S&P Price To Book

Investors will often look at the P/E ratio of the S&P 500 in order to gauge how expensive stocks are. Earnings, the denominator of that equation, are quite volatile, however. In a year like this one, where massive write-downs plague income statements, it is difficult to determine the market's true earning power.

Another method to gauge investor sentiment, though not nearly as popular, is the market's price to book ratio. Unlike earnings, book values are not nearly as volatile (unless of course, you are an over-leveraged bank), and therefore they can give us a decent indicator of how the market is valuing company assets. Courtesy of Comstock Partners, here is the price to book value of the S&P 500 over the last 30 years (original version here):

There are a couple of interesting observations to note in the above chart. First, on a price to book basis, during this recession the market did not fall to the depressed levels seen in the late 1970s. Second, the market's price to book value currently appears to be fairly close to its 30-year average (denoted by the horizontal blue line), despite the fact that the outlook for economic growth appears tepid.

Of course, there are a number of factors that make historical comparisons of price to book values difficult. Accounting methods of how book value is calculated have changed over the years, with an increasing trend towards making book value better reflect market value. Furthermore, there has been a shift when it comes to industries in the S&P 500, with manufacturing companies playing a decreasing role while knowledge-based companies (e.g. software, consulting, other services etc.), where hard-assets are not a determining factor, comprise a larger portion of the index.

For the above reasons, long-term comparisons of historical price to book ratios can be problematic. Nevertheless, investors can look at the price to book ratio over recent periods as a decent gauge of investor sentiment. Clearly, price to book ratios fell dramatically from their 2008 highs, but a large rally has resulted in a recovery of a significant portion of those losses. The above chart won't tell you where the price to book ratio will go, but it will tell you that investor sentiment has recovered to a large extent and that downside risks have increased as a result.

FDX vs UPS

Fedex (FDX) and UPS (UPS) have both faced tremendous challenges in the last year. Fedex is under fire for employee/contractor classifications, and both companies have faced soaring fuel prices and a slowing global economy. As such, the market may be punishing these very profitable companies, thereby offering long-term investors the opportunity to buy in at decent prices.

To gauge just how sour the market is on these companies, a look at their historical price to book ratios could be useful. In order to maintain and grow their operations, both companies must invest in transportation equipment, distribution centres, and technology; therefore we might expect the market value of these companies to be somewhat correlated to their book values. At the same time, as these companies increase their global scale, we would expect them to benefit from economies of scale, so we don't want to use P/B values from too far back.

Here's a look at the price to book values of Fedex and UPS over the last decade:


We clearly see the market souring on these firms, especially on Fedex. And as opposed to when we looked at the P/B values of banks and home builders, the book values of these companies are stable and not currently undergoing large write-downs.

Of course, this doesn't make either company a buy. Before buying, one must still look at the financial statements and understand what is being purchased. One interesting note is that UPS appears to trade at a huge premium to Fedex as a multiple of book value...why might that be? We'll explore this issue in a future post...

Price To Book: What Is It Good For?

We discuss the Price to Book values of various stocks quite often on this site, but how useful a metric is it? From a logical standpoint, as a purchaser of a business (which is how we view all our stock purchases), a prudent buyer ensures - barring certain exceptional circumstances - that he does not pay too much more for a company than the value of its assets. In this way, he receives downside protection to a certain extent. Though book value is not a perfect measure of the value of a company's net assets, it does provide at least some level of a proxy for it.

That's all well and good in theory, but what of it in the investment world? Do stocks with low P/B values outperform the market? There have been several studies that suggest that historically, stocks with lower P/B values have in fact outperformed, however, there are certain caveats to keep in mind.

One study that has gained industry credence was carried out by Bauman, Conover, and Miller. The authors used an international sample of stocks and divided them into quartiles based on P/B. They observed over the ten-year period of their study that the quartile of the lowest P/B stocks had mean returns of 18.1%, while those of the highest P/B had mean returns of 12.4%, representing an annual spread of 5.7%.

Based on this data, buying a basket of low P/B stocks may get you outstanding returns, but you may do even better if you can determine which of the low P/B stocks are worth purchasing and which are about to go bankrupt: the standard deviation of the returns for the lowest P/B stocks was 70 as compared to 57 for the highest P/B quartile, suggesting there were some big winners along with some big losers.

This is why looking for companies with low debt and good liquidity among issues trading at discounts to their book values can present great investment opportunities, some of which we discuss here.

