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Author: scrim1 Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 1933  
Subject: book value vs. intrinsic value Date: 1/6/2003 9:15 AM
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http://online.wsj.com/article_print/0,,SB1041802016741512224,00.html

Gateway's shares trade at a level valuing the company equivalent to its cash, which is roughly $1 billion. That cash cushion gives Mr. Waitt, who owns 30% of the company's shares, room to try yet another restructuring. But the company is expected to report 2002 revenue of $4.2 billion, less than half its peak two years ago. And despite a promise to eke out a profit one quarter this year, few analysts who follow the company now forecast one. "The reality is this is probably the fourth or fifth new strategy in as many quarters," says Joel M. Wagonfeld, an analyst at Banc of America Securities.

and..

Mr. Waitt is in no danger of losing his job. In addition to being chief executive, president and chairman of the board, he is also the largest individual stockholder. And some on Wall Street think the company could rebound if PC sales re-emerge from the doldrums. Stan Majcher, at value-investors Hotchkis & Wiley Capital Management, says it's a bargain. "It's trading close to net cash," he says.

Assuming this company doesn't burn through any more cash, it is trading near its cash value, which means the market is saying this business is worthless. The brand is worthless and the knowledge and investments Gateway has made over the last two decades is worthless.

I think some value investors confuse the difference between what Buffett considers value investing and what others consider value investing. Some characteristics that most investors associate with "value" is a low P/E, a low P/Book, or a high yield. Buying a company with a low p/e and low p/b ratio doesn't make for a rational investment. Neither does buying one with a high p/e or p/b ration. Buying $1 of economic value for 60 cents is. Buffett's investment philosophy is common sense investing or intrinsic value investing in my opinion.

Here's Buffett's view of the difference between book value and intrinsic value.

We report our progress in terms of book value because in our case (though not, by any means, in all cases) it is a conservative but reasonably adequate proxy for growth in intrinsic business value - the measurement that really counts. Book value's virtue as a score-keeping measure is that it is easy to calculate and doesn't involve the subjective (but important) judgments employed in calculation of intrinsic business value. It is important to understand, however, that the two terms - book value and intrinsic business value - have very different meanings.

Book value is an accounting concept, recording the accumulated financial input from both contributed capital and retained earnings. Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.

An analogy will suggest the difference. Assume you spend identical amounts putting each of two children through college. The book value (measured by financial input) of each child's education would be the same. But the present value of the future payoff (the intrinsic business value) might vary enormously - from zero to many times the cost of the education. So, also, do businesses having equal financial input end up with wide variations in value.

At Berkshire, at the beginning of fiscal 1965 when the present management took over, the $19.46 per share book value considerably overstated intrinsic business value. All of that book value consisted of textile assets that could not earn, on average, anything close to an appropriate rate of return. In the terms of our analogy, the investment in textile assets resembled investment in a largely-wasted education.

Now, however, our intrinsic business value considerably exceeds book value. There are two major reasons:

(1) Standard accounting principles require that common
stocks held by our insurance subsidiaries be stated on
our books at market value, but that other stocks we own
be carried at the lower of aggregate cost or market.
At the end of 1983, the market value of this latter
group exceeded carrying value by $70 million pre-tax,
or about $50 million after tax. This excess belongs in
our intrinsic business value, but is not included in
the calculation of book value;

(2) More important, we own several businesses that possess
economic Goodwill (which is properly includable in
intrinsic business value) far larger than the
accounting Goodwill that is carried on our balance
sheet and reflected in book value.

Goodwill, both economic and accounting, is an arcane subject and requires more explanation than is appropriate here. The appendix that follows this letter - "Goodwill and its Amortization: The Rules and The Realities" - explains why economic and accounting Goodwill can, and usually do, differ enormously.

You can live a full and rewarding life without ever thinking about Goodwill and its amortization. But students of investment and management should understand the nuances of the subject. My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely upon economic Goodwill. This bias caused me to make many important business mistakes of omission, although relatively few of commission.

Keynes identified my problem: "The difficulty lies not in the new ideas but in escaping from the old ones." My escape was long delayed, in part because most of what I had been taught by the same teacher had been (and continues to be) so extraordinarily valuable. Ultimately, business experience, direct and vicarious, produced my present strong preference for businesses that possess large amounts of enduring Goodwill and that utilize a minimum of tangible assets.


