I promised that I was going to be adding more value investing features to this website. One of them is going to be a weekly list of companies that pass a few of my custom value investing stock screeners. Each week I will highlight a different custom Value Investing screen I use when deciding to do further research on a company. This week I will highlight the 80-20 Screener;

80-20 Value Investing Screen

80-20 value investing Screen 8-19-11

I have attached a screen shot of part of my custom 80-20 Value Investing stock screener using Stock Investor Pro screen which is comprised of the following value investing elements:

Low Price to Book Value

1. Price to Book ratio in the bottom 20% of stocks screened. I have documented the low price to book strategy in the past.

High Piotroski F-score

2. a Piotroski F score of 7 or better. ( I will be high lighting this study in an upcoming article, that will be a must read article!) This helps weed out some of the worst companies.

Low growth in assets

3. The annual growth in total assets should be in the lowest 20% of companies screened (currently negative double digit asset growth). Studies have shown that companies with the lowest 20% of growth in assets outperformed the market as a whole.

Pass the Z-score

4. A passing score on the appropriate Altman Z score. That means above 3.o for Manufacturing companies and 2.6 for other companies.- This is for downside risk protection since the Z score helps warn of potential bankruptcies.

Good Net Current Asset Value

5. Net Current Asset value equal to or greater than 1.25 times market cap. I am looking for companies with assets close to NCAV.

Current Price Earnings Historically Low

6. Ratio of current P/E to 7-10 year P/E is less than 1.  I borrowed the next two criteria from James Montier.

Low Price to Sales

7. Price to Sales ratio  less than 1.

The purpose of this to aggregate multiple value investing criteria

Value Investing Ideas

I have not yet investigated any of the stocks on this list, but I intend to begin to evaluate at least one of the stocks a month beginning in the next couple of weeks, so please return.

Highlights of this weeks value investing screener.

Benchmark Electronics BHE is a new entry to this list and worth a look.

Several of these stocks trade with almost no volume or have very very limited financial information. Some of those include Chai-na-Ta Corp. CCCFF, Elegant Illusions EILL, Sonics& Materials SIMA.

Satyam Computers SAYCY is an Indian company that had a very large accounting scandal, so unless the issue of assets has been resolved satisfactorily, may be a false positive to passing the screen.

Good luck on your research, if you choose to take these companies to the next level of research. If you do, please report the results here.

Disclaimer: I do not currently have any holdings of any of the companies listed on the screener. I may without notice buy one of these equities, if I find it fits my investing needs. Nothing in this post or this website should be construed as investing advice. I am merely expressing my opinion and sharing what interests me in the value investing arena. Please do your own research.

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What is Low Price to FCF?

Two of the most important words in evaluating a company are Cash Flow. Old School Value Investors focused on Earnings. That is so 1950’s. I am not going to go into the details of Free Cash Flow. Please see the Chroma Investing Value Investing Terms FCF for a fuller explanation than I give here. The short version is that Free Cash Flow is what a company really has left over at the end of the year. It is the amount that you can turnover to investors in dividends, buy back stock, pay down debt or just let sit on your balance sheet.

Low Price to Free Cash Flow (P/FCF) is a measure that value investors find useful to analyze companies finances in relation to it’s current stock price. It is a stricter measure than the price-to- operational cash flow ratio as it backs out capital expenditures.  Here is the simple equation:

                                    Price to FCF = Market Cap / Free Cash Flow

A high ratio indicates that a company is expensive relative to its Free Cash flow. A low ratio shows that it is cheap in relationship to FCF. Like most of these value investing metrics you can reverse these and you will get the Free Cash Flow yield which is expressed as a percentage. With a Free Cash Flow yield, higher is better.

Simply put, Free cash flow is a measure of a company’s ability to generate cash, which is a starting point for stock pricing. Or as Warren Buffett said, “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

An easy formula for free cash flow is, FCF = Operating Cash Flow – Capital Expenditures. The numbers needed for the calculation are found on the Cash Flow Statement of the Financial Reports that a company issues in its 10K or 10Q.

How to use P/FCF in an Investment?

Let’s say you agree that using FCF can help you make your value investing decisions,  how might you go about it? Here are a few suggestions.

