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Monday, November 05, 2012


Today we will try to get back to business as usual in the markets. The earnings reports will begin to dominate the news once again. The bulls will look for any positive sign to be buyers as we head into year end and the bears will celebrate any signs of weakness. I will simply sit back and apply my usual sense of cynicism to the whole show. I confess that at this point I am most cynical about the bull case for the market. Earnings are following the same revenue light pattern with lowered guidance we have seen all year.  The economy is still solidly in better but not good mode and Europe is still a mess. The only real bullish case is low interest rates and as powerful as that has been I am not sure it is enough to keep moving the market higher.

My opinion on market direction does not matter that much as I am not a trader and evaluate stocks on a case by case basis. Once I was done updating my infrastructure and banking files this week I spent some time playing around with Piotroksi F-scores. They have been found to be very predictive of future stock price movements when combined with valuation and I used them in several ways the past few days to uncover opportunities. My cynical side also led me to use them to find some stocks that are best avoided by investors right now as a result of low scores and high valuations.

One thing I found interesting was how many of the growth darlings actually have a Piotroski score of 5 which is the line in the sand for using F-scores. Above 5 indicates potential outperformance and below that level is negative. 5 is just lukewarm market tracking stocks according to my research. Stocks that score a 5 but have been over loved include Chipotle (CMG), Intuitive Surgical (ISRG), Baidu (BIDU) and Broadcom (BRCM). Given their high valuation and middling scores I see no reason to own these stocks right now.

The other thing I note is that almost all of the large cap Real Estate Investment Trusts have a score fo 5 or lower. This group is overbought, overvalued and over loved by asset allocators. As much as I love real estate as an asset class for the next decade the large cap REITs are priced for perfection and beyond. Some of the REITs with scores below 5 include Equity Residential (EQR), Prologis (PLD) and SL Green (SLG). Given the high valuation and low F-scores I would not be willing to own the group and would consider shorting them if they continue to rise.

Telecom companies do not fare much better. Both AT&T (T) and Verizon have f scores of 5 and is highly unlikely in my mind that these stocks do any better than the broad market for the next year or so. Both have had a great run the past few years but there is no solid reason to buy them here. Century Link (CTL) has also done very well but now has an F-score of indicating strong possibility it lags the market over the market going forward.

One of the biggest stocks out there with very high valuation and an F-score indicating underperformance is Facebook (FB). I like the service and have a fairly active Facebook account to keep in touch and share ideas with friends and family all over the world. In spite of that I have been skeptical and bearish ion the stock since days one. I do not think they will be able to figure out how to monetize the user base using the current model. I do not know anyone who clicks ads on the site or buys products based on Facebook pages. I don’t think they ever convert to a subscriber model either. Facebook will be with us for a long time I suspect but it won’t be the wild growth stock some expect. With very high earnings and asset valuation and an F-score of just 4 I would avoid the stock and short strength in Facebook.

Now that I have embraced my inner cynic I will get back to my bread and butter and spend the rest of the week sharing some F-score based discoveries of safe and cheap stocks as well as longshots with a high probability of hitting the jackpot in the years ahead.

During our unscheduled market holiday I spent a lot of time doing research using Piotroksi scores. The F-score model has been a valuable tool in my arsenal for uncovering value stocks with high appreciation potential and I am looking at new ways to use the model. As we all know however, there is certain amounts of validity to the concept of its not broken do not try to fix it. The original research paper that introduced the model by Professor Joseph Piotroski was focused on stocks trading below book value ranked by F-score. Those with high scores outperformed the overall market by a wide margin.

With that thought in mind I sat down and ran a basic screen using the model I looked for stocks with scores over 6 that traded below book value. In my first version of the screen I added some financial strength criteria and only included those companies with a current ratio over 2 that owned as much as they owed. This should give us a list of financially strong companies that were cheap and had improving fundamentals and prospects.
My first observation is a familiar one. The list of companies that make the cut is shrinking rapidly as the market as churned higher.  There are only 134 companies listed on US exchanges that fit the bill. Only 31 of those are over $100 million in total market capitalization. Only 7 are larger than $1 billion in market cap. There simply are not that many solid companies with good fundamental prospects that trade below tangible book value right now. That is something of a red flag to me in terms of overall stock market potential over the next several months.

