Below Book - Part 1: Pull To Average
Down is not out when buying stocks below book value. Value investors have learned not to underestimate the pull to average. (PBL #1 2022)
Businesses or marketable assets trading for less than their equity book values. At any given time, the stock market will offer us such “bargain” prices in some sectors or geographies.
After a long period of strong returns, the start of 2022 has been more turbulent for global stock markets. Around 20% of the stocks in TIKR Terminal's global universe are now trading for a book value discount:
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Now buying “low” on a single valuation metric may seem like a too simple or outdated road to stock profits. Yet, investors in modern times before ours did well doing so, and for some good reasons.
This PiggyBack Letter (PBL) is first in a two-part intro to asset value discounts:
In this Part 1, we focus on statistical, economic, and behavioral aspects. How and why can simple book value discount investing offer return outperformance? And what does this tell us about average investor and company behavior?
Part 2 gets more practical. We will discuss some considerations when screening for asset discount cases to further research.
With this initial focus on conservative value, we are “piggybacking” on the modern value investing tradition as pioneered by Benjamin Graham and David L. Dodd. (Visit The Heilbrunn Center for Graham & Dodd Investing for more background.)
Johan Eklund, CFA
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As easy as P/B < 1?
Deduct the value of liabilities from the value of assets and equity is what remains (the residual). A company's book value of equity, "B", is the latest accounting value of equity we can look up on its balance sheet. And a book value discount is simply when a listed stock price, "P", offers us to buy at a Price-to-Book multiple, P/B, below 1.
In short notation: P/B < 1 or more correctly 0 < P/B < 1 (the left part filters out negative equity firms).
Chart 1 below provides a basic illustration of a 50% book value discount.
Now, despite the simplicity, low P/B stocks have proven to be a positive return factor. We can get such factors by 1) sorting the stock market by rising P/B and 2) cutting it into equal size slices (quantiles).
Without getting all academic, returns are above the market average for the lowest P/B stocks. They are also below average for the highest P/B stocks. Buying the lowest and avoiding the highest P/B slices has been an outperforming strategy. Over a century of data supports this outperformance for U.S. stocks (1). For many other Western stock markets, there are several decades of support (2).
Note that P/B discounts are a special case of such low P/B stocks, in that we set an absolute upper bound of P/B 1. So if the relatively lowest P/B slices of the market drift "too high" in P/B, we will no longer invest in those stocks. In demanding some P/B discount, we make sure to only buy "cheap" stocks (in absolute terms).
Figure 13 of this 2016 article by Starcapital’s Norbert Keimling shows what returns followed after investing at various P/B:s. Large return outperformance (upward sloping dots, left) followed investing at P/B discounts (“cheap” stocks):
The P/B discount local currency returns were 14% per year in real terms for the article's sample. So investors got these real returns plus the consumer price index (CPI) inflation.
This finding was for stock positions held over long, 10-15 year, periods. The data covered Western stock markets over the years 1980 to early 2015.
(Interested readers should read the full article. Besides P/B, it focuses on cyclically-adjusted P/E-ratios, CAPE, a concept we may revisit.)
So in recent decades, a simple book value strategy produced twice the historical 6–7% real returns for U.S. stocks (see e.g. Straehl & Ibbotson (2017)).
Today, we look back at a decade of zero interest rates, rising valuations, and record corporate margins for many Western stock markets. It will not get much better than that for stocks. As fundamentals-aware practitioners, we should expect lower than historical returns going forward. See for example GMO (2022).
Now, for book value discounts and other value strategies the outlook is different. The most important thing to understand is that a margin of safety to fundamentals is its own long-term valuation tailwind. The macro risks to cyclical demand, interest rates, and inflation will vary case by case.
Why do book value discounts work?
“If you buy companies that are depressed because people don’t like them for various reasons, and things turn a little in your favor, you get a good deal of leverage.” — Walter Schloss (Forbes, August 15, 1973)
A former student and employee of Benjamin Graham, Walter Schloss later ran an investment partnership together with his son Edwin Schloss.
