Halloween, and Some Scary October Values
(Guest Commentary by Bill Rempel – October 4, 2007)
Dear Subscribers and Readers,
Before we go on to Bill Rempel's guest commentary, I would like to point out to our subscribers the most recent strength in the Hong Kong stock market – along with the huge “one-day reversal” in the Hang Seng Index during the Wednesday trading session. Let us first take a look at the daily chart of the Hang Seng Index going back to early May:
As discussed on the above chart and in our prior commentaries, the Hong Kong stock market was the strongest major market during the third quarter. In fact, the Hong Kong market experienced its best performance in nearly a decade. From the trough in mid-August to the most recent peak on Wednesday's trading session (just over six weeks), the Hang Seng Index rallied nearly 50% (49% to be exact) – which is an impressive feat any way you look at it.
More importantly, the bottom in mid August was accompanied by a one-day reversal of approximately 1,200 points. Based on various studies on individual stocks and major market indices, one-day reversals can be a very powerful signal “change in trend” signal as long as the following conditions are met:
- The signal must be accompanied by a significant increase in volume. There is no hard measure for this, but this author would like to see at least a 50% increase in volume over the 21-day moving average – something which we got on the Hong Kong Stock Exchange on Wednesday's trading session.
- The market or stock must have already been overbought if one is looking for a topping signal, or oversold if looking for a bottoming signal. Based on the fact that the Hang Seng had rallied 50% from trough to peak in just a little over six weeks, there is no question that this condition has been satisfied in the Hong Kong stock market.
- The reversal must be accompanied by divergences in stocks in the same sector (if one is evaluating individual stocks) or stock markets around the world if one is evaluating a major stock market index. Given that the U.S. market has remained relatively weak, and given that no major European has been making new all-time highs recently, this condition has also been met for the Hang Seng Index.
While one-day reversals are generally more reliable as “bottoming indicators” as opposed to “topping indicators,” the probability is now high that the peak in Wednesday's trading session for the Hang Seng Index represented a significant top – at least for the rest of 2007. Given that most of the strength in the equity markets has been centered in Asia (excluding Japan), and especially Hong Kong and China in recent months, this one-day reversal in the Hang Seng Index is now definitely cause for concern – not only for Asian stock market investors but for U.S. stock market investors as well. Subscribers please stay tuned.
Let us now discuss Bill Rempel's guest commentary!
For those who had wanted to learn more about individual stocks, the art of stock selection, and model-based trading/investing, it is again time to see what one of our regular guest commentators, Bill Rempel, has to say. Bill is a prolific writing on the stock market and individual stocks and is the author of a very active market blog at: http://www.billakanodoodahs.com/
In this commentary, Bill is discuss his classic value screen – with specific details on two names on this screen, Adams Resources and Energy and Getty Images. Without further ado, following is biography of Bill:
Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill is a regular, monthly guest commentator on our website (see “One Possible Model of VIX Stock Market Timing” for his last guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.
Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."
Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice. Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.
Let's face it, value investing can be scary. What is usually called "value investing" is actually a mean-reverting sentiment trade, or a buy at a time when sentiment is profoundly against the idea of buying! We try to protect ourselves through various techniques, like screening the companies for tangible or intangible characteristics that provide a "margin of safety," and hope that it's enough to compensate for buying stocks that we have to hold our noses to click on.
My tried and true value screener has three sentiment measures in it. First, the price performance over the last 52 weeks must be less than or equal to zero. Considering that the broad indices are showing total returns in the teens, these stocks have been real stinkers. I also look at the Price/Earnings and the Price/Book ratios. I set the TTM P/E at 12 or lower to capture stocks whose popular sentiment is out of line with their earnings, at least, relative to the overall market. If one thinks of a P/E ratio as a discount to future growth, then a discount rate of 11.5% (one estimate of long-term stock returns) implies that a stock with P/E of 12 or lower is discounting a future growth rate of only 3%. A stock with very low P/E could be said to have sentiment against it. I set the P/B at 2.0 or less, and that screens out a large portion of U.S. equities, as well as capturing a well-known anomaly.
The next portion of the screener is attempting to measure the strength of the company, or more properly, the strength that management has shown. To approximate a "good company," I demand that 5-year compounded book value growth should be 5% or higher annually, and I demand a Return on Assets (ROA) of 5% or more in the trailing twelve month period. I also look for a Debt to Capital ratio of 67% or less. Keep in mind that all of these are proxies for a "good company" or "good management," and there might be other combinations of ratios that work as well.
I also am screening for net insider buying of zero shares or higher. Now, in my screening software, that implies only stocks with insider ownership will appear; your software may be different. I want to know that the company's management (a) has skin in the game and (b) believes in the stock enough to buy it, or at least, not be selling it.
There are two logistical items in the screener, namely the removal of OTC stocks and a $100 million market cap minimum. I've written about (and bought) smaller stocks before, but I'm moving forward with a minimum cap size in order to forward-test the strategy with some scale.
I do one final check, and unfortunately my screener doesn't do this for me: I look at the cash flow statement and eliminate stocks that don't have a pattern of operating cash exceeding income, and negative cash flow from financing operations. The accrual anomaly is a predictor of future earnings shortfalls, but less technically speaking, I want to find companies that generate their earnings from engaging in the business of the company, and not selling shares or debt.
