Hunting Stocks in a Slow-Growth Environment

by: Erik Dellith

We have relatively sluggish job growth, weak consumer spending, and protracted weakness in the housing market. Although it does not seem that any of these things are going to pick up substantially anytime soon, it doesn't seem as if we are on the verge of an utter collapse either. With that in mind, the U.S. economy will likely continue to grow, but at a trimmed pace from what we've seen recently. Here is one way to hunt for stocks in this environment.

The Hunt

Consumer spending has eased a bit lately. Friday's labor statistics show that the economy continues to add jobs, but at a slower pace, and, absent a significant improvement anytime soon, this could place further pressure on consumer spending. Current fiscal and monetary policy suggests that a catalyst to considerably propel growth ahead of its recent pace is lacking, as the present stimuli have already been in place for a while. Given those factors, we do not necessarily want to focus on consumer-oriented companies when looking for stocks. As part of the stock-screening process, we want to omit consumer cyclicals. Note that we are still permitting non-cyclicals.

Given the weakness in the real estate market, as well as potential issues arising from the soft labor market, we also want to exclude financials. Small regional banks have experienced a lot of pain in recent years. Although the pace of bank closures has slowed dramatically, and this might be a good time to gain more exposure to that market, we're going to skip it and all other financials for now.

Conglomerates are large companies that have exposure to many different parts of the economy. If we were looking to place a bet on economic growth, we would want some exposure to conglomerates. At this point, though, we'll pass. So, we omit conglomerates as well.

At this point, we can focus on companies that are in better defensive positions. Specifically, we want companies that have relatively less debt than their competitors. There is a plethora of financial research on the optimal debt level maximizing shareholder wealth. If these were ordinary times, then we might be more willing to stomach higher debt levels. Given the propensity for growth to slow, we don't want to take a chance with a potentially overburdened company. Thus, we focus on companies where the debt to equity ratio is less than the industry average.

As the economy recovered over the last year, some companies may have been tempted into taking on more debt to expand. This could have happened on an industry-wide basis, so that the industry average debt level rose. Therefore, simply focusing on companies with below-average debt-to-equity ratios is not sufficient. We also want to focus on companies that have been reducing their own debt burden. So, we focus on companies where the debt-to-equity ratio is less than it was a year ago.

In a slow-growth environment, corporate sales can still be increasing, just not all that quickly. This leads us to a couple of important points. First, we want to focus on the companies where more of that top-line growth will translate into earnings, so we filter for companies where the operating margin is better than the industry average. Second, given that it will likely be more difficult for companies to considerably grow their revenue, we want to focus on the firms that have some history of doing a good job, particularly relative to their competitors. We accomplish this in a couple of steps. One, we filter for companies where revenue growth is faster than industry median over the last quarter, year, and five years. Two, we screen for companies where the pace of revenue growth has been accelerating. More specifically, we filter for companies where revenue growth over the trailing twelve months is faster than the three-year average, and the three-year average is faster than the five-year average. Keep in mind that we do not necessarily expect these growth rates to continue. We are just using this focus on companies that might have better sales and marketing channels to more-effectively handle a challenging environment.

Valuation is also important. Arguably, companies with cheaper price tags should have less room to fall if the market takes a hit, but also have more room to climb than their peers that are valued more richly priced. For this reason, we filter for companies where the P/E ratio is less than the industry average. In this case, we are focusing on the forward earnings for both this year and next. Taking valuation a step further, we also filter for companies that have a PEG ratio of less than 1.5.

Fully recognizing that there are no guarantees, we would still like some reason to believe that the company will do well in the future. We turn to analyst forecasts and focus on companies where next year's EPS estimate is higher than this year's estimate.

Running this screen on Friday left us with a list of 7 companies, for further research to better determine if they should be part of our portfolio. Here is the list:

  • Amtech Systems, Inc. (NASDAQ:ASYS)
  • Chinacast Education Corp. (OTCPK:CAST)
  • Coeur d'Alene Mines Corp. (NYSE:CDE)
  • RehabCare Group, Inc. (NYSE:RHB)
  • Teradyne, Inc. (NYSE:TER)
  • TransGlobe Energy Corp. (NASDAQ:TGA)
  • Xerox Corp. (NYSE:XRX)

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.