Why Do Some Companies Trade At a Discount to Their Book Value?

Billionaire investor Warren Buffett’s investment into See’s Candies in 1972 was a turning point for him because it taught him about the value of a business with a strong economic franchise. When Buffett bought over the entire business, he had paid a rather large premium over book value for it.

But as it turns out, Sees has been a wonderful investment. This might fly against the face of some investors who believe that paying a premium to book value for a company does not constitute a sound purchase. But let’s see what happened when Buffett made an investment into a company because it was trading below its book value.

Buffett first plonked money into Berkshire Hathaway in 1962 when it was a failing textile company. He bought into it simply because it was cheap (below its book value). However, due to the declining economics of the textile business (it’s almost impossible to carve out an economic franchise from the manufacturing of textiles), Buffett openly claimed in 2010 that buying Berkshire Hathaway was probably the worst investment decision of his life.

Berkshire Hathaway’s textile operations recorded total revenue of close to US$530 million from 1976 to 1984 and yet produced an aggregate loss of US$10 million. If Buffett had not actively reinvested the cash flow from the textile business into other more profitable businesses like insurance and See’s Candies, his investment in Berkshire Hathaway would very likely have been a massive disaster.

There’s a lesson in there for us and that is, we have to question why a company might be trading below its book value. If the economics of the company’s business is very poor and declining, the market might be justified in awarding the firm a very low valuation (as it did for Berkshire Hathaway). But if a company does have a great economic franchise and is actually trading below its book value, then you might be looking at a company which could experience a turnaround in share price in the future.

When I look through Singapore’s share market, some of the companies which are trading significantly below their book values include Pacific Andes Resources Development Ltd (SGX: P11)Swiber Holdings Limited (SGX: AK3), and Wing Tai Holdings Limited (SGX: W05).

Share Price to book value (7 October 2014)
Pacific Andes 0.32
Swiber 0.37
Wing Tai 0.46

Source: S&P Capital IQ

Although the trio appear to be “cheap” now given their huge discounts to their book value, investors would need deeper analysis to tease out the reasons why these companies are trading at such low prices. You would need to make sure you are confident about the long-term economics of the business. Otherwise, you might end up with the next Berkshire Hathaway – the terrible textile one, that is!

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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 of the companies mentioned.