Many pundits are comparing the impending bear market of 2011 to 2008-9 without adding greater detail on what similarities exist. Most certainly, “risk-off” is contributing to an earnings multiple compression for nearly all stocks.
One way to take advantage of the tremendous value being created with stocks is to run a screener. Another way to screen for value stocks is to look at the put-call ratio. After trying both methods in the discovery of new investment ideas, it became clear that there is no real correlation between cheap stocks and future capital gains. Earnings and cash flow mattered more than share price or P/E valuation.
It is possible to run a screen for earnings growth and to buy companies that have a PEG – Price-earnings growth rate – of less than 1. However, future growth is a forecast. Past growth values is historical. Past performance does not necessarily dictate the future performance of an organization. Worse still, a company that is leveraging its future prospects by financing growth through debt can fail if the prospects are not as rosy as the company had originally hoped.
A cardinal sin for investors is to associate a low share price with value. This is, of course, incorrect. Many measures are available to determine the value of a company. For simplicity, let’s define earnings per share alongside a healthy business model for a company as desired for a value stock.
An unhealthy business model is apparent when a company is shrouded in governmental regulation and unknown risks. Unknowns are more dangerous for investors than for companies who divulge their problems. This is why many American financial stocks are in a firmly established downtrend. Both Bank of America (NYSE:BAC) and Citigroup (NYSE:C) are value stock teasers that have an unknown level of risk.
Bank of America last traded at $5.90 but had a reported book value of $21.92 and a cash per share of $11.78. Its Countrywide Financial unit has an unknown liability.
Citigroup closed recently at $24.63, and has a book value per share of $60.44 and cash per share of $9.52. Both Citi and Bank of America instituted fees to effectively remove free banking services for ordinary Americans. The moves have not yet drawn any attention from regulators.
While existing shareholders will hold on to these shares at current prices, value investors must avoid these banks until the unknown risks are revealed. When that time comes, share will probably rally significantly, but this upside premium would be worth paying for.
Another unhealthy business model depends on one customer for its earnings.
On Friday October 7, Sprint Nextel Corp announced that it would stop selling phones compatible with Clearwire’s current network at the end of 2012. This is an unexpected and an unusual move, because Sprint is a majority shareholder of Clearwire. Sprint owns 54% of Clearwire. Clearwire dropped to $1.39 and closed down 32.20% on the day. Clearwire’s business model was weak even before the news, because speculators did not think Sprint would drop its own network.
Sprint, already heavy in debt, did not have a healthy business model. The company had potential in taking on Verizon (NYSE:VZ) and AT&T (NYSE:T) by offering unlimited data plans, but the company is now in need of raising its debt to pay for a network upgrade. The company may be too saddled in debt to operate in the quarter ahead. The Apple (NASDAQ:AAPL) 4S offering will not be sufficiently competitive or contributory to positive cash flow to support interest payments to service a larger amount of debt.
Nokia Corporation (NYSE:NOK)
Nokia still has a heavy level of debt, with a debt/equity of 0.44. The company pre-announced in February that it was developing a Windows 7 Phone. In that time, sales for Symbian and Meego-based phones plummeted. Microsoft is the clear winner in the deal, but Nokia is holding all of the risks if the partnership fails. Nokia’s business model is under threat because the company does not have another product to fall back on. The company has bet its future on the success of one smart phone ecosystem.
Eastman Kodak (EK)
Eastman Kodak managed to hold a $2 to $3 stock price due to perceived value in its patent portfolio. The company’s inability to implement a digital strategy continues to worry investors. Eastman Kodak recently closed at $1.39, and has lost 76.64% of its value from its peak. Eastman Kodak may become a victim of tight credit conditions as it hurries to monetize its patent portfolio. Buying EK when time is running out will prove to be a losing strategy for value investors.
Disclosure: I am long MSFT.