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In my first few Screening for Value articles, I looked at results from one of the most straightforward value screens, 52-week lows. In this article, I introduce another classic: Low Price-to-Book.
Book Value is calculated by taking the total assets on a company's balance sheet and subtracting the total liabilities. It is also known as Shareholders' Equity, the term you will typically see in a set of accounts. It can be thought of as what the company believes it would receive if it sold off all its assets and paid off its liabilities. Unfortunately, it is doubtful that shareholders would receive book value in a liquidation situation. Many of the assets, such as inventories, are unlikely to be worth the amount recorded in the accounts if sold off rapidly. Book Value also includes the value of intangible assets such as goodwill that arises when a company acquires another company for more than its book value or capitalised development expenditure. These intangible assets may be worth nothing to someone else.
For this reason, many value investors choose to look at Tangible Book Value instead, also known as Net Tangible Asset Value, which excludes those intangible assets in the calculation. Again, it can be tempting to think that a company whose Net Tangible Asset Value is higher than the current market capitalisation, and hence has a Price-to-Tangible-Book-Value of less than one, can be profitably liquidated. This may be the case sometimes. However, liquidating a business still comes with the problem of receiving "fire-sale" values on assets. The costs of liquidating a company can also be high enough to erode any profits that would be made. However, trading below tangible book value implies that these assets are currently unproductive. In such cases, management teams face pressures to improve their efficiency, reduce their working capital, invest in better products, or shut down unprofitable business lines. If those assets can be made productive or sold off to someone else who can use them productively, then a company is likely to return to trading at a premium to its book value, generating a profit for investors.
That's the theory. Does it work? As you may know, Price-to-Book-Value has been one of the most widely studied factors by finance academics. In my opinion, Book Value has been a preferred metric partly because it is easy to find in the accounts and accounting standards on this measure haven't changed much over time. Hence there is data on this factor going back a long time, giving academics a lot to analyse. One quirk of history is that academic papers tend to reverse the equation and refer to Book-to-Price instead of Price-to-Book. This metric is the bedrock of the academic treatment of growth and value stocks.
In this framework, whether an investment is considered a "growth stock" has nothing to do with actual or expected growth rates of sales or earnings but whether a stock has a lower than average Book-to-Price metric. The assumption is that if an investor is willing to pay a high price for a company, then it must be growing quickly. Conversely, it is assumed that a stock with a higher than average book-to-price must be growing slowly and represents a "value stock". Given that studies have shown that the earnings growth rate for most stocks is mean-reverting over time, it makes sense that buying the set of cheaply-priced "value" stocks outperforms the more expensive "growth" stocks. And this is exactly what we see; in 1992, Gene Fama and Ken French published a paper that showed that high book-to-price stocks outperformed low Book-to-Price stocks (and small cap stocks beat large caps) in a way that other risk factors couldn't explain.
Since then, there have been extensive debates amongst academics as to whether the outperformance of "value" stocks is due to investors accepting higher risk and being paid a premium for this, or due to behavioural factors, such as a preference for the embedded leverage in fast-growing stocks. Academics have also found more factors that explain excess returns, such as momentum and profitability measures. These will be familiar to Stockopedia subscribers since they form part of the Momentum and Quality StockRanks.
Some researchers have suggested that including extra factors, such as these measures of momentum or quality, means that the outperformance of high Book-to-Price stocks is no longer statistically significant. However, Cliff Asness, from Quant firm AQR Capital, has shown that, when implemented in the right way, the “value” factor remains the bedrock of factor strategies. The other pushback the value factor has received is the fact that up until this year, it underperformed for almost a decade in the US. The theory is that accounting standards, particularly US GAAP, do not capture the full value of intangible assets, and intangibles have become much more important in profit generation in the modern economy. Therefore, Book Value does not capture all of this potential. There may be some truth in this, and I don't think Book Value is necessarily the best measure for a purely quantitive strategy. (This is why the Stockopedia Value Rank combines a variety of different metrics to identify cheap stocks.)
However, I am not aiming to develop new quant strategies in this article series but to use the stockopedia tools to find new interesting investment ideas. The academic evidence for the outperformance of the "value" factor simply provides confidence that we are looking in the right place. For this screen, I am going to use the more conservative Price-to-Tangible-Book-Value. In order to target the potentially most undervalued stocks and provide some margin of safety, I require this to be below 0.7.
In the 52-week-low screen, I included some additional factors, and it makes sense to use the same requirements here. In this case, I don't demand a Stockopedia Value Rank above 80 since the Price-to-Tangible-Book value is a direct valuation metric. The screen criteria that I retain are:
Market Cap Range £10m-600m These exact limits are somewhat arbitrary, but it makes sense to exclude the smallest stocks since they are likely illiquid, and it will be hard to invest sufficient capital into them. The upper range means that I am focussing on businesses that it is possible to analyse in detail and hopefully gain an analytical advantage. When I looked at resource stocks that were close to 52-week lows, a reader questioned why I was excluding the resource majors from my analysis. Of course, even without the market cap limits, there is no guarantee these would meet the screen's 52-week low or other criteria. But even if they did, the reality is that these are very large companies with many operations across many commodities. It is highly unlikely that an individual investor could analyse these better than the coverage of multiple professional analysts with access to management.
Current Ratio > 1.5 A reasonable current ratio means that current assets exceed current liabilities by a wide margin. This ensures that firms are likely to be financially strong enough to weather short-term setbacks while investors wait for these assets to be made productive again.
Excluded Industry Segments: Banking Services, Investment Banking & Investment Services, Residential & Commercial REITs, and Collective Investments. Again, I exclude these to focus on trading businesses.
