Intrinsic Value, With Short-Term Results

January 8, 2008 by Joe Ponzio

If you recall from an earlier post, I showed a quick potential profit from Sharper Image – in that case, a few-day return of more than 40% because the stock was trading so far below its break-up value. As time marches on and the ability to generate cash seems a distant goal, the value of that company continues to slip, as does its break-up value. (Remember: Every day that it can’t generate enough cash is another day that the company will need to dip further into savings, assets, or debt to finance operations.)

Quick, large profits can come from buying companies for well below their break-up value. I was revisiting some of Buffett’s early partnership letters (no, I can’t send them to you and I won’t post them without Buffett’s express permission), and I came across this 1960 play that resulted in massive, short-term profits from conservative value investing.

In his January 1961 letter to investors, Buffett revealed a secret play he had been making over the course of the previous eighteen or so months. In 1960, the Buffett partnerships gained nearly 23% while the Dow lost more than 6%. The large play? Sanborn Map.

The Sanborn Moat

Sanborn was a simple business – a mapmaker. The company published and continuously revised extremely detailed maps of all the cities of the United States. Every year or so, the company would revise these 50-some-odd pound maps detailing new construction, changed occupancies, new fire protection facilities, etc.

For seventy-five years the business operated in a more or less monopolistic manner with profits realized in every year accompanied by almost complete immunity to recession and lack of need for any sales effort.

Much of Sanborn’s business was done with insurance companies. Fearing Sanborn’s strength and pricing power dominance, some insurance companies placed insurance people on Sanborn’s board in a “watch-dog” capacity. Why? Control the supplier and you can control your profits. (Think Wal-Mart)

The Downward Spiral

In the 1950s, a practice known as “carding” began eating into Sanborn’s business and profits began to fall. By the late 1950s, Sanborn’s profits fell 80% from their 1930s levels of $500,000.

…this amounted to an almost complete elimination of what had been sizable, stable earning power.

In the 1930s, Sanborn was a $110 stock. In 1958, the company was trading for $45. (At a P/E of about 47. Still think P/E matters?)

What Buffett Saw

During the early 1930s, Sanborn had begun to accumulate an investment portfolio. Over time, about $2.5 million was invested – half in bonds and half in stocks. While its map business began publicly deteriorating, its investment portfolio was silently growing.

By the late 1950s, Sanborn’s investment portfolio increased to equal roughly $65 per share. In effect, buyers of the stock at $45 a share were acquiring an investment portfolio for $0.70 on the dollar, and were getting a map business for free!

At the time, Buffett invested roughly 35% of his partnerships’ assets into Sanborn. Mind you, Buffett was only managing about $4-$5 million at the time. Now you naysayers will cry, “Buffett earned a seat on the board and then spun off the investment portfolio. I can’t buy enough to get on the board!” True. What did that really do for him? It allowed him to speed up the process of spinning off the investment portfolio by putting a proposal in front of the SEC. (He didn’t want to blow Sanborn’s money on a shareholder proxy battle even though he knew he’s win.)

The Information Age Empowers You

What if he couldn’t get on the board? What if he didn’t really have a voice in Sanborn? In 1959, he’d have a problem. Today? No sweat! A simple press release, an announcement of the stock’s situation, and you’ve got yourself a corrected stock price. What investors and institutions wouldn’t perk up if a wire came across touting the Sanborn deal? Sure, they may not care about your estimation of Sanborn’s intrinsic value; still, $0.70 on the dollar in hard assets and a profitable business to boot? You’ll get their attention.

Can you really do that? Of course! So long as you are not scheming or trying to create a fake market in a stock, you are free to tell the world about your analysis. Think no one will care what Joe Blow from Nantucket thinks about a stock? Offer them a Sanborn deal and you’ll have their attention.

I Digress; Let’s End The Letter

Mohnish Pabrai helped value investors understand the difference between 1950s Buffett and 21st century Buffett. Who was 1950s Buffett? I’ll let him tell you:

Necessarily, the [explanation of the Sanborn deal] is a very abbreviated description of this investment operation. However, it does point up the necessity for secrecy regarding our portfolio operations as well as the futility of measuring our results over a short span of time such as a year. Such “control situations” may occur very infrequently. Our bread‐and‐butter business is buying undervalued securities and selling when the undervaluation is corrected, along with investment in “special situations” where the profit is dependent on corporate rather than market action.

Sanborn Deals Today

In 1959, Buffett had no problem investing in thinly traded stocks with small revenues and profits. How thinly traded? How small? Assuming Sanborn had grown in output by 3.2% (the average annual growth rate of all US industries from 1960 to 2000), added another 3% to its growth through inflation price adjustments, the company would have (assuming all things being equal) earned roughly $1.79 million in net income in fiscal year 2007. Total shares outstanding at the time? 105,000.

The Point: Be Business-Minded

We have all heard the scare stories about buying low-priced stocks (They’re low-priced for a reason!), thinly-traded companies (There’s no liquidity and they are super-volatile!) and diversification (The markets are scary! Buy everything – good and bad – so you can make 5% over the long-term!). If you focus on the short-term markets (let’s face it, yesterday’s 200+ point drop in the Dow was crazy) you’ll go insane and take on a ton of risk with a side of panic. If you think like a business owner, you may find some real gems in those “scary, small stocks.”

Now, I’m not telling you to run out and buy penny stocks. But don’t feel the need to limit your searches to companies with $X of market cap. $0.70 on the dollar is a good deal in any market. Just make sure you uncover the next “Sanborn” and not some junk that is tiny for a reason.

Virtually every Buffett partnership letter began with something to this effect (taken from the aforementioned letter):

However, I have pointed out that any superior record which we might accomplish should not be expected to be evidence by a relatively constant advantage in performance compared to the Average. Rather it is likely that if such an advantage is achieved, it will be through better‐than‐average performance in stable or declining markets and average, or perhaps even poorer‐than‐average performance in rising markets.

I would consider a year in which we declined 15% and the Average 30% to be much superior to a year when both we and the Average advanced 20%. Over a period of time there are going to be good and bad years; there is nothing to be gained by getting enthused or depressed about the sequence in which they occur. The important thing is to be beating par; a four on a par three hole is not as good as a five on a par five hole and it is unrealistic to assume we are not going to have our share of both par three’s and par five’s.

If you are judging your investment success and savvy based on the events of the past few days, weeks, months, or year, you shouldn’t be investing in common stocks – buy an index fund or bonds and be done with it. Your success is not judged by the daily swings of the markets in relation to the speed with which the Earth spins on its axis or around the sun, but by the truth that price follows value. (I just made that up. Catchy, no?)

A Note From Joe Ponzio

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