Consider Applying a “Garage Sale” Mentality to Investing

TK All-Star posted on 04/19/12 at 09:28 AM

Alan Brochstein takes a look at stocks with no Wall Street analyst coverage

Have you ever held a garage sale? If so, you likely noticed that someone always shows up well before the posted starting time. As annoying as this practice may be, it makes sense. The would-be-buyer wants to get a look at the goods before the general public arrives, hoping to find a bargain by getting in front of other potential buyers. Sometimes the shopper can arrive during the regular hours and still snag a great deal, especially if he or she is knowledgeable about the underlying value of the merchandise and able to discern a significant mispricing.  

The stock market in many ways resembles a garage sale. Every single day, almost every single share of stock trading is in an issue that is “used”. The market opens at 9:30 EST, but many folks show up early (pre-market) to try to get a jump on a stock, particularly if there is news, before the market opens. That can work, but I think a better way to apply garage sale bargain-hunting mentality is to be more knowledgeable about a stock than others, looking at stocks out of the limelight.

How can the small investor become more informed about a stock than big investors? It’s not likely to be by focusing on big companies, many of which are held by thousands of institutional investors and followed by tens of Wall Street analysts. It’s somewhat of a challenge for many individuals, but it can potentially pay to step out of the zone of high familiarity and focus on companies that most people likely don’t know even exist.

Many of these companies will be very small by definition, but often even larger companies don’t command a wide following. There are many reasons, including a lack of Wall Street analyst coverage, limited communication with investors, and a low float. Wall Street has cut back in recent years and has had to prioritize its research efforts. Smaller companies, those in several different lines of business and those that don’t engage in acquisitions are likely to be on the short-end of coverage. If a company has limited or no “sell-side” coverage, many institutional investors won’t buy the stock.

With the goal of finding some potential hidden gems, I ran the following screen using Baseline:
  • Member of the Russell 3000 Index
  • Market Cap > $500mm
  • Net Debt to Capital < 10%
  • Price to Tangible Book Value < 2X
  • Trailing PE < 15
  • 10-year Compound Sale Growth > 6%
  • 10-year Compound EPS Growth > 10%
  • 5-year Compound EPS Growth > 0%
  • 1-year EPS Growth > 15%

This screen is designed to identify companies with strong balance sheets, solid long-term historical growth in sales and earnings, recent above-market earnings growth and reasonable valuations. It’s just an example of how one can cull through a broad list of stocks to find those meeting certain criteria. While 8 companies qualified to make the final list, I am including only those with no Wall Street coverage:

Please remember that these are not recommendations. I am familiar with but don’t closely follow the three companies discussed and have used this exercise to demonstrate the concept of identifying companies with certain characteristics but a lack of analyst coverage. You should always do a thorough investigation of any company before investing in it.

I included some the same parameters for the S&P 500. As you can see, these stocks all trade below the 13.3 trailing PE for the S&P 500, though each of them has significantly outperformed (in terms of price) over the past decade. They have also all outperformed in terms of sales rate as well as earnings growth over the past ten-year, five-year and one-year periods.

Contango (MCF), by the way, is a rather unique natural gas-focused company that has just seven employees and is focused on smartly investing in new discoveries. National Healthcare (NHC), which currently has a 2.7% dividend yield, provides long-term health-care in the southeast. Seaboard (SEB) produces pork and turkeys, processes grain, produces sugar, provides electric power generation and provides ocean shipping.

These three companies are quite diverse in many ways. Each operates in a different part of the economy. SEB is very international, while the other two are domestically focused. While none of these is household names (though SEB owns half of Butterball Turkey and has many familiar brands). Even in price, they differ, as SEB trades at a price far from the average in the market. Stocks typically don’t get close to $2000 by accident! It takes a lot of success. While buying just 5 shares of a stock may not sound like a lot, a 10% gain could possibly result in a $1000 gain in the investment. SEB actually traded as high as 2705 last July. These companies all have excellent long-term track-records, and my impression is that they are all quite good at what they do, whether people are watching them or not!

One of the things I like to see in off-the-radar companies like these is what I call “alignment with outside shareholders”. This means, in simple terms, are the people in charge (the officers and the directors) acting like shareholders or hired help? I like to thoroughly review the proxy (DEF 14A), which is filed annually, where I can see how much they are paid, how much cash compared to stock compensation, what the bonus incentives are and how much stock they own. In the case of these three companies, insiders own approximately 75% of SEB, 26% of NHC (not including an employee fund of 11%) and 17% of MCF, all quite substantial. It’s important to read the 10-K (annual report) as well to make sure that the prospects remain favorable.

Just because a company isn’t widely followed doesn’t suggest it is a bargain, but often successful companies without a large following among Wall Street analysts or institutional investors can present a better-than-average opportunity for individual investors willing to invest their time in understanding the company. In this case, I have shared an example of three companies that appear to justify such further research. If you are a long-term investor, taking a “garage sale” mentality into your own investment process will hopefully lead to some great finds.

Alan Brochstein
Founder, Invest By Model and AB Analytical Services
TradeKing All-Star Commentator

Disclosure:  No Position in any stock mentioned.

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Posted by TK All-Star on 04/19/12 at 09:28 AM


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