Tuesday, November 17, 2009

Market and Book Value Arbitrage

The following is a guest post by Garrett Chan, a private investor who is currently raising capital to start his own firm. He may be contacted by e-mail for those who would like more information or who have questions about the article.

In its purest form, value investing is simply an arbitrage between price and intrinsic value. In other words, we see opportunity when, through careful analysis, we determine there exists a spread between the going price of an asset and its intrinsic value.

Likewise, Melcor has been discussed several times here as an investment based on its large discount to book value. However, it was also noted that real estate assets on its books are recorded at historical cost. Given that Melcor acquired assets as far back as the 70’s, it should come as no surprise that historical cost is a poor proxy for determining intrinsic value. In this case, real estate assets are materially understated and can be uncovered by the enterprising investor.

So how can we determine the market value of these assets if management does not tell us outright? Management is obviously aware of these true values as they state “net realizable value exceeds the carrying cost”. Actually, they do tell us, however indirectly it may be.

Like any other asset, the value of a building is the sum of discounted cash flows received over its lifetime. Therefore, we can roughly value the properties using the income Melcor receives.

Instead of using a full blown discounted cash flow analysis. We can use a popular tool used in the real estate industry called the “capitalization rate”.

Cap rate = Net Operating Income / Market Value

To find market value we can rearrange it to read:

Market Value = Net Operating Income / Cap rate

Melcor’s Investment Properties’ NOI totaled about $20M for 2008.

The average downtown office, suburban office, and retail property had a cap rate of 7% in the fourth quarter of 2008. This holds true in most major Canadian cities. The properties have a lease rate of 96% so these are not subpar assets. Melcor’s investment portfolio should then be worth roughly $286M at current market rates. These properties are valued at $158M on the books so the difference is $128M. This is material as shareholder’s equity is only $310M.
Even though management states net realizable value of land inventory is greater than its cost, we will leave the rest of Melcor’s balance sheet at book value since land inventory does not earn a regular stream of cash flows and cannot be reliably valued like the buildings.

Even so, after we add the “hidden” $128M, Melcor’s new book value becomes $438M. With 30M shares outstanding, this is $14.60; an increase of 41% over the $10.33 historical book value. Consider that the 52 week low of this stock was $3.25…

Also consider that management has grown historical book value at over 12% compounded annually for the last 14 years and was, until recently, a member of the Dividend Aristocrat Index.

Who says value investors can’t get quality companies on the cheap?

Disclosure: Garrett Chan has a long position in shares of MRD

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