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Financial Ratio Analysis: Sometimes Rules Of Thumb Do Not Work

Anyone who has ever tried to value a company has used some rules of thumb when conducting the financial ratio analysis. For me personally, these form a base upon which various screens and shortlists are structured. Looking for undervalued stocks can at times feel like looking for a needle in a haystack, and these rules of thumb can come in very handy to ease the screening process and get to the shortlist faster, so we can quickly commence the joyous process of reading the appropriate financial statements and conducting a deeper due diligence on each stock. So what kind of financial ratio analysis we are talking about? Which rules of thumb? Let’s start with some key valuation ratios. Insisting on a Low P/E Ratio may Cause You to Miss Greatly Undervalued Stocks Price/earnings ratio is one of the cornerstone ratios upon which many a screen is built. A typical value investor is very likely to add a P/E ratio filter in his or her screen. The rule of thumb that is used in this case is to keep your P/E ratio under 15. Some aggressive value investors (or more conservative, depending on your point of view) might filter out any stocks with P/E ratio above 10. The Problem There are cases where a company may see a temporary drop in earnings. This may be due to short-term difficulty, an unusual non-cash charge to the earnings, or for any multiple reasons. For example, an insurance company may face a large claims payout in a given year due to a vicious hurricane. This event is statistically not likely to be repeated every year and the company otherwise is healthy. This year’s earnings though are abnormally low, and hence, the P/E ratio is likely to be very large (Most sophisticated investors realize the short-term nature of this event and are unlikely to punish the stock price too much knowing that the earnings will recover quickly). Is this stock likely to be undervalued? Chances are, it is. Temporary distress creates opportunities. The problem is that a low P/E ratio screen will filter these opportunities out. The Solution A low P/E ratio screen still remains quite important. However, we would like to find these edge cases because most of the investors will not bother. While undervaluation is hard to find when the P/E ratios are higher, the ones that do exist are likely due to unusual situations, and can show a much larger profit potential. An easy screen to run is to create a screen with very high P/E ratios – let’s say 100 or more. One can also look at negative P/E ratio screens. With the stocks that these screens throw up, we will then go through them one by one and review their situation to find out whether an unusual situation exists (we will review these in detail), or if the stock is just normally overvalued with investor froth (we will ignore these). Insisting on a Low Price/Book Ratio may Cause You to Miss Some Outstanding Ideas Normally, value investors like to keep their Price/book ratio to be under 1. The idea is that there is enough equity in the business to justify the price being paid for the shares, so if something were to happen to the profits in the future, the stock price has assets backing it up and supporting it (so the likelihood of losses is lower). Other investors might be less conservative and will be okay buying a stock with P/B ratio up to 1.5. One should note that the nature of the business also dictates the correct P/B multiple one should be willing to pay. A service company, for example, that relies less on physical assets and more on human capital will sport a larger P/B ratio in normal course of business than a different company with a number of factories and equipment. The Problem It should come as a no surprise to anyone that the book value of the assets can be at large variance with what these assets will truly fetch in the market. Sometimes the book value is overstated, in which case we may consider a stock to be undervalued where as in reality it is not. Sometimes on the other hand, the book value is understated, in which case the stock may appear to be richly valued, even though in reality it may be a great investment. We also have situations where a company may have spent years destroying shareholder wealth to the point that the retained earnings and shareholders’ equity have become very small or even negative. If the business is now in a turnaround situation and the equity can be purchased at distressed levels, this may be a great investment. A very high or a negative P/B ratio will rule out these kinds of investments. The Solution We could screen for very high P/B ratios. Many of the stocks that come up will be anomalies that we will need to review in detail. In the past, we invested in TPL which carried almost a million acres of Texas land on its book at zero value since the land was acquired over 200 years ago and was fully depreciated by now. Given that the reason this trust exists is to monetize this land, its sole asset, it would have been curious if one did not wonder why it carried no real estate on its books, and why its P/B ratio was so high (21.52 at the time of writing). This case though does require looking into the books in greater detail. In case of high P/E ratios, the anomalies are normally easier to find and explain. Assets may be buried in the books for years inflating or deflating the stated book value, and unless we dig deep, we may never know the fact. Conclusion: Use the Rule of Thumb for Convenience, but Venture Outside the Box Occasionally So, if you miss some ideas, what is the big deal? There are many more, right? True. However, these many more ideas have a larger number of eyes already fixed on them. So, while you may find them, they may not have as great a profit potential as the stocks that keep under the radar for one reason or other. These two examples are how some stocks that may be undervalued continue to evade investors as they do not get caught in their screens.

