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How to find stocks on sale
Buying stocks when they're down is harder than it sounds. Here's how to screen out damaged goods.
By Jon D. Markman
A city bus drops me at a downtown Seattle street corner every weekday morning around 6:45, and I walk a short way to my office in the dark. After buying coffee at a Starbucks in the lobby, I march through a silent gallery of shops where signs provide an inescapable reminder of the ruination of retail this season: Sweaters, socks, toys and ball gowns, all marked 40% to 75% off.
If you love a discount, this is the time to take advantage, to be sure. And yet how many of us actually do buy the proverbial straw hat in winter? I am a bargain-hunter who favors items marked down at least twice, but it's mostly for instant gratification. If I were to buy a holiday gift for someone on sale this week from one of the shops in the lobby, I have zero confidence I would be able to find where I put it next December.
The stock market, though, tends to reward the patient bargain hunter -- and that's probably why fewer and fewer people seem to succeed at it. Buying shares for a three-week pop is a relic of the late '90s that reappears every few months when sentiment reverses sharply for a short while, as it did last July, October and earlier this month. We're definitely back to our fathers' market -- a time when it paid to slow down and take time to look for $10 stocks that might be $12 stocks in one year, not one day.
Whitney George, a portfolio manager at the Royce family of funds in New York and a master of the metaphor, refers to bear-phase periods like this as the planting season and bull-phase periods as the harvest season. When you plant seeds in the fall, you know that a chilly winter will prevent many plants from growing right away. And you know that a frost will even kill a few. But plant you must if you expect to be able to reap a crop in the spring. If farmers failed to sow just because there was a high probability of setbacks, nothing would ever be grown.
So even if you believe that for the most part U.S. stocks are overvalued and the broad market is headed for another big decline in 2003, it still makes sense to invest in well-seasoned companies whose shares are trading at 40% to 60% off their average five- to 10-year valuation. Take a handful of percentage points off, since a few of those years' valuations were nuts, and you might be looking at stocks that are trading at 75% to 90% off their average price-to-earnings multiple (P/E) -- and possibly even below their lowest multiple of the past five years. Then buy a few hundred or a few thousand shares and just grit your teeth if they go even lower, like a twice-marked down sweater that gets marked down a third or fourth time.
If it's good merchandise, it'll be worth twice what you paid for it the minute you take it home.
When the business, news and investor sentiment cycles turn, as they inevitably will, you will have a chance to profit from your patience. It's the investment equivalent of buying wholesale and selling retail.
How to find stocks on sale
One way to start the search for stocks like this: Screen the MSN Money database for profitable companies with market capitalization greater than $1 billion and five-year earnings growth of at least 7% per year that are trading at P/E multiples that are less than their five-year average multiple and are within 20% of their five-year low multiple. In the table below are the top 15 names that surfaced on Monday, ranked by the ratio of their current P/E to their 5-year low P/E, from low to high. (Click here for the screen.)
| Seeds for planting season | | Company name | Market cap | P/E ratio | 5-yr avg. P/E | 5-yr low P/E | Price chg/yr | 1/17 close | | Allegheny Energy (AYE, news, msgs) | 1.2 billion | 4 | 13.6 | 8.3 | -72.3 | $9.58 | | Electronic Data Systems (EDS, news, msgs) | 8.9 billion | 8 | 38 | 16 | -71.8 | $18.82 | | Tenet Healthcare (THC, news, msgs) | 8.9 billion | 7.4 | 26.2 | 11.9 | -56.3 | $18.80 | | Home Depot (HD, news, msgs) | 52.1 billion | 14.4 | 47 | 21.2 | -53.8 | $22.43 | | Safeway (SWY, news, msgs) | 11.2 billion | 9.9 | 25.8 | 14.4 | -36.3 | $25.56 | | TECO Energy (TE, news, msgs) | 2.7 billion | 6.6 | 15.3 | 8.8 | -38 | $15.50 | | DeVry (DV, news, msgs) | 1.15 billion | 18.1 | 39.5 | 23 | -39.5 | $16.45 | | CenturyTel (CTL, news, msgs) | 4.34 billion | 5.4 | 20.6 | 6.8 | 0.3 | $30.46 | | General Electric (GE, news, msgs) | 247 billion | 15.6 | 36.1 | 19.5 | -35.7 | $24.88 | | Freddie Mac (FRE, news, msgs) | | 8.3 | 19.5 | 9.9 | -4.9 | $64.72 | | Automatic Data Processing (ADP, news, msgs) | 21.6 billion | 20.2 | 35.4 | 22.4 | -37 | $36.10 | | Pfizer (PFE, news, msgs) | 185 billion | 21.9 | 48.6 | 23.6 | -25.1 | $30.04 | | Dollar General (DG, news, msgs) | 4.1 billion | 15.9 | 41.7 | 16.9 | -19.5 | $12.08 | | Old National Bancorp (ONB, news, msgs) | 1.4 billion | 12.4 | 22.2 | 13 | -1.4 | $23.46 | | Computer Sciences (CSC, news, msgs) | 5.6 billion | 14 | 28.4 | 14.4 | -27.6 | $32.53 |
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Now you've still got to do the hard work of studying the quarterly financials, analyst reports and news of these companies, but it's a start. Just don't expect to find a positive buzz that'll make you feel good about owning just about any of them. Companies get beaten down to these valuation levels because they're going through tough times and prior shareholders have traded out of them in disgust. Burned and rattled, they won't have positive bot mots to deliver to reporters who call at earnings-report time; they might be in trouble with federal regulatory authorities and their future will look bleak. But if you want to buy holiday gifts at 75% off in January, you've got to look past February through November to see the payoff in December.
