Passive Value investing: Screening for bargainsAs long as there have been markets, I am sure that investors have used screens to find good investments. It was Ben Graham, however, who systematized the process in his books on investing, by laying out the ten criteria (screens) that could be used to find cheap stocks. 1. An earnings to price yield > Twice the AAA bond rate (At the AAA bond rate of about 3.6% today, that would work out to an earnings to price ratio > 7.2% or a PE< 14)2. PE ratio today < 40% of the highest PE ratio for the stock over the previous 5 years3. Dividend yield > 2/3 or the AAA bond yield (At today's AAA rate, yield >2.4%)4. Stock price < 2/3 (Tangible book value of equity per share), where tangible book value of equity = Total book value of equity - Book value of intangible assets5. Stock price < 2/3 (Net Current Asset Value), where Net Current Asset Value = Current Assets - (Total Liabilities + Preferred Stock)6. Total debt < Book Value of equity7. Current ratio > 2, where current ratio = Current Assets/ Current liabilities8. Total Debt < 2 (Net Current Asset Value)9. Earnings growth in prior 10 years > 7%10. No more that two years in the prior ten, where earnings declined more than 5%.While we can debate the efficacy of these screens (I, for one, find that the fixation on net current asset value is too restrictive), it is quite clear what Graham was looking for: cheap companies with low leverage & stable and growing earnings, with liquid assets acting as a backstop and providing a margin of safety for investors.

Do screens work?Graham had three pricing screens among his ten criteria: PE ratios, a modified version of price to book ratios and dividend yields. In the decades since, studies (many from academics but quite a few from practitioners as well) have found  that at least two of these screens seem to work, at least on paper. Stocks that trade at low PE ratios and low PBV ratios deliver returns that beat the market, on a risk adjusted basis.

Let's start by reviewing the evidence. Rather than quote from studies that are at different points in time, I used the raw data (maintained very generously by Ken French at Dartmouth) to compute the differential returns that stocks, in the lowest and highest deciles of PE, PBV ratio and the  dividend yield, earned on an annual basis between 1952 and 2010, relative to the overall market:

Note that low (high) PE and low (high) PBV stocks have beaten (under performed) the market by healthy margins, before adjusting for risk, over time but that there is no discernible pattern with dividend yields. In fact, over the period, non-dividend paying stocks beat both the highest dividend

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yield and lowest dividend yield deciles in terms of returns earned. You can find more on past studies by going to my paper on value investing.

So, what's the catch?When it looks like you can make money easily, there is always a catch. Here are the three caveats on the "excess returns" that a low PE, low PBV strategy seems to deliver.1. Time horizon matters : The returns are in the long term (five years and longer) and there are time periods (some lasting for years) where the strategies under perform the market. For instance, looking across the entire period, for instance, it looks like while low PE stocks dominate high PE stocks over long periods, the latter group outperforms during periods of low economic growth (where growth becomes scarce).2. A proxy for risk?  While I did not adjust for risk in my computation for excess returns, most of the studies that have looked at these screens have controlled for risk, using conventional risk and return measures (betas, Sharpe ratio etc.). It is possible that there are other risks in buying these stocks that may not be full reflected in these risk measures. For instance, some stocks that trade at low price to book value ratios have high debt burdens and run a higher risk of default/distress.3. Transactions costs & taxes : A lot of strategies that make money on paper perform badly in practice because they expose investors to higher transactions costs and taxes. For instance, many of the stocks in the lowest PE ratio decile are lightly traded companies, with high bid-ask spreads and potential for price impact. Similarly, investing in high dividend yield stocks may expose investors to higher taxes.In a testimonial to how difficult it is to convert paper profits to real profits, it is worth noting that the James Rea's attempts to put Graham's principles into practice in an investment fund that he ran from 1982 to the late 1990s was an abject failure, with the fund ranking in the bottom 20% of the fund universe in performance. In a similar vein, Value Line's attempts to convert its screens (that also worked exceptionally well on paper) into a mutual fund also failed.

