A Great Way To Find Possible Value Stocks

by: Furbonacci

Every few months or so, I will go back to the drawing board and re-evaluate my approach to finding potential value stocks to research. This time around, I started with 6800 different stocks and decided to begin my filtering process by looking at the PEG ratio. Initially I tried to screen for stocks with a PEG less than 1. This yielded 721 results. PEG is an all-encompassing metric for value, especially when it is looking at forward earnings growth. Now I realize there are a bunch of assumptions being made when using forward earnings, but I've decided that for my research purposes, it will do.

I have also learned it is best to screen for equities that have a current volume of 50k or more, and this helps weed out all those pesky illiquid issues that have gotten me in trouble in the past. With 429 results, we are at the point where we are looking at potential "cheap" stocks that are probably liquid enough for me, the small investor, to get in without paying a bunch in spread premium.

Now what good is a stock, or a company, that cannot take advantage of its cheap stock valuation? If the company isn't generating enough free cash flows to buy back shares, then it is a company I do not want to buy. So I screen for those 429 stocks with P/FCF lower than 15. This gives me 139 results to work with, a much more manageable number.

Now I have 139 relatively cheap, cash generating and fairly liquid stocks. After going through the list, something struck me; at any point in time, a company without sufficient cash could do a secondary offering, diluting the shares I buy today. I wanted to screen for stocks with low P/Cash ratio, but I thought that by making my P/FCF more selective, I could weed out companies that are just squeaking by. By strengthening the screen to search for stocks with P/FCF less than 10, I know I can be sure that, even if a company does not have significant cash on hand at the moment, they should be able to produce it in a short amount of time, if needed.

Now with 84 results, it is time to take a step back again. After every edit to my screen, I like to take a step back and make sure I understand the logic behind every move, and I like to summarize where my screen is. So now we have top tier cash generating, fairly liquid, potential value plays. Since this is a value investing screen, I felt as though I need to be a bit more selective in my PEG screen. If company XYZ is trading at 30x earnings, but is only growing EPS at a 30% clip, there is little margin of safety. I would feel much better if I were buying a stock growing EPS at a 30% rate when it is trading at 20x earnings. With the PEG ratio reduced to .66 or better, with P/FCF less than 10 and current volume over 50k, I am left with 40 possible value opportunities.

Before the credit crisis, I would stop here and find the names in industries I thought I could understand. But today more than ever, debt must be taken into consideration before making any equity purchase. My final screen removes all equities that have a debt/equity ratio above .5. I believe .5 is the Equities Mendoza Line, the place where no value investment should be above. If a company has to worry about debt payments and covenants for their line of credit, then they cannot possibly operate the way I would like my business to operate. After all, when we are buying stocks, we are becoming part owners of a company. This final screen with debt/equity under .5, PEG .66 or better, P/FCF less than 10 and current volume more than 50k, yields 20 results.

I take my time to run through the names; some are recognizable and some aren't. What I focus on the most though, is industry. if I don't understand it, I cannot possibly take the next steps I need to take. Those steps are:

1. Reading earnings transcripts and articles here on Seeking Alpha.

2. Reading the past 2 quarterly reports and the last annual report.

3. Googling the living daylights out of the company and visiting their website.

In case you were wondering what those 6 stocks are that I will be researching, they are:

Vonage Holdings Corporation (NYSE:VG)

GT Advanced Technologies Inc. (GTAT)

Quanex Building Products Corporation (NYSE:NX)

Western Digital Corp. (NYSE:WDC)

Kulicke & Soffa Industries Inc. (NASDAQ:KLIC)

FSI International Inc. (NASDAQ:FSII)

Follow Furbonacci for updates on these equities in the coming weeks.

Disclosure: I am long (GTAT).