One of my favorite places to look for value is in the Current Ratio: Current Assets/Current Liabilities. If it's over 2:1, the company has more liquid assets than are required to operate the business in a prudent and orderly manner. From time to time there will be situations where the market overlooks this source of value.
When this is the case, if P/E is adjusted to reflect the excess current assets, the result may be low enough to suggest undervaluation. With that in mind, I created a screen to look for prospects on that basis.
Using the screener at Portfolio123, the following criteria were applied:
- Membership in S&P 1,500
- Current Ratio > 2
- Excess Current Assets (over 2:1) between 15% and 75% of Market Cap
- P/E adjusted for Excess Current Assets between 5 and 12.5.
Using the site's "Basic: Quality" ranking system, when backtesting the top 20 prospects were selected and held for one year, at which point the portfolio was rebalanced.
The screen performed well on most time periods. Here's a 10 year backtest, comparing it to the performance of the S&P 1,500:
Of some interest, the Beta for the portfolio was 0.80, with Alpha at 7.35%. The maximum drawdown during the financial crisis was somewhat lower than the benchmark index.
Here's the current output:
Cisco (CSCO) has been a battlefield, pitting critics of old technology and John Chambers against value investors. I've written two bullish articles, citing the strength of the balance sheet as well as the possible growth of businesses other than the company's well-known routers and switches. The P/E, when adjusted for excess current assets, is 10.67.
Corning (GLW) is a perpetual favorite, since I grew up in the town and my father worked there all his life. My bullish views have yet to be vindicated by the outcome. Again the bullish case rests on the strength of the balance sheet and the possible growth in lines of business other than display glass, the company's current claim to fame. The adjusted P/E is 10.28.
Kulicke and Soffa (KLIC) is a recent addition to my portfolio. The company is in the extremely cyclical semiconductor equipment business. Like many of the smaller technology companies, it has a strong balance sheet. To illustrate the computations involved in this screen, here's how I did the math:
Current Liabilities of $77.40 million X 2 = $154.80 million. Subtracting this number from Current Assets of $754.39, the excess is $599.59, divide by 76.57 shares = $7.83 per share. The current share price of $12.48, less the excess current assets, is $4.65. Dividing by EPS of 0.79 cents, the adjusted P/E is 5.88, verifying the computations performed by Portfolio123's software.
The company has been written up capably here on Seeking Alpha by Bret Jensen, who remarks that you are buying dollars for dimes in this case.
Cirrus Logic (CRUS) has drawn considerable attention, due to the combination of fine performance and excessive reliance on one key customer - Apple (AAPL). Ashraf Eassa has done a good job discussing the most recent development, loss of a socket in the iPad.
The stock tanked on the news and I took up a small speculative position.
I'm not familiar with the other names and don't have an opinion.
Frequently strategies that backtest well don't pan out in practice. My interest, when designing the screen, was to look for companies that were suitable for buying in-the-money vertical call spreads. So it isn't intended to find companies that will seriously outperform. It's more about finding situations where there are enough questions to create some volatility, together with valuations that provide some margin of security.
Briefly, the thinking is that with the cash or other excess current assets as a cushion, there is little downside in these names, particularly when the adjusted P/E is there to provide fundamental support. Because of the questions surrounding their business, a number of them have implied volatility high enough to make the sale of options attractive.
All things considered, this screen provides a good starting point for investors who are looking for value in the current exuberant market. By no means is it a shopping list.
The Investment Rationale
I interpret the backtest results to suggest that the market over-estimates the importance of various potential future difficulties that confront certain companies with strong balance sheets and genuine earnings. It could be stretching a point, but those I'm familiar with look a little bit like one trick ponies.
So if in the aggregate and over time the market misprices these situations, while providing a fair amount of implied volatility to support options prices, it makes sense to bet they won't go down and to be a net seller of time premium.
I'm long GLW, KLIC, CSCO and CRUS, by means of in-the-money vertical call spreads. The KLIC position dates back to August, the others were opened Monday.