a footnote on valuation

Although I’m now a died-in-the-wool growth investor, I started my career at Value Line, a firm that has seen better days but was founded right after the 1929 Wall Street crash on the principle that the “value line,” i.e., the stock’s price/cash flow ratio overlaid on a price chart, was the key to investment success. I also spent ten years as the sole growth product in a sea of value advocates. By far the strongest of them had the mantra that if a company could generate sales (even if there were no profits) it deserved consideration as a value-style investment.

I think that’s right.

My footnote is that there are groups of companies–financials and natural resource owners, in particular–where we’ve got to be especially careful about what the balance sheet and income statement actually say.

The recent problems with mid-sized banks like Silicon Valley Bank (SVB) or First Republic Bank (FRBC) are good examples. Both banks decided, for reasons best known to themselves, to invest depositors’ money in long-term Treasury bonds at a time when those bonds’ yields were at historic lows. This was in effect a huge bet that pandemic conditions that required such accommodative Fed policy would continue for a very long time.

As the pandemic came under control and interest rates began to rise, however, the value of these bonds began to shrink. I’ve read reports that suggest that in the case of FRBC its bond losses were large enough to wipe out all of its net worth. But accounting rules allowed mid-sized banks to continue to carry such bonds at their acquisition price, which meant that to the casual eye everything looked ok–which it wasn’t.

There are quirky rules for companies that drill for oil and gas as to how they account for unsuccessful wells. The more conservative method is to write the costs off immediately; the more liberal is to carry them on the balance sheet, in the hope that future successes will mitigate them. I only discovered this myself as a starting-out oil analyst, when one of my companies that appeared to have hefty profits cut its dividend because it was running out of cash.

Mining companies have a similar accounting issue. Typical practice is to mine low-grade ore when prices are high, and high-grade ore only when prices are low. A company that chooses to do the opposite may look great when prices are high, but could easily be forced to cease mining when they’re low.

more tomorrow