I spent some time over this past weekend testing a screening and back testing program suggested by a friend. As always when I take one of these things out for a test drive I ended up spending a lot of time testing and running various scenarios. Before my wife finally got irritated with me for spending too much time in the office on a nice weekend, I had run some extensive tests on all my favorite screens. As has been the case just about every time I run these things, the most successful screens were my perfect stock screen and, of course, community banks with strong balance sheets and loan trading below book value.
The perfect stock screen looks for companies that are profitable, pay a dividend, have strong balance sheets with low debt levels and high current ratios and whose shares trade below book value. Right now there are just a small handful of these stocks. This is to be expected, as the market has marched steadily higher. Last night, in the spirit of Charlie Munger and Carl Jacobi, I wondered what would happen if I inverted the screen and looked for imperfect stocks? I sat down and ran a screen looking for companies with lots of debt, low current ratios that are unprofitable, non-dividend payers and whose shares trade well above book value.
I found that there are a lot more imperfect stocks that there are perfect ones. There are only 10 perfect stocks right now in the U.S., while more than 80 come in on the imperfect side. The low rate environment has encouraged companies to take on a lot of debt the past few years and there are a good number of unprofitable companies with more debt than it is probably prudent.
The granddaddy of imperfect stocks is Amazon (AMZN). As I have said in the past, I like Amazon the company and we have deliveries here all the time, as we do a good bit of shopping on the site. I love my Kindle and the instant gratification of downloading books. However, the company has a good deal of debt, with a debt-to-equity ratio a little over 1, and it is not profitable.
The stock is trading at 16x book value, 90x free cash flow, 2x sales and 166x what the always optimistic and accurate Wall Street analysts are hoping the company might make next year. While the stock just keeps going up in spite of my reluctance to own it, I will remind you that the same thing was said about Cisco (CSCO) back in the 1990s. No matter how good the company is, eventually valuation reality sets in, and all too often these great companies become horrific sticks when that happens. I am not smart enough to figure out when to step off the breaking wave, so I avoid highly valued stocks like Amazon.
I know there are some noted value investors, like Monish Pabrai, who like Horsehead Holding (ZINC), the zinc miner. I am not one of them, as the stock easily passes my imperfect stock screen. The stock trades at 1.6x book value and the debt-to-equity ratio is 0.95, the current ratio is just 1.5 and it is not profitable. There is no dividend, nor is there one on the horizon. It is a great story, but the stock is not particularly cheap or safe right now.
Cornerstone on Demand (CSOD) describes itself as a leader in cloud-based applications for talent management. Apparently, that means it helps organizations recruit, train, manage and engage their employees, empowering their people and increasing workforce productivity. The website mentions empowering a few times, and that is one of those buzz words that I find worrisome. Even if I didn't, the company has a debt-to-equity ratio of over 6, is not profitable and is not expected to be profitable next year. The shares currently trade at a very modest 49x book value, 6.6x sales and 191x free cash flow. I cannot think of one single reason to buy this stock at this level.
Avoiding imperfect stocks can be as big a part of long-term returns as buying perfect stocks. Avoiding debt-laden companies trading at multiples that show high valuations just makes an enormous amount of sense to me, no matter how popular the company is or how good the story sounds.
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