Incorporating screens into investingIf you do buy into the effectiveness of screens at finding cheap stocks, there are two ways to incorporate screens into your investing.a. Bludgeon Screening: In this approach, all of the work in picking stocks is done by your screens. Thus, you start with a large universe of stocks and screen your way (using either more screens or tighter screens) down to a portfolio size (in terms of number of companies) that you are comfortable with.b. Screening plus: You use the screens to narrow the universe of stocks (which may contain thousands of stocks) to a more manageable number, but you then follow up using one of these approaches: Screening plus intrinsic valuation : You value each of the screened stocks using an intrinsic valuation model (a discounted cash flow model, excess return model or your own variant) and invest in the most under valued companies. You can also incorporate a margin of safety into this approach by only investing in stocks that trade at 30%,40% or 50% discounts on your intrinsic value. Screening plus qualitative analysis : Once you have the screened list, you may be able to apply qualitative criteria that you think separate winners from losers (moats, good management etc.) to find the stocks for your portfolio.A blueprint for screeningIn Graham's day, screening was an arduous process, with limited access to the financial statements of companies and no computing power. Today, screening has become easy with many sites offering stock screeners for all, sometimes at no cost: Yahoo! Finance, Google Finance and MarketWatch all offer simple screening tools. In fact, it has become so easy that investors sometimes get carried away, piling on redundant screens on top of each other and sometimes undercutting their effectiveness by doing so.

Before you start, be clear about your objectiveYou want to find a mismatched company, i.e, a company that is priced low, with none of the reasons for being priced low (high risk, low growth, low quality of growth). In other words, you want a stock trading at a low multiple, with low risk, high growth rates and high quality growth. What chance do you have of finding such a bargain? It may be low, but there is no harm looking.

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Step 1 - Screen for priceThe first step is to screen for low . With stocks, this will almost always require that you scale the market price to a common variable (revenues, earnings, book value etc.) to estimate a multiple. Here are your choices:

In making these choices, you have to be consistent. If your numerator is an equity value (market capitalization, stock price), your denominator should also be an equity value (net income, earnings per share, book value of equity). If your numerator is an enterprise or overall business value (enterprise value, value of firm), your denominator should be an overall firm number (operating income, EBITDA, revenues, book value of invested capital). Should you use an equity multiple or an enterprise value multiple? In some sectors, such as financial services, you have no choice but to use equity, since defining debt is close to impossible. In others, you have a choice, and here is my simple rule. If financial leverage varies widely across the sector (some firms have more debt than others), I would go with an enterprise value multiple. For comparisons across the entire market, enterprise value multiples tend to be more robust.

Once you have picked a multiple, you then have to choose your screening thresholds. In practical terms, you have to decide how low does a stock's pricing multiple has to be to qualify for your cheap list. There are three ways to find this threshold.a. You can use the rules of thumb that seem to be so widely prevalent: an EV/EBITDA less than 6 is cheap, a PE ratio in the single digits is low etc. While these rules of thumb may have made sense when first devised, it is doubtful that they make sense today.b. You can derive the "cheap" threshold from intrinsic valuation models. To illustrate, the PE ratio for a firm that pays its entire earnings out as dividends and has no growth should be as follows:

Intrinsic "cheap" PE threshold = 1/ Cost of equityIn June 2012, when the cost of equity was computed to be about 8%, the threshold for a "cheap" company would be 12.5 (=1/.08).c. You can derive the threshold by looking at the distribution of the values of the multiple across your sample, using the lowest decile (or lowest quartile) as your cutoff for "low". The table below lists the deciles for key multiples for US companies in January 2012:

Thus, looking for stocks with a PE less than 5 would give you stocks in the lowest decile whereas using a cut off of 10 for the PE would give you stocks in the top quartile, at least in early 2012.

Step 2 - Screen for riskCompanies that are very risky can look cheap, without being cheap. To screen for risk, consider first a breakdown of risk into three categories:(a) Operating risk, reflecting the risk that your revenues and costs can shift over time, as the market and the sector evolve.

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(b) Financial risk, coming from the use of debt, leases and other fixed commitments that can make your residual stake as the equity investor much more volatile.(c) Liquidity risk, that you face as as investor when trading on the stock, manifested as trading costs (bid ask spreads, price impact) and inability to trade at the extreme.

