During nearly two weeks in Mongolia, I saw and learned a lot. Most of it was very much Mongolia focused. I did witness one thing that will forever change how I value a business.
In the Western World, I have always thought that far too much was predicated on the notion of P/E multiples. Let’s face it, business is volatile. There are good and bad years. How can you possibly value a business based on last year’s earnings? Next year’s earnings are just a guess. You cannot possibly put a multiple on those.
For most of the past three decades, we were very fortunate in the US. The economy was stable, inflation was benign and interest rates remained low. This allowed business to be relatively predictable. Investors could value most businesses as cash flow streams that grew at a certain rate each year. The recent economic crisis has laid bare that sort of thinking. When the economy is growing a few percent a year, you can use fancy accounting to smooth out earnings. This becomes impossible during a severe contraction. The recent crisis has shown the volatility inherent in most businesses. It is just my hunch, but the disaster in 2008 wasn’t a fluke event. I think we will see a lot more economic volatility in the coming years now that the Federal Reserve has lost control of the business cycle. How do you value a business that has strong earnings one year and then no earnings the year after? How do you value a business with extreme volatility in annual results? P/E multiples become irrelevant. You need a different metric.
While visiting companies in Mongolia, I was struck by how perplexed they were when I asked them for an income statement. Usually the CEO’s first response to such a question was to take me on a tour of his facility. He would show me how much land he had and what sort of equipment he had. We’d go examine inventory or look at trucks. The whole idea of income seemed vague. When I looked through the formal income statements (if they existed), I was frequently confused. Why would a CEO expense 20 new trucks rather than capitalize and depreciate them? Didn’t he care that this turned a nice profit into an accounting loss for the year? Slowly, I was won over to their way of thinking. Income is volatile. The concept of ‘normalized earnings’ is nebulous at best. Why bother with it. Assets are what matter. Focus on the balance sheet!
The more time I spent in Mongolia, the more I realized that they think of economic life much like an insurance company would. You have a book value and some years that value grows (a profit), and some years it shrinks (a loss). Since for all practical purposes, debt does not exist in Mongolia, if your assets increase at year end, you’ve made money. Furthermore, there is currently a boom in asset values. As an investor, you can be confident that most assets are understated on the balance sheet.
Mongolia has gone through some turbulence since the end of Communism. As an emerging market, it is always going to be more volatile than the mature economies of the world. No wonder so much focus is put on the balance sheet. Assets are real. They cannot lie. Our country will be experiencing more economic volatility in the near future—you can almost count on it. I think it’s time that we act more like the Mongolians. Unfortunately, this will be hard to do. Look at General Electric, one of our country’s most prestigious companies.
Tangible Assets $676 billion
Total Liabilities $629 billion
Net Book Value $47 billion
To this untrained eye, it looks perilously undercapitalized. Even when you consider that much of the balance sheet is taken up by their financial business. You have 676 billion in tangible assets and a mere 47 billion in book value to support them. A ten percent decline in asset value would more than wipe out the book value. General Electric is one of the best run companies in the world, everyone wants to emulate them. Unfortunately, with it comes to the balance sheet that might not be a good thing. Whereas General Electric was able to survive the most recent crisis without too much stress, many other companies were nearly wiped out. Does this sort of risk taking deserve a premium valuation?
I usually try to invest in growing businesses. I always have paid attention to the balance sheet, but the income statement was my real focus. After the past two years, my thinking has changed. I saw lots of profitable companies get wiped out by the recent economic collapse. It’s amazing how quickly a rapidly growing business can run into trouble if demand falls off. If you have a strong balance sheet, you can survive. Those who were leveraged had real issues. It makes you value the balance sheet more and more. In Mongolia, they have seen all of this. They are focused on the balance sheet and with good reason. After seeing how they think of value, I want to also think of valuation differently—I want to think of it their way. Earnings are erratic, but book value is something you can count on.
This is the final post on Mongolia. I’m not quite sure how to make a clean transition from balance sheets to cashmere, but Mongolia is well known for its cashmere. Due to surprisingly strong demand (thanks mom), let’s see how a cashmere scarf gets made. You start with raw material (above).
The cashmere then goes through a series of combing and pressing stages where it is cleaned and sorted by fiber length.
Once the cashmere is sorted, it gets dyed.
The colored cashmere is turned into yarn which is wound in spools.
All the many colors of yarn are eventually knit into a scarf.
In the final step, all the sewing is done, brand logo is added and the scarf is put in a bag for shipment to a retailer.