More than seven decades ago, in their investing bible "Security Analysis," the famed value investors Benjamin Graham and David Dodd explained the core basis of a stock's value.
They wanted investors to view a company in the context of its liquidation value, as a means of ensuring that a stock was a bargain.
"By the liquidating value of an enterprise we mean the money that the owners could get out of it if they wanted to give it up. They might sell all or part of it to someone else, on a going-concern basis. Or else they might turn the various kinds of assets into cash, in piecemeal fashion, taking whatever time is needed to obtain the best realization from each. Such liquidations are of everyday occurrence in the field of private business."
When those words were written, a wide variety of companies could be bought for prices below their liquidation value. These days, such stocks are hard to find. Of the 1,500 companies in the S&P 400, 500, and 600, less than 2% of them trade for less than their liquidation value, or what we today cite as being below tangible book value.
Yet there is a compelling reason to stay focused on such stocks. These stocks often sport such low valuations because management has impeded investors from truly appreciating the value of underlying assets. Yet with the right moves to unlock that value, shares can rebound, at least all the way back up to book value.
Let me provide an example. Roughly two years ago, I noted that truck stop operator TravelCenters of America (NYSE: TA) was trading for just 39% of tangible book, largely attributable to unfavorable real estate agreements that were impeding profit margins. Management went on to negotiate better leases, and shares have nearly doubled in value since then (and still trade below book value).
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So it pays not just to focus on stocks trading below book, but only those that have a clear path to close that valuation gap.
Insurers, some of which trade at a deep discount to book, offer such a catalyst. Low interest rates have depressed their interest income, keeping them out of favor, even though their book values have been marching steadily higher in recent years. As interest rates start to rise, and book values begin to expand at an even faster rate, look for investors to newly appreciate these extremely cheap stocks.
To be sure, that many other stocks trading below book value have deep-seated problems that won't be quickly remedied. Retailers J.C. Penney (NYSE: JCP) and Ruby Tuesday (NYSE: RT), for example, are losing money every quarter, which will erode book value until operations turn around. Offshore drilling firm Rowan Cos. (NYSE: RDC) is solidly profitable -- but is in an industry facing a glut of newly built deepwater rigs. So shares lack catalysts.
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If you can look past some of the near-term headwinds in place for these companies, then much better long-term value plays are emerging.
For example, as I noted in my look at stocks recently hitting fresh 52-week lows, Atlas Air Worldwide (Nasdaq: AAWW) is expected to see a drop in 2014 profits due to reduced levels of military troop transport, but management's current initiatives set the stage for renewed profit growth in 2015, especially if global economic trade picks up.
And although regional airline carriers SkyWest (Nasdaq: SKYW) and Republic Airways (Nasdaq: RJET) are both suffering from a winter of many canceled flights and an incipient shortage of certified pilots, they both remain quite profitable, which will enhance book value.
The Unloved Energy Play
Deep value investors should check out Swift Energy (NYSE: SFY), which has historically been saddled with too much debt and too little output from its energy exploration efforts. Yet in recent quarters, as the company has shifted resources toward the productive Eagle Ford Shale, analysts think the company's asset base deserves a fresh look.
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Brian Foote, who follows the sector for Clarkson Capital Markets, thinks Swift's assets are worth $22 a share. That's nearly 80% above current levels and just below tangible book value. The stock is also getting support from founder Terry Swift, who bought 10,000 shares back in November at $14 apiece, soon after third-quarter results were announced.
Will Swift make a similar move when fourth-quarter results are released Feb. 27? Considering shares are now even lower than where they were back in November, it's quite possible.
Risks to Consider: As noted, below book stocks typically lack imminent catalysts so patience is often required.
Action to Take --> When companies are able to get past near-term challenges their shares often rise up, at least to book value, if not higher. In a market that has already rewarded most stocks, these out-of-favor names hold real appeal to contrarian investors.