As we move further along into what I am calling valuation week, I want to look at another of my favorite screens. I call it the academic combo screen.
I draw on the work of Joseph Piotroski, who developed the nine-point F-score model that measures a company's conditions and prospects to identify winning cheap stocks, in combination with the Altman Z-score, developed by New York University professor Edward Altman to measure the financial strength of a company. The result is a portfolio of companies that are strong and seeing improved business conditions yet still trade at a discount to book value.
I have used the measures for a long time with a great deal of success. Last night, while I watched the Orioles beat the Rays in a game that was closer than it should have been, I formally back-tested this approach, and the results are pretty good to say the least. I used stocks trading below book value, with Piotroski scores over 6 and Altman Z-scores over 3 as my criteria.
Over the past 15 years, the screen earns an average annual return of 20.41% vs. the market return of just 3.29%. For the 10-year period, it's 18.2% against 5.72% for the S&P 500, and for the last five years the combination wins by 20.66% to 11.43% for the broad market. The screen outperforms in both up and down markets and, like so many value screens, dramatically reduces the number of positions near market peaks. At the end of 2006, there were just six stocks, and in 1999 no stocks passed the screen.
Currently there are just 12 stocks that pass our combination screen. The screen has basically been in sell mode for the last six months as it sells stocks that no longer meet all three criteria and is finding very few new safe cheap stocks with an improving outlook. It is not as bad as late 2006, but it seems to be headed in that direction.
There are some old favorites on the list. Richardson Electronics (RELL) makes the list of safe cheap stocks with strong future prospects. It makes products that control, switch or amplify electrical power signals that are used in semiconductor manufacturing and visual technology solutions. The products are used in a wide range of industries, including some with strong growth prospects like alternative energy, aviation, health care and military markets.
Recent results have been less than impressive as management has reworked the company and introduced a new division that could actually be a huge growth driver. Richardson Healthcare provides diagnostic imaging components and technical support to hospitals, diagnostic imaging centers and other medical institutions. These products are used in radiology, surgery as well as CAT scan and MRI machines. That could be a huge business for Richardson in the years ahead.
The stock is trading at just 80% of tangible book value and has a Z-score of 4.8 and an F-score of 6. As a bonus, the stock has a decent dividend yield of 2.7%. Richardson reports after the market closes, so it will be interesting to see how it fared in what has been a difficult first quarter for many.
Alpha and Omega Semiconductor (AOSL) makes power semiconductors that are used by the computing, consumer electronics and communication industries. Its semiconductors do things like regulate power, protect circuits and control signal switching. Its chips are found in everything from laptops and cellphones to wind turbines and solar inverters.
Dr. Sik Kwong Lui, a co-founder of the company, just replaced the former chief technology officer to help move forward with plans to develop the next generation of power-related semiconductors, and that should help drive growth over the next several years. The stock is currently trading at just 82% of book value, and with an F-score of 6 and Z-score of 3.94 it is both safe and cheap at current prices.
The rest of the stocks in the portfolio are too small to mention here. They are all nano-cap stocks with market caps well under $100 million. All the screens and back tests I am running this week show very few qualifying stocks and most of them are fairly small as measured by market capitalization.
The combination of Z-scores, F-scores and book value has been a powerful one over the last 15 years. Given that there is a huge focus on balance sheet safety, financial conditions and prospects in the screen, I expect this will continue well into the future.
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