Assets vs. Earnings
A semi-thematic post takes me in a different direction today as I split from last week’s post – on hotel groups – and dive into what I guess is the opposite sphere of value. Many of those companies could be considered cheap because they traded at discounts to tangible book value; the one I distinctly decided wasn’t cheap was Intercontinental – in their case, you get very few net tangible assets for your money. The multi-faceted nature of investing means that there is always two sides to every story, though, and within a few hours red commented with almost the opposite to my gesticulations – that Intercontinental, in fact, looked to be reasonably priced, and that their lower price-to-book peer which I had highlighted was, in fact, slightly less golden.
The pivotal point, it turns out, is that metric I was discussing; the amount of assets you get for your money. I generally like companies with more assets to those with fewer – red prefers those with less, since:
… more of the gross profit gets passed down to profit (via lower depreciation) and more of the profit is distributable (because growth needs minimal capex)
It’s easy to see in real life terms, too, how less asset-intensive business models are more scalable. Amazon and eBay compared to brick-and-mortar retailers is basically a case in point of this! I still harbour that lingering doubt about firms with no asset backing, though; without assets, what’s protecting the value of my investment? The shallow version of this is a straight observation that the liquidation value is below market value. Is that relevant if liquidation isn’t likely, if finances are sound and the business is profitable? No, not really – since, by definition, if the company is using these few assets to make a great deal of profit – earning a high return on them – there would be no point liquidating them. There is value there, just in flaky intangibles – the systems in place, perhaps customer relationships, perhaps some regulatory barrier.
Anyway, a decent example that popped up on my screener for comparison was Hogg Robinson. Hogg Robinson are a company providing support services for large corporates – travel, expenses, and data management; essentially, niche specialisation at work – they’ve taken a part of something that all big companies have to wrestle with, and gotten good enough that they can do it for corporates sufficiently better than they can do it themselves so as to make the trade beneficial for both parties. Neat economics in action. Their client breakdown by sectors is diverse, too – finance sits at only 18%, which surprised me and probably some readers, too. There’s 5 different sectors accounting for above-10% stakes, and the largest is that aforementioned finance at 18%.
As I was hinting at before, their balance sheet is slim, too. £11.6m of property plant and equipment represents the ‘hardest’ fixed assets. They have a reasonable amount of long-term debt, but a larger amount of trade and payables – the cheap form of financing. The other big detriment to the company’s stated book value (basically nil) is the large pension deficit, which I won’t delve into deeply here, but is a whole extra can of worms to open as a concept generally, what with the way they are accounted for and the way the actuarial assumptions affect the values involved.
As someone who likes to have a reasonable level of asset backing, then, Hogg Robinson presents a dilemma. They’re doing well, and they’ve done well. Furthermore, it makes no sense for them to ever have much on book. Evidently there is at trade-off in my mind between buying a reasonable amount of earnings and buying assets. Where that level is is more difficult to discern, but there’s obviously factors which make me feel better about not having the asset backing. A history of profitability, or profitable growth, is definitely one of them. Hogg Robinson’s isn’t hugely long, but goes at least some way to mitigating the most obvious worry for asset-light firms – that, because they’re asset light, it costs nothing to set up a competitor and muscle in on their business.
It’s also nice to see a regulatory or ‘network’ sort of effect in play; the idea that either there’s barriers of entry there that protect incumbent firms. The network effect debate is one that gets floated a lot, but does make a lot of sense. Windows is often used as an example; the costs of changing operating system in an organisation with thousands of employees, all used to Windows, having purchased a number of Windows applications and set up all sorts of business critical systems on Windows computers.. that’s a powerful ‘intangible’. Hogg Robinson have proprietary systems and customer relationships. The difficulty is in gauging what value these have in ensuring the future cashflows to the business.
That’s the thing I’m struggling with at the moment – quantifying it. Tangible asset values strike me as one way of finding cheap companies, but also a way which artificially narrows your pool and excludes a lot of businesses which will continue to earn profits in excess of what the market’s price might suggest. I still like the theory behind the outperformance of low P/B, too – but broadening my horizons and trying to understand other reasons to expect a continuation of profits – or an uptick – seems like it could never be a bad thing.