Buffett writes the following about his investment in Berkshare Hathaway:

It probably also is fair to say that the quoted book value in 1964 somewhat overstated the intrinsic value of the enterprise, since the assets owned at that time on either a going concern basis or a liquidating value basis were not worth 100 cents on the dollar. (The liabilities were solid, however.)

So it might make sense to invest if the company were to liquidate, but not if the company planed to continue to operate. This is why investing in McDonalds because of the land is a value trap. The intrinsic value will be determined by the profits generated by the McDonalds concept.

From another letter.

When Buffett Partnership, Ltd., an investment partnership of which I was general partner, bought control of Berkshire Hathaway 21 years ago, it had an accounting net worth of $22 million, all devoted to the textile business. The company's intrinsic business value, however, was considerably less because the textile assets were unable to earn returns commensurate with their accounting value.

He goes on to say..

We remained in the business for reasons that I stated in the 1978 annual report (and summarized at other times also): "(1) our textile businesses are very important employers in their communities, (2) management has been straightforward in reporting on problems and energetic in attacking them, (3) labor has been cooperative and understanding in facing our common problems, and (4) the business should average modest cash returns relative to investment." I further said, "As long as these conditions prevail - and we expect that they will - we intend to continue to support our textile business despite more attractive alternative uses for capital."

It turned out that I was very wrong about (4). Though 1979 was moderately profitable, the business thereafter consumed major amounts of cash. By mid-1985 it became clear, even to me, that this condition was almost sure to continue. Could we have found a buyer who would continue operations, I would have certainly preferred to sell the business rather than liquidate it, even if that meant somewhat lower proceeds for us. But the economics that were finally obvious to me were also obvious to others, and interest was nil.


Some comments on another textile company.

For an understanding of how the to-invest-or-not-to-invest dilemma plays out in a commodity business, it is instructive to look at Burlington Industries, by far the largest U.S. textile company both 21 years ago and now. In 1964 Burlington had sales of $1.2 billion against our $50 million. It had strengths in both distribution and production that we could never hope to match and also, of course, had an earnings record far superior to ours. Its stock sold at 60 at the end of 1964; ours was 13.

Burlington made a decision to stick to the textile business, and in 1985 had sales of about $2.8 billion. During the 1964-85 period, the company made capital expenditures of about $3 billion, far more than any other U.S. textile company and more than $200-per-share on that $60 stock. A very large part of the expenditures, I am sure, was devoted to cost improvement and expansion. Given Burlington's basic commitment to stay in textiles, I would also surmise that the company's capital
decisions were quite rational.

Nevertheless, Burlington has lost sales volume in real dollars and has far lower returns on sales and equity now than 20 years ago. Split 2-for-1 in 1965, the stock now sells at 34 -- on an adjusted basis, just a little over its $60 price in 1964. Meanwhile, the CPI has more than tripled. Therefore, each share commands about one-third the purchasing power it did at the end of 1964. Regular dividends have been paid but they, too, have shrunk significantly in purchasing power.


Here are some interesting figures..

There is an investment postscript in our textile saga. Some investors weight book value heavily in their stock-buying decisions (as I, in my early years, did myself). And some economists and academicians believe replacement values are of considerable importance in calculating an appropriate price level for the stock market as a whole. Those of both persuasions would have received an education at the auction we held in early 1986 to dispose of our textile machinery.

The equipment sold (including some disposed of in the few months prior to the auction) took up about 750,000 square feet of factory space in New Bedford and was eminently usable. It originally cost us about $13 million, including $2 million spent in 1980-84, and had a current book value of $866,000 (after accelerated depreciation). Though no sane management would have made the investment, the equipment could have been replaced new for perhaps $30-$50 million.

Gross proceeds from our sale of this equipment came to $163,122. Allowing for necessary pre- and post-sale costs, our net was less than zero. Relatively modern looms that we bought for $5,000 apiece in 1981 found no takers at $50. We finally sold them for scrap at $26 each, a sum less than removal costs.

Ponder this: the economic goodwill attributable to two paper routes in Buffalo - or a single See's candy store - considerably exceeds the proceeds we received from this massive collection of tangible assets that not too many years ago, under different competitive conditions, was able to employ over 1,000 people.