1. You can buy stocks in companies that are low in Price to FCF as compared to the market as a whole. That is you can compare the P/FCF of a company to that of the overall market. For example you could compare the FCF ratio of General Electric to the S & P 500. Although, I could not find this information on Standard and Poor’s own website.

2. You can compare Free Cash Flows to some arbitrary number, say 10 or 15. You may want to do this if you can come up with some historic norm for Free Cash Flow.  If you can review historical data of FCF over a long period of time, it is possible to come up with a normalized ratio. You could use that number as your comparison.  Again, this will be difficult since historic data for Free Cash Flow is difficult to obtain very far back.

3. You can buy a stock using P/FCF either as a solo investing criteria(not recommended) or in combinations with other factors. For example you might use FCF ratio with such metrics as low price to book, a high acid test ratio, high ROIC, etc.

4. You can buy a stock when a company has a Low P/FCF in relationship to its own 5, 7 or 10 year financial history. I always like to compare current ratios to historic ones to get a relative idea if this metric is cheap for this particular company.

5. You can buy the stock of a company who Price to Free Cash flow is low relative to its industry. In other words you take a look at Exxon’s FCF ratio and compare it to the oil industry as a whole to get a relative industry ratio.

6. You can buy a fund that specializes in Low Price to FCF. This may be an index mutual fund or an ETF. I don’t know of any pure play funds on Low P/FCF, since most value funds use a combination of factors, but perhaps there is one that has escaped my notice.

So, why is low price to free cash flow so important, that it is worth investing?

Importance of Low Price to FCF

Low P/FCF has been a good indicator in the past of what makes a successful investment moving forward. Let me give a few examples.

Peter George Psaras wrote a study called “Back-test showing the power of Price to Free Cash Flow in the Investment Process” where he back tested buying Low Price to Free Cash Flow stocks from the Dow Jones Industrial Average for 1950 to 2007. His criteria was simple: buy every stock that had a Price to FCF ratio less than 15 and sell it after a year. The results were remarkable. The performance was 22.77% on average over the 58 years. The average gain for the DJIA was only 7.82% for the same period.  Quite an outperformance

I asked myself the question, what does this mean right now? So I created a stock screen with Stock Investor Pro using data from last Friday August 5^th. Here are the companies passing the screen:

I am not recommending any of these companies, but it does give you some idea why some high profile value investors are interested in Microsoft, Pfizer and Cisco to name a few. Perhaps a few of these companies are worth some further research.

Other investing studies have used the less stringent  Low Price to Cash Flow ratio (P/CF). Let’s see if there was a similar outperformance.

Does Low Price to Cash Flow work in shorter time Frames?

In their study, “Contrarian Investment, Extrapolation and Risk, Josef Lakonishok, Robert W. Vishny and Andrei Shleifer reviewed all the companies on the AMEX and NYSE from 1968 to 1990. They divided up the companies in to ten selections called deciles by Price to Cash Flow. They formed portfolios that they kept for five years. What they discovered is that the lowest Price to Cash Flow stocks outperformed the highest  Price to cash flow stocks on average during a holding period of 5 years. The average return for the  low P/CF stocks was 20.1% per year and amongst the high P/CF stocks it was only 9.1% with cumulative 5 year return of 149.4% to 54.3%. Perhaps not as exceptional as the Psaras study, but significant none the less.

This is one of those studies that is useful only in the abstract. Realistically an investor is not going buy the lowest  10% of p/cf companies on any exchange.  But it does continue to show that when you are considering value investing metrics that P/FCF should remain in the toolkit.

Low Price to Cash Flow Internationally

All this may be well and good in the United States, but do these kind of value investing metrics work abroad? A Michael Keppler looked at this in his study “Further Evidence on the Predictability of International Equity Returns: The Importance of Cash Flow in Country Selection.” While he did not use FCF specifically, it is instructive. He found that from 1970 to 1989 in the eighteen countries studied that the lowest price to cash flow country indexes produced a result of 19.2% on average in local currencies compared to the highest Price to cash flow country indexes with a return of only 4.7 % in local currencies.

Since this was based on buying index funds this study has an actionable element. But it would require a little research. You don’t think I am spoon feeding you everything, do you? An investor could research index funds based on different countries stock markets. They would need to have P/CF information on each index (preferably FCF). Compare the indexes and pick a small basked of low cost to cash flow indexes.

