Looking for Value Stocks in 2014? Look Behind the Numbers

The stock market has come roaring back over the past few years. Not only was the S&P 500 up 32% last year, but it's up an astounding 51% since 2011. If you go back to the bottom of the recession in early March 2009, this is what you get:

^SPXTR Chart

^SPXTR data by YCharts.

For anyone who's been sitting on the sidelines, waiting for the "correction" that will certainly come eventually, this has been a painful lesson in how impossible it is to time Mr. Market. For value-oriented investors, it may seem hard to find "cheap" stocks. But don't give up hope.

There are values to be found out there -- and there are also stocks that could well be value traps. Let's take a look at American International Group  (NYSE: AIG  ) , Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , and Annaly Capital Management  (NYSE: NLY  ) and see what we can learn.

Metrics that matter: The valuation and the story
Oftentimes, metrics like price to book value, or P/B, are used to find value in companies that are trading for less than either their typical valuation or that of peers. However, it's easy to get lost in the numbers and forget that these are real companies we're talking about. We must apply the context of the real world to any attempts at determining value.

P/B is commonly used to value financial companies like banks and insurance companies. Warren Buffett refers to P/B as a reasonable way to measure Berkshire Hathaway, and he sees a price of 1.2 times book value as compelling enough to buy back shares of the company. A recent share price of around $115 for the "B"-class shares pegs the company at about 1.29 times book value today.

While that's a bit too rich to compel Buffett to buy back shares, 1.29 time book value looks reasonable for individual investors:

BRK.B Price to Book Value Chart

BRK.B Price to Book Value data by YCharts.

While Berkshire shares currently trade around their June 2013 level, the P/B value has fallen by about 5% as Berkshire's net worth has grown based on acquisitions and investments. For a company like Berkshire, which has a solid base of both wholly owned companies and nearly $100 billion in shares of other public companies, that means more capacity to grow earnings over time, further compounding book value higher.

Back from the dead
Another company whose P/B ratio makes it look super cheap is AIG. AIG, of course, is still associated with the financial crisis, as its large bucket of credit default swaps wiped out about 90% of shareholder value when the company was essentially bankrupted and took a massive infusion from the Federal Reserve. To make a long story short, today's AIG, under the leadership of CEO Robert Benmosche, is a leaner and meaner company than the one the Fed rescued.

Today's AIG sports a P/B of 0.78, which is incredibly attractive when one looks at the long-term P/B ratio AIG has commanded:

AIG Price to Book Value Chart

AIG Price to Book Value data by YCharts.

AIG's P/B ratio has consistently stayed near 0.8 or below since 2010, so it's tough to know when -- or whether -- it will break out of this slump that makes it look more than 25% undervalued. Whether or not the market ever restores it to a P/B of one or more, today's AIG is a solid company that is doing a lot of good things for shareholders, like remaining disciplined in its core businesses and continuing to sell off noncore assets, beginning to buy shares back, and even reinstituting its dividend, though at a small level for now.

Higher interest rates bad for mortgage REITs?
Annaly Capital Management is one of the best-run mREITS, returning more than 441% to shareholders -- largely through its strong dividends -- since its founding. It has also carried a median P/B ratio of about 1.4 for most of that time, according to Fool analyst David Hanson. However, that doesn't mean today's multiple of 0.8 times book value makes Annaly Capital Management a steal.

What has changed? In a word, rates:

NLY Price to Book Value Chart

NLY Price to Book Value data by YCharts.

As the table shows, the company has lived in essentially one long period of declining mortage rates, meaning a steady line of customers looking to refinance to get a lower payment. However, that has changed, with the Fed beginning its "tapering" plan, which will lead rates to steadily increase for the foreseeable future.

How big will the impact of rate increases be? The Mortgage Bankers Association is forecasting refinance mortgages to drop a whopping 60% from 2013 to 2014.

Cheap versus value
It's just as important to consider the environment companies operate in as it is to look at the numbers. For AIG and Berkshire, both look to be fairly valued and well-positioned, while Annaly could be a value trap based on the mortgage environment going forward. The key lesson is to look beyond the numbers, whether you're looking for value stocks in 2014 or in any other year. 

What do you think? Share in the comments below.

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