My original intent was to publish the three quantitative models we have already discussed this week. I have found the Value Momentum, Rational Liquidation and Enterprise Value Growth and Income portfolios to be a valuable source of stock ideas and market information. Studying them can give some idea of what sectors are catching investors' attention and overall market levels in addition to individual stocks ideas. I plan to seed them with a smaller sum this year and see what kind of real world track record they exhibit going forward.
Before I move on, however, I decided I had to test my ideas of financial stocks and REITs valuation based on price to book value. Although many folks in the academic and investment world affirmed that using enterprise value worked well for financial stocks, I tend to think price to book works better. I had to test it for myself before moving onto other ideas and information.
Last night, I built and tested a financial stock model. I looked for banks, insurance companies and REITs that traded below book value and had adequate equity to assets. The model then purchased the 50 lowest by price of book value. I used a one-year holding and rebalance period, and even with that period, turnover was pretty low. At initial glance, it works a little better than the EV/EBITDA model with a marked outperformance both pre- and post-credit crisis.
During the credit crisis, it got thoroughly thrashed, with its only saving grace being that the portfolio was not fully invested, as few REITs and financials traded below book in the months before it all went bad. Even with reduced holding, the financial portfolio pretty well got its butt kicked during that time period, but the recovery starting in 2009 was impressive, to say the least.
The portfolio ends up owning a lot of smaller stocks. As seems to be the case with most value approaches, the last decade or so the real value is in the smaller stocks outside the major indexes and exchange-traded funds. If instant liquidity is part of your desired investment characteristics, you will not be able to use this approach. One of the real surprises this past year has been the discovery that real deep-value investing, whether in financials or other stocks, is a very small-cap endeavor. It is simply not scalable, and if it is your desire to run billions of dollars, you need to find another game to play.
When I run the screen today, it is heavily dominated by REITs, especially mortgage REITs. Business development companies (BDCs) are also well represented on the resulting list of undervalued financial stocks. The community bank stocks that make up the trade of the decade are a little over 20% of the portfolio right now. That's less than I would probably like to see, but I am not going to try to cherry-pick or tweak the model to produce the results I want. We will play it as it lies and see how the financial and real estate model does going forward.
The average market capitalization of the current portfolio is $2.8 billion, but the numbers are a little skewed due to a few large-cap stocks. The median market cap is just $326 million, so there is definitely a small-cap bias to the portfolio. The average price to book value is just 67%, so the stocks in the current mix are very cheap based on asset value. Because of the heavy weighting of M-REITs and BDCs, the average yield is 6.6%, so there is a nice income component to the current portfolio.
Even if you do not like quantitative value as a way of selecting stocks, the portfolio makes a fantastic shopping list. Some of my favorite small banks are on the list. My two favorite small-equity REITs, BRT Realty (BRT) and Independence Realty Trust (IRT), are in the current portfolio. Both are in the multifamily business and have been pretty much ignored by the market as they are not in most of the REIT ETFs that are attracting investor capital. In my opinion, both would make a fantastic acquisition for a larger multifamily operator.
The financials and REITs portfolio makes a fantastic shopping list for long-term value-oriented investors. It makes sense to spend a little time reviewing the stocks that made the cut this year.