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

intrinsic value estimate of approximately $6.25 compared to today’s market quotation of $4.25. This represents a potential upside of close to 50 percent. The stock currently yields 4 percent which should provide some income as well. Potential Risks There are a number of potential risks that could reduce the upside potential of an investment in George Risk Industries: 1. The company is majority controlled by CEO Ken Risk and there is no indication that the company plans to distribute the excess cash and marketable securities or to change their long standing policy of building up a portfolio of marketable securities far in excess of requirements to support the business. 2. The investments in marketable securities have failed to produce value for shareholders over the past decade. The company has delegated responsibility for management of the portfolio to an outside manager who has the ability to make trading decisions. It appears that there has been quite a bit of turnover in the portfolio and there is limited disclosure regarding what securities are held. 3. The downturn in housing could continue for an extended period (think of a Japan style “lost decade”) and eventually cause George Risk to operate at a loss, thereby reducing the intrinsic value of the ongoing business. 4. The company has indicated that it is interested in acquisitions and marketable securities could be liquidated to pursue such acquisitions which may or may not result in the creation of shareholder value. 5. Management has been late in filing a number of SEC reports over the past few years and this could indicate that they are having difficulty keeping up with the requirements of being a public company. Despite these risks to upside potential, it does appear that the risk of a permanent loss of capital is significantly reduced by the value of a well-established operating company along with the excess assets on the balance sheet. Limited Liquidity George Risk Industries is very illiquid and there are many days when no shares trade. On days when it does trade, the typical volume may be a few thousand shares. As the saying goes, it “trades by appointment”. The bid/ask on the stock is unusually wide with a typical spread of fifty cents or more. Therefore, any orders for the stock must be made using limit orders. I should note that so far I have found it impossible to purchase this stock anywhere near the prevailing bid despite daily limit orders over the past two weeks. I am viewing this more as an interesting case study in a Graham style investment than an opportunity to put any meaningful amount of funds to work. It is better not to obtain any shares than to offer too much and lose the margin of safety. Perhaps some of my readers will have better luck. Resources
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Special Situations/Asset Based Investing by Benjamin Graham, Seth Klarman, Marty Whitman and Others

Historical Data and Analysis – Excel 2007 (Source: Rational Walk Analysis) Historical Data and Analysis – Excel 2003 (Source: Rational Walk Analysis) George Risk Industries Website George Risk Industries SEC Filings Reader Questions A number of readers have asked questions about this article. A new post was written to address the questions. Click on this link for the Q&A.

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