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

Approaching Book Value

Over the last year, we have discussed many stocks that have appeared to trade at significant discounts to their intrinsic values. But lately, undoubtedly due in part to the market's rally, we find ourselves discussing previously downtrodden stocks that are actually approaching their intrinsic values. The latest example of this is Melcor (MRD), a property developer and property manager in the western part of North America.

This company operates primarily in Alberta, a province rich in oil. When oil prices are high (low), Alberta's economy is strong (weak). While energy prices are volatile, the market's (over)reaction to energy prices appears to be even more volatile, as we saw when we looked at Melcor's price to book over the last several years. At that time, Melcor traded at a 40% discount to its book value. While it's book value hasn't changed, the market value of the stock has almost doubled, bringing it to a level near its book value!

One wouldn't value Microsoft or Intel based on its book value, so why place so much emphasis on book value when it comes to Melcor? While land and property prices do fluctuate to some extent, their book values act as a reasonable proxy to market value, particularly if the land was purchased recently. This valuation metric can be used effectively to value homebuilders, for example.

For Melcor, the value of its assets is probably higher than its stated book value. This is due to the fact that some of Melcor's properties were purchased long ago and their prices have therefore appreciated. This makes it all the more surprising that this company can trade at such a large discount to its book value. Even if property prices in some of its areas were to drop by 20% or more, there is no reason why Melcor should trade at just half of its book value! Yet the market provided such an opportunity just a few months ago, and will likely do so again in the future.

But for now, since Melcor has risen to a level commensurate with its book value, much of the upside potential in the stock is now gone. As such, some investors may choose to sell and deploy the capital to situations where great upside potential still exists.

Disclosure: None

Price and Book Volatility

Last week, we looked at the historical price to book value of Melcor, and noticed that it sells today near historic lows. While this may suggest a buying opportunity to some, many would argue that varying levels of price to book ratios are appropriate based on changing expectations for the value of Melcor's book value. For example, if real estate prices are expected to increase, price to book values should be higher, since the company will experience gains as it sells land for higher than it is booked. Conversely, if prices are expected to contract, writedowns to book value should be expected, and therefore investors should only purchase at a discount to book value.

By separating out the components of P/B, we can get a good idea of whether this is what's driving the dramatic changes in Melcor's P/B (values in $millions):

Clearly, whether times are good or bad, Melcor's book value does not change dramatically. Even through this most recent downturn, which hit Western Canadian real estate prices hard due to their local economic exposure to commodity prices, Melcor's book value retreated only marginally or stayed flat. Through the commodity and real estate price run up from 2004 to 2007, book values did increase more than normal (as gains were realized), but not nearly enough to justify the dramatic price increases which made this stock fiercely overpriced!

Indeed, it would appear that while the market appears able to predict the direction of book values, it overreacts both when book values are rising and when they are not. This theme is not specific to Melcor. As we saw when we looked at several major US homebuilders, during times like these the market will often offer real estate at large discounts which are more than enough to offset any upcoming writedowns.

Determining whether a company or industry is historically cheap by looking at P/B values is not limited to home builders. We have previously seen how the relative valuations of banks can also be judged on this basis.

Disclosure: Author has a long position in MRD

Identifying Cheap

Most (though surprisingly not all!) investors like the idea of buying a stock for less than it is worth. But it's the calculation/determination of what a company is worth that trips most investors up. For some securities, however, determining this value can be relatively easy. For example, if a large proportion of a company's assets have a liquid market (e.g. a mutual fund), the calculation can be asserted with much more certainty.

While real estate is not quite as liquid as most stocks and bonds, it is not far-fetched to say that a company whose assets consist mostly of real estate should trade near its book value.

While some adjustments to book value may need to made to better approximate the current market value of the real estate (e.g. if the land was purchased long ago and has since appreciated), one might expect real estate companies to trade near their book values.

Consider Melcor (MRD), a property development company in Western Canada. A large component of Melcor's balance sheet consists of raw land (purchased over the course of a few years) which it prepares and sells as lots to builders. Another large component of its balance sheet consists of commercial property which it has owned and leased for several years or, in some cases, decades.

The following chart depicts Melcor's price to book ratio over the last two decades:

Melcor is trading, relative to its assets, at levels not seen since the mid-1990s. Readers who are pessimistic regarding the outlook for real estate should note that an investment in Melcor does not require a bullish stance on real estate, since this investment constitutes a purchase of real estate at a discount of approximately 50%! The value of the property does not appear in jeopardy either, as while the pace of sales has slowed down, Melcor is still selling its lots at a gain.

When investor sentiment sours, those who take advantage of the situation by purchasing assets at a discount stand the chance to gain the most over the long term.

Interested in another perspective on MRD, or any other stock that's currently on your mind? One of our sponsors, MarketClub, has offered our readers a free analysis of a stock of their choosing.

Disclosure: Author owns a long position in shares of MRD

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.