The cheapest six stocks in May

Still waiting…

Welcome to my little shop of horrors.

Before I introduce the cheapest six stocks this month, here’s the performance of previous £6,000 portfolios created using Dr Keith Anderson’s extreme price earnings ratio, the Naked PE, one year, two years, and three years ago.

As I discussed in the last update, the Naked PE’s predictive power broke down during the credit crisis, and these tables show just how badly an investor would have done had he bought the shares and held them until 1 June this year.

As a group, Naked PE companies have more than deserved their low price tags in recent times, although one or two of our quarterly portfolios have made spectacular returns.

Most disconcerting is the number of companies in the tables that have gone into administration, or delisted at very low prices, something that hadn’t happened in Keith’s tests of the Naked PE as far back as 1975.

Pubs ‘n Bars went into administration in December 2009 when its bank refused additional funding.

Regent Inns delisted, its shares worth about a penny, in June 2008, to cut costs as it tried to reverse a collapse in profits and onerous levels of debt.

Auto component manufacturer Wagon went into administration when it failed to secure funding in December 2008.

Cake maker Inter Link Foods sank under its debt load in July 2007.

Mice, a marketing company, ran out of money in June 2007.

Few people look at these companies, it’s painful for those who lost money in them, and investors are always looking for the next money maker. Often all that remains is the peremptory statements to the stock exchange I’ve linked to.

But it’s worth reflecting on them, because if, like me, you think the very cheapest companies are the most misunderstood, and those that survive can rebound in spectacular fashion, you need to avoid companies like these.

There are two factors common to the demise of these five companies. After their share prices began to collapse, none of them lasted more than about a year. And they were all undone by some combination of falling profit and lack of funding. Funding of course, gives troubled companies time to turn themselves around, and strong profitability means funding ceases to be a concern.

These factors, changes in levels of profitability, debt, equity, and liquidity are captured in the F_Score, a credit scoring system I use to protect the Thrifty 30 portfolio from toxic companies. A score of less than five out of nine is a definite no-no, but I prefer a score or seven or more for a company that is really in the mire.

At the time they featured in our Naked PE portfolios, Pubs ‘n Bars scored three, Regent Inns scored six, Wagon scored two, Inter Link Foods scored seven, and Mice scored six, according to the Sharelockholmes database. Applying the F_Score would have instantly ruled out two of the five, and probably ruled out two more. Only Inter Link looked attractive, statistically. Inter Links’ collapse was particularly sudden, though, and had an investor heeded the other common factor, the precautionary factor, he’d have probably dallied and been spared.

Recently I have added two graduates of our Naked PE portfolios to the Thrifty 30, Johnson Service and, just last week, Autologic. They have F_Scores of eight out of nine, and first appeared in our tables of the cheapest stocks over two years ago. Considering the businesses they are in, I think they will be survivors.

There are no guarantees though, which is why it is with some trepidation I unveil last month’s cheapest six stocks on the market:

Dawson, which supplies media to airlines, books to universities, and marketing services, first appeared in our tables a year ago, and has an F_Score of five according to the Sharelockholmes.com database.

Night club operator Luminar first appeared three months ago. It’s F_Score is five too.

Punch, a pub group, first appeared six months ago, and has an F_Score of six.

Local newspaper publisher Johnston Press first appeared in our tables two years ago, but it’s F_Score is just three.

Northgate, which rents out commercial vehicles, first appeared nine months ago. It’s F_Score is five.

Cosalt, which supplies marine safety products, is a new entry, and has an F_Score of four.

Keith waits until a company’s share price has moved up through its 50 week moving average before buying the shares himself. The only one of this group he owns is Johnston Press, the most familiar, having appeared in the tables for two years. As for the others, he has just two words:

Still waiting

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Blame the bullish analysts

Source materials for value investors: Shai Dardashti shares a compendium of articles from Forbes about Warren Buffett, back to 1969, and some classic articles by Benjamin Graham.

