Private Market Value

In a classic “Value Investing – From Graham to Buﬀett and Beyond”, the authors, Bruce C.N. Greenwald, Judd Kahn, Paul D. Sonkin and Michael Van Biema, write about noted investor Mario Gabelli’s use of PMV as a tool in his investment strategy.

“Probably no contemporary value investor is so closely identified with a modem variant of net-net as Mario Gabelli is with private market value (PMV), his potent contribution to the arsenal of value investing. Private here does not mean personal, individual, or secret. Gabelli defines PMV as “the value an informed industrialist would pay to purchase assets with similar characteristics” (Gabelli’s Web site, www.gabelli.com. Value Investing-US). This succinct definition needs some elaboration.

The PMV contrasts with the value that the stock market is placing on the equity of the firm. In the market, the last trade determines the value. All the players who make up the market- Mr. Market, as we have called this collectivity-have an equal say in what that price should be. They trade shares back and forth, some motivated by their sense of what the company is worth, others by the prior movement of the stock price itself. Over the course of a day, a month, or a year, the price can move one way or another without any fundamental changes to the business of the company or even, on a larger scale, to the outlook for the economy as a whole. Certainly there are moments when the market price is a good reflection of the intrinsic value of the company, but if that were constantly true, the price would not fluctuate so dramatically. The industrial buyer, concerned with the worth of business and the cash it can generate, has a less frantic disposition than the market and regards sharp declines in price as an opportunity, not as a cause for panic. In this sense, the PMV is little more than the intrinsic value as determined by the buyer of a firm who is more knowledgeable than the market about what the firm is really worth.

But PMV as an investment strategy has three additional features that make it a genuine innovation. First, as Roger Murray commented to Gabelli, PMV equals intrinsic value plus a premium for control. Unlike the passive investor who buys a security and hopes the company exceeds expectations, the industrial buyer is in a position to change the underlying business. He or she can fire incompetent management, dispose of unproductive assets, consolidate the operations with those of another firm, restructure the balance sheet, and do a host of other things to make the assets more productive and swell the cash flow. Because this buyer is probably familiar with the industry, it will not take long to turn things around. Because they can do more with the company than can the passive portfolio investor, they may be willing to pay more for it than the current market price. That extra amount is the premium for control. The payoff for portfolio investors such as Gabelli is that if they can identify firms selling substantially below their PMV, they can buy the shares and capture that control

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premium when the industrial buyer moves on the company.

The second innovative feature of PMV consists of the analytical tools that Gabelli and his associates have developed to allow them to estimate the PMV of the firms they follow. Like many value investors, they are look- ing for gaps in GAAP-that is, either assets or earnings power that are masked by generally accepting accounting principles and thus not revealed in standard financial statements. Some of these may be the old standbys: assets not reported at all on the balance sheet or carried at cost rather than current market value; operating income not disclosed on the profit and loss statement thanks to some unusual financial structure or the consolidation of profitable divisions with those that are losing money. Certainly the industrial buyer will not be blind to these values. If the Gabelli firm can discover them first, it stands to gain.

The other and more novel approach to exposing a PMV different from the share price is to move beyond financial data and focus on operating statistics. Many of the companies that have been in Gabelli portfolios are somewhere in the communications business, broadly considered: telephone companies, both fixed and mobile; cable and broadcast television companies; radio operators; and magazine and newspaper publishers. What these companies have in common are subscribers who pay for the services that the companies provide. The number of subscribers is an operating statistic. Knowing the number of subscribers helps the financial analyst compare the performance of different firms in the same industry: what their revenues or operating earnings per subscriber are. It also permits the analyst, on the basis of recent sales of firms within the industry, to see how much the industrial buyer was willing to pay per subscriber. If one wireless telephone company with 500,000 subscribers has just been bought out for $300 million, that suggests a per-subscriber price of $6,000, and it becomes the starting point for establishing the value of another wireless company. Certainly additional analysis is necessary, and adjustments must be made, but the approach to valuation begins with a PMV transaction-an industrial buyer paying so much for each unit of a revenue stream. It is a short step from here to a valuation of the entire company, which then can be compared with the current market value. A substantial difference suggests an investment opportunity. Other useful operating statistics are the num ber of hotel rooms, the population reached by a broadcaster, the number of square feet of marketing space, and the acreage in timber. In all these cases, the resource represents a stream of revenue that some industrial buyer has recently priced.

The third feature of PMV as an investment strategy is the recognition that it takes something-an event, a person, a change in perception-to narrow the spread between the market price and PMY. Gabelli calls this agent a catalyst, and the term has become widely adopted in the investment world to signify the source of a change. All investment strategies require a catalyst to make them payoﬀ. Even the most patient investor wants the

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value of the investment to rise within a reasonable-meaning relatively short-period; the longer the wait, the lower the annualized return. In most cases, the catalyst is left unspeciﬁed, which means that it is simply left to the market to recognize that the price of the shares should be higher. Beating earnings expectations is this kind of catalyst, something dependent not only on the performance of the company but also on its ability to surprise the analysts who cover it. Value investors in general, and PMV investors in particular, would prefer not to rely on such an amorphous and ﬁckle instrument.

