Uncovering Opportunities in All Markets

By Joe Ponzio on May 15, 2008  |  9 comments

In yesterday's comments, Vik, Jeff, Miguel S, and likely a number of others that did not post comments were curious: How the heck did I find Graham, and why was I looking at it in the first place? I think that question is posed to a lot of non-conventionalists that preach "FIND THE CASH FLOW!" and "BUY BUSINESSES WITH MOATS!", and then buy a bunch of companies that look a lot like overpriced or soon-to-fail garbage with little or no cash flow.

Legendary investor Peter Lynch said, "The person that turns over the most rocks wins the game. And that's always been my philosophy." You won't find a Graham Corporation — or any Small Fish for that matter — in a traditional stock screen for solid companies. Let's look at how you can turn over more rocks.

The Traditional Stock Screen

When screening for stocks on Morningstar, MSN, Yahoo!, Zacks, or virtually any other site, people tend look for some or all of the same characteristics:

• high returns on equity (or invested capital);
• 5-year revenue growth of 10%;
• 5-year earnings growth of 10%;
• low debt-to-equity ratio (less than 1 or 1.5);
• market capitalization over $500 million; and/or,
• positive free cash flow for up to ten years (on Morningstar Premium).

Wouldn't that be a wonderful company to own! If you find a company that meets these criteria and can be expected to do so in the future, you stand to make a ton of money. The problem is that companies like this are few and far between, and they don't usually sell at a substantial discount. While patience is a virtue, you have to remember that these are businesses — businesses that can have a bad quarter, a bad year, or even two or three bad years.

A single year of negative free cash flow at an industry leader isn't bad, but it's enough to get it kicked off the above list. A single year of bad earnings — particularly if it was the most recent year — might block it from the list. Here's the rub: the bad earnings would likely make the stock price plummet, thereby creating a potential opportunity. If you live inside this very rigid screening structure, you'll never see it.

What Is a Good Business?

A good business is one that can survive through the bad times and thrive in good times, right? When times are bad, prices get beat down; so, we would be wise to wait until the bad times — or just after the bad times — to start buying. I'm not talking about economic bad times (like we're having now) that send the markets down 10%, 15%, or more. The bad times are rough periods for an individual business.

Remember our Wal-Mart discussion nine months ago? Too short a timeframe to judge performance; still, Wal-Mart was experiencing tough times. Consumers were blowing money elsewhere, Wal-Mart was lowering guidance for the next fiscal year, and comparable store sales were weak. Wall Street had beat the stock down some 20% over the previous two months as speculators panicked about the short-term outlook on Wal-Mart's stock.

Wal-Mart was having a tough time on Wall Street. If the economy didn't start to tank as quickly as it had, Wal-Mart would have continued to have a tough time and we wouldn't have nearly bottom-ticked it as we did. (Better lucky than good, right?)

Tough Times In Business

Forget stock price for a minute. Let's focus on the business. What signals that a business is having a tough time? For one, its operations are not generating enough cash to support itself. Borrowing ensues, stock is sold, and it sheds assets to try to find a balance to survive. Then what?

If the business can survive that tough period of the cycle, it should be able to get back to positive cash flow — cash that can then be used to pay off the debt, repurchase stock, and/or begin acquiring assets (physical or human, like sales staff). Now in a balance again, the business can start focusing on growth through increased sales or larger sales that convert into more cash.

Though the plan doesn't always work out for some companies (they can't get out of the rut), this is the general cycle of business:

A lot of value investors try to find that absolute bottom — the point at which the business is beginning to turn around and growth is about to start happening. I'm not that adventurous; so, I try to buy in the recovery stage when it looks like the next growth cycle will be higher than the last (if I'm looking at these type of businesses). Turnarounds seldom turn; so, I wait until the turnaround is well underway.

The Graham Turnaround

If you look at the Statement of Cash Flows Morningstar presents (1998-2007), you'll see that Graham appeared to be in that contraction phase from 2002 to 2005, at which point it hit a balance and started its recovery. If things continued to be bad for much longer, Graham may have fallen off the face of the Earth. Instead, it was able to head into a recovery in 2006 and 2007.

Then, it started heading towards the peak of its next growth cycle. There is no way to know when that peak will hit or how high it will get; still, Graham was certainly growing rapidly — and well beyond the last peak.

How Do You Find a "Graham"?

Think about it: What happens when a business goes through a tough time? Negative cash flow. Negative earnings. A drop in Shareholder Equity. What happens when it starts to recover? Positive cash flow. Positive earnings. Growth in Shareholder Equity.

Play around with your stock screeners. To find Graham, I searched for companies with:

• free cash flow (Year 3) < 0
• free cash flow (Year 2) > 0
• free cash flow (Year 1) > 0

Then, I turned over a bunch of rocks and was able to narrow down my candidates to just a handful (50 or so) of opportunities. Then, I watched them for a few quarters to see what was happening at the business. Eventually, I found two opportunities — one of which was Graham Corporation.

Look for businesses that are coming out of tough times, and then see if you can predict their future and value them. You probably won't get the absolute bottom. Then again, you don't have to.

Also Filed Under "How to Search for Opportunities"

• The EDGAR Database: Watching Warren
• The EDGAR Database: A Primer
• How To Find A Stock With A Moat
• Uncovering Opportunities in All Markets