Why book value matters?

Most of the value investor understands the importance of book value in determining the intrinsic value of a company. Book value represents the hard assets including its inventory, fixed assets minus depreciation and its cash/receivables minus all the liabilities like provisions, accounts payable etc...Ben Graham suggests not to pay much higher than book value while buying shares of a company.

If this criterion is strictly followed, there might be some set of companies that an investor may not be able to invest in ever. These companies include FMCG firms like Nestle, HUL and GSK Consumer since they distribute most of their earnings as dividends and so the book value of the company does not increase much. These companies also work sometimes on negative working capital so their book value will be very less compared to their earning power and so their intrinsic value can only be calculated based on their earning power.

But in bull markets, like the one we are in, investor enthusiasm stops differentiation between these companies and average small/mid cap companies. See the following table for the examples:

* 2006 numbers
Company	Book Value March 2005	EPS March 2005	Share Price September 2005	P/B September 2005	P/E September 2005	Book Value March 2010	TTM EPS	Share Price Today	P/B Today	P/E today
Ador Welding	63.36	19.95	260	4.1	13	108.45	21.22	170	1.57	8
GMM Pfaudler	36.39	5.21	116.94	3.21	22.45	62.9	8.07	94	1.5	11.65
GM Breweries	25.63*	14.3*	117*	4.57*	8.18*	60.12	17.73	101.8	1.69	5.74
India Nippon	122.4	22.86	286.5	2.34	12.53	187.17	30.95	242	1.29	7.82
Gateway Distriparks	62.39*	7.88*	131.4*	2.1*	16.67*	61.91	7.4	120	1.94	16.22
TV Today	35.58	2.83	96.15	2.7	33.97	52.56	-7.17	62	1.18	NA
Voith Paper	141.15	17.22	200	1.42	11.61	217.81	21.44	200	0.92	9.33

Most of the companies were purely trading at that time based on their earning power and the importance of book value was completely ignored by Mr Market. After more than five years, they are trading at prices lower than what they were trading at in 2005. The loss is not even compensated from dividends since capital erosion is far more than the cash received by an investor from dividends. The story may not end here. In the bear market of 2001-2002, these vary companies were trading at a steep discount to their book value and the same may happen when the next bear market comes. This doesn't mean the investor should shy from buying these names since the loss would be a notional loss unlike the loss that has happened over the last five years which is real.

The typical experience of the speculator is one of temporary profit and ultimate loss. - Benjamin Graham

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Sometimes number two (or even five) is better than number one

This is a long post with some examples. This post is to highlight the fact that it is not always number one in any particular industry, either in terms of sales or profits, who is the best. There might be special situations when some company down the rank in terms of sales and profits doing better than the leaders in its industry.

Right in the short term Wrong in the long?

Even the value investors face a dilemma when they find a stock whose intrinsic value is decreasing. Even though the investor buys with a margin of safety of 50%, i.e. a stock with an intrinsic value of INR 100 at a price of INR 50, the sentiment of the market plays a huge role in returns. If the sentiment does not change for two years and the intrinsic value decreases at a rate of 15% a year, after two years, the intrinsic value of the stock will be INR 72.25 and the margin of safety will decrease to 30.8% instead of 50% with which the investor started. Let me take an example of one of the company I was researching lately. The company is Dredging Corporation of India. The company at the end of FY2008 (FY2009 balance sheet is still not out) had a net current assets (NCA) of INR 663.6 Crore. In the October 2008 - March 2009 carnage, the stock price reached INR 200 (the low was INR 180) and stayed there enough for a value investor to buy it. The total market cap of the company at INR 200 was INR 560 Crore, less than its NCA. The company gave INR 15 as dividend in FY2008 and is debt-free. The company had generated free cash flows (FCF) of more than INR 150 Crore over the last five years, giving price / FCF of just 3.7. The market was clearly not valuing the company correctly. Then came the pop in stock markets and the share price reached a high of INR 650 with the market cap of INR 1820 Crore, 3.25 times that of the bottom.

Now comes the long term valuation. Even though the company is producing an FCF of INR 150 Crore over the last 5 years, the operating profit margin of the company is under pressure lately due to high hire charges of dredge. Following table summarizes the impact:

Year	Sales	Hire Charges	% of Sales	Operating Profit	% of Sales
2009	684.97	261.62	38.19%	-87.04	-12.7%
2008	705.32	125.64	17.81%	84.63	12%
2001	402	30.47	7.58%	151.93	37.8%

The operating profit margin has gone down from 37.8% in 2001 to -12.7% in 2009. This clearly is a company with decreasing intrinsic value. It's the INR 145 Crore other income that allowed the company to report profits at net level.

Even though a value investor didn't analyze all these facts and just bought the stock based on NCA, he would have got 150% returns in just six months, not a bad bet I guess.

Remember that Warren Buffet made most of his returns with this kind of investments in the early days but tilted more towards long term approach later.

Are we following the footsteps of the US?

I want to bring to notice the shift in investor methods of valuing a company in Indian stock market lately. It seems that too much emphasis is given today on future growth in profits than the current and past earning power of the company, the method followed by value investors. As shown in my previous post, the earnings can become stagnant even though the economy is growing, as happened between 1996 and 2002. During these times, the valuation of the companies do not depend on their growth but clearly on the current earning power of the company. When the growth will evaporate, the P/E ratios of companies will come down near to inverse of after tax yields on bonds, i.e. earnings yield (inverse of P/E) will match the after tax yields on bonds. The CNX 500 clearly shows the shift of P/Es to higher levels over the last 6 years. If we consider the data between 1 January 1996 to 30 April 2003, which includes the P/E ratios of 2001 tech bubble, 53% of the time CNX 500 P/E was below 14 but if you take data between 1 May 2003 and 2 June 2009, that 53% comes at a P/E of 17.5. CNX 500 remained below P/E of 15 for 65% of the time during 1996-2003 and during 2004-2009, only 20%. The other reason for this shift can be low interest rate too, but keeping interest rate too low for long periods of time can also lead to disasters.

How does this shift in P/Es affect an individual investor? As can be seen in American Market, if it is already known that stocks give good returns over all the asset classes in the long run, they will be quoted higher by bidding up the prices and the outperformance will no longer happen. For Indian equity markets too, I feel that the recent shift in investor enthusiasm will erode the gains in future. Anybody who is investing today will after 10-20-30 years realize that they overpaid for growth. People who bought stocks in 1996-2003 period paid for value and are getting rewards for their conservative investment strategy. Investors buying today with a hope of growth are just diminishing their real investment returns of future. Seth Klarman, a renowned value investors had commented recently that stocks in the US were never allowed to become cheap in the last 20 years (average P/E of 24.9 vs 17.2). What followed is that at the end of this overvaluation, stocks underperformed the bonds as discussed here. A similar fate can be seen in Indian markets 10-20-30 years later when people like me are near their retirement age and will feel the same as Baby Boomers generation is feeling right now in the US, 'helpless'.

The only advice is "be cautious".

Psychology of Buying

My experience of last two years in stock market suggests that it is easier for a value investor to buy a stock at 50 while it is going down and has corrected from say 100 then to buy a stock at 50 which has risen from 30. As a value investor I have shunned investment in Indian stock markets the day Sensex moved past 11000. I thought that it has risen from 8000 to 11000 in just two months so most of the value it was offering is gone now. The fact is that I was investing at these vary levels in October 2008 when market had corrected from around 21000 levels in January 2008. The emotions are difficult to overcome and psychology of humans is hard to understand.