The Schlosses managed a diversified (and quite passive) strategy of statistically cheap U.S.-focused stocks. This compounded after-tax returns of almost 16% per year over 45 years for their investors. U.S. Large Cap stocks (the S&P 500 Index) compounded at 11% per year over the same period. Source: 47 Year Results of Walter and Edwin Schloss Associates, obtained via walterschloss.com
In PiggyBack’s recent background post we noted that value investors must make uncertain assumptions about the future. Without assumptions, we cannot value stocks.
In this letter, we have already hinted we can earn “value” factor returns by mere exposure to low backward-looking P/B multiples. Yet, this is not a paradox. We still commit capital to uncertain, long-term valuation assumptions. But we make those assumptions implicitly and smooth them by buying baskets of low P/B stocks.
Why this simple, low P/B “value” strategy works even as time changes is a matter of economics and human behavior.
Profitable is not always economical
To understand the investment economics of stocks, we can look to economic returns:
Shareholders are the owners of equity and profits of businesses. Thus they expect public companies to eventually start earning profits. Profits can be paid out as dividends now or reinvested to grow the equity (and be paid out in the future).
The accounting ratio of net profits over equity is the Return on Equity, ROE.
Shareholders as a group will seek to earn an economic return on their stocks. Economic returns are accounting returns minus a cost of capital. The latter compensates investors for exposing their capital to investment risks.
In the case of equity valuation, the cost of equity is the cost of capital that we compare to the ROE. This cost of equity is an invisible mix of the time value of money (interest) and risk premia. We set it by assumption or studies of the general stock market, and adjust it for business specifics.
So we express economic returns for equity as [ROE - Cost of Equity] spreads.
The pull to average
Now, for readers short on time, let’s ignore a lot of details and just trust us on this one:
Valuation theory justifies higher P/B multiples for higher future economic returns. Higher ROE drives higher P/B:s (cost of capital, reinvestment, and many factors inside the ROE matter as well).
The stock market tends to set higher P/B:s to reward companies with higher recent ROE:s. Recent lower ROE:s tend to get discounted with lower P/B:s. This naive extrapolation gets more extreme when the market gets joyful or gloomy.
The problem? High or low recent company ROE levels are generally not "sticky" trends that continue far out into the future. Quite the opposite, data and competitive reasons support that we should expect more extreme ROE:s to mean revert to more average (mean) levels. We should also expect investors to make more “mistakes” when P/B:s reach more extreme high or low levels. So P/B:s will also mean revert.
Readers who want a quick mean reversion take may glance at Chart 2. It sums it all up with “COMPETITION” as the big, invisible magnet that pulls to average:
ROE mean reversion: Competing for business returns
In theory, free competitive forces drive economic returns toward zero in the long run. We call this perfect competition and normal returns.
From the companies capital allocation perspective, competition for returns will:
Lower high ROE:s towards the cost of equity (from above). This happens when too much company investment chases similar high return potential opportunities. An ever-growing supply of capital may no longer find good enough new projects to earn high returns. Competition for limited demand may lower the return from existing projects. On average, the industry’s ROE falls. If competition is fierce it may compete away the industry’s economic returns to zero (or lower).
Caveat: Some businesses may have competitive advantages that prove both strong and sustainable. Such “moats” can defend a high return on larger pools of capital for longer, but it is an exception to the above rule.
Increase low ROE:s so that they approach the cost of equity (from below). Reinvesting at an ROE below the cost of equity is not long-term sustainable**. Whole sectors may find themselves struggling for profitability. For example, due to overcapacity. The long-term solution is often that the least competitive players get either shut down or bought up. Company-specific issues may require an appropriate turnaround plan. Usually, this involves improved operations and/or financing. Sometimes there are changes to corporate governance as well. In all these restructuring cases it is again competition that is the main driver. Only now, it is a competition for surviving for better times. Eventually, the restructured industry or company could see its ROE rise, as long as demand stabilizes. So the competition will also pull too low ROE:s toward recovery and cost of capital.