If the price they sold the equipment for was less than the removal costs, why did they decide to sell it? Why not just let it sit there. Also, why didn't they move the equipment to Mexico or China and take advantage of the cheap labor? Could they have created a sustainable business that way and still employ some of their old workers to handle sales and marketing and whatever else that needed to be done inside the States? If such a business were sustainable, I doubt it'd be a high ROE type of business. He still could have saved a few jobs.

This is from another letter.

Back when Berkshire's book value was $19.46, intrinsic value was somewhat less because the book value was enirely tied up in a textile business not worth the figure at which it was carried. Now most of our businesses are worth far more than their carrying values

Gateway is interesting, because most of its book value is liquid cash. There is little dispute as to what the cash is worth. If Gateway is able to burn little cash and reach profitability, then there should be decent upside in the stock, since you are buying the business for free.

Would someone buy Gateway at these levels (and would management sell)? IBM or HP might buy Gateway at these prices for the market share (GTW has 6-7%) and they could use Gateway's efficient manufacturing capabilities so they could take on Dell..? Could there any value to a HP or IBM if they decided to buy Gateway?

Legg Mason is one of the largest shareholders.

From the GTW 2001 Annual Report:

Finally, we will continue to refine our cost structure, specifically by improving our variable costs. Sure, we're spendind more on marketing our value and product leadership. That's essential to growing our busines. But we have to continue improving things like cost of customer acquisition, cost of fulfillment and cost of support, without sacrificing overall quality or customer satisfaction.

And, as we grow, we'll continue to get increased leverage from our fixed cost structure and expect to emerge as a healthy, profitable company in 2003. We're already well on the way.


Who knows if he's right, but Wall Street has them doing -$0.36 per share next year.
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Author: woodstove Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1577 of 1933
Subject: Re: book value vs. intrinsic value Date: 1/8/2003 10:25 AM
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Hi Scrim1,

Thanks for pulling all that info together. It's a very interesting problem, where book value fits in calculating IV of a company.

A good example is Graco. I don't know the full story not being aware of the company at the time, but it seems that Graco paid out a huge amount of cash some years ago to buy out a substantial shareholder. The company then had no book value to speak of, but its earning potential continued to be excellent.

Surely a company with X earning power plus Y excess assets should be worth more than a company with only X earning power and no excess assets, since it has the potential to pay out the excess assets. In the case of Graco the excess assets distribution mostly went to that substantial shareholder. Maybe a sound business decision by the board but maybe the other shareholders would have wanted a portion of the distribution too; the board's decision presumes that all the other shareholders are more interested in potential for future earnings.

There's another company I watch which has similar characteristics, earning power of about 35/sh and excess assets of 40/sh, and trades about 45. I've never been able to justify the purchase because I don't have enough understanding of the company's long term dispersal plan for its excess assets - though the people involved seem sensible value managers and honest trustees.

Another company I've invested in, a utility with excess assets, found that when it tried to sell those excess assets the proceeds above book value had to be returned to customers not distributed to shareholders. Excess asset investing can be risky.

Apropos of Gateway, it sounds interesting. I have no particular view on the company, never having researched it. I noticed a Gateway booth in an OfficeMax store when looking at OMX. I no longer follow OMX but if there is a better story there, then perhaps there is potential extra traffic around the Gateway outlets - or does that relationship still exist?

My general observation on retailing of home computers is that there is a lot of implicit warranty exposure - eg customer comes back and uses up lots of staff time etc with non-funded advice. That plus low margins seems to kill off most independent computer retailers after a few years of product has been sold. Perhaps Dell, with its phone support buffer, is able to deal with that situation better. Still, Gateway would seem to have a reasonable opportunity to fill its niche on a profitable basis.

Gateway is not the only company trading for its net cash. I have a major exposure to Cable & Wireless, which has market cap of about 1.1B pounds, net cash of 2.2B pounds, but an off balance sheet possible tax liability of 1.5B pounds, and suffers from an almost complete lack of confidence in management and board. Well, who knows... these situations seem to in maybe 80 pct of cases come out a bit better than the pessimism projects.

I think the comments you posted from Mr Buffett about use of capital get at the underlying problem. If a company is an efficient user of capital in its business, then it should probably run light with only as much in excess as is needed to fend off squeeze plays during business slowdowns. (For instance, to have a debt load so high that lenders can impose some sort of default trap, eg an EBITDA/debt ratio, is not prudent and is a sign that the business does not have sufficient assets - in my opinion.) If the company's purpose is to be a safe store of value, not necessarily return on investment, then it should be judged on how well it does that perservation function. In either case, or in combination, having a less than pretty good management or operational procedures may be the biggest risk.

