Top 25 Compounders that are Cheap; & Some Thoughts on Investment Process

Posted on Posted in Investment Ideas & Company Research, Investment Philosophy

Investors use all kinds of inputs to make investment decisions. When looking for individual stocks to buy, “bottom up” investors use balance sheet, income statement, and cash flow data to make decisions on whether or not to buy the stock in question.

Over the years my investment strategy has shifted to focus more on balance sheet numbers. Probably half of my screens and scans revolve around cheapness relative to assets, and the other half still use multiples of earnings/cash flow/sales, etc…  I have become more and more interested in assembling baskets of stocks with low multiples to assets and tangible book values, and I like to measure risk using the levels of debt and the ratio of liquid current assets to liabilities. This is just an evolution of style that was previously much more focused on the income statement. I still actively use cash flow and income statement data in my analysis, and I think any good value investor needs to use both balance sheet and income statement data.

But given the fact that I’ve become more interested in emulating the philosophies of say Ben Graham and Walter Schloss (for reasons I’ll save for another time), I’m still very much interested in analyzing earnings and cash flow. Some of my screens I now use to find cheap stocks relative to assets, and then I look for earning power within that select universe. After all, despite my interest in assets and tangible book value, the only logical reason a long term investor buys any asset is for the income (direct in the form of dividends or indirect in the form of per share interest in the company’s earnings) that the asset will produce over the ownership span of the asset. If no income is produced, there is no value for the ultimate owner of that asset. (i.e. the only way to make a profit on a non-income producing asset is to find another buyer to pay you more than your cost).

So after measuring cheapness relative to assets and earnings, I like to overlay some quality metrics such as return on capital to find cheap stocks that are also good. Of course, this is the general objective of all value investors. Greenblatt simplified all of this by saying “We like to buy stocks that are cheap and good”. His “Magic Formula” combines cheapness and quality to create a watchlist of the stocks that are the best of both worlds.

I prefer to measure stocks by cheapness, and then within that universe, I like to measure quality. It sounds similar to Greenblatt’s methods, but there are a few key differences. I’ll talk more about this in future posts: for now, check out a great blog called Turnkey Analyst, who explains this philosophy in-depth. Also, see Greenbackd, or the book they co-authored together called Quantitative Value.

I summarized these thoughts in order to explain the general way of how I try to find investment opportunities….

  1. Find a basket of cheap stocks relative to earnings or assets
  2. Within that basket, find the best ones as measured by ROIC, ROE, operating margins, or some other quality metrics

That’s the gist of my investment process.

But I mention this so I can now say that I have one screen I enjoy keeping an eye on each month that is somewhat contrary to the above method. This screen searches for the best businesses (as measured by returns on equity, capital, and growth of earnings and book value), and then also includes a simple P/E multiple filter to try to find great businesses at fair prices.

This is more of a Warren Buffett style screen. It attempts to find wonderful businesses at fair prices, despite my preference to find fair to good businesses at absolute bargain levels.

The screen (I use Morningstar) uses the following criteria:

  • Domestic companies with market caps of $250 million or more
  • Current Ratio > 1
  • Debt to Equity < 1
  • Return on Equity > 10% for each of the past 5 years
  • Book value growth > 10% per year for each of the past 3 years
  • Positive earnings growth for each of the past 3 years
  • Positive sales growth for each of the past 3 years
  • P/E < 15, or Forward P/E < 12

So the screen basically looks for well run companies that are not over-leveraged that have been able to achieve consistent growth in earnings, sales and book value…. all at a modest multiple of current or estimated earnings.

The screen currently has 51 stocks. I sorted the list by forward P/E, and here are the top 25 cheapest companies that fit the above criteria:

Top 20 Cheap Compounders

Many of these companies won’t be cheap enough to interest me. But many of these are above average companies at fair prices, and might be worth keeping on a watchlist. Take a look and you might find a few that interest you. Based on the numbers, I’m taking a closer look at the following:

  • Big Lots (BIG): I like this retailer. Has some near term hurdles and relatively poor recent results, but I think it’s undervalued relative to long term prospects and current earnings. Lots of pessimism… although it’s up 20% from the low set last month.
  • Cash America (CSH): I really like the CSH business model. Produces lots of free cash flow.
  • Nu Skin Enterprises (NUS): I’ve been interested in this stock along with Herbalife (HLF) since the now infamous Ackman short presentation.
  • ScanSource (SCSC): Don’t know anything about this tech company yet, but noticed it dropped 20% this week on a relative mild earnings report. Looks cheap based on P/B ratio. Earnings might be in question?
  • Dell (DELL): Has been cheap for some time. I’m still thinking about this one, along with HPQ.

I don’t own any of the stocks mentioned above, but may take positions in some of them in the near future. Hope you find a few in the list to investigate further…

4 thoughts on “Top 25 Compounders that are Cheap; & Some Thoughts on Investment Process

  1. John,

    love the blog, just found your site and plan on perusing through all of it. i commented on this because i wrote an article on Cash America last year. http://thestreport.com/category/stocks/cash-america/

    My blog is not very good; I used to do a lot more investing writing on it but now I have a structured process for my research, so now I only share thoughts I have every once in awhile (macro, regulatory, etc.)

    I like the screen you did (i’ll be looking through the companies), although I’m not a fan of screens in general… I also am unsure of why you’d insist on a positive current ratio. I’ve never really understood the current ratio, because if the business possesses good economics then it should be irrelevant as to the structure of their working capital. I’m pretty sure this would eliminate all pipelines and dominant big box retailers (WMT, COST) from your screens. Just a thought.

    I follow enough hedge funds/investors that I keep myself busy looking through their holdings. I also just explore random businesses internationally that strike me as interesting… but screening is something I gave up on awhile ago. I feel like if you follow enough intelligent people you start looking into situations on your own… I wouldn’t know though, am only just now starting heavily on my search strategy. So it’s an ongoing process.

    Contact me any time, would like to hear from you
    -Schneck

    1. Thanks for the nice words Andrew. I just visited your blog as well-great work. As for the screen, I modified a few of Graham’s screens. In one of his screens, I think he requires a current ratio of 2 or higher. I use 1 in some of my screens… basically just to try and minimize potential liquidity issues. It does eliminate certain stocks. However, I use a number of other screens that catch these stocks. I run 8-10 screens each month that catch a variety of potential undervalued stocks. I am very much in the Graham school-I use basic value metrics, adequate diversification, and limited company specific analysis. However, I do a lot of reading and over time intend to improve my qualitative analysis skills. I think the best results from the investors who are adept at combining both, but the first ingredient is valuation. My basic process is to seek out the cheapest ponds, and fish in those ponds. I try to look at the cheapest deciles using P/E, P/B, EV/EBIT, and a few other metrics. I’ll discuss more thoughts as I go… thanks for your comments and thoughts.

      Thanks for reading…

  2. John,
    Is the Morningstar screen comes from the Premium stock screener ? I can access the Morningstar through my local library but I can’t get access to the screener which allows me to set those parameters mentioned on your post.

  3. This is an older post, I know, but I ran some numbers and wanted to point something out.

    An portfolio with an equal amount purchased of each of the stocks in the screener above would have produced a 39% return from January 30 to today (March 10, 2014). I annualized this amount out to 35%. I wonder what the numbers would show if you performed a backtest on this screener – each year re-running the screen and rebalancing the portfolio.

    In any event, good post.

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