Go With What You Don’t Know?

Published August 20, 2012

| TradeKing

Alan Brochstein takes a look at solid but not well-known companies

You may be familiar with Peter Lynch, considered by many to be one of the best investors of modern times. Lynch, who spent his entire career at Fidelity Investments and ultimately ran its largest mutual fund, Magellan, was known for investing in the stocks of companies that he knew well. His philosophy suggested that individuals should consider investing in the companies whose products or services they purchased.

I can’t help but think how this concept, which certainly has its merits, can lead to a complete disaster. Of course, it’s not Lynch’s fault, as he suggested familiarity with a company was just a starting point, but I feel badly for those who have invested in Facebook (FB), Groupon (GRPN) or Zynga (ZNGA) and lost a substantial amount investing in “what they know”. Investing in what you know can lead to a bias of overconfidence.

I try to find companies that aren’t so well known but that might become better known in the future. One of my clients uses the tag-line “Investing in Tomorrow’s Blue Chips Today”, which is generally consistent with my own philosophy.

I ran a screen and shared the results in April, highlighting three companies with some very strong fundamental characteristics but no coverage by Wall Street. Today, I want to run a similar screen, but with a relaxed constraint on Wall Street analyst coverage. With the goal of finding some potential hidden gems, I ran the following screen using Baseline:

  • Member of the Russell 3000 Index
  • Market Cap > $500mm
  • Net Debt to Capital < 10%
  • Trailing PE < 15
  • 10-year Compound Sale Growth > 8%
  • 10-year Compound EPS Growth > 10%
  • 5-year Compound EPS Growth > 10%
  • 1-year EPS Growth > 10%
  • 2013 Projected EPS Growth > 8%
  • Fewer than 12 Wall Street Analysts

This screen is designed to identify companies with strong balance sheets, solid long-term historical growth in sales and earnings, recent above-market earnings growth and reasonable valuations. It’s just an example of how one can cull through a broad list of stocks to find those meeting certain criteria. Here are the 6 stocks that made the cut:

Please remember that these are not recommendations. I am familiar with but don’t closely follow these companies and have used this exercise to demonstrate the concept of identifying companies with certain characteristics but somewhat limited analyst coverage. You should always do a thorough investigation of any company before investing in it.

I don’t know about you, but few, if any, of these jump out as being a company that most people would know. I will tell you briefly about each one, but, first, let’s consider the big picture. Four of these stocks have more cash than debt (highlighted in green). Half of the stocks are tracking the market’s return this year, with one (Ascena Retail) beating the market and two (Allscripts and JDA Software) trailing. All of these stocks trade at a forward PE that is similar to the S&P 500’s 13 PE, and I shaded five of the six that all trade at more than 20% below the 10-year median.

I sorted the list alphabetically, with the worst performer of late, Allscripts (MDRX) at the top. This company sells software and solutions to doctors and hospitals. While the company may not be famous, it is somewhat infamous of late, with the stock plunging in April as they reduced guidance for 2012. Further, the CFO resigned and the chairman and three directors quit as well. The company announced a big share repurchase program and ended up buying 21mm shares at 10.87 in Q2.

While you may not know Ascena Retail (ASNA) by name, you might be familiar with its operating units, which include Dress Barn, maurices and Justice. The company just bought Charming Shoppes earlier this year. This one looks quite interesting to me.

Inter Parfums (IPAR) licenses Burberry (45% of sales) and other prestige brands of perfume, with a heavy focus on Europe. Directors and officers of the company own 47% of the stock. I find it impressive that the company is performing this well in what seems to be a challenging environment.

JDA Software (JDAS) is another company that recently stumbled, reducing its outlook for 2012 rather substantially when it reported results in early August. This company helps its customers automate their supply chains. Despite the bad news, the stock has rallied, providing an interesting backdrop from a technical perspective. If you are looking into this one, you should be aware that the company was behind on its SEC filings until recently due to an investigation, which is now closed following the restatements earlier this month.

Netgear (NTGR) makes networking, storage and digital media products for consumers and networking, storage and security solutions for businesses. The company noted that it expects Q3 to be challenging for its business customers but strong for its consumer customers, with over 20 new products introduced recently.

Finally, Quaker Chemical (KWR) provides chemicals and services to the steel, aluminum, automotive, mining, and aerospace and other industries. Officers and directors own over 5% of the company. After a couple of decades of unimpressive results, the company has done quite well since late 2005.

Just like knowing a company doesn’t make it an automatic buy, not knowing one doesn’t make it a buy either. Successful companies without a large following among Wall Street analysts or institutional investors could possibly present a better-than-average opportunity for individual investors willing to invest their time in understanding the company. In this case, I have shared an example of six companies that appear to justify such further research. If you are a long-term investor, spending some time learning about companies you don’t know just might lead to some great finds.

Alan Brochstein
Founder, Invest By Model and AB Analytical Services
TradeKing All-Star Commentator

Disclosure:  No positions in any stock mentioned

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