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  1. Home
  2. / Investing
  3. / Consumer Discretionary

Good Things Come in Threes

Putting a new twist on a familiar three-factor value screen.
By TIM MELVIN Apr 10, 2015 | 01:00 PM EDT
Stocks quotes in this article: RBCN, TWMC

Today I want to talk about a simple screen I have run at least once a week since computerized screening became available. Prior to that, I searched for these three factors in the weekly S&P statistical service, and stocks that passed were highlighted in yellow. It is a three-factor value screen that simple-searches for companies trading below book value with a debt to equity ratio below 40% and a current ratio over 2.

In a new twist, I limited my universe to just those companies that have market caps less than $150 million. The results over the past five, 10 and 15 years are outstanding, but it outperforms in both up and down markets. Over the 15-, 10- and five-year periods, the compound rates of return are 20.27%, 17.99% and 23.99%, respectively. It outperforms by a wide margin in both up and down markets. However, that's just the beginning of the story.

The next two paragraphs may be the most important I have ever written for individual investors. If you take this screen and limit the universe to those stocks that trade with a market cap above $150 million, every bit of the outperformance goes away. The screen pretty much matches the market in the 15- and 10-year periods and lags badly in the five-year period. If you limit it those stocks above $500 million in total market cap, you lag the market badly across all time frames. The higher your market-cap restriction, the better the performance.

The inverse is also true. The lower you go, the higher the returns are across all time periods. If you limit your universe to cheap companies with strong balance sheets and those below $50 million, you get returns that would make the best hedge fund managers blush. The five-, 10- and 15-year returns grow to 24.28%, 23.31% and 23.11%, respectively. That's with quarterly rebalancing. If you rebalance monthly, the returns become the stuff of legends, although transaction costs and spreads might trim your sails quite a bit. The size advantage of individual investors is very real and investors should pay a lot more attention to Roger Ibbotson's work on liquidity. Liquidity carries an enormous cost when you are investing in stocks.

I ran the screen this morning and while, for obvious reasons, I can only talk about a few of the stocks, there are some interesting companies on the list. Rubicon Technology (RBCN) sells electronics materials used in a wide range of applications, including light-emitting diodes, integrated circuits and optical applications. The company should see strong growth in the years ahead as more LED products are developed, particularly for mobile devices and high-end automobile lights. The balance sheet is solid, with $50 million in cash and no long-term debt. The stock is trading at 50% of book value and just 1.6x its net current asset value right now. The stock is attracting some attention by fellow value types, as Royce Funds, Aegis Financial and Ariel were buyers of the stock in the last quarter of 2014.

Trans World Entertainment (TWMC) is an old favorite that still makes the cut as a cheap stock with a solid balance sheet. The company is a tough business and music and video retailing has felt the pain of intense online competition. The company has added electronics products and what it calls trend items, and sales in those categories have been offsetting weakness in other product lines.

In the holiday season, sales of electronics and trendy stuff rose by 21% year over year. Insiders, including successful micro-cap investor Lloyd Miller, own 50% of the company, so they have a vested interest in a higher stock price. Trans World has no debt and almost $80 million in cash so the balance sheet is in great shape. At 70% of book value the shares are definitely a bargain issue.

Small companies that trade below book value with strong balance sheets seem to offer one of the best risk-reward opportunities in the market. The long-term returns from such an approach have been outstanding over the past 15 years. Best of all, there are no concerns with high-frequency traders or competition from larger funds, as they simply cannot get involved in most of these stocks.

Investing in this universe requires patience and discipline, but those are required for any successful investing approach. My advice is to go small to earn big.

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At the time of publication, Melvin was long TWMC, although positions may change at any time.

TAGS: Investing | U.S. Equity | Consumer Discretionary | Stocks

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