Don't lower your standards when picking stocks
Over a pizza late one night in college, a few male friends and I were discussing our “ideal woman.” Not surprisingly, we had similar visions — beautiful, intelligent, kind, sexy, fun. “But Chip,” said my friend Michael, “what makes you think this woman will be interested in you?” Chip was ready with his reply. “Well,” he said, “I figure when I get married, either the girl or I will have to lower our standards.”
In the realm of the stock market, people usually do lower their standards in some regard when they buy a stock. But when I run my “Old Faithful” screen, I look for simultaneous strength in several areas:
• Profitability. The return on stockholders' equity must be 15 percent or better.
• Growth. Earnings growth the past five years must average 15 percent or better.
• Balance sheet. Debt must be less than 50 percent of stockholders' equity.
• Valuation. The stock must sell for no more than 15 times the past four quarters' earnings and two times revenue.
Ten times since 1999, I have written a column recommending a few stocks from the Old Faithful screen. So far, the results have been excellent. My Old Faithful selections have been profitable nine times out of 10 (on a 12-month total return basis) and have beaten the S&P 500 eight times out of 10.
The average gain on my Old Faithful lists has been 29.8 percent, compared to 2.4 percent for the S&P 500 over the same ten 12-month periods.
The latest column, published April 30, 2012, lived up to the tradition. The four stocks I selected returned 31.2 percent through April 26, 2013, including dividends. Holly Frontier Corp., a refiner, led the way with a return of 76.4 percent. The sole loser was Cummins Inc., a diesel engine maker, which declined 2.2 percent.
Cautions: Past performance doesn't guarantee future results. Results of column recommendations are theoretical, and don't reflect trading costs or taxes. And the performance of my column selections shouldn't be confused with that of real-money portfolios At the moment, 21 stocks pass my Old Faithful screen, out of 3,310 stocks with a market value of $250 million or more. From these, I've selected five to recommend.
The largest, with a market value of $17 billion, is defense contractor Northrop Grumman Corp. (NOC), based in Falls Church, Va. I like it a lot, but feel that there are still more shoes to fall in Congress when it comes to cutting the budget in general and the defense budget in particular. Therefore, I would go in with half of a normal position now, and the rest in three to six months.
HollyFrontier Corp. (HFC), last year's big winner, still qualifies. Indeed, at six times earnings, it is the cheapest stock in the group as measured by price/earnings ratio.
It might seem strange to buy a stock after such a large advance, but one big gain doesn't necessarily preclude another. After doubling in 2004, Holly Frontier shares doubled again in 2005.
The cheapest stock in the group by price/book value ratio is Employers Holdings Inc. (EIG) of Reno, Nev., a specialist in workers compensation insurance. Shares go for only 1.3 times book value (corporate net worth per share). The price/earnings ratio is also cheap, at 7.
Employers Holdings has been profitable every year since it went public in early 2007. This year, analysts foresee a major profit drop, yet most of them like the stock.
Select Comfort Corp. (SCSS) of Plymouth, Minn., makes mattresses with adjustable firmness. It is the most profitable stock in the group, with a 42 percent return on equity.
Select Comfort is coming off of two years of very rapid earnings growth. This year analysts predict that earnings will only inch up about 1 percent. But I like the company, partly because it is debt-free.
One more that excites me is American Railcar Industries Inc. (ARII). Based in St. Charles, Mo., the company makes railroad cars, especially hopper and tank cars. Railroads have been doing well in this economic recovery, and gaining some market share from trucks.
Public since 2006, American Railcar has shown a profit every year but 2010. Last year it posted a record profit of $2.99 a share. Analysts look for the record to be broken with $3.65 this year.
Those are the five I'm recommending. If you want to find similar candidates, you can program my criteria into most screening programs used by individual investors, including those distributed by Yahoo Finance and the American Association of Individual Investors.
John Dorfman is chairman of Thunderstorm Capital LLC in Boston. He can be reached at firstname.lastname@example.org.