How well managed is Gateway? is the key question I guess. What is likely to be done with the $1B cash? Is it possible to deploy that to advantage in Gateway's market niche? Should the company be considering another way to relate to customers, or has it repeatedly failed in such attempts? If the company is to be evaluated in terms of its cash, ie as a store of value instead of or in addition to an operating business, how effective have Gateway's management been in preserving that value on behalf of shareholders? Do they continue to accumulate cash, or do they waste it on operational misadventures?

Woodstove

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Author: ZenvestorB Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1578 of 1933
Subject: Re: book value vs. intrinsic value Date: 1/9/2003 9:31 AM
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"If the company's purpose is to be a safe store of value, not necessarily return on investment, then it should be judged on how well it does that perservation function. In either case, or in combination, having a less than pretty good management or operational procedures may be the biggest risk.

How well managed is Gateway? is the key question I guess. What is likely to be done with the $1B cash? Is it possible to deploy that to advantage in Gateway's market niche?"

Hi Everybody,

Gateway is an interesting situation.

I'm not so confident that companies have very good chances as a preservation asset. In general, I think they are either in a growing or declining mode. For top companies they grow pretty well with occasional bumps, for declining companies, they seem to lose share, with the occasional spike in good economic times.

I think that in most cases, except for the rare case where liquidation is a reasonable probability, the value of the company mostly resides in the earning power and market place abilities versus asset values.

I think Gateway is a good example, while a market price at or near tangible book value is comforting and limits downside, I don't think anyone would consider it attractive unless they can get the business turned around and actually earn on the shares.

One of the ideas that I think Graham and Fisher both agree on is that value is ultimately dependent on what a company's future prospects (realized in real earnings) are going to be. I'd propose that then they differ on what factors are best used to make the investors expectations as safe as possible. Graham uses quantitative benchmarks and Fisher qualitative, both neither exclusively.

So Gateway's future, and I don't mean a few years out but more like ten years out, will be interesting to watch. I think it's very uncertain if it's a good company hiting a short term blip before resuming some growth or a deteriorating company, which will occasionally do well when its markets do well, but ultimately be a lesser company in the future.

ZB

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Author: ZenvestorB Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1579 of 1933
Subject: Re: book value vs. intrinsic value Date: 1/9/2003 9:48 AM
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"I noticed a Gateway booth in an OfficeMax store when looking at OMX. I no longer follow OMX but if there is a better story there, then perhaps there is potential extra traffic around the Gateway outlets - or does that relationship still exist?"

Hi Woodstove,

As a shareholder in OMX, I hope at your visit you purchased something.

I'm just about running up to my 3 year Fisher time-line on my first OMX purchases and my take is that it's possibly a similar situation to Gateway, though maybe farther ahead on the restructuring.

Like Gateway, it's really in OMX's hands as to whether it can prove itself as a viable competitor to bigger players. While they've definitely come off the bottom business wise, it's unclear as to where they would be in ten years. While I think the probability is that at some time over the next couple of years, when the economy picks up, OMX will produce better results but I'm not convinced that without an environmental boost, the company, on its own can go to the next level.

In regards to the in-OMX Gateway stores, I believe they stopped that program maybe a year or so ago. OMX replaced it with a deal with HP but it looks like that was more a suppler deal than any sort of staffing arrangement. OMX seems to have pretty much exited PC sales as a viable business line, they offer them but I don't think and it seems they don't think it's worth a lot of effort.

Hopefully, they will transition toward the smaller handheld, mixed devices and benefit from the increased growth there but they still need to deal with the disadvantage of lesser staffing than specialized electronics retailers.

As a business case OMX has been interesting, as an investment it's been OK, and as a future decision on how to go, it most likely will be somewhat uncertain.

ZB

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Author: woodstove Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1580 of 1933
Subject: Re: book value vs. intrinsic value Date: 1/10/2003 10:39 PM
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Hi Zenvestor,

Yes indeed I did spend some money at OfficeMax. Three trips to a single store while in a US city, not enough info gathered to evaluate the chain but a productive shopping time. I was particularly impressed by how efficient that store's layout was for the shopper to get in, select his purchase, and check out.

