Many stocks trade at large discounts to their book values. Some are destined to trade at such levels (or below) for prolonged periods, while others show strong price appreciation in subsequent periods. How can investors distinguish between the beaten down stocks that are destined to remain beaten down, and those that are potential investment opportunities?
There are three important items to look for. The first thing is to determine how convertible the assets are into cash. Reliable receivables, land, and fast-moving inventories are all quickly convertible into cash compared to highly-specialized fixed equipment for example, where the book value may be nowhere near the realizable value.
Second, it's important to consider the debt level of the company. With debt, any estimation errors of the value of the assets (discussed in point 1) are magnified, as discussed in the third paragraph of this post. Furthermore, if debt obligations are due soon, the company is less likely to be able to sustain itself to get to a point to where it can reward shareholders.
Finally, management's intentions are worthy of consideration. If management is sitting on a boatload of cash, but wishes to spend it on new projects with uncertain outcomes, shareholder risk increases.
Exactly one year ago, we discussed Quest Capital (QCC) on this site as a potential value investment due to its massive discount to its book value. The company was in the business of issuing short-term (approximately 1-year), land-secured loans to finance builders looking to complete projects that were to be sold to various customers.
On all three of the points discussed above, Quest scored well, making for a rather safe investment with strong upside. The loans were due to convert into cash or the land could be seized and then sold by the company (of course, some loans had to be written down as some land values fell below loan values), debt levels were low (allowing for confidence in the net asset values), and management's intentions to take the steps necessary to reduce the discount to book value were very clear.
As a result, the stock generated returns of over 50%, and it did so with little in the way of downside risk. With yesterday's price increase, Quest's price is now within around 10% of its book value, offering investors the opportunity to exit at a price close to fair value and redeploy their funds to the next potential opportunity.