One thing more than any other makes searching for value difficult these days: Loans.
The best way to search for discounted companies is to set up a screen that looks at net asset value -- assets minus liabilities. (To see how profitable value stocks can be, scroll down to the third table on this page: 12 value stocks, 12 winners, average gain of +88%!)
If the market capitalization of a company is less than the net asset value (or "shareholder equity"), then an investor may have found a bargain, as most companies trade at a multiple to rather than a fraction of book value.
But loans, believe it or not, totally screw that up. Consider: I ran a screen seeking U.S. companies with a market cap of more than $1 billion and a price-to-book ratio of less than 0.75. This returned about 40 companies, half of them financial institutions. And each one of them was on the list because of loans.
A loan, at least on the balance sheet, is carried at its historical cost. If you use $1 billion to make $1 billion worth of loans, then your books are going to show $1 billion worth of assets, less whatever amount has been paid back.
The trouble with that, especially these days, is that any given billion dollars' worth of loans likely isn't worth a billion dollars because of an increase in the default rate.
Some loans, of course, are going to go bad even in the best of times. That's never a good thing, but it's to be expected and it is rightly treated as a cost of doing business.
Today, however, default rates are much higher. They are so much higher, in fact, that they're far more than a mere cost of doing business -- something to be subtracted from the asset's overall return -- and have become a factor that means the value of the asset must be adjusted.
So even though a bank may have $100 billion in assets, the market is going to adjust the value of those assets based on the actual value of the loans rather than their historical cost. And, voila, you get a whole bunch of banks with "cheap" assets showing up on value screens. But the assets aren't classically cheap: You're not getting a deal if you buy these banks, you're getting what looks like a deal because of the disparity between the historical cost and the actual value of the assets.
So the trick -- or one trick anyway -- is just to throw out the banks and look at the other companies in the screen. And there are some interesting choices:
Wireless Telecom
Three wireless companies made the list: Sprint Nextel Corp. (NYSE: S), United States Cellular Corp. (NYSE: USM) and Leap Wireless International, Inc. (Nasdaq: LEAP).
Sprint Nextel hasn't made money for the past five quarters and is poised to deliver a net loss for 2010 as well. Unites States Cellular actually turns a profit, but it's already trading at well above what I would consider a fair valuation given its 2010 earnings outlook, which means it offers only downside. And Leap Wireless, which sells the popular prepaid Cricket cell phone service, posted a profit in only two years of the millennium's first decade and likely will lose even more this year.
Value Verdict: These stocks are cheap for a reason -- no one wants to own them. The companies aren't making any money and have bleak futures as far as the bottom line is concerned. Investors should look elsewhere.
The Coal-Fired Utilities
Two of the companies on the list are electric utilities over which hangs a cloud of uncertainty because of the cap and trade bill, which could restrict their operations or render them unprofitable. One of the companies is RRI Energy, Inc. (NYSE: RRI). It has had such deep-seated profitability problems -- multi-hundred-million-dollar losses in three of the past four years as well as the first three quarters of 2009 -- that it can't be considered.
The other, however, Mirant Corp. (NYSE: MIR), bears looking into. The company, which sells power to power companies rather than to individual customers, is profitable. Very profitable, in fact: Its operating margins are near 30%. Despite this, Mirant is trading at only five times its trailing 12-month earnings, a substantial discount to its typical valuation of about 7.5 times earnings.
This is for two reasons: The first is legislative risk. If Congress imposes strict emissions controls on power producers, Mirant's margins could be squeezed to almost nothing. Second, the overall earnings outlook for 2010 is for less than half the profit Mirant turned in for all of 2009.
Investors willing to look beyond the upcoming year and who foresee Mirant engineering its environmental footprint so as to comply and thrive despite emissions regulation likely see a lot of value in these shares. The United States will always need power and utilities will always need to purchase juice beyond their production capacity to handle peak demand. That bodes well for Mirant going forward.
The High Yielders
Two of the securities that emerged in my value screen are high yielders that look extremely promising for value investors who like a rich dividend stream.
The first is HRPT Properties Trust (NYSE: HRP), which owns commercial real estate in urban cores, much of which is leased to U.S. government agencies or to medical clinics. Its assets can be purchased for 65 cents on the dollar, a great deal given its earnings, which amount to a 7.4% yield. This payout -- amounting to some $26.9 million a quarter -- was easily covered by roughly $59 million in cash from operations in the most recent quarter.
The second high-yielding security my screen found is Brookfield Infrastructure Partners LP (NYSE: BIP), which owns electrical and transportation assets around the world. These assets offer geographic diversity, with no region composing more than a third of assets. The assets, power lines, railroads and forests, also generate steady cash flow -- 73% of revenue comes either from regulated businesses or long-term contracts. The stock pays a quarterly dividend and yields a respectable 6.2%. These assets are available to investors for only 72 cents on the dollar.
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