The Proper Use of Price/Book
Maybe 25%-33% of the time price/book is a completely worthless valuation method. Many companies have intellectual property that cannot be measured by book value. Many other companies have bought back so much stock, price/book becomes meaningless.
The other 67%-75% of the time price/book is the best one number too measure Wall Street’s interest in a company. Wall Street loves companies with high ROE’s and hates those with low ROE’s. Companies with high ROE’s usually sell at high multiple of book value. This is despite the fact that economists have consistently proven that most companies with high ROE’s have that measure revert to slightly above the mean over 10-15 years. Companies with below average ROE’s typically have that measure almost get back to average over 10-15 years.
I used to call this the most important graph in all of finance. Someday I will learn to insert graphs in Substack, but not today.
In the 1960’s to 1980’s academics believed stocks with low PE’s were the group with the highest returns. I never really trusted these studies, it was always interesting in the Basu study that stocks with negative PE ratios had the highest returns. I can remember exactly where I was standing in Charlottesville, Virginia when an academic handed me the Fama-French research paper. F&F’s groundbreaking work proved low price/book was the important factor correlated with excess returns.
F&F thought price/book was some kind of risk measure. Of course, it was. Price/book measures the risk of looking stupid. Portfolio managers love to own high price/book stocks because they have high profitability and plenty off Wall Street buy recommendations. Very few managers are willing to own the dirty, ugly stocks that have low price book ratios, and very few friends on Wall Street.
High price/book stocks have the “cheery consensus” that Buffett warned against. Low price/book stocks are only owned by those with great job security, and a willingness to stand against the crowd.
It is always wrong to say a stock is cheap because it has a low price/book. You must always confirm that by using other valuation measures.
It is usually right to say that any company that sells at a low price/book will be unpopular with Wall Street and most professional investors.
I use price/book as a screening tool to quickly get me to the stocks Wall Street hates the most. I usually set my screen to about 1.5x and get a list of about 300 non-financial stocks (remember F&F did not include financials in their data), and then narrow this list to a manageable group. I seldom choose those stocks with the very lowest price/books, these are often truly troubled companies.
Here are my top 20 names when I did my price/book screen:
Lumen - LMN - I will eventually have to look at this Mason Hawkins name. I am glad I waited from the dividend elimination.
Kelly Services - KELYA - This been on this list for a long time.
Goodyear - GT - Auto parts may get too cheap to ignore
Valhi - Titanium dioxide company created by great value investor Harold Simmons
Kohl’s - Herb Kohl sacked my parent groceries in the 1960’s. I know this company very well.
Xerox - XRX - a new idea, not a copier story anymore
Westrock - WRK - Corrugated box maker
Madison Square Garden - MSGE - straight forward asset value story except for Dolan, very tricky
Netgear - NTGR - a Victory-Sycamore idea, makes home internet gadgets
Scansource - SCSC - another Victory-Sycamore idea, tech distributor
Universal Corp. - UVV - supplier to the tobacco industry
Avanos - unusual little healthcare company
B&G Food - BGS - interesting second tier food maker, probably need the dividend to be eliminated
Gates Industrial - a great idea I have already worked on
Thor - too cheap to ignore
Heidrick & Struggles - a high end executive recruiter
Delek - DK - small, but interesting, refiner
MKS Instruments - MKSI - a high tech test equipment company
Treehouse Foods - THS - most likely too much leverage
Wolverine World Wide - WWW - we will still need shoes in a recession
These are 20 solid ideas that I will need to investigate in the future.
I use low price/book to find some ideas, but often more than 50% -75% of my ideas do not fit the low price/book category.
There is only one manager in America that use low price/book exclusively, a small NY manager call Don Smith & Co..