Rely on the Numbers

 | Nov 10, 2011 | 1:45 PM EST
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I spent some time this morning thinking about the idea of relying on just the numbers and ignoring the constant strange news flow that is dominating the daily gyrations of the stock market. I have learned to use this approach to keep emotion and stress out of investing. Although I am a self-confessed news junkie, when it comes to picking stocks, I do not want something as strange as Greek politics or Italian lifestyle choices to affect my decision making process.

I try to keep most of my focus on tangible book value, but I am starting to see a lot of merit in using the combination of Z and F scores as well. It just makes sense that buying stocks that are financially healthy with improving fundamentals is an approach that can easily be combined with valuation to help produce winning stock picks.

I think that this can also apply to finding stocks to avoid or sell. Stocks with dangerous balance sheets or basic fundamentals that are deteriorating will find it difficult to move higher. In the current climate, I believe it makes sense to always have a few of my "chicken shorts" on the books after the market makes a sharp up move. Right now, when I look at the numbers on the broader market, I see that it is somewhere between fairly and slightly overvalued. According to the work of the good folks at Investor's Intelligence, the market is on the low side of overbought for the short to medium term. The Schiller PE ratio and GDP-to-market-cap ratio show the same on a longer-term view. Having a few shorts on the books makes sense for more aggressive investors.

With that thought in mind, I went searching for stocks that have poor numbers using the Z score, F score, or best of all, both measures. One of the names that leapt off the list is in the real estate business. I was surprised, as that is one of the areas of the economy that has been a disaster and most real estate is cheap right now. The exception to that is real estate owned by the large, public Real Estate Investment Trusts (REITs). It is doubly true of the REITs that own apartment buildings. The real estate crisis has led to a foreclosure wave and as a result the number of renters in the country has risen sharply. That makes so much sense it has become a strong investment theme for many investors.

Essex Property Trust (ESS) is the poster child for the sector. Shares of the West Coast apartment operator have almost tripled off the lows of 2009. The company is actually doing pretty well in the current apartment boom. Rental rates are rising; occupancy rates are fairly stable. The company is making money and growing by acquisition. Currently Essex owns more than 32,000 apartments in 155 communities. It is a decent business.

However, the numbers are really high for even a really good business. The shares trade at more than 3x book value and have an EV (enterprise value)/EBITDA (earnings before interest, taxes, depreciation and amortization) ratio of more than 25. The Z score is .8, as the company has roughly $33 million of cash and total debt of more than $2 billion. The F score measure of fundamentals is just 4, indicating that the shares will underperform the market. The dividend yield is just 3% at the current level, which is very low for a long-term real estate investment. The funds-from-operations yield is roughly 7% which, while not terrible, is below the level where I would consider the shares to be cheap. By the numbers, the stock is not cheap and the outlook for its price is not great. So this stock is one to avoid or consider selling short. I am going to look for put spreads to see if I can establish a "chicken short" in the shares at a favorable risk-reward ratio.

I love following the news, and I will debate the mess in Europe or the morass of American politics anytime -- preferably over some malted or distilled beverages. When it comes to the markets, I prefer to leave the news and noise out of the picture and rely on the numbers.

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