The six cheapest stocks in August
Posted on September 3, 2008 by Richard Beddard
Filed Under Companies, Investing, Naked PE |
Apologies for bringing you August’s list in September. As predicted, holiday and the scramble to meet deadlines either side of it kept me away from the blog.
Here are the cheapest six shares according to Dr Keith Anderson’s Naked PE ratio. As I have explained, his studies show it’s better at picking out undervalued companies than the POPE (Plain Old Price Earnings Ratio).
Since Keith sent me the list, Barratt’s price has recovered a bit but the list still shows six companies with prices at jaw-droppingly low levels relative to their long-term earning power, especially when you consider their size and the sectors they operate in.
That’s because they are in trouble. To show you how much trouble, I’ll focus on International Greetings (IGR). As a gift-wrap and greetings card business it stands out from the usual suspects; knocked down property and media companies.
Reading through the latest results, published in August for the year ending March 31, it’s easy to pick out harbingers of a bombed out share price; aggressive expansion, diversification away from giftwrap into book publishing and photo frames, and operational problems at its factories.
It may be a case of what Peter Lynch called ‘diworseification’, where a company puts size above profitability and loses focus. Diworseifications are interesting when they restructure, selling off unprofitable businesses and cutting costs to focus on profitability once more.
The good news (for investors) is that International Greetings is restructuring. It’s closed a factory in Latvia and is making people redundant in South Wales. It’s moving production to China, and outsourcing more of its manufacturing.
The bad news is its overdraft. In March, the company had borrowed £65m of its £90m limit. Its bankers renewed the overdraft last month until August 2009 and will, apparently, renew it again if the company meets expectations.
Although the company lost £12m last year, chief executive Nick Fisher expects profitability this year. Otherwise, it looks as though the bank has founder Anders Hedlund’s family, which owns more than 50% of the company, and the rest of the shareholders by the cojones.
So why waste time on these companies? Where the outlook is, to say the least, highly uncertain.
Keith’s research shows that most of them recover and make abnormally large profits for shareholders.
The explanation for this anomaly may lie in a human behaviour. When a company is in as much difficulty as International Greetings, investors just switch off. It’s difficult to enthuse about a company which is, temporarily at least, so unsuccessful, and there’s plenty of reason to believe it could go bust.
Investor’s negativity translates into sales and a depressed share price.
When I started writing about the Naked PE, I quoted an average annual return of 39% for a portfolio of the six cheapest stocks on the market rebalanced every year between 1975 and 2004. Keith recently updated his figures and added some new companies to the database he uses to test his theories.
The revised return figure is 28%; lower, but still remarkable. The last four years has been particularly bad for bottom fishers, though. A portfolio started in 2004 would have lost money so far and some of the selections have gone bust.
As a trader, Keith tries to avoid that outcome by waiting two years from the mid point of the company’s share price collapse. If the company is still around then, he says the chances are it will survive.
I’m experimenting with a measure that promises to distinguish between companies getting into trouble and those emerging from it. Piotroski’s F_Score is also drawn from the shelves of academia. It combines nine measures of a company’s fundamental health – its profitability, its working capital and its debt – into one number that identifies companies with the financial strength to turn themselves around.
Sadly, International Greetings’ F_Score is low. That doesn’t mean the company is doomed, but it does add to the growing list of reasons to wait until it’s clearer the company will recover.
Footnotes:
- Not infallibly, of course, that would be too good to be true. More on the F_Score in a future blog. Meanwhile here’s a link to Piotroski’s paper (PDF).
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4 Responses to “The six cheapest stocks in August”
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Hi Richard,
It’s been a long time since I posted any replies.
Reading about the current failure of the naked PE ratio I wonder if there are any systems which could work reliably in the this market.
I am currently not using my own momentum system as it simply does not work right now.
However I am sure that in the right markets, it will work like a charm, so for now I wait.
I am sure the naked PE ratio will also work in the right markets but I think it would help if Keith Anderson also developed a measure of reliability.
e.g. This is the recommendations of the naked PE ratio and the reliably factor is 63% or something like that!
Perhaps the F_Score is what is needed.
Hi Robin, Great to hear from you. I’ve spoken to a number of people who created systems (Greenblatt’s magic formula. John Mulligan’s Star system - which I’ve mentioned on this blog). They all suffer periods of underperformance. John once admitted that during such a period he once felt like throwing in the towel although that would have been, in hindsight, a very bad idea.
The Naked PE isn’t a system per se, in that Keith doesn’t recommend people liquidate their current portfolio and buy the six cheapest stocks every year (although that’s what he simulated in backtesting the theory).
He thinks he could improve the results by using price momentum. Intuitively I’m not keen on momentum so the F_Score is an alternative which kind of measures ‘business momentum’. I haven’t tested low long-term PE’s with high F_Scores, but Piotroski tested companies on low price to book ratios and found those with the highest F_Scores did best.
Looking at companies with low Naked PE’s (see Wagon, and International Greetings posted recently) there are ‘issues’ that could demolish the investment case even if business is improving. Wagon’s 86% owned by a US vulture investor who probably has his own agenda. International Greetings is dependent on a huge overdraft and therefore at the bank’s mercy.
So, using the Naked PE as a way of spotting recovery shares rather than as an automated trading system involves a rather exhaustive strategy of finding very cheap stocks, checking whether the business is actually recovering and then seeing if there are any other things that could scupper the stock.
If a company doesn’t meet all three criteria then it’s perhaps best to wait until it does. The theory is that the market is slowest to recognise good news from the most beaten up stocks so there’d be time to buy into the recovery. Intuitively that makes sense. Everybody’s turned off these stocks. Look at how few comments I get when I write about them!
Apologies for the lengthy stream of consciousness, but I’m glad you’re still reading and responding
I probably need to write a proper post outlining where I’m going with all this.
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