The Asset Play as an Investment Strategy

In our view markets are currently being priced assuming an optimistic growth scenario for the economy in general. As a result, LTIM are now reducing positions in cyclical companies/sectors/industries. We should add we are finding it harder to purchase companies at good prices considering their stable earning power.

A good price is a rather subjective concept, confirmed by speaking to several investment advisors whom will give several different responses. For LTIM it has a rather precise concept. It means we pay a reasonable multiple for stable free cash flow generation, whereby the yield we expect to receive at the price paid is higher than the return we expect to achieve from our portfolios (which is cash rates + 3% over a three year average). As a result, any growth will effectively come for “free”. At current market prices, few companies are offering growth for free. Hence our difficulty in purchasing companies on a stable earning power basis.

However, we are not building up a cash position larger than 15-20% of the portfolio in an environment where inflation risks seems to be increasing. Whilst we are reducing cyclicals, we will not simply wait for the next market crash to occur. Whilst growth assumptions have to become more aggressive to purchase a stream of future earnings, companies trading at market prices below their net physical assets are still available in certain industries. This is the domain of the asset play strategy. In this domain, net physical assets are at least as important as future free cash flow.

Asset play strategies usually involve the purchase of companies that are currently unloved. Investor demand for visible earning growth ensures that earnings, rather than assets, is the variable markets are most sensitive to when placing a price on a company that is publically traded on a stock exchange. We see this from the way stock prices shift aggressively if reported earnings are greater or less than estimated, by the format of analyst reports that emphasis the earnings evolution of a company in the next 12 months, as well as the way companies are crudely valued by many market participants applying a multiple on estimated short term earnings.

This focus on short term earnings can be physically measured by viewing how investors are allocating capital in the equity markets. For example, in the US the average holding period of a common stock in 1940 was around 7 years. In 2007, the average holding period was 7 months. It seems no one wants to forecast a companies earnings beyond 2 quarters. That seems to fit in well with what my hedge fund buddies say, and do.

The aim of the asset play is to try and take advantage of this “time arbitrage” that seems to exist in publically traded securities. It is common knowledge that certain asset heavy companies that suffer cyclical stress or poor news can be bought on the secondary market at a price considerably cheaper than their net real assets. However, assets plays can remain asset plays for a considerable period of time, which can dilute the potential return of the investment strategy.

In LTIM asset plays we therefore look for a specific catalyst that can reveal the hidden value within a companies balance sheet. In this environment, for a short period of time, the assets can lead the stock price, as opposed to the earnings. Marty Whitman would refer to such a catalyst as resource conversion, an important source of return for the value investor. The catalyst usually comes in the form of a new owner holding the asset. Hence relevant market transactions would be a new aggressive passive or majority shareholder, a merger or acquisition, or the selling of assets. Such a market based transaction can make visible the discrepancy between the price of the asset on the balance sheet and its true value in the market. As a result, the price to book ratio expands.

Asset plays are an interesting diversifiaction in a portfolio when growth assumptions become too aggressive, as is the case now for many companies we would like to own, but are not happy with the prices they are currently available. Furthermore, for those investors who fear inflation, such asset plays are an interesting way to gain access to physical assets at a relatively good price, which does not seem to be available via purchasing commodities via spot or futures markets at the moment.

In practice, we often combine an asset backing with a stable earning power assumption. As a result we feel comfortable the potential for a permanent loss of capital is minimal due to the net assets behind the company if a liquidation was to occur, whilst any growth in future earnings will come for free. As a result returns are likely to come from earnings, but a resource conversion event is a possible bonus. We like the risk -return characteristics of such investments when the price is right. Many opportunities are being provided in such unloved sectors as real estate - a sector much loved by everyone only a few short years ago...