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| The Basics | Pick stocks like the Super Value Gurus
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Value-oriented managers have individual strategies, but they have plenty in common. Here's a way to combine their stock research approaches in one screen.
By Harry Domash
Recently, I've had the opportunity to study the strategies of many value-oriented money managers. Although not all are superstar names, all had market-beating track records.
Here's what I found most interesting from my research.
Although each manager had fine-tuned their evaluation techniques, their strategies for finding value candidates worth analyzing were remarkably similar. It struck me that a single stock screen could be defined that would yield a list of stocks of interest to many value managers.
So I've combined a dozen or so of these selection strategies into what I've dubbed the "Super Value Guru" screen. I'll get into the details in a minute, but first some background.
Marching to a different drummer
Most investors I know, especially beginners, are growth investors. They are looking for the next hot stock. A company with new products that will capture the market by storm, sending sales and earnings, as well as the share price, to the moon.
Value investors hear a different drummer. They know that the market always overreacts to news, either good or bad. They seek out stocks that stumbled, inciting the growth crowd to rush for the doors, driving the share price far below its real value.
But a low stock price is not enough; value investors try to pinpoint the quality companies that will recover from their current problems. No perpetual cash burners need apply. Value investors want firms that, although going through a rough period, have a solid history of profitability. These are the stocks that will return to their winning ways once they've overcome their difficulties.
Even though I designed my Super Value Guru screen to come up with stocks that I think would be of interest to value pros, few would blindly buy the stocks turned up by any screen. They all believe in the value of due diligence, and most are passionate about the value of learning everything they can about a company before they buy.
Without further adieu, here's my Super Value Guru screen.
Get a grip on value
The first step is defining the value stock universe. From my perspective, value stocks should meet two basic requirements.
Obviously, the share price must be down. For me, that means it must be at least 25% below its five-year high. You can stiffen that requirement if you get too many hits.
Screening Parameter: Last Price <= 0.75*5-year High Price
Next, the best value candidates are stocks that stumbled in terms of profitability, so profit margins should be below historic levels. Income tax payments can distort the profitability picture, so I use the pretax margin. Current margins should be at least 10% below the five-year average. Again, try stiffening my requirement if you get too many hits.
Screening Parameter: Pre-Tax Margin <= 0.9*Pre-tax Margin: 5-Year Avg.
Now that we've scoped the overall value universe, we can pinpoint the best candidates.
Bigger is better
Many value managers prefer big companies. These firms have usually been around for a long time and have the resources to overcome temporary setbacks.
However, not all agree on what constitutes big enough. So I set up the screen to require a minimum $500 million market capitalization, which allows the largest small-cap stocks, and all mid- and large-caps. Increase the minimum to $2 billion if you just want to see large-caps.
Valuation ratios tell the story
I know this isn't a big surprise, but, in fact, most value managers rely on valuation ratios to qualify candidates. While some look for low price-to-earnings (P/E) stocks, using P/E means that you could miss many promising candidates. Here's why.
Usually, a value candidate's problems start with a falloff in earnings. Even though the share price drops, the earnings shortfall often causes the P/E to rise, not fall. This example tells the story.
Say a company earned $1 per share last year and is trading at $20. Using those numbers, its P/E is 20 ($20 divided by $1). Now assume something bad happens and this year's earnings plummet to $0.25 per share. Say the share price drops to $10 on the news and stays there for the year. Now the P/E, instead of dropping, actually increases to 40 ($10 divided by $0.25).
Many value managers avoid that problem by using ratios other than P/E to identify candidates. The price/book (P/B), price/sales (P/S) and price/cash flow (P/CF) ratios are the favorites of the value crowd. Some use all three, while others have a particular favorite. For my Super Value Guru screen, I use all three.
The price/book ratio compares the stock price to the shareholder's equity, which when expressed as a per-share number, is called book value. The book value is the theoretical value of the company's assets if it were liquidated. Some managers only consider stocks with P/B below 1. But since I'm using all three ratios, I allow a little more leeway and set my maximum P/B at 2.
Screening Parameter: Price/Book Value <=2
The price/sales ratio compares the recent share price to the last 12 months' sales, expressed on a per-share basis. Some value investors treat P/S similar to the P/B ratio and set a maximum acceptable ratio, usually in the 1.5 to 2 range. However, firms in low profit margin businesses, say grocery stores, always have low P/S ratios. Thus, relying on a fixed P/S usually results in a preponderance of low profit-margin stocks.
