How to avoid the dash to trash

Business Times - 20 Jun 2009

SHOW ME THE MONEY

In the current fickle market, here's a way to find stocks that are potentially good long or buying candidates

By TEH HOOI LING SENIOR CORRESPONDENT

BACK in May 2008 - it seems so long ago - James Montier of Societe Generale wrote a global strategy report titled Joining the Dark Side: Pirates, Spies and Short Sellers. He screened stocks for three characteristics: a high price-to-sales ratio; deteriorating fundamentals (as measured by a low Piotroski F-score - I'll elaborate later); and poor capital discipline (as measured by high total asset growth).

'Each of these characteristics is a telling sign - but when combined, they become even more potent,' Mr Montier wrote.

According to him, over the period 1985-2007, a portfolio of such European stocks rebalanced annually would have declined more than 6 per cent per annum in absolute terms; in comparison, the general market was rising 13 per cent per annum. The basket of stocks suffered absolute negative returns in 10 out of 22 years. It underperformed the index in 18 of the 22 years. Similar findings hold for the US, Mr Montier said.

However, in the few years leading up to 2008, this strategy totally backfired. The basket of stocks that one was supposed to short, based on the above criteria, actually outperformed the general market. 'This attests to the extreme nature of the dash to trash that we had witnessed,' said Mr Montier.

In any case, in May last year he ran the screen and saw a record number of stocks passing the criteria for the short basket. Generally, such a screen would yield 20 stocks in European markets. But when he looked, the number of stocks totalled 100. In the US, the typical average number would be 30 stocks; last year, however, it was 174. 'The opportunities are on the short, not the long side, currently,' concluded Mr Montier. 'Perhaps it is time to join the dark side.'

Events have indeed proved him right. Now that prices have corrected significantly - despite the sharp rebound in the last three months, equity prices are still some 30 per cent below the levels in May 2008 - and the economy is supposed to be on the mend, perhaps we could try to do the reverse of what he has done to see what names we come up with as potentially good long or buying candidates.

First, let's go through the criteria. The first one for Mr Montier is valuation. From a short-seller's perspective, the most useful valuation measure is price-to-sales. According to Mr Montier, high price-to-sales stocks allow investors to hone in on counters that have lost touch with reality.

Here's what Scott McNealy, then CEO of Sun Microsystems, apparently said in 2002: 'Two years ago, we were selling at 10 times revenue when we were at US$64. At 10 times revenue, to give you a 10-year payback, I have to pay you 100 per cent of revenue for 10 straight years in dividends. That assumes I can get that by my shareholders.

'That assumes I have zero cost of goods sold, which is very hard for a computer company. That assumes zero expenses, which is really hard with 39,000 employees. That assumes I pay no taxes.

'And that assumes that with zero R&D for the next 10 years, I can maintain the current revenue run rate. Now, having done that, would any of you like to buy my stock at US$64?'

With that first criterion, I went to the Bloomberg terminal and downloaded all Singapore-listed stocks and their price-to-sales ratios. SingTel is trading at just over three times its revenue, Wilmar at 0.78 , DBS Group at 2.1 and CapitaLand at 4.6.

Singapore Airlines and Keppel Corp are both trading at less than their revenue - 0.93 and 0.84 times respectively.

The company that stands out from the rest of the big-cap stocks is Singapore Exchange (SGX). Its market capitalisation is a whopping 12.5 times its revenue. But the thing is, SGX raked in a net earnings margin of 62 per cent. So its price-to-earnings multiple is a more palatable 15 times. So for 'buy' candidates, the better measure would be price-to-earnings ratio, or my favourite, price-to-book (P/B) ratio - the lower the better. For the record, Mr Montier's short screen is for companies with price-to-sales ratios of more than one.

The second characteristic Mr Montier uses to sieve stocks to short is deteriorating fundamentals.

Here, he uses Joseph Piotroski's F-score. There are nine measures that relate to a company's profitability, the health of its balance sheet and its operating efficiency that one looks at to arrive at the F-score. The checklist is:

• positive net earnings;
• positive cash flow from operations;
• increasing return on assets (ROA);
• higher operating cash flow relative to net income;
• decreasing long-term debt as a proportion of total assets;
• increasing current ratio;
• stable or decreasing number of shares outstanding;
• increasing asset turnover; and
• increasing gross margins.

If the answer is yes for each item on the checklist, the score is one; no, and the score is zero. Companies with improving fundamentals will have higher F-scores (seven to nine), and those with deteriorating fundamentals will have low F-scores (below three).

Piotroski's strategy calls for buying a company with the requisite low P/B ratio and an F-score of eight or nine. Piotroski's research shows that low P/B stocks with high rankings are less likely to go bankrupt or to fall drastically in price than those with low rankings. This provides a greater safety margin.

Mr Montier's final criterion is capital discipline. Companies that have grown their total assets by more than a double-digit percentage will pass through his short screen.
So let's say our 'buy' criteria should be companies with price-to-sales of below 1.2 times, Piotroski F-score of more than seven and total asset growth of less than 20 per cent from a year ago.

The lone stock the screening process spits out is Singapore Petroleum Corp. Its market cap is less than half of its sales, and its Piotroski F-score is seven. And it didn't have a big asset growth in the year just ended; in fact, its asset base shrank 22 per cent. But arguably, investing in a depressed market may yield long-term rewards.

According to the Bloomberg screen, other stocks that come close to meeting the criteria (although not quite all of them) include SembCorp Marine, Keppel Corp, Cosco, Venture, SembCorp Industries, Yangzijiang, Noble Group and Thail Beverage. Readers, of course, are advised to verify for themselves if these stocks do indeed meet the criteria - and to decide if they deem the criteria sound enough, to begin with.