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Buffett Hates this Valuation Tool. You Can Use it to Outperform Markets by 200%

Dec 18, 2017

Rahul Shah, Editor, Smart Contrarian

Warren Buffett hates book value. In one of his annual letters, he shared an anecdote that explains what led him to look at his once favourite valuation metric with deep suspicion.

Here's what he shared.

  • Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole.

    Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery. The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.

    Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.

The assets that were sitting on the balance sheet at a princely value of almost a million dollars, fetched a big fat zero when it was time to sell them off.

Imagine someone buying this company at a 50% discount to its book value i.e. half a million dollars. The guy would think that he's getting a deal of a lifetime, when all he would be getting for his money is a worthless piece of scrap.

This was one of the main reasons Buffett drifted away from investing in asset-intensive industries at below book value, to companies where he didn't mind paying a hefty premium to book as long as the company had extremely valuable intangible assets in the form of a well-known brand or a patent.

If Buffett is right, what explains our success in Microcap Millionaires?

As our subscribers would know, no stock in the service has been recommended using a valuation metric other than book value.

Every stock that has been recommended so far has found a place in the service only because it was trading at atleast 20% discount to book value. And this rule has served us extremely well.

Out of the 34 positions that we have closed so far, only 4 have closed in the negative. This means a strike rate of close to 90%. And all this by relying on book value as a measure of valuation.

The difference is that Buffett's hatred for book value stems from the liquidation proceeds he got out of his sale.

Whereas we use it for our Microcap Millionaire recommendations to gauge the relative undervaluation of our stocks vis-a-vis the rest of the universe.

We don't expect any of the companies we recommend to end up under liquidation.

We just look at the book value to tell us how low the stock has gone and whether the upside-to-downside ratio is now in favour of the investor.

These are all good quality stocks with pristine balance sheets that are just going through some tough times.

And they are likely to bounce back once business conditions improve. We are betting more on reversion to the mean than looking to cash in on the liquidation proceeds.

So, as the track record of Microcap Millionaires shows (it has outperformed the benchmark index by 200%) - relying on book value can be more a boon than bane - as long as you use it right.

Good investing,

Rahul Shah (Research Analyst)
Editor, Smart Contrarian

Brain Food for the Day

The Value Investor Who Swore by Book Value

While Buffett made his displeasure for using book value as a valuation tool absolutely clear, he had nothing but the highest respect for the late Walter Schloss, his dear friend and a strong proponent of using book value for valuing companies.

Here's Buffett paying a rich compliment to Walter Schloss.

  • Walter continues to outperform managers who work in temples filled with paintings, staff and computers. And he accomplishes this feat by rummaging among the cigar butts on the floor of capitalism.

    It's quite a 38-year record, a tribute to Ben as a teacher, Walter as a student, and to the advantages of a free puff.

And here's an excerpt from a fine article in Forbes on Schloss.

  • Schloss screens for companies ideally trading at discounts to book value, with no or low debt, and managements that own enough company stock to make them want to do the right thing by shareholders.

    If he likes what he sees, he buys a little and calls the company for financial statements and proxies. He reads these documents, paying special attention to footnotes. One question he tries to answer from the numbers: Is management honest (meaning not overly greedy)? That matters to him more than smarts.

    Schloss doesn't profess to understand a company's operations intimately and almost never talks to management. He doesn't think much about timing - am I buying at the low? selling at the high? - or momentum. He doesn't think about the economy. Typical work hours when he was running his fund: 9:30 a.m. to 4:30 p.m., only a half hour after the New York Stock Exchange's closing bell.

Microcap Millionaires is indeed in good company.

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1 Responses to "Buffett Hates this Valuation Tool. You Can Use it to Outperform Markets by 200%"

Ravi Shanker Bommakanti

Dec 19, 2017

It is not correct to say Buffet hates Book value as a tool. I understand that he uses book value of Berkshire and increases in book value as the primary indicator to assess and grade the performance of Berkshire versus the S&P Index in the US.

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