The next screen I want to look at to start the New Year is one I call Rational Liquidation Value. I take the current assets plus 70% of all other assets and subtract all debt. It's close to the net current asset value approach but assigns some value to non-current assets. It gives a very rough idea of what a company might be liquidated for if done in a totally rational process, not a fire sale. While that may not be realistic, out here in the real world it does a fantastic job of identifying deeply undervalued stocks.
Once I have the initial list, I then limit purchases to those stocks with Piotroski F-scores and Altman Z-scores that indicate the company can survive financial conditions and is showing some signs of improvement. That list is then ranked based on F-scores and the top 50 stocks are purchased. This model is rebalanced quarterly to eliminate any stocks where the financials start to deteriorate.
The model handily outperforms the market and has what I call the gentle timing effect of deep value investing. This approach also tends to build cash as the bull market ages and becomes fully invested after a steep decline. There simply are not that many safe and cheap stocks in the later stages of a bull market. The performance after a decline is somewhat breathtaking and reverts as the bull market continues. Currently, if using a minimum market cap of $50 million, the portfolio is only 28% invested. If you allow all-caps you would be about 52% invested in the current market.
As with most of my value models, this one has a consistent small-cap bias. The truth is that deep value lives in the small and micro-cap world. It only works for individual and smaller institutions. It is not scalable, so if you want to be the biggest kid on the block, the deep value approach is probably not for you.
The current stocks in the portfolio have an average market cap of just $275 million. The average stock trades at just 81% of tangible book value and is financially solid with an average Z-score of 3.3 and F-score of 6.5. Six of the 14 stocks pay a dividend and the average yield of all 14 stocks is 1.18%.
Some of my favorite stocks are in the financially strong Rational Liquidation Value portfolio. Stage Stores (SSI) has been struggling as many of the stores are being hurt by lower oil prices and the stronger dollar, but they are profitable and expected to remain so in 2016. The company raised the dividend back in June and reinstated the buyback plan in November so management is much more confident about the future than the market appears to be. The shares yield over 6% right now, so you will be well compensated while waiting for the market to agree with management. (Stage Stores is part of TheStreet's Dividend Stock Advisor portfolio.)
I have owned West Marine (WMAR) for some time. It falls into what I call the addictive lifestyle category of companies. Boaters may delay buying the newest and brightest stuff for their boat, but they will eventually buy them unless they become destitute or the boat sinks. There are some signs business is beginning to turn as the latest earnings report showed 5.2% sales growth and earnings growth of 20% year over year. Online sales grew by 25% and are now more than 8% of total sales. If we see any sort of economic upturn going into summer boating season, we could see a nice earnings pop for West Marine. Insiders own about 27% of the company, so they have a vested interest in seeing a higher stock price over time. The stock easily passes my safe test with an F-score of 7 and Z-score of 3.98.
I have not yet purchased shares of K12 (LRN), but I doubt I will exit 2016 without a position in the stock. One more earnings miss or broad market selloff will bring the stock well into my "too cheap not to own" space. K12 provides content for the virtual schools in Orange County, Fla., and we have several friends who are using their programs to home-school their kids and they rave about the educational content. I have yet to hear one complaint about the program. The stock is trading at a discount to book value and the F and Z scores show a financially solid company.
The chart below shows the other companies included in the initial Rational Liquidation Value portfolio for the first quarter of 2016. We will revisit in April and see how the initial picks do and what new names might be added.