It's been nearly 80 years since economists Benjamin Graham and
David Dodd wrote their investing bible
Security Analysis
. Their book established a framework for value investors like
Warren Buffett and David Dreman to make their fortunes.
Graham and Dodd's whole approach was based on one simple premise:
We have no way of knowing what the future holds and can't easily
predict future income statements, but we do know what assets a
company possesses. And we like stocks that are worth less than the
company's assets. That balance sheet-focused approach, which we now
think of as "stocks selling below
book value
," goes in and out of fashion but has proven its mettle time and
again.
After a strong two-year rally, the Graham and Dodd approach can be
a challenge: most stocks are now worth well more than the
balance sheet
assets. But I've found a handful of companies that are trading for
less than 80% of tangible book value (which means that intangible
assets such as
goodwill
are not included in the analysis). These companies are sitting on
hard assets that if necessary could be sold, and which comprise
more value than the current share price would imply. (I also
focused on companies worth at least $500 million and excluded any
insurers.)
Of course, you need to understand the context of a company's
assets. A company like
USEC (
USU
)
, which supplies uranium to nuclear power plants, values its
uranium assets at more than $1 billion. If the nuclear industry
severely retrenches, then the value of the company's mines and
other assets would be worth a lot less than the stated book value.
Then again, my colleague Nathan Slaughter has made a clear and
compelling case for why investors are short-changing uranium
stocks. [
Read his analysis here
.]
If he's right, then USEC's currently stark valuation will be
noticed by value investors.
In a similar vein,
Hercules Offshore (Nasdaq: HERO)
trades for much less than the acquired value of its assets. Note
the phrase "acquired value." This provider of oil drilling
equipment paid more for drilling rigs than they are currently
worth. If demand for drilling equipment rises, as many expect, then
Hercules' balance sheet will merit greater attention from the value
crowd. Hercules recently acquired roughly $400 million-worth of
rigs from
Seahawk Drilling (Nasdaq: HAWK)
for about $100 million, and when balance sheet figures are updated,
this stock will look even cheaper on a price-to-book (P/B) basis.
Here are a pair of "below book" plays that look too good to pass
up.
iStar Financial (
SFI
)
Since
I recommended
iStar in mid-November 2010,shares have risen 65%. At the time, this
lender toreal estate developers was facing a mountain of its own
loans that were soon coming due. The challenge for iStar was to
re-finance its loans so that it could buy more time until the
real estate
sector rebounds. In November, I predicted that "any fruitful
discussions about loan extensions could push
shares
up 50% toward $8, and a materially strongereconomy could push this
stock to $15 or $20."
Shares are already up to $9, and I still see another strong move
coming, perhaps with 50% or more upside. That's because iStar has
more work to do to clean up the balance sheet, but looks
well-positioned to meet that challenge. Even though iStar has
re-financed more than $2 billion in debt in recent months, another
$600 million comes due later this year. Thanks to an
improvingcommercial real estate market, iStar now has the ability
to sell off some key assets to raise that cash. Thoseasset sales
should come later this year, and coupled with just a bit of better
news out of the
commercial real estate
market, shares could move up to the low- to mid-teens by year's
end.
Aircastle Limited (
AYR
)
With rising oil prices, investors should be concerned that major
airlines will throttle back orders for new planes. [See: "
Why This Well-Known Dow Stock Could Tumble
"] Then again, if oil prices cool and global economic activity
picks up, demand for planes would remain strong. In either
scenario, I prefer Aircastle, a
derivative
play on aircraft demand.
Aircastle buys planes directly from manufacturers and then leases
them to airlines and other customers. Aircastle assumes the risk of
ownership, but theprofit spreads can be immense when times are
good. Judging by Aircastle'scash flow statement, times are quite
good:Free cash flow (
FCF
) has steadily risen from $60 million in 2007 to $343 million in
2010.
So why do I prefer this stock to
Boeing Co. (
BA
)
? Because shares of Boeing trade for nearly 20 times book value
(which admittedly undervalues its intellectual property of how to
build planes) while Aircastle trades well below tangible book
value. Smith Barney estimates strong FCF in coming quarters will
boost Aircastle's tangible book value to $17.80 by the end of 2011.
That happens to be the firm's price target and is more than 40%
higher than the current share price.
But what if the
economy
turns south and demand for aircraft slumps? Then shares of
Aircastle would likely just tread water while shares of Boeing
could tumble. That's why I think a paired-trade approach to these
two stocks (shorting Boeing, and going long on Aircastle) makes
ample sense.
Action to Take -->
If the market heads toward a correction, then it pays to focus on
the balance sheet-centric names. These are what I call "sleep at
night" stocks. You don't need to toss and turn about waking up to
sharply lower stock prices since they already reflect a very dim
view from investors. Either of these two stocks falls into this
category, and along with the other stocks I mentioned earlier,
deserve at least some consideration for your portfolio.
-- David Sterman
P.S. -- According to my colleague, a Russian "nuclear
catastrophe" will hit the United States in 2013… and when it does,
31 million American's will suffer. Amazingly, no lives will be lost
and a handful of energy stocks could rise hundreds of percent. I
know it sounds bizarre, but this bulletin explains what you need to
know…
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.