One Up on Wall Street: How to Use What You Already Know to Make Money In

by Peter Lynch

  Just as often as book value overstates true worth, it can understate true worth. This is where you get the greatest asset plays.

  Companies that own natural resources—such as land, timber, oil, or precious metals—carry those assets on their book at a fraction of the true value. For instance, in 1987, Handy and Harman, a manufacturer of precious metals products, had a book value of $7.83 per share, including its rather large inventories of gold, silver, and platinum. But these inventories are carried on the books at the prices Handy and Harman originally paid for the metals—and that could have been thirty years ago. At today’s prices ($6.40 an ounce for silver and $415 for gold) the metals are worth over $19 per share.

  With Handy and Harman stock selling for around $17 per share, less than the value of the metals alone, is this a good asset play? Our friend Buffett thought so. He’s held a large position in Handy and Harman for several years, but the stock hasn’t gone anywhere, the company’s earnings are spotty, and the diversification program hasn’t been a rousing success, either. (You already know about diversification programs.)

  Recently it was announced that Buffett is cutting back his interest in the company. So far, Handy and Harman looks like the only bad investment he’s ever made, in spite of its hidden asset potential. But if gold and silver prices rise dramatically, so will this stock.

  There are many kinds of hidden assets besides gold and silver. Brand names such as Coca-Cola or Robitussin have tremendous value that isn’t reflected on the books. So do patented drugs, cable franchises, TV and radio stations—all are carried at original cost, then depreciated until they, too, disappear from the asset side of the balance sheet.

  I’ve already mentioned Pebble Beach, a great hidden asset play in real estate. I could still kick myself for missing that stock. But real estate plays like that are all over the place; railroads are probably the best examples. Not only do Burlington Northern, Union Pacific, and Santa Fe Southern Pacific own vast amounts of land, as I mentioned before, but it’s all carried on the books at a cost of next to nothing.

  Santa Fe Southern Pacific is California’s largest private landowner, with 1.3 million of the state’s 100 million acres. Nationwide, it owns three million acres in fourteen states, an area four times the size of the state of Rhode Island. Another example is CSX, a southeastern railroad. In 1988, CSX sold an 80-mile right-of-way to the state of Florida. The land had a book value of almost zero, and the track was valued at $11 million. In the deal, CSX retained off-peak use of the track—so revenues were unaffected (freight ships during off-peak hours)—and the sale brought in $264 million after taxes. Talk about having your cake and eating it too!

  Sometimes you’ll find an oil company or a refiner that’s kept inventory in the ground for forty years, and at the original cost of acquisition from the days of the Teddy Roosevelt administration. The oil alone is worth more than the current price of all the shares of stock. They could scrap the refinery, fire all the employees, and make a fortune for the shareholders in forty-five seconds by peddling the oil. It’s no trouble to sell oil. It’s not like selling dresses—nobody cares if it’s this year’s oil or last year’s oil, or whether it’s fuchsia or magenta.

  A couple of years ago Channel 5 in Boston sold for something like $450 million—that was the fair market price. However, when that station was originally awarded its license, it probably paid $25,000 to file the proper papers, maybe $1 million for the tower, and another $1 or $2 million for the studio. The whole shebang was worth $2.5 million on paper to begin with, and the $2.5 million was depreciated. At the time it was sold, this enterprise probably had a book value that was 300 times too low.

  Now that the station has changed owners, the new book value will be based on the $450-million sale price, so the anomaly will disappear. If you pay $450 million for a TV station worth $2.5 million on the books, the accounts call the extra $447.5 million “goodwill.” Goodwill is carried on the new books as an asset, and eventually it, too, will be written off. This in turn will create another potential asset play.

  The accounting methods for “goodwill” were changed after the 1960s, when many companies vastly overstated their assets. Now it’s the other way around. For instance, Coca-Cola Enterprises, the new company that Coca-Cola created for its bottling operations, now carries $2.7 billion worth of goodwill on its books. That $2.7 billion represents the amount that was paid for the bottling franchises above and beyond the cost of the plants, inventory, and equipment. It’s the intangible value of the franchises.

