Eight Thrifty Value Stocks for 2004
At the start of each year I search through the S&P500 in an effort to uncover a few thrifty value stocks. Aside from sticking to large companies, I also look for inexpensive yet profitable businesses with little debt. So far, the results have been quite gratifying.
Three ratios are very useful when searching for companies with little debt. The debt-to-equity ratio is perhaps the most well known and it is calculated by dividing a company's long-term debt by its shareholder equity. Although the amount of debt that a company should be comfortable with varies from industry to industry, debt-to-equity ratios of more than one are generally on the high side. I prefer to consider companies with lower ratios and look for a debt-to-equity ratio of not more than 0.5. 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 current assets to be at least twice as large as current liabilities. In other words, I stick to companies with current ratios of two or more. 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 it should be two or more.
These debt-related ratios are very useful for determining a firm's ability to shoulder debt but 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. Off-balance sheet debt is often ignored by investors, but it can be a source of considerable concern. For instance, Enron floundered under hard to find off-balance sheet debt. So, as with most screening techniques, further investigation is warranted before a final decision is made.
Continuing to look for safety, it is useful to consider companies that have some earnings and cash flow from operations over the last year. After all, it is unlikely for a business to go under when it is profitable and has cash coming in.
Finally, price is always an important factor for a value investor. As always, I'm not so much interested in a stock's price-per-share but in its price in relation to a fundamental factor such as earnings. In this case I've used sales as my fundamental yardstick and have screened for stocks that trade at a price-to-sales ratio of less than one. Table 1 shows a summary of my criteria for selecting thrifty value stocks.
Regrettably, the thrifty value stocks were not profitable in 2002* when the twelve stocks selected lost an average of 1.9%. However, this result was much better than the S&P500 which fell 22.1%. I also tracked the performance of twelve randomly selected stocks which luckily gained an average of 2.9% in 2002.
Thankfully the situation was much improved this year with the ten thrifty value stocks gaining an average of 38.8% from December 31 2002 to December 3 2003. Once more, the S&P500 index trailed with a gain of only 23.0%. In comparison, the ten randomly selected stocks did not fare as well with a gain of only 22.7%.
So far, the thrifty value stocks have outperformed both the index, and a similar number of randomly selected S&P500 stocks. This year, I've decided to drop the somewhat frivolous random selection of stocks and stick to tracking only the S&P500 and my value picks. I should also hasten to add that one should not expect this method to routinely outperform the index. I fully expect that it will encounter a down year, from time to time.
I used the MSN.com deluxe stock screener** to find this year's stocks and on December 3, 2002 it yielded the eight securities shown in Table 2. Half of the stocks found this year were also on last year's list with Big Lots (BLI), Leggett & Platt (LEG), W.W. Grainger (GWW), and Snap-on Inc. (SNA) being new additions. I've also included each stock's current dividend yield which should be of interest to investors looking for income. As with any stock screen it is worth taking some time to more fully investigate each stock before investing.
It is interesting to note that the number of stocks found has been falling over the years with twelve in 2001, ten in 2002 and eight this year. To my mind this trend is somewhat worrisome and a sign that the U.S. large-cap market is becoming less of a bargain. So, perhaps more than ever, investors should remember Warren Buffett's admonition that "Unless you can watch your stock holding decline by 50% without becoming panic-stricken, you should not be in the stock market.".
* See the Canadian MoneySaver articles Stingy Selections & Dartboard Dynamos (January 2002) and Stingy Selections & Dartboard Dynamos 03 (January 2003)
Date: Jan 2004
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