Price-to-Book Near Unprecedented Levels

ING's quantitative team makes a compelling case for stocks on a price-to-book-value basis.  Over 400 stocks in the Russell 3000 have a price-to-book ratio of less than 1.  This reading of over 400 companies is the index's highest number of cheaply priced stocks in over 20 years.

Opportunities Knock
by Pavel Vaynshtok, Senior Quantitative Analyst

In “Mary Poppins” a frustrated Mr. Banks exclaims, “Kindly do not attempt to cloud the issue with the facts, dear!” With so much uncertainty in markets these days investors may feel just like Mr. Banks, burdened by the complexity of the issues and unwilling to consider any more facts. In what follows, I will risk providing more facts in hopes of bringing greater clarity to what may prove to be some of today’s biggest investment opportunities.

Over 13% of Russell 3000 stocks are trading at a price-to-book ratio of under 1. That is, these stocks can be bought at a discount to their underlying value. This apparent opportunity can partly be explained by accounting peculiarities: as many investors recently discovered with financials, book values aren’t always what they seem. Not surprising, then, is that 36% of stocks that fit into this “trading at a discount” category are in the financials sector, with 26% more in consumer discretionary. The number of such cheap stocks is at the highest level in 20 years (Figure 1).

One-Eighth of Russell 3000 Stocks Look Cheap on Price-to-Book

These stocks often have fundamental problems and, in fact, a strategy of buying these securities has done poorly historically. But when the strategy works, the returns are often strong. The last two years have been unprecedented in terms of magnitude of negative returns to this strategy and, if history is any guide, the snapback will be strong and lasting.

There are few controversies about which investors have stronger opinions than about energy. Many claim that the recent performance of energy has as much to do with fundamentals as with the dollar. This is only a part of the story. As Figure 2 shows, correlation between energy futures and the $/euro exchange rate is currently high, but has historically been volatile, and often negative. The same figure indicates that performance of the futures isn’t always positively correlated with performance of energy stocks. For investors looking to benefit from energy volatility, the highest correlation with the futures is in the energy equipment and services industry (+0.4), followed by oil, gas, and consumable fuels (+0.3). The lowest correlation is in insurance (-0.3) followed by airlines (-0.28).

Correlation of Euro and Energy: Volatile And Often Negative

About a year ago, I wrote about the virtues of deep value investing1, noting that since 1985, deep value outperformed in 19 out of 22 years2. As luck would have it, the year that followed has been a tough one for deep value: this style of investing is down 17.8% since July 2007, having underperformed the index by about 1% over the same period.

Time is Ripe for a Rebound in Deep Value Performance

The question that many investors should be asking is when will history repeat itself? When will deep value come back strong, just like it did in January? Judging from the rearview mirror of history and from the positive performance in July and August, deep value’s comeback may already have started. n

1.  “The Deep Value Puzzle,” ING Investment Weekly, July 16 2007
2.  Defined using Morningstar classification, with deep value being the lowest 20% by Morningstar score within the R3000 universe.

EconomicsRichard M. Todd