Let me quickly admit that everything that follows could be wrong - one possibly shouldn't own ANY stocks or any assets. With that said, typically there are some stocks that go up even during the worst of bear markets. The goal of this article is consider how one should go about finding the best stocks to own when almost every stock is cheap by most metrics and certainly down a lot in price. It seems to me that the sellers, seeking liquidity at any cost, are selling what they own en masse and without regard to valuation. Surely there will be some babies in the bathwater.
Should we buy value?
Being cheap isn't too special these days. Using StockVal, I took the universe of all domestic stocks with market capitalization in excess of $50mm and found that 36% (1262 out of 3490) are trading below book value. While this anomaly is certainly more evident in smaller companies, 266 companies in excess of $1 billion market cap (24%) fall into this camp. Now, as most investors know, book value (assets minus liabilities) isn't necessarily an indicator of the liquidation value of a company, but it's a good start. There are several factors that can diminish its value such as:
- Intangibles can't be recognized in liquidation
- Long-term assets are worth less than carrying costs or even replacement cost
- Inventory is worth less than carrying cost
- Accounts Receivable aren't collectable
- The company can have liabilities not reflected on the balance sheet
So, while we can't put a lot of faith in the market being cheap because so many stocks trade below book value, we can certainly take comfort that the current prices do reflect a lot of pessimism. What about other measures? Perhaps the most popular measure of stocks is the PE ratio. By any stretch, PE ratios are extremely low, especially when compared to risk-free assets (i.e. the 5-year Treasury is 2.6%, while most large companies have a PE of 13 or less). Again, we have to be careful. Why? The "P" is known, but the "E" isn't. I had already written about the overly optimistic forecasts for 2009 earnings BEFORE this massacre. In that late-September analysis, I had suggested that EPS for 2009 would be about $80. Unfortunately, the contraction is likely to be worse than I thought, perhaps significantly. We might see EPS as low as $60. It's actually very difficult to project - there will be lots of "one-time" and restructuring charges that could disguise a plunge in "operating" earnings.
Interestingly, in the past four weeks, the 2009 estimate has come down from 104 to 97, but expect it to decline significantly. Even the 2008 estimate is likely still too high at 74. I had wrongly expected some growth in 2009 and believe that my updated expectations most likely account for this "shock". Again, though, stock prices at the end next year will be based upon expectations for 2010. EPS growth should be significantly higher than I had expected (the bigger the fall, the bigger the bounce), but they probably won't be anywhere near the $92 I had been expecting. I would estimate 75-80 at this point. So, using a simple long-term PE metric and assuming a 15 multiple, one gets to 1125 a year or so from now if things get "back to normal".
If one strips away this analysis and looks at the big picture, it is clear that stocks should have declined somewhat due to a deeper-than-expected recession, but probably not as much as they did (will operating EPS be lower than $60?). The trough earnings in 2001 was $39, down about 31% from the peak. The long and deep recession of the early 90s witnessed a 23% contraction. 60 would represent a 35% decline from the peak. In the chart below, you can see that long-term trend in earnings. Three things stand out: For 20 years, the growth in the S&P 500 approximates the EPS growth now (despite a plunge in interest rates), the trailing PE is rock-bottom (hopefully) and the dividend yield relative to the 5-year Treasury (another value measure) is off-the-charts (as are many indicators).
What Should We Buy?
Again, the answer may very well be nothing. Certainly if the deleveraging isn't close to being over, almost every stock will face massive headwinds. If one were to be extremely optimistic here, one would not take the cautious approach that I am about to recommend but rather wade in hand over fist and buy the stocks of companies that have high leverage of their own: Banks, GE, Industrials with lots of debt, etc. Unfortunately, I have a feeling that the forces that be aren't likely to quickly recede and suggest a more cautious approach. While the screen I am about to convey captures only some of the attributes investors should seek, it is a good starting point. Here are some essentials in my opinion:
- Sales aren't easily deferred
- Strong Balance Sheet
- Low Capital Intensity
The first point is this: How essential NOW are the products or services of the company? My screener won't help me on this one, but consider whether the buyers can operate their business without making purchases. One that jumps out and isn't on the screen would be ADP. I believe that there are some companies that could actually see IMPROVEMENT in their business due to the environment (or certainly gain share).
