Chapter 51—Discrepancies between Price and Value (Continued)

One Minute Summary:

This chapter gave additional reasons for discrepancies between price and value of a security, such as seasoned and unseasoned issues, contractual and non-contractual comparables, and special supply and demand circumstances.

Chapter in Detail:

Seasoned issue—an issue of a company has a high reputation among investors due to its long and successful operating history. The price of a seasoned issue may exhibit price inertia even when its financial statements or future prospects have been weakened.

Unseasoned issue—an issue that usually belongs to the industrial field. Unseasoned issues are very sensitive to adverse developments of any nature. Therefore, during a business storm, a group of unseasoned issues is likely to suffer more than a group of seasoned issues, which speculative opportunities may arise for a security buyer.

Misuse of comparables—an issue is quantitative preferable to others in a similar industry does not imply that issue is a sound purchase. The issue must be considered as attractive on a stand-alone basis.

Contractual related comparables—when a senior issue is more preferable than its junior securities based on quantitative factors, one should consider switching to the senior issue as a sound investment. Any improvement in the business should reflect a better return than one made in the common stock.

Special supply and demand factors—short-term speculative purchases due to temporary excitement in an issue, or its related industry.

Practical Application:

1. Washington Mutual (WaMu) as a seasoned issue—an analyst may examine WaMu’s financial statements and reveal significant information about its financial position. At the peak of WaMu’s operation, the option ARMs and subprime mortgage represent over 50% of its loan portfolio.
2. Buy an issue that you can fully understand its business fundamentals, unless a significant, demonstrable discrepancy exists between its current price and value.

Three Quotes:

1. “We have warned against an overready acceptance of a purely quantitative superiority. The future is often no respecter of statistical data.” Pp. 691
2. “He buys by reputation rather than by analysis and he holds tenaciously to what he has bought. Hence holders of long-established issues do not sell them readily, and even a small decline in price attracts buyers long familiar with the security.” Pp. 688
3. “These disparities [of prices between senior and junior securities] arise from the frequent failure of the general market to recognize the effect of contractual provisions and often also from a tendency for speculative markets to concentrate attention on the common stocks and to neglect the senior securities.” Pp. 693

Three questions to the group to test understanding:

1. Why price inertia exists?
2. In valuing comparables between companies in the same industry but with different capital structure, how would the analyst account for the differences?
3. When an industrial issue appears to be undervalued from its comparables, what would be the best course of action?

Clarifications & Group Discussion:

1. Would you consider expanding your investment horizon to include more senior securities?
2. What other additional factors may contribute to discrepancy between price and value?
3. Do we have more “seasoned” industrial issues today?
4. Technical analysis is a form of special supply and demand?

Chapter 43—Significance of the Current-Asset Value

Chapter 43—Significance of the Current-Asset Value

One Minute Summary:
This chapter is about using current asset value as an approximation of a company’s liquidation value—book value of current assets should be adjusted to reflect liquidation value. Companies that are selling under liquidation value usually demonstrated unsatisfactory earnings trend, which may continue to operate at a loss and nullify the intrinsic value to below price paid. As a result, the analyst should examine companies that have reasonable basis of earning improvement based on past records and future prospects.

New terminology / Concepts / Ideas / Technical Items / Useful Examples:
• During liquidation, non-current assets are to experience the most shrinkage; thus, as a safety measure, current asset value provides a rough measure of the liquidating value.
• History may serve as an indication of future. In the chart, Manhattan Shirt would likely to yield better results since its net current asset was reduced by 10% during a very difficult period, compared to 60% of Hupp Motor.

Additional comments:
• Liquidating/market value for real estate, buildings, machinery, equipment, nonmarketable investments, intangibles, etc are more easily obtainable today. If the analyst is confidence about his/her source of information, the percentage of liquidating value to book value can be adjusted higher than what is suggested by the chapter.

Practical Application:
• Past history of a bargain issue should be examined to determine whether an investment in such issue will yield satisfactory results in the future.
• To be considered as an attractive investment, these bargains must have potential catalysts in either improvement in future earnings, potential sale or merger, or liquidation distribution.

Three Quotes:
1. “Common stocks that (1) are selling below their liquid-asset value, (2) are apparently in no danger of dissipating these assets, and (3) have formerly shown a large earning power on the market price, may be said truthfully to constitute a class of investment bargains.” Pp. 570
2. “…voluntary withdrawal from an unprofitable business, accompanied by the careful liquidation of the assets, is an infinitely more frequent happening among private than among publicly owned concerns.” Pp. 559
3. “Dividends paid to common-stock holders do not in themselves make the stock any safer. The directors are merely running over to the stockholders part of their own property; if the money were left in the treasury, it would still be the stockholder’s property.” Pp. 573

Three questions to the group to test understanding:
1. What kind of liabilities may be off balance sheet?
2. How would you go about to confirm the book value of current assets on the balance sheet?
3. How would you value the capitalization structure when the debt instruments (preferred or fixed coupon debts that have a convertible feature into common stocks)?

Clarifications & Group Discussion:
1. Case study of Bennett Environmental Inc.

2. What essences should we take away from this chapter since the “net-nets” are less obvious in today’s market?

3. Today, some businesses may have their intangible assets understated. Would you consider “mark-up” the value of these assets? If yes, how would you assess the value, and should the intangibles be considered as a current asset?

4. Would you apply similar discount percentage to the book value for different asset classes suggested by the chapter?