If anyone does this research please report back.

Why does Price to FCF work as a Value Investing Metric?

No one knows for sure but here are a couple of my guesses.

1. Companies with low prices related to any value metric, Earnings, Book Value, Sales etc. are unpopular. Otherwise their price wouldn’t be low. Something is bothering the market, bothering it so much that it MAY be undervalued. Low Price to FCF investments are a contrarian investment by definition, and mostly people want to say they own Apple or Netflix, not Aeropostal or Microsoft.

2. Cash Flow may be more honest than earnings, a commonly used measure of a companies performance. As Damodaran said in his book Investment Fables, “Accountants measure earnings by subtracting accounting expenses from revenues. To the extent that some of these expenses are non-cash expenses … and because accrual accounting …does not always yield the same results as cash accounting, accounting earnings can be very different from cash flows.” (Italics are mine)

Having a healthy Free Cash Flow gives a company options. It is a sign of a financially sound company thriving in its industry. Free cash flow is often used for stock buy backs, dividend payments and in reducing debt.

Finding such companies is usually easier in a bear market ( like now) or when a company misses earnings, makes a mistake which leads to bad press, all of which can temporarily depresses its stock price. Investors finding such opportunities should, as they say, “strike while the iron is hot”.

Please come back each week as we write about various Value Investing Criteria to help you build your Value Investing arsenal. Add your comments if you have any thoughts about using  Low Price to FCF in investing. Finally, if you haven’t already done so, please sign up for email list (I promise I won’t spam you.) or like ChromaInvesting on Facebook.

Disclosures: I do not have any financial interest with aaii.com or Stock Investor Pro, but I am a paid member of the first and I have purchased the second for the past two years. I am making no recommendations on stock purchases or sales, just expressing my opinion on what I am exploring right now. I am not a professional investment advisor but a Film and television producer, thus everything here is for entertainment purposes only.

If you would like to download post you can here.

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The confirmed speakers are

Bill Ackman, Pershing Square
Leon Cooperman, Omega Advisors
James Chanos, Kynikos Associates LP
Adam Weiss and James Crichton, Scout Capital Management
Alexander Roepers, Atlantic Investment Management
Joel Greenblatt, Gotham Capital
Guy Gottfried, Rational Investment Group
Michael Kao, Akanthos Capital Management
Whitney Tilson & Glenn Tongue, T2 Partners

I can say that Michael Kao and Guy Gottfried were both very popular speakers at the last Value Investing Congress I attended in May. I am also curios to hear Jim Chanos speak, since he is a legendary short seller. Finally, Whitney Tilson is always good for the T2′s long and short actionable idea. If you decide to go be sure to use my Value Investing Congress discount coupon N11CI4

If you would like more information about this Value Investing Conference, or any other, please go to my Conference page which has the most up to date information on Value Investing Conferences.

Disclosures: I am a media sponsor of  the Value Investing Congress.

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The idea is fairly simple.

Set up some investing criteria, and when a stock passes the rules you buy it. You also create criteria for selling. Such as when the stock reaches a certain percentage gain you sell it. Obviously, you also need rules for selling after a certain period of time if your stock does not appreciate.  if you do not have a gain you sell after specified period of time you sell. Also, if you find a better value proposition I may need to sell a stock before I would otherwise sell it. I will attempt to keep this a mechanistic portfolio, that is to remove my opinions, gut instincts, the emotion,  from the process, as much as is possible. I will not do a lot of analysis. In many ways this will be like holding a Magic Formula Portfolio except that I will definitely have some element of asset value element in the criteria. This will be separate from the Small investor portfolio, and will start with more money, initially say $5000. This should allow me to hold 10 positions of approximately $500 each.

This will be a true experiment in the sense that I cannot forecast the outcome. There seems to be contradictory research out there that suggests that value investing is superior to growth investing, but also that human’s are certain psychological limitations that may limit us from truly maximizing returns, even if we know we are engaging in the limiting behavior. Thus the 80-20 investing Portfolio is an attempt to remove as many of my own limitations from the process as possible.

