STREET DOGS

Research suggests that relying on the price/book ratio as a filter for cheap stocks is a mistake. Book value is a measure of a company’s assets, less its liabilities. In theory, if you can buy a company for less than the value of its net assets (a p/b ratio of less than one), you’re potentially snapping up a bargain. If a company is trading for much more than its book value, you might be overpaying.

However, a new paper from Travis Fairchild at O’Shaughnessy Asset Management reveals that from 1993 to 2017 firms with negative book value (liabilities greater than assets) and firms that looked expensive on a p/b basis but cheap on other measures tended to beat the wider market.

So what’s going on? Two key things, says Fairchild. First, valuable intangible assets — such as a firm’s brand or investment in research & development — are often understated on the balance sheet. Second, long-term assets such as property are often on the balance sheet at below market value due to a firms’s depreciation policies. Buybacks and rising dividend payouts may exaggerate this issue by taking cash from the balance sheet, shrinking a firm’s understated book value. You can miss out on otherwise attractive companies because the value of their assets is understated.

What are the lessons for investors? First, never rely on a single valuation metric. You need to consider cash flow, profitability, and the sustainability of the business model, among other things. Second, be aware that in investing there are few constants. What worked well in one era or against one economic backdrop may not continue to work. Always double-check and test your assumptions, and don’t get attached to one methodology.

Adapted from an article by John Stepek at MoneyWeek

Michel Pireu (pireum@streetdogs.co.za)