The screens for risk can broadly be categorized as follows:1. Price based screens:  While many value investors express disdain for betas, there are other price based screens that are based upon prices (standard deviation, volatility in the stock price) that they may still be willing to use as measures of composite risk. In fact, you can use screen for liquidity risk, using market data, by looking at the bid-ask spread or the trading volume/float in a stock.2. Accounting based screens:   Accounting statements can provide snapshots of risk, though they are stronger in measuring some types of risk than others. You can measure exposure to financial risk fairly well, using ratios that measure the capacity to make interest or debt payments (interest coverage, fixed charge coverage ratios), operating risk less well (variability in earnings over time) and liquidity risk not at all.3. Risk proxies : While this may be applying a broad brush, you may use the sector a firm is in as a proxy for risk; thus technology companies may be viewed as risky companies and utilities as safe companies. Alternatively, you may believe that large companies (measured in market capitalization or revenues) are safer than small companies.4. Sector specific screens : If you are screening for cheap stocks within a sector, you may use measures of risk that are specific to the sector. Among bank stocks, for instance, you may look at regulatory capital ratios or exposure to problem assets/businesses; banks with lower regulatory capital or greater exposure to toxic assets are riskier. As with the multiples, you can see the quartiles of the distribution for these variables for US stocks in January 2012 in the table below:

Step 3- Screen for growthIf you are a value investor who views growth as icing on the cake, you may not look for  high expected earnings growth but you may still want to screen for companies with moderate growth prospects or at least try to avoid companies with negative earnings growth. In screening for growth, you should stay true to the consistency principle, focusing on growth in equity earnings, if you are using an equity multiple (like PE) or growth in operating earnings, if you are using an enterprise value multiple and you would rather be forward looking in your growth estimates (using expected future growth, if available) rather than backward looking (historical growth). The quartiles of growth measures for US stocks in January 2012 is in the table below:

Step 4 - Screen for quality of growth If you are employing a growth screen, you also want to ensure that the firm is not spending too much to deliver that growth. To screen for quality of growth, you can employ one of two approaches:a. Accounting return measures: Dividing the accounting earnings by accounting book value gives you a measure of accounting returns:Return on equity = Net Income/ Book value of equityReturn on invested capital = Operating income/ (Book value of equity + debt - cash)While they are aggregate measures for the whole firm and accounting earnings/ book value are susceptible to accounting manipulation, you want firms that are able to earn high returns on their

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growth investments in your portfolio. At the minimum, the returns should exceed the costs (the cost of equity, if ROE, and the cost of capital, if ROIC).b. Sector specific measures: You can also measure efficiency of growth using sector specific measures, such as profit margins (net or operating) in retail, capital invested per subscriber (in cable or other subscriber-based businesses) or capital invested per kWh of power produced (for power companies).The quartiles for ROE, ROIC, net and operating margin for US companies in January 2012 are reported in the table below:

Step 5: Rinse and repeatOnce you run your screens, check the stocks that come through the screens for two potential problems. The first is sample size. If your screens return only a handful of stocks, your screens have been set too tight and you should consider relaxing one or more of your screens (settling for lower growth or higher risk). The second is sector concentration. If you end up with stocks that are in one or a couple of sectors, you may want to consider modifying or adding to your screens to get more diverse portfolios.

While you can screen for free at Yahoo! Finance and Google Finance, you get far more flexibility in defining your own screens if you have access to a database. For US companies, you can tryValue Line or Morningstar, both of which provide real time data for the entire universe of traded stocks and are not unreasonably priced. For screening of stocks outside the US, you can use Capital IQ, Factset or Bloomberg, but the price tag gets higher. There are some innovative sites out there that are offering better screening tools and large databases, such as RobotDough, a site that combines an impressive database with powerful screening tools, AAII and Zacks (which has a combination of free and premium screens).

