Last night I was talking stocks and baseball with an old friend who mentioned that he had read an article some years back that said simply buying smaller-cap stocks that were profitable and traded below book value was a winning strategy. I quickly tested it and found that this simple selection method performed like Gaylord Perry with a zipper full of Vaseline. It blew the market away over the last 15, 10 and five years by a very wide margin. More importantly for some of us deep-value types, it also does so over the trailing one- and three-year periods where many other value strategies have lagged.
I noticed that the portfolio contained a lot of small banks, so I was curious just how much they added to the outperformance. My small-bank-centric brain wondered if perhaps just buying profitable small banks below book wouldn't be better. When I broke out the banks, performance stayed about the same. The non-bank stocks performed every bit as well as the bank stocks.
Next I wondered what would happen if we added a little extra margin of safety to the non-financial stocks. Adding a requirement that the stocks in the portfolio have an Altman Z-score high enough to indicate financial stability actually improved the performance by a Fed percentage point. Adding the safety factor also improved the outperformance in down markets by quite a bit.
The list of stocks we get when we run the screen today is pretty interesting, but very short. Like every other screen, the profitable safe and cheap small-cap screen has something of a natural timing effect, as it produced more candidates near market bottoms and far fewer as we near a top. Right now just 20 non-financial stocks make the grade. That is the lowest number since August 2007. There is a message in the information, but I will let you decide for yourself how important it is.
There are some old favorites on the list. Seneca Foods (SENEA) has shown up on several safe and cheap screens over the past couple of years. The company is not in a really exciting business, as it packs and cans fruit and vegetables that are sold under various brand labels. It also packs and processes canned and frozen food for the Green Giant division of General Mills (GIS). The stock is cheap at 86% of book value and the company earns a Z-score of 3.27, so there is a margin of safety in the balance sheet. The company is profitable and should continue to be over the next year.
The company recently announced that it expanded its stock buyback plan and now has more than 3 million shares authorized for repurchase, so management is aware of the need to boost shareholder value going forward. This may not be the most wildly exciting stock you'll ever own, but I think long-term shareholders will be well rewarded.
One more interesting stock that fits the bill is ITT Educational Services (ESI). The company has been accused of covering up the amount of money it stood to lose due to defaulted student loans, but the company has contested the charges. The stock has doubled off the post-accusation lows after posting a better-than-expected quarterly earnings report. While the stock is cheap at 72% of book value and the Z-score of 3.6 would seem to indicate a margin of safety exists, the SEC claims make this more a speculative pick than some other stocks on the list. If ITT successfully defends itself or reaches a cost settlement with the agency, the upside could be enormous. A more adverse settlement could hurt quite a bit, so I would stay small and move very slow if I was going to buy this stock.
Universal Stainless and Alloy Products (USAP) makes semi-finished and finished specialty steels, including stainless steel, nickel alloys, tool steel and certain other alloyed steels. These products are used in a wide range of industries including aerospace, power generation, oil and gas and heavy equipment manufacturing. In spite of weakness in key markets like oil and gas, the company is producing solid results, with sales increasing across all its business lines in the first quarter.
In spite of the improvements in sales and earnings, the stock is still very cheap, with the shares trading at just 70% of book value. The Altman Z-score of 2.17 is well above the distressed level, so the company should not have financial problems in the foreseeable future. It is worth noting that the company also has a Piotroski F-score of 7, so conditions and prospects are improving for this company.
The profitable small-cap approach to deep-value investing appears to have a great deal of merit, and I will be adding this screen to my arsenal of stock-picking tools.