The latest labor report is unsettling. Not only did June’s figure come in well below expectations following Thursday’s ADP National Employment Report, but the results for April and May were revised downward. In fact, the latest figures suggest that the job gains in May and June combined were less than what was initially reported for May alone. In such an environment, equity investors need to be particularly careful. Here, we take a closer look at the labor market and discuss stock selection in the current environment.
False Hope And Tough Reality
June’s ADP National Employment Report increased investor optimism that the economy had successfully weathered the recent problems (“soft patch”) and that growth was starting to pick back up a bit. This hope was dashed when the government reported its perspective of the job market. According to Reuters, economists expected the economy to create 90,000 jobs in June. The number came in at only 18,000. That hurts. But the real pain isn’t necessarily that the economists were wrong, but that the labor market is barely creating jobs. To make matters worse, the government also revised downward the number of jobs created in recent months. In the Bureau of Labor Statistics [BLS] report for May, total non-farm payroll grew by 232,000 positions in April and only 54,000 positions in May. In the June report, we see that the numbers for April and May were reduced to 217,000 and 25,000, respectively.
The latest government numbers are concerning to say the least. I had previously been relatively optimistic that the economy would be able to avoid another recession. The first three months of the year saw payrolls swell 497,000 (based on data from the BLS), while the economy grew a tepid 1.9%, according to the BEA. Now, my optimism is fading and my caution is growing: The economy added only 260,000 positions in the second quarter. Realistically, many people probably would not notice any substantial difference between the economy slipping into a statistical recession, from the current slow growth path.
I still expect the economy to pull out of the recent soft spot, just not with the same vigor I had anticipated before reading the latest employment report. Figure, there are still some relatively bright spots. For example, according to the Federal Reserve, manufacturing industrial production largely rebounded in May from the weakness in April. And, according to the Census Bureau, new orders for durable goods also rebounded in May following a decline in April.
Although there are signs of life, I am concerned about heightened risk to the downside. This causes me to be very cautious (yes, even more so than I’ve been in the past) with selecting stocks. Given the likelihood for muted growth, I want firms with little debt that are trading deep in value territory.
The first glance at the consumer at the latest labor figures makes me want to run away from anything related to the American economy – fast. But, upon closer reflection, I am willing to reconsider. The idea in this approach is that, even though the economy might not be creating jobs nearly as fast I would like, it is still adding something. It’s not much, but it’s something. And something in terms of job creation is still better than nothing, or worse, job losses.
With that in mind, I’m not looking for a specific sector play. I am willing to include almost all sectors at this point. (Given the ongoing weakness in real estate, I am willing to exclude the finance sector.) What I do want, however, is to find certain companies that stand to handle the currently adverse climate a bit better than their competitors.
The first step is to find companies with relatively low debt. I don’t want to end up holding a company that can’t meet its interest payments. Thus, a key requirement of this stock screen is that a company’s debt to total equity must be less than half the industry median.
I also want to take steps, as imperfect as they may be, to exclude companies that have little debt but are becoming more leveraged. As such, I require that a company’s debt to equity ratio be less than it was in the same quarter a year prior. Running the screen on Friday afternoon yields 1,310 companies at this point.
Similarly, I include interest coverage (or times interest earned). This is the ratio of earnings before interest and taxes [EBIT] divided by the interest expense. Hence, it tells us how many times EBIT can cover interest. While it may be tempting to focus exclusively on the most recent quarter, I don’t want any seasonal issues to skew the comparisons, so it is better to use the trailing twelve month [TTM] figures. I require that a company’s interest coverage ratio must be more than 50% higher than the reading for its industry. This works well to make highlight companies with manageable debt levels and reduces the list to 440 names.
The focus now turns to valuation. It is not enough to require that a stock be priced “cheaper” than its competitors. I want stocks that are much cheaper. I expand the screen to include stocks with P/Sales and P/E ratios that are less than 80% of the industry average. This reduces the list of companies to 159 companies.
A company can be priced cheaper than its peers for different reasons, including deteriorating business conditions. I want to weed out companies that might be suffering more than others. To do this, I focus on operating margins and revenue growth. First, I require a company to have a TTM operating margin that is wider than the industry norm. There are now 132 names on our list. Next, I require that the TTM revenue growth rate must be faster than the industry median. This sinks our list to 81 companies.
In an effort to highlight companies that are expected to fare relatively well over the next year or so, I turn to earnings estimates and require that analyst estimates for earnings per share [EPS] are higher next year than they are for this year. Similarly, I examine P/E ratios that are calculated on those EPS estimates and require that the forward P/E ratios must be lower than the industry medians. This reduces the number of members of the list to 31.
Finally, I take a plunge into the deep end of the value pool and require that the PEG ratio – the forward P/E divided by the expected long-term EPS growth rate – must be less than one. This slashes the number of companies down to a manageable 16, for further research. Here is the list as of Friday:
- Amtech Systems, Inc. (NASDAQ:ASYS)
- City Telecom (H.K.) Limited (CTEL)
- China Valves Technology, Inc. (OTC:CVVT)
- DDi Corp. (NASDAQ:DDIC)
- The Dolan Company (NYSE:DM)
- Exceed Co. Ltd. (NASDAQ:EDS)
- ICF International, Inc. (NASDAQ:ICFI)
- LHC Group, Inc. (NASDAQ:LHCG)
- LTX-Credence Corp. (LTXC)
- Murphy Oil Corp. (NYSE:MUR)
- Nanometrics Inc. (NASDAQ:NANO)
- Power-One, Inc. (NASDAQ:PWER)
- Shuffle Master, Inc. (NASDAQ:SHFL)
- SkyPeople Fruit Juice, Inc. (NASDAQ:SPU)
- TESSCO Technologies, Inc. (NASDAQ:TESS)
- WMS Industries Inc. (NYSE:WMS-OLD)
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.