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  1. Home
  2. / Investing

3 Stocks With the Right Mix of Quality and Deep Value

Combining 2 academic theories results in an interesting and valuable screen.
By TIM MELVIN Jul 15, 2015 | 02:00 PM EDT
Stocks quotes in this article: PINC, RMAX, UIS, CG

With the wife and youngest in Texas, I have been left to fill my time this week with random activities, while trying not to mess up the house too badly. I've watched a lot of baseball, read a bunch of books and played around with several stock-picking scenarios.

The other night, while viewing the epic Home Run Derby (I love the new format), I ran some screens combining two academic theories that have worked well in both theory and practice. This turned up some interesting ideas that are worthy candidates for folks that must be invested all the time or those of us who like to emulate Hetty Green, Andy Beal and Mr. Womack.

University of Rochester Professor Robert Novy-Marx redefined quality in his paper "The Other Side of Value." He defines quality companies as those that show a high level of gross profitability compared to the total assets used to produce the profits. He discovered that "Profitability, as measured by the ratio of a firm's gross profits to its assets, has roughly the same power as book-to-market predicting the cross-section of average returns." In other words, buying quality stocks performed as well as purchasing stocks below book value, over time.

I combined that theory with the enterprise value-to-EBIT ratio that Tobias Carlisle has done such a fine job of researching in his books Deep Value and Quantitative Value, along with Wesley Gray. He found that those stocks trading at a low EV-to- earnings before interest and taxes outperformed the market by a significant margin over time. This makes a great deal of sense, as EV/EBIT is the multiple that many leveraged buyout shops and private equity firms use to search for value.

It has been an incredibly valuable addition to my value tool box.

So I set my screener to find stocks where gross profits were at least one-third of the total value of the company's assets. I then ranked them by the EV/EBIT ratio. Right now, the average takeover multiple is about 10, so I want to find stocks trading at around half that level or less, to identify high-quality stocks that are also cheap enough to consider for a long-term deep value portfolio. The screen produced some interesting stocks that are worth further consideration.

Yesterday, I mentioned that David Rubenstein of The Carlyle Group (CG) identified health care as one of the areas where his firm is still able to find investable opportunities. Premier, Inc. (PINC) shows up on our screen of cheap, quality companies and it is in what it calls the healthcare improvement business.

Working with an alliance of 3,400 U.S. hospitals and 110,000 healthcare providers, North Carolina-based Premier provides integrated data and analytics, supply chain solutions, advisory and other services that lower costs and improve efficiency. The stock trades with an EV/EBIT ratio of just 4.5 and its gross profits are 45% of total assets. I have been looking for a healthcare company that is cheap enough to buy and will be spending some time looking into this cheap, high-quality candidate.

RE/MAX Holdings (RMAX) has been strong lately. I am not a believer in a rapid recovery for real estate and home sales, but think there will be a long slow recovery and that should be great news for this company. Business has been pretty good and RE/MAX recently doubled its quarterly dividend to $0.125 per share and declared a special cash dividend of $1.50 per share.

Gross profits are 48% of total asset and RMAX was recently trading with an EV/EBIT ratio of 4.6. I will not chase the stock, but given my long-term view of housing it will be pretty high on my "buy in a correction" list.

Unisys (UIS) is one of the oldest of the old tech companies and that image is masking a lot of good things going on at the company. It is active in the cloud computing space, and with Unisys Stealth, the company has entered the cybersecurity marketplace. Despite a pension deficit, Unisys is catching up and higher rates would help the company get the plan back to a fully funded status.

This really is not your father's Unisys and the stock is worth another look. UIS shares trade with an EV/EBIT ratio of 5.2 and gross profits are 33% of total assets.

Combining the ideas of quality and deep value, the EV/EBIT ratio makes sense to me and can help find ideas I might have otherwise overlooked.

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At the time of publication, Melvin had no positions in the securities mentioned.

TAGS: Investing | U.S. Equity

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