In the stock market bible The Intelligent Investor, Benjamin Graham suggested a set of criteria for stock selection. These timeless criteria have helped and inspired millions of investors worldwide. These criteria turned buying stocks from a speculation into an investment.
However, the dream deals that fit all his original criteria have become almost extinct now (e.g., stock price below two-thirds of tangible book value per share, stock price below two-thirds of Net Current Asset Value, et al). However, from time to time, extreme market panics offer opportunities that almost fit all dream criteria. As you will see in this article, now is one such time.
Here we picked the 10 most beaten-down stocks based on a Graham-type screening. We've designed a screener based on the following criteria:
1. Low PE
2. Earning growth in the past five years
3. YTD loss
Criteria 1 and 2 are completely consistent with Graham’s original thinking. And criterion 3 is designed to capture the recent panic sell-off.
To be also consistent with his original thinking and to reduce the speculative nature of our selections, we’ve applied this screener to the stocks with positive earnings and with a market capitalization of more than $300M. Our final list is the stocks with the highest combined scores on all three criteria. The score is an equal-weighted average of each stock’s ranking on these criteria.
And the results are tabulated below:
Before moving on to comment on the details of each selection one by one, let's first take a look at the overall picture. The next table shows the basic statistics of these 10 stocks, their current PE, forward PE, growth expected in the next three to five years, and also the expected returns. A few key observations:
I wouldn't be surprised by such outsized returns. If it happens, it will be just another demonstration of the timeless power of valuing investing, which has been well documented in so many past studies and also in our own investing journey.
As an example, the following chart shows the excess return of stocks divided into 5 quintiles relative to the S&P 500 index. The first quintile contains stocks with the highest PE ratio, and so on. You can clearly see the positive correlation. Stocks in the first quintile, i.e., with the highest PE ratio in the first 20th percentile, underperformed the S&P 500 equal weight index by 2.08%. The performance almost linearly improves as the PE ratio goes down. And stocks in the fifth quintile, those least expensively valued produced an average annual excess return of 1.41%.
In the remainder of this article, we will detail our top choice – the Meta Platforms. We then will make some brief comments regarding the remaining nine.
Now with the above background, let's move on to our top candidates Meta Platforms (FB). If there's one company that needs no introduction in this list, it's probably FB. Graham would have been surprised, and maybe would find it totally reasonable, that a stock like FB would be at the top of his criteria.
Shortly after FB reported its Q1 2022 earnings, the stock price suffered by more than 26%, erasing more than $250B in its market value. Currently, its stock price is more than 35% from its recent peak and the stock lost more than 30% YTD. We will get to the details of why it dropped (and why it should not) later. But this is a clear example of the market’s knee-jerk reaction, as you can see from the following chart.
And the message from this chart is really simple. A stock with the quality and growth potential like FB should never trade below 10x of its pretax earnings according to what I call Buffett’s 10x pretax rule. However, at its current valuation, it's trading close to that when adjusted for its cash position (it has no debt but a large net cash position on its balance sheet). To be more specific, when adjusted for its cash position, FB is now traded at about 11.9x of its pretax earnings (“EBT”) and only 10.6x of its FW EBT.
In case you're wondering what is Buffett's 10x pretax rule, it has been detailed in our earlier writings. And here's a very brief summary of its gist and why a stock like FB should never trade near 10x EBT:
First, Buffett himself paid ~10x pretax earnings for so many of his largest and best deals. The list is a really long one, ranging from Coca-Cola, American Express, Wells Fargo, Walmart, Burlington Northern, and the more recent Apple. So it cannot be coincident.
Second, after-tax earnings do not reflect business fundamentals. Taxes can change from time to time due to factors that have no relevance to business fundamentals, such as tax law changes and capital structure changes. Plus, there are plenty of ways to lower the actual tax burden of a company. That is why we (or Buffett) prefer EBT over other earning metrics.
Third, pretax earnings are easier to benchmark, say against bond earnings. The best equity investments are bond-like, and when we speak of bond yield, that yield is pretax. So a 10x EBT would provide a 10% pretax earnings yield, directly comparable to a 10% yield bond.
As a result, if I buy a business with staying power at 10x EBT and even if the business stagnates forever, I am already perfectly happy to be making a 10% return pretax. Any growth is a bonus.
So by valuing the stock at about 10x EBT, the market essentially is pricing the stock as a business that would stagnate forever.
