VALUE INVESTING
Three Property Value Plays

By Stephen Bland (TMFPyad)
April 29, 2005

In Value Investor, I have tipped three value shares in the property sector since we started publication in January 2004. On one, London Merchant Securities (LSE: LMSO), I called a sale on some weeks back for a profit of around 38%. The others, both still in play, are Freeport (LSE: FPR) up about 14% from last year and a third company, tipped very recently in the latest issue. (The average gain for all Value Investor picks to date, last measured on 13 April, is 12%).

Doubt has been expressed by some as to whether the property cycle has peaked, and in that case whether it is too risky to buy shares in the sector. I should stress for those possibly unaware that property companies usually invest in commercial property of various kinds, not residential. In particular, the two property shares held at present are both involved in shopping centres, though they do not operate in the same way.

I have always maintained that there are two key ratios applicable to property shares. The first ratio is discount to net assets. This is the most important value ratio with all shares. However, property shares are valued principally on an assets rather than an earnings basis and because nearly all stand at a discount to assets, it is in the level of discount relative to the sector that value may be found.

The second ratio is gearing. Most property companies will have debt, often very large in relation to assets. Very few if any have net cash so therefore the value angle is to locate those with the least gearing.

These two tests, the shares with the greatest discount to assets and lowest debt, both by sector standards, are the starting list in the search for potential value plays from the property sector. My latest tip shows up well on these tests.

However, in a recent article here I commented that assets can sometimes be a moving target. Thus it isn't too helpful if you find a share in whatever sector that is trading well below book only to find that book itself has shrunk some time later so that you end up with the P/TBV from hell. The sort of shares where this could be a problem are where the assets possess a volatile valuation. Listed investments would be a good example of such assets. Commodities and minerals could be another.

Property isn't that volatile normally but there are cycles during which it turns sour. When that happens, property shares suffer a double blow because not only does the value of their assets fall sharply but also the discount to assets widens as investors avoid the shares. In the depths of such recessions property shares go very cheap but great patience is required to profit because the cycles can be much longer than many think. As a result the earliest callers of a turn are usually wrong.

The prospect of falling property values is what has given some readers cause for doubt over my property plays. Doubts of course have been dashed over London Merchant because I scored a useful profit there.

When I was considering my most recent property tip for Value Investor, I did have in mind the possibility that we could be staring a property crash in the face. Sooner or later that is precisely what will happen, it always does, just as stock markets go through bear phases. It is the natural order of things. But I just don't think we're there yet and hence have no doubts about my latest selection.

There is a difficulty with property valuation in that unlike quoted shares, there isn't a ready market for property upon which to arrive at a value and each one is different. Consequently the figures used by property companies have to be the opinion of a valuer with rent yields being the principal behind the calculation. These yields fluctuate over time. It is something with which all property companies are afflicted. Clearly the process is open to question because you  never know the true market value of a property until it is sold but it's all we've got.

I think there is still some mileage in some property shares for the reasons I gave in the last month's Value Investor. But you'll need to subscribe to get the full reasons behind my regular share selections.

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