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The Problems With Liquidation Value


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By ZENWAY - Posted on 12 January 2009

Famed value investor, Thomas A. Russo of investment advisor Gardner Russo & Gardner, expressed his doubts about value investors’ fixation on liquidation value as a downside protection. “When you reach for the net-net, it often disappears,” said Russo when he gave his musings on “global value” equity investing at New York Society of Security Analysts (NYSSA) on May 22, 2008.

Exit costs can eat into liquidation value.

Russo stressed the value of consumer brands and express serious doubts about liquidation value currently used by many value investors as a downside protection. In today’s legal environment, when it comes a time to close the business and tap into the liquidating value, you could have a whole line up of exit costs eating into the cash pile, including environment dumping costs, labor-related layoff costs, retirement healthcare benefits, executive benefits, and so on. Besides, the book value of a dying business could be over-stated. This echoes the doubt about liquidation value expressed by Warren Buffett, Chairman of Berkshire Hathaway (BRK.a, BRK.b), who had first-hand experience at liquidating some of Berkshire’s textile assets. The experience of firing thousands of employees was so painful for him that he moved away from liquidation game ever since.

Band value is usually understated on the books.

Russo’s fixation on consumer franchise was due to his training under the late Bill Ruane of Sequoia Fund (SEQUX) where Russo worked as an understudy after graduating from college. Value investors’ move from liquidation value to consumer brands was partly due to Charlie Munger’s influence on Warren Buffett. Charlie Munger, based on his legal work, realized early on that, many consumer companies’ legally enforceable trademarks, patents and brands are not even reported on the balance sheet, yet those brands have real value because they can charge a premium for their products and bring in high return on invested capital. On the other hand, the liquidation value of the equipment for a commodity business is often questionable, not to mention replacement value, which can be a number in the air.

Consumer brands are easier to do research on.

It is also harder to estimate the liquidation value of the equipments without flying around and seeing all the plants, whereas a consumer brand investor can feel and taste the products and watch the ads almost every day. Thomas Russo’s favorite research technique is to go into people’s homes and peek into their refrigerators. Looking around the refrigerator and the kitchen, Russo would ask: “Why do you prefer this brand rather than the others?”

Russo also talks to foreigners in theme parks and on planes. He would ask them about the various brands in their respective country and try to assess the pros and cons of various products. The more expensive research method is to fly all over the world to visit those companies.

You can ride the brands for the long term.

“The scarcest resources of value investors is our time,” observed Thomas Russo. Therefore, his operating motto, as he puts it, is “Focus, focus, focus, focus.” By focusing on a few industries, you gain broad industry contacts and a global perspective about various competing brands. You would have deeper insights about the value proposition of various franchises.

With brand power as tail wind, you can afford to invest for the long term rather than praying everyday that the liquidation can go through as early as possible in order to stop the bleeding of cash. Russo also stressed that he has the advantage of putting the unrealized gains to work when he has brands behind him. Russo subscribes to Warren Buffett’s idea of buying only 20 stocks during a life time and hold on to them forever. That way you can really focus.

Trustworthiness is at the heart of financial brands.
When discussing the brand value of Citigroup (C) and AIG (AIG), Russo pointed out that, when dealing with financial franchises, you really have to trust the people who report the numbers to you. He doesn’t do any global investing in the field of financial companies. He feels the physical distance between him and the managers are too far to overcome. He even feels very far away from the guys on Wall Street nowadays. The whole room laughed at his observation.

In front of a full room of value analysts at NYSSA, the intellectual home of the late Benjamin Graham, the father of value investing, Russo pointed out the paradox of value school of thoughts: “We all try to buy value, yet when we look at our portfolio carefully, all our big profits come from growth.” And all that growth often comes from powerful consumer brands spreading all over the globe.

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Brian Zen, CFA, founder of Zenway.com Inc., a New York-based registered investment advisory firm, owns shares in Berkshire Hathaway, Citigroup and AIG. To request the complete notes of Thomas A. Russo’s talk at NYSSA, please click here: http://zenway.com

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