Such mispricing is completely caused by short-term market reactions. Probably one of the key factors that contributed to such market reaction (or overreaction) is the following chart. In its recent earnings release, FB reported its daily active users (“DAU”), a standard metric to measure social media engagement. This number shows how many users logged in and engaged with the firm’s apps (which include Facebook, Instagram, Messenger, WhatsApp, and so on). As you can see, it reported a DAU at 1.93B users. However, analysts expected 1.95 billion daily active users on Facebook, but Meta reported “only” 1.93 billion. Such miss was interpreted as a key indicator that the growth trajectory for the company is now in question.
We think this is an overreaction. We think what happened in the last quarter is only a random fluctuation caused by temporary issues (such as supply chain difficulties suffered by its customers and the advertisers).
FB not only will not stagnate forever. On the opposite, it's well poised to capitalize on strong secular growth opportunities as detailed below.
In the near term, besides missing analysts’ expected 1.95 billion daily active users, FB’s results actually maintained its strong growth. It generated revenues of $33.7B in the last quarter, showing growth of 20% year over year.
In the recent and the next few years, the business is expected to maintain a very healthy and scalable margin as shown below. At its current staggering scale, FB has been actually able to maintain an MROCE (Marginal Return on Capital Employed) that's essentially the same as its average ROCE so far. As seen, the ROCE has been on average 69.8% in recent years, and the MROCE has been on average 70.8%. And the small difference is most likely due to investable uncertainties in the financial data and rounding off errors. So this result suggests that FB has not reached the stage of diminishing return yet - gravity has not caught up yet. And FB will continue its high and consistent ROCE.
At Berkshire’s more recent annual meeting, Buffett said, "We've always known that the dream business is the one that takes very little capital and grows a lot.” And he then mentioned that Apple (AAPL), Alphabet (GOOG) (GOOGL), Microsoft (MSFT), and Facebook (FB) are terrific examples of that. There is no surprise here. FB not only requires little capital to grow a lot, its strong MROCE also shows it can still employ large amounts of incremental capital at very high rates of return, another trait of dream business that Buffett commented on multiple times (the highlights are added by me):
Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of incremental capital at very high rates of return.
Looking further out, FB is well positioned with so many futuristic opportunities in augmented reality and virtual reality business. It broke out its Reality Labs revenues last quarter. We are also optimistic that its aggressive investing in the Metaverse division will keep generating new business ideas and growth opportunities.
Now we move on to the rest of the nine other choices.
Moderna is probably another business that needs little introduction in this list. Although most people are probably only familiar with its COVID vaccine, it's actually a clinical-stage biotechnology company whose drugs and therapeutics could potentially treat various diseases. Its platform is based on Messenger RNA, or mRNA. And Moderna believes mRNA could be used to create a new class of medicines with the potential to improve patients’ lives in many ways – beyond fighting COVID.
Currently, the equity is more than 30% lower in value YTD and lost more than half of its valuation since its price peaked in Sept 2021, a short four months ago. Risk-tolerant investors should find the stock intriguing at its current level now. Indeed, there are uncertainties ahead (as listed below). But the stock is now only valued at 7.4x of PE, we believe the correction is overdone, and the risks have been more than priced in.
The risks that we see include:
CALX is a software-application business. It develops, markets, and sells broadband communications access platforms, systems, and software for fiber- and copper-based network architectures. Its software is a key technology that enables communications service providers (“CSPs”) to transform networks and connect to residential and business subscribers.
The demand from broadband service providers remains robust. And CALX has been enjoying more than 30% CAGR in its profit growth. The stock price rallied to a peak of $76 at the end of 2021 from its bottom level of $5.6 amid the COVID crash –more than 1300%. The stock price has corrected to the current level of $50 amid the recent sell-off. With the 13x price rally since 2020, at its current price, it's valued at about 36x of current PE, and it's the most expensively valued stock in our selection. However, potential investors may find such valuation justifiable considering A) its high growth potential, B) its strong balance sheet (no debt and about $230M of cash position), C) our secular need for broadband services (not only work, but also homew ork, education, and entertainment), and D) finally also the US federal and state government’s commitment to bringing broadband service to rural areas.
The risks we see primarily price volatility risks. Its recent 13x price run-up, combined with near-record high valuation of the overall market, can expose the stock to large volatility fluctuations.
GPI operates in the automotive retail industry. It had 239 franchises globally, and its retail network conducts business globally in the U.S., U.K., and Brazil. Through its dealerships, it sells new and used cars and light trucks, arranges related vehicle financing, sells service and insurance contracts, provides automotive maintenance and repair services, and sells vehicle parts.