Homebuilders Ranked By Discount and By Debt

We saw here that there are home builders trading at huge discounts to their book values. Could some of these offer a chance to buy land at a big discount? It's worth taking a deeper look at some of these issues. If they are leveraged to the hilt, they might not be as attractive as they seem. So here's a second look at this list, but this time including each company's debt to capital ratio:

Clearly, many of these companies are leveraged to the hilt. I don't think it was their original intentions to have so much debt, but recent writedowns have probably forced them into this situation.

Notice Cavco (CVCO) has no debt on its books. A company in this condition is able to weather cyclical downturns fairly easily, and that's one of the reasons we prefer companies with little debt. Notice, however, that it's trading to a 73% premium to book value, so it's not immediately obvious whether its trading at a discount to its intrinsic value.

The companies that look somewhat appealing in this chart are M/I Homes (MHO), followed by Lennar (LEN). They trade at significant discounts to book, with debt to capital in the 30% range. Might be time for a closer look!

XHB: Not A Real-Estate Play

We've seen here that certain home builders are showing large discounts to their book values right now. But some of these companies might actually be in trouble. For those who don't have the time to dig through each individual builder's finances, or for those who prefer a diversification strategy, a home builder ETF exists called XHB that tracks a whole slew of builders.

However, a closer examination of the underlying securities of XHB reveals this ETF not to be exactly what it purports to be.

First of all, it has quite a bit of exposure to retail. Home Depot and Lowe's make up almost 10% of its portfolio! Another problem is that three of the companies in XHB (Standard Pac, MDC, and Ryland) are heavily involved in mortgage financing. So you thought you were making a play on real-estate, but you end up owning mortgages you know nothing about, for another 10% of your portfolio!

Third, this ETF has another 25% of its holdings not in homebuilders, but in home accessories! With companies like Tempur-pedic (mattresses!), Sherwin-Williams (paint!), and other companies involved in furniture, carpets, and interior decorating, beware! I'm not saying that these companies don't have some correlations to the housing market, but by no means are these real-estate plays!

Finally, the builders we looked at which have the largest discounts to their book values (rankings here), do not even appear in XHB. It's possible they're too small for the ETF to hold without affecting their values.

In any case, if you're looking to benefit from the discounts to book values that home builders are trading at, XHB is not for you. Its exposure to retail, mortgage financing and various other sectors (adding up to almost half the portfolio) combined with the fact that even its home builders are not the cheapest ones out there, mean that if you want to take advantage of the discount to book values that are out there, the best strategy is to buy the individual securities yourself!

Homebuilders Ranked By Discount to Book Value

We saw that market values tend to rotate around book values for home builders here. We also saw that markets tend to overreact both to the upside and the downside here, creating buy opportunities. Currently, most home builders are trading well below book value. Could this be a buying opportunity? Here they are, ranked by biggest discount to book:

Why such a spread between the top of the list (discounts in excess of 75% book values) and the bottom (barely any discounts!)? It could be that investors believe there are way more writedowns coming for those at the top. Investors may also have more confidence in certain managements' abilities to navigate through these difficult times.

Upon closer examination, notice the largest builders tend to have the smallest discounts. If we take a look at the discounts relative to the sizes of the companies, we get a chart that looks like this:

Notice how the largest discounts to book value (in excess of 50%) are for companies smaller than $250M. Also note that the largest companies tend to have the smallest discounts. Could it be that managements for the smaller companies are worse, or that they are more risky, or have higher debt levels? It's possible. Another reason could be that the stock market is less efficient for those smaller companies as we've discussed here (hence we see more variation among the discounts for the smaller companies), since they are too small for many institutions to buy.

It's worth taking a closer look at the companies with the largest discounts to book to see if they offer large margins of safety!

Homebuilder Values Overshot to the Downside?

We saw here with Orleans Homebuilding that markets can be fairly adept at figuring out whether book values will increase or decrease, but that they tend to overshoot their marks, offering buy opportunities when they overshoot to the downside. But was Orleans a one-off? Let's look at a few more builders to see if there's a common theme emerging.

Here's a look at Dominion Homes, operating in 3 states in the US:

We do see here once again several occasions where the market predicts the direction of book values before they occur (1994, 1996, 2001,2006). However, we do see occasions where the market is wrong as well, with a big drop in 1998 and 2002. Once again, we also see that on almost each of these occasions, the market overshoots, offering dramatic buy opportunities in 1996, 2000, and possibly today?

The next chart is of California Coastal Communities:

This one is a bit perplexing, with market values taking a huge plunge in the early nineties. Market value continues to underperform book throughout the 2000s (until a bout of irrational exuberance in 2004), suggesting for some reason investors were turned off by this company. I'd be interested to dig into why this was trading at such a sharp discount.