Odds of successI have always believed that, as an investor, you need to bring something unique to the table to be able to take something away in terms of excess returns. In other words, just as  we look at competitive moats for successful businesses, you have to think about your competitive moats as an investor. With screening, consider the competitive advantages that Ben Graham saw for the intelligent investor in 1951, when he put together his classic screen list. The first was access. With limited access to financial statements and no easy-to-use tools, only a few tenacious investors could use these screens. The second was discipline. Investors had to stay away from distractions and fads and stay true to those stocks that made it through the screens. The third was patience. Investors had to hold the screened stocks in the long term to generate the promised returns. Today, with widespread access to data and analysis tools , the first advantage has dissipated, leaving behind patience and discipline as your potential advantages. It can be argued that an automated screening/investing process, with no human input, is less likely to succumb to emotion than the most disciplined, patient human being. Put more bluntly, if all you have to offer as an active investor is screens, you are unlikely to beat a machine doing the same. With screening plus, whether you make money depends on the quality of what you do after you screen. If you are skilled at intrinsic valuation or qualitative assessment, you may generate excess returns, relative to the market.

In closingTo illustrate the screening process, I used Capital IQ data and used two sets of screens to arrive at a list of "cheap" stocks from a universe of 7542 publicly traded companies in the US.Equity screen: Low PE (<10.11, in bottom quartile), above-average expected EPS growth rate (>13.50%, above median), below-average book debt to equity ratios (<27.21%, in bottom quartile), high ROE (>13.60%,top quartile)    --> See the  19 stocks that made it through these screensEnterprise value screen: Low EV/EBITDA (<4.51, bottom quartile), above-average expected revenue growth (>7%, above median), below-average book debt equity ratio (<27.21%, below median), above-average ROIC (>9.41%, top quartile)   --> See the 13 stocks that made it through these screensI would not be rushing out to buy all of the stocks on either list, but I think it is worth following through

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and doing intrinsic valuations of these companies. Anyone up for it? If so, you are welcome to use my generic valuation spreadsheet.

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Contrarian Value Investing - Going against the flow....Nokia came out with an awful earnings report yesterday, with warnings of more bad news to come, and its stock price, not surprisingly, plummeted.

While investors are fleeing the stock and a ratings downgrade looms, is it a contrarian play? What about JP Morgan Chase? Or Research in Motion? Netflix or Green Mountain Coffee, anyone? By focusing on stocks that other investors are abandoning, contrarian value investing is the "anti-lemming" strategy, but it takes a unique personality and a strong stomach to pull off successfully.

The basis for “contrarian” investingThe core belief that underlies contrarian investing is that investors over react to both good and bad news, pushing prices up too much on the former and down on the latter. If you carry this view to its logical conclusion, it then follows that prices will reverse in both cases as investors come to their senses.

While you may believe that investor overreaction is the norm, is there evidence to back up the claim? The statistical and the psychological evidence is mixed and contradictory. On the one hand, there is significant evidence that investors under react to news stories (earnings reports, dividend announcements), leading to momentum (and drift) in stock prices, at least over short periods. On the other, there is also evidence that investors over react to information, with price reversals occurring over longer periods. In behavioral finance, as well, there are two dueling "psychological" characteristics at play: the first is that of "conservatism", where individuals, faced with new evidence, update their prior beliefs (expectations) too little, thus creating under reaction, and the second is "representativeness", where individuals over adjust their predictions, based upon new information. To reconcile the co-existence of the two, you have to bring in two factors. One is time, with under reaction dominating the short term (days, weeks, even months) and over reaction showing up in the long term (years). The other is the magnitude of the new information, with over reaction being more common after big events. 

Contrarian investing strategiesWithin the construct of contrarian investing, there are at least four variants. In the first,  you invest in the stocks that have gone down the most over a recent period, making no attempt to be a discriminating buyer. In the second, you focus on sectors or markets that have been hard hit and try to identify individual companies in these groups that have been "undeservedly" punished. In the third, you look at companies that have taken hard hits to their market value but that you believe have underlying strengths which will help them make it back to the market's good graces. In the final approach, you buy stock in beaten up companies with the same intent (and expectations) that you have when buying deep out of the money options. You know that you will lose much of the time but when you do win, your payoff will be dramatic.

