Back in the old days, book value was *the* measurement that value investors threw around to validate “margin of safety” when investing in stocks.
If you read the classic investing texts like Security Analysis or The Intelligent Investor, they advocate for the buying of stocks that sit well below book value. This style of investing is sometimes called “cigar butt” investing, or “net-net” investing.
Essentially this style of investing means you’re buying dollar bills for less than a dollar. This means buying assets like cash, real estate, land, inventory, and equipment minus the value of all outstanding liabilities, for less than they’re actually worth.
Sounds pretty awesome right? But this investing methodology is rarely used in “modern” times.
Is book value investing still a relevant investing technique? Or, has the investing world changed? Let’s find out!
The Balance Sheet Was Everything
Back in the 1950’s and 1960’s book value investing technique was a very viable technique. Super investors like Warren Buffett, Charlie Munger and Bill Ruane invested in companies trading below book value and built massive fortunes doing it.
A lot of time has passed since those days. Companies have changed considerably from the capital heavy business models of the early 20th century. Back then, to grow a business you either opened new stores, built new factories or bought new machinery. A company could only grow as fast as their balance sheet grew.
Confused? This concept is easier to understand if I provide an example…
Imagine you own a shoe company that makes tennis shoes. The company’s main asset is a factory that outputs 30,000 pairs of shoes per year. The factory uses raw materials like leather, plastic, or rubber and produces finished goods in the form of tennis shoes.
If this shoe company wants to double sales of shoes to 60,000 per year over the next three years, they’ll need to invest. The company’s options are to either begin investing in expensive machinery that will double factory output (like robots), or simply build a second factory.
This kind of business growth requires a HUGE amount of capital to implement.
Furthermore, if you opted for improvements to the existing factory, it could be disruptive to the existing factory output while the machinery is installed — The existing production of 30,000 shoes might actually fall while the bugs get ironed out.
Modern companies rarely grow in this manner anymore. Most shoe companies (to continue our example), now outsource production overseas to factories owned by other companies. This is outsourcing is advantageous because it allows companies like Nike to spin up (or spin down) production factories quickly without heavy capital investments.
Share Buybacks And Book Value
Besides the low-capital business models that have become popular in recent years, there’s also other factors that can affect a modern company’s book value per share — like share buybacks.
Back in the early decades of the 20th century, share buybacks were not a common practice. It’s wasn’t until the 1980’s that this practice began to grow in popularity.
In modern times, share buybacks are extremely commonplace. Companies buy back shares with excess cash all the time… but how does it affect book value?
Believe it or not, share buybacks actually lower book value under most circumstances. This seems counter-intuitive because buybacks are supposed to increase share value, but the accounting mathematics don’t lie — If you use company cash to buy back shares when they trade above book value, then book value will decline for every share purchased.
This negatively affects the price to book value multiple, but has the positive effect of raising future earnings per share.
Good companies that can continually buy back shares may actually end-up with flat or declining book values per share … despite a flourishing business.
Visa (the credit card company) provides a perfect example of a prospering business with a flat book value per share:
In some instances, if a company buys back enough shares, book value can actually become negative over time.
I’m not kidding, this actually does happen — Moody’s provides one example of this happening in recent years. Check out how Moody’s book value has dropped into negative territory:
Clearly Moody’s isn’t a worthless company as the book value implies. At both Visa and Moody’s, revenues continue to grow year after year despite showing no growth in the “accounting value” of the share equity.
It may seem strange, but I think this is a perfect example of how old analysis tools don’t value modern business activity appropriately.
Modern Businesses And Book Value
Today, modern companies have few balance sheet constraints that restrict growth. Companies like Facebook have no factories, warehouses, or inventories to speak of. Instead, they have internet servers, a bunch of computers for employees to use, and they rent a few office buildings. That’s it.
As you would expect, Facebook’s market capitalization is so far removed from book value it’s not even funny — Facebook is currently trading at 7.97 times book value.
But what about companies that aren’t internet companies and still make and sell physical “stuff”? They’re not immune either.
Modern valuations are so far removed from book value it’s almost shocking. Even companies like Deere that still own factories are valued at many times book value.
So, do any companies still trade below book value? A quick stock screen reveals the answer — A few do.
Most of the companies sell for less than book value are deeply troubled companies. With names like Gamestop, Abercrombie & Fitch, and Regal Entertainment you can quickly understand why. Sooner or later they’ll either go out of business, go private, or be acquired.
There’s also a large number of insurance and reinsurance companies that show up in such stock screens (Metlife for example). This is mainly due to poor industry conditions. These industry condition might change someday in the future, but who can (accurately) predict when that will happen?
Most investors looking for financial independence lack the appetite for such troubled investments — There might be years of bad news to stomach and bankruptcy court at the very end. It’s a very rough ride for investors.
It’s also worth noting that even professional value investors can get fooled into making bad investments in companies that trade below book value. This was recently the case with a company called HorseHead Holdings.
A lot of really famous value investors like Guy Spier and Mohnish Pabrai got sucked into a HorseHead bankruptcy last year. These guys are incredible investors that regularly beat market returns, and yet they still ended-up getting wiped out when the creditors took control.
Yes, there could be real value hidden away in companies that trade below book value, but I don’t recommend this style of investing anymore.
On one hand, you have very few companies that now fit into this category — and most are pretty crappy companies. This makes finding safe “net net” style investments that much harder.
There’s also the question of execution — For most smaller investors, “net net investing” is really about waiting for a “blip” in the stock price to realize profits. It can happen and you realize profits OR the company can simply fall into bankruptcy where equity shareholders typically get wiped out.
For a few years in my investing past, I actually tried to do this — I invested in businesses trading below book value that still had a little life left in them. I did pretty well at the time (with returns in the 15-20% range), but I attribute this mainly to luck.
Now I try to be a farmer instead of a hunter when I invest. Companies and times have changed. I say “leave book value investing in the past” where it belongs.
The stress of trying to catch one of those “blips” before a company goes bankrupt just isn’t worth it to me anymore. I would rather accept smaller returns, but sleep better at night knowing my dollars are invested in good companies with solid futures.