Three Stocks for the Scrooge in You

Unless you've been living under a rock pretty much all of your life, you know a little about Charles Dickens' A Christmas Carol, in which mean old miser Ebenezer Scrooge gives Christmas a big "bah humbug." In the end, of course, Scrooge learns the value of generosity through the ghosts of Christmas Past, Present, and Future. (Though you need no such spiritual prodding, do you? Check out our annual Foolanthropy charity drive to see how you can help some worthy causes.)

The funny thing is, I've learned that it can pay to be a little like Scrooge when it comes to stock investing. It all started when I, selfishly, asked the editors whether I could approach Fool favorite and It's Earnings That Count author Hewitt Heiserman, Jr., for an interview about how he screens for potential earnings power. (Buy the book to see what I mean. Or, if you're a Motley Fool Hidden Gems subscriber, you can get access to Tom Gardner's interview with Mr. Heiserman here, and to a follow-up on the private discussion boards posted here.)

A miserly stock screen
After a thorough discussion and not a few emails bothering him at all hours, we created a screen that seeks conservative growth stocks for the paranoid and miserly investor. Here's how it looks, along with Mr. Heiserman's reasoning behind each criterion:

• Annual earnings per share growth of 7% or better over at least the last 12 months: "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% may just be starting to accelerate, leaving plenty of opportunity for investors."
  
  
• 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. As with earnings, 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. Take Colgate-Palmolive (NYSE:CL), which is cutting 4,000 jobs to help boost profits since sales aren't growing fast enough. Low sales growth is almost always a red flag."
  
  
• 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." (For more on this, check out Bill Mann's explanation of the elements of ROE.)
  
  
• Debt equaling no more than half of equity: "This helps eliminate the firms who have high ROE but who 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." (Indeed, this is entirely the point of Philip Durell's Motley Fool Inside Value newsletter.)

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?

No Tiny Tims here
I ran these criteria through my new favorite -- and free -- screener at MSN Money. You can find it here. More than 40 stocks came up, so I added another criterion that Mr. Heiserman says he has found to be very useful: the price-to-earnings-to-growth, or PEG, ratio. He suggested we eliminate all stocks with a PEG of 1.5 or higher. (That's stocks trading for more than 50% higher than their earnings expected growth rate.)

So, what did we come up with? Have a look:

Three stocks, three stocking stuffers
All of these stocks are potential winners based on our screening criteria. So let's dig even deeper. For Hidden Gems, Tom Gardner looks for companies that generate ample structural free cash flow. But calculating that takes time and research. Since this is an initial screen only, we can use a thumbnail version by checking the "Key Statistics" for each stock at Yahoo! Finance. At the bottom of each report is a line item for free cash flow. Let's compare that with enterprise value, looking for firms that trade for no more than 15 times enterprise value-to-free cash flow.

Can you hang on while I fire up my calculator? Thanks. OK, there. We're down to three firms, one of which I've already profiled: Taiwan Semiconductor (NYSE:TSM). The other two are Docucorp (NASDAQ:DOCC) and First American (NYSE:FAF). Are these two worth further study? You might think so after seeing these numbers: Docucorp, which creates software that helps companies manage complex documents such as insurance policies, trades for only 7.3 times cash flow, while First American, a title insurer among other things, sells for a miniscule 6.2 times cash flow.

Let's run one more test. Remember that balance sheet comment Mr. Heiserman made earlier? He suggests putting good candidates under the lens to see how much of their positive net worth is really tangible. Anything less than 50% is bad, and 75% or higher is preferable. How do we get the number? Easy. On the balance sheet are generally two line items: intangibles and good will. Add these two together, and divide by total assets.

Let's check Taiwan Semiconductor first. Wow. Nearly 90% of the chip manufacturer's assets are in hard goods, cash, property, and the like. That's very solid. Docucorp is at 31%. Still solid, but not nearly as good as Taiwan Semiconductor. And how about First American? Well, the firm comes in at 39%. That's still within our margin of error, but probably a little too close to the edge. Moreover, First American's EPS growth is well more than 30%. That pace may be hard to keep up, but you'll find out only through further study.

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?" I thought so.

Fool contributor Tim Beyers does not own any of the stocks mentioned in this story. Nor is he a Scrooge. In fact, Tim has participated in the annual Foolanthropy charity drive for three straight years and plans to do so again. Join him. You can view Tim's Fool profile and stock holdings here. The Motley Fool is investors writing for investors.