Caveat: Full return recovery to the cost of capital is far from certain. There may be structural issues that make an industry a poor allocator of capital. For example, if players receive investment funding, bailouts, or guarantees at non-market terms. Here mean reversion in ROE could be “too little, too late”. We can still pick better than industry stocks at depressed valuations, but the industry economics would stay poor.
** Exception: In some cases, net profits, and thus ROE, do not reflect the underlying earnings. In these cases, we can look at some mix of cash flows, operating profits, and adjustments.
P/B mean reversion: Competing for stock returns
In stock markets, the competitive force is the flowing of global capital to the highest expected risk-adjusted returns. In doing so the stock market sets current stock valuations that look far into the future. (Each trading participant need not be aware of this as long as other participants are willing to profit from their mistakes.)
While this pricing process is somewhat efficient on average, it is messy and more prone to valuation errors in the lower and higher P/B ranges:
The reason why high P/B “glamour” stocks underperform statistically is that they, as a group, tend to get overvalued. The stock market increases P/B:s across stocks related to promising opportunities. Several human biases will make investors tend to exaggerate the potential and downplay the risks of such situations. And it usually gets worse the higher the valuations go. Eventually, more and more investors will realize the stock is overvalued. Overvalued here means trading (very far) above intrinsic value (where the intrinsic value corresponds to some lower P/B range). This implies that this stock's forward-looking risk-adjusted returns are lower than the stock market's. As more sellers seek to get out at lower prices than there are new buyers to support, P/B revalues lower. This continues until investors see the stock's risk-adjusted return as competitive again. Return to sanity if you will.
Caveat: The stock market will often get things right. High P/B:s will often correctly forecast risk-adjusted returns that are at least as good as the stock market. But statistically, the valuation errors will be to the downside. This means that we can improve our returns by just staying out of the highest P/B stocks, which is what many value investors do. (While one can establish an investment edge in the highest valuation stocks this requires some very different mindset and toolsets.)
Low P/B “value” stocks outperform as a group because they tend to get undervalued. Firms get punished hard by the stock market for cyclical industry downturns, temporary execution problems, financing problems, or non-business reasons. Sometimes stock market pricing gets dislocated* for non-fundamental reasons. We find such stocks among the low P/B stocks. Here investors have behavioral biases that tend to err more and more on the pessimistic side the lower the valuation goes. Near-term risks are exaggerated or extrapolated indefinitely. Potential is overlooked or neglected. At some point, investors may get confident that one of these stocks is undervalued. This means that its intrinsic value is in a higher P/B range and that its expected risk-adjusted returns are higher than for the market. As more investors get willing to buy at higher prices than there are sellers left, the P/B rises. Eventually, the P/B may reach intrinsic value (or higher with some price momentum).
Caveat: The stock market will again often get things right. Low P/B:s will often turn out to have been “cheap for a reason” as shareholders are wiped out in bankruptcies or get caught with sub-par returns. This does not invalidate the statistical edge of low P/B investing. But it highlights the need for diversification and for assessing the risk-reward of each such situation.
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* Technical note: Market dislocations
Stock markets experience recurring hiccups and crises (market dislocations). Then low price multiples are not only the resulting consensus of willing parties agreeing in orderly trades. Instead, they may be a function of short-term supply and demand disruptions. In such times we may see:
Unwilling "forced" sellers liquidate assets at almost any price.
Absence of otherwise willing and able buyers. Some investor types may get blocked from buying a troubled asset class. For example, institutions facing new restrictions or changes to regulations.
If a crisis goes on far enough there may even be unwilling holders. For example, if many defaulting or restructuring major debtors give up assets or issue new securities to their creditors. The receivers may have rules or incentives to sell out as soon as the assets or securities become liquid. This may be long before valuations reflect more long-term characteristics again.
This may be obvious to some, but... dislocations can offer great value investing opportunities.
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Johan Eklund, CFA
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