MANY investors view net asset value (NAV) not only as a gauge of possible upside through market mispricing, but more importantly as a guarantee against huge leaks of capital. Technically speaking this is true. On a company’s balance sheet NAV — or rather tangible NAV (which strips out intangibles) — should offer a reassuringly reliable underlying value.
That’s why investors punting a deep NAV play often contend that "if the company were liquidated today, the net assets would be worth more than the share price". If only it were so simple. Unfortunately balance sheet NAV can never really be insulated against unexpected swings in operational form, wasteful strategic detours, sudden economic changes or stubborn debtors. It’s also worth remembering that NAV is a snapshot of company at a particular time. This snapshot can be a month to three months old by the time it’s viewed by an investor.
Three months is a critical time lapse, remembering that situations where a share price hugely discounts NAV are mostly applicable to companies enduring strenuous trading times or struggling for traction in a turnaround effort. To put it bluntly, dabblers in deep NAV situations are not usually blessed with operational comfort in the form of thick trading margins or reassuring cash flows.
Still, investor interest is always piqued where the tangible or audited NAV is far greater than the share price. Essential to the investment test is a simple inquiry as to whether a company can continue operating without grinding away large chunks of NAV. Obviously there is a huge dependence on management to know when shareholder value is at risk from operational drag. It’s worth recalling CE Peter Watt’s noble effort to save value for shareholders in struggling call centre group Dialogue, or, more recently, Delta EMD’s prudent decision to quit increasingly unviable operations in order to return as much of the remaining balance sheet value to shareholders as possible.
Unfortunately, there are many more examples of management pressing on with operations that will ultimately be detrimental to shareholders. Dorbyl unwisely insisted on continuing with an automotive component manufacturing subsidiary that subsequently burnt through a substantial cash pile shareholders believed might fund a special dividend. More recently, construction services specialist Protech Khuthele spent much effort staving off a buyout offer by larger rival Eqstra, only to stumble into business rescue after hitches in contract settlements.
Though there is comfort in a company’s value being underpinned by a solid asset base, it’s rare for executives — especially those depending on salaries rather than holding significant equity positions — to concede that operational viability cannot be attained. An asset manager behind a investment boutique specialising in delving into deep value situations, but who doesn’t wish to be named, stresses the key to effectively unlocking NAV lies in the hands of management. "We tend to focus on companies where the CE and directors have significant equity stakes. In such companies the allocation of capital tends to be carefully scrutinised."
He argues that investors who fixate on NAV are open to much more risk if they invest in companies where executive management benefits mostly from remuneration packages or share option schemes. "We don’t like it when management and shareholder interests are not aligned. We also don’t like share option schemes as they can encourage executives to take calculated risks for short-term gains in a bid to boost the share price."
Another critical question is whether investors can believe the value ascribed to assets by directors, which would include property, plant and equipment, as well as investments. Flagship Asset Management director Niall Brown stresses that investors should ensure that asset valuations are not grossly inaccurate. Some companies’ claims of sizeable value on properties and investments have been exposed as woefully overvalued when corporate action (takeovers or asset strips) triggered a reality check. A recent example would be Afrimat’s takeover of Infrasors, which resulted in a marked downward adjustment of valuations on tangible assets.
Brown says investors looking at deep value opportunities need to ensure the assets being evaluated can be properly quantified and that the company is not geared to the gills (which could force a desperate sale of assets). "We enjoyed considerable success in picking Austro, where the asset base was solid and not encumbered by a huge pile of debt." Investors can peruse three intriguing deep value options in the form of Argent Industrial (tangible NAV R12,42/share versus a market price of 564c), Sentula Mining (tangible NAV of 170c/share versus a share price of 27c) and unlisted liquor group KWV (tangible NAV of R17,85/ share; over-the-counter price of 850c).
On paper, Sentula represents potentially the biggest opportunity to unlock value, discounting its hard NAV by a mind-boggling 84%. But Sentula also carries the most risk of net asset erosion, as it operates in the tough mining services sector. The value previously accorded to its assets is also questionable. Rather worryingly, NAV has fallen steadily from over 500c/share in 2011 and in Sentula’s last set of results there are several provisions and impairments, including a hefty R375m write-down on certain mineral rights. It’s a huge temptation for opportunistic investors to want Sentula to wind down its operations and cash out the supposedly rich NAV. But CE Robin Berry is adamant the company can provide a platform for growth as a focused mining services provider.
Essentially, investors have to ponder whether a protracted (and perhaps risky) operational recovery will unlock more value in the long term than the freshly impaired 170c/share intrinsic NAV. Argent also offers a gaping discount on NAV despite dragging through impairments of R240m in the year to March. The company is selling 12 properties for R278m. But though the property sale proceeds represent a chunky 300c/share, shareholders are not in line for a special dividend. The property sale proceeds are earmarked for a share buy-back exercise and to cull debt, and it appears CE Treve Hendry also wants to invest in existing businesses "with growth potential" and new businesses in the "high-growth" branded manufacturing niche.
Again, investors need to decide whether a revamped operational thrust will result in Argent closing the gap on its stated NAV. But unlike Sentula, Argent, despite operating in the brittle steel services and manufacturing core, is profitable, with normalised earnings of R82m in the past financial year. This is equivalent to 90c/share and can be regarded as good-quality earnings with gross operating cash flows coming in at R103m.
KWV, arguably, offers the most intriguing deep NAV play. Its shares offer a more than 50% discount on tangible and (very) conservatively managed assets. KWV’s R1bn worth of inventory — mainly brandy and wine stock — alone is worth close to R14/share. And as long as KWV can churn out decent operating profits, the value of the liquor stock is largely fortified. But what is a more contentious issue for KWV investors is the value of the so-called heritage assets, which comprise a substantial art collection and various properties, including the flagship Laborie estate.
At last week’s AGM, KWV chairman Marcel Golding reiterated that the heritage assets were not for sale; CE Andre van der Veer added that the "nice thing about these assets is that they go up in value every year".But shareholders are undecided on whether KWV’s heritage assets represent dead capital or actually enhance the brand image of KWV’s up-market brandy and wine ranges. If KWV, buoyed by a weaker rand and award-winning products, can deliver consecutive sets of solid profits, the enhancement argument will take root and perhaps the share price will close the gap on its NAV. Even if its profit performances are mixed, the downside risk in KWV is limited.