Investors have often wondered why seemingly undervalued stocks never seem to get off the ground. Hongkong Land is a prime example of this. Why can’t the stock price narrow the discount between its price and its net asset value (NAV)?
In March this year, CapitaLand’s management gave the market a partial answer. CapitaLand trades at a discount to NAV, and its management had an aim to narrow this discount. For several years, the developer — soon to be restructured — focused on ROE. The stated target was 8%. In 2018, this was raised to 10%.
At an ROE of 10%, CapitaLand would have to make net profit of around $2.3 billion, given its shareholders equity of $23 billion, give or take, and total equity of $39 billion. The higher CapitaLand’s net profit, the more capital would accrue to its shareholders equity because companies put aside retained earnings, or revenue reserves.
Enter Andrew Lim, group CFO of CapitaLand. In at least three briefings on the merits of CapitaLand’s restructuring into CapitaLand Investment (CLI) — a real estate investment manager (REIM) — Lim articulated that CLI’s ROE needs to match its cost of capital. The business model of a REIM is a discussion for another day.
A stock’s ROE matching or exceeding the company’s cost of capital could make the difference between an undervalued company based on its P/NAV — or a value trap — so the rationale goes.
Value traps are investments that are trading at such low levels and present themselves as buying opportunities for investors but are actually misleading. For a value trap investment, the low price is often accompanied by extended periods of low multiples as well.
To be undervalued, Hongkong Land needs to be a lot more profitable than it is currently. The same rationale goes for seemingly permanently undervalued real estate based companies such as Frasers Property, OUE, Hong Fok Corp, Far East Orchard, Bonvests Holdings and so on (see table). At some point, some of the 20 stocks in the table (ranked by market capitalisation) will find a trigger that could narrow its P/ NAV discount.
The table comprises asset-based companies trading at or below a P/NAV of 0.6 times. The ROE is based on latest filings, as calculated by Bloomberg.
Stocks whose ROE approaches or exceeds its WACC (weighted average cost of capital) or its cost of equity (a high bar) are the ones with the potential to narrow the P/ NAV discount. These may include Yanlord Land Group, Tuan Sing Holdings and Sinarmas Land.
Each developer is likely to have its own idiosyncrasies and the table is just the starting point for more research. There are other ways to separate undervaluation from value traps, so stay tuned.
