Know When Not To Buy

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About: Vitesse Semiconductor Corp. (VTSS), Includes: AAPL, MSCC, NDAQ, SPLS
by: Backroom Analyst
Summary

Screening technology is a great way to find companies that match one's philosophy and algorithm.

It is important, though, to make sure the company passes the smell test, before one enters a "Buy" order.

I provide one illustration why one should always thoroughly research a company, and one company to avoid right now.

Introduction

I have a screen which has served me well over the last 14 years. It is not perfect, but it has been very successful finding me winning stocks. Its algorithm is to look for financially safe companies with positive free cash flow. These companies have a strong five-year history of earnings and revenue growth. After I cull that universe down, I then use a six-step process to determine whether the stock meets certain discounted cash flow requirements. It has taken a lot of research and refining, but it is a successful screen, and the numbers prove it.

Using a strategy of buying the best twenty available stocks, and holding them for one year yielded a 15.02% (±21.55%) return since 1999. Using this approach would have yielded positive returns during 2000 (24.09%) and 2001 (26.86%), and would have kept losses in 2008 (-19.07%) to a far lower level than the overall market. Twelve month rolling backtest data show that it beats the overall market 74.3% of the time. It is a good solid screen, and one that I use frequently.

I won't hide the fact, though, that I do try to mimic the philosophies of Warren Buffett and other gurus as much as possible. If you want to get an idea of what that looks like, read here on why Buffett recently bought Apple (NASDAQ: AAPL). It makes sense to me to learn from the masters of Wall Street, and you should too.

That does not mean one should merely use a quant approach to stock selection. It is important to use the most important screening criteria, and that is you, the investor.

An Illustration

Vitesse Logo

I found this example by accident. I was attempting to research whether a "Buy and Hold" forever strategy would work with this screen. It clearly does not, and I want to outline one stock in particular that will show that one should always perform due diligence when selecting appropriate investments.

In January 2000, two stocks passed my Intrinsic Value screen. They were Staples (NASDAQ: SPLS) and Semiconductor (VTSS). Both of these companies were dogs, almost from the beginning, and Vitesse illustrates the point I am about to make. Let's say it was more than a dog; it rolled over, and died.

These are Vitesse's financial highlights as of January 1, 2000, that can pass many screening criteria:

  • Altman Z-135.54
  • Free Cash Flow-Positive
  • Average Analyst Recommendation-Strong Buy
  • Earnings Growth:
  1. One Year-33.82%
  2. Three Year-58.74%
  3. Five Year-62.51%
  • Price/Earnings to Growth-1.41
  • Stock Splits:
  1. 3 for 2-March 3, 1997
  2. 2 for 1-May 27, 1998
  3. 2 for 1-October 21, 1999

What is there to not like? Here, we have a company that is financially strong, has robust earnings growth, appears to have growth potential, and the analysts like it. This stock appears to be a no brainer. So, one buys 100 shares at $56.25/share, and just sits on it, right?

What Happened?

Here is an outline of what happened to Vitesse after our "smart" purchase.

  • Added to S&P 500 (December 11, 2000)-$64.25/share
  • Delisted from S&P 500 (August 20, 2002)-$1.37/share
  • Reverse stock split (1:20) (June 30, 2010)-$0.26/share
  • Bought out by Microsemi (NASDAQ: MSCC) (April 28, 2015)-$5.28/share

Without the extensive history lesson, Vitesse fell victim to the tech bubble bursting like so many other companies during that time. They certainly were not the only one which did. It never recovered. Here, we have a company that was once worth over $8 billion, and was bought out for $389 million. Basically, our entire investment would have been worthless when it was all over.

Notice we would not have been the only ones fooled. Ten analysts viewed the company has a "Buy". The S&P 500, which has a fairly stringent process for inclusion in its index, viewed the company as worthy of consideration. They too, were fooled.

Were there any warning signs? At what point could one have said, "Enough!". It was not until March 28, 2001 when the company announced poor earnings results. This would have been the first media report after it was added to the S&P 500 (based on an EBSCO search). The problem is that Vitesse had already closed at $29.06/share on March 27, 2001. We would have lost 48% of our investment by then.

There were earlier signs, though. On December 19, 2000, a mere eight days after Vitesse was added to the S&P 500, the company came out with their annual report. In that report, one would have seen that revenues had increased 56.8% year over year. Yet, we have two big red flags. Earnings, the one thing that should always matter, had declined 55.9% over the same period year-over-year. Throw in the other issue where the long-term debt had increased 44,129% (yes, that number is correct). That debt load caused Vitesse's Altman-Z score to collapse to a value of 1.1. December 19, 2000 was the day to get out! If one had, then they could have sold their position at $55.12/share, thus limiting their losses to a small 2.1%.

If one thinks about, though, there were other warning signs the day Vitesse was bought. In January 2000, its Price-to-Sales ratio was 18.2x, and its Price-to-Earnings ratio was 115.3x. The value investor, especially one who follows gurus such as Fisher or Lynch, would have taken a pass on this company right away. Fisher limits the P/S ratio to 3.0 and Lynch was not interested in companies with a P/E ratio greater than 45. Sometimes the best investment is the one you don't buy.

That Was Then, This Is Now

True. 2000 was a strange year where we found out valuations and earnings really do matter. We also have more information available to us now, than we did then. With financial sites like Seeking Alpha, there is no excuse for not finding good information on pretty much any company out there. Are we acting any differently? Not based on what happened prior to 2008, and not based on what is happening now. I have contended for the last two years that this market is overvalued, and it will not take much in this political environment for the market to go through a major correction.

Don't Make The Same Mistake Again

I wanted to find a company which has high valuations, poor financials, and declining earnings. There is one company that has some of the markings that Vitesse had so many years ago.

Nasdaq Inc. (NASDAQ: NDAQ) is a leading provider of trading, clearing, exchange technology, listing, information and public company services across six continents.

Price (06/02/2017) $67.50
Market Cap ($Millions) $11,148.91
P/E Ratio (TTM) 81.33
Altman-Z Score 1.47
Earnings Growth -74.30%
Price-to-Sales Ratio

3.05

Of course, I am not saying Nasdaq will go straight to zero, but the data is pretty overwhelming. Stocks with high valuations do not perform as well as stocks with low valuations. That has been proven time and again. If you are interested in this company, do some research. For me, I will take a pass on this one.

Let's see what others are saying about Nasdaq Inc.

  • Morningstar (3 Stars/Hold)
  • S&P Capital IQ (3 Stars/Hold)
  • The Street (A-/Buy)
  • Zacks (NYSEARCA:HOLD)
  • RBC Capital Markets (Sector Perform)

Conclusion

Stock screening is an effective tool, and it certainly is the basis of the advice I provide. I caution, though, that one should continuously review their portfolio, and do the proper research it takes to find companies that have the potential to outperform the market. In the meantime:

Happy Investing!

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.