Hi friends. In my book, “Choose Stocks Wisely,” I tell some personal stock investing success stories and some horror stories. The disappointing experiences shared focus on my ventures into a couple of dry bulk shipping companies. These were some significant losses taken and I learned a lesson I attempted to write about via telling of the experiences with dry bulk shipping investments. Dry bulk shippers had been going gangbusters but when I bought, they were in a period of declining demand. So, the great value I saw in the balance sheet numbers of these shipping companies was not real because the book value of the main asset, namely ships, was vastly overstated on the balance sheet.

What transpired with dry bulk shippers has occurred in more recent times with oil and gas drilling companies. While the entire oil sector has been clobbered by the lasting decline in oil prices, the drillers have been decimated the most. I thought today I’d briefly revisit the matter discussed in my book regarding companies (like dry bulk shippers) with most of their money tied up in property, plant and equipment (or fixed) assets.

My Scorecard approach discounts all assets with the exception of cash without discounting liabilities. Albeit I give credence to a substantial portion of the stated book value of property, plant, and equipment, it’s important to recognize that while fixed assets are tangible (hard) assets, their real worth is driven by the demand for their usage, not merely their existence. In a period of failing demand, that real worth of fixed assets could require much deeper discounting than my Scorecard entails.

Property, plant and equipment assets are depreciated with usage (except land), thus reducing the book values on the balance sheet over time. However, where demand is in a tailspin, as is presently still going on with oil drilling companies (although oil is considerably off the absolute lows and OPEC has made gestures of production cutbacks) while most of their money is tied up in drilling rigs either not being utilized or in service but realizing day rates well below what’s needed to keep the companies running, the value after depreciation shown on the balance sheet is likely still very overstated. This is true because accounting rules don’t require impairment write downs of fixed assets until extreme thresholds are crossed; and by that time, the stock prices of the companies have likely already fallen precipitously to price in the carnage.

I don’t think the proper angle to take with fixed assets is to treat them as worthless (discount them to zero) when scoring because to do so would likely eliminate most capital intensive sectors from investing consideration, which are as good when they are good as they are bad when they are bad. Further, we would be disregarding physical assets; that is, assets that can be seen and touched.

But here’s the real comment I want to offer today. Thinking on the balance sheet assets, while on one end, cash is an easy asset to put a cash value on and on the other end, intangibles are virtually impossible to put a cash price on, fixed assets are somewhere in between. As stated in my book, no scorecard can capture everything as a valuation proxy. I’d say a good rule of thumb when considering an investment in a capital intensive company that passes my kind of scorecard equity muster is to carefully observe the business arena and determine whether it is amid a rising tide of demand or facing a demand downdraft. If demand is good those “illiquid” fixed assets will likely be generating solid cash flow, ample to pay the bills and reward owners. Conversely, if demand is sinking, those fixed assets may become an albatross around the company’s neck and potentially jeopardize the company’s future. Just as ships became a dime a dozen for dry bulk shippers, drilling rigs have become a dime a dozen among the drilling community.

Have a great weekend.