This post is written by Puneet Khurana. Puneet has been investing in the markets for last 12 years and is an ex-student of MDI where he studied under Prof. Sanjay Bakshi. After working for various India focused hedge funds for many years, Puneet is currently managing money for friends and family and is Managing Partner of Stoic Advisors (a unique financial consulting firm). He blogs at Pragmatic Investing . You can connect at email@example.com or LinkedIn or Twitter
He conducts " The Investing Lab - Bridging theory and Practice " with me and Jatin Khemani
Let’s assume that you own a hospital (say Hospital C). You have been doing well in your market and currently have the third largest market share, and you are thinking of installing 500 slice CT machine (because both your two major competitors (Hospital A and Hospital B have one each) and it will cost you around 2 crores. You bought the machine and now it is installed. Now here is the question. What is the value of this CT machine?
“It is 2 crores”, you might say.
“But then, what is value of the same machine at Hospital A and Hospital B?”
“It is also 2 crores. What kind of a ridiculous question is this?” you respond.
“But is it? Why should I give the same value to your machine which is being used to do the scan of around 5 people a day for average revenue of 2500 per scan? This gives you annual revenue of around 40 lakhs.
Whereas B does about 8 people a day for average revenue of 2800 (72 lacs annually) and A does around 11 people a day for an average of Rs.3100 (1.1 cr annually)”
“But I have paid the same amount as them”, you snap.
“Ahh.. Here it is. You see, what you are telling me is the price of the machine and not the value.”
Remember the golden words
“Price is what you pay, Value is what you get”
You might have paid the same price for this CT machine but what you derive out of the same asset is not the same as your competitors. They get more value out of the same asset than you do. Ultimately, the value of an asset is nothing but the discounted future cash flows and their cash flows are far higher than yours.”
Well, readers, this is an actual conversation with one of my clients who incidentally have an hospital and is currently looking to maximize the value of his firm (Let’s leave the motives for some other time)
But you get the idea; the value of an asset is based on how much that asset can make and not on the purchase price (Gross Book Value or Net Book Value).
Pretty Elementary huh?? Need no Sherlock Holmes here to understand this but somehow we as market participants ignore this basic concept. Now there are few types of investment ideas where this simple concept is often ignored by market participants. The intent of this post is to clear air on such investment ideas. First of them, is what is commonly referred as Asset Plays.
These are these companies where they have some asset on the balance sheet which is so high in value that the current value of the “complete company” looks very cheap with respect to the “price of that asset”. Most commonly that asset is Land.
So the argument goes something like this
“ There is this company X. Market value of this company is Y crores but the land value itself is Z crores which is close to Y so essentially, you are getting all this land for the price you pay plus the business which is earning so much is coming for free.”
There is no dearth of such ideas, especially companies which have bought huge lands and utilized part of it for their manufacturing unit and remaining to make nice gardens. Or they are just land parcels which are lying without any utilization per se. So as per the previous argument which I presented, what is the value of that land? Don’t tell me the Price. That, I know (via Book value if it’s a recent purchase or simple market research if book value can’t be relied upon). It’s the value I am concerned with.
In such asset plays, the ‘Value’ can be far lower (even zero if there is no plan to use the asset, and there is no activism possibility, No ‘Larry- the liquidators’), or it can be equal or higher than the ‘Price’. I need the following answers before paying heed to any such asset plays.
Why should I value this asset at current Market Value?
Is the management going to use this asset to create some stream of cash-flows?
If yes, what will those cash-flows be? In some cases, the answer is possible to calculate because there have been past congruence of actions and words of management; hence the revenue stream is calculable using some research. ‘Nesco’ is a good example of such a company. In other cases, you have to weigh in the management words and their past records of words v/s action.
But, what if management is silent on the matter and doing nothing too?
Well, in that case, this will end up as a clear case of ‘Value trap’. The market will never realize the value of this asset and it will remain that elusive value buy where the only trigger is ‘Hope’
Is the management going to sell this asset?
If yes, will the cash flow come to the shareholder (via a special dividend)? If it’s not coming to shareholders directly, what is going to be the use of that cash? If it’s another asset they plan to buy from it, what is the expected revenue stream from that asset?
A recent example of such a company is ‘Amrutanjan’ which plans to sell land which it has in the heart of city and wants to shift to outskirts. What it might do with that cash, I wouldn’t know but if you have an idea about the management quality, you can take that call and give the value accordingly with obvious ‘Margin of Safety’
Why should the ‘Price’ of this asset matter to me as a shareholder? If the company has no plans to monetize that asset, why should I include the ‘Price’ of this asset in my calculations of ‘Value’ of such company? There are numerous examples of such companies. You pick and choose from so many stories that you ‘hear’ on the street.
There is one important point to note here. An efficient use of the asset is also considered as monetization. It doesn’t always mean selling. So if a company has that empty area where existing setup is and if it can/plans to use that land to add existing capacity or something else, that is also considered as monetization of that asset. Look at all the empty land which ‘Wonderla holidays’ has. What if they use that land to add more rides or make resort there or anything of that sort which create revenue stream. (Not that Wonderla holidays is an asset play, it was just for the sake of example)
Anyways, let’s move forward. The other type of investment ideas where the same fallacy is replicated is that of ‘Cash Bargains or Near Cash bargains’
Cash Bargains or Near-cash bargains
Just like any other asset, Cash is an asset too. So the same thought is applicable here too.
Haven’t you heard so many times, that the cash on the books (Net cash after removing debt) is close to the market cap of the company and hence the company is worth investing?
Well, it’s certainly worth looking into but investing, I am not so sure about. So by now, you should guess what are the pertinent questions to ask?
Why should I value this Cash at its Book value?
What is the company going to do with the cash?
Now, think about it, if the answer was so clear, why would the market not giving the cash its due. It is obviously not that easy to answer because more often than not, the market doesn’t have the answer to this question. So in this case, what is the next best question to ask?
Well, that is actually a simpler question to ask. What is the management track record in creating wealth for the shareholders? Have they utilized there capital well in the past? Look for a great long term track record of the company and management and you can know whether the cash should at all be valued or not and may be it should be value at higher value if the company has a phenomenal record. So the cash on books of someone like Piramal is more valuable than on the books of MTNL.
In the next part of the article, I will extend the same argument further to look at acquisitions and holding companies. Till then, happy Investing.