4 Stingy Stocks for 2005
I look for two qualities when searching for bargain stocks; they must be cheap and they must be safe. Not surprisingly, it is often difficult to find stocks that are both cheap and safe. Indeed, the popularity of value investing has increased and good deals are becoming rare.
When it comes to cheap, I usually look for stocks with low prices in relation to book value, earnings, sales or cash flow. I find that it is usually best to initially search for cheap stocks using only one or two of these fundamental values because each search reveals a slightly different list of stocks. When developing my annual list for the Canadian MoneySaver I stick to stocks with price to sales ratios of less than one.
Stocks with low ratios can be tricky which is why I also want a degree of safety. Because large firms tend to be more stable than smaller firms, I limit my search to stocks in the S&P500.
More importantly, companies with little debt and lots of assets are in a much stronger position than firms with large debts. Three ratios are very useful when searching for companies with little debt. The debt-to-equity ratio is calculated by dividing a company’s long-term debt by shareholder equity. The amount of debt that a company can comfortably support varies from industry to industry but debt-to-equity ratios of more than one are generally too high. I prefer to consider companies with even less debt and look for a debt-to-equity ratio of 0.5 or less. Next up is the current ratio which is calculated by dividing a company’s current assets by its current liabilities. Current assets are defined as assets, such as receivables and inventory, that can be turned into cash within the next year. Current liabilities are payments that the company must make within the next year. Naturally, an investor would like a company’s current assets to be much more than its current liabilities and I prefer companies with current assets at least twice as large as current liabilities. Finally, a company’s earnings before interest and taxes should be large in comparison to its interest payments. The ratio of earnings before interest and taxes to interest payments is called interest coverage and I like this ratio to be two or higher.
While the debt ratios that I've selected are very useful when determining a firm's ability to shoulder debt, they are not perfect. Some long-term obligations may not be fully reflected on a company's balance sheet and are, sensibly enough, called off-balance sheet debt. Regrettably, off-balance sheet debt is often ignored but it can be a source of considerable consternation. Consider the case of Enron which floundered under a mountain of hard-to-find off-balance-sheet debt. As with all screening techniques, a more detailed investigation of each stock is warranted before a final investment decision is made.
Continuing to look for safety, I demand that a company has seen some earnings and cash flow from operations over the last year. After all, it is less likely that a business will go under when it is profitable and has cash coming in the door.
I've summarized all of my criteria in Table 1 and I've used the same criteria over the last three years to find interesting value stocks.
In 2002 the stocks selected based on my screen managed to outperform the S&P500 by 20.2 percentage points even though they lost 1.9% in absolute terms. In comparison the S&P500 was walloped by a 22.1% decline. The situation improved in 2003 with my value stocks gaining an average of 38.8% or 15.8 percentage points better than the S&P500 which gained 23.0%.
The good times continued in 2004 with value stocks gaining 29.8% from December 3, 2003 to December 1, 2004. The S&P500, as represented by the SPY exchange-traded fund, gained 13.4% which is 16.4 percentage points less than 2004's value picks.
So far, my strategy has gained 76.7% since 2002 whereas the S&P500 has gained only 8.7%. I'm pleased to report that my selections have had a very good run and they've outperformed the index by 68.0 percentage points. I should also hasten to add that I don't expect this method to routinely outperform the index. I fully expect that it will encounter a down year, from time to time. Recent history is instructive because the late 1990s saw value stocks languish for many consecutive years.
To find this year's crop of value stocks, I used the MSN.com deluxe stock screener on December 1, 2004 which yielded the four securities shown in Table 2. The majority of the stocks found this year were also on last year's list with Louisiana-Pacific (LPX) being the only new addition. I've also included each stock's dividend yield which should be of interest to investors looking for income.
Remember that it is worth taking time to fully investigate each stock, and to talk to your investment advisor, before investing. After all, there is no such thing as a risk-free stock.
It is interesting to note that the number of stocks found by my screen has been falling over the years with twelve in 2001, ten in 2002, eight in 2003 and only four this year. To my mind this trend is worrisome and a sign that the U.S. large-cap market is becoming less and less of a bargain.
Date: Jan 2005
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