A Stock for Scrooge

Last year, I asked Foolish friend Hewitt Heiserman Jr., author of a must-read investing book titled It's Earnings That Count, to help me screen for cheap stocks possessing a high degree of earnings quality. In the process, we found that when it comes to stock investing, it can pay to be a little like Charles Dickens' infamous Christmas miser, Ebenezer Scrooge.

Allow me to explain. Heiserman is a self-described "cautiously greedy investor." That means he's looking for well-managed companies with proven earnings growth that can be bought on the cheap. It gets more detailed than that, of course, and that's why he published the book. Click here to buy it. Or, if you're a Motley Fool Hidden Gems subscriber, you can try before you buy by reading Tom Gardner's interview with Heiserman. That's here. Go ahead, click away; I'll wait for you.

(Foot tapping.)

Back? Great, let's move on.

A miserly stock screen
I asked Heiserman whether he thought we ought to change the screen at all before I showed him last year's results. He said no -- his only regret was that our favorite stock screener at MSN Money doesn't include enterprise value-to-free cash flow. He would've included it otherwise. (By the way: Me, too.) So he still likes the screen as is. Here's another look at it, with Heiserman's reasoning behind each criterion:

• Average five-year revenue growth of 8% or better: "This is your indicator that the company is making a product or service that customers can use. But it's important to watch out if the number is too high. For example, 40% is likely unsustainable. On the other hand, if you've found a company growing at only 2% to 3%, it probably operates in a mature market. Low sales growth is almost always a red flag."

• Annual earnings per share growth of 7% or better over at least the past 12 months: "As with sales, you don't want 20% to 25% because that's probably not sustainable long-term, and any company that is growing that fast may be peaking. A company growing at 7%, however, may just be starting to accelerate, leaving plenty of opportunity for investors."

• Average five-year return on equity (ROE) of 10% or better: "This is simply the best way to gauge management's use of shareholders' money to fund growth. A higher number here is usually better, though it's important to remember that a highly leveraged firm can still have a high ROE."

• Debt equaling no more than half of equity: "This helps eliminate the firms that have high ROE but are also so highly leveraged that they would be in trouble if creditors came calling at the wrong time. I think one of the great lessons of the late '90s is that investors forgot about this and the rest of the balance sheet."

• Institutional ownership of 60% or less: "John Neff gave a great quote in which he relayed some advice from his father. His father said merchandise well bought is merchandise well sold. That's a motto for the value investor, but it can also be a motto for the conservative growth investor. Low institutional ownership leaves room for mutual funds and others to come in and discover the firm and push the share price higher. On the other hand, if 98% of the stock is already owned by institutions, then the most likely decision they'll make next is to sell, and that will create downward pressure on the shares."

• A short interest ratio of 5% or less: "Considering the way shorts make money, they have to be more dogged and more research-intensive. It's hard to imagine that you or I would know more about any individual stock than the most tenacious participants in the stock market. High short interest is always a warning sign."

• A price-to-earnings ratio lower than the industry average: "There's no substitute for getting in on a stock cheaply. A lower-than-average P/E increases your chances of finding a stock selling at a discount." (Incidentally, this is also another secret to Neff's winning approach. By investing in low-P/E companies, he generated an average return of 14.3% annually over 24 years as the head of Vanguard's Windsor fund, a truly remarkable record.)

Add it all up, and it quickly becomes clear: Investors seeking quality shouldn't compromise but instead should hoard their cash until they find the most promising investments. Sound like anyone you know?

Hoarding the wealth
So, how did we do over the past year? Pretty well, I'd say:

Our conservative growth portfolio beat the index -- represented here by the S&P 500 SYDR exchange-traded fund -- by nearly 10%.

It gets better, however, when you limit the returns to just the three picks we made for 2005. Together, they walloped the index by more than 20%. It's worth noting, however, that we were hardly alone. Philip Durell, chief analyst for Motley Fool Inside Value, made First American Financial (NYSE:FAF) a pick for the October 2004 issue. (Full disclosure: Heiserman owns shares in the company and says he's long on its prospects.)

Don't pour the egg nog ... yet
As you might imagine, I'm feeling pretty good about our 12-month results -- so good, in fact, I'm going to run the screen again. This year, MSN found 37 stocks that could prove worthy. That's too many. So, once again, I eliminated all stocks with a price-to-earnings-to expected growth, or PEG, ratio of 1.5 or higher. (In simple English: A stock with a PEG of 1.5 is trading for 50% higher than its expected earnings growth rate.)

