VALUE INVESTING
Why Assets Are Crucial For Value Shares

By Stephen Bland (TMFPyad)
April 15, 2005

In my sharetipping newsletter Value Investor we present two value trading shares in each monthly issue for readers to consider, apart from the longer term holds in the high yield portfolio where one new share per month is added.

Since the newsletter started in January 2004 to date, we have sold twelve of our trading selections with an average total return of about 19% each and an average holding time of about 8 months each (the average gain for all selections to date is 12%). Within those figures there is great variance with the largest profit by some way being Camellia (LSE: CAM) at 58.7% and the lowest Ultraframe (LSE: UTF) with a loss of 58.4%. Three shares made a loss averaging 36.9% each and nine made a profit averaging 37.6% each.

Looking at the three losses being Ultraframe, Montpellier (LSE: MPL) and Churchill China (LSE: CHH), clearly value did not work too well in those cases. Can we do anything in future to avoid such situations?

To answer the question I need to go back to one my most basic value tenets of all. Minimise the downside. The idea is that a deep value share, if it goes wrong and inevitably some will as with any regular trading strategy, should fall by only a restricted amount in the event of bad news thus demonstrating damage limitation. The most important fundamental which serves to protect downside in my view is low price/tangible book value. This is particularly the case where those assets consist as much as possible of valuable items such as property, realisable investments and cash rather than plant and machinery etc. Ultimately the market is very likely to re-rate a share upwards, despite a poor trading record, where an excessive discount to such assets exists.

I don't think it an accident that amongst our realised Value Investor losses above, Churchill China probably had the best quality asset cover and as a result our hit was a loss of only 3.4%. Incidentally I've retipped it as a buy in Value Investor recently, primarily because of what I believe to be the still excellent asset situation.

Low P/E, high yield, lack of debt all play their part in value share selection but earnings can be hit or turn to loss in a bad patch, dividends can be slashed and net cash, whilst ensuring that a business is unlikely to go under, may not of itself always do that much to prevent a share price collapse.

But a P/TBV (share price divided by tangible net assets) of under 1 at purchase should be the largest single prop under a share price that is being hit by bad news on trading, because net tangible assets are probably not going to be hit excessively by that bad news, though on occasion that can happen. So if a share price falls and assets remain intact, then the discount deepens making it more attractive. I'm not saying that this will happen immediately, often the initial shock will create a large hit to the price, but eventually that asset cover should deliver its protective embrace to the shareholder. Finding such shares is something we try to do in Value Investor though we feature as well value shares where P/TBV is not necessarily that low, but where we believe the rest of the value case to be particularly appealing.

One of the problems with all this is that assets can change value sometimes. If, for example, the historical balance sheet that was analysed by us to reveal an attractively low P/TBV is based on a large element of realisable investments, then clearly the asset value will vary with the market value of those investments.

A moving asset value has been one of the problems with that old favourite of value players, Royal & SunAlliance (LSE: RSA). It's a large company and therefore especially attractive as a value play on the face of it because, other things being equal, bigger is better, Royal's assets have fluctuated dramatically over the years. You could have bought the shares some time ago at a discount to net assets for a much higher price than today and thought you were getting a bargain. However, asset value fell away dramatically thus murdering any discount obtained earlier and leaving the investor without that most precious of value measures, P/TBV under 1.

There are numerous reasons why asset value can fall away. If those assets include a large proportion of liquid investments like shares and bonds then their worth will fluctuate with the markets concerned. Even property assets, amongst the most reliable of all asset backing, would suffer in a property slump. If the assets include estimates of some kind then those can be inaccurate and later changed for the worse if the basis is found to be questionable. This was the case with Shell (LSE: SHEL) and its oil reserves a while back some may recall. A more recent difficulty for asset values is the new accounting standard which compels the balance sheet to show pension deficits amongst other warts. That will hit the headline net asset value of companies with such deficits where previously the deficit was shown by note.

Potentially downward shifting asset values are part of the risks involved in value trading. But this risk is not so great that it invalidates the strategy, it's just something with which value investors have to live and it doesn't happen that often anyway.

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Stephen owns shares in Royal & Sun.