• Angus Crennan

Second generation value investing

Never forget value is different from price. Value is what you get, price is what you pay.

A fashionable coat is a great example.

Imagine a branded coat costs $5000 and everyone wants it. This coat never goes on sale and the people who own it are proud of that. You see the coat for $2000, so you jump on it. Having purchased at this price you are happy. You have $5000 of value for $2000, right?

The fact is you have been anchored at $5000. If you stripped the brand and prestige then the coat would likely be worth a lot less than $2000. It probably cost $100 to make. What we are buying is not the physical object but all that goes with it, the intangibles and the feelings they evoke. In the same sense that a pleasure boat can be ‘worth it’ even if it simply consumes cash, or attending the cricket for that matter, lifestyle attributes are real enough for people to happily pay for them.

Investors face the same question: Is there place for intangibles in the shares we purchase?

Of course there is. The ‘shares equivalent’ of that $100 cost of production is tangible assets.

There are going to be times we see shares listed at tangible asset value, or even at the value of cash on their balance sheet. For example sometimes poor quality mining companies might trade at a share price that equals the cash on their balance sheet divided evenly between shareholders. In very rare occasions companies will trade below their net asset value, ie they are worth more liquidated than they are as a going concern.

We might call these ‘first generation’ value opportunities and they are straight out of Ben Graham’s playbook. Careful investigation of these businesses will generate value for the investor, however the investor ultimately is getting poor companies at prices that reflect their poor quality. For example a mining company with resources in the ground and $1 per share of cash should be a bargain at $1 per share. However what happens if the company cannot extract the resource and continues to incur expenses? Equally a manufacturing company looking to liquidate its plant might find the prices it receives well below the values it has been carrying those assets on its books.

Ultimately its hard to see these opportunities being more than short term. At Balmoral we are cautious about short term because we know time is the friend of high quality investments.

Which leads us to businesses trading at premiums to their asset values. Intuitively we understand we are buying something more than the assets in that we are also getting a business using those assets. Its in this space that the best businesses are, the sorts of businesses which will increase in value over time. Simply put what we need is a way to determine how to value this component.

Really the value we receive from an investment is the future cash flows we will receive. This requires we move from focusing on the balance sheet to focusing on the income and the cashflow statements.

We will develop this further in future posts.

Balmoral Asset Management

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