Investing by the book

Investors love profits — the bigger the better. But when evaluating potential stock buys, it’s important to consider more than just how much a company earns. You should also take a gander at what it owns. You can often spot valuable opportunities when you find solid assets selling for low prices.

One way I like to look for bargains is by examining a company’s book value. This is the historical value of all its assets minus its liabilities. The price-to-book-value ratio (P/B) that you see quoted on many financial websites compares this book value to the current price of the company’s shares. If you buy stocks with low P/Bs, you’re buying assets at a bargain price.

Investors who do so often enjoy good returns. In August 2004, I highlighted seven low-P/B darlings. Since then, three have been taken over by bigger firms, demonstrating just how attractive low P/B firms can be. (Another firm on my list, Sears Canada, is the target of a takeover struggle still in progress.) The three companies that were taken over generated an average 51% capital gain for investors.

Even without takeovers, low P/B firms often do well. In fact, my entire list of seven low P/B stocks gained an average 73% from Aug. 14, 2004 through to Jan. 1, 2007, beating the S&P/TSX Composite by about 15 percentage points.

Encouraged by these stellar results, I decided to go hunting again. Just like last time, I started with the large companies in the S&P/TSX Composite. I selected the stocks with the lowest P/B ratios, looking in particular for companies trading below book value. By the standards of today’s market, these are very cheap firms.

But I didn’t want to focus only on P/B ratios, since a low ratio may signal a firm is in lousy shape. I wanted to invest in profitable businesses. Hence, I subjected each of my low-P/B firms to a further test by examining their earnings yield — how much they earn per share, compared to their share price. Since core inflation is running at roughly 2.3% a year, I wanted stocks that could at least keep up with inflation, meaning an earnings yield of more than 2.3%. I further required that my stocks pay a dividend. After all, I like to be paid while waiting for better times.

In 2004 seven stocks that traded below book value passed all my tests, but only two managed the feat this year. So I decided to also include three other stocks with slightly higher P/B ratios. Here are this year’s low-P/B darlings.

West Fraser Timber (WFT) is our least expensive candidate. It trades at only 91% of book value. The company labors in the depressed forest products industry, but it has churned out a string of annual profits. Its stock trades at a price-to-earnings ratio (P/E) of 16 and pays a dividend yield of 1.4%.

Laurentian Bank (LB) is the sole survivor from my 2004 list. This Quebec-based bank is only slightly more expensive than last time at 97% of book value. It pays a hefty 3.8% dividend yield. For what it’s worth, I own a handful of Laurentian Bank shares.

Linamar (LNR) is the first of two auto-parts firms to make it into this year’s list. With GM and Ford on the ropes, autoparts companies have been put through the wringer. Linamar is a case in point, trading at only 124% of its book value. Earnings have been erratic over the last 10 years, but the company has maintained profitability and grown its book value. The company trades at a P/E of only 10 and pays a 1.7% dividend yield.

Magna International (MG.A) is perhaps best known as Frank Stronach’s firm. Stronach founded the auto-parts maker and maintains control through multiple voting shares. Not coincidentally, he also has a generous compensation package. Nonetheless, Stronach’s firm has been successful over the years. Magna trades at 127% of book value and at a P/E ratio of 15. It pays a 1.9% dividend yield.

Kingsway Financial Services (KFS) is the most expensive of our bargains, but this auto insurer remains relatively cheap at 135% of book value. Both its growth and value characteristics have earned it top marks for two years running in MoneySense’s Top 200 list. The stock trades for only 8.4 times earnings and pays a dividend yield of 1.2%.

I suggest that you explore the low price-to-book bargain basement only if you’re adventurous. Sometimes low price-to-book stocks spiral downward. Still, there is lots of opportunity here if you’re prepared to endure the downturns.