While investing, I like to look for companies with low price-to-book (P/B) ratios. Of the portfolios tracked by GuruFocus, the “Top 25 Historical Low P/B Ratio Companies” portfolio has performed the best, and is outperforming the S&P 500 by 24.02 percent since its inception in 2010. The book value of the company is the value of its assets minus its liabilities, essentially what is left if the company is liquidated. Buying a stock with a P/B ratio below 1 means that you are buying the company below its liquidation value. Of course it is not that simple, people are not likely to buy every company with a low P/B ratio just to liquidate it and keep the difference. There are costs involved with the process, and it is likely that thousands of lives would be devastated due to job losses. The value of the assets could also be in question. They could be overstated and inventories would likely have to be written down. A liquidation sale typically involves items at a deeply discounted price. Also if a company has a low P/B ratio, it might be reflecting the expectations of a decreasing book value.
To help alleviate these issues, I searched for companies selling at deep discounts to book with a P/B ratio of 0.5 or less. I added the additional screen of finding companies with an increasing book value. Only four stocks met my criteria and two of them were from South Korea; KB Financial Group (KB) and Korea Electric Power Corp (KEP).
South Korea’s economy has rebounded lately. Its GDP growth rate slowed to about 2 percent in 2012 and 2013. It is now at 3.9 percent, its highest level since 2011. Disinflation has subsided and inflation is at a healthy level of 1.7 percent. Even though the South Korean economy is growing at a much faster rate than the United States economy, the iShares MSCI South Korea Index Fund (EWY) is up about the same amount as the S&P 500 for the past year at 20 percent.
KB Financial Group Inc (KB)
KB Financial Group Inc is trading at half of its book value and has a low P/E ratio of 11.10. With banks, the concern about a low P/B ratio is whether the loans on the books need to be marked down. KB’s largest subsidiary, Kookmin Bank, is South Korea’s top mortgage lender, but it is not likely that more than half of the loans will default in an improving economy. The bank is also well capitalized with a Tier 1 Capital ratio of 12.78 percent. As of September 2010, Basel III norms have asked for Tier 1 capital ratios of 8.5-11%.
Not everything is perfect at KB Financial. Late last year Kookmin Bank admitted wrongdoing by employees in three separate investigations. The allegations are that Kookmin employees faked government bonds used to fund housing policy and embezzled money from their sale, the bank’s Tokyo branch lent more than permitted to a Japan-based firm to secure returns used to set up a slush fund, and the bank didn’t return interest as required to businesses for a mortgage product. These are serious allegations, but now that these issues have been brought to the forefront, the new CEO that started in July of 2013 can work on improving the internal controls.
KB Financial’s historic median P/B ratio is 1.1, but it could take years for the bank to reach those levels while it is cleaning up its messes due to the lack of internal controls. Its post Great Recession median P/B ratio is 0.80, a more reasonable valuation until confidence is fully restored to the bank. With a P/B ratio of 0.80, the stock would be priced at $48.40, making it undervalued by 30 percent. The book value of the company has shown stability. It has grown every year since 2008 and at an annual rate of 9.93 percent for the past five years.
Earnings are down almost 50 percent total over the past two years, but they are still positive, giving the stock a P/E of 11.10. The large decrease has subsided with earnings only being down 3.2 percent for the last quarter. The stock has one analyst covering it, and the analyst is estimating full year 2014 earnings per share to be $3.75, a 25.8 percent increase over 2013. Using the GuruFocus DCF Calculator, earnings only need to grow at 5.69 percent to justify its current price of $33.90.
Value Partners is the investing guru to following in relation to KB Financial. They specialize in Asian securities and are the largest shareholder of the gurus we follow. Value Partners (Trades, Portfolio) initiated their position in the fourth quarter of 2013 with a purchase of 282,310 shares.
Korea Electric Power Corp (KEP)
Korea Electric Power Corp, also known as KEPCO, is also trading at half of its book value. The company generates approximately 93 percent of the electricity in South Korea and is 51.1 percent owned by the government. Just like KB Financial, KEPCO needs to work on its internal controls. In May of 2013 two nuclear power plants were ordered to suspend operations and a third plant had its shutdown extended. Cables that were supplied with fake certificates had to be replaced at the plants. A fourth newly built reactor had to delay its opening for the same reason. South Korea previously halted operations of some of its 23 reactors in November of 2012 after a scandal emerged over parts being supplied using fake documents. It was disappointing to see that it was not addressed in the 2013 Annual Report. Hopefully this is not politics as usual.
The problems with the shutdown plants seem to have subsided with earnings turning positive for the first time since 2007. KEPCO has also turned into an exporter of their nuclear technology. In 2009 they secured an $18.6 billion contract for setting up four nuclear reactors in the UAE, due to be completed in 2017-2020. In January of this year, KEPCO’s CEO, Yoon Sang-jick, said that the project is on the right track.
The stock currently has a high P/E of 52.60 largely due to the plant shutdowns last year in combination with high fuel costs. Earnings have rebounded and are expected to be at $2.13 per share for 2014. 2013’s EPS was only $0.04. The analyst covering KEPCO estimates that EPS for 2015 will be $2.85, a 33.8 percent increase over 2014’s estimate. According to the GuruFocus DCF Calculator, earnings only need to grow at 2 percent per year to justify its current price when using 2014’s full year estimated EPS. Only a 10 percent growth rate values the company at $31.42 per share with a margin of safety of 40 percent. The book value of the company has also been stable, growing every year since 2008. The growth rate in book value per share for the last five years has been 8.73 percent. Even with its recent problems, a company with increasing earnings and trading at half of its book value is a bargain.
Donald Smith is the guru to follow when it comes to KEPCO. He is the largest shareholder of the gurus we follow with 2,602,989 shares. His strategy is to buy stocks with low price-to-tangible-book value per share and significant earnings potential over the next 2-4 years. His last purchase was a little over a year ago in the second quarter of 2013.