Seth Klarman says value investors prefer bonds:

Bonds are a senior security, offering more safety, and they have a catalyst built into them.

Look at this chart next time you’re tempted to believe analysts’ estimates. They’re too bullish.

Peter Temple presents his Dos and dont’s of stock screening.

Eugene Fama, defends his hypothesis. More regulation isn’t an antidote to free, efficient markets, he says, because governments don’t have the right incentives.

According to Martin Wolf, slashing government spending now is like starving yourself when you’re desperately ill. Paul Krugman agrees.

Watch out for pension liabilities lurking in company balance sheets. Companies are underestimating longevity and inflation.

Saj Karsan, publishes a list of actual risks unlike, say, beta.

Hans Rosling predicts the exact date average incomes in India and China will catch up with Western levels.

The cheapest six stocks in February

Naked PE exposed

When we introduced the Naked PE to readers of this blog in 2007, its historical record promised amazing predictive power. A £1,000 portfolio of the five lowest Naked PE shares formed in 1975 and rebalanced every year (i.e. sold and reinvested in the new five lowest Naked PE shares) would have been worth nearly £7m in 2007, a compound return of 32%. Extremely cheap shares delivered extremely good returns.

As we have documented, though, the Naked PE performed catastrophically during the stockmarket meltdown and Keith’s latest calculations show that, by 2009, our portfolio would have been worth £1,588,000, a quarter of its value two years earlier.

That’s still a 24% compound annual return since 1975, though. To put that in perspective, an investment in the market average would have returned just over £100,000 over the same period and an investment in five most expensive stocks every year, just £10,000.

But the last few years would probably have destroyed the confidence of a Naked PE investor blindly buying the cheapest companies and selling them after a year, a story told in the portfolios we published in February 2007, 2008 and 2009:

• February 2007’s portfolio has lost 37% in three years, and only four of the six companies remain listed. The best performer is Bionostics, which was taken over at a premium and made us 48%. The worst performer was MICE which delisted.
• February 2008’s portfolio has lost 55% in two years. The best performer is International Greetings, which made us 31%. The other five companies lost us money and SCS Upholstery delisted, leaving investors with nothing.
• February 2009’s portfolio has doubled in value, the biggest winner is Johnson Service, which made us 239%, and the only loser is STV, which lost us 27%. Both companies are in this month’s portfolio, as well as second place Johnston Press, which returned 203%.

Back in 2007, the incredible long-term performance of the Naked PE seemed to be the best demonstration yet devised of the value effect, the fact that, perhaps contrary to financial theory, it’s possible to consistently beat the market by buying cheap shares. Now we are not so sure.

To understand why, we need to take a step back and examine what the Naked PE is. In his research (read the papers), Dr Keith Anderson, inventor of the Naked PE, decomposed the eight-year average PE into four factors and re-weighted them according to how much each one influenced future returns. The factors were:

1. Investor confidence: If investors lack confidence (and the average PE of all companies this year is low) then subsequent returns are better.
2. Industry: If the company is in a high growth industry (and the average PE of companies in its sector is high), returns are better.
3. Size: If the company is small (and the average PE of companies of a similar size is low), returns are better.
4. Idiosyncratic factors: Other factors, some of which are specific to the company itself.

This ‘decomposed’ PE is not the Naked PE, although in some of our past updates I have erroneously conflated the two. Having recomposed the PE out of the three factors Keith identified, he is left with a remainder which represents everything else that influences returns. Although a low decomposed PE was a pretty good predictor of returns, Keith found that small portfolios of the very cheapest companies based solely on the fourth factor, the remainder, did even better.

Keith hypothesised that extreme circumstances unique to these companies repulsed investors to such a degree they were the most mispriced companies on the market, and he christened his ‘idiosyncratic PE’ the Naked PE.

That was three years ago, though. Having updated his research through to 2009 he finds that the cheapest 10% of stocks according to the decomposed PE have done almost as well in percentage terms as small portfolios of Naked PE companies (in round numbers, 22% compounded annually instead of 24%).

