Saturday, August 25, 2007

Delving into Investing Theory

As I was thinking about the recent credit problems, I couldn't help but think there was a lesson to be learned for investing as a whole. Looking from today, we can say that some lending got completely out of hand. Since lending really is a form of investment, we can look at their rationale for making these loans to find the fault. Loan underwriting relaxed to a point where banks became less concerned with borrower's ability to pay, and instead focused on the asset price securing the loan. This can be seen in the rise in lending debt-income ratios, the percentage of income of the borrower going to pay off debts. Banks conventionally have a limit at 36%. Subprime lender Delta Financial, considered one of the better underwriters, went up to 55%; Other subprime lenders rarely disclosed their maximum limit. These lenders tried to make up for this by having lower Loan-to-Value ratios(LTV), which is the loan amount compared to the value of the house. This added more principal security.

The problem as I see it is one of financial misunderstanding. To me, an investment has an asset value and an asset cost. The asset value is simply the net present value of future cash flow, while the asset cost was what was paid to acquire the assets. So, a loan's "asset value" is really the discounted sum of the borrower's interest and principal payments, along with the cash-out value if or when the borower defaults. The asset cost though is simply the amount of money that was loaned. From this perspective, we can see that the problem was that lenders lost track of asset value when they became less concerned with the borrower's income and relied more on the underlying home price. If the homes could be sold for their full value this wouldn't be a problem, but there are very significant costs associated with foreclosures. So many mortgage companies made loans that were carried at face value when their real value was considerably less, given the likelihood of default.

Similarly, this same behavior can be seen during stock market bubbles. A stock is also worth the net present value of its future cashflow. This means the sum of the cash flow from the operating business as well as a final gain (or loss) if the company needs to be liquidated. In stock market bubbles, investors become less focused on the present value of the investments they purchase; instead, they are buying an asset at a certain cost and hoping it will appreciate when they sell it to someone else. The business' ability to justify the price through its cashflow becomes an afterthought. So for a long time, equity investments can be carried on the books at a price that is much higher than logic would justify.

Your goal in investing is to be buying when asset cost is significantly below asset value.
The beauty of Ben Graham's philosophy was its simplicity. His strategy was to invest in companies at two-thirds of their Net Current Asset Value (NCAV), or their current assets minus total liabilities. Current assets are expected to be converted into cash within 18 months, and they can usually be taken at near face value. Such an investment situation means that if the company stopped operations immediately, it would have enough cash to pay all of its obligations and then give what is left over to shareholder's for a decent return in a relatively short period of time- hence, you were buying a company for less than its NPV under a scenario where the fixed assets and the company were treated as worthless. So, there was a high level of cash security for this type of investment, yet the upside was also pretty limited. But Ben Graham knew that fixed asset values can be much different than their costs, and wanted to make a strategy that any Average Joe could use.

The days of finding pure NCAV ideas are getting slim these days as information has become much more available. Today, a investor must become much more accurate and comfortable in make income projections for a business. This means analyzing competitive advantages will play a much more important part in security analysis, and there will be the possibility for larger gains- and mistakes- for investors.

1 comment:

Alex said...

Nice article, Nick. The lending debacle also highlights another truism: Take care of risk and the upside will follow.