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, Think Finance (588 clicks)
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The objective here is to find great companies that are somehow sustainable, and are trading at a sensible valuation. This search involved several criteria, starting with...

A high ROE (> 20%)

A high ROE is the hallmark of a great company, able to deploy capital at high return rates, and thus to compound the investment into incredible growth of value, earnings, and hopefully, share price.

However, a high ROE carries with it some risks, namely that it might not be sustainable – in that case, buying into an high ROE would be tantamount to picking a cyclical top, so further qualitative and quantitative analysis needs to be undertaken.

Low Price / Free Cash Flow (< 15)

This will be the main valuation metric we’ll use, to make sure we’re not buying into some kind of bubble valuation even if the company is a good company. Free Cash Flow is the gold standard in cash flow, it’s already done with capex and is potentially available for the shareholder, to pay back debt or to expand the business. Invariably, a good business will always throw off a lot of cash, and if you’re not paying an exorbitant multiple for it and it’s somehow sustainable, you will be doing a good deal.

Insider transactions net positive in the last 6 months

Insiders know better. You don’t need them to be buying a lot of stock as they usually have other ways of getting stock, such as through stock options or stock awards, but you sure don’t want them to be falling all over themselves to get rid of the stock, in spite of it supposedly being a nice deal on a good company. We’ll be happy if they are standing put or buying.

EPS growth next year

We are not very demanding on predicted growth, as predictions many times fail, but there needs to be some kind of reason to believe earnings will fall next year, as that at least puts away most cyclical tops. We certainly don’t want to be buying a high ROE at a cyclical top – this quantitative criterion will filter some of those, and we hope to qualitatively filter the rest.

Moderate to strong sales growth quarter over quarter (>10%)

We want our company to be growing nicely. Growth is always desirable, and although growth in the future is hard to estimate, growth in the present is not, and shows momentum. Of course, afterward we’ll need to have a qualitative opinion on how likely that growth is to cease in the short term.

Finally we want our candidates to be going up in 2011

When there’s weakness, there’s sometimes a reason and we don’t want to have to find that reason. So the stocks we will analyze will have to at least be positive year-to-date.

This is what we got

With these criteria in place, these are the candidates we got:

Credit Acceptance Corp. (CACC), in auto loans

CF Industries Holdings, Inc. (CF), in fertilizer (nitrogen, phosphate)

Cypress Semiconductor Corporation (CY), in semiconductors

DUSA Pharmaceuticals Inc. (DUSA), a drug manufacturer (skin related)

EasyLink Services International Corporation (ESIC), in EDI (electronic data

interchange)

EZCORP, Inc (EZPW), in pawn shops

KLA-Tencor Corporation (KLAC), in semiconductor equipment

The Kroger Co. (KR), in grocery stores

NeuStar, Inc. (NSR), provides services to telecom carriers

Rockwood Holdings Inc. (ROC), in specialty chemicals

World Acceptance Corp. (WRLD), in small loan consumer finance

First, a brief look at the fundamentals - (click charts to expand)

We can see that we’ve got mostly reasonable valuation ratios, with the P/Es ranging from 5.56 for EGIC to 25 for CY, and PEGs are generally not demanding, ranging from 0.45 for CF, up to 1.36 for CY.

Financial ratios are also pleasing – we already knew the ROEs would be high, but Return on Assets (ROA) is also pretty high expect maybe for KR and ROC. Running a lot of stores or industrial plants is understandably draining on that particular ratio.

Debt is a bit higher mostly at the finance companies (CACC, WRLD) and those requiring a lot of assets to perform (KR, ROC). A bit of a surprise with ESIC, here, though.

Qualitative review

Credit Acceptance Corp. (CACC)

CACC has increasing estimates, and the auto market has seen its low and should be in an upward trajectory for some time. Credit quality is also increasing, so the main trends that favor CACC all seem in place.

Although I would usually shy away from finance companies, as they are intrinsically harder to predict and dangerous (due to leverage), in this case every fundamental trend seems favorable and the valuation is very compelling. The stock is also in a very well defined uptrend.

