The Bear’s Lair: Book Value works best

Nineteenth century accounting worked differently from accounting when I was going through business school, and very differently from today’s accounting. Investors were told not to buy “watered” stocks and bonds, advice that would be laughed at by a modern professional investor. Yet with modern mark to market accounting we have far less certainty, much more unnecessary risk and less useable information. It’s time to go back 150 years, and do our books like the Pennsylvania Railroad.

You can see the defects of mark-to-market accounting most clearly in the books of mining companies, which have been greatly destabilized by this new paradigm. Mining is a difficult business; the price of most natural resources fluctuates so wildly that it is more or less impossible to know which investments make sense.

It is also impossible to hedge the risk except by entering into a long-term “tolling” contact with a big buyer which essentially transfers the risk to him. That method was used a lot in the 1970s and 1980s, especially with facilities such as natural gas pipelines, but in today’s litigious, highly-indebted world, it works much less well, because sleazy lawyers can find ways of allowing the buyer to weasel out of long-term purchase obligations that have become onerous. Short-term hedges, in the futures market, protected a number of extraction companies very well in the short-lived downturn of 2008, but as Linn Energy (Nasdaq:LINE) for example, has found to its cost, if the price downturn lasts longer than a year or so you run out of hedge.

It is thus necessary to line up financing for a major mining project in advance. What’s more, as much of that financing as possible needs to be equity, or the kind of self-hedging financing that can be obtained through forward gold sales contracts, for example, which transfer much of the gold price risk from the mine to the financier.

In the old days, if you had a mine project with a sufficiently low cost of extraction, and you lined up finance in advance, you were home free. The mine cost $1 billion, say, and if its sales prices on completion were low for a time, you didn’t make any money, or even ran at modest losses. However, the mine stayed on your books as an asset, its book value being determined by what you paid for it. If you built it reasonably efficiently and had not overpaid for the materials and other costs used in building it, investors know that an equivalent mine could only be built for an equivalent cost, probably rather more if there had been inflation. They could therefore make an accurate determination as to what your assets were worth and, in a downturn, pay an appropriate fraction of that, provided you weren’t about to run out of cash.

With modern accounting, this is no longer possible. If resource prices decline sharply, the accountants recalculate the value of the mine based on what it could make at the new lower price and then, if that amount is less than it cost, force a write-down. Since resource prices fluctuate wildly, this can result in a $1 billion mine being written down to say $200 million, even though there is no way it could be reproduced for $200 million or anything like that.

The accountants will argue that the new lower value reflects the earning capacity of the mine in the lower-price environment. However, consider then what happens if prices rebound in the following year. The mine is again worth $1 billion, but is permanently in the books at $200 million. The accountants do not allow the asset to be written back up, and quite right too – the games options-driven management could play with asset values being written up at random don’t bear thinking about. Consequently, the company is now vulnerable to all kinds of fast-buck artists in the takeover market, since its assets are hugely understated. The book value of the mine no longer bears any relation to reality at all.

This absurdity results from a fad that has swept the accounting profession in the last three decades, that of “mark-to-market” accounting. Of course it makes sense for traders to mark their positions to market on a daily basis, and to report each quarter the value of those positions. However, the less liquid an asset is, the less sense it makes to mark it to market. Thus private equity firms report the gain in positions each year and pay out a percentage of that notional gain in cash – a practice both deeply damaging to the shareholders and deeply dangerous to the long-term health of the business, which will generally lack both liquidity and staff after a bad year.

In the case of long-term fixed assets such as mines, mark-to-market accounting makes no sense at all, as I have demonstrated above. For these assets, we need to return to a concept fashionable in the early days of railroad and industrial accounting, that of “watering” assets or stock.

If you read the investment pages in the 1850s, you would see lengthy discussions of the extent to which a company (normally a railroad) was “watering” its capital, in other words issuing stock or worse still bonds for which there was no fixed assets backing. To the investors of those days, railroad pirates like Jim Fisk or Jay Gould were crooks because they watered their stock, when to modern eyes their insider trading and other governance eccentricities were far closer to criminality. To modern eyes, the 19th century focus on watering seems eccentric – most modern companies trade at share prices far above their book asset value, and nobody pays much attention to the figure.

Nevertheless, there was a fundamental economic reality behind the 19th Century concern over stock watering. If you built a railroad and issued twice as much stock and bonds as was needed for the physical assets, the extra capital required servicing, either by interest on the debt or dividends on the stock. Since a very high proportion of a railroad’s annual costs consisted of its capital charges, if your railroad had twice the charges it needed, another company could come in and build a parallel railroad, issuing half the amount of debt and stock, and would be able to undercut you on freight rates forever from the date of the new railroad’s completion. By doing so, the new railroad would capture the great majority of the traffic, and the original railroad would be forced to file for bankruptcy.

This happened a number of times in the nineteenth century (think for example of the war between the Erie Railroad and the New York Central, with parallel lines running from New York up the Hudson River to Albany.) To investors who thought of their investments as primarily based on fixed assets, requiring a pre-determined return on the capital used to finance them, the “watering” phobia was thus entirely rational.

“Watering” went out of fashion as an accusation in the 20th Century for a number of reasons. First, the types of assets being financed broadened, to include for example the major consumer goods companies whose earnings generators included intangible assets such as brands. For these companies, an amount of “water” reflecting the value of the brands was appropriate, and did not leave the company vulnerable to being undercut by a start-up competitor. When tech companies came along after 1950, the value of patents and sheer know-how also became a factor. 1960s IBM was indeed vulnerable to competitors, but because they were nimbler, not simply because its stock sold at a massive multiple of its nominal book value.

Then after the Gold Standard was abandoned in the 1930s, book values became increasingly irrelevant, because of inflation. By the 1970s, the older a company’s assets, the more its book value was likely to be understated. The first leveraged buyout companies, fast-back artists to a man, focused on companies whose downtown headquarters had been built in 1926 and by 1970 were stated in the books at a tiny fraction of their true value. That, together with the long post-war bull market in stocks, caused book value to be more or less abandoned as a method of investment appraisal. You might have wanted to find Benjamin Graham’s ideal investment, a company selling below the value of its “quick” assets, but you could search high and low and not find one.

Thus modern “mark to market” accounting has simply driven the nail in the coffin of asset based valuation of companies. However, I would argue that the accountants have done us a major disservice thereby. Now that inflation has subsided for a time, book asset values are pretty meaningful, and for those companies such as mines the energy sector, transportation companies and infrastructure in general, where asset acquisition is a major part of their cost, book value is the most important criterion for investment and “watering” remains a major management sin.

The truths of investment are eternal, but accountants reflecting new fads such as modern financial theory and “mark-to-market” accounting make it impossible for sound long-term investors to use them.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)