8 Stingy Stocks for 2006
I look for two qualities when hunting for bargain stocks: they must be cheap and they must be safe. Not surprisingly, it is often difficult to find stocks that are both cheap and safe.
When it comes to cheap, I usually look for stocks with low prices in relation to book value, earnings, sales or cash flow. I find that 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 stick with stocks in the S&P500.
More importantly, companies with little debt and lots of assets are much stronger than firms living on credit. 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 companyís long-term debt by shareholder 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 a debt-to-equity ratio of 0.5 or less. Next up is the current ratio which is calculated by dividing a companyís 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 companyís 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. Finally, a companyís 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.
While the debt ratios that Iíve selected are very useful when determining a firmís ability to shoulder debt, they are not perfect. Some long-term obligations may not be fully reflected on a companyís 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. Consider the case of Enron which floundered under a mountain of hard-to-find off-balance-sheet debt. 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 demand that a company has had 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 Iíve used the same criteria over the last four years to find interesting value stocks. Table 2 summarizes the strong past performance of the method, which has gained a total of 120.1% since inception and outperformed the S&P500 (as represented by the SPY exchange-traded fund) by 102.5 percentage points. I should also hasten to add that I donít expect this method to routinely outperform and I fully expect that it will encounter a down year, from time to time.
This year there are eight value stocks that pass the stingy stock test and they are shown in Table 3. Reebok International (RBK) would have passed, but I excluded it from the list because Adidas has offered to buy Reebok for $59 per share. Even so, this yearís list is twice as long as last yearís list which is a pleasant development for bargain hunters.
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.
Additional Information: See the Canadian MoneySaver articles Stingy Selections & Dartboard Dynamos (January 2002), Stingy Selections & Dartboard Dynamos 03 (January 2003), Eight Thrifty Value Stocks for 2004 (January 2004), and 4 Stingy Stocks for 2005 (January 2005).
Date: January 2006
Update: Feb 25 2006
First published in January 2006.
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