By TEH HOOI LING
SENIOR CORRESPONDENT

MY BACK- TESTING of stock prices over the last few years has shown time and again that buying a basket of stocks which are trading at a deep discount to their book value almost always yields better-than-market returns.

The real-time portfolios that The Business Times tracks also show this to be the case. In the previous set of five portfolios that we started in October 2003, the lowest price-to-book (PTB) portfolio was the best performer; it turned the dummy capital of $150,000 to more than $1 million by 2007. In the current crop of portfolios, however, the lowest PTB portfolio is trailing others. Maybe it needs more time for the economy to recover further before some of the stocks can trade nearer to their book value.

The use of PTB as a predictor of a company's future stock performance was first highlighted by US finance professors Eugene Fama and Kenneth French in their breakthrough study in 1992. No other measure had nearly as much predictive power - not earnings growth, price/earnings, or volatility. (Book value is typically the cost of the assets acquired by the company net of depreciation. PTB can be calculated by using the stock's market cap divided by its total equity.)

In the current crisis, I finally had a chance to personally test this strategy of buying deeply discounted stocks. And since then, I've become an even bigger convert that buying good stocks which are trading at either below their book value (or below their normal range of multiples to their book value) pays.

In 2004, I tested the entire market's PTB as an indication of value for the market. I found that there was a clear inverse relationship between the average market PTB and the Straits Times Index's returns a year later. The period I looked at then was from 1983 until 2003.

I tried to relook the data in a different form. This time, I plotted the PTB of the entire market against the market return a year later on a time scale. From the first chart, you can see clearly that every time the market traded below its book value (that is, when the PTB was under one), the return a year later was stupendous.

I looked at monthly numbers. There were six occasions between 1994 and 2008 when the Singapore market's PTB fell to one or below. These six occasions were all in 1998, between June and November. The market rebounded between 59 per cent and 115 per cent a year later.

This year, in end-February, the Singapore market was trading at 0.92 times its book value. Even in end-March, it was still trading at about book value. Since then, of course, the market has rebounded more than 50 per cent. The market now is trading at about 1.65 times book. This is not an excessive level yet.

In the past 15 years, when the market traded at between 1.5 and 2 times book, the market ended lower a year later on 51 per cent of those occasions. The median return a year later was minus 2.5 per cent, the average being 0.7 per cent. The maximum return was 56.9 per cent, and the minimum return was minus 47.3 per cent. Hence, the odds are pretty even.

But given that we are now still at the lower end of that 1.5-2 times range, the risk - if history is anything to go by - is still not off the chart.

The key takeaway is to load up on stocks when the market, on average, is trading at a discount to its book value and to start trimming as it gets nearer to 2 times book. Anything above 2.2 times has always led to the market trading lower a year later in the past 15 years. These are, of course, past numbers and apply uniquely to Singapore. Things may change, but I think it will remain a good guide as to when to enter and exit the market.

Individual stocks

Individual stocks too have their own range of PTB ratios that they trade in. A friend commented that he had sold his stake in Noble Group recently because the stock had traded to above 2.5 times its book. He added that, historically, every time Noble traded to near that level, it tended to correct downwards. The same friend had bought into Noble last October, when it was trading at below its book value.

He told me then: 'Noble trading at below book value was something that I have never seen, nor do I think we will see it again any time soon. So when you see this, you back up the truck and invest all you can.' Between then and now, Noble has more than doubled.

That comment set me thinking: is there really a range of PTB multiples that stocks trade within - that is, when they hit the upper limit, their stock prices will weaken, and when they hit the bottom, they will rebound?

So I plotted the PTB multiples of various STI component stocks over the years against their stock price return a year later. Indeed, there seems to be a discernible relationship: buying the stock when it is trading way below its normal PTB range almost always guarantees a good return. And cashing out at the top of the range is almost always wise (see charts).

For example, Keppel Corp traded between a low of 0.3 times its book value and a high of 4.5 times. If you had bought Keppel when it was trading at 0.3 times its book value (in end-September 1998), your return a year later would have been a whopping 311 per cent. Had you got in when it was trading at 4.5 times book (in end-January 2008), some 67 per cent of your capital would have been wiped out by end-January this year. Keppel is now trading at 2.6 times book.

Different companies have different multiples of book that the market prices them at. How high the PTB gets is a function of the return on equity (ROE) that the company is able to generate. If a company is able to generate earnings above its cost of capital, then investors should be willing to pay more than the book value of its assets. Conversely, if a company's net earnings cannot even cover its cost of capital, then investors will invest in the company only if it is trading below its book value.

A company's PTB is thus not static over time; if it is able to raise its ROE, then its PTB should also go up. So you may uncover an underpriced stock if you find one which is increasing its ROE, but with its PTB staying the same.

Typically, however, high ROEs can't be sustained over the long term due to a phenomenon called 'the reversion to the mean'. So, in general, it is not prudent to chase stocks with PTB ratios. Reversion to the mean also explains why, over time, stocks trading at a deep discount to their book value tend to trade up to their book value. Of course some may go bankrupt. But those that turn round should more than make up for those that don't. Hence a portfolio approach is key in this strategy.

This article was first published in The Business Times.