About electronics, I'm not sure whether those items fit with my concept of OfficeMax, which runs more to home office consumables. But the SOHO stationery market has not been a big study for me.

Benj Gallander and Ben Stadelmann are fans of OMX. Their articles appear in Canadian Moneysaver and in the Toronto Globe and Mail.

Your observation that companies are either in growing or declining mode agrees with experience. I guess there is a personality factor, and growing businesses attract managers who want to be involved with growth. It's probably useful to watch for instances of personality mismatch, for instance a person who requires growth to feel successful may not make the best value-preserving choices for a cyclic. Most managements of cyclics say something about managing for a decent return on equity over the industry cycle, but whether their actions correspond or they thrive on low-returning acquisitions may be an indicator.

The other point you make, considering the future of a company ten years out, is very relevant to margin of safety. The underpriced asset value buys are much shorter term I believe. I don't necessarily expect those firms to prosper long term, just to be re-evaluated a bit less negative than at the time of purchase. But if things drag on, no news to change the story, then the lack of longer term prospects might turn a decent underpriced buy into a speculation. I guess it's always a speculation, given it depends upon timing and opinion rather than a good underlying business model.

Woodstove

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Author: ZenvestorB Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1584 of 1933
Subject: Re: book value vs. intrinsic value Date: 1/13/2003 7:38 AM
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"The other point you make, considering the future of a company ten years out, is very relevant to margin of safety. The underpriced asset value buys are much shorter term I believe. I don't necessarily expect those firms to prosper long term, just to be re-evaluated a bit less negative than at the time of purchase. But if things drag on, no news to change the story, then the lack of longer term prospects might turn a decent underpriced buy into a speculation."

Hi Woodstove,

I think a very interesting development that relates to asset values vs. the future could be playing out in Middle Eastern oil.

Strangely enough, the value of a lot of companies assets depends on what happens related to Iraqi oil. A few different scenario's look possible:

One could be Iraqi oil goes into US friendly hands. If this is the case, I can see that as a big influence toward a moderate breakdown of OPEC qouta holding which could eventually drive crude down to the low teens.

On the other hand, if those reserves can't be secured, further security issues with other Middle East resrves could put a premium on secure sources like that on US territory or even the Canadian oil sands, while middle eastern rserves could be discounted.

Then there is the possibility, most likely remote, that Iraqi oil can de disabled for a substantial amount of time (5 or more years), in this case there probably will be a big premium on safe supplies and a moderate premium even on other Mid-East supplies.

Of course, these possibilities also trckle down to related or unrelated situations, refiners certainly will be affected but even the general economy will be affected by any of these scenario's.

Who knows what will happen but I'm watching the situation pretty closely so I can get some idea of what my petro equity assets might be worth in the future.

ZB

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Author: woodstove Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1586 of 1933
Subject: Re: book value vs. intrinsic value Date: 1/14/2003 10:04 PM
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Hi Zenvestor,

Asset value of oil in the future is not something I have a good idea of but there are a few parameters / relationships that I have guessed at. These are not worth trading on, just hypotheses that might someday be useful if I get into oil related investing.

- US dollar vs oil needs to be adjusted re changes in dollar valuation. Maybe it helps to look at oil/gold ratio, currently .09, since there is a certain residual "real money" requirement for purchase (or acquisition by force) of rights, labour, material, continuity etc for oil projects. On that basis, I think $15 oil is unlikely though it may be $15 in terms of 1999 dollars.

- There is a price at which energy substitutions occur. I did one ratio for power generation from wind turbines vs natgas, a back of envelope calc with poor info, but got $4.50 natgas as tradeoff price. Easily the number may be half or twice that, but somewhere in say $2.50-$10 natgas it might become sensible to use wind power whenever feasible considering the situation and the steadiness of demand / storage capabilities. Hence I think natgas above $10 (constant dollars) is not likely sustainable. Using a max oil/gas price ratio of 8x, oil above $80 (constant dollars) is not likely sustainable for energy generation, ie above $80 oil may become primarily a feedstock for chemical transformations. With suitable allowance for special situations, time to adapt etc but if it is long term asset prices one is planning on I think oil projects costing above $80/bbl (cons dol) will be poor investments.