Over time, that difference of just over 2% still makes a big impact. £1,000 invested in portfolios of decomposed PE shares since 1975 would be worth £761,000, half the value of Naked PE portfolios invested over the same period. But the Naked PE’s extreme returns come at the cost of extreme volatility, which means that without tempering it with other statistics to protect us from failing companies, it’s probably too hot to handle.

We’re debating whether we should continue publishing Naked PE tables, switch to the decomposed PE, or do something else, but in the meantime I’m going to keep publishing the quarterly Naked PE updates. Although its returns over the last three years have undermined its previous record, the Naked PE still lives up to its ‘extreme’ billing.

Night club operator Luminar (LMR) is the only new entry in February’s table:

The other five companies should be very familiar, being stalwarts of previous tables.

Luminar is typical of companies identified by the Naked PE in that it’s currently doing badly. Sales have fallen thanks to increasing youth unemployment and competition from bars and pubs, its founder and chief executive is stepping down, last year the company had to raise money from investors, and it’s "actively managing cash resources" and deferring investment.

Although he invests in some of the companies that appear in his Naked PE portfolios, Keith waits until returning confidence confirms a company’s increasing likelihood of survival. He holds shares in Johnston Press, and Johnson Service and confesses to occasionally forgetting which is the newspaper group and which is the dry cleaner.

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Welcome to Berkshire Hathaway

Stephen Penman, author of this excellent textbook on financial analysis, says EP (earnings:price) and BP (book:price) work better together than separately.

The demographic maths implies equity returns will continue falling until the middle of the decade, says Buttonwood.

Monevator has launched Stock Tickle, a place where he can indulge his speculative fancies without confusing readers of his more sober blog.

The Credit Suisse Global Investment Returns Yearbook, urges caution on emerging markets.

Business should add value, says John Bogle, but by definition financial services companies subtract it.

Valuation is the most important driver in emerging markets, says China-bound Anthony Bolton.

Warren Buffett welcomes at least 65,000 new shareholders to Berkshire Hathaway, and inducts them into his way of thinking in his 2009 letter to shareholders.

My hero, Peter Lynch, says all that’s changed after the ‘lost decade’ is that companies are making more profit and their share prices are cheaper.

Empires are complex systems, says Niall Ferguson, historians analyse the black swans (aka unexpected events) that end them.

The cheapest six stocks in November

Investing at the extremes.

Here are the companies currently at the top of Dr Keith Anderson’s ‘six of the best’ tables of extremely cheap stocks.

All but one have appeared in previous selections. Johnston Press (JPR) now holds the record. It’s been in the top six a total of six times since we started publishing the tables in February 2007. Its first appearance was in May 2008, and its been a regular pretty much ever since. Johnson Service (JSG) has appeared five times, debuting in November 2007.

Findel (FDL) and White Young Green (WYG) appeared in our last table, published in August, and Dawson Holdings (DWN) first appeared in the table before (May). The only new entry is Punch Taverns, (PUB) which hitherto had not been listed for long enough to qualify for a Naked PE.

I’ve commented about some of the companies in this quarter’s table in Money Observer Magazine’s Share Snapshot column, which looks at the month’s highest risers and fallers.

In April, I wrote:

Fourth on our list of risers is Johnson Service, a shrinking conglomerate whose most visible component is Johnson Cleaners, the dry cleaning chain.

The shares rose 109%, after the company published its results for 2008.

Under John Talbot, a turnaround specialist, Johnson has paid off a big chunk of debt, a good sign since it was a debt fuelled acquisition spree that got the company into trouble. Mr Talbot seems confident, having bought shares throughout the year and again after the results.

But Johnson had to sell one of its most profitable businesses and raise money from shareholders, just to stay afloat. A recovery remains to be seen.

