According to the April 20th issue of Barron’s, the price/book ratio of the S&P Industrials is around 2.17. This figure was well over 3 a year ago and as high as 10 back in 2000. That said, the historical average (excluding the mega-mania of the 1990s-200s) is around 1.7 times book value. The bear market has brought overall stock market valuations to their lowest level since the late 1980s.
I’m no longer ultra-bearish on the overall stock market, but the bear market may still be far from over. I have NO IDEA how low valuations will drop, when the bottom will be, or how low the bottom will be. I do recommend keeping some exposure to stocks, as the lowest valuations since the late 1980s should mean that there are now some bargains out there.
I have been intending to buy more stocks, but the two things that have been stopping me are being busy with other things in my life and my fussiness in selecting stocks. I don’t buy based on the popular stats like PE ratios, price/book ratios, or price/sales ratios. Before I buy a stock, I crunch through the numbers from the official financial statements, and I also think about what risks there might be that the past financial performance of the company don’t reflect.
One example that I considered but passed up is VDSI, VASCO Data Security International. This business security systems/products company generates an enormous amount of free cash flow on very little plant/property/equipment, has more than enough cash on hand to pay off ALL liabilities, and has a management team more concerned about running the business than brown-nosing Wall Street. The price has dropped precipitously in the face of fast AND profitable growth. I learned from the book _The Little Book That Builds Wealth_ (a book that explains how to find companies with economic moats) that business services companies prosper due to customer switching costs. (Switching to a competitor would be such a logistical nightmare that customers rarely do it, and that gives the company plenty of pricing power and high returns on its capital.) However, I am concerned about the possibility
that VDSI’s technology could become obsolete as well as the possibility that one security breach could damage its reputation and allow a competitor to emerge from nowhere and take over its market share.
Another factor that I weigh heavily is something I call net liquidity – liquid assets minus ALL liabilities. If a company has a non-negative net liquidity, that means that it could pay off all liabilities immediately without having to resort to a fire sale of assets. A non-negative net liquidity is quite an asset given the tight credit markets, but most companies out there have negative net liquidity. I don’t eliminate companies with a negative net liquidity, but it is a factor in my appraisal process. Too many companies out there have an enormous negative net liquidity that dwarfs their annual free cash flow. You can see why so many companies have been cutting back on investment. On the other hand, a company with substantial positive net liquidity has room to grow without having to rely on borrowed money.