An education in bargain hunting
One that catches my eye on this list is DeVry (DV, news, msgs), a small mid-cap company that provides technical and business education to students throughout the United States and Canada. With unemployment on the rise, business education is a surprisingly hard sell. In December, DeVry reported that undergraduate enrollment in their fall courses declined 12% from the previous year to 10,303. That followed a 6.1% fall enrollment decline in 2001. Moreover, total student enrollment was down 5.9% in the fall, to 45,200, versus a 5.3% increase in the prior period. Merrill Lynch, which has a "sell" rating on the stock, says enrollment trends may be stabilizing but probably have not hit bottom. The Merrill analyst, Lauren Fine, said in early December that new management is focused on cutting costs and slowing expansion, but that she believes shares will be negatively impacted by market conditions.
DeVry had previously been a tremendous stock, rising 3,500% from its initial public offering in 1991 at a split-adjusted $1.15 to its peak at $41.50 in November 2000; compare that to the 265% increase in the S&P 500 ($INX) and 425% increase in the Nasdaq Composite ($COMPX) over the same period. Its high P/E multiple over that period was about 58, and its low around 23. Yet the bear market has humbled many of the mighty, and shares now trade around $16.50, yielding a trailing P/E multiple of 18.
What distinguishes the stock, however, is that the quality of its earnings appears to be remarkably strong. According to a study by Earnings Quality Analytics, a research group that's affiliated with the managing member of my hedge fund, DeVry's operating cash flow and free cash flow are both accelerating more rapidly than net income -- a rare and positive sign in troubled times. Due to apparently improved collection procedures, moreover, accounts receivable decreased for the three months ended Sept. 30, 2002, while revenues increased -- another indication of strong operating results. If you look at the company's recent annual reports, condensed at MSN Money at this page, you'll see that sales, net income and net cash have all advanced in tandem even as share prices have declined.
| DeVry's earnings | | Annual Income Statement ($ MM) | Jun-02 | Jun-01 | Jun-00 | Jun-99 | Jun-98 | | Sales | 647.6 | 567.0 | 505.3 | 419.4 | 351.9 | | Total Net Income | 67.1 | 57.8 | 47.8 | 38.8 | 30.7 | | Annual Cash Flow ($ MM) | | | | | | | Net Cash from Operating Activities | 115.3 | 85.2 | 71.3 | 54.6 | 47.0 |
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Source: MSN Money
In my view, this is the sort of company that should rebound nicely once the economy turns, employment rebounds and investors refocus on fundamentals. If you are a DeVry student or faculty member, or current or former investor, and have a similar or contrasting opinion, let me know by writing to supermodels@jonmark.com and putting "DEVRY" in the subject field. Investing in bargain-priced stocks is always an education. If you want to wait for further deterioration before buying in, consider putting in a limit order near the $12 level the stock reached in October.
Fine Print
I received more than 400 responses to my column on UCLA physicist Didier Sornette and his model predicting further declines in U.S. stocks, many of them erudite and brilliant in their own right. Next week, my column will explore readers' thoughts on the use of mathematics and natural laws to understand the market for equities. On Dec. 4, my column ("Ready for a nasty reversal of fortune?") explained the concept of outside reversal weeks and suggested that the rest of the month would show a decline in broad indexes -- as it did. Now you should be aware that last week was another outside reversal week that has the potential to sharply undermine the up-move of early January.
Jon D. Markman is senior investment strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at supermodels@jonmark.com. At the time of publication, his fund held long positions in DeVry and Freddie Mac and a short position in Allegheny Energy, but positions can change at any time.
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