A Formula for Value

• ByTim Melvin, RealMoney.com Contributor
• On 1:00 pm EDT, Wednesday August 5, 2009

One of the biggest problems at my house is book storage. I read a lot and keep most of the nonfiction things I read and give away the fiction when I am finished. Over the years the shelves have filled to capacity. They are not organized in any fashion at all and you can find David Darst's The Art of Asset Allocation next to Phil Hellmuth's Play Poker Like the Pros. I just put them on the shelf as I finish them.

To combat the problem I have taken to occasionally going though the shelves to see which -- if any -- are candidates to be given away. I rarely find any of course, but do often come across books that need to be revisited.

That was the case the other day when my failed attempt at pruning the shelves turned up one of the best investing resources I have ever read. New York University business professor Aswath Damodaran has written several excellent books on valuation, but his best by far is Investment Fables.

In the book, Damodaran looks at many of the cherished investment theories and breaks them down by the numbers. He is democratic in his approach testing all the theories be they growth or value oriented.

One of course is price to book value. He correctly points out that a lot of companies trading below book value should trade there. They are over-leveraged unprofitable companies. The one criterion is not enough to assemble a successful portfolio. He demonstrates that by adding return on equity to the equation, results can be improved substantially.

His model portfolio of stocks in the bottom quintile of price to book that are also in the top quartile of return on equity trounce the market over time. I have tested this myself in the past and found that it's held true for the years since the book's release.

I ran the screen again yesterday and found that just 100 companies make the list. When I cut the list off at those above $100 million in market cap, the list falls to just 76 companies. This reinforces my belief that there is extreme value in the micro-cap stocks. It is a great place for long-term value investors to shop for ideas right now.

I was pleased to see that some of the names I won and have written about make the list of potential outperforming stocks. Old favorites Breitburn Energy and Prospect Capital both make the list. I have suggested both of these several times and deeply undervalued stocks that have the potential for high long-term returns.

Linn Energy has leaped ahead in price since several other RealMoney contributors and I suggested it last year but it still makes the cut trading just below tangible book value. Rowan, a stock that I have owned for some time, is also on the final list of low price to book, high-return companies. I talked about refiners last week and both Tesoro and Western Refining are also on the final screen results.

One of the more intriguing issues that shows up on the list is Babcock & Brown Air. At first glance this would seem to be a terrible business right now. The company is the fourth largest lessor of airplanes in the world.

Although the airline business is not in the greatest shape these days, all 62 of the company's planes are under lease or committed to a lease. The leases have an average of 5.2 years to run. Management has been able to repurchase debt at a fraction of face value to shore up the balance sheet. The company has over $150 million in unrestricted cash and appears to be in good shape to survive the recession.

The stock has moved well off the lows in March but still trades at just 60% of tangible book value. The return on equity is a very respectable 18.5%. The PE on expected earnings is just 7. As a bonus, the shares pay a dividend a shade over 10% so you get paid while waiting for the recession to end and the shares to recover in price.

Two years ago the company traded at 3 times the current price and could regain a lot of the ground over the next two years. The company reports earnings Thursday morning and it would make sense to hold off purchasing the shares until then.

Damodaran's book looks at a lot of investing theories, including buying low PE ratios or stocks with high earnings growth. He tears all the strategies down to uncover what is right as well as what is wrong with each approach. The resulting knowledge is very useful in putting together stock screening approaches that uncover potentially profitable ideas. It is one of the classic must-read investment books.

Buzz up!