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Active at Passive Prices
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Norm Speaks
I look for two qualities when hunting for bargain stocks: they must be cheap and they must be relatively safe. Not surprisingly, it is often difficult to find stocks that are both cheap and safe.
When it comes to cheap, I usually seek stocks with low prices in relation to book value, earnings, sales, or cash flow. It is best to initially search for cheap stocks using only one or two of these fundamental values because each search reveals a slightly different list of stocks. When composing my annual stock list for the Canadian MoneySaver I stick to stocks with price-to-sales ratios of less than one.
Stocks with low price-to-sales ratios can be tricky which is why I also want a degree of safety. Because large firms tend to be more stable than smaller firms, I only consider stocks in the S&P500.
More importantly, companies with little debt and lots of assets are much stronger than firms living on the edge of insolvency. Three ratios are very useful when searching for companies with little debt. Perhaps the most important is the debt-to-equity ratio which is calculated by dividing a company's long-term debt by shareholder's equity. The amount of debt that a company can comfortably support varies from industry to industry but debt-to-equity ratios of more than one are generally too high. I prefer to consider companies with even less debt and look for debt-to-equity ratios of 0.5 or less.
Next up is the current ratio which is calculated by dividing a company's current assets by its current liabilities. Current assets are defined as assets, such as receivables and inventory, that can be turned into cash within the next year. Current liabilities are payments that the company must make within the next year. Naturally, an investor would like a company's current assets to be much more than its current liabilities and I prefer companies with current assets at least twice as large as current liabilities. After all, you can be pretty sure that the company's creditors will demand prompt payment of the current liabilities. On the other hand, some of the current assets, such as a firm's inventory, might not actually be worth as much as management expects.
Finally, a company's earnings before interest and taxes should be large in comparison to its interest payments. The ratio of earnings before interest and taxes to interest payments is called interest coverage and I like this ratio to be two or more. But it is important to remember that a debt-free company does not make interest payments and wouldn.t have an interest coverage figure. Nonetheless, debt-free firms should not be excluded from consideration.
While the debt ratios that I've selected are very useful when determining a firm.s ability to shoulder debt, they are not perfect. Some long-term obligations may not be fully reflected on a company's balance sheet and are, sensibly enough, called off-balance sheet debt. Regrettably, off-balance sheet debt is often ignored but it can be a source of considerable consternation. For instance, sneaky legal liabilities can sideswipe what might otherwise be a good investment. As with all screening techniques, be sure to embark on a more detailed investigation of each stock before making a final investment decision.
Continuing the safety theme, I also want a company to show some earnings and cash flow from operations over the last year. After all, it is less likely that a business will go under when it is profitable and has cash coming in the door.
All of my criteria are summarized in Table 1 and I've used the same criteria over the last five years to find interesting value stocks. Table 2 summarizes the strong past performance of the method. Since a rocky start in 2001, the stingy stocks have provided a total gain of 183.6% assuming that the old stocks were sold and the new stocks purchased each year. In comparison, the S&P500 (as represented by the SPY exchange-traded fund) lagged by 151.3 percentage points over the same period.
| Table 1: Stingy Stock Criteria |
| 1. A member of the S&P500 2. Debt-to-Equity Ratio less than or equal to 0.5 3. Current Ratio of more than 2 4. Interest Coverage of more than 2 5. Some Cash Flow from Operations 6. Some Earnings 7. Price to Sales ratio of less than 1 |
| Table 2: Past Performance | |||
| Period* | Stingy Stocks | S&P500 (SPY) | +/- |
| 2001 - 2002 | -1.9% | -22.1% | 20.2 |
| 2002 - 2003 | 33.8% | 23.0% | 10.8 |
| 2003 - 2004 | 29.8% | 13.4% | 16.4 |
| 2004 - 2005 | 29.2% | 8.2% | 21.0 |
| 2005 - 2006 | 28.9% | 12.6% | 16.3 |
| Total Gain Since Inception | 183.6% | 32.3% | 151.3 |
| Source: quote.yahoo.com * Indicates the time between articles and not calendar years. | |||
Despite outperforming the S&P500 by at least 10 percentage points a year, I should hasten to add that I don't expect my method to routinely produce stellar results. I fully expect that it will encounter a down year, both compared to the S&P500 and absolutely, from time to time.
Bargain hunting was a little more difficult this year with only five stocks passing the stingy test down from eight stocks last year. This year's crop of stingy stocks is shown in Table 3.
| Table 3: Stingy Selections for 2007 | ||||||||
| Company Name | Share Price | P/S | D/E | Current Ratio | Interest Coverage | P/CF | P/E | Dividend Yield |
| Ashland (ASH) | 67.99 | 0.59 | 0.03 | 2.1 | 366.0 | 14.7 | 26.9 | 1.6% |
| Dollar General (DG) | 15.46 | 0.54 | 0.31 | 2.1 | 23.7 | 9.7 | 16.2 | 1.3% |
| Genuine Parts Co. (GPC) | 46.61 | 0.77 | 0.18 | 3.1 | 31.4 | 14.9 | 17.4 | 2.9% |
| Leggett & Platt (LEG) | 23.69 | 0.77 | 0.47 | 2.6 | 9.1 | 9.4 | 16.1 | 2.9% |
| Liz Claiborne (LIZ) | 42.62 | 0.90 | 0.36 | 2.4 | 12.7 | 10.9 | 17.1 | 0.5% |
| Source: www.stingyinvestor.com, www.msn.com, December 2, 2006 | ||||||||
I hope that I've piqued your interest, but be sure to fully investigate each stock, and talk to your investment advisor, before investing. Remember that, although the stingy stocks are relatively safe, there is no such thing as a risk-free stock.
First published in January 2007.
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