Safety in Numbers — ‘Value’ Is More Than Just ‘Cheap’

by Tim Melvin | August 15, 2013 2:29 pm

It’s hard work finding value stocks to buy — but it’s worth it in the end.

Once we have defined a universe of cheap stocks[1], we have to work the list down to those that qualify as safe. Right now there are just over 2,000 stocks that trade below tangible book value traded in the U.S. markets. We certainly cannot afford to buy all of these — nor would we want to, for most of them.

The vast majority of stocks that are cheap are cheap for a solid reason. They are horrible businesses, or overleveraged companies on the way to disappearing forever. There’s not much hope of recovery for the business, and the stock will likely lose you money. I want to find those names that are not just cheap, but safe as well. In order to eventually recover and thrive, a cheap company has to survive.

“Safe” starts with the balance sheet. I hate debt on the balance sheet and would prefer to own debt-free companies. Bottom line, I want the company to have more assets than debt on the books. I want the gross profits to be many times the annual interest payments. I understand that debt and leverage are part of the business model for many companies, but I want to make absolutely sure the company has enough money coming in to pay the bills — and enough assets to sell to pay down debt, if needed, without going into bankruptcy. Adding this qualifier brings us down to about 1,400 total companies.

I want to see a company with lots of liquidity, and the ability to pay the costs of its day-to-day operations. I look first at the current ratio, or the current assets divided by the current liabilities. I want to see a number higher than 2 — again, indicating more than enough assets to pay the bills. Adding these stipulations brings us down to just about 450 stocks.

Now we will check the survivability of the company using the Altman Z score. This ratio uses several factors from the financial statements to measure a company’s ability to survive. A number over 3 indicates a healthy company with no sign of distress. This requirement brings us down to just 160 companies that are not only cheap but safe enough to consider buying.

And that’s my research universe. Right now it is smaller than usual, as the market has moved up in straight line for an extended period of time.

I will look through the list for stocks trading at a discount to net current assets or showing signs of fundamental improvement in the business. I look closely at the ownership list of each company to see if their activists are involved in the stock, or if any smart-money investors have been accumulating the stock. I look to see how much stock the insiders own and whether they have been buying or selling shares. By the time I am done with the qualitative measurements, I will narrow the list down further to 25 to 50 companies in a bull market and 100 or so near the bottom of a bear market.

It’s time-consuming and labor-intensive, but it produces a list of cheap stocks with the potential for spectacular returns. And in value investing, there’s no substitute for hard work.

  1. we have defined a universe of cheap stocks:

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