The largest company that is attractive to me is an old friend. I have owned Rowan Companies (RDC) before and think the company is well positioned for the future. The company has divested its non-core land drilling and manufacturing division Rowan is now focused on offshore drilling rigs. The company built three ultra deep-water rigs without contracts and it looks like the gamble is going to pay off for Rowan and its shareholders. The first of the new rigs is now under a three year contract with strong day rates.
The stock has been down this week after missing the always highly accurate analyst estimates.  The stock now trades at just 90% of tangible book value and has a Piotrokis score of 6. Given the offshore and deep water focus of the company the cheaper the stock gets the more likely a takeover becomes in my opinion. They have very little debt and a solid balance sheet. Given the growth prospects of deep water drilling an acquisition would make sense for several larger competitors. Given the lack of leverage on the books I would not rule a potential financial buyer such as a private equity fund either.

Dawson Geophysical (DWSN) is energy related company that is cheap based on asset value and has a high F-score. The company acquires and processes seismic data for the oil and gas industry. Lower utilization and reimbursement rates put pressure on revenues in the third quarter but management has said they expect conditions to improve for the rest of the year. We will find out this week when the company reports earnings.

The company has done a good job of transitioning form natural gas research to more oil related seismic services. They are also expanding into Canada and expect operations to begin in the great white north next year. Dawson spent a lot of money expanding its equipment portfolio as well as adding new crews last year and 2013 looks like it may be the start of a solid payoff for the company. The stock trades a little bit below tangible book value and has an F score of 8 so the fundamentals are already beginning to improve. The company has minuscule debt and a strong cash position so they are well positioned to grow as the economy recovers and oil and gas demand picks up.

The current list of cheap stocks with solid balance sheets and high f scores is very limited right now. Energy names dominate the list of larger market cap stocks which makes sense since this is one of the cheapest sectors right now. As we have increasingly found the last two years the really interesting companies are microcaps that are not in the tradable indexes or ETFs.

 The F-score is a useful tool in all steps and stages of stock selection process but it really shines in finding investments with a little more of a long shot flavor to them. These are companies that are carry more debt that n I would usually consider and traded at steep discounts to their asset value. A high F-score indicates to me that the fundamental s of the company are improving and they are generating sufficient cash to carry the debt load and there is a high probability the two edged sword of leverage cuts in our favor.

Once again in running the screen for leveraged companies trading below tangible book with high scores I note an unusually short list of candidates. Just 24 US listed names make the final cut. Only 8 of these have a market cap in excess of $100 million. There is only one stock with a market cap over the billion dollar mark. The list of opportunities for cheap stocks is getting shorter and smaller as the market has worked higher this year.

It is still a pretty interesting list of long shot cheap stocks. One my favorite REIT investments made the list. Arbor Realty (ABR) is higher than out original purchase price by a comfortable margin but fundamentals keep improving and the stock is still a solid buy in my opinion. The shares trade at 80% of the $7.58 tangible book value and management estimates that total asset value after adjusting for swaps is over $11 a share. Arbor has been making loans and originated more than $80 million of new loans during the quarter. They also purchased $30 million of residential mortgage securities in the quarter. After a solid quarter Arbor management raised the quarterly payout by 10%. The company has an F-score of 7 indicating a substantial chance of strong appreciation in addition to the dividend payout.

The aircraft leasing business is well represented on the list as well. I recently highlighted AerCap Holdings (AER) as a cheap stock with a high ranking from S&P. The stock still trades at less than 70% of tangible book value and has an F-score of 6. Aircastle Limited (AYR) also has an F0score of 6 and trades at less than 60% of tangible book value. Aircastle has a portfolio of 155 jet aircraft that are leased to 64 different airlines around the world. The fleet is 98% leased with more than 4 years of average lease life so cash flows should be relatively stable for the company. The shares currently yield 5.4% at the current price.

Another one of those pesky shipping companies makes the list as well. I am gun shy due to past poor results from shipping stocks but they are constantly showing up on my lists of cheap stocks with high long term appreciation potential. Global Ship Leasing (GSL) is a container leasing company with 17 ships on long term leases to CMA CGM S.A, the world’s third largest liner company in the world, with an average lease life of more than 7 years. Unlike many shipping companies Global has been generating operating profits throughout the global recession with operating profits every quarter since the start of 2008. They have been using their cash flows to de-lever the balance sheet and paid off almost $140 million of debt in the past three years. The shares trade at around 50% of tangible book value and the improving fundamentals are reflected in the F-score of 7.

Using asset value and F-scores has helped me uncover some great opportunities over my career. Right now the list is small and most of the candidates are in industries such as aircraft leasing, shipping and commercial real estate, as reflected by the three companies mentioned, that have been hit hard by the economic weakness. As long as the world does not really end these should return to prosperity over the next decade and shareholders in these stocks should do very well.

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