The economy is a mess and nobody knows how long it will stay that way. So rather than looking at who beats estimates by how much (the usual favorite metric among investors), the big issue is staying power - which companies are most likely to be able to withstand a potentially prolonged flat-line economy and still be relevant when conditions finally improve. One potential clue is a balance sheet with zero debt. Such firms won't be admired by academic capital structure theorists, but in times like these, they might garner respect from Wall Street, especially if their stocks are bargain priced.
The Debt-free Bargains screen
After establishing a basic universe (no OTC or ADRs, no Finance stocks, Market Cap at least $250 million and Price at least $5), this screen uses the following rules:
- Total debt equals zero. This is the core theme. It's measured as of the latest available balance sheet.
- Trailing 12 month EPS above zero.
- Quick Ratio of at least 2.00. These tests assume that profitable and reasonably liquid companies have a better chance of maintaining strong balance sheets. Liquidity is especially important nowadays, since it's not clear how easily companies can get new borrowings on reasonable terms if they decide they want to take on debt.
- Price/Book less than or equal to 1.25. This basic valuation test is less intense than the one in the book-value bargains screen but it's still conservative. After eliminating the smallest least liquid stocks, the average Price/Book ratio is 2.78; the market cap weighted average is 2.67 and the median is 1.5.
After looking at two other deep-bargain screens geared toward a depressed market (book-value bargains and cash bargains), I know the first question that needs to be tackled is how many stocks we're likely to see in lists created by a screen like this, how much insight can be gleaned from backtesting, and whether it would be practical to implement such a strategy on a purely rules-driven basis.
As it turns out, though, this screen produces more testable lists. That's not to say we always see an abundance of passing companies. But since mid-2002, we have had at least five passing companies in 53 out of 84 trials. For much of the past year, the lists have been in double digits. Whether or not this gives me enough confidence to rely on the rules alone, as opposed to individual-company fundamental analysis, is borderline. So I'll look at the screen as is, and again by applying a rule that when more than five companies make the list, I'll sort and narrow down to five.
Figure 1 shows the results of the backtest I did on Portfolio123 for the full screen from 3/31/01 - 12/22/08.
That's not bad. I notice the dip in 2008, but it seems more in line with the market than was the case for other deep-bargain screens.
Figure 2 likewise covers 3/31/01 - 12/22/08, but limits the results to the five best stocks sorted based on 5-year relative (company versus industry average) return on investment (ROI).
The five-year sort metric, focusing as it does on companies with longer-term track records of superior performance, clearly added a defensive quality to the protocol and reduced our losses in 2008.
Figure 3 shows what happens when I use trailing 12 month (TTM) relative return on investment as a basis for sorting.
It's very hard to say which version of ROI produces better recent performance. So here are some one-year tests. (Note that the 2008 performance won't precisely match what we saw in Figures 2 and 3 since the screen-run dates may not fall out on the exact rebalancing dates used in the tests that started 3/31/01.)
Figure 4 shows the latest-year result when we use the five-year average ROI.
Figure 5 shows the result of the latest-year backtest using TTM ROI.
The recent upward blip in the TTM version is quite conspicuous. I checked the companies on the list and saw nothing that I'd dismiss as an aberration. So clearly, TTM ROI wins out in the most recent periods. I wouldn't say it's a statistically convincing victory. I see little substantial performance differences in Figures 2 versus 3 and in most months from Figures 4 and 5. I could compare the specific numeric results, but I think that sort of hair-splitting would amount to little more than data mining.
So statistically speaking, I'm going to call it a tie. For purposes of actual stock-picking, I'm going to use the TTM version of ROI. While it may not be my first choice if I'm adopting a long-term orientation, it does have a "what have you done for me lately" quality that seems a worthy tie breaker right now, given that we still have no idea how long it will take for economic conditions to improve.
As noted, I wouldn't argue with anyone tempted to simply buy the list based only on the rules. But then again, with the economy so bad, I likewise wouldn't diminish the value of one-on-one examination.
Any sort of fundamental study needs to be done in the proper context. All companies face abysmal earnings prospects for the foreseeable future. One who would dismiss a company for that reason probably shouldn't be pursuing a deep-value investing strategy at all.
Assuming one is willing to accept that situation and buy in bad times (a potentially great strategy since we know how vigorously good cyclical stocks can soar at the first hint of recovery, but risky since we don't know when that will start), here are the final five debt-free bargains with the best trailing 12 month return on investment:
- Lufkin Industries (NASDAQ:LUFK). This firm makes equipment primarily for use in oilfield drilling. It was a star not long ago, as soaring oil prices sparked a surge in activity. Now, given the recent reversal in oil prices, LUFK's earnings prospects look less rosy. When oil prices are lower, producers drill less aggressively and, hence, LUFK is less prosperous. But in terms of long-term staying power, it's not as if oil drilling is going to cease. LUFK was profitable before oil surged a few years ago and its stock is now back down near early-2005 levels. As to the future of oil, I'm not an expert, but then again, how many such prognosticators exist? (When oil was last at $40, how many forecast a rise to $150? When oil was at $150, how many forecast a drop back to $40?) But I do know the obvious: that it's taking a substantial global economic downturn and a massive liquidation of speculative holdings to get oil back to $40. Is it difficult to imagine oil moving up, at least a bit, when the economy recovers, even if speculators don't come back? All in all, LUFK seems to fit well with the concept of this screen.
