Quarter of Belgian shares dangle below book value

One in four Belgian stocks is trading below its book value. Although the ratio has lost popularity in recent years for valuing stocks, it provides guidance in difficult times and a long-term comparison can point to buying opportunities in some sectors.

Accounting is for many one of the least liked parts in the subject of economics, but indispensable for investors to get a good picture of a company. Perhaps you've superseded school knowledge, hence some theory first. Book value constitutes the company's equity. You find it in the balance sheet on the liabilities side, which reflects where a company gets its resources. Broadly speaking, it consists of the capital raised by shareholders at incorporation and through subsequent capital increases, accumulated legal reserves, and retained earnings. If a company does not distribute its full profits, the book value increases. If there is a loss, it is deducted from the book value. A reduction in capital also eats away at equity.

According to many textbooks, book value is a lower limit for a healthy business. These are companies that earn returns in excess of the cost of borrowing money. Many also see it as a measure of value. Because equity is invested in various assets, such as buildings, land, inventory or licenses, it gives a picture of a company's assets.

Destroy or create value ?

With stocks listed below their book value, investors theoretically assume that they are destroying value for their shareholders in the long run rather than creating it. That is why many problem names figure in the list of stocks below their book value. Examples are the debt-laden carpet maker Balta BA , the shipping companies Euronav and Exmar suffering from low shipping rates, or the diaper manufacturer Ontex that incurred a lot of debt to take over a cat in a bag in Brazil.

The National Bank, quoted well below book value, is a special case. Its dividends are low relative to its profits because a significant portion of the profits are transferred to the state.

Two companies bear negative book values, making it impossible to calculate a price-book value. The maker of cooling towers and heat exchangers Hamon has accumulated enormous losses and survives only by the grace of its main shareholder: the Walloon government. This year, it will have to make up for it again.

Telenet is also struggling with negative equity, due to the generous dividends and capital reductions that flowed to shareholders. Yet that is not a problem for the telecom group. The company is posting generous cash flows. Because of its monthly subscriptions, Telenet is so secure in its revenues that banks don't worry about its weak balance sheet, as long as customers don't start walking, of course. The main shareholder Liberty Media has played the game brilliantly and in the meantime got far more out of the company than it ever put in.

The higher the return on equity, the higher the price book value may be.
- Patrick Millecam

Cyclical companies

'Telenet is a perfect example of why book value often provides little guidance for valuing a company,' says Geert Smet, deputy editor-in-chief of De Belegger magazine. 'The book value in itself does not say much, although the long-term evolution can give an indication of performance or valuation. Especially with smaller stocks or cyclical companies, it can be an indicator. At steel cord maker Bekaert, a low price-book value in the past always pointed to a buying opportunity.' At more than 1.5 times book value, Bekaert currently appears fairly valued.

'We too hardly use book value in our models,' says Patrick Millecam, partner and chief strategist at the asset manager Value Square. 'We value companies based on their earnings potential. For certain cyclical sectors, such as commodity companies, shipping or a steelmaker like ArcelorMittal, book value can be interesting as a point of comparison in a long-term perspective. It is often better to invest in those sectors when the outlook is poor and losses are being made.

Debts

So looking only at book value as an investor makes little sense. The ratio says nothing about debt and profitability. Let's take Vranken-Pommery as an example. The world's largest champagne maker after LVMH is not even quoted at half of its book value of 41 euros. That is spotty by that ratio and points to the group's many assets such as vineyards and chateaux. But Vranken also carries a towering debt of 684 million euros. Even in a corona-free year, the bulk of operating profits flow into interest payments. Banks and bondholders benefit, shareholders less so. Vranken is trading at 73 times its profits, which is prohibitively expensive by that ratio.

Smet does point out that book value can be a holdout in times when companies see their revenues suddenly decimated, as in the corona outbreak. Amusement parks, cinema operators, fitness chains and hotels saw their cash flows suddenly disappear. 'The balance sheet is then very important to know who can survive,' says Smet. 'You can set the book value against the debts. High debts with meager equity make a company vulnerable if something goes wrong. Investors don't buy that.'

In the pandemic year, one in three Belgian companies saw its equity fall, compared with only one in four in a normal year. It is one reason why the number of companies quoting below book value has risen from 15 to 26 percent of the share price board in 10 years.

Goodwill

A big problem with book value is the valuation of goodwill. This is the part that a company puts on the table in an acquisition more than the equity of the prey. If the acquired company's operations do not live up to expectations, the acquirer will have to write off goodwill, causing equity to plummet. Chemicals group Solvay, for example, wrote off 1.5 billion euros last year, roughly equivalent to the goodwill it paid to acquire U.S. lightweight composites maker Cytec in 2015. Due to the slowdown in aerospace, that business is turning a lot less revenue and profit.

'In international accounting standards IFRS, companies have to do tests to justify goodwill on the balance sheet, and write it off if necessary. Those tests do leave the necessary flexibility with the companies,' says Smet. 'I have the impression that before IFRS, goodwill was written off more quickly.'

It is striking how quickly book value has lost popularity with investors in just a few years. Even super guru Warren Buffett has not reported the book value of his holding company Berkshire Hathaway since 2019, whereas he has done so systematically since 1964. He argues that book value understates true value. Moreover, Berkshire's major holdings are unquoted. For holding companies, intrinsic value is a better measure anyway.

What Works on Wall Street

'Author James O'Shaughnessy proved in his standard work, "What Works on Wall Street," that investing in the cheapest companies based on stock price book value was a good strategy in the very long run, but over the past 10 to 20 years that has been much less the case,' Millecam says. Much of the explanation lies with the success of technology companies, which are posting phenomenal earnings growth with relatively small equity.

'The best ratio to find low-cost companies right now is to plot entrepreneurial value (stock market value + debt) against gross operating profit, called EV/ebitda,' says Millecam. That ratio also takes into account debt and profitability, which price-book value says nothing about.

'There is still a clear relationship between the return on equity (ROE) that a company realizes and the price-book value. The higher the ROE, the higher the price-book value may be,' says Millecam. It explains why thriving growth companies like chipmaker Melexis, cookie maker Lotus Bakeries, or e-commerce company Smartphoto listed sharply above their book value, but turned out to be by no means bad investments.

DISCLAIMER

• Source: The Time
• Author: Serge Mampaey
• Link: https://www.tijd.be/markten-live/homepage/kwart-van-belgische-aandelen-bengelt-onder-boekwaarde/10306147.html?