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Most investors value companies on their earnings potential, using metrics like the P/E ratio. This makes sense, as it's the future earnings returned to shareholders through dividends in the long run, that (theoretically) justify the investment. Growth investors seek as much growth as they can get, at the lowest possible P/E, while value investors often hunt for a low PE without as much regard for potential growth. They typically want to get the stock for less than it is worth, while a growth investor typically is willing to pay fair value with the hope that growth continues.
Value investors look beyond just near-term earnings, which often can be depressed for a variety of factors. Some of these situations might include a recent mistake that's depressed earnings, such as getting stuck with too much inventory, or perhaps an event that was out of the firm's control, like rising labor costs.
When earnings aren’t particularly helpful, value investors might look at the value of the company’s underlying assets. After all, sometimes assets can be of more value in the hands of a different owner. Some investors will use the Price to Book Value metric, which compares the market capitalization to equity. For the non-accountants, this means comparing it to the difference between the value of the assets less the liabilities (financial obligations). Keep in mind: this is all based on historical values rather than current values.
A really good value investor might be able to calculate current (rather than historical) values and then determine if the current price is below the value of the net assets. Most of us don’t have the tools to pursue this type of analysis, but a more refined approach to simple Book Value is to use Tangible Book Value, which considers only hard assets, like cash, receivables, inventory and plant and equipment and disregards intangible items like the value of patents or goodwill (the excess paid over book value when another company has been acquired). Because this is a more defensive metric (how low can it go?), it’s more conservative to ignore things that aren’t easily converted to cash.
While Tangible Book Value does suffer from several flaws, it can be helpful to assess a stock's downside potential. Companies can trade below tangible book value, even for long periods of time. Some of the factors that might impact the ratio are near-term losses (rather than earnings), obsolete inventory (which might need to be written off), receivables that can’t be collected (which might need to be written off), an empty factory that can’t be sold at the accounting value, etc.
Finding "Deep Value" Stocks
With the sharp decline in stock prices this summer, there are many stocks trading close to or even below tangible book value. In order to hone in on some potential bargains, I created a screen targeting valuations that are low based on other metrics (P/E), growing companies (not losing money) with strong balance sheets. Here are my constraints:
- Market Cap: > $500mm (because TradeKing wants me to keep it above $500mm)
- Price to Tangible Book Value < 1.15X
- Trailing PE < 15 (and non-negative)
- P/E vs. 5-year Average P/E < 100%
- Profitable Most Recent Quarter
- Sales Growth > 5% past year
- 5-Year ESP Annualized Growth > 0%
- Net Debt to Capital < 5%
- Leverage (Assets/Equity) < 3X
Reminder: this screen is just an illustration for identifying stocks to research further. You should do a thorough investigation of any stock before investing.
I find it interesting that most of these stocks are from the technology sector. The sector stands in stark contrast to 2000, when sector valuations were generally very high. I happen to have owned Tech Data (TECD) in my Top 20 Model Portfolio since December. I have long followed it, along with Ingram Micro (IM), its key competitor. Both companies have high levels of inventory and receivables due to the nature of their distribution businesses, but neither company was too hurt during the 2008-2009 downturn in terms of having to write-down their assets.
I have also followed AVX (AVX) and Vishay (VSH) for more than a decade and find both to be very interesting at the current valuation. AVX is majority-owned by Kyocera. Corning (GLW) is a former high-flyer and is the largest company to make this screen by far.
I don’t follow the other three names as closely, but I will share a common concern investors may have with them: government exposure. Triquint (TQNT) is involved in handsets and communication, but military constitutes a big market for them. AAR (AIR) is involved in various aspects of aircraft maintenance and repair, including military work. Finally, Atlas Air (AAWW) has been aided by the U.S.'s two ongoing wars, as it has provided shipping services for the military. With that said, these concerns look to be possibly more than priced in to the stocks' current valuation.
Hopefully I have shared a tool that you can use to identify stocks worth investigating further. With so many investors focused on just earnings, sometimes it can be valuable to use a different approach. In this case, we have looked for stocks that have good valuation based on Price to Tangible Book Value, but have taken several steps to refine our candidates. Remember, screening is a starting point as part of a more thorough investment process.
Disclosure: Alan Brochstein is long TECD in his model portfolio currently.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Trader Network, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
Alan Brochstein maintains a business relationship with TradeKing.