Corporate Balance Sheets Offer Bullish Sign

Includes: ARO, GYMB, KIRK, SCL
by: John P. Reese

We've all heard the reasons to be fearful of stocks right now -- potential spillover from the European debt crisis, questions about the housing recovery's sustainability, a burgeoning national debt and budget deficits. All of those (and more) have been highlighted pretty extensively in the media.

But there are also plenty of reasons to be optimistic. And in a recent opinion piece for The Wall Street Journal, strategist Bob Doll pointed out some particularly interesting bullish signs. In fact, Doll (portfolio manager and chief equity strategist for fundamental equities for Blackrock) said that despite the formidable challenges the U.S. faces, “overweight positions in U.S. equities are more than warranted” right now.

One of the most interesting factors Doll addresses involves corporate balance sheets. Unlike many companies in other countries, U.S. firms went into cost-cutting mode and became much more efficient when the financial crisis hit, he writes. As demand rebounds, that has them in very good shape. For nonfinancial companies, cash on the balance sheet is close to 11% of assets -- a 60-year high, he says. And he notes that, according to Citigroup, unit labor costs are falling at the fastest pace in 40 years. Doll writes:

The importance of improving America's productivity growth can't be overstated. High productivity tends to lower unit labor costs and boost corporate profits. High cash levels are already generating dividend increases, share buybacks, capital investments and M&A activity -- all extremely shareholder friendly.

Doll's comments on clean, cash-rich balance sheets and increased productivity got me wondering which U.S. firms might have those characteristics, and also have shares that get approval from my Guru Strategies (each of which is based on the published approach of a different investing great). I searched for Guru Strategy-approved companies that have current ratios (current assets/current liabilities) of at least 2.0 and more net current assets than long-term debt (criteria that my Benjamin Graham-inspired method uses); free cash flow yields (free cash flow/share price) of at least 9%; and profit margins of at least 5%. I found several stocks that fit the bill. Here's a look at some of the best of the bunch.

Kirkland's, Inc. (NASDAQ:KIRK): This Nashville-based home décor retailer has about 280 stores across 28 states. The small-cap ($414 million market cap) has a very strong balance sheet, with no long-term debt and a current ratio of 3.04. And it also has a free cash flow yield of 9.4%.

Kirkland's gets approval from the model I base on the writings of Motley Fool founders Tom and David Gardner. This model likes Kirkland's 9.0% profit margins, lack of any long-term debt, and exceptionally low 0.08 P/E/Growth ratio, a sign that this fast-growing stock is selling on the cheap.

Aeropostale Inc. (NYSE:ARO): This New York City-based teen clothing retailer -- which has profit margins of 10.6%, a free cash flow yield of 9.1%, and a current ratio of 2.52 -- gets approval from four of models, including my Warren Buffett-based strategy. The Buffett approach looks for firms with lengthy histories of earnings growth, manageable debt, and high returns on equity (which is a sign of the "durable competitive advantage" Buffett is known to seek). Aeropostale fits the bill. Its EPS have increased in every year of the past decade; it has no long-term debt; and its 10-year average ROE is an impressive 32.9%.

My Peter Lynch-based strategy, meanwhile, considers Aeropostale a "fast-grower" -- Lynch's favorite type of investment -- thanks to its impressive 33.6% long-term EPS growth rate. (I use an average of the three-, four-, and five-year EPS figures to determine a long-term rate.) Lynch famously used the P/E/Growth ratio to find bargain-priced growth stocks, and Aeropostale's 0.37 P/E/G falls into my Lynch model's best-case category (below 0.5). This model also likes that Aeropostale has no long-term debt.

The model I base on the writings of hedge fund guru Joel Greenblatt is also keen on Aeropostale. It likes the firm's 16.1% earnings yield and 71.6% return on capital.

Finally, my James O'Shaughnessy-based growth stock model likes that Aeropostale has upped earnings in each of the past five years, and that it has a key combination of characteristics -- a solid relative strength of 67 (a sign the market is embracing the stock) and a low price/sales ratio of 1.25 (a sign it hasn't become too pricey).

Stepan Company (NYSE:SCL): This Illinois-based company makes chemicals used in consumer and industrial cleaning compounds, including detergents, shampoos, lotions, toothpastes and cosmetics. Its products are also used in agriculture, food, pharmaceuticals, resins and plasticizers, and thermal insulation products.

Stepan ($686 million market cap) has a current ratio of 2.17, free cash flow yield of 15.4%, more than twice as much net current assets as long-term debt, and profit margins of 5.3%. The market has also been embracing it, part of the reason it gets high marks from my Momentum Investor strategy. The stock has a relative strength of 81, and Wall Street's appreciation of it appears to be merited: The firm has been growing earnings at a 40.8% clip over the past five years, has a 27.6% return on equity, and a reasonable debt/equity ratio of 31% -- all reasons that the Momentum model likes the stock.

The Gymboree Corporation (NASDAQ:GYMB): Based in San Francisco, Gymboree offers play programs for children, as well as children's toys and clothing, and has close to 1,000 stores around the U.S., and in Canada. The $1.3 billion market cap firm has a free cash flow yield of more than 10%, profit margins of 10.5%, and a current ratio of 3.74.

Gymboree gets approval from both my Peter Lynch- and James O'Shaughnessy-based models. My Lynch-based strategy considers the stock a "fast-grower" because of its 28.1% long-term growth rate. It likes Gymboree's 0.44 P/E/G ratio, and the fact that it has no long-term debt.

My O'Shaughnessy-based growth model, meanwhile, is keen on Gymboree's solid 64 relative strength and reasonable 1.3 P/S ratio. It also likes that the firm has upped EPS in each of the past five years.

Disclosure: Author long KIRK, ARO, and GYMB

About this article:

Want to share your opinion on this article? Add a comment.
Disagree with this article? .
To report a factual error in this article, click here