What Is Asset Stripping?

A much more aggressive form of value investing is called asset stripping.

Generally, the value investor is a long-term participant who has spotted underpriced assets. This investor may need to wait some time before the market agrees and prices the company at a highr level.

However, there are bigger players in this game too. They are management teams of hedge funds, vulture funds, special situations funds and more. These managers will purchase large blocks of company stock and then use the influence that buys to pressure company management.

The pressure that they apply will be aimed at changing the direction or strategy being taken by the firm. This will often involve hard decisions that usually lead to parts of the company being sold. By selling some parts of a business, corporate debts can be lowered or loss making subsidiaries jettisoned to leave a healthier and more profitable firm. This will help the market price rise and investors will hopefully make a more acceptable return on their investment.

At the top end of the scale come the really big boys. They are comprised of private equity firms, deal makers, hedge funds and other rival corporations. It is generally their aim to borrow large amounts of money, win control of a target company in a hostile takeover and then sweat the assets to produce a return. The assets may be managed differently, sold or restructured.

Many of these deals occur every year. Often they will result in sales of some or all parts of a company. This is the art of the asset stripper and it is one that can be hugely profitable if the asset stripping activity is successful.

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Asset stripping can often involve selling every part of a purchased corporation to a different organisation. If the sales create more cash than was paid for that part of the firm, a profit has been made. Whilst each individual part of a firm may only bring in a small percentage gain, the overall value 'unlocked' can amount to tens or hundreds of millions! This money finds its way into the hands of the purchasers - who can become very wealthy, very quickly.

In an ideal world, sales of property of subsidiary companies will generate cash which can be used to repay lenders. As more parts of an operation are sold, more debt will be repaid until the purchaser owns a company with manageable or zero borrowing, or better yet a pile of cash from sales.

One of the problems with the approach is the human element. Typically, the companies that fall victim to this kind of approach are not in the best financial health. There can be many reasons for this, but as a general rule, companies that are doing well do not trade for bargain basement prices in the market.

This means that when a corporate raider comes in and takes control, there will be an immediate emphasis on closing or selling any loss making parts of the business. This can mean job losses which staff and unions obviously dislike. It can be argued that this is a good thing (since a loss making business is going to be closed or restructured sooner or later) and that this at least benefits shareholders. Such hard decisions are never taken well by those impacted and can lead to bad feeling in the staff and client base.

Some deals are less savoury than others of course. There have been deals where some parts of a group were moved offshore to take advantage of international transfer pricing rules to lower a tax bill (a gain is a gain), while others have been so close to the edge that legislators are left wondering is asset stripping legal. (Transfer pricing is a method of reducing tax requirements by hosting parts of a business or supply chain in low(er) tax jurisdictions).

Generally, the company or fund that is buying stock has conducted a lot of analysis and has spotted something that the current company management seems to have missed or an opportunity that they do not wish to pursue. It is this close business analysis that can be the difference between making a profit or a loss on the overall deal.

Sometimes the fund buying the stock does not actually need to do very much. Like a shark circling a victim in the water, they have sensed some weakness in company management and the mere act of buying a large block of stock might be enough to jolt the CEO into action. In such circumstances the management might decide to sell a business unit or perform some sort of buyback to raise the share price (sometimes known as greenmail) and let the buyer sell out for a profit. This is one of many reasons why day traders and fund managers follow the purchases and sales of large blocks of stock so closely.

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A great example of the games played with listed companies has been unfolding in 2013. Legendary deal maker and activist investor, Carl Icahn, currently (August 2013) holds a large position in the American nutritional company, Herbalife.

As this article explains, his very profitable long position is in direct contrast to that of a rival fund manager, Bill Ackman of Pershing Square. It was actually Ackman that was shorting the stock (with a target price of US$0 per share) and acting like a vulture.

Unfortunately for Ackman, Icahn found what seem to be some important flaws in his thinking and bought a substantial holding in the company. Doubtless it gives him no joy to see his rival caught in such a short squeeze...

In a situation like this, a company that employs some 35,000 people appears to be a plaything between very powerful and well financed rivals.

The basics

The most important thing to remember is that the whole process starts with locating undervalued assets on a balance sheet. If a company is stock is trading at a level that is below what these assets could be resold at, there will be someone in an investment bank or hedge fund looking at the opportunity. When others in the same industry or sector have identified such a company, there will likely be action from various parties in the coming months.

If the idea of asset stripping seems a little odd or confusing, a great way to learn about it is to watch either or both of the following films:

Wall Street featuring Michael Douglas as Gordon Gekko and Charlie Sheen as Bud Fox, or OPM (which stands for Other People's Money) featuring Danny DeVito, which is what the above movie clip is of.

Both films look at the impact of asset stripping by major players on the corporations and employees impacted whilst also being entertained by the big-shot Wall Street types making the deals. The first, Wall Street, looks at ways in which information might be gathered illegally to provide an edge in a transaction.

It ought to be noted that the processes described above are generally a little different to those employed in private equity deals. There, a company is typically bought with a substantial amount of borrowed money, new management is dropped in to improve performance and squeeze as much out as possible and then hopefully the company will be able to repay some of the debt and then be floated onto the stock market or sold on to another large firm in the same sector. Either outcome will net the buyers a very large capital gain (if it all goes to plan).

The problem, of course, is that sometimes all that debt sinks the company and thousands of jobs are lost as the company declares bankruptcy.

When a private equity firm buys an established business with lots of borrowed money, the investment risk rockets upwards. Very small changes in the operating environment can make a huge difference to the financials and if they are negative changes, the company might sink under the debt burden. Therefore, if interest rates change negatively, or the economy - or a sector of it - slows substantially, or if some part of the cost base, such as fuel prices, goes up, the viability of the company is suddenly threatened.

A related example, that your author has some knowledge of, happened in the UK banking sector. In 1997 Lloyds Bank purchased the Cheltenham and Gloucester Building Society. C&G was founded in 1850 and had been able to grow its profits in every single year of operation! What a history. However, during the 2008 banking crisis, Lloyds was "forced" into an unexpected purchase of HBOS. This new larger company suddenly had too many branches across the UK, in breach of European anti-competitive legislation. Something had to go and C&G is now closed to new business and it's four thousand plus members of staff and two hundred branches are all gone. Situations like this happen every year around the world...

If you would like to read more about value investment, please visit the following pages:

What Is Value Investing?

What Are The Value Investing Basics?

Problems With The Value Investing Approach

The Value Investing Rules Of Ben Graham

The Good And Bad Of A Value Investing Strategy

Value Investing With Warren Buffett

Value Versus Growth Investing