The biggest hurdle to this kind of investing is devising the system with which to follow. I have almost finished the development stage for  the criteria I will use for buy and sell signals. They will of course be value oriented and research driven. I will lay the criteria out in a separate post, that should be lengthy so I can refer to the research supporting the theory of investment criteria. If you have any thoughts on this subject I would love to hear them.

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Burry was the guru behind Scion Capital. He was a great stock picker and later made $100 million buying credit default swaps, investing against the housing bubble.

I am not going to recount the article. Read it if you are interested in what great investors do. It is a great read. I am just going to share with you the what I take away from the article.

1) Do not Follow. That means Warren Buffett, Seth Klarman or Mike Burry. You must come up with your own investment stategy. It has to work for you , if you want to be successful. Understand the principles of Ben Graham, but don’t be a slave to his ideas. “To succeed in a spectacular fashion you had to be spectacularly unusual.”

2) Use your differences to your advantage. Burry felt he was different because he only had one eye (although it turned out not to be his real difference). That is a good metaphor for most investors. We are all a little different. Understanding our differences and utilizing it to our investing advantage is imperative. I know this sounds a little self-helpy, but what the hell.

3) Bargains are found in the discard bin not on display at Tiffany’s. To be a value investor you must keep looking when others give up, or don’t understand something. Use your understanding of an industry, or circle of competence to your advantage. Burry referred to the “ick” factor. That is he ended up buying stocks of companies, where his initial reaction was “Ick.” But subsequent research revealed a value opportunity.

4) Never stop expanding your circle of competence. Burry taught himself investing. He taught himself about bonds, then the securities that were packages of subprime loans. He went where others simply did not tread, either because it was two difficult to understand, or assumed that since all the smart people were creating these issues, that betting against them was not a good idea.

5) don’t be afraid to short. I am of course not referring to actual shorting of a stock. Too much risk. But Burry found a way in Credit Default Swaps (CDS) to invest against the mortgage bonds.

6) just because someone tells you an investing idea is bad, even if they can articulate why, doesn’t mean you shouldn’t invest in it. Some investors like Monash Pabrai like to attach probabilities to an investment. If the probability of success is high, make a larger investment proportionally. I won’t call it probability, because I don’t believe anyone can accurate assess the probability of success in the investing world. There are simply too many unknowns. But that does not mean we cannot assess whether or not our investment thesis is stronger than another investment idea.

7) Don’t get emotional about your investments. I have stated this before on this blog. But it is always worth remembering and I am reminded of it from Parker’s comment.

If you read the Vanity Fair article, please let me know if you culled something interesting that I missed, particularly if it was really obvious.

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The important distinction between Value Investing and speculating is that Value Investing involves research, and some analysis. Mostly, it is about properly valuing a company and buying at a discount to intrinsic value. Speculating requires you guess the correct direction of a market, stock or commodity. Within that statement I am not sure that this concept actually falls within the simple concept of value investing I just laid out. The paper is called The Asset Growth Effect in Stock Returns by Cooper, Gulen, and Schill. You should read it. It is not hard to follow. And they do a better job than I do of explaining their own findings. However for the 80/20 people…

Here is the concept: take all non financial, US stocks and look at their growth in assets, Total Assets( t)- Total Assets( t1)/ Total Assets (t1). Then you arrange then in deciles (10% groups) from highest to lowest. The lowest deciles of Asset growth stocks beat the highest decile by more than 20%/year. This equals a return of 23.28%. Not too shabby. But this is another typical value investing idea that is sort of like Einstein’s theory of relativity. The more you explore the more it defies the world that you know. This research seems to imply that hi ROA companies are likely to experience sub par returns while low ROA companies will likely have outsized returns. Isn’t that contrary to everything we learn in Investing 101? But if you look at Table 1 of the study, the high asset growth companies have an average ROA of 21%. Sounds great, right? The low asset growth rate stocks averaged -3.1% ROA.

There are actually a couple of problems for the practical investor. First, the strategy seems to require a relatively large outlay of stock purchases, which is simply not feasible for the small time investor. If you are required to buy 10% of the stocks evaluated that is hundreds and hundreds of stocks. Second, the What is wrong with Back Testing phenomenon is also important to take note of here. Any back tested concept that requires a specific purchase date and rebalancing time frame, has the potential to buy and ineffective or unprofitable times, when a less inflexible model might not. But who knows. I am still reeling from the concept that low ROA may be good.

