Finding Certainty – A First Look At The P/TBV Screen Results

26th Mar by Mark Simpson

6 comments 1552 reads

In last week’s article, I explained how looking at the balance sheet of a business could provide certainty in the currently uncertain UK markets. The idea is that by buying shares in businesses that trade at a discount to book value, investors harness the power of capitalism to make currently unproductive assets productive again. Not every business will experience this mean reversion, but for those that do, the effect can drive strong investor returns. The maths is fairly simple. If I invest in a business that is trading on 0.5x Tangible Book Value, which currently generates a return on equity of 5%, then I will be paying a P/E of 10 for this enterprise (on a debt/cash-free basis). However, if that return on equity increases by 15%, then the net profit will triple. The market will likely view this as favourable and give the business a rating closer to market averages, if not beyond. If this traded on a P/E of 15, then this would be a 350% return on investment.

These returns typically take time, and a management team committed to getting the best out of the business’s assets. However, the scale of the returns that the winners generate will make up for the stocks where the mean reversion in corporate performance never arrives. I screened for potential investments that may benefit from a return to productivity for their assets last week and generated 42 ideas:

Based on the following criteria:

Given that the type of re-rating that generates high returns is hard to predict and often subject to a large degree of randomness, it is tempting to simply play the numbers game and invest in all these stocks. However, I believe a small amount of extra research can improve the risk-reward ratio. Here is my initial look at these stocks.

Extractive industries

One of the big themes amongst these screen results is the abundance of commodity stocks:

One of the downsides of these is that their assets often exist in faraway lands and are subject to very high political risk. For example, Enwell Energy (LON:ENW) and Ferrexpo (LON:FXPO) operate in Ukraine, with all that currently entails. The good news…

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M Wharrier

27th Mar

Useful piece, thank you. While TB is no panacea, it is useful when thinking about replacement cost, in a more inflationary environment, together with wider industrial value.

Anthony127

Housebuilders do look cheap when looking at their book values, and the intention of the Government to build 1.5m homes over the current parliament suggests that this area could do well.

However it is up to the Government to create the conditions where this would happen. They certainly didn't help matters by increasing employers NI contributions as this is inflationary and only increases the build costs, also the forthcoming decrease of the stamp duty threshold for first time buyers will only decrease demand.

It would have been wiser in my view to have increased income tax; this would at least have been deflationary and perhaps lead to a quicker reduction in interest rates.

The UK Bank Rate is 4.75% which compares with the Eurozone rate of 2.5%. Conscious of the quicker reduction in rates I bought the Irish Housebuilder Cairn Homes (LON:CRN) which has done reasonably well.

Improved planning will be a helpful factor but the most effective approach would be to contain inflation, reduce interest rates and thereby increase mortgage demand.

Mark makes the point that investors will need to be patient and wait for the cycle to turn, however I think this has been the case for a long time now and I cannot see any pending actions that will make the business cycle turn more effectively, this suggests to me that the level of patience required could be considerable indeed.

Mark Carter

Prof. Aswath Damodran pondered the question of low PBV,

Suppose you had a company A that earns 20% ROCE and company B that earns 5% ROCE. Neither has borrowings. Suppose that neither has reinvestment opportunities either, so they generate constant cashflows in perpetuity.

Suppose you require a return on investment of 10%. How much would you be willing to invest in either company. The answer is that for company A you would be willing to pay 2X book value, whereas for B you would be willing to pay only 0.5X, if you do the maths.

This assumes that everything else is equal, of course, which it rarely is. But it illustrates the point that you would be willing to pay different multiple of book values depending on how goo the company's return on capital is.

So in a company like WYN, investors might be entirely rational in paying only a fraction of book value.

There's the question of "mean reversion". Banks are a really good example. When interest rates were low, they were earning meager returns on equity, so their PBV were low. As interest rose their profits increased. Consequently their ROEs increased. Investors got a double-dip. ROEs increased and the market increased their willingness to pay a higher multiple on PBV .

Everything depends on whether you think returns on capital will revert to former levels and the timeframe involved.

Mark Simpson

28th Mar

Yes, wise words.

The good news is that ROCE is one of the most mean-reverting metrics in finance, at least in a capitalist economy. Basically, there are two ways of making money in stocks by doing securities analysis (there are other ways using momentum etc., that may be equally valid but don't rely on assessing the underlying business). The first is to find the few stocks that have high ROCE and resist that mean reversion, i.e. the moaty ones. The second is to invest in the ones that have a low ROCE and mean revert. The second way is far easier, in my opinion, not least because only a few per cent of stocks actually have an enduring moat, and the market usually knows about it and bids the stocks up far higher than 2xBook.

There are a few pitfalls with the second way, too: companies where management have no incentive to seek that mean reversion or are so bad that they have no hope of the assets becoming productive. This is what I am trying to filter out with this screen and initial look at these companies.

Just because it is easy doesn't make it simple, though. The psychology makes it difficult, as typically, investors have no idea when the mean reversion will occur and whether there will be further determination in trading first. The market screams that you are an idiot for even considering such a poor company.

The moaty way of investing may be much more difficult analytically, but is often much easier psychologically, as other investors (and professors) congratulate you for investing in such a wonderful business. So I see why others are willing to do the incredibly hard work to find companies with enduring moats. I'm just built differently!

Bronstein

1st Apr

Hopefully our government will hire you as a consultant.

My day rate is very reasonable...for a consultant ;-)

Finding certainty – a first look at the P/TBV screen results

Extractive industries

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Mark Simpson

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