If investing is about anything, it's about valuation. Though the term connotes math geeks and spreadsheets to many, the idea is simple: Determine a "sticky" price -- a valuation -- that you believe a stock will eventually gravitate toward, and if that estimate is significantly greater than the current stock price, buy that stock. Describing some valuation methodologies as complicated would be an understatement, but valuation doesn't have to be complicated to be effective. One of the simplest methods is one of the best, in my opinion.
A company's book value is the accounting value of the firm -- its assets minus its liabilities. This value approximates what the shareholders would theoretically receive in the event of a corporate liquidation. When a company trades below its book value, the market is, in a sense, implying that the company is worth more dead than alive. For a poorly managed company at risk of going out of business, book value may be a fair -- or even generous -- price to pay. On the other hand, if a company is profitable and trading at or below that level, it may represent a potential value for investors.
Just because it's trading below the firm's book value is no guarantee that a company's stock will rise. Companies trading under book value are often beaten down for good cause. But proponents of low price-to-book stocks believe that, on the whole, stocks trading below book value have felt more than their fair share of the market's wrath -- and that the market won't go on punishing them forever.
The cheap price of Life
In December 2003, I was searching for value investments. Some of the companies that I considered were mortgage giants Fannie Mae
But another company caught my eye: Presidential Life
Looking at Presidential Life, I noted that it had returned to profitability, it had a decent and well-covered dividend, it maintained its dividend even while losing money, and it was trading for below its potential liquidation value. The value investor in me saw an offer I couldn't refuse, so I purchased a small stake in the company. Including commissions, I paid $14.15 per share on Dec. 29, 2003, a price I thought represented a great value for the firm. If its price merely rose to the company's book value over the next year, I would receive a 15.7% capital gain along with a 2.8% yield, or an 18.5% pre-tax total return.
The market, of course, had a different short-term idea. In March 2004, the company traded as low as $12.29 per share, more than 13% below my purchase price. My value investment had turned into one of the worst performers in my portfolio. Upon reevaluating the company, I decided that its subsequent price drop had no basis in the fundamentals of the company and that its lower price made it a better value. My value focus helped me avoid panic selling and gave me the fortitude to hold on through this rough patch.
I remained convinced that the company was value-priced and that there was no reason for it to be trading below its book value. At the time the company reached its lowest, its book value had risen to $16.66 per share, and the company had reported a profitable close to 2003. If I thought it was a value at $14.05 per share with a book value of $16.38 per share, then at $12.29 per share with a book value of $16.66 per share, it looked like a downright steal. Rather than sell to protect what remained of my capital, I slept soundly at night maintaining my position, knowing that eventually the market would realize its irrational mistake and bid the company back up to a more rational level.
And in Presidential Life's case, patience was a virtue. As of this writing, it has rebounded to a more rational $17.70 per share. That represents a gain of 44% from its March lows and a gain of 25% from my purchase price last December. The dividend has been paid quarterly and remains $0.10 per share per quarter. In contrast, from the date I purchased Presidential Life until now, the S&P 500, as measured by the Spider
New dumpsters to dive into
While its rebound means that Presidential Life no longer looks like the dirt-cheap value stock it was in December, I'm confident that the market will present other candidates for value investors.
Looking to unearth some value stocks of your own? Take a free trial of our newest newsletter -- Motley Fool Inside Value -- and let us help with the digging.