- The Iraq production of oil is said to be 3 pct of world demand, and is not the US usage about 25 pct? Hence all Iraqi oil, even if output were to double, would be 25 pct of US usage. On the other hand, the cost. The war is anticipated to cost $200B, and I think some estimate is around of $1200B to govern Iraq. Can the US really afford it? Where is the labour force to come from? I have some doubt the concept of a protectorate in the regions of Iraqi oilfields (Baghdad or not aside) is a financially justified project. Oilfield projects are multi-decade investments and require various social and industrial infrastructure to be built up and sustained. For an example of unintended consequences, we need look no further than Venezuela where an attempt to encourage a coup has resulted in damage to facilities and a serious disruption of essential supply.

- If one wants to make money from the situation, one possibility is to count on volatility. The safest long term prediction I can make is there will be more volatility than is anticipated by planners. An LTBH may not be the best strategy.

- Considering the political backing of the current US administration it seems unlikely that low-cost oil, even if obtained, will necessarily be sold as low-price oil. An investment in plastics or similar industries on the assumption of lower input costs may not work out. But volatility of input costs, and of perceptions of costs, may present opportunities for good buys into oil-using firms. The kerfluffle in Canada recently re hypothetical costs / impact of Kyoto provided an opportunity to get into a firm which does oil-related construction projects; there will probably be more such fluctuations.

- The uncertainty, future oil prices somewhere between unusually low and unusually high, might be disrupting drilling projects in Canada and elsewhere. I have hedged most of my oil services holding to retain only a net 1 pct long position, believing that uncertainty re prices/demand, as well as capital scarcity, may result in a slowdown of activity. On the other hand I am also betting on supply scarcity and hence ST higher prices, just not enough LT predictable scarcity to cause a sustainable increase in domestic oilfield activity. So I have some holdings in a firm that is adept in capturing the benefits of temporarily high prices.

- It seems to me that whatever position one takes on the situation(s) and investment opportunities, it is necessary to build a hedged portfolio that balances the various possibilities into a combo that is fairly sure of acceptable return even if not the most dramatic gain if everything lined up one way. Most things are well beyond my capability to project, particularly when it gets into the political and military aspects, so I have leaned towards non-oil situations (eg communications) mostly, and to fairly modest but profitable domestic businesses if oil related.

- One final comment - bringing the discussion back to the title of this thread: A recent article stated that the ratio of market cap to book value of US stocks was 4.7, which seems a fair bit higher than would be justified. It assigns 1.0 part to net assets or cost to build a business and 3.7 parts to the operational value of the business processes. Given the possibility that economic uncertainty eg reluctance to extend credit may cause a slowdown of process, it seems that assets might become more important and process a little less important. Hence investing in oil and other tangibles or a bit of shift in portfolio may be justified as a swap. One of the reasons I've decided that oil services firms might be more reasonably valued near book value ie cost to construct rigs for a while at least.

The book value vs intrinsic value comparison is not very accurate for an individual firm, but on an industry or whole market basis it should have some validity. Particularly since most oil reserves have changed hands and hence are on some firms books at fair value not just their cost to find and develop.

- One additional comment: We are used as investors to having delays in the info we use. Eg the Intel press release today reflects sales over a three month period Oct-Dec, so the info is an average of 2 months old. The control of information coming from the mideast is quite thorough and it should be assumed that similar delays in reporting may occur. One way to deal with that difficulty is to imagine that it is two months hence, ie mid March, and imagine what might be the situation reported then - and suppose it might possibly be the situation in place at present. For instance, it would not surprise me greatly, though I do not necessarily think it is the case, if mid March there were to be US troops occupying some of the oilfields in Iraq. Besides the uncertainty for one's own decision making, think of the potential for volatility in perceptions as a result of inconsistent release of information.

Anyway, I'm planning to keep things simple myself, and let most of the non-domestic uncertainty, volatility and apparent opportunities go by. There are plenty of real productive business opportunities and assets close to hand that can even be visited in person if it seems necessary.

Woodstove

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Author: ZenvestorB Big red star, 1000 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1587 of 1933
Subject: Re: book value vs. intrinsic value Date: 1/15/2003 9:24 AM
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"- US dollar vs oil needs to be adjusted re changes in dollar valuation. Maybe it helps to look at oil/gold ratio, currently .09, since there is a certain residual "real money" requirement for purchase (or acquisition by force) of rights, labour, material, continuity etc for oil projects. On that basis, I think $15 oil is unlikely though it may be $15 in terms of 1999 dollars.