With these criteria, I get 38 results from the screen:
This is a larger number than the 52-week-lows screen. However, nine of these results (Gem Diamonds (LON:GEMD) Inland Homes (LON:INL) Kenmare Resources (LON:KMR) Logistics Development (LON:LDG) Ocean Wilsons Holdings (LON:OCN) OPG Power Ventures (LON:OPG) Pharos Energy (LON:PHAR) Serabi Gold (LON:SRB) Wentworth Resources (LON:WEN) ) I have already started to analyse since the 52-week lows screen also identified them as potential value investments. This is to be expected, there is often overlap between different measures of value, and the same stock may appear on multiple screens. In addition, I can see from an initial scan that a number of these companies may not be worthy of further investigation, leaving a manageable number to investigate further. In my next article, I will start to look at some of the new ideas this screen has generated.
About Mark Simpson
Value Investor
Author of Excellent Investing: How to Build a Winning Portfolio. A practical guide for investors who are looking to elevate their investment performance to the next level. Learn how to play to your strengths, overcome your weaknesses and build an optimal portfolio.
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Thanks Mark, really interesting and useful as usual and I look forward to hearing about your investigations.
I was wondering if in one of your next assessments of measures you might be covering the EV to Sales metric? I know this is also widely used and I for sure would appreciate your thoughts/comments.
Hi KevinS1,
I will probably cover a few more of the classics such as EV/EBIT or Dividend Yield before I get round to something like EV/Sales. This is used more often when there are no near term profits, either due to being a turnaround or a pre-profit growth stock. I’ll add it to the list, though.
Cheers,
Mark
I’m very much enjoying this series Mark. One thing that is important with value stocks is, “what is the outer?”. That is, how is the value going to get unlocked? A long time can be spent waiting for value to be outed, creating opportunity cost along the way.
Will you be covering this during the series of articles?
Hi Brilliant Leader,
It is certainly something to consider. However, I have often found the idea of a catalyst or an "outer" to be too hard to predict. I think it works for specific special situations, but often low valuation is enough of a catalyst on its own. The reason is that the market is forward-looking. I have certainly failed to capitalise on good investment opportunities in the past because I have tried to be too cute on timing - trying to anticipate when others will view a stock differently and rerate rather than simply buying when obviously cheap. The value investor's best weapon is usually just patience.
I think a more general article on avoiding so-called "value traps" may be a useful topic for the future, though. So thanks for the idea.
Cheers,
Mark
Hi Mark,
I highly recommend to readers your excellent book "Excellent investing: How to build a winning portolio" which I got from Amazon yesterday. Not had the time to read it fully yet, and have been skimming, but it is a hidden gem as it based on real world trading/investing experience often missing in many books. I really like how you explain risked NAV in the section "Personal section - Encore oil"; I come across this term all the time in Oil and Gas stocks, but never quite understood it, nor its relation to the share price, but you've explained it perfectly. Not many authors can explain these terms as well as you. The other sections look just as good. Are there any more books in the pipeline? Wouldn't mind a book version of these articles.
Also, I think you would make a perfect addition to the SCVR, but covering resource stocks as Paul and Graham don't have expertise in that area. There are so many good oil and gas stocks and mining stocks out there, especially now with the high energy/commodity prices, that missing out on this opportunity could be once in a lifetime. You've mentioned Base Resources earlier, which I have now started looking into but it could do with a full article analysing it, and stocks such as San Leon Energy (LON:SLE), Chariot (LON:CHAR), Parkmead (LON:PMG), Trinity Exploration and Production (LON:TRIN), Iog (LON:IOG) have performed brillantly recently , or are about to. Lack of coverage of such stocks is a shame as the potential returns are phenomenal. I believe that quite a few here are wanting someone to cover resource stocks regularly as this is seriously lacking in Stockopedia currently, like a Simon Thompson of IC if you will. He was the only reason why I subscribed to IC.
Thanks
I agree with your conclusion Mark that an article on avoiding value traps would be appropriate. That was the crux of my point rather than market timing per se. I look forward to reading your thoughts.
Cheers
Simon
Hi Guybrush,
Thanks for buying my book and for the kind comments :-)
I am currently working on a follow-up book, which has a working title of "Investing Rules" or maybe "21 rules for Investing" or something similar. The idea is that investors can overcome many of the behavioural biases that negatively impact their performance by applying simple rules where they are likely to be led astray. Many of us know that the ability to generate positive change is proportional to the ease of implementation, and this will be an easy-to-read book that will aim to deliver this. Some of these rules I introduce in Excellent Investing , but there are plenty of others that can also have a positive impact on performance too.
Longer-term, I would like to produce a value investing book with some of the concepts from these articles plus a more in-depth look at some of the history, tools and evidence of outperformance of value investing. But part of why I enjoy writing these articles is it gives me the writers' deadline to get content out in a timely fashion. Plus, it is synergistic to my own investing; I have been finding new ideas that are not currently on my watchlist to analyse further.
Kind of you to suggest that I could be the "house" resources analyst. However, primarily I am a value investor who is willing to consider cash-flow-positive resources stocks, with one eye on the capital market cycle, rather than a resource analyst who looks for value. I think an SVCR resources analyst would need to also consider pre-production or companies that are in the ramp-up stage, and this requires some more specific knowledge that I don't think I possess.
Cheers,
Mark
*Past performance is no indicator of future performance. Performance returns are based on hypothetical scenarios and do not represent an actual investment.
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Thanks Mark. Before reading your article, my knowledge of book value was no more than its definition: total assets - total liabilites. And I thought that was all I needed to know, but your article has shown what I was missing. Another superb article, which may be too technical for some here judging by the lack of interest, but no less important.