By The Numbers: Cheap Stocks With Solid Fundamentals

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Includes: ABG, ACCO, AMAT, APO, ARCO, BB, BBY, BLBD, CACC, CACI, CSWI, DECK, DQ, EME, ESIO, ESNT, ESRX, EVR, FFIV, FL, GIB, GWR, HCA, HI, HLI, HMC, INVA, LAZ, LH, LNTH, LRCX, LYB, MIK, MSGN, MTG, MU, MYGN, ON, OXM, PENN, SEDG, SNI, SPY, STMP, TER, URBN, USNA, VALE, VMW, WNC, ZUMZ
by: Andres Cardenal, CFA

Summary

Investing in cheap companies is good, and investing in cheap companies with strong fundamentals can be even better.

Introducing a quantitative system focused on price to free cash flow, return on assets, and long-term growth expectations to combine valuation and fundamental soundness.

Backtested performance is quite promising, and the system can be a valuable source of potential ideas for further research.

Smart investing doesn’t need to be too complex or sophisticated. At the end of the day, it’s all about buying strong companies trading at reasonable valuations. In Warren Buffett's words: “Price is what you pay and value is what you get,” so you want to get as much value as possible for a conveniently low price.

The numbers alone don’t tell us everything we need to know to make an investment decision, we need to analyze the business behind the numbers in order to truly understand the risks and potential reward. However, focusing on companies with solid quantitative metrics can be a smart way to search for investment ideas with superior potential.

System Design

To begin with, we exclude over-the-counter stocks and companies with a market capitalization level below $500 million from the universe. This is to guarantee a minimum liquidity level, so the system is more realistic and suitable for investors who keep company size in consideration when making investment decisions.

The system requires the price to free cash flow ratio to be below 20. In other words, investors are getting at least 5% of the purchase price in annual free cash flow from the company.

Accounting earnings are subject to all kinds of assumptions and even manipulations from management, but free cash flow is a cleaner and more transparent metric. A price to free cash flow ratio below 20 doesn’t guarantee that the stock is necessarily undervalued, but it certainly excludes companies with unrealistic valuations from the list of potential candidates.

Business profitability is a key consideration. All else the same, the higher the company’s ability to generate profits with its capital, the higher the returns investors can expect over time. For this reason, the system requires the return on assets ratio to be above 5%.

One of the most dangerous mistakes an investor can make when hunting for undervalued opportunities is investing in value traps, meaning companies facing a permanent deterioration in their fundamentals.

Even if the stock is attractively priced and the company is currently making money when earnings are declining in the long term, even the most tempting bargain can turn out to be an expensive mistake.

In order to avoid value traps, the system requires companies to have an expected long-term growth rate in earnings of at least 5% per year. Earnings expectations don’t always materialize, but it makes a lot of sense to avoid companies with an expected contraction in earnings over the long term.

Among the companies that meet the specified criteria, the system invests in the 50 stocks with the highest price momentum. Time is money in the markets, so we don’t just want to buy the right stocks for the right price, we also want to buy them at the right time. By focusing on stocks that are delivering superior performance, the system makes a more efficient use of capital over time.

Backtested Performance And Recommended Portfolio

The backtest builds an equally weighted and monthly rebalanced portfolio with the 50 stocks selected by the system. The portfolio is assumed to have an annual expense ratio of 1% to account for trading commissions and similar considerations, and the benchmark is the SPDR S&P 500 Trust ETF (SPY).

The backtest begins in January of 1999, and the system produced an average annual return of 13.65% since then, more than double the annual return of 6.17% produced by the benchmark in the same period. In cumulative terms, the system gained 1056.31% versus 214.37% for the benchmark. Alpha generated by the system was 8.16% during the backtest period.

Backtest data and chart source: Portfolio123.

In plain English, a $100,000 investment in the SPDR S&P 500 Trust ETF in January of 1999 would currently be worth around $314,400, and the same amount of capital allocated to the portfolio recommended by the system would have a much larger value of $1.15 million.

It’s important to keep in mind that past performance doesn’t guarantee future returns, and implementing a quantitative system in real life can be more difficult than it seems to be. However, it still makes sense to expect attractive returns when investing in companies with solid fundamentals and trading at modest valuation levels.

The table below shows the 50 names currently selected by the system, including key data points in the system such as market capitalization, price to free cash flow ratio, return on assets, earnings growth expectations, and momentum rank.

As always, please remember to do your own research in order to make sure that a particular company fits your overall investing strategy and risk tolerance level before making an investing decision.

