Three ways to discover good value stocks
Today it’s harder to find good stocks at good prices, says a U.S. advisory that uses three ratios to find winners like a major Canadian tech stock.
Perhaps people are “selling in May and going away.”
The market has been tumbling and fears of a correction are no doubt cropping up in many minds.
Yet stock markets have been remarkably buoyant for over two years, snapping back from a series of economic setbacks, natural disasters and political crises.
In fact, two years of bullish behaviour have made the investor’s job more difficult in one sense. How do you keep finding stocks with solid profit potential that are cheap at the price?
One Wall Street advisory has an answer. You make careful choices based on specific benchmarks.
Dow Theory Forecasts, which has developed its own, patented stock-picking system over the years, identifies three such benchmarks.
In today’s market, they are price/cash flow ratio, price/sales ratio and enterprise ratio.
The advisory explains why these three ratios do such a good job of predicting performance among stocks. Then it highlights four stocks that score well on these three counts.
One is a Canadian tech stock that has had its share of both good and bad news, yet remains firmly on this advisory’s buy list.
The shorthand version
Earnings are the prime measuring stick for stocks, but quite a few non-cash items can be blended into earnings, says this advisory. And that can give a skewed picture of a company’s operating strength.
So it uses the “shorthand version” of cash flow, which is net income plus expenses like depreciation and amortization.
In 12-month periods over the past 10 years, the cheapest one-fifth of the stocks on the Dow Jones by price/cash flow ratio beat the average stock by an average 7.2 per cent.
Revenue cannot be manipulated as easily as earnings, the advisory notes. That makes the price/sales ratio a “stable and reliable measure of valuation.” Over 10 years, the top scorers in this ratio have outscored the average stock by an impressive 10 per cent.
The third benchmark measures “a company’s total takeover price relative to its underlying earning power.” It is enterprise value (EV) — the combined value of debt and stock market value minus cash — over EBITDA (earnings before interest, taxes, depreciation and amortization).
The leaders in this ratio have turned in the highest winning percentage over the past five, 10 and 15 years, says the advisory.
The stocks the advisory highlights rank among or near the cheapest 20 per cent of all U.S.-traded stocks in at least two of these three ratios.
The first is a controversial choice.
A sharp divide
Research in Motion (TSX-RIM; NASDQ-RMM) now has its Playbook on the market. “The tablet’s new operating system garnered rave reviews,” says the advisory, “though critics panned its software, which some said made the device seem incomplete, as though it had been rushed to market.”
Nevertheless, software updates should help the RIM Playbook “carve out a niche in the corporate world.”
Still, not everyone is impressed. “There’s a sharp divide over RIM’s outlook,” admits the advisory. Some say the Playbook is the top challenger to Apple’s iPad, others pronounced it “dead on arrival.”
Anlaysts’ profit estimates for the next fiscal year are similarly divided, ranging from a decline of 19 per cent to an advance of 20 per cent. Trading at less than eight times consensus estimates, Research in Motion “doesn’t need to manage much growth to justify a higher share price.”
The most revealing benchmark for this stock, adds the advisory, is enterprise value. It is 40 per cent below rivals in the S&P 1500 Index and 73 per cent below the industry average. In short, RIM is “unduly cheap.”
The numbers for this Canadian stock have kept it on this advisory’s list for some time and they keep it there today. Trading at $46.80, it is a Buy and Long-Term Buy (best buy for the next 24 months).
Favorite punching bag
Three U.S. stocks also get high marks for their low ratios — a utility, an oil company and a second high-tech entry.
Exelon (NYSE-EXC) is an electrical utility that has seen its share price take a hit following the nuclear crisis in Japan. Nuclear plants account for over 80 per cent of Exelon’s power. It is also stuck with “unfavorable pricing conditions” and expiring hedges on power prices.
Yet Exelon remains a solid company with a substantial yield — 5 per cent on a $2.10 dividend — and it trades at an attractive discount to its peers in both price/sales and enterprise ratio. The price is $41.33.
Hess (NYSE-HES) is an integrated oil and gas company with worldwide operations. It has 10 years of proven reserves, with a focus on oil that looks good given the state of oil prices.
Its enterprise ratio is a full 45 per cent below the industry average. Its price/cash flow and price/sales ratios also give it a nice discount tag.
Last week, Hess came in with strong first quarter results, exceeding estimates. It is a Buy and Long-Term Buy, trading at $77.33 and yielding 0.5 per cent on its $0.40 dividend.
Hewlett-Packard (NYSE-HPQ) needs no introduction, but it has had to do a lot of work to catch up in the past few years. Indeed, it has been “a favorite punching bad for investors and rival executives.”
The dismissal of CEO Mark Hurd was an unseemly spectacle and pricey acquisitions have also stunted the company’s growth. Its latest guidance was down, and its role in the personal computer market is suspect.
Not surprisingly, the shares look cheap. The enterprise ratio is 40 per cent below the average for computer hardware stocks. Yet with all this, per-share profits are projected to rise 14 per cent in the next fiscal year.
If it hits that target, the shares could hit $50, says the advisory. They’re at $41.00 today, yielding 0.8 per cent on the $0.32 dividend.
If the market continues to slide, many more stocks will look cheap. Some will become great buying opportunities, and some will not.
Use the right benchmarks, says this advisory, and you’ll be able to separate the contenders from the pretenders.
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