Benjamin Graham, the "Dean of Wall Street" and mentor to US investor Warren Buffett, was a big fan of "cigar butt" stocks struggling but cheap companies with "one last puff in them". He particularly liked firms that were trading below book value (that is, their assets minus their liabilities). In theory, such stocks are a win-win proposition. Either business bounces back, along with the share price; or the company fails, but its assets can still be sold off for a profit.
Graham's strategy can work well. Aswath Damodaran of New York University found that from 1952 to 2010 a strategy of buying stocks with the lowest price/book (p/b) ratio beat buying those on the highest p/b by around 6% a year. But before you go hunting for cigar butts, there are a few key points to consider about valuing assets.
Tangible and intangible assets: we often think of assets as being physical items such as land, buildings or machinery. However, an asset can be a non-physical item, such as a trademark, patent or brand. Intangible assets can be very valuable technology companies often consist of little more than intangible assets but can be much harder to value objectively than traditional assets. Tangible assets are easier to value but one must take into account damage or depreciation (eg, machinery wearing out).
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Valuation accuracy: in theory, companies have to assess accurately the value of their assets. In practice, these valuations are subjective. During the financial crisis, for example, it became clear that the value of securities held on banks' balance sheets was far lower than their models suggested. Energy companies, meanwhile, often value their reserves during periods of high commodity prices, then don't update them when prices fall. This gives the impression that they are worth more than they actually are.
Asset liquidity: a firm may seem to have plenty of valuable assets, but it might be hard to sell them at their book value particularly in a bankruptcy situation. For example, a manufacturer might struggle to find a buyer for a specialist machine, and so may have to sell it for a fraction of what it is worth, or even scrap it. Even financial assets can be hard to sell if market conditions deteriorate.
Hidden liabilities: understating liabilities has the same impact as exaggerating asset values it makes the company's book value look healthier than it is. In 2009, US car giant General Motors was forced into Chapter 11 bankruptcy when its healthcare and pension costs proved far higher than expected. Litigation and tax liabilities can be another headache for value investors.
Matthew graduated from the University of Durham in 2004; he then gained an MSc, followed by a PhD at the London School of Economics.
He has previously written for a wide range of publications, including the Guardian and the Economist, and also helped to run a newsletter on terrorism. He has spent time at Lehman Brothers, Citigroup and the consultancy Lombard Street Research.
Matthew is the author of Superinvestors: Lessons from the greatest investors in history, published by Harriman House, which has been translated into several languages. His second book, Investing Explained: The Accessible Guide to Building an Investment Portfolio, is published by Kogan Page.
As senior writer, he writes the shares and politics & economics pages, as well as weekly Blowing It and Great Frauds in History columns He also writes a fortnightly reviews page and trading tips, as well as regular cover stories and multi-page investment focus features.
Follow Matthew on Twitter: @DrMatthewPartri
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