In a bull market, valuation plays second fiddle to growth and momentum. Even in a bear market, if one can identify companies that have the capacity to stand up to the headwinds, one can benefit from "crowding in". Simply put, the investors that like growth have very few options, so they all focus on the same few names, driving them potentially to very rich valuations.
I believe that we are in a bear market, though, as I have described, I expect the investment climate to be good this quarter. My views are based less on any change in the economic outlook (still lousy) but more on valuation for the most part. Simply stated, stocks overreacted during Q1, with too many stocks of good companies pounded beyond merit while the bad ones were perhaps pounded even more. I have written about small-caps generally being attractive (back to same relative price now after getting worse subsequent to my article), but I am a bit nervous about the valuations of some of the ones I have favored and have sold or trimmed many of them (America's CarMart (CRMT), Dorman Products (DORM), Men's Wearhouse (MW), Met-Pro (MPR), Shoe Carnival (SCVL), and Thor (THO)). I have written about several of these companies, all of which were deep value plays. I was definitely early on most, but, fortunately, I used the lower prices to build larger positions. I credit the strong YTD performance of my Top 20 Model Portfolio (up 9.9%) to the massive recoveries in these small-cap names (primarily consumer discretionary).
So, what now? Many of the deep value names have been snapped up. While I believe that we are nearing the top of the range and will be careful about deploying capital immediately, I am not expecting that the next pullback will create the kind of values that we saw last month at the lows. I continue to believe that investors should and probably will trim companies with inferior capital structures. We are too far from the next economic upturn to place bets on those companies for now (I expect a very long period of weak growth to follow the negative growth rather than a "v-shaped" economic recovery). One area that could get some focus, though, are the few high-growth companies, but ones with strong balance sheets.
To try to identify potential candidates, I screened for the following attributes:
- Market Cap > $100mm
- Price vs S&P 500 (13 weeks) > 0 (favorable price momentum)
- Total Debt to Cap < 20% & Net Debt to Cap < 0 (strong balance sheet)
- 3 yr historical EPS growth >20 (Company has grown)
- 3 yr historical RPS growth >10 (Company has grown top-line)
- FY2 EPS / FY1 EPS > 15% (Company is expected to grow)
- PE > 18 (Market views it as a growth stock)
That last attribute may confuse readers, but I am not looking for a company that is totally underappreciated by the market. If you can find those, they are obviously better! In this case, I am trying to identify companies that have grown historically and, for whatever reason, are expected to continue to grow. My thesis is that the PE for these stocks MAY be too low. Even if not, the growth itself could help the stock hold up better in a weak economy. Here is what StockVal kicked out (click to enlarge):
I intend to check back on this screen in the coming weeks, as no doubt it will change. I like that several different economic sectors are represented. Not surprisingly, given the recent rally, the group is overbought (last column) for the most part, though a few names aren't. The PE ratios are generally high at 27-30 typically. They tend to be lower than they have been over the past 5 years. Generally, I would like to buy stocks with rising estimates. The data I share represents not this year's estimates but the following year's. In most cases, the estimates are probably falling for this year, which is OK with me. Note also that the typical stock is still 35% below its 52-week high. Given how weak Healthcare has been lately, some of these names could actually be timely now. Generally, I would look to buy stocks that have a Price Momentum Index below 1 (9 of the 24 are there now).
So, this is just a first step, not a buy recommendation (just to be clear). Some of these stocks will not meet expectations and will most likely get crushed due to the high valuation relative to the market. After all, who wants to pay Dom Perignon prices for non-vintage champagne? If you want proof, I can send you the 15 stocks (one of which I own) that meet all the criteria except that they have been underperforming over the past 13 weeks. I bought the one after it got slammed, and, in fact, this might be an even better strategy (buying long-term growth companies that hit the speed-bump and reset the bar). With that said, though, at least conceptually, buying winners can work, even in a bear market.
This rally has been massive and has been driven by a reversion to the mean for some deeply oversold stocks. If I am correct that this has been a valuation rally and not a reflection of better times ahead generally, then investors should want to own companies that can better weather the storm. Companies that can grow (as reflected at least by high historical growth and high expectations as evidenced by PE multiples above the market) or companies with strong balance sheets both fit the bill. The screen above hopefully incorporates both of these attributes.
Disclosure: No position in any of these stocks