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.

NakedPEAug09

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.

11 Comments

Monevator September 3, 2009 at 7:50 am

Can’t help agreeing that list is best approach as a source of ideas rather than a source of a mechanical fodder strategy. What did the old time programmers say? Garbage In, Garbage Out?

I do appreciate holding your nose and closing your eyes is the point of a mechanical approach.

What I shudder to think about is that Touchstone and White Young and Green both came onto my radar at various points in the past couple of years. I even held Touchstone for a small, and thankfully profitable time.

Think Johnston Press just completed a big fund raising, either with its bankers or via rights issue, don’t recall which. Either way likely very dilutative, so those figures *may* be out of date (haven’t checked!)

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Chris September 3, 2009 at 6:58 pm

Please note Dawson Holdings is no longer “the newspaper distributor” (see NEWS for DWN):

“Following the administration and disposal of Surridge Dawson (that is, Dawson*s News business) which was announced on the 3 August 2009, the Group now comprises three businesses, namely Dawson Media Direct Limited, supplying newspapers and magazines to airlines, Dawson Books Limited, supplying books and eBooks to academic institutions and Dawson Marketing Services Limited, a fulfilment business.”

The news business has all gone to two rival companies: Menzies (MNZS) and Smiths News (NWS)

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Richard Beddard September 4, 2009 at 7:01 am

Hi Monevator, thanks for popping by. I don’t think it’s garbage, in. There’s logic to the Naked PE in that by using long-term averages it identifies companies with superior (past) earnings records at very low prices. I think its failure over the last two years reveals that you can’t rely on it alone. In that period five of the companies it identified went bust. In the previous two decades, none did. It looks to me like a quality filter, like Piotroski’s F_Score, might reduce the risk of ruin.

I know that feeling! Watching a company you’ve shown interest in subsequently blowing up. And buying such a company and watching it blow up…

JPR’s rights issue was June 2008, it recently refinanced its debt (see the interim announcement: http://www.iii.co.uk/investment/detail/?display=news&code=cotn:JPR.L&action=article&articleid=7497808 ) but it’s not dilutive.

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Richard Beddard September 4, 2009 at 7:07 am

Hi Chris, thanks for clarifying that. Lazy of me to continue referring to it as a newspaper distribution business when it’s now something rather more difficult to describe.

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Peter Rogers September 4, 2009 at 8:13 am

“By pouring money into the financial system when private investors would not, the US Government was doing what a good value investor would”

Really?
I don’t think so, the rescued banks were insolvent, and they will probebly become insolvent again once the rescue cash has run out, do value investors buy companies when the bablnce sheet shows that they are hopeless basket cases, no, debt is the biggest risk when buying a lowly valued company, the banks were and still are hoplessly overlevereged and a continued rise in bad debts will keep sending them back to there repective governments for many years to come.

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Wormz September 4, 2009 at 8:43 am

Re Monevator’s point on dilution – the same may apply for Northgate and Findel. I’ve held both shares recently – still holding Northgate but have sold Findel because it isn’t that cheap with the dilution. Are EPS definitely readjusted for additional shares in issue? I always stick to MCap/Average earnings.

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Richard Beddard September 4, 2009 at 9:08 am

Hi Wormz, thanks for your comment. The earnings per share calculation uses weighted average shares in issue as its denominator for the year in question so next year’s eps figure will reflect the rights issues and placings undertaken by these companies.

Past eps calculations, as used in the Naked PE use the number of shares in issue for the years concerned.

So I’m not sure what Monevator means by ‘out of date’. EPS figures in earlier years aren’t going to change because of a subsequent rights issue so they’re not wrong or out of date. On the other hand you could argue that they’re less relevant as a guide to the future now the profits have to shared among more investors. Mind you, you could argue that past profits are less relevant for any number of reasons not least the local news business is vastly more competitive in the age of the Internet!

Still, Keith’s research showed that the Naked PE had much greater predictive power than the Plain Old PE (POPE).

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Richard Beddard September 4, 2009 at 9:17 am

Hi Peter, thanks for your comment. I agree with you.

If you read Justin Fox’s post though, which I was linking to, you can see his argument, which is that Governments knew they would do whatever they had to, to keep the banks solvent so perhaps they could invest with confidence.

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Wormz September 4, 2009 at 9:35 am

Thanks for your reply Richard. I see your point. I guess I personally would agree that the historical EPS values are less relevant after a rights issue. But as you say, the naked PE works – and you can’t argue with that.

One more point about rights issues based on a chapter from James Montier’s Behavioural Investing book (I got on to him through you – so thanks). He says that the performance of value companies that carry out share buy backs is significantly better than value companies who issue shares over the long term. There’s definitely been a bounce with decent companies following a rights issue recently (Mecom is a cautionary tale) but it will be interesting to look at the longer term.

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Richard Beddard September 4, 2009 at 9:51 am

My pleasure Wormz I’m glad to have been some use to you in recommending BI, which is an excellent book.

I mentioned in the article that rights issues can be a bad omen for shareholders and it was Montier’s work I was thinking of at the time.

As for the Naked PE working, it seems to work under most market conditions but like a lot of quantitative approaches it breaks down when things get really extreme. I think it’s interesting that Keith doesn’t use it mechanically even though (like me, he prefers to let the numbers guide him).

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Step forward… The real Thrifty 30 : Interactive Investor Blog January 16, 2010 at 11:31 am

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