Oil Prices- The Asset Allocation Perspective

We see meaningful contagion, should an unexpected decline in oil prices spill over to equity and credit markets. We usually see lower energy prices as a net positive for riskier assets such as equities and high-yield bonds. Despite the recent declines in energy prices, we maintain our modest overweight to equity and high-yield bonds. With oil prices continuing to fall we have been spending an increasing amount of time analyzing and debating the impact of lower energy prices on our portfolios. In the short term our main concern is that we see meaningful contagion, should a sharp and largely unexpected decline in oil prices spill over to equity and credit markets, resulting in a significant “risk-off” event. To some extent we have seen that happen over the last few months, but considering that West Texas Intermediate (NYSE: WTI ) Oil has declined 40% since June 30, the impact on U.S. equities and credit markets has been relatively modest so far. The closing of a mutual fund last week – Third Avenue’s Focused Credit Fund – received a significant amount of media coverage and has continued to spook the markets this week. But we must be careful not to apply what happened to this specific fund to the broader credit markets. Specific to the Third Avenue fund, it was modest in size and held a significantly greater amount of distressed assets than the vast majority of dedicated high-yield bond funds. So while risks are no doubt elevated, we think the probability of a full-blown credit crisis remains relatively low. But if oil falls further from already low levels, the potential for contagion increases. As asset allocators with a long time horizon (strategic time horizons of 10+ years and tactical horizons of 12 to 18+ months), we usually see lower energy prices as a net positive for riskier assets such as equities and high-yield bonds, particularly for countries that are net importers such as the U.S. and most of developed Europe and Asia. The argument is that gasoline prices act like a consumer tax: when prices decline consumers will spend more, stimulating the economy. Yet the speed of the decline is increasingly concerning, as is the fact that the credit market is structured differently than it was during other periods when oil dropped quickly. Two of these structural differences in the credit markets concern us. First, dealers are holding significantly less inventory as a percentage of total issuance. This is the result of post-crisis regulation that limits dealers’ ability to be the source of liquidity to the extent they were in the past. Secondly, the credit sector is much more exposed to energy today than in the past. This is the result of the availability of cheap credit over the past several years, combined with expectations that energy prices would remain well above the marginal cost of production. Despite the recent declines in energy prices, we maintain our modest overweight to equity and high-yield bonds. We believe the higher interest rates offered by high-yield bonds compensate investors for this risk. But we remain focused on this issue and re-evaluate our view daily, given the increased volatility in energy prices and the broader markets.

