Previous blogs in this bargain-hunting series have spotlighted book value, cash, lack of debt and divined income as themes that could provide opportunities in this bear market. But we ought not ignore the most basic factor of all, one that should play well not just in times of crisis but in any kind of market: a strong track record of above-average corporate performance.
The Performance Bargains screen
There are countless ways to identify good, fundamentally-strong companies, some simple and straightforward, others very complex. When times are good and stock prices are high, it's often necessary to devise obscure tests of quality, not so much because such companies will really be better, but because we need to work harder to find firms whose merits have yet to be fully appreciated in the investment community. But now, with the market so badly shaken, with shares of great companies having been trampled as badly as shares of laggards, we have the luxury of being more direct in how we define good performance.
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 simple rules:
EPS growth exceeds the industry average for the trailing 12 month and five-year periods.
This is about as simple as it gets. If you poll investors for what they look for in a desirable company, it's hard to imagine many, if any, not having EPS growth near or at the top of the list. The above rules evaluate EPS growth over the past five years and the trailing 12 months. It's tempting to require a minimum growth rate, as many do on most occasions. But now, with business conditions as bad as they are, it seems like doing this might too easily drive the result set down toward zero. So to be realistic, I'm happy if a company has a consistent track record of outperforming industry peers.
Return on Investment exceeds the industry average for the trailing 12 month and five-year periods.
Return on investment is not likely to loom large in a poll asking Wall Street practitioners for their favorite characteristics. But it (or some variation, like return on equity) is one of the textbook favorites. And even if not always in the conscious awareness of practitioners, it's still valuable to them, since companies that consistently generate strong corporate returns are the ones that often have the greatest capacity to produce good rates of EPs growth going forward. I chose return on investment rather than return on equity since the former is more balance-sheet neutral. A company with lackluster returns on investment could boost return on equity simply by using more borrowed capital. That's a perfectly legitimate thing to do. But in an atmosphere of financial crisis, I'd rather tilt instead to companies that owe their profit performance to the strength of the plain-vanilla business operations as opposed to the aggressiveness or creativity of a CFO.
Given the un-exotic nature of the rules used here, the screen often identifies more stocks than the average investor is willing to hold in a portfolio. So I decided to narrow the list to 10 by selecting those companies that rank highest in terms of net cash (cash minus total debt) per share divided by share price. This recalls the kinds of rules I used in other deep-bargain screens. But this is only for a final narrowing-down in a list composed of performance basics.
The screen was backtested on Portfolio123.com based on four-week holding periods and assumption of 0.5 percent price slippage on each trade.
Figure 1 shows the test results for the full screen from 3/31/01 - 12/30/08.
We see here that the up-market performance of this screen is fine: an average monthly excess of 2.58 percentage points relative to the S&P 500. The down-market test raises an eyebrow, but lets defer consideration of that pending a look at Figure 2, which gives us a closer look at the past year.
Now, we see the relative-performance shortfall occurring during the good portions of a generally bad period. But the down-month performance was relatively strong.
Putting the two together, it seems that whatever defensive qualities this screen (and the net-cash sort) may possess are apparent only in a substantial bear-market environment.
Ultimately, though, the most significant aspect of Figure 2 is the way it compares with comparable tests conducted for the other deep-bargain screens referred to above: Most of those screens got hammered in the past year, but this one did not. Going forward, it seems plausible to argue that if we're in for another significant plunge in 2009, downside risk from this screen may not be worse than the overall market (something I would not suggest for the others in this series).
Figure 3 takes a look at the last occasion when the market staged an initial surge from a major bottom.
That is what we'd hope to see this time around. There's no guarantee it will happen. The nature of the two bear markets is not identical (the 2008 collapse reflected a widespread asset allocation move, liquidation by many of equity holdings; earlier this decade, much of what occurred stemmed from deflation of formerly over-hyped tech-related stocks). But such distinctions are inherent in the backtesting process. No two periods are ever identical, so we need to make reasonable assumptions about whether the differences are likely to be relevant to future stock performance. In this case, I think not. I see no reason to doubt that once stocks move upward, investors will again favor shares of companies with track records of consistently superior fundamental performance.
With some other screens in this series, I discussed considerations relating to fundamental over-ride; situations where I would or might be inclined to let my judgment take precedence over the screen and drop some stocks that pass the strictly-numeric tests. Here, I have no such temptation.
The rules I articulated are pretty much good for all seasons. Admittedly, in normal times, better models can be created as I tune the rules more tightly to hunt harder for good stocks that may not be fully appreciated by the market. But as noted above, in the current climate, where the baby has been thrown out with the bathwater, we can keep it simple. This approach isn't leading me toward any major company-specific abyss (as would be the case, for instance, if I required cash hoards that are huge relative to the share price, something we don't usually see unless there are problems), so I see no reason to over-rule the screen.
Table 1 lists the top 10 stocks that currently appear in this screen based on the ratio of net cash to price per share (regardless of how high or low these ratios actually are).
Looking at these selections reinforces my determination to simply go with the screen. This collection of businesses provides a nice cross-section of market opportunities:
- Apple needs no particular commentary. We all know what that company is about and it seems uncontroversial to suggest its stock ought to participate nicely in a market recovery, when that takes place.
- Dolby is another one we've all heard of although unlike Apple, we may need a clue to jolt our memories. Think of the last time you were in a decent movie theater. Think of the brand associated with the sound system. That should ring a bell. Beyond theaters, the company is well represented in the home electronics market. All in all, this is another firm that should feel the general economic pain, but ought to fare well once things improve, and where we can feel fine relying on its overall fundamental track record.
- Assuming equal weighting, as is usually the case with these screens, VAALCO and Royal Gold give the list a 20 percent exposure to a potential rally in resources, which is reasonable to expect assuming any market turnaround would reflect expectations of improved economic trends down the road.
- Aeropostale and PetMed Express provide 20 percent exposure to basic consumer discretionary spending. That's under pressure now but as with resources, it's hard to imagine a market turnaround not being accompanied by better forward expectations for this area. Neither firm strikes me as having a super-spectacular must-have business, but garden-variety fundamental execution on the part of companies can lead to much success with screen-based investing, so I'm happy to let the numbers speak for themselves with these firms.
- Stryker gives the list some nice exposure to health care, given the company's prowess in orthopedic implants, surgical equipment and pain management products. These aren't low-end commodity-type products, but they aren't so exotic as to make them more vulnerable than others in this sector when those who sign checks count the dollars more closely.
- As to Cognizant, we've probably all reached the saturation point in terms of how much more we want to hear about IT outsourcing. Whatever we think about it, the activity is here in a big way and it's not likely to diminish any time soon. Cognizant is a fundamentally strong player in this arena.
- Finally, we have Sun Hydraulics, which deals with fluid power, and II-VI (pronounced two-six; if you know chemistry and the periodic table of elements, this should make more sense to you), which deals with laser optics. These are straight plays on manufacturing, with II-VI being the higher-tech entry. Without use of screen-based stocks selection, there may be little reason to expect either of these firms to come to mind. But companies like these, firms that aren't household names but which measure up under the screening rules, are the sort which have produced so well for so long for many who invest in based on such criteria. In last year's equity liquidation, they certainly felt their fair share of pain. But assuming we normalize again, it seems reasonable to assume they'll perform in line with what we hope for from a screen like this.
Bottom line: This list looks like a nice expression of the overall theme of this screen: bargain hunting among habitually well-performing companies.