- Sigma Designs (NASDAQ:SIGM). This electronics firm makes integrated circuits mainly for home multimedia products. Its big item is the emerging Internet protocol television (IPTV) area. It's also involved with DVD, HDTV, and portable media players. The economy is crimping developments in these areas now, but looking ahead, these are growth businesses. Nothing will come easily as competition will grow: Broadcom (BRCM) is getting involved with IPTV. But this screen is not about unassailable economic moats (assuming they really exist, a highly debatable topic). It's about fundamentally decent companies with balance sheets that give them the wherewithal to ride out storms, and bargain-priced stocks. SIGM fits the bill.
- Cognex (NASDAQ:CGNX). This company has an interesting technological expertise: machine vision systems, or in other words, computers that can "see." Sample applications include reading unique ID codes marked directly on items such as semiconductor wafers and engine parts, ensuring that safety seals are present on pharmaceutical packaging, verifying product assembly, guiding placement of electronic components onto printed circuit boards, detecting surface defects in steel, paper and plastics, and verifying the fill level on beverage containers. This seems like a nice collection of important but cyclical activities. So as is often the case nowadays, expect considerable profit pressure for a while. But fundamentally speaking, CGNX seems like a very reasonable example of the investment theme expressed by this screen.
Korn/Ferry International (NYSE:KFY). This is a leader in the executive search area. It also provides other kinds of talent management consultation. Not surprisingly given what's happening in the world, business, previously strong, hit a brick wall. Management guided for a 40%-45% year-to-year revenue drop in November and left the door wide open for further downside revision. I'd hesitate to expect the revenue decline to reach 100 percent, but I can't rule out the possibility that we're going to learn how low a normally-vibrant publicly-traded corporation's revenue stream can actually go. The good news (sort of, depending on whether or not one works at KFY) is that it's primarily a people-based business, meaning that costs can likewise be cut quite far. The stock, in the vicinity of $10, is about half its 52-week high and well above the mid-single digit lows achieved in 2002-03. That's good in that it reflects an investment-community belief that KFY's ability to cut costs (it already made substantial layoffs) will suffice. Or it's bad in that it reflects an investment community failure to come to grips with how far revenues could conceivably fall. The 2001-2003 annual decline amounted to 48 percent. But this slump is more broad based, so I wouldn't assume 48% is the ultimate floor. I'm impressed by the company's survivability, which is what this screen is all about.
The stock is a tough call. As we saw with homebuilders a few years ago, even when it became apparent that the business was coming under pressure, analysts and investors were slow to come to grips with how much pressure we'd see. I wonder if that may be happening here. I'm really on the fence, but may, perhaps, give a slight nudge to keeping this stock on the list based on the likelihood that any further stock slide could be vigorously offset later on, since KFY seems like the type of stock that would rally quickly and vigorously once we see the first hint of eventual better economic times.
- Methode Electronics (NYSE:MEI). In some ways, this feels like Korn/Ferry II. We have a long-standing successful company, industrial components with the biggest market being auto parts sold to the domestic manufacturers, whose revenue could come under breathtaking pressure in the near future. Sticking with the KFY reference point, MEI suffers by comparison insofar as it is a manufacturer and, hence, unable to cut costs as drastically as can a consulting firm (although MEI is certainly doing what it can in this area). On the other hand, selling to Ford (NYSE:F), Chrysler and GM has rarely been hip, meaning MEI stock hadn't been inflated (except for a 1999-2001 interlude). As of now, the stock is priced at levels not seen since the early part of the Clinton administration. So I wouldn't exactly say investors are optimistic about MEI. (Not only is the once-big-three the primary customer base, it's already known that Chrysler's business is moving elsewhere even if it survives.) And MEI management has not been passive: the firm has been working aggressively to diversify its revenue base and has been having some success: auto is now about 65 percent of revenue, down from around 80 percent a couple of years ago. Sensors are an important part of what MEI does and this is a growth area as more equipment gets smarter. I wouldn't argue with anyone who believes this company should be dropped from the list, but given the nature of the theme I'm pursuing, I'll come off the fence on the side that says MEI fits.
As you can see, the last two calls, KFY and MEI, were very difficult. Besides the merits of each situation, my decision to "go" is also influenced by the backtests, the fact that I believe this screen would be acceptable for use in a buy-the-list strategy and that companies with severe baggage like that are par for the course when one seeks liquid, profitably, debt-free companies with bargain-priced stocks. There have to be reasons why other companies in the backtests made it onto a screen like this. Presumably, Wall Street knew about all the baggage. (Whatever one may think of the current market culture, it's hard to deny there's an abundance of information.) And we see from the backtests that the market has, on balance, managed to look over the valleys when the kinds of fundamentals sought by this screen are present.