That left seven stocks to put under our portfolio tree. Here's a look at each:

*Short interest is calculated against share float, which was unavailable for these stocks at the time of publication.

A few stocking stuffers
There are some great stocks in this year's portfolio. For example, Encore Wire (NASDAQ:WIRE), one of the leading sellers of copper wire for residential homes, was a special pick for Hidden Gems. It's up more than 88% over the past 52 weeks.

South Korean steelmaker Posco (NYSE:PKX) has its own fan in Mathew Emmert, chief advisor for Motley Fool Income Investor. The stock has slightly lagged the market since being included in the May issue, but it has trounced the S&P by more than 6% over the past 52 weeks. Its expected dividend yield of 3.3% also warms the heart like a steaming hot cup of cocoa.

So does Southern Peru Copper's (NYSE:PCU) stratospheric return on equity and microscopic PEG ratio. Sure, this copper miner could face a more difficult commodities market as supply ramps up to meet demand in 2006. (Posco could face the same, of course.) But the stock is cheaply valued and pays a world-beating 9% dividend that appears sustainable. Doesn't that sound tastier than your average fruitcake?

And, finally, I'm glad to see the return of Taiwan Semiconductor (NYSE:TSM), a winner from last year's portfolio that is increasingly becoming known as the world's leading semiconductor foundry.

Put this Tiny Gem under the Christmas tree
My favorite, however, is Nobility Homes (NASDAQ:NOBH), for it possesses many of the characteristics that Tom and fellow analyst Bill Mann seek in choosing Hidden Gems. And that, Fool, should get your attention. Tom and his guest analysts are each walloping the market by more than 20% as of this writing.

How does Nobility Homes stack up, you ask? Let's review. First, it's obscure and boring. The Florida-based company makes pre-manufactured dwellings that can sell for anywhere from $20,000 to $80,000.

Second, Nobility Homes boasts heavy insider ownership. According to this proxy filing, founder and CEO Terry Trexler and son Thomas own close to two-thirds of the company. Form 4 Oracle reports some stock option exercises and sales by Tom Trexler, but probably not enough to bring total family ownership to less than 60%.

Third, and finally, the company has a history of producing generous amounts of owner earnings (OE). Indeed, OE and net income have been practically identical over each of the past three fiscal years. Both have grown by about 14% annually during that time. A check of this press release shows full-year 2005 income of $6.2 million, up 33% from 2004.

Accelerating sales and earnings growth gets my attention, especially when it far exceeds trading multiples. That appears to be the case here: Nobility Homes trades for just 17.5 times my estimate of $6.2 million in 2005 owner earnings.

But there are two problems. First, housing prices are way up over the past year, and the black-box prognosticators aren't sure that trend is sustainable. If a fallout of sorts were to occur, this might hit results pretty hard. And second, Nobility Homes isn't a small-cap stock. Instead, it's a micro-cap, with barely more than $100 million in market value. That disqualifies it from consideration for the primary Hidden Gems portfolio.

Tom and Bill don't ignore such opportunities, though. A separate feature within the newsletter called "Tiny Gems" captures special situations where all the pieces are in place, except for liquidity. And it's here that I believe Nobility Homes fits in just fine -- a Tiny Tim of a present for the Scrooge in you.

Bah, humbug
Like Scrooge, it can pay to be downright mean when it comes to screening candidates and weeding out losers in your portfolio. Only that way will you ultimately learn to demand the quality your portfolio craves. Sometimes that even means you'll find nothing. But that's OK. I mean, really, wouldn't you rather wait for the gift your portfolio deserves than buy a few lumps of coal in the name of "putting money to work"? Me, too.

Foolish best wishes for a Merry Christmas to you and yours.

Go ahead; get small. Motley Fool Hidden Gems selections are small, unloved, and ripe for multibagger gains. Tom Gardner, Bill Mann, and the rest of their Foolish guest analysts are outpacing the market with their picks by more than 20% as of this writing. Get in on the action by taking a risk-free trial. Or sign up today and get Stocks 2006, the Fool's guide to our analysts' picks for the year ahead, free. All you have to lose is the prospect of better returns.

Fool contributor Tim Beyers respects all kinds of growth, but he loves his children's growth most of all. Tim didn't own shares in any of the companies mentioned in this story at the time of publication. You can find out what is in his portfolio by checking Tim's Fool profile, which is here. The Motley Fool has an ironclad disclosure policy.