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  1. Home
  2. / Investing

A New Way to Find Safe and Cheap Stocks

I found a few using the acquirer's multiple.
By TIM MELVIN Oct 29, 2014 | 03:00 PM EDT
Stocks quotes in this article: OXY, SGU, SAFM

I have been running a lot of screens this week and testing some ideas that have come up in recent conversations. While my favorite metric is and will be price-to-book value, I am aware that other methods have also produced strong results. One measure that has been discussed a lot recently is the Enterprise Value-to-EBITDA ratio. In his recent book, Deep Value: Why Activist Investors and Other Contrarians Battle for Control of Losing Corporations, Tobias Carlisle refers to this metric as the acquirer's multiple. It is easily my second-favorite metric to use in my search for safe and cheap stocks. EV/EBITDA is the most used multiple by private equity and leveraged buyout (LBO) funds in their search for companies to buy.

Over the years, a screen that has worked well for me is one that finds stocks trading below book value that also have high Piotroski F-scores and high Altman Z-scores. This screen finds stocks that have strong balance sheets and improving fundamentals. It has been a very effective tool for me. This morning, I sat down and ran this combination, and I substituted low EV/EBITDA value for price-to-book value. I came up with an interesting list of stocks worth considering by long-term-oriented investors.

Occidental Petroleum (OXY) is one of the largest companies to show up on the list. The oil and gas company has operation in North America, the Middle East, Africa, and Latin America. It is spinning off its California operations, so the U.S. exposure is going to be primarily in the Permian Basin going forward. Occidental also manufactures and markets basic chemicals. It has 22 chemical plants in the U.S. and one each in Canada and Chile. The stock has been pressured recently by lower oil prices, and it is down to bargain levels with an EV/EBITDA ratio of just 4.8. The strong balance sheet gives them an Altman Z-score of 3.25, above the 2.99 cut-off for healthy companies, and the F-score is an 8. The stock has a dividend yield of 3.26%, so you get paid to wait for oil prices to firm, and for value-adding management plans to execute.

Sanderson Farms (SAFM) is the third-largest poultry processor in the United States, with anticipated production of more than $3 billion pounds of meat this year. The company had a decent second quarter, with sales rising by about 4% and profits up over 11%, but it was short of analysts estimates and the stock has sold off a bit. Chicken prices have been going up recently, while corn prices are falling, so the company should have a decent quarter to report this time around. The balance sheet is solid, and the company gets a Z-score of over 9. Conditions and prospects are improving steadily, and the company earns an F-score of 7. Trading at an EV/EBITDA measure of just 4.7, the stock is cheap at these prices.

I have owned Star Gas Partners (SGU) for some time, and I have no intentions of selling in the near future. The propane and heating oil distributor continues to grow by acquisition. It has combined a bunch of small and regional distributors into the nation's largest retail distributor of home heating oil, based upon sales volume. It operates throughout the Northeast and Mid-Atlantic. The company's CEO Steve Goldman told investors in the most recent earnings release that Star Gas "remains actively engaged in seeking additional potential acquisitions that can drive Star's expansion into new geographic regions and areas of customer penetration."

Star Gas is in solid financial shape, with a Z-score of 3.87 and an F-score of 8. It is cheap, based on the acquirers multiple of just 4.3. Star gas is a great income stock, with a current yield of 5.6%. I expect to own this company for many years, if not decades into the future. It is one of those sleepy little stocks that end up quietly turning into an enormous winner over time.

I prefer price-to-book value, but it makes no sense to be blind to other techniques that have worked over time. Enterprise value-to-Ebitda has been an effective measurement of corporate value. Combining it with F scores and Z scores can help find safe, cheap stocks with the potential for strong performance.

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At the time of publication, Melvin is long SGU.

TAGS: Investing | U.S. Equity | Stocks

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