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Ben Graham approach - EXXa USG MRK LIBHA

10/15/2004

Recent new pick Exx.a USG

The past half month has been very busy for me to manage the Blast Investor model portfolio. It was actually pretty rare for me to have 2 new picks in so short time frame. Even with today's big run up of USG, I still maintain original analysis on USG, it is worth $40 and my target for USG is $100 a share in 5-6 years time frame.

Benjamin Graham approach - average historical earnings

Utilizing average historical earning per share for valuing a stock was core idea in my previous 2 new pick reports. For those who have read Intelligent Investor book should be aware that this type of security analysis method for Exx.a and USG is very similar to the method described in that book. Well, they should be.   As many of my newsletter long time readers already knew, I started as a speculative momentum trader more than a decades ago. Later on I moved into long term value investment field. In the earlier years of my stock trading or  investing career, I tried all kinds of trading and investing methods, William O'neil, Technical Analysis, stocks, options, short term, long term, blind buy & hold, etc  until I found Benjamin Graham. I learned most of my value investment skills from his books.  In my opinion, he and his student Warren Buffett created best money-making investment method, which is far superior and far safer to any other methods I know of today.  For that matter, obviously since that day, I have been loyal student of Mr. Graham as well.

Margin of safety :  Asset is key, PE is not most important metrics

Margin of safety is most important concept in value investing.  One of the secrets that few people understand even today is that PE alone is not most important factor in defining the safety of a stock. Low PE can not provide adequate safety in many cases. Earning can get lower and lower, and stock price can go lower and lower into a bottomless dark hole. One example is MRK, which has very low PE=10 and pretty strong average earning over past decades. However, consider this, it has price to book ratio of 4 and expiration of patents and poor earning visibility ahead, it is not that a safe stock that I would consider to plunge into.

In contrast, asset or liquidation value is key for margin of safety. This is well spelled out in Ben Graham's book. For most industry, Ben Graham already lay out a simple method to calculate this: NCAV value or Net Current Asset Value, which exclude machine tool equipment in balance sheet to obtain true liquidation value of a stock. For some special industry such as oil , or natural gas stocks, private acquisition per reserve valuation or  Benjamin Graham mining stock modeling of reserve PV-10 Net Asset Value (NAV) is more appropriate for determining true liquidation value. For real estate related stocks, an income-appraisal or per square foot comparative analysis based appraisal would be more approapriate for true liquidation value determination.

Why liquidation value is such important safety defense line? Very simple, if I can control that company at purchase price below liqudiation value, I will vote out all the existing board of directors and shut down and liquidate the company with decent profit. Well, I may not have enough money to buy certain stocks, somebody else might be likely to pursue that in a merger or acquisition attempt.

Although book value does not reflect true liquidation value in many cases, book value is correlated to liquidation value in many cases. The higher the book value, the higher the liquidation value in a typical industry.  Compare book value of MRK (4)  to that of Exx.a (PB=0.9) or USG (PB = 1),  I would feel much safer to hold Exx.a or USG rather than holding MRK. What about value of MRK patents? Well it is expiring and I will put the value of MRK patents to zero if I can not determine the true value of the patents easily.

Questions on USG

One question I received from subscriber is: What will happen to 2 billion plus asbestos estimated liability on USG balance sheet if Congress eventually pass the asbestos trust fund bill in 1-2 years? 

Here is my opinion on this issue:

It will depend on timing of the bankruptcy final ruling vs the bill passing date as well as the final bill/new law wording on
this issue.

• If the bill comes into law earlier than USG bankruptcy ruling,  2 billion plus asbestos liability will likely to disappear or at least large portion of the liability will likely to disappear because:

1. The judge will be likely to rule that all liability claim go to fed $140 billion trust fund according to the new law  even if the new law does allow other method of liability compensation. This means USG will only be liable for 52 million a year trust payment and no other additional asbestos payment.
   
2. The current Republican oriented bill also say that if within 60 days the bankruptcy case is not ruled, all the asbestos claim goes to fed trust fund and it will not be allowed for bankruptcy court to determine the asbestos lawsuit liability issues.
   

• If the bankruptcy ruling comes earlier than the bill becomes law, whatever judge rules will determine the result for this estimated 2 billion liability. However, here is the issue to consider:
  

1.  The USG bankruptcy + asbestos lawsuit is in mess and I do not see that it can be solved easily.  The current sick asbestos patients want to get as quick money and as large money as possible from USG;  the non-sick asbestos creditors may not want to destroy USG business because they need payment from USG in the future if they become more sick; The bank creditors are in line with equity holders because they want asbestos liability as small as possible so that they can get their loan principle back from USG.
   
2. The bankruptcy final ruling may not be very friendly to asbestos creditors. A recent scientific publication disclosed that out of hundreds and thousands of past asbestos X-ray reports that lawyers submitted as proof of asbestos medical damage, less than 5% of them were actually real under review of most prestigious Radiologists. For sure some of the unethical Doctors were paid to make fake medical diagnostics report. Potentially asbestos is becoming a biggest legal scam in America.
   

• Final wording of law will also determine the future of 2 billion liability
  
1. The current bill is Republican oriented. The Democrats differ mainly from Republicans on this particular issue. Republicans want all unresolved asbestos lawsuits go to trust while Democrats want the existing lawsuit to finish in court even if the bill passes. 
2. Current senate election will influence the final bill. If  Republicans capture the majority, then the final bill will be likely to be investor friendly. If Democrats capture the majority, the final version on this issue will be less investor friendly.
3. From my point of view, Republicans or Democrats are not big deal. As long as the bills can pass, USG price will shoot up significantly from here.  USG has strong balance sheet and strong cash, even if the final version of the bill is Democrats oriented, Investors can still benefit from the certainty of the asbestos liability.

LIBHA  recent earning

LIBHA recently issued interim report, it seems the situation is pretty tough this year as raw material going up dramatically. I expect situation of raw material price surge will be alleviated next year because China economy is cooling off.

In order to make profit on this stock, I will likely to hold this stock in my model portfolio for 3-4 years just like my first LIBHA stock pick report said. The turnaround is probably going to be really long and tough. Still it is favorable in Risk/reward for Long Term Investment Point of view considering the strong real estate asset margin of safety protection.

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