A little over one year ago I became fascinated with finding companies trading below book value. It seemed so simple! Go to Google Finance, crank open the balance sheet tab of a company's financials, sneak a peek at the "Total Equity" line, and see how it compared to market cap. It led me to conduct an experiment and make a spreadsheet of companies that were underappreciated by Mr. Market that I thought had a chance of proving him wrong.
The list actually turned out to be pretty successful, but for the wrong reasons. A few companies that I took the time to actually research were easy winners from the start. Some companies turned out to be successful (aka lucky) picks despite limited research. But others became horrendous flops no matter how much research I had conducted. Luckily, I learned a few things along the way.
The easy winners
Hess (HES 0.37%) was one of my favorite companies on the list. Despite it having a growing presence in the Bakken at the time, investors sent shares down after a temporary setback in production. The impact on sales was minimal and the long-term growth opportunity remained intact. By all accounts Hess was a great company caught in traffic. The good news is that rush hour doesn't last forever. Shares were trading at about $45 per share when I wrote the blog post linked to above, but have recovered nicely since.
The second well-researched pick that worked out in the long run was satellite manufacturer GeoEye. After a few balks, the company was acquired by DigitalGlobe (DGI). Similar to Hess, GeoEye was caught in a temporary downturn caused by short-term-minded investors. The company still held the highest-resolution commercial remote-sensing satellite and, despite having a smaller geospatial archive than DigitalGlobe, was 3.6 times more efficient in turning its imagery into revenue. The company was trading at $19 per share 13 months ago, but ended life as an independent company at over $35 per share.
The third well-researched pick was Renewable Energy Group (REGI). The nation's largest biodiesel producer was a recently public company at the time and probably got caught in the punishment unleashed upon industrial biotech companies that failed to live up to their early promises. I just didn't think it was justified for REG. Biodiesel is produced in a relatively simple process. Better yet, the company was growing and poised to continue growing with capacity additions looming. Investors finally caught on after REG notched its first year with $1 billion in sales in 2012, and sent shares 120% higher in 2013.
These easy winners all had several things in common. The market got worked up over temporary issues, fundamentals did not deteriorate, and each business had a solid plan for the future. Unfortunately, being right doesn't force you to rethink your strategy. Suffering some shocking blows -- even in an experiment -- does.
The horrendous flops
I wrote a blog post explaining why Knightsbridge Tankers (NASDAQ: VLCCF) made the right move in slashing its dividend and why its prospects were looking up. The shipping company was extremely undervalued at the time, so why was I wrong? I made the mistake of thinking that a company trading below book value represented good value for shareholders. In reality, many shipping companies were -- and are -- trading below shareholders' equity because their fleets are enormously valuable assets. Unfortunately, that inflates book value enormously. It may not seem so harmful at first, but perpetually low charter rates have actually forced many shippers -- including Knightsbridge -- to sell tankers at less than market value to keep the lights on. Those practices can erase large chunks of book value overnight.
So, how did Hess make it through its rough patch if Knightsbridge is still reeling? The difference is that sometimes entire industries face large fundamental changes -- not just baseless short-term fear. Charter rates were slaughtered after the global financial crisis, remained dismally low thanks to European austerity, and have continued to lag the world's economic recovery today. That is a justifiable reason to be wary of keeping companies at book value, because they are extremely dependent on revenue captured from those rates. Crying about a few less wells being drilled due to slower-than-expected permit approvals is not.
Also making the list of horrendous flops were several solar, semiconductor, and pulp and paper companies. The solar industry faced falling subsidies in Europe, dumping allegations from Chinese manufacturers, and consolidation. Big deals. The semiconductor industry is struggling with falling PC and solar sales and will soon face the end of Moore's Law. Big deals. And the pulp and paper industry's inefficiencies were exposed during the financial crisis, which forced many companies to make difficult restructuring decisions that are just now paying off. Big deals.
The Foolish lesson
The point is that book value isn't created equally. From time to time you can find great companies facing temporary obstacles. Just don't make the mistake of thinking that any one metric can make you a successful investor. Companies in some industries trade well above book value, but that has nothing to do with their ability to return sustainable value to shareholders. As I found out in my experiment, the opposite is also true. Avoid this value investing pitfall at all costs.