The second point requires a lot of work. A balance sheet can be "strong" by not having a lot of debt, perhaps none, but there is more. How much cash is there? Are the inventories too high? What about the AR? Is their equity mainly "intangible"? If they do have debt, is it due in the next few years?
The final point is that some companies have to spend money just to keep the doors open, even if sales are plunging. The DRAM industry is a great example - lots of CapEx and rarely any profits. With "capital preservation" a key theme for companies as well as investors, one should be very careful about companies that have high CapEx requirements (or that require additional debt or equity infusions).
Ok, so now what? The stocks below may fall into the category of the best stocks to own during global deleveraging, but there are no guarantees that they will rise. The supply of stocks will probably be going down (bankruptcies), but so is the demand (mutual fund redemptions). Still, professional investors will, for the most part, have to own SOME stocks. If the environment remains tough, here are some that I expect will benefit at least relatively:
For the third time, allow me to hedge: This is not a "buy" list, but rather an "investigate" list. I do believe that some of these stocks could hold in well as they seem to be much "safer" than the typical stock yet very oversold. This is what I did:
- Market Cap >$1 billion
- P/B < 1.5
- Tangible P/B < 2.5
- Total Debt/Cap < 25%
- Leverage < 2 (Assets/Equity)
- CapEx/Sales < 5%
- Positive 2009 expected earnings
I wanted to restrict the market cap - there are many others that would make this list and I am happy to share those with anyone interested. Keep in mind that small-caps can really suffer immensely when liquidity is contracting, as it is now. I didn't want to restrict P/TB to give-away levels, though some do make the list. The leverage constraint gets around non-debt liabilities being high. Finally, while some of these companies may indeed show losses if the economy deteriorates even more, I didn't want to start off with losses being expected.
So, the list is fairly broad in terms of the different economic sectors. Not surprisingly, Tech seems to be over-represented. I have followed ZBRA for many years and lost interest due to the lack of growth. Still, consider that they sell a lot of consumables and that their printers can wear out. KLAC and LRCX seem extraordinarily inexpensive with tremendous resources to wait for their customers to buy again, though some of them will need to do so. I wonder about NVDA - it sure is cheap. Their competitive position in the middle markets may be weakening, but they are the technology leader in graphics. AVX is a stub company (Kyocera). One has to think that their long-term position in the industry could be strengthening as KEM and VSH head for possible bankruptcy. With that in mind, be careful with AVT. More than 1/2 its equity is in inventory. It may be price-protected in normal times, but these aren't normal times. They have a lot of exposure to KEM and VSH. AR exceeds 75% of equity.
Looking at the other sectors, it would seem like NBTY could fit the bill, as vitamins are deemed relatively essential to many consumers. I haven't been a fan of KG since doing some extensive work on the company in 2001 and question the ability of management to effectively deploy its massive wad of cash. MGLN, on the other hand, has a lot of qualities that cautious investors should seek, including having an "essential" service for its customers and highly recurring revenue. PSA should do well, though it seems expensive in some regards. Its balance sheet is phenomenal. The retailers are a tough call. I like value-oriented brands and retailers due to what I view as a replacement cycle of sorts. Remember, these companies have catered to pressed consumers for a while now (gas prices). Additionally, there could be some trade-down. I don't have any comments regarding the Materials or Industrials companies, but they could be those babies in the bathwater.
So, this screen has the goal of identifying companies that may offer some protection from further economic deterioration due to a combination of valuation and financial risk. As investors begin to make sense of this massive change in the landscape, I would expect that we will see a move towards companies viewed as defensive. While an industry can be deemed defensive, often the valuation leaves it exposed on the stock price front. These stocks hopefully have the valuations low enough and a superior risk profile relative to the market in general.
Disclosure: Long COLM