In this article, we discuss 5 ways to find businesses with hidden value.
Finding value-oriented investments can be a challenge in today’s market. Opportunities for mispriced assets seem to be far and few. As an investor looking to limit downside risk and maximize upside potential, what should you do?
Check out our H2 hedge fund letters here.
David Einhorn Buys Three New Stocks: These Are The Names And Theses (Q3 Letter)
David Einhorn's Greenlight Capital funds returned 5.9% in the third quarter of 2020, compared to a gain of 8.9% for the S&P 500 in the same period. This year has been particularly challenging for value investors. Growth stocks have surged as value has struggled. For Greenlight, one of Wall Street's most established value-focused investment funds, Read More
One thought is to abandon traditional whole company analysis and focus your attention towards identifying businesses with pieces undervalued.
Undervalued assets within a business can show up in all different shapes and sizes. These opportunities can be tedious to find but often exist because they do not show up directly through easy to use screening. What’s challenging to unearth often holds opportunity. Finding these opportunities do not require you to abandon screeners altogether. Once you have formed a list of hunting grounds, you can use a screener like finbox.io's to get you started on your tactical search. Let’s explore five examples of areas you might find undervalued asset opportunities.
1. Historical Carrying Cost
Real estate is typically a well-understood asset class. Valuation is simple and straightforward making most real estate holdings an easy to understand asset. However, what many investors fail to consider is that General Accepted Accounting Principles (GAAP) allow for real estate to be carried at historical purchase prices.
For example, if a company purchased a building and land for $200,000 75 years ago, it can still carry that purchase on the balance sheet at $200,000. Even if today the property has appreciated and is valued at $25,000,000 it still carries at $200,000. This difference can create a significant margin of safety on ordinary investment opportunities.
How to find: An easy way to begin your search for undervalued real estate holdings is to think of businesses where real estate directly impacts their business model. For example, property management companies often own a portion of the properties they manage. While their earnings are typically related to their operations as a service business, their real estate holdings can create a great margin of safety on their balance sheet. Another example is retail. It was a common practice for large older retail organizations to own the real estate they occupied. Some retailers still carry that real estate.
Once you have your list of businesses, take a look at how the balance sheet has changed over the history of the business. Previous 10-Ks and annual reports will give you a better understanding of when the real estate was acquired. Breaking down geographical areas will allow an insight of where specific pieces of real estate may have appreciated faster than others. If there is an area of the country that has rising real estate prices, it could be advantageous to focus your search on operators that focus in that area. Higher real estate value creates a more considerable margin of safety.
2. Carrying Value of Other Assets
Real estate isn’t the only tangible asset that offers hidden value opportunities. Sometimes a business will have useful assets that are well and functioning but either out of the spotlight or showing up as salvage value.
One example is Carl Icahn’s use of railcars with his purchase of ACF and American Railcar Industries. As Icahn detailed in an interview with DealBook;
“In the railcar business, the secret is very simple. You make railcars, but the government wants to incentivize you so you can depreciate the railcar over five, six, seven years, but you can keep It for forty years. You get this great depreciation which is a great tax incentive.”
Another type of asset with similar attributes is helicopters. As detailed in “The Manual of Ideas” by John Mihaljevic, Eric Khrom of Khrom Capital Management used this exact strategy. Khrom cites;
“Oil prices were falling like a rock during the crisis of 2008-2009. I took it as an approach that the company PHI owns over 300 helicopters. There is actually a blue book on helicopter values. What I discovered, unlike airplanes, is the fact that helicopters have a very stable asset value. They don’t fluctuate as heavily as airplanes do. Helicopters are interchangeable between many industries. You don’t just have to use them for oil and gas; you can use them for police, tourism, etc. If one country suffers, you can move them to another country. I did the liquidation value analysis, and I noticed that PHI was trading for maybe thirty cents on the dollar. So regardless of what happens with the oil and gas industry, and regardless if this company made another profit or not, the helicopter fleet itself was trading at a tremendous bargain.”
