1 Important Problem with This Popular Investing Technique

sunglass sunglasses book readIn serious investment books, it’s not uncommon to find the idea that investors should invest in companies that are trading at prices much lower than their book value (the book value of a share is calculated by subtracting its total liabilities from its total assets).

The idea was first popularized by the intellectual father of investing, Benjamin Graham. The core principle behind it is that shares that are worth less than their assets sans all liabilities are actually priced below their true economic worth.

But while it sounds logical in theory (buying a company’s assets at a discount sounds like a great deal!) and investors who have followed such a method have done reasonably well, there are some pitfalls that you might have to be aware of.

Book value isn’t real value

Firstly, feeling safe that there is real transferrable value in a company’s assets might be an illusion. For example, restaurant operators tend to hold assets that are of little value outside its specific use in the business. 

Soup Restaurant Group Ltd (SGX: 5KI) has more than S$4 million in plant and equipment on its balance sheet. However, most of the asset value resides in renovation costs the company has spent; its kitchen equipment; and the furniture used for its restaurants. These assets have very little value of their own outside of Soup Restaurant’s business. So investing into such a company simply because it’s selling for below its book value might not make much sense as those assets don’t carry much transferrable value.

Value traps

Secondly, companies that carry low price-to-book (PB) ratios might be value traps. Value traps are companies that seem to be a bargain based on a number of financial metrics – but such shares would never see their share prices improve much as their underlying businesses are either stagnating or are worsening.

Given that companies with low PB ratios trade at that price often because they are either poorly-managed or have lousy businesses, it’s easy to see how such shares can become value traps if one isn’t careful.

Many value investors circumvent this issue by investing in a large number of such shares (often going up to the hundreds) and try to allow statistics to bury the value traps; statistically, a large portfolio of shares that are trading at such cheap prices tend to do well even if a handful of individual issues might fare poorly. But, that’s not very practical for individual investors given trading costs and the logistical hassle of having to deal with shares of hundreds of companies.

A business that can’t be liquidated

Lastly, shares that are selling for below their book value are attractive to bargain hunters because they are theoretically worth more dead than alive. But here’s the crux – the book value can only be realised if the company is being liquidated.

Putting aside the issue that it might be a rather odd way to invest (you’re investing into a company with the hope that it goes bankrupt!), there are two big difficulties with banking on a liquidation. The first is that, as a small shareholder, you can hardly influence management’s decision on that matter. The second is that liquidation might not be the best way to recover value from a company for its shareholders.

Foolish summary

Investing in companies with low PB ratios have been very fruitful for great investors like Benjamin Graham and Walter Schloss. But, it’s still important for individual investors to know the risks that underlie this strategy.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn't own any shares of companies mention above