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Picking stocks on book value back in vogue

Dot-com investors never paid attention to book value, which, at its most basic, measures a company's assets minus liabilities. When Internet stocks, which typically had little or nothing in the way of tangible assets, were soaring based on expectations of future growth, investing in a company because it looked cheap compared with its assets didn't work well.

But now, dot-coms are filing for bankruptcy, and suddenly book value has caught on again as a stock-picking technique and as a way to limit risk in a rocky market. Portfolio managers are once again buying stocks that trade for low multiples of book value per share. Their finds include Southern Co., an Atlanta utility whose stock sells for two times the company's book value, and Cambridge Technology Partners, a Cambridge, Mass., technology-consulting company that has fallen on such hard times that the stock sells for about as much as the company's net cash per share, which is even less than its book value per share.

After being trounced in recent years by "growth" stock investors who go for higher-risk investments, "value" managers, those bargain hunters who look so closely at book value, are laughing all the way to the bank.

"Whatever happened to those guys that kept telling us that we were all crazy for caring about what we paid for a stock?" James Barrow asks. He is co-manager of the $25-billion Vanguard Windsor II Fund, which is part of the Vanguard Group of funds. Windsor II lost nearly 6 percent in 1999 but gained more than 13 percent in this year amid declines in broad market indexes and double-digit losses at many mutual funds focused on stocks of companies with fast-growing earnings or revenue. Barrow's favorites include Southern Co., whose price-to-book ratio is about a third that of the overall Standard & Poor's 500 Index.

Stocks trading at low multiples of book values aren't flashy. Martin Whitman, manager of $1.85-billion Third Avenue Value Fund, has collected low book-value stocks such as American Power Conversion, a West Kingston, R.I., company that makes surge protectors, and Credence Systems, a Fremont, Calif., semiconductor-equipmentmaker. Credence's stock closed at $23 Friday, well off a 12-month high of $79.38 in May.

These companies, Whitman says, have virtues missing in most Internet stocks: They are making money. Also, they sell for less than 10 times next year's projected earnings, compared with a price/earnings multiple of more than 20 for the S&P 500 index; they have little or no debt; and they don't have to sell more shares to generate cash to keep them alive.

To be sure, Whitman says, book value won't matter in the short run as much as whether a stock makes its quarterly earnings. But, he notes, earnings modify book value. "If book value is unimportant, so are earnings." When critics of value investing complain about the "value trap" _ that is, cheap stocks that stay cheap _ he replies that patient value investors are rewarded when the value of their stock is recognized in a takeover, or through "general market recognition." Meanwhile, the value investor avoids what Whitman calls "the growth trap," or massive losses when expectations for expensive stocks don't pan out.

While investing based on book value didn't work during the tech and Internet boom of the late '90s, the approach was under assault even before then. Some investors worried that book value _ specifically, the depreciated value of a company's assets, including cash, accounts receivable and inventories, less its liabilities _ was corrupted as a financial benchmark.

Inflation had boosted the value of many assets marked down by depreciation, such as real estate. Meanwhile, expensive acquisitions had loaded up balance sheets with an intangible asset called "goodwill," whose value can be calculated in completely different ways, depending on what kind of accounting was used in the acquisitions. Therefore, comparing book values of different companies could at times be almost meaningless. Goodwill is an accounting term for the premium paid by an acquirer in excess of a company's tangible value.

Indeed, some investors, such as Barrow, decry the coming change in accounting rules that will allow companies to carry goodwill from acquisitions on their books without having to write off a portion each year. He fears this change would make it even easier for companies to pay too much in takeovers, which would put even more goodwill on the books. "Book value in some cases has become quite grossly distorted by acquisitions. There's so much goodwill on these books," he says. In fact, if a company has been an aggressive acquirer of other companies, he says, he won't consider book value as a benchmark.

Janet Pegg, an accounting analyst at Bear Stearns, says that growing sums of goodwill on company balance sheets will exaggerate the difference between book value and "tangible" book value, which excludes intangible assets such as goodwill, patents and rights to airport landing slots. If you don't think book value should necessarily shrink, it isn't necessarily bad that goodwill write-offs may end, she says.

Adversity has boosted the prominence of book value. Rob Mohn, manager of $220-million Acorn USA Fund, part of the Liberty Funds, says, "Now that some sectors are in a bear market, people are falling back on book value" as an investment tool. "In the past, it was at grungy blue-collar industrial companies, and at banks and insurance companies, where you heard the phrase "book value,' " he says. But there are "many small-cap(italization) tech stocks that went public in the past year or two and that are sitting on a huge pile of cash," and whose prices have plunged. "Some of these stocks look intriguing on a liquidation or book-value basis. The reason you look at book value is you don't have to go through making assumptions about how much cash flow they're going to generate. It's more of a salvage operation."

On that basis, Mohn likes Cambridge Technology, whose stock closed at $2.63 Friday. In 1998, it traded at more than $58, and its 12-month high is $27. As with many tech consultants, Cambridge's stock has been hammered by the decline in spending that followed last year's rush to fix potential Y2K computer problems, among other tribulations. The stock's book value is $3.78 a share, including net cash of $115-million, or $1.83 a share. Cambridge is burning through about $8-million in cash a quarter, Mohn says, but he expects the company to stanch the bleeding. Given that the current stock price is about the same as the company's cash per share, the stock market "is valuing its business at zero. We think it's logical to buy anything for free."

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