Name

M. Cap ($millions)

P/FCF

ROA %

Growth E%

Momentum Rank

Vale SA (VALE)

$73,673.24

9.85

6.67

14

89.69

Honda Motor (HMC)

$64,233.26

16.12

5.65

5.07

82.09

Applied Materials (AMAT)

$58,331.80

16.76

16.42

12.78

88.83

Micron Technology (MU)

$51,195.18

10.37

23.33

15.76

86.53

VMware (VMW)

$50,295.66

19.63

8.18

13.18

84.21

LyondellBasell Industries (LYB)

$42,900.95

18.51

19.73

6.95

68.62

Express Scripts Holding (ESRX)

$42,610.28

7.25

7.1

13.73

69.57

HCA Healthcare (HCA)

$35,359.29

15.25

6.3

12.65

87.65

Lam Research (LRCX)

$29,962.44

19.89

13.77

17.25

68.49

Best Buy Co. (BBY)

$21,661.28

16.82

8.47

14.07

70.28

Laboratory Corporation of America (LH)

$18,152.36

16.08

8.23

11.15

77.66

CGI Group (GIB)

$16,940.44

16.28

8.86

9.89

73.32

Scripps Networks Interactive (SNI)

$11,407.48

14.01

9.3

7.2

77.6

ON Semiconductor (ON)

$9,532.12

13.82

11.48

12.89

86.41

F5 Networks (FFIV)

$8,969.24

12.78

16.97

9.52

83.37

Teradyne (TER)

$8,519.55

18.23

8.78

13.17

69.82

Lazard (LAZ)

$6,654.54

12.04

5.35

11.99

92.29

Apollo Global Management (APO)

$6,641.06

19.45

9.97

10.91

84.55

BlackBerry (BB)

$6,467.86

7.38

10.08

27.33

69.59

Credit Acceptance (CACC)

$6,216.08

11.37

10.22

17.75

74.01

Foot Locker (FL)

$6,028.54

14.62

13.91

6.29

66.32

MGIC Investment (MTG)

$5,332.46

13.19

6.27

7.83

86.62

Essent Group (ESNT)

$4,649.04

14.04

16.67

11.85

85.8

Genesee & Wyoming (GWR)

$4,575.65

18.34

7.01

12

71.11

EMCOR Group (EME)

$4,506.97

14.3

5.52

14

67.02

Michaels Companies (MIK)

$4,455.44

10.43

16.65

14.35

81.31

Urban Outfitters (URBN)

$3,829.81

14.95

8.92

15

96.25

Evercore (EVR)

$3,728.28

10.47

12.46

14.32

89.88

CACI International (CACI)

$3,697.44

14.66

6.84

10

79.33

Stamps.com (STMP)

$3,235.95

18.99

22.05

22

69.13

Houlihan Lokey (HLI)

$3,041.57

16.1

14.69

18.06

67.25

Deckers Outdoor (DECK)

$3,030.38

10.81

5.38

7.87

97.05

Hillenbrand (HI)

$2,886.82

11.88

6.31

13.75

92.41

Penn National Gaming (PENN)

$2,550.29

8.06

15.09

12.53

81.43

Myriad Genetics (MYGN)

$2,277.01

18.39

10.4

11.63

73.21

Arcos Dorados Holdings (ARCO)

$2,036.85

20

5.25

22.02

77.07

SolarEdge Technologies (SEDG)

$1,971.70

18.7

15.79

22

97.11

MSG Networks (MSGN)

$1,885.89

9.75

32.9

6.02

83.75

USANA Health Sciences (USNA)

$1,847.43

17.54

12.63

15

78.55

Innoviva (INVA)

$1,807.95

17.48

35.95

55.79

88.62

ACCO Brands (ACCO)

$1,455.09

8.57

5.42

11.5

84.87

Asbury Automotive Group (ABG)

$1,432.42

8.01

7.12

14.68

87.59

Wabash National (WNC)

$1,410.09

14.29

9.9

15

73.57

Oxford Industries (OXM)

$1,336.04

17.31

7.66

11

80.11

Lantheus Holdings (LNTH)

$770.58

19.87

11.62

12

65.9

CSW Industrials (CSWI)

$748.89

19.2

6.95

11

82.32

Electro Scientific Industries (ESIO)

$591.49

17.29

9.03

12

72.18

Daqo New Energy (DQ)

$560.29

7.27

9.21

7

71.87

Blue Bird (BLBD)

$536.87

16.67

11.59

13.75

93.15

Zumiez (ZUMZ)

$507.57

13.97

5.28

15

88.68

Disclosure: I am/we are long MU, LRCX.

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.