- There is a price at which energy substitutions occur. I did one ratio for power generation from wind turbines vs natgas, a back of envelope calc with poor info, but got $4.50 natgas as tradeoff price. Easily the number may be half or twice that, but somewhere in say $2.50-$10 natgas it might become sensible to use wind power whenever feasible considering the situation and the steadiness of demand / storage capabilities. Hence I think natgas above $10 (constant dollars) is not likely sustainable. Using a max oil/gas price ratio of 8x, oil above $80 (constant dollars) is not likely sustainable for energy generation, ie above $80 oil may become primarily a feedstock for chemical transformations. With suitable allowance for special situations, time to adapt etc but if it is long term asset prices one is planning on I think oil projects costing above $80/bbl (cons dol) will be poor investments.

- The Iraq production of oil is said to be 3 pct of world demand, and is not the US usage about 25 pct? Hence all Iraqi oil, even if output were to double, would be 25 pct of US usage. On the other hand, the cost. The war is anticipated to cost $200B, and I think some estimate is around of $1200B to govern Iraq. Can the US really afford it? Where is the labour force to come from? I have some doubt the concept of a protectorate in the regions of Iraqi oilfields (Baghdad or not aside) is a financially justified project. Oilfield projects are multi-decade investments and require various social and industrial infrastructure to be built up and sustained. For an example of unintended consequences, we need look no further than Venezuela where an attempt to encourage a coup has resulted in damage to facilities and a serious disruption of essential supply."

Hi Woodstove,

I think you underestimate the importance of the possibilities of Iraqi oil. The Iraqi reserves are the biggest next to Saudi reserves and their potential to move the price of oil is significant.

As seen through the past 12 months or so, the futures oil prices are mostly based on projection which incorporates a significant level of expectation. Even as crude shows $30+ prices, the supply/demand level would indicate a price closer to $20, even with Venz. cutbacks. Without past OPEC production cuts, given the current economic environment a price closer to mid teens would probably be pretty close for now.

I'm not sure how relevant the $/gold relationship is to the strictly supply/demand longer term effect of pricing on the economically necessary commodity like oil. Right now, currently available supply, though with differing variable production hindrances far outweigh demand. The perception of additional ease for getting access to a huge pool of cheap oil, I think would necessarily send prices down hard.

Regardless of the news about Venz, the facts would indicate that OPEC and mainly middle east oil is and will still be for the foreseeable future the dominant factor in oil pricing. The key being not so much production but export %. For example, Russia can certainly produce but given that they also increase their industrial infrastructure, I don't think they could match the export % of the Middle East, especially with decent production out of Iraq.

Here are some clips I've seen recently that show some of the data:

""Mexico's state oil monopoly Petroleos Mexicanos, also known as Pemex, exported an average of 1.69 million barrels a day of crude oil in the second half of 2002, out of a production of around 3.2 million barrels daily. Pemex plans to raise its crude production to 3.5 million barrels a day this year."

"Russia's oil output is growing for the fifth consecutive year and set to rise by a further 10 percent in 2003 from the current 8.0 million barrels per day level."

"The Venezuelan strike, launched on Dec. 2 by groups seeking to oust President Hugo Chavez, has squeezed Venezuela's exports by about 80 percent, or 2 million barrels a day."

"The Organization of Petroleum Exporting Countries decided to increase its production target by 6.5 percent, to 24.5 million barrels a day."

I think there is more than enough evidence that the US has a vested and growing strategic interest in securing Middle East Oil, especially shown with the worry presented with a relatively nominal disruption from Venz. Imagine the effect from a global export change of 4 to 6 million barrels a day either way, for the world economy in general and the US in particular.

From my perspective, most macro things are relatively meaningless in the long term but from the first oil crisis in the 70's the price of oil has been a pretty good indicator of what kind of growth is available for the economy in general. Hopefully, however the situation works out, it will be best for everybody.

ZB

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Author: woodstove Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: 1588 of 1933
Subject: Re: book value vs. intrinsic value Date: 1/15/2003 8:58 PM
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Hi Zenvestor,

Thanks for the data points! Gradually I'm acquiring an idea of the world oil situation - reserves, production, internal usage and export volumes.

Part of what keeps me away is concern that the "entry fee" for learning the oil investing game is fairly high - either time invested in learning or money invested in initial mistakes. There are lots of experts in the industry and in investment firms following it, and I think it is stiff competition.

