VALUE INVESTING
Property Shares

By Stephen Bland (TMFPyad)
October 29, 1999

Some interesting points from a reader this week on the value board on whether the approach to identifying undervalued shares that I have described earlier in this series would apply to property companies. Well in general it does not and I thought that this might make a good article, so here I am.

The pyad and similar deep value styles are effective in looking at companies that have a trade: that is, those that manufacture or deal in goods or services. This is because such shares are traditionally valued primarily on a multiple of their earnings per share, specifically on their Price to Earnings (P/E) ratio. This applies to the great majority of listed shares. There are good reasons for this. EPS is the prime measure of the health of a trading company. A rising EPS will lead in time to a rising share price and quite likely to a rising dividend as well. And the reverse of course. P/E is by far and away the most commonly used analysing ratio for trading companies.

But there are two classes of share that do not have a trade in the sense I use it above. They do not manufacture or deal in goods or services. These are property shares and investment trust shares. They are fundamentally fairly straightforward operations although the equity structure, particularly of investment trusts, can get complicated. I propose to look at how to find value in property shares.

A property company will buy or develop property and then let it. There will inevitably be occasional dealing in property but for most of them that is not the object. The primary aim is to hold for growth. As a result of this, the income of the company will be represented by rents in the main, rather than profits and losses on sold properties. But the long term objective of these companies is not simply to generate an income, which may frequently be modest in relation to the capital employed, after expenses, but to produce capital growth in the assets they hold. That is, in most cases with this type of company, their mission in life.

As a result of the pursuit of capital growth rather than income by most property companies, the market will place a much greater emphasis on valuing them on a net asset value basis rather than a multiple of EPS. Note that this is in direct contrast with trading companies. The key ratio for the latter is P/E. Net asset value is hardly looked at, except perhaps by value players, who are in a small minority. But the reverse is the case with property companies. P/E is pretty unimportant and net asset value is everything.

Which brings me to a crucial point with these shares. In the great majority of cases, property shares generally trade at a discount of net asset value to the share price. In our language, Price/Book is almost constantly less than 1. Thus what is very attractive in a pyad share which is a trading business, in conjunction with our other value filters, means nothing in the context of property companies, because that is the norm. It is very rare to find such companies trading at P/BV over 1.

Another important point with property companies is that they will mostly have debt. The degree will vary of course but it would be rare indeed to see a property share without any form of debt. So again this runs contra to the pyad view on debt.

So the pyad approach is looking distinctly shaky with asset companies. The P (P/E) means little. The Y (Yield) may be useful, we'll take a look later. A (Assets) are nearly all less than the share price and D (Debt) they nearly all possess. So what do we do to locate value in asset companies? All is not lost. We need simply to modify the approach to suit asset-valued rather than earnings-valued companies.

I suggest, first of all, agreeing with the judgement of the market, unfortunately – I know it goes against the grain – that EPS has little importance here. I don't mean that large losses are acceptable but as long as the company is making money the actual P/E means not too much. It will often be massive with asset companies. 20, 30, 40 maybe. Normally, as one who will never, never understand those who buy shares on double digit P/Es I would laugh. But as I said, that is trading company mode. For property shares don't worry too much as long as interest and dividends are well covered. That is important.

Yield though remains useful, I believe, even for property companies. It produces cash for the investor. That most wonderful of commodities, and one rarely given sufficient credence by most commentators, I feel. I've said this before but in the whole of investment analysis, the dividend is probably the only thing that is absolutely reliable when looking at past results. It is actual cash paid out and you can't argue with it. People will argue about most everything else, such as EPS, asset value, and so on. But cash is cash. Never underestimate it. Most investors do. The value player recognises this weakness in others and capitalises on it. A decent yield is wonderful whilst you are waiting for the share to perform. It may give you as much or more than cash on deposit.

Net asset value, as I say, is the way property companies are judged. So although they nearly all trade at P/BV under 1, the question arises as to the degree of this ratio. If one property share is at 0.9 and another at 0.8, then other things being equal the lower is more attractive. Other things are not equal, of course, but I wanted to make the point. The quality of the property portfolio is important. Residential property is rare and the assets of property shares are usually comprised of various classes of commercial holdings. Shops, offices, warehouses and factories are the most common with a few interesting minority types such as docks, airports and so on.

The location of the property, as well as its type, is also important. Some areas have more obvious attractions than others. I am sure everyone knows the ancient joke in this game: "What are the three most important factors in selecting property? Location, location and location."

Debt will nearly always be present so we are back to degree again, as with the asset value. A conservatively managed property company would have a lower debt to asset ratio than a more speculative one. Clearly the lower the debt the lower the risk. Minimise the downside, remember? As true here as with trading companies and pyad.

What can go wrong? Well, unless you are about ten years old it will be obvious that the property market is cyclical. Just like shares. Although the very long-term trend may be positive, there exist downturns and occasionally downright catastrophes in property shares. In such circumstances the capital value of the portfolio will plunge and those with relatively high debt may be in trouble if falling rents caused by the failure of the tenants leave the company inadequately covered for interest payments on the debt. In a decent downturn many will go bust completely.

To sum up, deep value investing with property companies means finding low P/BV compared with other props., together with as low a debt ratio as you can find and a decent yield. And the best time to buy them is in a property slump because the good go down with the bad. But whenever, establish the sector norm at the time you wish to go in, then try and find those that are undervalued relative to the sector on the above criteria. Having done that, try to establish why the companies on your short list are so undervalued. Remember that there may be good reasons, like all their assets are in some dodgy place or something.

As with all deep value investing, do not compromise with props. Either you find deep value on asset and debt and yield grounds with no question marks, or you don't. It needs to be a screaming buy. You need patience: wait, then go in only for the kill, not just to chew off an ear.

Questions and comments to the Value Shares board, please.