  Under the current rules of accounting, Coca-Cola Enterprises has to “write” this goodwill down to zero over the next four decades, while in reality the value of the franchises is rising by the year. By having to pay for goodwill, Coca-Cola Enterprises is punishing its own earnings. In 1987 the company reported 63 cents, but actually it earned another 50 cents that went to writing off the goodwill debt. Not only is Coca-Cola Enterprises doing considerably better than it would appear on paper, but every day the hidden asset is growing larger.

  There’s also hidden value in owning a drug that nobody else can make for seventeen years, and if the owner can improve the drug slightly, then he gets to keep the patent for another seventeen years. On the books, these wonderful drug patents may be worth zippo. When Monsanto bought Searle, it picked up NutraSweet. NutraSweet comes off patent in four years and will continue to be valuable even then, but Monsanto is writing the whole thing off against earnings. In four years NutraSweet will show up as a zero on Monsanto’s balance sheet.

  Just as in the case of Coca-Cola Enterprises, when Monsanto writes something off against earnings, the real earnings are understated. If the company actually makes $10 per share in profits, but has to devote $2 of that to “pay” to write things off such as NutraSweet, when it stops writing off NutraSweet the earnings will rise by $2 a share.

  In addition, Monsanto is expensing all its research and development in the same fashion, and someday when the expenses stop and the new products come onto the market, the earnings will explode. If you understand this, you have a big edge.

  There can be hidden assets in the subsidiary businesses owned wholly or in part by a large parent company. We’ve already gone over Ford’s. Another was UAL, the diversified parent company of United Airlines before the brief period when it was called Allegis (not to be confused with ragweed and pollen). Fidelity’s airline analyst Brad Lewis spotted this one. Within UAL, Hilton International was worth $1 billion, Hertz Rent A Car (later sold to a partnership headed by Ford) was worth $1.3 billion, Westin Hotels was worth $1.4 billion, and the travel reservation system another $1 billion more. After subtraction of debt and taxes, these assets together were worth more than the price of UAL’s stock, so in essence the investor picked up one of the world’s largest airlines for free. Fidelity backed up the truck on this one, and the stock was a twobagger for us.

  There are hidden assets when one company owns shares of a separate company—as Raymond Industries did with Teleco Oilfield Services. People close to either situation realized that Raymond was selling for $12 a share, and each share represented $18 worth of Teleco. By buying Raymond you were getting Teleco for minus $6. Investors who did their homework bought Raymond and got Teleco for minus $6, and investors who didn’t bought Teleco for $18. This sort of thing happens all the time.

  For the past several years, if you were interested in DuPont, you got it cheaper by buying Seagram, which happens to own about 25 percent of DuPont’s outstanding shares. Seagram became a DuPont play. Similarly, the stock in Beard Oil (now the Beard Company) was selling at $8, while each share included $12 worth of a company called USPCI. In this transaction, Beard and all its oil rigs and equipment was yours to keep for a minus $4.

  Sometimes the best way to invest in a company is to find the foreign owner of it. I realize this is easier said than done, but if you have any access to European companies, you can stumble onto some unbelievable situations. European companies in general are not wel
l-analyzed, and in many cases they’re not analyzed at all. I discovered this on a fact-finding trip to Sweden, where Volvo and several other giants of Swedish industry were covered by one person who didn’t even have a computer.

  When Esselte Business Systems came public in the U.S., I bought the stock and kept up with the fundamentals, which were positive. George Noble, who manages Fidelity’s Overseas Fund, suggested that I visit the parent company in Sweden. It was there that I discovered you could buy the parent company for less than the value of its U.S. subsidiary, plus pick up numerous other attractive businesses—not to mention real estate—as part of the deal. While the U.S. stock went up only slightly, the price of the parent company’s stock doubled in two years.

  If you followed the Food Lion Supermarkets story, you might have discovered that Del Haize of Belgium owned 25 percent of the stock, and the Food Lion holdings alone were worth a lot more than the price of a share of Del Haize. Again, when you bought Del Haize, you were getting valuable European operations for nothing. I purchased the European stock for Magellan and it rose from $30 to $120, while Food Lion gained a relatively unexciting 50 percent.