The last chart is of Meritage Homes:

This is a bit more typical from what we saw earlier, with markets correctly predicting directions of book value, while nevertheless overshooting both to the downside and upside, providing opportunities when market values are much less than book values.

Can the Market Predict Land Values?

Although rarely exactly equal, we've seen how market values tend to track the book values of home builders over time here and here. Here's an example of a particularly volatile home builder when it comes to its price to book over time. Orleans Homebuilders (OHB) operates in 14 markets across the US:

But what is causing this volatility? Is the market price bouncing around all over the place, or is the book value constantly changing, or some combination thereof? Here's a look at the price and book values separated out to see how they've moved over the same period:

Clearly, market values are more volatile than book values, suggesting one can take advantage of the situation by buying when market values are low and selling when they're high.

However, we do see the market having some ability to predict the direction of the book value. In the late 80s, we notice market values are lower than book values, correctly predicting that book values are about to fall (which it appears they do for this company throughout the late 80s). Again in the early 2000s we see the market correctly predict book values are about to shoot up, and soon enough, book values shoot up thereafter.

At the same time, despite the market's accuracy in predicting the direction of book values, it overshoots its mark almost every time. Once again, this is clearest in the late 80s where markets are far below book values ever reach (creating a buying opportunity) and again in the early 2000s where markets clearly overshoot the top.

Most recently we've correctly seen markets punish home builders (with OHB being no exception) in advance of the drop in book values. The question is, at what point will it have overshot its mark? By having enough of a margin of safety between the market and book value, you can protect your downside. Here we calculate how well that would work.

Small Homebuilders Are A Bargain vs Book Value

In this post, we saw that home builders' market values track decently well with their book values. But those were the largest of home builders. Here, we look at Price to Book values for the smallest cap builders. All of these companies (Brookfield, Comstock, Meritage, Orleans, California Coastal, and Tousa) have market caps under $500 million, so they may present opportunities that the large builders don't, as we've discussed here in our discussion about why small caps are better investments.

Once again, we see periods of fear as well as exuberance for these stocks. In the early 90s, there is some tremendous opportunity to buy these companies for presumably much less than the land they own! It takes several years, but eventually by the mid to late 90s, those investors got rewarded.

In the first half of this decade, we see clear evidence that the market is extremely optimistic on land values, as investors are willing to pay more than 3 times book value for many of these companies.

Today, we see some possibilities for some great opportunities. Many of these small companies are trading for much less than their book values! Of course, P/B is just a screening tool. One still has to dig into the financial statements of these companies and make sure there is value there to be had. But if this screen is any indication, there may be an opportunity to buy real estate at bargain prices through these companies, presuming there is a margin of safety to cover any write downs!

What's Book Value Worth?

Do people care about price to book value when they buy a stock? For a given stock on Google Finance, you won't find the price to book value shown anywhere on the page. On Yahoo's finance site, you have to scroll down the 12th page of info (titled 'Statistics') to find the P/B. It would seem P/B is not an important measure in investor's minds.

For companies like Microsoft and Accenture, book value won't help you figure out the intrinsic value of the company. Their assets are knowledge based. But are there some companies out there where book value is an appropriate measure for intrinsic value?

Consider land developers. They acquire land for the purpose of development, and for the most part try to sell those developments as soon as they can. I would argue that book value is a pretty decent approximation of the intrinsic value of those companies. Sure, it's not perfect. In some cases, land could have been purchased years ago, and is therefore underestimated at strictly book value. So you still have to dig into the financial statements of the company to figure out what the properties are worth, but as a screening tool, looking for a low P/B ratio can be useful.

Here's the price to book ratio since 1985 for several large US homebuilders (Centex, Hovnanian, Lennar, Toll, DR Horton, Beazer):

A couple of interesting things going on here. We do see some irrational exuberance at times, where companies are trading for 3 or more times book value, but they come crashing back down when times aren't so great. In the 1980s we may be seeing the high inflationary times drive up the appetite for hard assets such as real-estate. In the early 2000s we see the runup in valuations of pretty much every builder.

We can also see times when it looks like these stocks are great bargains. During the 1991 recession, they're all trading below book value, and in many cases with large margins of safety!

Today, we see these stocks trading near the bottom of their P/B range. Could this be a buying opportunity? This chart clearly shows there currently aren't huge expectations built into these stocks. But there could still be more writedowns to come, which would reduce book value. Therefore, you'll want to look for a healthy margin of safety before jumping in.

Also consider that these are the largest, most famous US homebuilders. Smaller builders may have less analyst coverage and so may represent bigger bargains!