4 Stocks Selling for Less than Book Value

It’s been nearly 80 years since economists Benjamin Graham and David Dodd wrote their investing bible Security Analysis. Their book established a framework for value investors like Warren Buffett and David Dreman to make their fortunes.

Graham and Dodd’s whole approach was based on one simple premise: We have no way of knowing what the future holds and can’t easily predict future income statements, but we do know what assets a company possesses. And we like stocks that are worth less than the company’s assets. That balance sheet-focused approach, which we now think of as “stocks selling below book value,” goes in and out of fashion but has proven its mettle time and again.

After a strong two-year rally, the Graham and Dodd approach can be a challenge: most stocks are now worth well more than the balance sheet assets. But I’ve found a handful of companies that are trading for less than 80% of tangible book value (which means that intangible assets such as goodwill are not included in the analysis). These companies are sitting on hard assets that if necessary could be sold, and which comprise more value than the current share price would imply. (I also focused on companies worth at least $500 million and excluded any insurers.)

Of course, you need to understand the context of a company’s assets. A company like USEC (NYSE: USU), which supplies uranium to nuclear power plants, values its uranium assets at more than $1 billion. If the nuclear industry severely retrenches, then the value of the company’s mines and other assets would be worth a lot less than the stated book value. Then again, my colleague Nathan Slaughter has made a clear and compelling case for why investors are short-changing uranium stocks. [Read his analysis here.]
If he’s right, then USEC’s currently stark valuation will be noticed by value investors.

In a similar vein, Hercules Offshore (Nasdaq: HERO) trades for much less than the acquired value of its assets. Note the phrase “acquired value.” This provider of oil drilling equipment paid more for drilling rigs than they are currently worth. If demand for drilling equipment rises, as many expect, then Hercules’ balance sheet will merit greater attention from the value crowd. Hercules recently acquired roughly $400 million-worth of rigs from Seahawk Drilling (Nasdaq: HAWK) for about $100 million, and when balance sheet figures are updated, this stock will look even cheaper on a price-to-book (P/B) basis.

Here are a pair of “below book” plays that look too good to pass up.

iStar Financial (NYSE: SFI)
Since I recommended iStar in mid-November 2010, shares have risen 65%. At the time, this lender to real estate developers was facing a mountain of its own loans that were soon coming due. The challenge for iStar was to re-finance its loans so that it could buy more time until the real estate sector rebounds. In November, I predicted that “any fruitful discussions about loan extensions could push shares up 50% toward $8, and a materially stronger economy could push this stock to $15 or $20.”

Shares are already up to $9, and I still see another strong move coming, perhaps with 50% or more upside. That’s because iStar has more work to do to clean up the balance sheet, but looks well-positioned to meet that challenge. Even though iStar has re-financed more than $2 billion in debt in recent months, another $600 million comes due later this year. Thanks to an improving commercial real estate market, iStar now has the ability to sell off some key assets to raise that cash. Those asset sales should come later this year, and coupled with just a bit of better news out of the commercial real estate market, shares could move up to the low- to mid-teens by year’s end.

Aircastle Limited (NYSE: AYR)
With rising oil prices, investors should be concerned that major airlines will throttle back orders for new planes. [See: “Why This Well-Known Dow Stock Could Tumble”] Then again, if oil prices cool and global economic activity picks up, demand for planes would remain strong. In either scenario, I prefer Aircastle, a derivative play on aircraft demand.

Aircastle buys planes directly from manufacturers and then leases them to airlines and other customers. Aircastle assumes the risk of ownership, but the profit spreads can be immense when times are good. Judging by Aircastle’s cash flow statement, times are quite good: Free cash flow (FCF) has steadily risen from $60 million in 2007 to $343 million in 2010.

So why do I prefer this stock to Boeing Co. (NYSE: BA)? Because shares of Boeing trade for nearly 20 times book value (which admittedly undervalues its intellectual property of how to build planes) while Aircastle trades well below tangible book value. Smith Barney estimates strong FCF in coming quarters will boost Aircastle’s tangible book value to $17.80 by the end of 2011. That happens to be the firm’s price target and is more than 40% higher than the current share price.

But what if the economy turns south and demand for aircraft slumps? Then shares of Aircastle would likely just tread water while shares of Boeing could tumble. That’s why I think a paired-trade approach to these two stocks (shorting Boeing, and going long on Aircastle) makes ample sense.

Action to Take –> If the market heads toward a correction, then it pays to focus on the balance sheet-centric names. These are what I call “sleep at night” stocks. You don’t need to toss and turn about waking up to sharply lower stock prices since they already reflect a very dim view from investors. Either of these two stocks falls into this category, and along with the other stocks I mentioned earlier, deserve at least some consideration for your portfolio.

P.S. — According to my colleague, a Russian “nuclear catastrophe” will hit the United States in 2013… and when it does, 31 million American’s will suffer. Amazingly, no lives will be lost and a handful of energy stocks could rise hundreds of percent. I know it sounds bizarre, but this bulletin explains what you need to know…