As of today, there is a veritable bonanza of stocks on this screener! I have eleven candidates, nine of which appeared last month. These are in some of the most hated, indeed, the scariest, of industries in the current market environment. Here are the nine current stocks that qualified last month:
Charlotte Russe (CHIC)
CNA Surety Group (SUR)
Gehl Company (GEHL)
Investors Title Co. (ITIC)
Nautilus Group (NLS)
One Liberty Properties (OLP)
PMI Group (PMI)
Triad Guaranty (TGIC)
There are two new qualifiers:
Adams Resources & Energy (AE)
Getty Images (GYI)
I'm assuming any regular readers have assessed their opinions of the previous nine qualifiers, so I will concentrate on the two new ones.
Adams Resources & Energy (AE) just squeaked by the market cap limitation, at $118 million.
Their value "brag sheet" is long, indeed. P/E is under 8, and the P/B is very low at 1.35. Their enterprise value is only $95 million, and the company has no long-term debt. Income for the current quarter exceeds operating cash, but in four of the last five years, and in the combined five years, income is a fraction of cash from operations, which implies (but doesn't prove) high-quality earnings. Cash from financing is negative in just about every timeframe, usually because of a smallish dividend, but occasionally because of paying off debt. Current ratio is 1.22. Lastly, about ¼ of this company's book value is cash on the balance sheet. One could consider this an acquisition target based on cheapness, except for the ownership profile. The management would have to go along with it!
This is a small-float company, and insiders own about half of the stock, with institutions owning about 32% of the remainder. Generally speaking, I like a company to have skin in the game, but 50% is a bit much, and could potentially imply control of the company to the detriment of minor shareholders. The company has no short ratio to speak of, and considering how light the float is and how tight the ownership is, I bet it would be a hard borrow. On a net basis, my screener says the insiders are holding pat.
They have only one year in the last ten where they've lost money. While the book value growth hasn't been the smoothest in the world, going from $6.67 per share to over $20 in nine years is decent growth for company equity, and the growth rate has been 13.7% over the last five years.
So what do they do?
AE does marketing and transportation of crude, natural gas, and petroleum products, and they also engage in some exploration/development in the Gulf of Mexico. Most of their operations are in Texas, with some operations in Michigan and they will transport for hire anywhere in the lower 48 and Canada.
Adams doesn't have an analyst following, and they are small with little debt, so I doubt that the current poor sentiment towards the stock is the result of missed expectations or eating something that disagreed with them (acquisition problems). It seems likely to me that the poor sentiment is based on macro opinions, and the essence of "value investing" is, in my opinion, finding good companies to bet on, against the "macro consensus."
I have not read their proxy or any other filings; were I in full "value investor" mode, this would be the next logical step, and one that's very worthwhile in assessing risk. At the current time, I'm forward-testing a year-term buy/hold on all the value stocks that have passed my screener in the last year, and AE is an addition to that test, but I do not have a "real" position in this stock and don't have immediate plans to add one.
Getty Images (GYI) is a much larger company at $1.6 billion in market cap. They also squeaked by the screener with a TTM P/E of 11.9. P/B is refreshingly low, however, at 1.21, and the price to sales is under 2. There is analyst coverage, with a projected PEG of 1.15, strong compared to the S&P 500 value. The debt to equity is smallish at around 0.3, and cash per share is about 1/6 of the book value.
GYI has been very aggressive at growing the book value over the last ten years, and over the last five, but doesn't have the long history of positive earnings that AE has. Getty lost money through 2001, but has maintained a profit since.
I'm also not as fond of the cash flow statement for GYI. Over the cumulative five year period, cash from financing is negative, but it's only negative in the last fiscal year, and in a big way, with a huge retirement of stock in fiscal 2006. I do like the consistent pattern of operating cash exceeding income, and the company has been plowing money into investment in the last five years. Unfortunately, their investment returns haven't beat the band, but I do still like their fairly consistent high ROA.
There's at least one insider stepping up to buy in the $30s, which is encouraging, considering that the stock had been in the 80s just two years ago. Oddly, these are two years in which the diluted EPS has been growing, although not by leaps and bounds.
Getty is another company with a tight ownership profile, 18% insiders and 73% institutions. The short ratio is only 2 days to cover, and there is no dividend. The float is mid-sized at 50 million or so shares.
This stock "became a value" by my screener's metrics when it fell well under $30 per share in late September, sometime after the last time I ran the screen. That movement was either continuation or capitulation following the break under $40 that came along with a $0.02 miss on analysts' projected EPS for 2Q07. Earnings estimates for the next year have also moved down in recent months.
A further argument for "lowered expectations" creating a "value stock" can be found through addressing what Getty does for a living. They provide images! No, they're not providing that kind of images, otherwise, I'd be expecting growth. No, they provide stills, stock footage, editorial images, and illustrations. This might include product shots, content for annual reports, documenting some sports or news events that can't attract network coverage, etc. They also provide "image management" for companies to handle their portfolio of promotional images. It seems to me that the decline in the stock can be traced to macro bets against such a company, i.e., what is the first expense that other companies might cut in a recession? Could the answer be, "Getty?"
Again, I haven't read the filings, although that would be the next "value investor" step. I will be tracking GYI as part of my evaluation of the value criteria, but I don't have a "real" position in this stock and don't have immediate plans to add one.