How to find: You can begin your search for this type of investment opportunity by generating a list of assets that either hold value in the long term (like helicopters) or offer higher depreciation yields compared to their working lifetime (like railcars). Once you have a list of assets, begin screening for companies that incorporate those types of assets in their business model. From there, compare the equipment they are carrying on the balance sheet to what marketable values are available if the company were to liquidate.
3. Net Operating Losses (NOLs)
While it may seem counterintuitive to seek out companies with losses, it can be quite profitable to find NOLs and NOL shells. An NOL shell is a company that previously or currently has substantial loses. In the past, a U.S. company of this nature could “carry back” the loss two years (assuming prior profitability) for a tax break. Also, the NOL could be used to carry the losses forward over the span of 20 years to offset future taxable income (net operating loss carryforwards). This strategy was a longtime favorite for investor Sam Zell. Under the new tax code (section 3302 of the Tax Cuts and Jobs Act of 2017), the carryback previously allowed was eliminated. Additionally, any NOL arising after January 1st, 2018 will be limited to 80% value of the carry forward. Although the new tax code lessens the value compared to before, NOLs are still a decent hunting ground for finding hidden value.
How to find: NOLs show up on the balance sheet as deferred tax assets (DTA). Often they are found within companies with high R & D cost but can be discovered elsewhere too. You can calculate the value of the NOL by looking at what the company is making, what the current DTA carrying value is, and what the company looks like with and without that tax asset. Before the revised tax codes, it wasn’t uncommon for NOL heavy companies to be scooped up as acquisition vehicles.
Is it a surprise to see cash on this list? Cash is a pretty easy asset to screen for and extremely easy when assigning a current market value. While finding businesses with cash isn't so much a challenge, it is easy to overlook the impact that cash has sitting on the balance sheet. Many investors fail to adjust their analysis for cash positions.
For an overly simplistic example, let's say you had the option of investing in two different companies trading at the same price of $100. Both companies make $20 in a given year. However, one company comes with $50 cash in the bank account whereas the other does not. All things equal which company would you rather buy? The decision is obvious. The company sitting with $50 in cash gives us that much more margin of safety.
In the example above, both companies might show up on screener ideas because of their Price to Earnings or Price to Cash Flow ratios. However, if we apply a cash-adjusted analysis to the current price, we soon see that the company with cash on the balance sheet is trading at an even lower and more advantageous value multiple. As more cash builds up, the margin of safety widens.
How to find: To look for businesses with ample cash on the balance sheet, you will want to screen for "cash and short-term investments." It’s rather straightforward; the trick is remembering to adjust your other multiples to reflect the cash position.
5. Investments in other Companies
The strategy of finding companies with significant positions in other publicly traded companies leans heavily on unearthing advantages in-between reporting periods. This is how it works… Let’s say company A has a significant position (greater than 10%) in publicly traded Company B. The position amounts to 30% of Company A’s overall equity market value. Now let’s assume Company B doubles in price. This hypothetically should create an additional 30% value increase in company A. Many investors overlook this because the realization of the price increase will not show up until Company A updates its balance sheet. In addition, like the example above with cash, positions in other companies can create a margin of safety. All things equal, if you come across two companies with the same operating profiles but one has significant positions in long-term investments, you’ve increased your margin of safety.
How to find: To find these opportunities you will want to screen for companies with substantial long-term investments on their balance sheet. You can also consider making a list of historical spinoffs where the parent company retained a significant position in the spinoff.
Overall, it can be a bit tedious finding businesses with hidden value. It takes digging and a creative angle of analysis. Ultimately its what isn’t obvious that makes it an opportunity itself.
Zell, S. (2017). Am I being too subtle?: straight talk from a business rebel. New York: Portfolio/Penguin.
Mihaljevic, J. (2017). Manual of Ideas: the Proven Framework for Finding the Best Value Investments. Wiley & Sons Canada, Limited, John.
Article by Carter Johnson, Finbox.io