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I have discovered a blog that sifts through Finance Studies to look for papers that can help with investing. The blog is called the Empirical Finance Research Blog. While it may sound dull, it is actually a terrific resource. The writer reviews financial papers and then evaluate them for practical investing on a scale of 1 to 10, 10 being the best. He also lays out his proposed investment strategy based on the research. One of the best aids I have found. I have one complaint. And it is selfish. The blog posts irregularly. His last post was from January.

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But what is back testing? It is a process where one takes an idea like investing in low price to book stocks. You formulate a method, for example, that you will buy only price to book stocks in the lowest quintile (20%) on the last trading day of the month and rebalance your porfolio quarterly. Then you test this idea in past period of time. These are usually tested over longer periods. In my post last month about Ben Graham’s Stock Selection Criteria, Oppenheimer back tests the strategy from 1974-1981. In the post on Buying Low Price to Book stocks, Ibbotson back tested from 1967-1984.

I have used these and other academic studies to form the basis of an investment strategy that underpines this website. In fact, it was some of this same back tested research that sparked the idea of 80/20 investing, which I am still developing. But I am not an academic, I am a small time investor. And like many of you, I am really only interested in real returns. So I am keenly aware of some of  the practical limitations of back testing. When I began my research on Graham, years ago, I was puzzled by something. Graham had developed a set of investing criteria. And someone set up a fund that set out to capitalize on this method. The studies show that it should have worked. But it didn’t. The fund had to disband a few years later. Why? What was the disconnect?

So what is the Problem with Back Testing? It turns out there are several Problems for the practical investor.

1) Friction- Friction are the Brokerage Commissions, taxes and bid-ask spread issues that Damodaran referred to. Broker commissions and taxes you can calculate, but because many of the value investing approaches studied deal with small cap stocks that are often illiquid, the difference between the bid for a stock, the amount an investor is offering to buy the stock at, and the ask price, that is the price the seller of that stocks is asking for, can often be quite large, sometimes 10% or more. This cannot be easily calculated in an academic study.

2) Buying on an arbirtrary time frame- For academic research you must attempt measure results over a given time , with specific criteria, but the best deals will not always occur on the end of the month, or once a year.  Rebalancing at mechancial intervals, may also limit your profits, by telling you exit a position too early or too late.

3) Survivor bias- Taleb speaks about this as  a general problem with the investing community in general, and economists in particular. Is the back testing incorporating the number of companies that fit the strategy but failed or when bankrupt?

4) Portfolio limits- If you have a limited investing portfolio such as $5,000, you cannot know going into a year knowing how many opportunities you will have. With such a small portfolio you cannot possibly invest in every opportunity that arises. But that is the very assumption you supposed accept. If 40 opportunities arise, you buy all forty, and if five arise then buy only five. In what proportions? Do you leave everything else in cash?

Are their any solutions to these problems? Some. But not neccessarily solutions that you will be happy with.

1) Friction- There are several ways of dealing with the friction issues. Some I have written about before. For brokerage commissions, select a good discount broker or one that doesn’t charge fees for maintaining a certain balance. Tradeking, my primary broker, charges just $4.95 a trade. Taxes can be controlled by  investing in tax advantaged accounts like ROTH or traditional IRA’s. But bid-ask spreads are a little trickier.  My favorite strategy is to sell on good news. I have noticed that the volume on thinly traded stocks tends to go up when there is good news and investors are trying to buy the equity. Since value investing is also a contrarian strategy, good news is often a catalyst for a price rise and a good opportunity to exit a position. Another tactic is simply patience. Set up flags when a stocks price reaches a certain price. Then put in a limit order. And wait.

2) Buy when opportunities present themselves. Don’t be afraid of cash. It is a better alternative than losing money. I think Graham’s idea of holding for a 50% gain or two years is a good starting place for parameters to frame your investment horizon. But you shouldn’t completely exit a position just because you have reached a 50% gain, if your analysis suggests  a larger upside. Perhaps, in that instance you take a portion of your profits off the table. Two years should be the outside to hold an investment that is not performing. Maybe. If you discover a much better investing opportunity, two years could be too long.