CF Industries Holdings, Inc. (CF)

CF’s valuation is also very compelling, particularly its present EV/EBITDA under 3.50. However, CF’s industry is cyclical, and CF right now is trading at the same price as it reached in the 2008 top. A characteristic of cyclical companies is that they appear very cheap at the top, and their ROE is always very high. Estimates have been broadly going up, but next year’s got a little cut recently.

In spite of the fantastic valuation, I’d skip CF.

Cypress Semiconductor Corporation (CY)

Cypress is also in a famously cyclical industry, semiconductors. This, coupled with decreasing estimates both for 2011 and 2012, and a much higher valuation than other stocks listed here, makes me skip it as well.

The >15 EV/EBITDA on revenue that is hardly growing is also not attractive. And besides, the chart isn’t looking too healthy either.

DUSA Pharmaceuticals Inc. (DUSA)

DUSA has a low valuation and carries no debt. However, it’s a really small company and not growing at very impressive rates (revenue growing close to 15% year over year right now). Although it seems a very nice company, it might fall into obscurity and go nowhere for a long time, as it happens frequently with rather smallish companies not growing fast enough to become more visible.

EasyLink Services International Corporation (ESIC)

ESIC has declining estimates for 2011 and 2012. As we’ve said before, declining estimates usually lead to underperformance in the stock price. We’d need a pretty strong reason to ignore the falling estimates, and we don’t have one, making us skip ESIC.

EZCORP, Inc (EZPW)

EZPW has rising estimates on a very attractive valuation. Also, it has little debt in spite of the (financial) activity it performs in, a testament to its cash generation.

Although one could think that an economic recovery could slow EZPW’s business, truth is that the economy is uneven and there’s great income pressure in a large swath of the population, for instance evidenced by the more than 45 million people already on food stamps – and that trend is so smooth upward that it’s hard to predict its end.

All in all, EZPW seems a good choice, with a forward PE of just 8.10 and growth as far as the eye can see.

KLA-Tencor Corporation (KLAC)

KLAC is in an even more cyclical industry than semiconductors – which is semiconductor making equipment. However, its valuation is a lot less demanding than Cypress’ with EV/EBITDA standing at just 5.1. Also, although there have been some cuts in estimates for 2011, 2012 has not been downgraded much.

It’s hard to consider it as investable because it’s deep cyclical, but at this valuation it seems borderline.

The Kroger Co. (KR)

Kroger is cheap, in a stable business and recently with rising estimates. Its chart could be a bit better, but offers the chance of a breakout. It pays a 2% dividend, although there are much better yields out there.

Given the defensive nature, though, the stock seems adequate for today’s environment.

NeuStar, Inc. (NSR)

NSR is in breakout mode, while still trading at a reasonable valuation . The services rendered by NSR, particularly number portability, seem to have good lock-in features as well as contractual price increases, making for a business that’s not only throwing off money, but also likely to stay that way and actually increase the cash it generates.

Earnings estimates are still rising. Seems like a good opportunity.

Rockwood Holdings Inc. (ROC)

ROC is profiting from higher TiO2 and Lithium prices, and still seems cheap enough. However, there are some worries regarding the TiO2 cyclicality. Lithium should be helpful for the medium to long term, but falling estimates in 2012 are a bit worrying.

This is also borderline, like KLAC.

World Acceptance Corp. (WRLD)

Good trend and rising estimates. The stock, however, seems like a bit worse than EZPW, a bit more expensive, although it’s probably benefiting from the same trends as CACC, and those trends don’t look like they’ll weaken soon, making this a good candidate for investing, as well.

Conclusion

Of the 11 stocks we considered in this search:

Four we’d avoid (CF, CY, DUSA, ESIC)

Two were borderline (KLAC, ROC)

And five we’d consider buying (CACC, EZPW, KR, NSR, WRLD)

Source: 5 High Quality Companies To Buy, 4 To Avoid