  Back in the U.S., right now you can buy stock in various telephone companies and get a freebie on the cellular business. In every market they have awarded two cellular franchises. You’ve probably heard about the one that’s given to a lucky person who wins the cellular lottery. Actually, he or she has to buy the franchise. The second franchise is given to the local phone company at no cost. It’s going to be a great hidden asset to investors who’ve paid attention. As I’m writing this, you can buy a share in Pacific Telesis of California for $29 and get at least $9 a share worth of cellular value already. Or you can buy a $35 share of Contel and get $15 worth of cellular.

  These stocks are selling at p/e ratios of less than 10, with dividend yields of more than 6 percent, and if you subtract the value of the cellular, the p/e’s are even more attractive. You won’t get tenbaggers out of these large telephone utilities, but you’ll get a good yield and the possibility of 30–50 percent appreciation if everything goes right.

  Finally, tax breaks turn out to be a wonderful hidden asset in turnaround companies. Because of its tax-loss carryforward, when Penn Central came out of bankruptcy it didn’t have to pay any taxes on millions in profits from the new operations it was about to acquire. In those years the corporate tax rates were 50 percent, so Penn Central could buy a company and double its earnings overnight, simply by paying no tax. The Penn Central turnaround took the stock from $5 in 1979 to $29 in 1985.

  Bethlehem Steel currently has $1 billion in operating-loss carryforwards, an extremely valuable asset if the company continues to recover. It means that the next $1 billion that Bethlehem earns in the U.S. will be tax-free.

  CASH FLOW

  Cash flow is the amount of money a company takes in as a result of doing business. All companies take in cash, but some have to spend more than others to get it. This is a critical difference that makes a Philip Morris such a wonderfully reliable investment, and a steel company such a shaky one.

  Let’s say Pig Iron, Inc. sells out its entire inventory of ingots and makes $100 million. That’s good. Then again, Pig Iron, Inc. has to spend $80 million to keep the furnaces up-to-date. That’s bad. The first year Pig Iron doesn’t spend $80 million on furnace improvements, it loses business to more efficient competitors. In cases where you have to spend cash to make cash, you aren’t going to get very far.

  Philip Morris doesn’t have this problem, and neither does Pep Boys or McDonald’s. That’s why I prefer to invest in companies that don’t depend on capital spending. The cash that comes in doesn’t have to struggle against the cash that goes out. It’s simply easier for Philip Morris to earn money than it is for Pig Iron, Inc.

  A lot of people use the cash flow numbers to evaluate stocks. For instance, a $20 stock with $2 per share in annual cash flow has a 10-to-1 ratio, which is standard. A ten percent return on cash corresponds nicely with the ten percent that one expects as a minimum reward for owning stocks long term. A $20 stock with a $4-per-share cash flow gives you a 20 percent return on cash, which is terrific. And if you find a $20 stock with a sustainable $10-per-share cash flow, mortgage your house and buy all the shares you can find.

  There’s no point getting bogged down in these calculations. But if cash flow is ever mentioned as a reason you’re supposed to buy a stock, make sure that it’s free cash flow that they’re talking about. Free cash flow is what’s left over after the normal capital spending is taken out. It’s the cash you’ve taken in that you don’t have to spend. Pig Iron, Inc. will have a lot less free cash flow than Philip Morris.

  Occasionally I find a company that has modest earnings and yet is a great investment because of the free cash flow. Usually it’s a company with a huge depreciation allowance for old equipment that doesn’t need to be replaced in the immediate future. The company continues to enjoy the tax breaks (the depreciation on equipment is tax deductible) as it spends as little as possible to modernize and renovate.