Sort of like soybeans, which I have some of to sell every year in late fall. I've tried various ways to sell them most profitably, one year in five equal lots from January to May, another year in a large lot when it seemed price was high, and it's been pretty much a random result for me. There is a storage cost equivalent to negative 6 pct annual interest to hold soybeans at the elevator waiting for a better price. What has been the best, it turns out, is to sell the beans fairly soon after received (minimizing storage fees) and transfer the money into the stock market, a place where I have some advantage. Instead of soybeans market where I do not have an advantage (never having paid the dues to learn the game) and am competing with professional traders and buyers.

The main resources I would imagine turning to, to learn about the oil market, would be TMF's oil and gas and oil services boards, and some of the TMF and Yahoo boards for specific companies which sometimes have an expert contributing. Those in turn link to some industry sites with good data. I'm sure there are other ways to get into the industry info too.

How did you learn about oil and gas industry & trading?

You said "currently available supply ... far outweighs demand". That is where it gets problematic for me - how to gather the info to be able to state that is the case? I could look at reserve reports, but given that reserves are at an unusual low, on the face of it supply would appear to be less than demand. Yet I'm sure you're right, based upon the price of gasoline prior to the past few weeks. Also, economic activity reduced is presumably cutting demand; to what extent is demand solely related to an industrial slowdown and will rebound when production picks up? Lots to get into!

It's a fascinating subject but I'm not sure it's one where I can make a reasonable return. At present, it does seem possible to play the cyclic aspect in some commodities, maybe in oil. That is, there are enough smart traders and volume that the oil pricing market is efficient. If one plays down the middle buying at say 20 pct of high-low spread above cyclic low and selling 20 pct below cyclic high, then I can imagine there could be a dull but decent return without knowing much of anything about the oil industry itself. That is as long as one does not try to play the extremes using projections of non-trend price shocks, does not use leverage, does not buy into time-decaying forms of investment, etc.

But a better return on investor time seems to be, for me, industrial firms and mispricing - particularly situations which are not popular with analysts, and well-reported situations that attract overpessimism.

And, in terms of playing the oil market, I wonder if it is not wiser to hire a specialist via investing in a suitable trading firm. I have an investment in a steel distributor which is essentially a steel trader, as they do very little remanufacturing - they basically buy steel when it is cheap, inventory it, and sell it when it is dear. A return of 13 pct/yr on average over almost 3 decades. Far better than I could trade steel without getting into the industry myself - and why do that when there is an honest enthusiast who is willing to allow us minority shareholders come along for the ride?

One point you are implicitly making, I believe, regarding oil is related to the fact that pure assets are more likely to be priced responsively to changes in supply and demand. That is, commodities are relatively unencumbered by business organizations with their various credit and management uncertainties and possible illiquidity of their securities.

How nice it would have been to be able to invest directly in Kmart sales volume, instead of in the derivative of stock price, filtered thru their net margin, management problems, cash crunch, eventual bankruptcy etc. There might have still been a decline in total sales, but one could try to predict that via store visits or keeping an eye on supplier activity.

Back to oil and mideast. I agree that OPEC seems to be the key to price in future. Canadian oil sands, for instance, are still prone to troubles with the technology and the costs are said to be something like $12. And it is maybe more if one adjusts the accounting to recognize capitalized costs which possibly should be more rapidly depreciated. Are any of the oil sands projects cash flow positive yet? I haven't learnt of them.

I just cannot believe that the current war/political plan which calls for an attack on Iraq and subsequent occupation, is going to be as trouble-free as anticipated. Nothing in prior experience of government projects, in any country, convinces me that plans subject to political process review are fully disclosed in all their contingencies. Maybe for a while things look good but not for the years-long duration necessary to justify the costs. And those costs are not just material and labour but also lives, relationships, principles - not easy to equivalence to monetary expenditures or forecast out what may develop as consequences.

So I'm guessing there may be more volatility than anticipated. Right now it is on the upside at $30+/bbl, and maybe in a few months it will be on the downside at $15/bbl as you suggest. But then back to $25+ every time there is a glitch? Either to find a company that is adept at capturing the value from those trading cycles, or to directly play the volatility. But not so much, in my opinion, to count on finding an energy-producing or energy-using LTBH that will not accumulate price-fluctuation gains but is just a flow-thru of its input costs to remanufactured outputs.

Well, we shall see.

Woodstove

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