Aqua America – A Retirement Stock

Analyst project positive revenue and earnings. Financial strength A-. Great price momentum. Retirement investing is a little different than the Total Return Investing you may have been doing all your life. You used to swing for the fence knowing that time, volatility and regular capital additions to your portfolio would prove the principles of long-term dollar-cost averaging. During retirement and distribution phase of your life, dollar-cost averaging works against you and becomes your worst enemy. Your new goals are: Capital preservation A conservative total return that exceeds your withdrawal rate, taxes and inflation A return that beats the market You fully research a stock and make sure you have the information needed to rationally decide the stock is a good addition to your portfolio. I use a screener provided by Barchart to find stocks that currently are having a positive price momentum and then make sure they fit the criteria listed above. When I screened the Russell 3000 Index stocks today, Aqua America (NYSE: WTR ) was right near the top of the list. Aqua America is one of the largest U.S.-based, publicly traded water utilities and serves nearly 3 million people in Pennsylvania, Ohio, North Carolina, Illinois, Texas, New Jersey, Indiana and Virginia. First I make sure the stock is outperforming the market. Why would I want to add a stock to my portfolio unless it significantly does better than the market? I use the Value Line Arithmetic Index as my Market benchmark for 2 reasons: 1) it contains 1,700 stocks with a total capitalization of almost 95% of the U.S. stock market, and 2) it is not weighted by capitalization, so the big stocks have the same weighting as the small ones. During the last year, while the market was down 2.79%, WTR gained 17.30%: I like to research the stock’s underlying fundamentals to see if that price momentum is warranted. Market Cap $5.28 Billion P/E 23.26 Dividend yield 2.45% Revenue expected to grow 4.80% this year and another 5.30% next year Earnings are estimated to increase 5.80% this year, an additional 7.10% next year and continue to compound at an annual rate of 5.55% for the next 5 years Financial Strength A- The overall sentiment of the investing community is very important. A stock will not maintain its upward momentum is some of the major players are starting to bail. Wall Street analysts have issued 4 strong buy, 2 buy and 4 hold recommendations on the stock to their clients Institutional investors own about 48.18% of the outstanding shares. During the last year, 170 added to their positions, while 140 decreased their shares for a net gain of 1.998 million shares Insiders decreased their positions with 22 buys and 36 sells but the net result was only down 225,665 shares On TheStreet, Jim Cramer’s staff gave the stock an A+ buy rating I like to follow the individual investors on Motley Fool, and its readers voted 540 to 32 that the stock will beat the market Short sellers have almost doubled their positions from around 2.846 million shares at the beginning of the year to 5.747 million shares recently I use Barchart for technical momentum data and only consider day from the current 6-month period: 100% technical buy signals Trend Spotter buy signal Above its 20-, 50- and 100-day moving averages 9 new highs and up 3.75% in the last month Relative Strength Index 63.29% Barchart computes a technical support level at 29.02 Recently traded at 29.99 with a 50-day moving average of 28.71 I try to compare my stock to the largest 3 stocks in the same sector. In the Water Utility sector, Aqua America gained 17.30% in the last year, while America Water Works (NYSE: AWK ) gained 14.00%, Companhia de Saneamento Basico do Estado De Sao Paulo (NYSE: SBS ) lost 23.21% and American States Water (NYSE: AWR ) gained 22.19%: Additional comparisons: American Water Works Market Cap $10.56 billion P/E 21.82 Dividend yield 2.40% Revenue expected to grow 5.40% this year and another 4.90% next year Earnings estimated to increase 6.50% this year, an additional 7.20% next year and continue to increase at an annual rate of 7.34% for the next 5 years Wall Street analysts issued 4 strong buy, 7 buy and 5 hold recommendations on the stock Financial strength B+ Companhia de Saneamento Basico do Estado de Sao Paulo Market Cap $ 3.02 billion P/E 44.00 Dividend yield 1.94% Revenue expected to decline by 53.50% this year but grow again by 16.50% next year Earnings are estimated to decrease 66.10% this year, increase by 168.40% next year and compound at an annual rate of 12.30% for the next 5 years Wall Street analysts issued 2 buy and 2 hold recommendation on the stock They did not rate the financial strength America States Water Market Cap $1.53 billion P/E 24.19 Dividend yield 2.23% Revenue expected to decline .70% this year, rise again by 4.10% next year Earnings are estimated to increase by 1.30% this year, an additional 6.30% next year and compound at an annual rate of 4.00% for the next 5 years Summary: My opinion is that the 2 best in the sector are WTR and AWR, but I think Aqua America has a slight edge. It has good price momentum, stable revenue and earnings projections, high financial strength and is expected to give investors an annual total return in the 11% range for the next 5 years. Below I have included a chart of the price against the 20-, 50- and 100-day moving averages plus a 14-day high/low turtle chart, which shows recent upward price momentum. If you’re looking for an exit point to protect your gains, the 50-100 Day MACD Oscillator has been a reliable technical trading strategy for this stock.