VALUE INVESTING – BE CRITICAL WHEN USING BREAK-UP VALUE APPROACH

In times of economic uncertainty, value investing is one of the favourite valuation approaches investors use as it is purportedly one of the safest methodologies. However, investors must be wary and critical before using such an approach because in equity investments, there are no valuation methods without any risks.

With many developed economies already in a recession and Malaysia experiencing practically a pause in growth in 4Q08 y-o-y, investors are likely to be enticed into using this approach for their equity investment decisions.

One of the most popular methods in value investing is to invest in stocks that trade below the liquidation or break-up value. A more aggressive investor would evaluate the prevailing price of the securities against its net assets value (NAV). A conservative investor would assess the current price of a stock against the value of its net tangible assets (NTA).

While NAV refers to the shareholders’ funds item on the balance sheet, NTA removes all intangible asset items including goodwill, deferred tax assets and other intangible assets. The rationale is simply that intangible assets may have lower or no value at all when the assets or businesses of a company (or group of companies) are broken up and sold separately. Further, goodwill such as brand value may have a lower intrinsic value than the reported value on the balance sheet during times when business activities slow down.

While the uncertainty on the value of intangible assets can be addressed by using Price/NTA per share instead of Price/NAV per share, there are also some other delicate issues to consider when using such a valuation method. Whether these issues have been addressed or not remains to be seen.

This relates to the other components of assets, both current and long-term, on the balance sheet. In addition, it also relates to the company’s earnings for the current and future financial years that will affect the shareholders funds.

As far as the writer is concerned, there are three major asset items that may affect the accuracy of using such an approach: receivables, inventories and investments.

Receivables

Receivables are current assets derived from the company selling its goods and/or services on credit terms: it can be listed under trade or other receivables. Under current economic conditions, the ability of a company to convert all the receivables within an acceptable period of time into cash may be questionable. Some of its customers or debtors may no longer be in a position to pay their outstanding debts to the company due to cashflow problems.

One way to overcome this would be to ascertain if the receivables of a company have been rising in relation to either cost of goods sold or revenue over time. For trade receivables, it is important to analyse the receivables turnover, which tells us whether or not the average number of days that credit terms are being settled by trade debtors has risen.

Inventories

Inventories are also classified under current asset items and can be divided into two – raw materials and/or semi-finished products that will be processed into finished products; and finished products that are pending sales. Both have become risky under the current economic uncertainty.

For one, a company may have produced goods based on the previous sales momentum, but the economic slowdown or recession may dampen current and future sales. This may affect the number of months needed to clear the inventories. In addition, slower sales and rising inventory may also impact the use of raw materials and semi-finished products as the company slows its rate of production.

For inventories – finished and semi-finished products and raw materials – that are relatively perishable, write-downs may become necessary when they are not saleable anymore. The same also applies to finished products that become obsolete within a short period of time.

There may be instances when finished products must be sold at prices lower than the production cost to get rid of them before they become obsolete. This can also mitigate unnecessary rising costs for storing the rising quantities of unsold finished products.

Investments and Earnings

Investments, a long-term asset item, may also need to be reviewed under the current economic conditions. Under present accounting standards, the lower of cost or value principle is already conservative. However, an investor must make certain that the reported value of investments on the balance sheet is not lower than the prevailing value, more so if the value may have dropped below the cost as at the reported date and may have dropped further as at the current date.

Current year earnings potential may also affect Price/NTA or Price/NAV of a company. If the company were to report losses during its current financial year, both ratios above will definitely become higher than previously because retained earnings, an item under shareholders funds, will be adjusted downwards. This may explain the abundance of companies already making losses with low Price/NTA or Price/NAV.

It is not the intention of this article to criticise the liquidation or break-up value approach in equity investment decision making. We wish to stress here that investors who apply the Price/NTA or Price/NAV per share approach must also include other related analyses such as analyzing relevant financial ratios and expectation of current and future earnings before making a value investing decision.

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Article Contributed By Ameer Ali Mohamed. Ameer is Director, Financial Research of NextVIEW. He has a total of 20 years experience as a corporate journalist, investment analyst and fund manager, including as research head of two stockbroking firms and CEO/CIO of a funds management company.

Republished with permission.
This article was published in the Just Say It column in Shares Investment (Malaysia edition) March 2009. You can get the latest copy of Shares Investment (Malaysia edition) at leading bookstores in Malaysia.