1. The Biggest LosersIf you believe that investors tend to over react to events and information, the effects of that over reaction are most likely to be seen in extreme price movements, both up and down. Thus, stocks that have gone down the most over a period are likely to be under valued and stocks that have gone up the most over a period are likely to be over valued. It follows, therefore, that if you sell short the former

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and buy the latter, you should be able to gain as the over reaction fades and stock prices revert back to more "normal" levels.

In a study in 1985, DeBondt and Thaler constructed a winner portfolio, composed of the 35 stocks which had gone up the most over the prior year, and a loser portfolio that included the 35 stocks which had gone down the most over the prior year, each year from 1933 to 1978. They examined returns on these portfolios for the sixty months following the creation of the portfolio and the results are summarized in the figure below:

An investor who bought the 35 biggest losers over the previous year and held for five years would have generated a cumulative abnormal return of approximately 30% over the market and about 40% relative to an investor who bought the winner portfolio.

Looks good, right? Before you rush out and load up on the biggest losers of the last year, a few notes of caution:1. Watch out for transactions costs:   There is evidence that loser portfolios are more likely to contain low priced stocks (selling for less than $5), which generate higher transactions costs and are also more likely to offer heavily skewed returns, i.e., the excess returns come from a few stocks making phenomenal returns rather than from consistent performance.2. Timing is everything:      Studies also seem to find loser portfolios created every December earn significantly higher returns than portfolios created every June. This suggests an interaction between this strategy and tax loss selling by investors. Since stocks that have gone down the most are likely to be sold towards the end of each tax year (which ends in December for most individuals) by investors, their prices may be pushed down by the tax loss selling.3. Time horizon matters:  In a test of how sensitive the results were to holding period,Jegadeesh and Titman tracked the difference between winner and loser portfolios by the number of months that you held the portfolios and their findings are summarized in the figure below.  There are two interesting findings in this graph. The first is that the winner portfolio actually outperforms the loser portfolio in the first 12 months. The second is that while loser stocks start gaining ground on winning stocks after 12 months, it took them 28 months in the 1941-64 time period to get ahead of them and the loser portfolio does not start outperforming the winner portfolio even with a 36-month time horizon in the 1965-89 time period. 

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If you feel that, in spite of these caveats, this strategy may work for you, you can take a look at a list of the 50 companies that have gone down the most (in percentage terms) over the last 52 weeks (June 2011-June 2012). I have added a stock price constraint (to ensure that you don't end up with low-priced stocks) and reported the dollar trading volume per day (as a red flag for trading costs).  I have compiled the list for the US (with price>$5), Europe (with price>$5), Emerging Asia (with price>$1), Latin America (with price>$1) and global (with price>$5). Your timing is off (since it is not January) but you can still browse for bargains. You can also adapt the screening plus strategy that I talked about in my post on passive screening and subject the companies on these lists to follow up analysis (intrinsic valuation or qualitative assessments)>

2. Collateral DamageIt is not uncommon for markets to turn negative on an entire sector or market at the same time. In some cases, this is justified: a big news story that affects an entire sector, or a macro economic risk that hurts a market. In others, it may represent either an over reaction by investors to the idiosyncratic problems of an individual company in a sector or a failure to consider that companies within a market/sector may have different exposures to a given macroeconomic risk. As an example of the former, consider how banking stocks were punished on the day that JP Morgan Chase reported its big trading loss. As an illustration of the latter, you can look at the Spanish stock market, where investors have punished all companies (though some are less exposed to Spanish country risk than others) over the last year.

