Cheap Is Not Enough

 | Dec 30, 2013 | 12:30 PM EST
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The cornerstone of the asset-based deep value approach is that cheap is not enough. A security also has to be safe to be considered for purchase. It is necessary to have strength in the balance sheet and income statement so that the company can survive long enough to thrive.

I use a range of tools to determine safety when picking stocks and two of the more important ones are the Altman Z-Score and the Piotroski F-score. These two academically-developed tools can help measure the financial strength of a company and measure improvements in the income statement and cash flow statements as well. We only want to invest in those companies that can survive long enough to thrive.

It just makes sense to use the philosopher Carl Jacobi's advice to invert, always invert, and use the SE tools to find stocks that we should avoid no matter how good the story. There are a lot of stocks out there that are "rebound" candidates, or are part of some super sexy future trend that should make us richer than Croesus that simply do not measure up. These issues might even be cheap, but they are certainly not safe. Even worse prospects are those stocks that are expensive and not cheap on our statistical measures.

As a quick reminder an F-screen below 5 indicates worsening fundamentals and the stock should be avoided no matter how cheap it appears at first glance. A Z-Score of less than 2 indicates financial distress and a real chance of insolvency in the future.

Top of our list of stocks to avoid is J.C. Penney (JCP).There is a lot of speculation about the old-line retailer's ability to turn itself around and to regain a measure of its former glory. The company earns a Z-score of a just 1 and the F- score is an anemic .52, so there is a real question about this firm's ability to survive -- much less ever thrive again. Investors who want to bet on a turnaround in this company are probably better off looking at the debt issue of J.C. Penney to see if an adequate return and margin of safety might be available.

Molycorp (MCP) is another great story stock that many traders are hoping can stage a rebound. The company is one of the rare earth miners that is global in nature and that operates outside of China. They mine minerals like lanthanum, cerium, neodymium, praseodymium and yttrium -- heavy rare earth concentrates, which include samarium, europium, gadolinium, and terbium. While most of us don't think about these elements in our day-to-day lives, they are used in a wide range of electronic devices, rechargeable batteries, lighting and many other products.

On the surface this looks like a great story but the truth is that rare earth elements just are not that rare. China still dominates the market, but Australia and South Africa are also seeing an increase in rare earth mining operations. Molycorp has an F-score of just 1 and the Z-score is negative so there is no margin of safety to be found in this stock. Shares in this company right now are just a roll of the dice and at 1.6x tangible book value the odds are not in your favor.

One stock that surprised me a little bit is Navistar (NAV). I haven't looked at the commercial truck, bus and diesel engine company in some time as it rarely trades below tangible book value. Although Carl Icahn has a stake in the company, the shares appear to be neither cheap nor safe at this level. Earnings have been in decline for the past five years and the company is expected to show just a very small profit next year.

In the most recent quarter they saw another revenue decline and lowered their projections for cash flows in the first quarter of next year. All of this is showing up in the company scores as the F-score is just 2 and the Z-score in only .45.

Using the Z and F scores has turned up a lot of winning stocks. These tools help us find stocks that trade below book value and have the wherewithal to survive until they thrive. It just makes sense that we can also use them to find stocks with no margin of safety that should be avoided by most investors.

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