In September the company started paying dividends again and now the shares stand 18p above their 5p low in February. That may explain why Keith owns Johnson Service, but doesn’t own any of the more recent additions to the table. Typically these companies are in financial difficulty, and he thinks its best to wait until the share price has moved up through its 50 week moving average before gambling on recovery. Had he bought Johnson Service the first time it had appeared in the table, the shares would have cost him 68p

Table topping White Young Green is, perhaps, in the most trouble. Having breached its bank covenants, the engineering consultancy is swapping debt for equity and planning to give part of the company to employees to stop them leaving. Existing shareholders will end up owning just 15%. Although the shares are extraordinarily cheap, investors are receiving a much smaller claim on the future profits of the company in return, even assuming it makes a full recovery. That explains, at least in part, why the share price is so low in relation to past profits.

The Naked PE is a souped-up version of the traditional PE ratio. Instead of comparing the price to one year of earnings or profits, it uses the average of the previous eight years. It also makes adjustments to favour smaller companies and companies in growth sectors.

In theory, these adjustments should boost the predictive value of the PE ratio, which Keith verified by back testing portfolios of Naked PE shares. But the financial crisis has been troublesome for the Naked PE, as some of our portfolios have shown.

A year on, £6,000 invested in last November’s portfolio would be worth £22,806 including dividends. £6,000 invested in November 2007’s portfolio, though, is worth just £1,625 today. On its first birthday in November 2008 the portfolio was worth less than £1,000.

Running concentrated portfolios of extremely cheap shares has turned out to be risky during a financial crisis. When the market crashed in 2008 and the first months of 2009, companies on low valuations, as measured by traditional PE and price to book ratios, suffered badly. When the market recovered, they rebounded most strongly in a move pundits labelled ‘the dash for trash’.

Investors probably thought problem companies with heavy debts and low valuations might go bust in the depression many predicted, but as the economic news got better, or at least less worse, they bought the shares, anticipating their survival.

For extremely cheap shares, as measured by the Naked PE, the market’s verdict was even more extreme on the way down, and on the way back up.

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New pages

Like the Naked PE, the Thrifty 30 method uses a long-term price earnings ratio, but marries it to measures of financial strength to try and weed-out the shares most unlikely to recover.

This week I’ve published four new permanent pages explaining the Thrifty 30, and the wider purpose of this blog:

1. About this blog
2. About the Thrifty 30
3. Thrifty 30 shortlist
4. State of the Market

I’ll update the charts and tables most weeks on Wednesdays.

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Imagine an investment’s gone bust, then ask why

Jason Zweig gives some advice on avoiding confirmation bias, or the ‘Yes-man’ in your head. Imagine an investment’s gone bust, then ask why.

Finance theory is a crude approximation of reality, say chaos theorists.

Saj Karsan links earnings, profit margins and valuations to explain the link between the value of a company and the business cycle.

Gold is glittering, says Buttonwood, with all the preconditions of a bubble.

Buffett’s ‘lost his mind’, says arch value investor Bruce Greenwald. He’s paid far too much for Burlington Northern.

The cheapest six stocks in August

In practice:

Six of the ‘best’

Here are the six cheapest stocks on the market. As Dr Keith Anderson, the inventor of the econometric method for divining them likes to say, they’re six of the best.

They’re not the best companies, they’re the six most unappreciated shares on the market. People may not like them for good reason, but their prices have fallen far lower than they may deserve. Should these companies survive and prosper, investors will recognise the shares are cheap and buy them, so they are, by Keith’s measure, the companies that are most likely to give investors the best return. The best investments, then.

That measure is the Naked Price Earnings ratio, one number that compares the share price to the eight year profit record of a company and also takes into account its size, and its business sector.

Since study after study demonstrates that smaller companies on low valuations tend to beat the stockmarket averages, you’d expect the Naked PE to do well, and in recent decades it’s done outrageously well, right up until the point I started publishing quarterly updates. But its performance through the credit crunch makes the stockmarket euphemism for ‘volatile’, a roller-coaster ride, seem quaint.