Its topline and bottom-line have been advancing remarkably thanks to strong vehicle margins and the price hikes in used vehicles. For example, during the third quarter, earnings were up 38% year over year, to $9.62 a share. The 2021 earnings are expected to be near $35 per share, also most doubling its 2020 level.
Looking forward, we expect this momentum to persist for several reasons: A) increased consumer demand, B) the business’ capital allocation flexibility and its active acquisition activities, and C) management’s efforts to improve the company’s service volume and diligent cost control. Furthermore, the share repurchase authorization was lifted by $116 million to $200 million, creating another short-term support for the stock price.
The risks we see primarily price volatility risks. Its line of business is notoriously cyclical. Combined with a near-record high valuation of the overall market. Its stock price is subject to large seasonality and volatility fluctuations.
CWH is an Auto and Truck Dealership firm. It offers a variety of services to recreational vehicle (“RV”) owners and enthusiasts. It operates through two brands: Camping World and Good Sam. Camping World operates 171 retail and 170 selling/servicing RV locations (sells new and used towable and motorhomes) in 36 states. Good Sam provides insurance programs, financing, and emergency roadside services.
CWH is one of the businesses that enjoyed an unexpected benefit from COVID. As the COVID pandemic hinders travel plans, many people begin to favor road trips and mini getaways in RVs and creating a boost for CWH. As an example, revenues and share earnings for the first nine months surpassed 2020 tallies by more than 28% and 86%, respectively. As a result, this stock price rallied to a peak of $46 during 2021, a more than 1300% rally from the bottom of the COVID crash – making this lesser-known stock a ten-bagger since 2020. The stock price has corrected to the current level of $32 amid the sell-off. Despite the large price rally since 2020, at its current price, it is only valued at about 5.6x of current PE and 4.9x FW PE.
The positive momentum likely continued in the near future. Demand for RVs is expected to stay healthy mostly because the new COVID variants are still hindering long-distance and air travel plans. The recent surge in delta and Omicron cases could persist longer.
There are a few risks worth monitoring for this investment:
AAWW is in the Air Services business. It's a major provider of global air cargo services. Its specific services include ACMI leasing, global scheduled service, commercial charter services, and U.S. military charter services.
AAWW is seeing record cargo volumes and elevated charter yields thanks to a combination of unexpected tailwinds. For instance, the ongoing global logistic chain interruption actually benefited AAWW. While global airfreight demand has surged past pre-pandemic levels, supply has not fully recovered. At the same time, the cost of ocean cargo has more than quadrupled over the past year, therefore benefiting air cargo businesses such as AAWW.
Looking forward, we expect many of these tailwinds to continue. AAWW’s own management believes those above factors are pushing more customers to shift to airfreight. Also, passenger jets handle about half of the world’s airborne cargo. Therefore, the slow recovery of passenger jets will add another catalyst to AAWW.
Also note that as a mid-cap air cargo business, AAWW enjoys a healthy balance sheet with Long-term debt at $1.69B and a long-term interest of $100M only. Its debt coverage ratio is a very healthy 7X (EBIT income divided by Interest Expenses).
AAWW faces some competitions. Many of AAWW’s closest rivals have stumbled and are unable to ramp up operations as quickly. But they are ramping up and will be competing more effectively in the near future.
VSTO is in the leisure business. It's a designer, manufacturer, and marketer of consumer products in the outdoor sports and recreation markets. The Shooting Sports segment is its largest segment, contributing more than 68% of 2020 sales.
VSTO is also one of the businesses that enjoyed unexpected benefits from COVID. As the COVID pandemic hinders travel plans, many people begin to look for alternative leisure options, and demand for VSTO’s services and products has soared. The onset of the pandemic has driven sales of ammunition and other outdoor products markedly higher.
The stock price rallied to a peak near $49 toward the end of 2021, a more than 1100% rally from the bottom of the COVID crash – making this lesser-known stock a ten-bagger since 2020. The stock price has corrected to the current level of $39 amid the sell-off. At its current price, it is valued at about 5.4x of current PE.
Looking forward, we expect a further expansion of its profit margins. VSTO has been operating very efficiently, which should help offset higher raw material costs. In the meantime, the company remains active on the acquisition front. It has just completed the buyout of golf accessories manufacturer Foresight Sports. And it has then decided to acquire Stone Glacier, a maker of lightweight hunting gear. We're optimistic about these add-on acquisitions and expected to contribute to the growth in the near future and leverage the synergies to further optimize its operational efficiency.
