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Phantom Book Value is a phrase I have coined in order to put a name on a concept I have seen several times in recent investment commentary. When a company writes an asset down to market value, this reduces book value and earnings, but book value will recover if the asset subsequently increases in value, generating future profits. The past few quarters have featured a deluge of mark to market losses - I am questioning whether some of the blood in the streets may not be ketchup.
Homebuilders would be a good place to start the discussion. I follow homebuilders and have a small position in my SLOport and a somewhat larger amount in my personal portfolio. They have been assiduously taking losses on inventory, some of it by abandoning options, but some of it by marking land and lots to market. I have been monitoring their price level by comparing it to book value, looking for them to recover to the historical midpoint on P/B. I recently reduced the positions somewhat because they were getting close to that target. But looking at my profits on the holdings, and noting that the homebuilders tend to rally early in a recovery - they seem to be trying to rally now - I begin to wonder, if business picks up a little and if they are selling from marked down inventory, wouldn't that make for profit improvements?
Another point, Lennar (LEN) on 11/30/2007 announced a deal with Morgan Stanley, whereby they formed a joint venture that bought a diversified portfolio of land from Lennar. This was land that had been marked down. Lennar has a 20% ownership interest, but 50% voting rights, and the right to receive a disproportionate share of profits if certain goals are met. I read a good analysis, it is like the holy grail of tax minimization/avoidance, so on and so forth. What you have to wonder about is how management of any homebuilders you may own deals with the phantom book value of marked down assets. The phantom values may return to life after making their way off the books to other entities, controlled by whom?
Financial generally may be a fertile field for this line of thinking. There literally is no market for many bonds backed by sub-prime, and many banks and insurance companies have taken mark to market losses on bonds that may in point of fact revert to full value as they are paid off and mature. There is always something left, and some bonds that are trading at 30% of face value may be worth 45% of face value, a 50% increase.
It also could be a fertile ground for activity along the lines of the Lennar deal mentioned above, selling marked down assets out to an entity controlled by whom? You may be grateful if you own or buy stock in a company that has held its mark to market losses rather than liquidating in a distressed market.
Based on the idea of Phantom Book Value, I think some careful shopping in Homebuilders, Insurance Companies, and Banks might produce some nice gains as recovery proceeds and the markets return to normal.
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Comments (1)
Good post Tom. I've been thinking about this as well, especially since last fall. Many if not most of the bank write downs (and homebulders) have come at least partially because there is no ability to "price to market" because there is currently very little or no market for some items on their balance sheets. So this concept seems intuitively true.
What I have never really understood is the concept of "book value" taken as an absolute. I mean, I get it, but unless a company is 100% in cash, there is no way the book value can be totally accurate. The concept of book value is a moving target at all times (while some may not move much since they are easily valued.) Value can cange every minute of the day so "trading to book" seems to be a slightly ambigious term.
Certainly with such huge swings of late in valuation, this concept becomes more obvious and important to the bottom line.
One company that might do well with "write-ups" could be Merrill Lynch due to the fact that once Thain took over, he was able to write a huge amount down in a kitchen sink quarter because the write downs were the responsibility of the previous CEO.
I believe that will make it easier and more possible for "write-ups" for MER once the system clears and these structured finance products become liquid and can be priced more objectively and allow MER to recoup some of it's write downs as Thain could have easily been too over-agressive.
I guess we will see.
Uncle John
Posted by Uncle John | February 28, 2008 4:09 AM