A Dangerous Opportunity

As an investor who loves a bargain, I salivate when I see a tiny price tag on a stock.

Intuitively, this makes sense. The cheaper a stock's price multiple, the more bad stuff that can occur before your investment becomes a bad one. That's why you frequently hear analysts like me say, "There are certainly problems, but they're priced in already."

But sometimes a stock looks like it has hit rock bottom, only to hit rock bottomer and destroy your investment.

There's an opportunity in the market today that has me considering both scenarios. These stocks are really cheap-looking. But given a historical example, it could be a dangerous opportunity.

The dangerous opportunity
Like a P/E ratio below 10, a price-to-book ratio below 1.0 typically signals market doubt.

Currently, the market has serious doubts about the dry bulk shippers, which transport raw materials such as coal, ore, cement, and grains. Check out the P/B ratios of these major dry bulk shippers.

Company Name

P/B Ratio

Diana Shipping (NYSE: DSX  ) 0.75
Navios Maritime Holdings (NYSE: NM  ) 0.49
DryShips (Nasdaq: DRYS  ) 0.45
Eagle Bulk Shipping (Nasdaq: EGLE  ) 0.23
Genco Shipping & Trading (NYSE: GNK  ) 0.21
Paragon Shipping (NYSE: PRGN  ) 0.21
Excel Maritime Carriers (NYSE: EXM  ) 0.13

Source: Capital IQ, a division of Standard & Poor's.

Wow, four of the shippers trade for less than a quarter of book value. That appears to be a deal even if they had to close up shop and liquidate. But before we get too excited about these seemingly too-good-to-be true P/B ratios, let's look at an industry that looked just as compelling just a few years back.

Below is a list of the largest public homebuilders and their price-to-book ratios on Dec. 31, 2007. Similar to the dry bulk shippers, homebuilders had seen their stock prices fall to seemingly rock-bottom levels. By then, all but one of them had P/B ratios below 1.0. Some significantly below. Let's see how investors who jumped in have done since.

Company Name

P/B Ratio (Dec. 31, 2007)

Total Return Since Dec. 31, 2007

NVR 2.56 35%
MDC Holdings 0.94 (28%)
Toll Brothers 0.89 6%
Ryland Group 0.87 (40%)
DR Horton 0.74 (4%)
KB Home 0.73 (52%)
Lennar 0.56 11%
PulteGroup 0.52 (31%)
Meritage Homes 0.45 55%
Beazer Homes 0.20 (58%)
Standard Pacific 0.17 5%

Sources: Yahoo! Finance and Capital IQ, a division of Standard & Poor's.

Given that the S&P 500 has been pretty much flat after accounting for dividends, the seemingly cheap homebuilder industry has been at best an "eh" proposition. We see two winners, five losers, and four relatively flat stocks.

Also notice that there doesn't seem to be a correlation between lower P/B ratios and better returns. In the most extreme case, NVR was more than twice as expensive as any other homebuilder. Yet it ended up with the second best total returns.

There are two related lessons here:

  1. Low P/B ratios can be deceiving.
  2. Sometimes expensive beats cheap.

Applying these lessons to today
We know what happened with the homebuilders. As the housing bubble continued to burst, the houses the homebuilders held on their books didn't prove as valuable as was believed at the end of 2007. Their P/B ratios were artificially low.

At their highs, American home prices were 1.47 times today's prices. Think of the havoc that price volatility wreaked and then view this statistic on dry bulk shippers.

In 2008, the Baltic Dry Index, a measure of how much the shippers can charge, was 8.87 times today's price!

That's what makes assessing the opportunity in dry bulk shipping so dangerous. Because shipping rates change so violently (due to factors including recent oversupply, oil shocks, and the price of the commodities they ship), predicting the future contract terms (and hence earning power) of a shipper's ships is very difficult. Like the homebuilders before them, the book value of these shippers is only as good as the income their assets can produce.

Furthering the lessons from the homebuilders, the most expensive shipper, Diana, may be cheaper than it looks. While most shippers employ sizable amounts of debt that increase bankruptcy risk, Diana has a net cash position -- i.e., more cash than debt. Diana could well be this group's NVR.

That said, be careful out there. I do believe there is some opportunity in shipping for the intrepid, but these waters are choppy. As you do your due diligence, don't be lulled by the siren song of just one or two too-good-to-be-true numbers.

For some less dangerous opportunities (at least according to our analysts), check out our free report that details five stocks The Motley Fool actually owns. The last stock write-up is mine. Click here to access it now. It's free!

Anand Chokkavelu doesn't own shares of any company mentioned and is mostly a landlubber. Motley Fool newsletter services have recommended buying shares of MDC Holdings and Meritage Homes. Motley Fool newsletter services have recommended shorting Standard Pacific. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (41)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 20, 2011, at 5:55 PM, xetn wrote:

    I don't know the current position, but about mid-2009, there were hundreds of cargo ships (of every strip) anchored and mothballed off of Singapore. There was just not enough traffic for them. Plus, countries like China were building huge ships at a record rated, which was adding to the already oversupply of ships.