3) Surviving Survivor bias. Look for tools to minimize the chances of a company failing. The most important thing is preservation of capital or as Buffett says, “Rule number #1 is don’t lose money. Rule #2 is don’t forget Rule #1. ” These tools may include the Altman Z score, the Piotroski F score and other more simple financial metrics such as the acid test.

4) Portfolio- Decide how many companies you are willing to invest in. Invest in great investment opportunties when they arise. Keep a Focused Investment strategy. It is possible that if you chose to invest in 8 companies, that after a price drop, one of the companies you have already invested in is the best value, and you should add to your position.

This does not mean a simple approach to investing cannot work. But I am more suspicious of mechanical investing that I was before.

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For followers of this site you will understand why this is doubly interesting to me.

First, it follows a value based approach to investing.

Second, it fits into the 80/20 style of investing.

Before I get to the interesting results, here are the 10 criteria that make up the new Ben Graham Formula.

1. An earnings-to-price yield at least twice the AAA bond yield.
2. A price-earnings ratio less than 40 percent of the highest price-earnings ratio the stock had over the past five years.
3. A dividend yield of at least two-thirds the AAA bond yield.
4. Stock price below two-thirds of tangible book value per share.
5. Stock price two-thirds “net current asset value.”
6. Total debt less than book value.
7. Current ratio greater than two.
8. Total debt less than twice “net current asset value.”
9. Earnings growth of prior ten years at least 7 percent on an annual basis.
10. Stability of growth of earnings in that no more than two declines of 5 percent or more in the prior 10 years.

According to the Gurufocus article The Investment Methods of Benjamin Graham. The first five criteria in the new Graham formula were related to reward and the second five to mitigating risk of loss of capital. One needs to select a stock with at least one from the reward and one from the risk mitigation section. Very few if any stocks will pass all 10 critieria.

Oppenheimer discovered that two of the Ben Graham criteria, number 1 and number 6, produced exceptional returns.

Oppenheimer found that the mean return during the time studied (1974-1981) was 38% vs. the S & P 500’s 14%. A remarkable out-performance.  He also found that using criteria 3 and 6 would have achieved mean annual return of  26%.

How do you use this criteria? Old Ben said to hold the stock for two years or 50% appreciation, whichever came first.

I wonder if this study has been updated or researched for a longer period of time. If it is still true, why would anyone try anything else. This may be the highest substantiated automatic formula I have ever heard of, and yet it gets strangely little coverage from Tweedy Browne.

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As Whitney Tilson of T2 investments said, “the overwhelming majority of great investors that I’m aware of practice focus investing. They invest infrequently, only when they’re highly confident that the odds are heavily in their favor, and then they bet big.” Focus investing is the same idea as the Buffett-Munger concept of only swinging at the Fat pitch. As Charlie Munger said at a Bershire Hathaway annual meeting, “If you took out our 15 best ideas, most of you wouldn’t be here..We have this investment discipline of waiting for a fat pitch.” You will get a lot of investment ideas pitched to you. Most you should let go. But when you see a pitch that is perfect for your investing style, one that you understand, one that is right where you like to hit, then don’t hold back and put everything you have into the swing. Finally Robert Hagstrom said in his book, The Warren Buffet Way, “Reduced to its essence, focus investing means this: Choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term market gyrations.”

Focus Investing  is such a fundamental part of my investing strategy, that I sometimes forget it is with me. I have never owned more than 10 stocks at one time, even though I have 3 trading accounts. Sometimes I have had more than one position in a company in different accounts. If it is a great idea, pile on. Every time I look at making a new investment I look at what I have invested in, and I look at the available investments that I am aware of and ask myself the question, is this a better opportunity than one I have already invested in? But more importantly, is it a great investment? Is it an investment idea that has so much going for it that is seems almost foolish not to put my money down.

For the small time investor or beginning investor, you do not have the time or fortitude to track the 30 plus equities that persons who recommend diversification suggest. The fewer companies you own pieces of the fewer places you have to watch for the proverbial ball dropping. You are more likely to understand the company. Focus Investing is ultimately like Value Investing itself. It either makes sense to you or it doesn’t. If it doesn’t try something that does work for you.

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