In recent months I have talked a lot about how the pool of cheap stocks has been shrinking and that has a sort of natural timing force on new money portfolios. If you can't find stuff to buy, you will end up holding a lot of cash.
Even investors with older portfolios full of stocks bought at bargain prices are seeing cash balances build up as older names reach full value and there are no safe and cheap stocks to replace them. Those of us who consider ourselves deep value investors are finding scarce pickings right now.
I thought it might be useful to give you some idea of just how thin on the ground safe and cheap stocks are right now as the market grinds higher. It has really reached the point where that is reminiscent of late 2006 and 1999. I am not in any way making a market call, or suggesting a massive crash -- although at 53 years old and lots of time left, I would throw a party if that happened. But I want to show that stocks are not as cheap in absolute terms as the talking heads might have you believe.
One of more successful and productive screens is based on the Walter Schloss approach to the markets. The legendary investor beat the market by a healthy margin for almost 50 years by focusing on stocks trading below book value with sound balance sheets and insider ownership.
In normal times, there will be 40 to 60 names on the list and 20 or so with market caps above $100 million. In a really bad market, there might be a couple of hundred on the shopping list and at least 50 or 60 with $100 million and higher market caps. This morning, out of a 7,000 stock universe, there are just 25 stocks that pass my screen in total. Five of those are above the $100 million level and only one of them trades with an eight or lower handle on the price-to-book-value ratio that I prefer when buying cheap stocks.
My perfect stock screen has been pretty good at producing safe and cheap stocks. I never get a huge list of stock trading below book value that are profitable, have a sound balance sheet and pay a dividend. But in normal times there are usually 50 or 60 total perfect stocks. In bad markets that might get up around 100 or so. Today, there are just six with only Hardinge (HNDG) and LS Starret (SCX) over $100 million in market capitalization.
Over the past couple of years I have had some success using the idea of combing the gross profit-to-assets ratio and price-to-book value model developed by Professor Robert Novy Marx of Rochester University. He found that combing these two measurements beat every other valuation model from 1953 though today.
There are never a lot of these high quality cheap stocks but this morning my screen produces just 15 stocks. Several of these are companies like hhgregg (HGG) and ITT Educational Services (ESI) where I have serious doubts that operating profits will stay anywhere near current levels.
Hercules Offshore (HERO), West Marine (WMAR) and Arcelor Mittal (MT) are all stocks I would be willing to buy at the current price but I already own them. It is still an extremely short list of candidates.
Even my simple shopping list builder screen of stocks has shrunk considerably. This list includes stocks below book value with an F-score indicating fundamental improvements and a Z-score high enough to indicate the light bill would be paid and the doors kept open.
This screen in a more normal environment has 100 plus names on the list of potential candidates worth further investigation. Today, there are only 14 names on the list and four of those are stocks I have recently rejected because a deeper dig showed operational and fundamental concerns about the company.
I am not smart enough to predict market direction and I have doubts that anyone is able to with any measure of consistency. I am smart enough to figure out when businesses are priced at levels that are not beneficial for buyers and that's pretty much where we are today.
I have no idea if we get new inventory of safe and cheap stock via individual names pulling back, sector rotation or a broad market pullback. But I do know that for a deep value bargain hunter there is little to do today. It is time to practice the difficult art of doing nothing until we get inventory creation.