    I just took a peek at Singapore with Google Earth and there are a lot of ships still there but I cannot determine if they are mothballed of just at anchor.

  • Report this Comment On July 20, 2011, at 6:30 PM, Howard1ii wrote:

    This is totally off the topic of shipping companies and "dangerous opportunities." What's your take on a Utility ETF like XLU? It offers a distribution of ~4.0% with a 0.2% expense ratio. The top 10 holdings includes most of the utilities on the Income Investor recommendations list. Seems like a pretty low risk way to get 4%, so I am assuming I am missing something.

  • Report this Comment On July 20, 2011, at 7:00 PM, 11x wrote:

    When looking at price/book ratio, one must also consider what kind of profits one could generate off that book value. For example, a capital intensive manufacturing company like GM or Ford will have a lower price/book than a software company like Microsoft where "their assets go home at 5 every day" that doesn't really need capital or capital equipment to generate profits.

  • Report this Comment On July 21, 2011, at 1:29 AM, crca99 wrote:

    thx, I learned something. P/E <10, P/B<1 signal doubt. I didn't know that. Also helpful to see housing comparison. I stopped watching teekay shipping long ago out of fear it looked too good and must have hidden risks, you too it seems.

  • Report this Comment On July 21, 2011, at 3:32 AM, Shawnerz wrote:

    "But sometimes a stock looks like it has hit rock bottom, only to hit rock bottomer..."

    That's funny right thar- I don care who you are!!

    :-0

  • Report this Comment On July 21, 2011, at 5:46 AM, karlinacudahy wrote:

    Encouraging and sensible article. That's a great way to approach an overwhelming situation.

  • Report this Comment On July 21, 2011, at 10:30 AM, imacg5 wrote:

    The book values listed on these dry bulk companies is based on the cost of the ships, minus accumulated depreciation.

    And since most of the ships were bought at the peak of the ship demand, those prices were over inflated.

    The real values of their ships based on resale value is much lower.

    The glut of ships, with more on the way, will ensure that the values and the charter rates will remain depressed.

  • Report this Comment On July 21, 2011, at 3:49 PM, louis564 wrote:

    The shippers have been in free fall and I don't

    see any signs of recovery given the problems

    that we have in Europe and the new problems

    in China.

  • Report this Comment On July 22, 2011, at 4:50 PM, aaanglemyer wrote:

    Price-to-Book is helpful but I prefer to use is Price-to-Economic Book Value. Economic Book Value is calculated as follows:

    NOPAT / WACC + Excess Cash + Discontinued Operations + Unconsolidated Subsidiaries - preferred stock - minority interest - ESO liability - debt - - under funded pensions

    Economic Book Value provides a truer picture of the pre-strategy value of the company.

    EXM's Price-to-EBV of .1 implies that the market expects EXM's cash flows to decrease by 90%. This seems like a drastic drop. You should only buy a stock if your expectations greatly differ from the expectations of the market and the market's exceptions for EXM are incredibly bearish. In fact, of the 2,209 R3k companies with positive Economic Book Values, only 9 companies have a Price-to-EBV lower than EXM. If you believe, like I do that EXM's cash flows will not decrease by 90%, then EXM is a strong buy opportunity.

    Check out the following link for more information on identifying strong buy opportunities: http://blog.newconstructs.com/2010/05/19/how-to-make-money-p...

  • Report this Comment On July 22, 2011, at 10:47 PM, underdone wrote:

    An interesting point about the Dry Bulk sector.

    Many analysts have been talking about oversupply of vessels but I checked out 4 stocks. Dry Ships did not have vessel utilisation rates but of the 3 that did capesize vessels (the area where there were supposedly excess orders for newbuilds) showed utilisation rates of 100%, 100%, and 99% with the long term avarage utilisation rate roughly equivalent to the plant utilisation rate of slighly more than 90%.

    Where is this oversupply of vessels that were supposedly built in 2010 and 2011? No one seems to own them.

    It seems that the excess orders were either cancelled or justified (perhaps because of subsequent scappings)

    So all I can say is that it seems odd that the dry bulk freight rates continue to remain abnormally low. But then who knows when they will reflect market reality and untill then Dry bulk shippers are risky.

  • Report this Comment On July 27, 2011, at 6:37 PM, DevilzAdvoqate10 wrote:

    SHIPS, SHOES & SEA£ING-WAX. Things aren't always how they seem. Remember what happened to Onassis in the '40s. The war had not only killed millions of people, but stifled trade - you couldn't GIVE ships away. But Aristotle did a fag-pakket kalkulation & realized, even if trade returned to pre-war levels, there weren't ENOUGH ships. Moreover, because of the war, people traveled & bought abroad more, so they'd need even MORE ships than before. Maybe he could afford to take the risk, but sometimes "facts" are only "lies, damned lies & statistiks"! Caroline 319 (England).

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