  Coastal Corporation is a good illustration of the virtues of free cash flow. By all the normal measures the company was fairly priced at $20 a share. Its earnings of $2.50 a share gave it a p/e of 8, which was standard for a gas producer and a diversified pipeline company at the time. But beneath this humdrum opportunity, something wonderful was going on. Coastal had borrowed $2.45 billion to acquire a major pipeline company, American Natural Resources. The beauty of the pipeline was that they didn’t have to spend much to maintain it. A pipeline, after all, doesn’t demand much attention. Mostly it just sits there. Maybe they’d dig down to patch a few holes, but otherwise they’d leave it alone in the ground. Meanwhile they’d depreciate it.

  Coastal had $10–11 per share in total cash flow in a depressed gas environment, and $7 was left over after capital spending. That $7 a share was free cash flow. On the books this company could earn nothing for the next ten years, and shareholders would get the benefit of the $7-a-share annual influx, resulting in a $70 return on their $20 investment. This stock had great upside potential on cash flow alone.

  Dedicated asset buyers look for this situation: a mundane company going nowhere, a lot of free cash flow, and owners who aren’t trying to build up the business. It might be a leasing company with a bunch of railroad containers that have a 12-year life. All the company wants to do is contract the old container business and squeeze as much cash out of it as possible. In the upcoming decade, management will shrink the plant, phase out the containers, and pile up cash. From a $10 million operation, they might be able to generate $40 million this way. (It wouldn’t work in the computer business, because the prices drop so fast that old inventory doesn’t hold its value long enough for anybody to squeeze anything out of it.)

  INVENTORIES

  There’s a detailed note on inventories in the section called “management’s discussion of earnings” in the annual report. I always check to see if inventories are piling up. With a manufacturer or a retailer, an inventory buildup is usually a bad sign. When inventories grow faster than sales, it’s a red flag.

  There are two basic accounting methods to compute the value of inventories, LIFO and FIFO. As much as this sounds like a pair of poodles, LIFO actually stands for “last in, first out,” and FIFO stands for “first in, and first out.” If Handy and Harman bought some gold thirty years ago for $40 an ounce, and yesterday they bought some gold for $400 an ounce, and today they sell some gold for $450 an ounce, then what is the profit? Under LIFO, it’s $50 ($450 minus $400), and under FIFO it’s $410 ($450 minus $40).

  I could go on about this, but I think we’d quickly reach a point of diminishing returns, if we haven’t already. Two other popular accounting methods are GIGO (garbage in, garbage out), and FISH (first in, still here), which is what happens to a lot of inventories.

  Whichever method is used, it’s possible to compare this year’s LIFO or FIFO value to last year’s LIFO or FIF
O value to determine whether or not there’s been an increase or a decrease in the size of the inventory.

  I once visited an aluminum company that had stockpiled so much unsold material that aluminum was stacked up to the ceiling inside the building, and outside it took up most of the employee parking lot. When workers have to park elsewhere so the inventory can be stored, it’s a definite sign of excessive inventory buildup.

  A company may brag that sales are up 10 percent, but if inventories are up 30 percent, you have to say to yourself: “Wait a second. Maybe they should have marked that stuff down and gotten rid of it. Since they didn’t get rid of it, they might have a problem next year, and a bigger problem the year after that. The new stuff they make will compete with the old stuff, and inventories will pile up even higher until they’re forced to cut prices, and that means less profit.”

  In an auto company an inventory buildup isn’t so disturbing because a new car is always worth something, and the manufacturer doesn’t have to drop the price very far to sell it. A $35,000 Jaguar isn’t going to be marked down to $3,500. But a $300 purple miniskirt that’s out of style might not sell for $3.

  On the bright side, if a company has been depressed and the inventories are beginning to be depleted, it’s the first evidence that things have turned around.

  It’s hard for amateurs and neophytes to have any feel for inventories and what they mean, but investors with an edge in a particular business will know how to figure this out. Whereas they didn’t have to do so five years ago, companies must now publish balance sheets in their quarterly reports to shareholders, so that the inventory numbers can be regularly monitored.

  PENSION PLANS

  As more companies reward their employees with stock options and pension benefits, investors are well-advised to consider the consequences. Companies don’t have to have pension plans, but if they do, the plans must comply with federal regulations. These plans are absolute obligations to pay—like bonds. (In profit-sharing plans there’s no such obligation: no profits, no sharing.)