About a decade ago, I penned a paper on measuring company risk exposure to country risk that argued that we (as investors) were being sloppy in the way we assessed exposure to country risk, using the country of incorporation as the basis for measuring risk exposure. With this view of the world, US and German companies are not exposed to emerging market risk, an absurd argument when applied to companies like Coca Cola and Siemens that derive a large chunk of their revenues from emerging or risky economies. By the same token, all Brazilian companies are equally exposed to country risk, though some (such as the aircraft manufacturer, Embraer) derive most of their revenues from developed markets. This laziness in assessing country risk does provide opportunities for perceptive investors during crises. This was the case when Brazilian markets went into a tailspin in 2002, faced with the feat that Lula, then the socialist candidate, leading in the polls, would win election to lead the country. As Embraer fell along with the rest of the Brazilian market, you could have bought it at a "bargain basement" price. If you are interested in following this path, here is my suggestion. Start putting together a list of companies like Embraer, i.e., emerging market companies that have a significant global presence and then wait for a crisis in the emerging market in question. When there is one (it is not a question of whether, but when....), and your "global" company drops with the rest of the market, you are well positioned to take advantage.

It is trickier, though, playing this game within a sector. Consider the JP Morgan Chase case. While the trading loss was clearly specific to JPM, you could argue that the event affected the values of all banks at two levels. The first is by increasing the chance that the Volcker rule, barring proprietary

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trading at banks, would be adopted, it affects future profitability at all banks. The second is the fear that in response to the loss, the regulatory authorities would require higher capital ratios be maintained at all banks. If those are your concerns, you should focus on banks that do not make have a large proprietary trading presence and are well capitalized. If investors have over reacted across the board, those banks should be trading at attractive prices.

 3. Comeback BetWhen stock prices drop precipitously for an individual stock, there is usually a reason. If the drop reflects long term, intractable problems, there may be no reversal. If the drop reflects temporary or fixable problems, you are more likely to see prices reverse. As you look at the reasons for the price drop, you should keep in mind your overriding objective, which is to find a company whose price has dropped disproportionately, relative to its  value.

Here are some possible reasons for a stock price collapse, with the ingredients for a comeback:a. Unmet expectations: When expectations are set too high or at unrealistic levels, it is inevitable that investors will be confronted with reality not matching up to expectations. When that happens, they will abandon the stock, causing stock prices to drop. (Netflix and Green Mountain Coffee, both of which make the list of biggest losers over the last year are good examples of what happens to high flyers when they disappoint...)Ingredients for a comeback: Expectations have dropped not just to realistic levels but below those levels. Investors have over adjusted.b. Corporate governance issues: Events that lay bare failures of managers and oversight by the board of directors shake investor faith and, by extension, stock prices. A case in point would beChesapeake Energy, where the CEO, Aubrey McLendon, stepped down after evidence surfaced that the board of directors had allowed him to use $800 million in personal loans to acquire stakes in company-operated oil wells.Ingredients for a comeback: (a) A new CEO from outside the firm, (b) with a full cleaning out of management team and revamping of board of directors, and (c) an activist investor presence.c. Accounting fraud/ manipulation: As investors, we start with the presumption that financial statements, while reflecting accounting judgments that may work in the company's favor, are for the most part true. Any suggestion of accounting fraud can lead to a meltdown in the stock price, not to mention open the company up to legal jeopardy.Ingredients for a comeback: (a) Full reporting of all accounting misstatements, with (b) removal of top management, and (c) no legal jeopardy.d. Operating/Structural problems: Operating problems can range from problems with a key product (see Dendreon, on the list of biggest losers last year) to deeper structural problems, where the company's products just don't match up well to consumer demands or to the competition.Ingredients for a comeback: (a) Management that is not in denial about operating problems and (b) a realistic plan for dealing with operating problems.e. Financial problems: When operating problems combine with significant debt burdens, you have the seeds of distress, which can spiral very quickly out of control, as suppliers, employees and customers react pushing the company deeper into trouble.Ingredients for a comeback: (a) A clear debt restructuring/repayment plan, (b) Solid operating performance.

Whatever the reason or reasons for a price collapse, investors have to follow up by asking and answering three questions:1. Is "it" a one-time or continuing problem? While the line between one-time and continuing can be a shade of grey, the answer is critical. One time problems tend to have much smaller impact on value than continuing problems, and are easier to deal with and move on.2. How fixable is the problem? Some problems are more easily fixable than others. In making this judgment, you should look at three factors. The first is whether the problem is entirely an internal problem or whether it is partly or mostly due to outside or macro factors. Internal problems are easier to remedy than external ones. The second is whether the solution can be "quick" or will take "time". Thus, a firm with significant debt may be able to restructure that debt quickly, whereas a firm that has deep-rooted structural problems will need more time. The third is whether the managers of the firm seem to have both a reading of the problem and a solution in hand.3. Is the market decline disproportionately large? To make this assessment, you have to work through the consequences of the problem for the determinants of value: its effect on current cash flows, the expected value of growth (both the level and the quality) and the risk in future cash flows.

