Value Investing in Today's Market

Some might say we at Morningstar take a conservative view of stock valuation. We believe the value of any business is the present value of what that firm can earn in the future. However, Benjamin Graham, Warren Buffett's mentor and a successful investor in his own right, was even more conservative. One of Graham's favorite investment techniques was to purchase stocks trading for less than the firm's current assets minus total liabilities, or less than what the business owns now. Purchasing these stocks, known as "net-nets," is like picking dollar bills off of the sidewalk. In either case, the investment result tends to be quite pleasing.

Graham's Net-Nets
Accounting convention defines current assets as the sum of cash and assets, such as accounts receivable and inventories, that can be easily converted into cash within 12 months. By subtracting all liabilities from the current assets figure, we arrive at what Graham called "net-current-assets," or a company's liquid net worth. Unfortunately, net-nets are rare in today's market, but they can still be found occasionally, and the idea of looking for value in a company's balance sheet is still an effective tool in the value investor's repertoire.

Finding Net-Nets in Today's Market
In the fourth edition of The Intelligent Investor, Graham listed no fewer than five profitable companies whose shares were trading for less than the underlying net-current-asset value. Low-hanging fruit, however, tends to disappear quickly, and as enlightened readers of Graham ventured forth to hunt for such bargains, net-nets have become increasingly scarce. Indeed, the authors of Value Investing: From Graham to Buffett and Beyond lament, "in the contemporary investment world net-nets are, only with the rarest exception, a distant memory."

Investors should not despair though. The market, with its varied moods, will still occasionally offer shares of reasonably sound companies at or close to net-net prices. The conditions that may lead to bargain pricing include unwarranted pessimism caused by a severe market decline, a company reporting disappointing results, or a company simply being in an unpopular industry.

The next time boundless pessimism floods the markets or a particular industry, use this  Graham screen in Morningstar's Premium Stock Screener to uncover profitable investment ideas. The screen looks for companies with a lot of cash (at least 40% of assets) and whose net cash (cash minus long-term debt) is at least 50% of the market capitalization. These requirements are more liberal than Graham's classic net-net definition, but further restricting the screen to stocks rated 5 stars by Morningstar analysts reveals two names:  Siebel Systems  and  NetIQ . Both of these stocks have declined substantially since reporting disappointing second-quarter results. Siebel Systems, a leader in customer-relationship-management software, has a market cap of $3.8 billion, but holds $2.1 billion in cash and virtually no debt. In the past 12 months, Siebel generated $238 million of free cash flow. NetIQ, provider of system management and Web-analytics software, has a market cap of $565 million with $288 million in cash and no debt. Recent weeks have seen a flurry of insider buying as NetIQ executives took out the checkbook to purchase shares.

Economic Net-Nets
Economic net-nets are an expansion upon Graham's technique premised on the idea that accounting conventions may not reflect economic reality. Recall that Graham defined net-current-assets as current assets minus all liabilities. However, the accounting distinction between current and fixed assets is somewhat arbitrary, and balance-sheet values may be understated. For example,  Sears  carries about $5.5 billion of inventory that is classified as a current asset. However, Sears can liquidate its inventory for cash only if it goes out of business, and the inventory would likely be sold for less than its carrying value. As a going concern, Sears' inventory is essentially a fixed investment subject to seasonal markdowns, changing tastes, obsolescence, or theft.

Compare Sears' situation with that of Tejon Ranch (TRC), a small company that owns 270,000 acres of land north of Los Angeles. This land is part of the plant, property, and equipment (PP&E) that is carried on Tejon's balance sheet as a $68 million noncurrent asset. First, we must ask whether any of the many assets lumped into Tejon's PP&E can in reality be easily converted into cash. Take for example, the Tejon Industrial Complex, which covers 1,450 acres of industrial and commercial space directly adjacent to California's busy Interstate 5 highway. The complex appears to be a more of a current asset than Sears' inventory. Tejon could readily find purchasers for the vacant land or income-producing property in the complex, and continue ahead as a going concern.

Second, we must determine the true economic value of Tejon's assets. The stock currently trades for about $38 against a book value of $7 per share. This obviously disqualifies Tejon as a net-net on an accounting basis. However, the balance-sheet notes state that Tejon's land, acquired in 1936, is carried at historical cost. Using a back-of-the-envelope calculation, Tejon's $68 million PP&E line implies a value of $250 per acre of land. California land values have certainly increased since 1936, and this calculation ignores valuable assets such as buildings and other improvements. To determine whether Tejon at $38 per share qualifies as an economic net-net, investors must calculate the true economic value of the firm's real estate assets. This process is more time consuming than running a mechanical screen, but very few sensational investment ideas are uncovered without some measure of diligence. As a guidepost, companies with substantial real estate holdings are a good place to start looking for economic net-nets.

Net-Nets vs. Great Businesses
All things being equal, we would much rather own great businesses with wide moats, such as  Coca-Cola (KO) or  Anheuser-Busch (BUD), whose intrinsic values grow over time. Net-nets are seldom great businesses, and investors should be prepared to sell them once the gap between price and intrinsic value is closed. However, the lessons of Graham's net-net technique can still uncover bargains in today's market and can be a profitable tool for value investors.