The main risks we see are A) the higher raw material costs due to inflation pressure, and B) also a tough comp in the near term given its recent spectacular growth pace. But in the next a few years, we still expect a healthy growth rate.
CNR engages in Building Products and Equipment. It manufactures and markets metal and nonmetal products used externally in structures for both the commercial and residential construction industries. Operating segments in 2020: Windows, (41%); Commercial, (34%), and Siding, (25%).
The recent housing boom gave a large boost to its profit. Both topline and bottom-line almost doubled from the numbers a year ago. For example, its share earnings will be in the $5 range this year, compared to a loss of about $3.8 last year. Although note that most of the income was the result of the sale of two businesses for cash considerations of $1.2 billion. But after excluding this income, its adjusted and normalized share net is still expected to be $1.87 next year. And the stock price is currently at $14, a more than 20% correction YTD, it is currently valued at about7.5x of its FW PE.
Looking forward, we expect the tailwind to continue as the housing market boom persists. For example, in its Window business, sales rose over 11%, despite volume increasing only 1.3%, vs. the previous year. The situation was similar in the Siding segment. The supply/demand imbalance and strong demand due to low financing costs for homebuyers are expected to keep providing favorable pricing power for CNR.
The main risk we see here is the financial is its financial strength. Currently, its long-term debt represents more than 73% of total capital, which is quite high. Its current debt coverage is only about 4X (defined as EBIT income divided by Interest Expenses).
FLWS is a Specialty Retailer. It provides a broad range of gift products, including flowers, plants, gourmet foods, candies, and other gifts. Products are sold primarily via e-commerce, which accounted for 89% of its 2021 sales.
The business has been enjoying healthy growth – both organically and through bolt-on acquisitions. Organically, the top line increased roughly 9% over the prior-year figure. It has also expanded its product offerings and well-positioned for continued top-line gains. On the acquisition front, it has just acquired Vital Choice. Vital Choice provides premium seafood and sustainably farmed shellfish, pastured proteins, organic foods, et al, adding over 400 new offerings in the ‘‘better for you’’ category.
We're optimistic about this acquisition. As consumers become more conscious of their food choice and spend more time cooking at home due to the COVID pandemic, Vital Choice should nicely complement the company’s gourmet foods business.
The main risks we see in the near term are cost control and inflation pressure.
BZH is a Residential Construction firm. It builds and sells single-family homes in 13 states. The company operates in three regions of the United States: the West (accounted for 56% of fiscal 2021 deliveries), East (22%), and Southeast (22%). It carters to homebuyers in the medium range of the market. In 2021, for the 5,000-plus homes that it sold, the average price was about $400k.
The recent housing price boom gave a large boost to its profit. Both topline and bottom-line almost doubled from the numbers a year ago. And the stock price rallied to a peak of $26 during 2021, a more than 600% rally from the bottom of the COVID crash. The stock price has corrected to the current level of $17 amid the sell-off. At its current price, it is only valued at about 3.6x of current PE and 3.4x FW PE.
Looking forward, we expect the housing price to remain high in the near future. The primary catalysts include the industrywide supply/demand imbalance of available homes and the still low financing cost for homebuyers. These factors will continue working in the favor of the builders and sellers.
There are a few risks worth mentioning:
The recent sell-off created an attractive opportunity for value investors. If you have been following our articles, you would know that we promote concentrated bet. In our experiences, a few carefully chosen stocks from a well-understood approach actually offers LOW risks and high return potentials. The ten stocks chosen here offer an excellent balance of diversification, quality, and outsized return potentials.
Thanks for reading and look forward to your comments and thoughts!
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This article was written by
** Disclosure** I am associated with Envision Research
I am an economist by training, with a focus on financial economics. After I completed my PhD, I have been professionally working as a quantitative modeler, with a focus on the mortgage market, commercial market, and the banking industry for more than a decade. And at the same time, I have been managing several investment accounts for my family for the past 15 years, going through two market crashes and an incredible long bull market in between.
My writing interests are mostly asset allocation and ETFs, particularly those related to the overall market, bonds, banking and financial sectors, and housing markets. I have been a long time SA reader, and am excited to become a more active participator in this wonderful community!
Disclosure: I/we have a beneficial long position in the shares of AAAPL either through stock ownership, options, or other derivatives. 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.