In chapter nine of their 2014 book, "Strategic Value Investing: Practical Techniques of Leading Value Investors," authors Stephen Horan, Robert R. Johnson and Thomas Robinson explored the application of these asset-based models, beginning with book value.
According to the authors, "Asset-based approaches sometimes have the advantage of providing clarity and objectivity in an otherwise ambiguous setting."
Asset-based models come into their own when the net assets of a company (assets minus liabilities) are greater than the market price. Here are some areas where asset value may be relevant:
- Gold mining stocks, because it's hard to predict future cash flows and the fluctuation of commodity prices.
- Oil firms such as Exxon Mobil (NYSE:XOM) can be valued on their proven oil reserves, minus extraction costs, given the vagaries of future oil prices.
- Timber companies like Weyerhauser (NYSE:WY) may not only own the timber on the land they own, but also the land on which the trees stand, including mineral rights. So, there is also a real estate component.
- The financial sector, as discussed below.
This is the most common class of asset-based valuation and comes from the balance sheet. A company's net liabilities are subtracted from its net assets to arrive at book value. Bear in mind that many assets on the balance sheet will be listed at their historical cost minus adjustments (like depreciation), while others will be listed at market value. Book value excludes intangible assets such as brand names or IP, but it may include their acquisition cost.
The usefulness of book value varies from industry to industry; it is more important in the banking industry, for example than in industries that rely on patents, intellectual property and brand names.
Book value per share is calculated by dividing net assets by the number of shares outstanding. For value investors, the goal is to find companies that have relatively high book-value-to-market-value (BV/MV) ratios (like stocks with low price-earnings ratios). The inverse of the book-to-market ratio is the price-to-book-value ratio.
The authors reported, "The evidence that high BV/MV stocks outperform low BV/MV stocks is quite pervasive." They point to a significant body of research to back up this claim, including the work of two leading academics. "Fama and French (1980) found evidence that firms with high book-to-market ratios outperform firms with low book-to-market ratios on a consistent basis. These findings have stood the test of time. Very few relationships are as strong and persistent as this so-called book-to-market effect," they wrote.
Why is there a book-to-market effect? There are several potential reasons:
- The market may undervalue or neglect some companies.
- Future prospects may be unfavorable.
- They company may have poor management.
In addition, academic research has found that investors have a behavioral bias that leads to systematic undervaluation of distressed stocks and overvaluation of growth stocks. When reversion to the mean occurs, distressed stocks enjoy relatively high returns while growth stocks experience relatively low returns.
As noted elsewhere in the book, investors can take a top-down or a bottom-up approach in their analysis. In the case of bottom-up, investors would run a screen based on price-to-book value and use that to find the best candidates (all else being equal). Note, though, that this approach will likely produce a disproportionate number of financial sector stocks.
Top-down investors will begin by considering the prospects for the overall economy and specific industries, then screen a selected industry using the price-book ratio to identify the best candidates. The authors used the example of doing an analysis during a recession and determining there should be a strong economic recovery, with higher levels of consumer-disposable spending. In that scenario, the investor would screen specialty retailers to look for those selling at relatively strong multiples of book-to-market values.
Referring to this approach, the authors wrote:
"The top-down methodology is an example of the aphorism first attributed to John F. Kennedy, 'a rising tide lifts all boats.' The logic is that if the market recognizes that an industry is prospering, then valuations will improve. If an investor can identify securities that are more undervalued in an industry than others, then these valuations should improve more than average."
Asset-based value is another helpful tool for establishing the value of firms; however, it is limited to the extent that it only works well for companies with tangible assets. Most notably, these are the natural resource and financial industries.
It does not work well for companies with significant intangible assets, such as brand names, patents and intellectual property. That rules out many retailers that depend on brand names and tech companies that depend on patents and other types of intellectual property.
For value investors, the key takeaway is that firms with high book-to-market ratios have consistently done better than firms with low book-to-market ratios.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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This article first appeared on GuruFocus.
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