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VALUE INVESTING
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Following last week's discourse on whether value is Foolish or not, which generated some interesting discussion on the value board, I return this week to my regular brief look at a particular value share; though almost certainly not a deep value pyad share, the latter being rather rare. In fact if I could find one a week I would conclude that the filters are too loose and would tighten them up considerably. I don't want pyad shares to be common. I want them to be rare and hence more valuable. And I'm not sure I want to disclose them here, in any event. Anyway, Alliance & Leicester (LSE: AL.) is one of several former building societies that went public, in common with Abbey National (LSE: ANL), Halifax (LSE: HFX), Woolwich (LSE: WWH) and Northern Rock (LSE: NRK). The whole banking sector over the last year or so has been characterised by the most massive declines. A&L itself is now trading at less than half its peak, reached last year, and in fact is at an all-time low since it floated. Here are the usual facts: These fundamentals, when compared with, say, the FTSE 100 averages, are very cheap and hence the company's appearance in a value trawl. Compared with other members of the bank sector they are similar to fellow mortgage banks, that is the former building societies, but much cheaper than the far more diversified clearing banks. However all the banks, both clearers and mortgage, have suffered severe price falls as they fall out of fashion. Note in particular one very interesting point on the big bank slide, which carries an important message for the dedicated value player. The falls have been against a background of rising earnings per share (EPS), not against falling EPS as a casual observer might expect. Most experienced market observers will tell you that it is EPS that drives share prices. I agree with that view. So how come such huge falls of 50% and more can occur in companies with rising EPS? Because EPS-driven share price growth applies only over the long term, many years. But over the short term, other factors like sector fashion and sentiment will drive the price. When a whole sector is out of favour, as the banks have been over the last year, no amount of good news can stem the flow. Just as when a sector is in full cry, no bad news or warnings about overvaluation makes any difference. As a value player, though, you look for something out of favour, but critically, unreasonably so. Banks are starting to look unreasonably undervalued and A&L is one of the more attractive ones possibly, although I don't find a great deal to choose between the mortgage banks. It does, though, have Girobank, which may increase its appeal to potential bidders, although I advocate against buying on bid hopes alone. I have often commented on a historical price to earnings (P/E) ratio of 7 being a buy signal for banks. At that or below I find them cheap, although one has to consider the prevailing circumstances. The major clearers like Lloyds TSB (LSE: LLOY) are still well over that: Lloyds is on about 12. My data on A&L indicates that 55% of its profits are derived from mortgages, the balance being personal banking – presumably non-mortgage moneylending – and commercial banking. It is thus very prone to a downturn in mortgage business and in fact has been losing market share. The management have stated that they do not wish to get into a price war in the highly competitive and over-supplied mortgage business, and prefer to have a lower level loan book with higher quality (for which read higher interest rates) than chase new business at any price. As a result of this, A&L and all the mortgage banks are very prone to any downturn in the housing market. Any problems in this area and I would expect A&L to fall much further, perhaps to a trailing P/E of 4 or 5. The shares would become really attractive to me if they fell below 319p because, on the 1999 accounts, that is book value. By an interesting quirk of fate the P/E at that level on 1999 earnings per share would be 4.9, which fits my above comment. However, there are no real signs of a serious crack in housing quite yet, although there has been a definite slowdown in London with properties being harder to sell and prices falling. But I am not sure whether this is just a lull or the first signs of trouble. One possibly useful indicator is that the Royal Institution of Chartered Surveyors or some such body released a report in the last few days that the current London property state is in their view merely a blip and strength will return in the autumn. My view is that if vested interests like this are trying to tell us it is a blip, then we may well be in for real trouble, in which case of course hold on till later when A&L will get cheaper; much cheaper. I'm getting in danger of overanalysing now, a serious crime in my book. So in conclusion then, A&L is already a value play at current levels. However, value investors all have different criteria about their entry points. One or two of our readers have commented that they are going in now. Others have taken the "wait and see" approach, with the risk that the shares have already bottomed out and thus they may miss out. I think that if one is in it for the longer term, several years, then now may be a fine time, in case it has bottomed. But for the deep, deep short term players it is probably not quite cheap enough yet.
Where Next?