Alternative valuation methods are harmful to one's pocket

Ben Graham taught us to look for discounts to net current asset value in order to protect against large declines in stock prices. Net current assets are current assets (cash and equivalents) minus current liabilities (all debts to be paid within a year).

But despite this method being proven to provide good results with minimal downside, people still choose to dream up their own convoluted valuation methods for investment.

Consider for example the use of the "eyeballs" metric at the peak of the dot-com bubble. Firms with no income were being appraised based on the number of people visiting these companies' web sites. That can barely show potential for future revenue, and it says nothing about real earning power nor what matters, profit-making.

While "eyeballs" seems ridiculous in hindsight, it wasn't questioned by many back then.

Other unproven valuation metrics are created all the time. Consider for example "economic goodwill". It states that the difference between market capitalization (share price times number of shares outstanding) and net tangible book value is the amount of "additional value that the market has assigned to a company, based on intangible assets, such as quality of management, growth prospects and efficiency of operations, that don't appear on a balance sheet".

The theory was that the lower this amount compared to the average of return on assets, return on equity, debt-to-equity ratio, and percentage growth of earnings divided by percentage growth of revenue, the cheaper a company would be.

This one study from 2000 thus picked the 10 most undervalued companies back then based on this metric, as shown below. The number in parenthesis is the return on their market price from 2000 until now.

American Power Conversion (-100% -- delisted)
Computer Associates (-74%)
Intel (-77%)
Microsoft (-58%)
Pomeroy (-81%)
Symantec (+63%)
Tellabs (-92%)
Verisign (-92%)
Viant (-100% -- delisted)
Xilinx (-78%)

To be sure, no valuation shortcut is infallible. Ben Graham never said the net current assets method can prevent loss. It can't, since the future is and will always be unknown. But if anything, it provides the best protection one can get short of clairvoyance.

People should be happy to buy dollar bills for fifty cents. Anything else is speculation.

Ben "Nostradamus" Graham

The markets and the economy are cyclical beasts. We all know that. But from time to time we all (or almost all) forget about it. That's part of the cycle too.

Nothing new so far, right?

What amazes me the most, though, is how predictable these cycles are. No, not the timing of them. Just how they happen and that they will happen. The same mechanisms, over and over again.

Just to illustrate one, consider this short passage from Security Analysis, by the legendary Ben Graham, from 1934. Regarding real estate assets:

During the great and disastrous development of the real estate mortgage-bond business between 1923 and 1929, the only datum customarily presented to support the usual bond offering -- aside from an estimate of future earnings -- was a statement of the appraised value of the property, which most invariably amounted to some 662/3% in excess of the mortgage issue. If these appraisals had corresponded to the market values which experienced buyers of or lenders on real estate would place upon the properties, they would have been of real utility in the selection of sound real estate bonds. But unfortunately they were purely artificial valuations, to which the appraisers were willing to attach their names for a fee, and whose only function was to deceive the investor as to the protection which he was receiving.

The method followed by these appraisals was the capitalization on a liberal basis of the rental expected to be returned by the property. By this means, a typical building which cost $1,000,000, including liberal financing charges, would immediately be given an "appraised value" of $1,500,000. Hence a bond issue could be floated for almost the entire cost of the venture so that the builders or promoters retained the equity (i.e., the ownership) of the building, without a cent's investment, and in many cases with a goodly cash profit to boot.

(Security Analysis, Second Edition, 1940, Ben Graham and David Dodd, pages 139-140. All emphasis are theirs).

Recap: inflated, self-serving appraisals. Check. Zero money down investment. Check. Greater fool's theory. Check. Did he allude to bonds having high credit ratings due to inflated asset prices ("deceive the investor ... of the protection he was getting")? Check again.

Sounds familiar?

Lessons from the 20's

I just came across this snippet below, from Saj Karsan's excellent summary of the famous Security Analysis book, by Graham & Dodd. Apparently banks didn't learn the lessons from the 20's. I wasn't aware of these things either -- if only I had read this book more carefully when I first read it, a few years ago.

Saj writes (emphasis mine):

"""
A popular type of guaranteed security is common in the real-estate mortgage market. A bank will sell investors a mortgage, and will guarantee payments on that mortgage. Unfortunately, for this type of self-guarantee to be worth anything, the following principles must be kept:

1) Loans must be conservatively financed
2) The guarantee must come from a company well-diversified

If loans are not conservative, then declines in real-estate values will result in deterioration in loan values. If the guarantor is not diversified, a general decline in real-estate values will serve to place the guarantor in receivership, which makes for a most dubious guarantee.

As simple as these principles are, in practice problems have arisen. In the roaring 20s, new and aggressive firms provided loans at levels so as to leave very little equity in the mortgaged property, despite the fact that appraisals were made at dubiously high levels. In order to compete with these firms, reputable ones would be forced to lower their standards. The industry spiraled out of control, and guarantees turned out to be useless in the ensuing carnage as firms were forced into receivership.
"""

All this sounds exactly what happened recently. Last year, an ex-Lehman mortgage trader I know, talked about how investment banks had to lower their standards or lose business to more aggressive banks. The result we all know: rule number 1) above was violated and when RE prices declined (even though they never decline!), things went haywire. Many loan guarantors (AIG included) weren't well-diversified enough, violating rule 2).

All hail Ben Graham, the new Nostradamus.