Low P/B Ratio Defense Small Caps

As I rationalized here, there are currently some beaten up stocks in the small cap aerospace and defense sector. I argued that the sharp price drops and low price to book ratios (P/B) make some of those stocks appear to be undervalued.

Calculating the historic price to book ratio on some of those small cap stocks can be used to further indicate relative value. In order to compare the current P/B values to the historic averages I constructed table 1:

Table 1: Price to Book Ratios for selected small cap aerospace and defense sector companies for the 2000 - 2008 time period

A few observations are clear from the numbers in table 1. First, the current P/B ratios for all three small cap stocks (TATTF) (OSI) (ARTX) are considerably below their historic averages. Secondly, the P/B ratios for those same stocks are at or extremely close to their all time low P/B ratios over the 2000 - 2008 time period. We can conclude that these small cap stocks appear to be very cheap compared to their historic P/B levels.

Would I recommend buying these stocks with just this analysis? Definitely not.

In order to be confident of a buy, we should have a deep understanding of these businesses and the industries they operate in to be reasonably certain of their true asset values and earnings power. However, the current analysis does offer up 3 potentially very cheap aerospace stocks that can be further researched to determine their true intrinsic business values. A rigorously calculated intrinsic business valuation compared to current market prices will demonstrate whether those companies are truly undervalued or not.

Comments

[najdorf:]

I don't think P/B ratios are particularly useful unless you include some analysis of the make-up of the B. I understand this is a preliminary screen, but you really have to be cautious with P/B and I don't think it's even a good screen to start with - better to look at earnings and future expectations.

The reason P/B got a good reputation is that back in the Benjamin Graham heydeys he was able to buy companies that held net cash and high-rated bonds right around their market capitalization (i.e. you were buying the cash and bonds and getting a company that might actually turn a profit in the bargain). The idea was that even if the company couldn't turn a profit, they could at least liquidate and pay off investors.

I don't think these companies are that sort of value pick. If I look at the balance sheet for ARTX, the assets are about half goodwill and intangibles. If the company were earning on that goodwill/intangibles, if those indicated that they had acquired profitable companies and developed useful intellectual property, it would be fine. But they're not earning - earnings have actually been negative. So it seems that their might be a goodwill writedown in the future for ARTX, because you can't really profitably liquidate the goodwill of a company that doesn't turn a profit.

The rest of the assets that are making up the book value are a little better, but inventory is pretty high (almost a quarter worth of revenue), as are recievables (similar magnitude). This suggest a fairly inefficient company. You also have to consider that their property and equipment may be specialized to the particular products they produce, so it may not actually possess its stated book value if it can't be used in a profitable business.

I figure that if ARTX could clean up their inventory and recievables they probably could do a lot better on cash flow for a few quarters, but is the underlying business actually profitable? Can they rely on government contracts flowing to a small and unprofitable company? Tread carefully here - all that book value could fall apart in a hurry. There's a reason the price is so low.

2008 Jul 29 07:54 PM

[Reyer:]

Hi Najdorf,

thanks for the well constructed comments. We are actually remarkably similar in our views. I never just take P/B and trade off that. I am also very careful when I do intrinsic business valuations to ensure that the earnings potential of the company and the replacement value of assets is used. So I do a careful evaluation of the quality of assets for the replacement value. I consider specialization of equipment in my process for asset valuation. If there is a large amount of goodwill and intangibles on the books, I mark it down severely if the earnings do not justify it. I tend to look at goodwill and intangibles as a writedown waiting to happen and I need to be convinced that they are worth what management claims.

I totally agree with you, with a lot of these apparently cheaper looking companies, book value can fall apart quickly, so its investor beware for sure.

However I have done a lot of intrinsic business valuations and you do tend to find value in some of these companies if you look enough. I still like the low P/B screen and low P/E screens to to help me find potentially undervalued companies, but we both say, its only a starting point.

Regarding these companies above, you could be right as I haven't done an intrinsic valuation yet, but I'll tell you what, I will do all three and if any look good to me, I will post it. Then we could discuss further if you like.

Regarding Benjamin Graham plays, there's still some net net plays and liquidation plays out there if you look hard enough, but the mainstream analysts aren't going to talk about them because they are usually small cap's.

cheers,
Reyer

2008 Jul 29 10:14 PM