A Quick and Easy Screen to Find Good, Cheap Companies

Finding value stocks can often be difficult. Other times, there just isn't anything cheap enough to satisfy the strict requirements of fundamentalists. Value investor extraordinaire Seth Klarman has, at times, kept upward of 50% of his Baupost Fund in cash simply because he couldn't find any stocks worth buying. With the exception of a 2009-esque fire-sale market, stumbling across superior value picks is a process of sifting through (and throwing away) hundreds of companies, keeping an ear to the ground for quiet hints, and just plain old luck. For those of you who have a life outside of the SEC's EDGAR database, here is a quick and easy screen that can help identify potential value targets.

Disclaimer
Before you start running and screening, remember that a company can show up in these screens for a variety of reasons; it's never an automatic winner just because it matches a few numbers. These screens are a tool not so much to find great companies, but to cast out a good portion of the thousands of public companies that aren't anywhere close to what you're looking for. With that in mind, let's get to it.

Ebit-duh
We most often flock to the classic price-to-earnings ratio to do our fly-by-night value analysis. It can be useful, especially when used as one of many valuation models -- think P/E correction as a catalyst. But the P/E ratio fails in two areas:

  1. "Earnings." This is the after-all-is-said-and-done bottom-line number that is subject to all kinds of accounting methods. If you were a private buyer buying a private business, you'd likely want to see the raw sales numbers to get a good idea of the cash flow coming through the door. Using EBITDA (earnings before interest, tax, depreciation, and amortization) as your earnings basis effectively gets around this issue.
  2. Debt. Again, if this transaction were to take place on the private market, you'd likely be paying a lot of attention to the debt you are buying, along with the equity of the target company. Somehow, this is often lost when buying public companies. Using enterprise value, or EV, as part of the equation, makes sure that debt is factored into the value of the company. 

You can probably guess now that the first part of this screen involves the EV/EBITDA ratio. Now, what's a cheap number in this category? Depends on the type of company you are interested in, but I am a real cheapo, and shoot for an EV/EBITDA under 8.

Now, here's the downside -- I have yet to find a free stock screener that has this metric built in. Premium screeners do have it, if you want to pony up the cash. EV/EBITDA is listed for individual companies on the Yahoo! Finance Key Statistics page, so we'll come back to that. Let's move forward and use criteria that are available to us plebes.

Give me your unwanted
As a general rule, I want what other people hate when it comes to the market. The stronger their conviction, the more confident I feel about the opposite. Call me negative, but it follows the famous Buffett rule of "be greedy when others are fearful," and vice versa.

Doing a screen for the percentage of a stock's float that is sold short gives you a real quick idea of what people are currently hating on. Sometimes, it's for good reason (Green Mountain Coffee); other times, it's a sign to look deeper. Staying with our deep-value criteria, I use a short interest of 15% or greater. This means that at least 15% of the company's shares outstanding are betting against the company. When we apply this screen on Finviz.com (a useful tool), we are immediately brought to 301 companies. Not bad, not bad.

Let's refine it even further.

Give me your cash, too
Now, when I'm hunting for companies, I want my cake, and I want to eat it, too. That's why I'm going to set a five-year EPS growth rate of 15% or more. This is very healthy growth for many companies, so it makes sense that it slims our pickings down to 114 on Finviz. The one drawback of this criterion is that it ignores companies that have recently lost money, but could be in the midst of a turnaround (Research In Motion, anybody?).

The results
For the sake of time, I'll just pick out a couple of companies that seem interesting based on our screen. Remember, the 114 companies will be slimmed down even more after we've weeded out those with an EV/EBITDA above 8.

STEC (Nasdaq: STEC  ) is certainly an interesting company in this screen. The data storage company has suffered from negative earnings the last couple of quarters, yet last quarter's loss was less than expectedAt a dirt cheap valuation, with nearly 80% of its market cap in cash, and no debt on the books, STEC is in prime turnaround (or takeover) territory.

Travelzoo (Nasdaq: TZOO  ) has been on the radar of value investors for some time. At an EV/EBITDA of 6.59and a return on equity over 50%, the online travel company could soon follow on the heels of success stories such as Expedia and Kayak Software. Over 53% of the company is held by insiders -- a solid vote of confidence from the C-suite. The company is on the low end of its 52-week range due to a $50,000 fine from the Department of Transportation.

In an upcoming article, I'll take a closer look at these companies, and others that show up on the screen, to show what else you should look for in your hunt for value opportunities.

 

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