There are two kinds of catalysts: specific and environmental. Specific catalysts are those changes, either anticipated or recently occurring, that alter the prospects of a particular company. The grimly labeled “death watch” stocks are attractive to investors who believe that the departure of the CEO or a large shareholder will allow the company, once freed from restraints, either to improve its performance or to restructure itself, includ- ing here selling the whole thing. Gabelli invested in the supermarket chain Giant Foods after the founder died, anticipating either an increase in earnings or the sale of the company. The sale did occur, at a 50 percent premium to Gabelli’s cost, but it took three years to complete. The slower-than-anticipated unfolding of the catalyst resulted in a somewhat lower annualized return on his investment. Other company-specific catalysts include all types of financial or operational restructurings, such as the spin-off of a division or a significant repurchase of shares, a change in management, and investments in new business developments. Changes like these stir the pot and reward investors who understand the company and can see, before the market, that improved earnings are on the way.

Environmental catalysts are disruptive shifts in the world in which businesses operate. We refer not only to global warming, which is obviously an environmental catalyst however one uses the term, but to changes in the political, social, and economic climates as well. For example, the destruction of the Berlin Wall in 1989 was the symbolic representation of a major catalyst for change in the years ahead. With the end of the Cold War, firms in the west such as Boeing, General Electric, Coca-Cola, Siemens, and a host of others would be able to sell their wares in the former Soviet Union and its previous allies. At the same time, the end of the Cold War held out the prospects that defense budgets would shrink-bad news for those firms heavily dependent on military contracts. One should have predicted that there would be consolidation in the defense industry, although deciding ahead of time who would be taken over and at what price may have been more difficult.

In many instances, the environment in question is the government, in its legislative, administrative, and regulatory roles. Even in the most free market of countries, governments cast enormous shadows over the economy and the companies operating within it. Changes in laws, regulations, and tax rulings, as well as other

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administrative decisions like monetary policy and contracting standards-all of these can alter the rules and modify the rewards that shape business decisions. The passing of the Telecommunications Act of 1996 has allowed new entrants to compete against the incumbent local exchange carriers in their local markets. Various additional pieces of legislation, along with judicial and regulatory decisions, have promoted the radical restructuring of the telecommunications industry in both the United States and abroad. Companies that didn’t exist ﬁve years ago now have market values in the billions and are bought, sold, merged, or transformed every week. Again, for the astute investor who has the ability and the tools to grasp the implications of these governmentally induced changes, opportunities abound.

Other environmental catalysts emerge as the consequences of disruptive shifts in technology that facilitate the reorganization of whole industries. The most unavoidable one in our time is the Internet and all the related changes that flow from breaching the protective barriers of time and space. Although it is far from clear at this moment which kinds of firms and which industries will profit from the corrosive impact of faster and deeper communications, what is certain is that there will be losers and winners, and that the landscape of many industries will be redrawn.

Consolidation is one result of many of these environmental catalysts: Big companies buy up smaller ones (sometimes the other way around) to take advantage of new opportunities that are suddenly legally permissible or commercially feasible. By knocking over some of the barriers of space and time, the Internet and other advances in telecommunications are some of the forces behind “globalization,” meaning here the spread of ﬁrms beyond their national boundaries on an unprecedented scale. “Want to be a global heavyweight in the telecommunications game? Better buy that small wireless company in Indiana to expand your footprint and ﬁll in your service area.” Whatever the motivations, consolidations advance on many fronts. And there is nothing that brings PMV to the surface as quickly as whole industries in the throes of a consolidation frenzy. For Gabelli, prepared with techniques for appraising PMV and adept at spotting catalysts, it is a heady time.

Aside from a few specific international funds, the Gabelli firm confines its universe to domestic, cash-generating franchise business. It defines cash generating as operating earnings plus depreciation and amortization less capital expenditures for the maintenance of the franchise (EBITDAcapex). Its approach is one stock at a time, bottom up, which is typical of most value investors. It does try to identify large scale trends-economic, demographic, political, or cultural-that will help or impede the earnings of the company moving forward. In 1999 trends that influenced the firm’s thinking were working women (leading to the idea that cats would become the pet of choice and increase the demand for kitty litter), speed, the digital revolution, globalization, aging

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populations, free ﬂow of capital and ideas, education, entertainment, and Euroland as a place of opportunity. But these themes merely identify potentially rich ﬁshing grounds; they need to be supplemented with the valuation tools before the company makes a purchase decision.”