I'll admit it has been extremely difficult for me to look for stocks in the real estate and banking sectors over the last couple of years. I also have to admit that I have missed quite a party in the REIT space especially, as a diverse range of operators such as Simon Property Group
That doesn't mean one can't look for value in the sector and even find some candidates for the portfolio, even after the huge market rally we have seen since September. However, finding discounted companies in this environment involves more than just using traditional valuation methods. In situations like this, I turn to market legend Benjamin Graham to see if there is something that piques my interest in the land of real estate.
Searching for cushion
We often hear commentators talk about book value or tangible book value when researching stocks. Generally, the closer a stock is trading to book value, the cheaper it is, and if it's below book value, the stock is even cheaper. However, usually there is a reason the stocks trade at these values. For example, I recently wrote about how many financial stocks are currently trading below tangible book value. Even large bellwethers such as Citigroup
Benjamin Graham's deep value search
In situations like these, I look for quality companies that fit value investing legend Graham's net current asset value model. Whereas book value measures total assets minus liabilities, NCAV is a bit more complex. Graham's value screen only includes current assets such as cash, inventory, and accounts receivable, then subtracts all liabilities.
Basically, the idea is to look for companies that trade near or below a conservatively calculated liquidation level if the company were to go out of business or liquidate. Graham liked to buy stocks that trade at near two-thirds or less of their NCAVs.
When using this metric for companies heavily leveraged to real estate, I prefer companies with large cash cushions because of the difficulty in valuing the real estate.
In my research, the point is not to find the stocks that trade at the largest discount to NCAV, because you'll mostly find penny stocks and other microcaps that I can't discuss in this space. Instead, I suggest looking for companies that come close to meeting these requirements and provide a nice cushion in the event of worst-case-scenarios.
A Graham pick
Naturally, Avatar Holdings
More specifically, Avatar develops adult communities in Florida and Arizona and manages the facilities, which include recreational developments such as golf courses. The overdeveloped retirement areas have been hit hard by the recession, but there is still only so much land in warm areas of the country where older families can move to as they age. While real estate values remain depressed, I would have to believe that they won't remain depressed forever, especially as I start looking for my beachfront property about 50 years from now.
Despite the downturn, the company has maintained a relatively strong balance sheet. Avatar has a market capitalization of about $222 million, with $160 million in cash and about $64 million in debt. So if you were to buy the entire company right now, you would get back more than 40% of what you paid right back in net cash. Pretty awesome deal, and that doesn't even include the unlimited tee times at your new golf courses.
Avatar shares traded at 19.44 as of Friday's close, which means the company trades at about 60% of its NCAV of 32.41, and at a price to book of 0.52. So Graham would approve, according to the NCAV calculation.
Does this mean you should run and buy this stock immediately? No, but it shows that if you do there is a large margin of safety in Avatar's hefty cash balance, even if we can't truly value the worth of the company's real estate. Don't take my word for it, take Benjamin Graham's.
Graham’s disciple, Warren Buffett, is buying up a health-care company. Click here for a three-page free report detailing the company.
Andrew Bond owns no shares in the companies listed. 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.