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Using this framework, let's look at JP Morgan Chase. At first sight, it looks like a slam dunk. The trading loss was reported to be $2 billion at the first announcement and it seems like a fixable problem in the short term, with better risk management in place. The fact that the market capitalization went down by more than $30 billion on the announcement of the loss seems to suggest an over reaction, but there is more to this story than meets the eye. The first is that the trading loss of $ 2 billion is an estimate and the actual losses may be higher (the rumor mill suggests that they could exceed $5 billion). The second is that the loss will reduce the current regulatory capital and may increase the target regulatory capital ratio that JP Morgan aspires to reach over time; the combination of a lower current capital ratio and an increasing target capital ratio will translate into lower returns on equity, going forwards, and lower cash flows available to stockholders in the future (in the form of dividends or buybacks). To make a judgment on whether the stock is a bargain at the current price, I used a simple test. The price to book ratio for a mature bank can be written as:Price to book ratio = (ROE - Expected growth)/ (Cost of equity - Expected growth)Conservatively, if you assume a growth rate of 1.5% in perpetuity and a cost of equity of 9% (about 1% higher than the cost of equity for an average risk company), the return on equity implied at the JPM's current price to book ratio of 0.73 is about 7%:0.73 = (ROE - 1.5%)/ (9%-1.5%)Implied ROE = 6.98%The ROE in the most recent year for JPM, prior to its loss, was 10.34%. Even allowing for higher regulatory capital requirements (which will increase book equity) and lower profits (perhaps from the Volcker rule), the adjustment seems like an over reaction.  I know that there are other fears hanging over large banks, but I have a spreadsheet that I think contains a a conservative valuation of JPM that yields a value of about $46/share, well above the current stock price of $35. You can use it to make your own judgments for JPM or any other bank.

4. "Long odds" optionThere is one final scenario: a company whose stock price has collapsed, with good reason and where a turnaround is neither anticipated nor expected. In other words, the stock looks fairly priced, given its prospects and problems today. However, let's assume that the firm has proprietary assets is in a risky business, where technology shifts could make today's winners into tomorrow's losers and vice versa. You could consider investing in this company's shares, for the same reasons that you buy an out of the money option.

In effect, you are leveraging the fact that equity in a publicly traded company has a floor of zero and that your losses are therefore restricted to the prevailing market value of equity. For your option (equity investment) to have a big payoff, though, you will need  the value of the firm's assets to increase significantly from existing levels (because of a new product, market shift or an eager acquirer) and that will require that your firm have a proprietary technology/product/licenseand operate in a  shifting, risky business. While the value of the assets could drop just as precipitously, you care less about downside because you don't have much to lose (since your equity value is so low).

Nokia (NOK) and Research in Motion (RIM) come to mind as potential option plays. They both have proprietary technologies and patents (though the market does not think that either technology looks like a potential winner in the market today) and operate in a risky business where the landscape can shift dramatically over night. While the Blackberry technology is a more reliable cash provider for RIM, there are three factors that tip me towards Nokia. The first is Nokia's stock price has dropped far more than RIM's over a shorter period, reducing the cost of my option. The second is that Nokia's debt burden is a mixed blessing: it could cut my option game short, if Nokia defaults, but it also leverages any upside in value. Small changes in Nokia's asset value will translate into big changes in equity value. The third is that the turmoil in the Euro zone adds to the value of my option. Put differently, I like Nokia because it is riskier than RIM, but risk is my ally, not my enemy, with an option. If you plan to invest in Nokia, do so with the full recognition that you may have to write off the entire investment a few months or years from now, but if the stars align, watch out!!!

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