Judging by 2007 and 2008, Naked PE shares are only ‘the best’ if you enjoy having the fillings rattled from your teeth and the sudden rush of blood to your head as you plummet to what seems like certain death. Five companies in our list, Wagon, Regent Inns, Inter Link Foods, MICE, and SCS Upholstery delisted, probably leaving investors with nothing.

But as the table shows, this year some of the Naked PE shares made enormous returns.

In fact, since the first portfolio in February 2007, had an investor bought a £1,000 share every time a company appeared in the list and held them until last Friday, he’d have made a small profit of about £8,000 on his investment of £66,000 drip-fed into eleven quarterly portfolios of six shares. It would have been a harrowing ride though. In December 2008, just eight months ago, he’d have been down £30,000 with only £18,000 of his investment left (if he hadn’t already called it quits).

It’s not a realistic investment strategy, but it’s easy to calculate and it illustrates what happened to extremely cheap stocks during the credit crunch.

Of the new entrants, Touchstone (TSE) and White Young Green (WHY) look like they’re in serious trouble. Touchstone, a software consultancy intends to cancel it’s AIM listing. Keith says:

I’m a fan of letting the computer make the investment decisions, as it can’t be worse than I am, but buying Touchstone with that information available would be taking things too far.

The same goes for White Young Green, an engineering consultancy, which has halved in price since he compiled this quarter’s six cheapest stocks and is currently negotiating with its bankers. Keith says:

Although they have been falling for almost two years, my rule of waiting until the share price goes up through the fifty-week moving average would have protected me.

In extreme markets, like 2007 and 2008, it seems the Naked PE breaks down as a predictor of high returns so, to protect himself from ruin, he tries to pick the survivors by waiting until the price has started to recover, as it may for the other two newcomers Northgate (NTG) and Findel (FDL). Northgate is a light commercial vehicle hire company and Findel  owns home shopping network Kleeneze among other businesses.

Northgate is in the 99% club, says Keith, meaning its share price has fallen from over £11 to just 11p since 2007. Both Findel and Northgate have recently raised money from shareholders, which can be a bad omen for share prices, but Keith sees a pattern:

The shares we come across here often seem to have rights issues, then stage a recovery shortly thereafter. Taylor Wimpey and DSG spring to mind.

He says.

Dawson Holdings (DWN), the newspaper distributor, has been in our list for two consecutive quarters, and Johnston Press (JPR), the newspaper group, has appeared five times, the first in May 2008.

It too has staged a recovery following a rights issue and its share price has risen from a low of 5p to nearly 35p. It moved up through its fifty-week moving average in April, indicating it might be a survivor.

In theory:

The world’s biggest value investor

By pouring money into the financial system when private investors would not, the US Government was doing what a good value investor would. It will be no surprise if it makes money out of it, but don’t forget the real costs of the credit crunch, measured in lost-taxes and stimulus measures says Justin Fox.

The cheapest six stocks on the market

In practice:

160% in six months ain’t bad

For the first time since February 2007, I’m starting our quarterly exercise in bottom fishing, ‘the cheapest six stocks on the market’, with good, even spectacular, news.

Each quarter Dr Keith Anderson, of the University of York, calculates the cheapest six stocks on the market using the Naked PE ratio he invented, (this month’s list is at the end of this post).

Last February’s portfolio is up! So is the previous November’s.  In fact they’re not just up, most of the companies have doubled, or tripled in value. At least.

If you’d plunged £6,000 into the six cheapest stocks in November, which is not to be recommended for reasons that will become apparent, you’d have nearly £16,000 now.

Taylor Wimpey has more than quadrupled from a purchase price of 7p in November to around 33p and the worst performer in the November portfolio, Johnson Service, is up nearly 50%.

There’s only one loser in February’s portfolio, STV, down 23% a small loss when you consider Johnson Service and Johnston Press have nearly tripled in price.

These were the media companies and house builders with cyclical businesses and big debts hit hardest by the credit crisis and recession. Investors questioned their survival but now, judging by the improvement in the market this spring, they think the recession will be more benign than the depression we feared then.

Since the once dire prospects of these companies have improved most, they’ve rallied furthest.

