Beware: 'bargain' stocks may be toxic

published 7 November 2008

Since Warren Buffett declared that he was buying back into the stockmarket a few weeks ago, pundits have been eagerly providing evidence to back him up. The latest sure-fire 'buy' signal is the 'price to book' value (P/BV) ratio. "Value investors... say the market is now incredibly cheap by historic standards," says Andy Yates of Digitalook.com. He points out that 15 FTSE 100 companies now trade at less than half of their book value, and almost one in three blue-chip stocks trades on a P/BV ratio of below one. So should you snap up these 'bargain' stocks? Sadly, it's not that simple.

The price-to-book ratio

For example, say the current share price is £2.50 and a firm has £200m of 'net assets' (total assets less all short- and long-term liabilities) and has issued 100 million 'ordinary' voting shares. In this case, the 'book value per share' is £2 (£200m/100 million) and the P/BV ratio is 1.25 (£2.50/2). Or you can just take the firm's market capitalisation of £250m (100 million shares x £2.50) and divide by its total net assets of £200m, to get the same result, 1.25. But what does it mean?

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If the P/BV ratio falls below 1 and you buy the shares, it means you are getting a firm's assets for less than they would theoretically be worth if the company were to be liquidated there and then. Take Royal Bank of Scotland (RBS), for example. Recently its P/BV ratio has fallen as low as 0.12. In other words, for every 12p you invest in buying the bank's shares, you are getting £1 of balance-sheet value. Another way of saying the same thing is that the market has priced the firm at just 12% of what it might be worth.

RBS is far from alone. Daniel McAllister points out in the Financial Times that cruise-ship firm Carnival is trading at a P/BV of only 0.21, British Airways can be picked up for 0.45 and retailer Kingfisher for 0.54. And the bargains don't stop at the FTSE 100. As Bloomberg's Michael Tang says, following the 60% decline in Hong Kong's Hang Seng index in the past year, the market's average price to net assets ratio (based on 33 companies) is sitting at just over 1, the lowest level since 1998. "The last time the Hang Seng was as cheap on a price to book basis, the index rallied by 76% over the next year."

Panic-stricken markets do occasionally throw up opportunities to make a fast buck, and fear levels have certainly been way above normal recently. The CBOE Vix 'fear guage' has tripled in a matter of months. But even so, in many of these cases, stocks that look cheap on a P/BV basis are cheap for good reason. Take banks such as RBS. A P/BV of 0.12 looks dirt cheap. But that's because no one knows for sure whether the Government's multi-billion-pound bailout will work, or when. And no one is sure what ABN Amro, bought by RBS at pretty much the peak of the market, is worth. What's more, as we head into a full-blown recession, who knows the true scale of further write-downs linked to exuberant corporate lending? All of this spells further asset write-downs. In other words, you can't trust the 'book'.

Basing investment decisions on a single ratio is tempting, but wrong. Making money from stocks is rarely that easy. As a minimum, do look at P/BV alongside earnings forecasts although these are also pretty unreliable when heading into a monster downturn and above all cash flow. So while, as Yates says, "there are definitely signs buyers are hunting around for bargains again", don't be too quick to join them. The recession has a long way to run, and a harder toll to take on stock prices. Hayes Miller, a portfolio manager at Baring Asset Management, sums it up: "We're waiting to buy... it's just too early."

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.