I spend a lot of my day running tests on various screens. I probably get 20 new ideas a week of different combinations of fundamental data points that seem to make sense as a way of uncovering safe and cheap stocks. While they all seem brilliant, at first, the vast majority of them go down to ignoble defeat when tested. A very wise man and successful trader once told me, 'if it can be tested, it must be tested.' That has turned out to be among the best kernels of advice I have ever received -- as many of my inspirations and grand breakthroughs have ended up as shredded spreadsheets in the circular file. It is very rare that I add anything to my list of regular screens.
One measure that did make it through, this year, was the enterprise-value-to-earnings before interest and taxes (EV/Ebit). Both Tobias Carlisle and Wesley Gray -- together in their book, Quantitative Value, and individually -- have proven that this measure is a valuable tool for identifying cheap stocks. I have run my own torturous test of mangling data to attempt to disprove the value of the enterprise multiple, but my findings support theirs across the board. Stocks with low ratios outperform the market, and are a fantastic measure of value. That makes sense, as it is one of the most important metrics used by LBO and private equity firms when screening potential investments.
Last night, I combined this proven measure with two of my other well-proven stock-picking variables. I used my go-to measure of price-to-book-value, and further weeded out the list to include only those stocks that passed professor Robert Novy Marx's gross profitability definition of quality companies. I ended up with a list of stocks that should be high quality companies, and that are quite cheap. Because I have become mildly safety-obsessed after the past two years, I further limited the output to just those companies that also have an Altman Z-score of 3, or higher. The remaining shortlist offers up undervalued securities that are not in danger of serious financial difficulties over the next few years.
There are some interesting stocks on the list. I mentioned Nevsun Resources (NSU) when it popped up on a screen not too long ago. The company mines for gold, copper, zinc, and silver deposits in Africa --and its primary output is copper. It is expanding its zinc operations, but for now the price of copper is very much a controlling factor. Like most commodities, copper has been in a free fall -- declining by 23% over the past year. The stock is cheap, with an EV/Ebit ratio of just 1.8, and a price-to-book-value ratio of 90%. Gross profits are 26.13% of profits, so it just barely crosses our minimum threshold to be a quality stock. The balance sheet seems to be safe, with a Z-score of 3.24. As a bonus, the shares are currently yielding 5.5%.
I sold my original stake in TravelCenters of America (TA) last year, when the stock ran up, but shares are now falling back into a range where they are worth considering, once again. This company operates 256 service centers under the TravelCenters of America and Petro Stopping Centers brands, in 43 states and Canada, selling fuel, and offering both full service and fast-food dining options. The company also operates convenience stores and gas stations under the Minit Mart brand. The stock currently trades at just 80% of book value and the EV/Ebit ratio is 5.1. The Z-score is 4.93, so the company should be financially solid. Gross profits are 96% of total assets, so it is on the high end of the quality scale.
I probably should have pulled the trigger on Stage Stores (SSI) when I had it on my radar screen and it fell below $10 on Panic Monday. The company operates 850 specialty department stores in 40 states and a direct-to-consumer channel under the Stage, Bealls, Peebles, Palais Royal and Goody's brands. The core philosophy is to sell well-known brands in smaller towns and communities around the US -- and it makes sense to me. It recently announced a store-closure plan to cut expenses and missed Wall Street's earnings estimates, and the stock has fallen sharply. At this price, Stage Stores trades at just 80% of book value and the EV/Ebit ratio is only 5.9. The Altman Z-score is 3.19, so the balance sheet is in good shape. The stock also has a very attractive yield of 5.4%. Gross profits are 49% of total assets, so they easily make the grade as a quality company.
Combining the three valuation measures, and throwing in an additional measure of balance sheet safety, produces an interesting list of stocks worth further consideration by aggressive, patient, long-term investors.