Bag a bargain without getting burned

"The worst is yet to come in the US" is how Kenneth Rogoff, former IMF chief economist, summed up the outlook for the world's largest economy this month. And it doesn't look good on this side of the Atlantic either. British economic growth ground to a halt in the second quarter, while last Monday the French prime minister, Franois Fillon, said that France would begin crisis talks aimed at preventing a eurozone recession when EU ministers meet in Nice in September. So despite recent stockmarket falls, it looks likely that times will get even tougher for investors. So what, if anything, is worth buying right now?

Avoid "value traps"

Rogoff reckons that "the financial crisis is only at half-way point". If that's right, and we are also near the middle of the current bear market, then there are two keys to good stock-picking says Morgan Stanley's Teun Draaisma. One is to find cheap stocks. Right now, we are almost at the point where the average valuation gap between cheap and expensive stocks has hit two standard deviations. Backtesting from 1975 by the bank shows that cheap stocks "virtually always outperform expensive stocks" in the 12 months following this point. Indeed, history suggests that the right stocks will "outperform by 21% in Europe and 17% in the US". But which cheap stocks should you buy? This is where the other key point comes in. The companies that do well are not just cheap, but also feature strong balance sheets pick a stock with a weak balance sheet and you'll end up at best disappointed, and at worst holding a liquidation candidate. In short, you'll have fallen into a "value trap".

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What makes a good balance sheet?

There are many ways to stress test a balance sheet, which is "the first hurdle to overcome for any investments before value or growth considerations are taken into account", says Draaisma. One of the most comprehensive and better-known is the Piotroski score. Devised by a University of Chicago accounting professor, it's a simple nine-step method that rates a stock primarily using balance-sheet criteria, backed up with decent cash flow and earnings strength. The score for each test is either one if a firm passes, or zero if it fails. Combine all nine and you get a total score between zero and nine.

The nine Piotroski hurdles are as follows (score one for "yes" and zero for "no"): positive net income; positive cash flow; operating cash flow above net income; a lower ratio of debt to total assets than the previous year; increased working capital (or "net current assets" on a balance sheet); higher asset turnover (sales/total assets indicates productivity); higher return on assets than the previous year; the same or fewer shares outstanding than a year ago; and, finally, rising profit margins. Stocks with a score of five or more have financial strength. Once you've captured stocks that are robust, you then need to weed out those that are good value.

The Greenblatt stock screen

Now for Joel Greenblatt's stock screen that, backtested, would have generated outperformance in 16 out of 18 years from 1990. An added attraction is that it's simple. You whittle down the list of financially robust stocks by screening for a low enterprise value to earnings before interest, tax, depreciation and amortisation (EV/ebitda); and a high return on total capital employed (ROCE). The maximum return then comes from buying the winners, while shorting stocks with the opposite profile. However, that's not easy for private investors and it's risky should a shorted stock rise rather than fall. But you can still profit handsomely by sticking to the best buys. The other consideration is liquidity there is no point tipping stocks that cannot easily be bought, so the screen filters out shares that have either an average daily traded volume of below $10m, or a market capitalisation of less than $5bn.

What EV/ebitda and ROCE tell you

EV/ebitda is a variant on the price/earnings (p/e ratio), used to weed out cheap from expensive stocks. However, rather than comparing a company's market capitalisation (number of shares x current share price) to one year's profits after tax, it arguably paints a fuller picture. It combines market capitalisation with all long- and short-term balance-sheet net debt (debt minus cash) to get an "enterprise value". It then compares this to one year's earnings, but only after subjective accounting deductions, such as depreciation and amortisation, have been stripped out ("ebitda"). As with a p/e ratio, a low EV/ebitda number, says Greenblatt, means a stock is potentially good value.

As for ROCE, it too is a well-established measure of a firm's returns relative to its overall size. It looks at profit after tax as a proportion of total balance-sheet assets the higher the better.

Combine a low EV/ebitda with a high ROCE and you have, in essence, a cheap stock that's growing quickly. What of the alternative combinations of the two ratios? A low EV/ebitda and a low ROCE means a company is struggling, whereas high EV/ebitda and high ROCE reveals solid but expensive stocks. The final possible permutation high EV/ebitda and low ROCE suggests a stock that has been strong but is now on the wane: the classic "fallen angel" (see table).

What to buy now

Three stocks that cut the mustard according to these measures are energy company StatoilHydro (NYSE:STO), temporary staff-placement specialist Randstad Holdings (AMS:RAND) and lastly steel systems and piping giant Rautarukki (HEL:RTRKS). None promises a fast buck, but at current prices, all look like good long-term bets.