Comparing P/S ratios to a company's industry eliminates that problem. So, I define cheap stocks as those trading at P/S ratios at least 25% below their industry average.
Screening Parameter: Price/Sales Ratio <= 0.75* Industry Average Price/Sales Ratio
Finally, the price/cash flow ratio compares the recent share price to the last 12-month's per-share cash flow. Cash flow is the cash that actually moved into, or out of, a firm's bank accounts. Bank account balances can't be manipulated nearly as easily as reported earnings, so many value investors consider cash flow the best earnings gauge. Most set the P/CF ratio limit at 10 or 11. However, once again, since I'm using three valuation ratios, I loosened the upper limit somewhat and set it at 15.
Screening Parameter: Price/Cash Flow Ratio <= 15
Best bets already know how to turn a profit
As I mentioned earlier, value investing isn't just about finding cheap stocks. It's more about spotting long-term profitable companies that have been unduly punished for short-term problems.
Return on equity (ROE), which is net income divided by shareholders equity, is the most widely used profitability measure. Most money managers I've talked to, whether value or growth, require at least a minimum 12% ROE, and many specify 15%.
However, since a value stock's current profitability is usually depressed, value managers look at historical ROEs. If everything else looks good, they assume that the firm's ROE will return to historical levels when it recovers.
Consequently, my screen looks at the five-year average ROE. I set the minimum at 7.5%, since the long-term figure will be depressed by the current results. Try increasing the minimum to 10% if you get too many hits.
Screening Parameter: ROE: 5-Year Avg. >= 7.5
Debt can be a heavy anchor
Value managers prefer low-debt stocks because they figure that debt-servicing costs could cripple recovery efforts. I use two debt measures to rule out such stocks.
The debt/equity (D/E) ratio compares long-term debt to shareholder's equity. In general, lower is better, but what's low depends on the industry. For instance, utilities, with highly predictable revenue streams, typically carry much higher debt levels than, say, tech stocks with notoriously unpredictable sales. I finesse that problem by comparing D/E to each stock's industry average. Passing stocks' D/E ratios must be at least 10% below their industry average.
Screening Parameter: Debt to Equity Ratio <= 0.9* Industry Average D/E Ratio
Current ratio (CR) looks at the firm's ability to pay its immediate bills. It compares short-term assets such as cash and accounts receivables, to current liabilities such as accounts payables. CRs above 1 mean that current assets exceed current liabilities, which most value managers consider a prerequisite for value candidates. Consequently, I require a minimum current ratio of 1.
Screening Parameter: Current Ratio >= 1
Dividends not a drain
Most value managers see dividends as a good thing. But they don't want to see value stocks paying out too much of their income to shareholders while they're struggling to fix current problems. The payout ratio is the percentage of net income that a firm pays out in dividends. The MSN Deluxe Screen has a parameter that checks for payout ratios above 85%. I use it to eliminate stocks paying out that much.
Screening Parameter: Dividend Payout Ratio Above 85% False Now
At the time of publication, my screen turned up 12 value candidates in a variety of industries ranging from trucking to aerospace. The results may vary over time, and as with all screens, the results are not a buy list. Instead, these are stocks that value investors might find worthy of further research.
| Super Value Guru finds | | Company | Industry | Recent price | | Natuzzi (NTZ, news, msgs) | Home furnishings and fixtures | 10.50 | | Emcor Group (EME, news, msgs) | General contractors | 42.23 | | Northeast Utilities System (NU, news, msgs) | Electric utilities | 18.00 | | Royal Group Technologies (RYG, news, msgs) | Synthetics | 10.16 | | Linens 'n Things (LIN, news, msgs) | Home furnishing stores | 24.24 | | Triumph Group (TGI, news, msgs) | Aerospace/defense products and services | 36.70 | | Performance Food Group (PFGC, news, msgs) | Food wholesale | 24.70 | | USF (USFC, news, msgs) | Trucking | 35.46 | | H.B. Fuller (FUL, news, msgs) | Specialty chemicals | 26.97 | | Monaco Coach (MNC, news, msgs) | Recreational vehicles | 18.85 | | Maximus (MMS, news, msgs) | Education and training services | 29.66 | | THQ (THQI, news, msgs) | Multimedia and graphics software | 20.89 |
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Note: As of Jan. 11, 2005.
At the time of publication, Harry Domash did not own or control shares of any of the equities mentioned in this article.
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