But, despite the successes of the last six months, the bear market of 2007 and 2008 has been catastrophic for the Naked PE, which up until then had an extraordinary record predicting higher share prices. Of the 21 companies that appear in Keith’s portfolios, four have delisted, or are in the process of delisting, leaving investors with nothing.

If an investor had invested £1,000 in each Naked PE share, each time Keith included it in a portfolio, the table above shows how she’d have done, assuming no sales and £15 in charges and tax for each trade.

It’s a hypothetical exercise, Keith doesn’t use the Naked PE this way, and doesn’t recommend we do either, but the table does, I think, illustrate events so far.

As well as the four failures, four other companies have made losses of 70 to 85% on the average price our hypothetical investor would have paid. Many would regard those as failures too. Certainly they’re unlikely to recover those losses completely for a long time.

Seven of the 21 companies are in profit.

The recent bear market has exposed a flaw in the Naked PE. When share prices are pushed to extremes, it’s too quick to indicate a company is cheap. The old adage, that a share can always get cheaper, holds true. A company can also go bust. Keith says:

The naked PE tells you when a share is cheap, not necessarily when to buy it… [That’s] why I always use the log charts option on Interactive Investor. It gives a much better idea that even if a share has lost 90% already, it can still lose a lot more.

To protect the picks in his own portfolio from that fate Keith monitors the old lists, looking for evidence the company is surviving (if it’s still listed after two years, it’s a good sign) and the price is recovering (it’s moved up through its 50 week moving average). He caught Taylor Wimpey, DSG and Journey earlier in the year but missed out on Barratt at 110p. He says:

I should have bought when they went up through the MA [moving average) at about 110p… That’s what comes of not trawling through the charts in my watch list regularly enough.

I’m toying with a different approach. Joseph Piotroski demonstrated that of all distressed companies, those with the strongest finances are most likely to turn around. I think we could improve returns by marrying strong companies with a high F_Score, his measure of financial strength, to low Naked PE’s. Piotroski concluded that companies are likely to be stronger coming out of a slump, than going into one, so the F_Score could be an aid in timing when to buy one of the cheapest stocks on the market.

The F_Scores in the table are from Sharelockholmes.com, and indicate that STV, Vodafone and Johnston Press merit attention.

Here’s this month’s table (as of 10 May). As usual, Keith is most sceptical about the new entries. Dawson, which distributes newspapers, has lost two contracts recently and Pubs ‘N’ Bars is tiny. The market values the whole company at under £2m.

In the case of the Naked PE, it’s the old lists that are most interesting.

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The bid’s off at Carluccio’s (CARL), an expanding restaurant chain with solid looking finances. On a six-year PE of 18, I think it’s still a bit pricey for safety-first investors, though.

In theory:

Growth v Value, it really isn’t a fair fight.

Over the past forty years, firms with low asset growth have returned 20% more than firms with high asset growth reports Empirical Finance Research Blog. A new Paper by Michael Cooper, Huseying Gulen and Michael Schill of various American universities concludes that low-growth companies aren’t as risky as investors think (and, presumably, rapidly growing companies are riskier).

Meanwhile, there’s some good news about short-sellers for a change. Even those who don’t short can profit, just by investing in shares the shorters are avoiding. CXO Advisory‘s blog reports on a study by Ekkehart Boehmer, Zsuzsa Huszar and Bradford Jordan, also of various American business schools.

Star Trek script writer, and lecturer in randomness, Leonard Mlodinow  says it’s possible to decrease the odds of bad outcomes, but that doesn’t mean they won’t occur. He’s talking about cancer, but he could be talking about investing.

Pension Insurance Corporation may have the money to buy out company pension funds, but judging by its pursuit of rival, Paternoster, many others are running short of capital.

James Kwak of The Baseline Scenario, says that when an industry innovates, a few innovators profit and lots of customers benefit through competition. By contrast the financial industry innovated but refused to compete on costs and price.

How Google ended up in the auction business (Wired).