Wednesday, July 9, 2008

Melcor's Price Drop and What It Means

Melcor (TSE: MRD), a land developer in Alberta, has enjoyed enormous gains over the past few years, but the shares have fallen of late. Alberta's hot economy had caused a tightness of supply in the real estate market, but recently the market has cooled off from its highs, and share prices of Melcor have plummeted, falling from highs of $29 to their current price of $13.25.

Is there something wrong with Melcor? Absolutely not. It's a well run company with valuable assets. The price drop is simply a result of the unjustified price run-up that preceded it! We saw here that home builders tend to track their book values over time. Here's a look at Melcor's price to book value over last several years:
We clearly see evidence that investors were not very discriminating throughout 2006 and 2007, as they were willing to pay several multiples of book value for this company. The stock price has since cooled to a more reasonable level of 1.5 times book.

However, investors who bought at the peak, and the analysts who pumped it, are feeling the pinch. Recently, Desjardins analyst Jeff Roberts re-iterated his buy rating, and a Globe and Mail article recently pumped this stock, suggesting the book value of Melcor understates the actual value of the real estate under ownership (since book value has land assets listed at cost, while those properties have increased in value over the last few years). Roberts believes the real estate market in Alberta is poised for continued growth.

While this may be true, nobody really knows. However, we do know that throughout the 90s and early 2000s, you could buy this company (and thus the land they owned) at great discounts to book value, as seen from the chart above, offering a tremendous margin of safety. There were, however, no analysts pumping this stock at that time. When a market is hot (such as it is in Alberta), there will be analyst coverage galore, and buyers willing to pay any price for a stock.

This is why value investors prefer industries that the market has discarded. As Alberta's real estate market was ignored in the 90s, a prudent buyer of Melcor at that time would have cashed in with incredible profits. Today, a value investor would seek out industries and companies that are out of favour and with low analyst coverage, in order to find the next generation of companies trading with large margins of safety to their intrinsic values, rather than follow the herd.

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