Epiphany Investing

Searching Out the Optimal Portfolio of “Revelation” Stocks

Inside the Numbers for November; Big Buyers Only Tiptoeing

Posted on | November 30, 2008 Time: 1:49 am |

I wanted to close out November with a review of the performance trends in what I’ve categorized as fundamentally cheap stocks, using the S&P 500 as my universe. The original idea was to be on the lookout for the re-emergence of sideline capital, the large institutional buyers that are looking to buy long and reallocate their cash-heavy AUM. Until these buyers come back into the market, we’re simply not going higher than the upper bounds of the past eight weeks.

The filtering (details below) did a good job of not excluding a broad class of stocks, which can often be a nasty side effect of stock screens. Punch in a seemingly innocuous filter for operating margins and - poof! - there goes Wal-Mart (WMT) from your results list. My filtered group reflects all sectors, and currently the group has just 47 members out of the S&P 500, down from 66 last month.

So What is Cheap? Depends on the Market….

Now I know that my definition of “fundamentally cheap” is largely subjective. We each have our own metrics, our own statistics that best crystallize our investment thesis. My collection of metrics is tweaked to reflect the unique nature of our current financial crisis, mainly that it is credit driven.

I don’t want to be anywhere near balance sheet risk; in a long-term recession this will lead to a gradual erosion into bankruptcy for many companies that seem healthy enough right now. So my filters for above-water current ratios (over 1.0) and debt/equity below 50% help to weed out stocks that might be operating a bit too close to the sideline. You can bet that the largest chunks of sideline cash - the ones that are fundamentally-focused, long buyers of equities - will be looking for companies that score well in these metrics, if only in the name of fiduciary responsibility in a dangerous economic climate.

My filter for free cash flow (Price/FCF under 20x) seems prudent as well, and does a decent job of acting as proxy for solid net margins. As with balance sheet risks, I don’t want to be anywhere near investing in a company that can’t preserve decent returns on capital.

The final filter is the now mysterious P/E ratio. For most times in our life, this metric is like the hammer or the screwdriver in the fundamental investor’s toolbox. These days, the P/E is more like that leftover screw in an IKEA assembly set; you know it was supposed to get used, but damned if you can figure out where it goes.

But over the course of the next month, we should begin to see 1st half 2009 earnings estimates for individual companies get into their “proper ranges”. The sell-side community, plodding as always, will eventually get around to it. So while the usefulness of the P/E may be at all-time lows, it’s value should rise dramatically throughout December. I tossed in a filter for forward P/E ratios under 10 times, just to ensure that I am getting companies at market multiples or lower (see DJIA Performance Studies for metrics on the Dow Jones).

Re-Cap of Earlier Iterations

In the first iteration {Inside the Numbers: Why We Haven’t Bottomed Yet} on October 23, the “value” group had drastically underperformed the S&P in the past month. I concluded that the 1500 basis point difference was too much to ignore, and forecast new lows.

In my second iteration, done on November 18, the “spreads” if you will, between the S&P 500 as a whole and my filtered group tightened about halfway. A promising sign, but the value group still lagged the broad market considerably. Two days later we hit a new low of 752 on the S&P.

Today’s Numbers

For the month of November as a whole, more of the same - underperformance from the value group. Just so we all agree on where sea level is, note that the performance of the S&P 500 for November was -3.64%.

34% of the S&P was down 10% or more in November, versus 40% of the filtered group;

61% of the S&P was down any amount, versus 74% of the filtered group.

But on a positive note, we saw parity in both groups over the past week, which means we’ve seen some increased interest from those key pockets of sideline capital. A full 90% of the filtered group rose over 10% last week, versus 86% of the S&P. It’s just tiptoeing in terms of nominal dollars (given the light volumes over the past week), but the velocity has picked up. This is a very encouraging sign.

Parting Thoughts

The next week will be a fascinating battleground. Anecdotal tales of Black Friday may mention postive sales results, but my spot checks of ASPs reveals absolutely massive discounts. Margins are getting crushed out there. But this should not surprise the markets; we made it through last week even though several economic indicators revealed record-setting weakness.

We should see rate cuts by the week’s end from the ECB, the Bank of England, and Australia. Past that, the only positive catalyst out there is government stimulus news and capital inflows from previous cash positions. The fundamentals are there for the taking, and for the selective eye there is a Christmas wish list of value.

Ryan Barnes

More on this topic (What's this?)
ROSENBERG: THE MARKET LOOKS TOPPY (THE PRAGMATIC CAPITALIST, 3/3/10)
The Dividend Stock Recovery: Get Ready for a High-Yield Bonanza (Investment U, 2/22/10)
A Comprehensive Look At Investor Sentiment (The Technical Take, 3/4/10)
Read more on S&P 500 (SPX) at Wikinvest
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