As the past several years of market turbulence have illustrated, stock prices can definitely swing wildly in the short-term. Even the seemingly strongest companies can suffer serious price declines at times, leaving investors looking with disbelief at the new, drastically reduced value of their holdings.
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While it's true some companies have fared better than others over this most recent challenging period, it is too difficult for the individual investor to identify those particular safe haven stocks beforehand. A more realistic strategy for the individual investor is to limit purchase selections for your portfolio to only those stocks that have limited downside risk potential in the first place. That way, on average, your portfolio will probably be safer than the overall market and will be less likely to suffer serious price declines when difficult times inevitably arrive again.
Finding Safety in Book Value
Ben Graham, who is generally regarded as the father of value investing, preferred constructing portfolios with only those stocks that traded at a low price-to-book value multiple. In fact, Graham would only buy a stock if it traded at a price less than two-thirds of its book value. While some of those low priced stocks would truly be losers, Graham reasoned that, on average, the portfolio as a whole was likely to be undervalued, and thus on average end up a winner. (Learn more on book value, in our article Digging Into Book Value.)
While this strategy worked well for Ben Graham, times have changed significantly since his era, and it is typically not feasible for individual investors to construct an entire portfolio of stocks priced well below book value. There are just too many smart people participating in the market for that many bargains to be left lying around for too long Even so, starting with a shortlist of stocks trading at low book values is a great place to begin searching for undervalued stocks. Here are five stocks that may very well turn out to be book value bargains as envisioned by Graham so many years ago:
|Company||Market Cap||Price/Book Value||Forward P/E|
|DryShips (Nasdaq: DRYS)||$975 M||0.4||3.1|
|BP plc (NYSE: BP)||$91.2 B||0.9||4.2|
|Loews (NYSE: L)||$14.1 B||0.8||8.3|
|Sun Healthcare Group (Nasdaq: SUNH)||$345 M||0.8||7.9|
|SUPERVALU Inc. (NYSE: SVU)||$2.3 B||0.8||5.7|
|Data as of market close, July 5, 2010.|
BP: Bargain or Bust?
Despite the obvious problems BP is currently facing regarding the gulf oil spill, the cost of which has now eclipsed the $3 billion mark, the company will likely survive. Regardless of your opinion of the environmental consequences of the gulf spill and who is ultimately responsible for it, the fact is that the incident has caused BP shares to plunge, falling from the $60 range in April of this year to currently trade around $31.
While BP's problems are no doubt serious, its halved share price begs the question of whether the entire value of the company's future earnings is really going to be half of what it would have been had this incident not occurred. After all, a company with a market cap north of $90 billion should be able to deal with a $3 billion accident without ruining half of its entire business.
And even if so, the company is already trading at a steep discount to its integrated oil and gas peers. For example, Chevron (NYSE: CVX) currently carries a forward P/E of 6.7, while Exxon Mobil (NYSE: XOM) is priced at 8.2. Even with BP's current conundrum, is its forward P/E ratio of only 4.2 really justified when such similar companies are trading at valuations 1.5 to two times higher?
The Bottom Line
Just as Ben Graham reasoned so many years ago, buying companies trading at low price-to-book valuations is not a surefire way to pick winning stocks. Some will definitely turn out to be losers, but on average, an entire portfolio of stocks purchased at low book values will likely do well. In BP's case, the company has a long history of solid operating performance and long-term growth. Assuming the gulf oil spill does not completely ruin the company, investors who buy into the stock at such a low book value may very well end up seeing Ben Graham's reasoning reflected in their portfolio's returns in the years to come. (For more, see 4 Steps To Picking A Stock.)
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